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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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 March 31, 2011

OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 001-10315

 
         
 
 
HealthSouth Corporation
 
(Exact name of Registrant as specified in its Charter)

   
Delaware
63-0860407
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
   
3660 Grandview Parkway, Suite 200
Birmingham, Alabama
35243
(Address of Principal Executive Offices)
(Zip Code)

 
(205) 967-7116
(Registrant’s telephone number)
 
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 x No ¨
 
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 the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  x       Accelerated filer  ¨       Non-Accelerated filer  ¨       Smaller reporting company  ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x
 
The registrant had 95,127,171 shares of common stock outstanding, net of treasury shares, as of April 27, 2011.






CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
 
This quarterly report contains historical information, as well as forward-looking statements that involve known and unknown risks and relate to, among other things, future events, our business strategy, our financial plans, our future financial performance, our projected business results, or our projected capital expenditures. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “targets,” “potential,” or “continue” or the negative of these terms or other comparable terminology. Such forward-looking statements are necessarily estimates based upon current information and involve a number of risks and uncertainties, many of which are beyond our control. Any forward-looking statement is based on information current as of the date of this report and speaks only as of the date on which such statement is made. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include, but are not limited to, the following:
 
•  
each of the factors discussed in Item 1A, Risk Factors, of our Annual Report on Form 10-K for the year ended December 31, 2010, as well as uncertainties and factors discussed elsewhere in this Form 10-Q, in our other filings from time to time with the United States Securities and Exchange Commission, or in materials incorporated therein by reference;
 
•  
changes in the regulations of the healthcare industry at either or both of the federal and state levels, including those contemplated now and in the future as part of national healthcare reform, and related increases in the costs of complying with such changes;
 
•  
changes or delays in, or suspension of, reimbursement for our services by governmental or private payors, including our ability to obtain and retain favorable arrangements with third-party payors;
 
•  
our ability to attract and retain nurses, therapists, and other healthcare professionals in a highly competitive environment with often severe staffing shortages and the impact on our labor expenses from potential union activity and staffing recruitment and retention;
 
•  
competitive pressures in the healthcare industry and our response to those pressures;
 
•  
our ability to successfully complete and integrate acquisitions, investments, and joint ventures consistent with our growth strategy, including realization of anticipated revenues, cost savings, and productivity improvements arising from the related operations;
 
•  
our ability to attract and retain key management personnel; and
 
•  
general conditions in the economy and capital markets.
 
The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no duty to update these forward-looking statements, even though our situation may change in the future. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements.
 

 


Financial Statements (Unaudited)
 
Condensed Consolidated Statements of Operations
(Unaudited)
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
(In Millions, Except Per Share Data)
 
             
Net operating revenues
  $ 538.1     $ 491.0  
Operating expenses:
               
Salaries and benefits
    259.1       241.9  
Other operating expenses
    76.7       66.9  
General and administrative expenses
    26.9       26.3  
Supplies
    29.9       28.3  
Depreciation and amortization
    20.3       18.3  
Occupancy costs
    12.3       11.6  
Provision for doubtful accounts
    5.4       6.9  
Loss on disposal of assets
    0.2       -  
Professional fees—accounting, tax, and legal
    3.8       2.9  
Total operating expenses
    434.6       403.1  
Loss on early extinguishment of debt
    -       0.3  
Interest expense and amortization of debt discounts and fees
    35.1       30.5  
Other income
    (0.6 )     (0.7 )
Loss on interest rate swaps
    -       4.3  
Equity in net income of nonconsolidated affiliates
    (2.5 )     (2.6 )
Income from continuing operations before income tax (benefit) expense
    71.5       56.1  
Provision for income tax (benefit) expense
    (5.6 )     2.5  
Income from continuing operations
    77.1       53.6  
Income (loss) from discontinued operations, net of tax
    14.4       (3.1 )
Net income
    91.5       50.5  
Less: Net income attributable to noncontrolling interests
    (11.7 )     (9.8 )
Net income attributable to HealthSouth
    79.8       40.7  
Less: Convertible perpetual preferred stock dividends
    (6.5 )     (6.5 )
Net income attributable to HealthSouth common shareholders
  $ 73.3     $ 34.2  
                 
Weighted average common shares outstanding:
               
Basic
    93.1       92.7  
Diluted
    109.0       108.0  
                 
Earnings per common share:
               
Basic:
               
Income from continuing operations
               
attributable to HealthSouth common shareholders
  $ 0.63     $ 0.40  
Income (loss) from discontinued operations, net of tax,
               
attributable to HealthSouth common shareholders
    0.16       (0.03 )
Net income attributable to HealthSouth common shareholders
  $ 0.79     $ 0.37  
                 
Diluted:
               
Income from continuing operations
               
attributable to HealthSouth common shareholders
  $ 0.60     $ 0.40  
Income (loss) from discontinued operations, net of tax,
               
attributable to HealthSouth common shareholders
    0.13       (0.03 )
Net income attributable to HealthSouth common shareholders
  $ 0.73     $ 0.37  
                 
Amounts attributable to HealthSouth common shareholders:
               
Income from continuing operations
  $ 65.4     $ 43.8  
Income (loss) from discontinued operations, net of tax
    14.4       (3.1 )
Net income attributable to HealthSouth
  $ 79.8     $ 40.7  


 
The accompanying notes to condensed consolidated financial
statements are an integral part of these condensed statements.
 
 
 
1

HealthSouth Corporation and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)
 

 


     
March 31,
   
December 31,
 
     
2011
   
2010
 
     
(In Millions)
 
Assets
             
Current assets:
             
Cash and cash equivalents
    $ 141.0     $ 48.4  
Accounts receivable, net of allowance for doubtful accounts of
                 
$25.1 in 2011; $25.9 in 2010       240.9       224.9  
Other current assets
      139.5       132.9  
Total current assets
      521.4       406.2  
Property and equipment, net
      682.5       685.4  
Goodwill
      431.3       431.3  
Intangible assets, net
      46.5       48.8  
Deferred income tax assets
      674.4       679.3  
Other long-term assets
      125.0       121.1  
Total assets
    $ 2,481.1     $ 2,372.1  
                   
Liabilities and Shareholders’ Equity (Deficit)
                 
Current liabilities
                 
Accounts payable
    $ 50.8     $ 48.9  
Accrued expenses and other current liabilities
      287.1       310.4  
Total current liabilities
      337.9       359.3  
Long-term debt, net of current portion
      1,550.8       1,496.8  
Other long-term liabilities
      132.7       130.8  
        2,021.4       1,986.9  
Commitments and contingencies
                 
Convertible perpetual preferred stock
      387.4       387.4  
Shareholders’ equity (deficit):
                 
HealthSouth shareholders’ deficit
      (11.6 )     (85.2 )
Noncontrolling interests
      83.9       83.0  
Total shareholders’ equity (deficit)
      72.3       (2.2 )
Total liabilities and shareholders’ equity (deficit)
    $ 2,481.1     $ 2,372.1  


 
The accompanying notes to condensed consolidated financial
statements are an integral part of these condensed balance sheets.
 
 
 
2

HealthSouth Corporation and Subsidiaries
Condensed Consolidated Statements of Comprehensive Income
(Unaudited)
 

 


   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
(In Millions)
 
COMPREHENSIVE INCOME
           
Net income
  $ 91.5     $ 50.5  
Other comprehensive income (loss), net of tax:
               
Net change in unrealized gain on available-for-sale securities:
               
Unrealized net holding gain arising during the period
    0.7       0.6  
Reclassifications to net income
    (0.5 )     (1.3 )
Net change in unrealized loss on forward-starting interest rate swaps:
               
Unrealized net holding loss arising during the period
    -       (2.1 )
Other comprehensive income (loss), net of tax
    0.2       (2.8 )
Comprehensive income
    91.7       47.7  
Comprehensive income attributable to noncontrolling interests
    (11.7 )     (9.8 )
Comprehensive income attributable to HealthSouth
  $ 80.0     $ 37.9  



 
The accompanying notes to condensed consolidated financial
statements are an integral part of these condensed statements.
 
 
 
3

HealthSouth Corporation and Subsidiaries
Condensed Consolidated Statements of Shareholders' Equity (Deficit)
(Unaudited)
 

 

   
Three Months Ended March 31, 2011
 
   
(In Millions)
 
   
HealthSouth Common Shareholders
                   
   
Number of Common Shares Outstanding
   
Common Stock
   
Capital in Excess of Par Value
   
Accumulated Deficit
   
Accumulated Other Comprehensive Income
   
Treasury Stock
   
Noncontrolling Interests
   
Total
   
Comprehensive Income
 
Balance at beginning of period
    93.4     $ 1.0     $ 2,873.5     $ (2,818.4 )   $ 0.5     $ (141.8 )   $ 83.0     $ (2.2 )      
Comprehensive income:
                                                                     
Net income
    -       -       -       79.8       -       -       11.7       91.5     $ 91.5  
Other comprehensive income, net of tax
    -       -       -       -       0.2       -       -       0.2       0.2  
Comprehensive income
                                                                  $ 91.7  
Issuance of restricted stock
    1.9       -       -       -       -       -       -       -          
Receipt of treasury stock
    (0.2 )     -       -       -       -       (4.3 )     -       (4.3 )        
Dividends declared on convertible perpetual
                                                                       
preferred stock
    -       -       (6.5 )     -       -       -       -       (6.5 )        
Stock-based compensation
    -       -       4.2       -       -       -       -       4.2          
Distributions declared
    -       -       -       -       -       -       (9.8 )     (9.8 )        
Other
    0.1       -       0.3       -       -       (0.1 )     (1.0 )     (0.8 )        
Balance at end of period
    95.2     $ 1.0     $ 2,871.5     $ (2,738.6 )   $ 0.7     $ (146.2 )   $ 83.9     $ 72.3          

 
   
Three Months Ended March 31, 2010
 
   
(In Millions)
 
   
HealthSouth Common Shareholders
                   
   
Number of Common Shares Outstanding
   
Common Stock
   
Capital in Excess of Par Value
   
Accumulated Deficit
   
Accumulated Other Comprehensive Loss
   
Treasury Stock
   
Noncontrolling Interests
   
Total
   
Comprehensive Income
 
Balance at beginning of period
    93.3     $ 1.0     $ 2,879.9     $ (3,717.4 )   $ -     $ (137.5 )   $ 76.4     $ (897.6 )      
Comprehensive income:
                                                                     
Net income
    -       -       -       40.7       -       -       9.8       50.5     $ 50.5  
Other comprehensive loss, net of tax
    -       -       -       -       (2.8 )     -       -       (2.8 )     (2.8 )
Comprehensive income
                                                                  $ 47.7  
Dividends declared on convertible perpetual
                                                                       
 preferred stock
    -       -       (6.5 )     -       -       -       -       (6.5 )        
Stock-based compensation
    -       -       3.8       -       -       -       -       3.8          
Distributions declared
    -       -       -       -       -       -       (7.9 )     (7.9 )        
Other
    0.3       -       0.6       -       -       (1.7 )     (0.3 )     (1.4 )        
Balance at end of period
    93.6     $ 1.0     $ 2,877.8     $ (3,676.7 )   $ (2.8 )   $ (139.2 )   $ 78.0     $ (861.9 )        

 



 
The accompanying notes to condensed consolidated financial
statements are an integral part of these condensed statements.
 
 
 
4

HealthSouth Corporation and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
 

 


   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
(In Millions)
 
Cash flows from operating activities:
           
Net income
  $ 91.5     $ 50.5  
(Income) loss from discontinued operations
    (14.4 )     3.1  
Adjustments to reconcile net income to net cash provided by operating
               
activities—
               
Provision for doubtful accounts
    5.4       6.9  
Depreciation and amortization
    20.3       18.3  
Loss on interest rate swaps
    -       4.3  
Equity in net income of nonconsolidated affiliates
    (2.5 )     (2.6 )
Distributions from nonconsolidated affiliates
    2.7       2.1  
Stock-based compensation
    4.2       3.8  
Deferred tax (benefit) expense
    (3.4 )     0.4  
Other
    0.9       1.7  
(Increase) decrease in assets—
               
Accounts receivable
    (21.4 )     (21.3 )
Other assets
    (13.9 )     (2.1 )
Income tax refund receivable
    0.1       9.0  
Increase (decrease) in liabilities—
               
Accounts payable
    1.9       (2.9 )
Accrued interest
    10.7       14.5  
Other liabilities
    8.6       2.1  
Premium on bond issuance
    4.1       -  
Government, class action, and related settlements
    (4.3 )     (0.8 )
Net cash used in operating activities of discontinued operations
    (1.4 )     (2.2 )
Total adjustments
    12.0       31.2  
Net cash provided by operating activities
    89.1       84.8  




 
(Continued)
 
 
 
5

HealthSouth Corporation and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Continued)
(Unaudited)
 

 



   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
(In Millions)
 
Cash flows from investing activities:
           
Capital expenditures
    (15.3 )     (14.0 )
Proceeds from sale of restricted investments
    0.3       3.4  
Purchase of restricted investments
    (7.6 )     (0.4 )
Net change in restricted cash
    10.1       (11.4 )
Net settlements on interest rate swaps
    (10.9 )     (11.9 )
Other
    -       0.2  
Net cash provided by investing activities of discontinued operations
    -       7.9  
Net cash used in investing activities
    (23.4 )     (26.2 )
                 
Cash flows from financing activities:
               
Proceeds from bond issuance
    120.0       -  
Borrowings on revolving credit facility
    40.0       -  
Payments on revolving credit facility
    (107.0 )     -  
Principal payments under capital lease obligations
    (3.7 )     (3.5 )
Dividends paid on convertible perpetual preferred stock
    (6.5 )     (6.5 )
Distributions paid to noncontrolling interests of
               
consolidated affiliates
    (13.3 )     (11.1 )
Other
    (2.6 )     (1.6 )
Net cash provided by (used in) financing activities
    26.9       (22.7 )
                 
Increase in cash and cash equivalents
    92.6       35.9  
Cash and cash equivalents at beginning of period
    48.4       80.9  
Cash and cash equivalents of facilities held for sale
               
at beginning of period
    -       0.1  
Less: Cash and cash equivalents of facilities held for
               
sale at end of period
    -       (0.1 )
Cash and cash equivalents at end of period
  $ 141.0     $ 116.8  


 

 


 
The accompanying notes to condensed consolidated financial
statements are an integral part of these condensed statements.
 
 
 
6

HealthSouth Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements
 

1.
Basis of Presentation
 
HealthSouth Corporation, incorporated in Delaware in 1984, including its subsidiaries, is the largest provider of inpatient rehabilitative healthcare services in the United States. We operate inpatient rehabilitation hospitals and long-term acute care hospitals and provide treatment on both an inpatient and outpatient basis. References herein to “HealthSouth,” the “Company,” “we,” “our,” or “us” refer to HealthSouth Corporation and its subsidiaries unless otherwise stated or indicated by context.
 
The accompanying unaudited condensed consolidated financial statements of HealthSouth Corporation and Subsidiaries should be read in conjunction with the consolidated financial statements and accompanying notes filed with the United States Securities and Exchange Commission in HealthSouth’s Annual Report on Form 10-K filed on February 24, 2011 (the “2010 Form 10-K”). The unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the SEC applicable to interim financial information. Certain information and note disclosures included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been omitted in these interim statements, as allowed by such SEC rules and regulations. The condensed consolidated balance sheet as of December 31, 2010 has been derived from audited financial statements, but it does not include all disclosures required by GAAP. However, we believe the disclosures are adequate to make the information presented not misleading.
 
The unaudited results of operations for the interim periods shown in these financial statements are not necessarily indicative of operating results for the entire year. In our opinion, the accompanying condensed consolidated financial statements recognize all adjustments of a normal recurring nature considered necessary to fairly state the financial position, results of operations, and cash flows for each interim period presented.
 
Stock-Based Compensation

In February 2011, we issued 0.7 million of restricted stock awards to members of our management team and our board of directors. The majority of these awards are shares of restricted stock that contain a service and either a performance or market condition. For these awards, the number of shares that will ultimately be granted to employees may vary based on the Company’s performance during the applicable performance measurement period. Additionally, we granted 0.2 million stock options to members of our management team. The fair value of these awards and options were determined using the policies described in the 2010 Form 10-K.
 
Recent Accounting Pronouncements
 
Since the filing of the 2010 Form 10-K, we do not believe any recently issued, but not yet effective, accounting standards will have a material effect on our consolidated financial position, results of operations, or cash flows.
 
2.
Investments in and Advances to Nonconsolidated Affiliates
 
As of March 31, 2011 and December 31, 2010, we had $30.2 million and $30.7 million, respectively, of investments in and advances to nonconsolidated affiliates included in Other long-term assets in our condensed consolidated balance sheets. Investments in and advances to nonconsolidated affiliates represent our investments in 15 partially owned subsidiaries, of which 11 are general or limited partnerships, limited liability companies, or joint ventures in which HealthSouth or one of our subsidiaries is a general or limited partner, managing member, member, or venturer, as applicable. We do not control these affiliates, but have the ability to exercise significant influence over the operating and financial policies of certain of these affiliates. Our ownership percentages in these affiliates range from approximately 1% to 51%. We account for these investments using the cost and equity methods of accounting.
 
 
The following summarizes the combined results of operations of our equity method affiliates (on a 100% basis, in millions):
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
Net operating revenues
  $ 20.4     $ 20.1  
Operating expenses
    (13.1 )     (12.9 )
Income from continuing operations, net of tax
    5.6       5.9  
Net income
    5.6       5.9  

3.
Long-term Debt
 
On March 7, 2011, we completed a public offering of $120 million aggregate principal amount of senior notes, which included an additional $60 million of our 7.25% Senior Notes due 2018 at 103.25% of the principal amount and an additional $60 million of our 7.75% Senior Notes due 2022 at 103.50% of the principal amount. These additional notes will be governed by the previously executed agreements for our 7.25% Senior Notes due 2018 and our 7.75% Senior Notes due 2022.
 
Net proceeds from this offering were approximately $122 million. We used approximately $45 million of the net proceeds to repay a portion of the amounts outstanding under our revolving credit facility. The remainder of the net proceeds is included in Cash and cash equivalents in our condensed consolidated balance sheet as of March 31, 2011. We intend to use the remainder of the net proceeds to redeem a portion of our 10.75% Senior Notes due 2016 when they become callable in June 2011.
 
Our long-term debt outstanding consists of the following (in millions):
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Advances under $500 million revolving credit facility
  $ 11.0     $ 78.0  
Bonds payable—
               
10.75% Senior Notes due 2016
    495.7       495.5  
7.25% Senior Notes due 2018
    336.9       275.0  
8.125% Senior Notes due 2020
    285.6       285.5  
7.75% Senior Notes due 2022
    312.0       250.0  
Other bonds payable
    1.8       1.8  
Other notes payable
    35.8       36.4  
Capital lease obligations
    85.4       89.1  
      1,564.2       1,511.3  
Less: Current portion
    (13.4 )     (14.5 )
Long-term debt, net of current portion
  $ 1,550.8     $ 1,496.8  


 
8

HealthSouth Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements
 


The following chart shows scheduled principal payments due on long-term debt for the next five years and thereafter (in millions):
 
   
Face Amount
   
Net Amount
 
April 1 through December 31, 2011
  $ 10.2     $ 10.2  
2012
    14.3       14.3  
2013
    11.9       11.9  
2014
    8.0       8.0  
2015
    17.9       17.9  
2016
    507.3       502.4  
Thereafter
    1,000.0       999.5  
Total
  $ 1,569.6     $ 1,564.2  

For additional information regarding our indebtedness, see Note 8, Long-term Debt, to the consolidated financial statements accompanying the 2010 Form 10-K.
 
4.
Derivative Instruments

Interest Rate Swaps Not Designated as Hedging Instruments
 
In March 2006, we entered into an interest rate swap to effectively convert the floating rate of a portion of our credit agreement to a fixed rate in order to limit the variability of interest-related payments caused by changes in LIBOR. Under this interest rate swap agreement, we paid a fixed rate of 5.2% on a notional principal of $984.0 million, while the counterparties to this agreement paid a floating rate based on 3-month LIBOR. The expiration date of this swap was March 10, 2011. The fair market value of this swap as of December 31, 2010 was ($12.1) million and is included in Accrued expenses and other current liabilities in our condensed consolidated balance sheet.
 
In June 2009, we entered into a receive-fixed swap as a mirror offset to $100.0 million of the $984.0 million interest rate swap discussed above in order to reduce our effective fixed rate to total debt ratio. Under this interest rate swap agreement, we paid a variable rate based on 3-month LIBOR, while the counterparty to this agreement paid a fixed rate of 5.2% on a notional principal of $100.0 million. Net settlements commenced in September 2009 and were made quarterly on the same settlement schedule as the $984.0 million interest rate swap discussed above. The expiration date of this swap was March 10, 2011. The fair market value of this swap as of December 31, 2010 was $1.2 million and is included in Other current assets in our condensed consolidated balance sheet.
 
These interest rate swaps were not designated as hedges. Therefore, changes in the fair value of these interest rate swaps were included in current-period earnings as Loss on interest rate swaps.
 
During the three months ended March 31, 2011 and 2010, we made net cash settlement payments of $10.9 million and $11.9 million, respectively, to our counterparties. Having made the final payments on these swaps in March 2011, we no longer have any outstanding derivative positions.
 
See Note 9, Derivative Instruments, to the consolidated financial statements accompanying the 2010 Form 10-K for additional information related to these interest rate swaps. See also Note 6, Fair Value Measurements.
 
5.           Guarantees
 
Primarily in conjunction with the sale of certain facilities, including the sale of our surgery centers, outpatient, and diagnostic divisions during 2007, HealthSouth assigned, or remained as a guarantor on, the leases of certain properties and equipment to certain purchasers and, as a condition of the lease, agreed to act as a guarantor of the purchaser’s performance on the lease. Should the purchaser fail to pay the obligations due on these leases or contracts, the lessor or vendor would have contractual recourse against us.
 
 
As of March 31, 2011, we were secondarily liable for 38 such guarantees. The remaining terms of these guarantees ranged from 2 months to 99 months. If we were required to perform under all such guarantees, the maximum amount we would be required to pay approximated $32.2 million.
 
We have not recorded a liability for these guarantees, as we do not believe it is probable we will have to perform under these agreements. If we are required to perform under these guarantees, we could potentially have recourse against the purchaser for recovery of any amounts paid. In addition, the purchasers of our surgery centers, outpatient, and diagnostic divisions have agreed to seek releases from the lessors and vendors in favor of HealthSouth with respect to the guarantee obligations associated with these divestitures. To the extent the purchasers of these divisions are unable to obtain releases for HealthSouth, the purchasers have agreed to indemnify HealthSouth for damages incurred under the guarantee obligations, if any. These guarantees are not secured by any assets under the agreements.
 
6.           Fair Value Measurements
 
Our financial assets and liabilities that are measured at fair value on a recurring basis are as follows (in millions):
 
         
Fair Value Measurements at Reporting Date Using
 
As of March 31, 2011
 
Fair Value
   
Quoted Prices in Active Markets for Identical Assets
(Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
   
Valuation Technique (1)
 
Other current assets:
                             
Current portion of restricted
                             
marketable securities
  $ 22.9     $ -     $ 22.9     $ -       M  
Other long-term assets:
                                       
Restricted marketable securities
    22.5       -       22.5       -       M  
As of December 31, 2010
                                       
Other current assets:
                                       
Current portion of restricted
                                       
marketable securities
  $ 18.2     $ -     $ 18.2     $ -       M  
June 2009 trading swap
    1.2       -       1.2       -       I  
Other long-term assets:
                                       
Restricted marketable securities
    19.3       -       19.3       -       M  
Accrued expenses and other
                                       
current liabilities:
                                       
March 2006 trading swap
    (12.1 )     -       (12.1 )     -       I  

 
(1)
The three valuation techniques are: market approach (M), cost approach (C), and income approach (I).
 
In addition to assets and liabilities recorded at fair value on a recurring basis, we are also required to record assets and liabilities at fair value on a nonrecurring basis. Generally, assets are recorded at fair value on a nonrecurring basis as a result of impairment charges or similar adjustments made to the carrying value of the applicable assets.
 
During the three months ended March 31, 2011 and 2010, we did not record any gains or losses related to our nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis as part of our continuing operations. During the three months ended March 31, 2011 and 2010, we recorded impairment charges of $1.3 million and $0.6 million, respectively, as part of our results of discontinued operations. These charges related to a hospital that was closed in 2008. We determined the fair value of the impaired long-lived assets at the hospital primarily based on the assets’ estimated fair value using valuation techniques that included an offer we received from a third-party to acquire the assets and third-party appraisals.
 

 
10

HealthSouth Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements
 


As discussed in Note 1, Summary of Significant Accounting Policies, to the consolidated financial statements accompanying the 2010 Form 10-K, the carrying value equals fair value for our financial instruments that are not included in the table below and are classified as current in our condensed consolidated balance sheets. The carrying amounts and estimated fair values for all of our other financial instruments are presented in the following table (in millions):
 
   
As of March 31, 2011
   
As of December 31, 2010
 
   
Carrying
 Amount
   
Estimated
Fair Value
   
Carrying
Amount
   
Estimated
Fair Value
 
Interest rate swap agreements:
                       
March 2006 trading swap
  $ -     $ -     $ (12.1 )   $ (12.1 )
June 2009 trading swap
    -       -       1.2       1.2  
Long-term debt:
                               
Advances under $500 million revolving credit facility
    11.0       11.0       78.0       78.0  
10.75% Senior Notes due 2016
    495.7       534.4       495.5       543.2  
7.25% Senior Notes due 2018
    336.9       348.4       275.0       280.5  
8.125% Senior Notes due 2020
    285.6       314.7       285.5       311.8  
7.75% Senior Notes due 2022
    312.0       324.0       250.0       258.1  
Other bonds payable
    1.8       1.8       1.8       1.8  
Other notes payable
    35.8       35.8       36.4       36.4  
Financial commitments:
                               
Letters of credit
    -       48.7       -       45.6  

7.           Income Taxes
 
Our Provision for income tax benefit of $5.6 million for the three months ended March 31, 2011 is comprised of: (1) estimated income tax expense of approximately $23 million based on the application of our estimated effective blended federal and state income tax rate of 39.1% to our pre-tax income from continuing operations attributable to HealthSouth offset by (2) the settlement of federal income tax claims with the Internal Revenue Service for tax years 2007 and 2008 which resulted in an income tax benefit of approximately $24 million and (3) other items, primarily related to a reduction in unrecognized tax benefits due to the lapse of the applicable statute of limitations for certain federal and state claims, which resulted in a tax benefit of approximately $5 million.
 
We have significant federal and state net operating loss carryforwards (“NOLs”) that expire in various amounts at varying times through 2034. We assess the realization of our deferred tax assets quarterly to determine whether an adjustment to our valuation allowance is required. As a result of these assessments in prior periods, we maintained a valuation allowance against our deferred tax assets, including substantially all of these NOLs. During the fourth quarter of 2010, and as discussed in more detail in Note 19, Income Taxes, to the consolidated financial statements accompanying the 2010 Form 10-K, based on the weight of available evidence, we determined it was more likely than not a substantial portion of our deferred tax assets will be realized on a federal basis and in certain state tax jurisdictions in the future and decreased our valuation allowance by $825.4 million to $112.7 million as of December 31, 2010.
 
The $702.7 million of net deferred tax assets included in the accompanying condensed consolidated balance sheet as of March 31, 2011 ($28.3 million included in Other current assets) reflects management’s assessment it is more likely than not we will be able to generate sufficient future taxable income to utilize those deferred tax assets based on our current estimates and assumptions. As of March 31, 2011, we maintained a valuation allowance of $105.9 million due to uncertainties related to our ability to utilize a portion of our deferred tax assets, primarily related to state NOLs, before they expire. During the first quarter of 2011, we reduced our valuation allowance associated with certain capital losses by $6.8 million primarily as a result of our settlement with the IRS for tax years 2007 and 2008, as discussed above. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence including management’s estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable state tax jurisdictions, or if the timing of future tax deductions differs from our expectations.
 
 
Our utilization of NOLs could be subject to the Internal Revenue Code Section 382 (“Section 382”) limitation and may be limited in the event of certain cumulative changes in ownership interests of significant shareholders over a three-year period in excess of 50%. Section 382 imposes an annual limitation on the use of these losses to an amount equal to the value of a company at the time of an ownership change multiplied by the long-term tax exempt rate. At this time, we do not believe these limitations will restrict our ability to use any NOLs before they expire. However, no such assurances can be provided.
 
Our Provision for income tax expense of $2.5 million for the three months ended March 31, 2010 primarily includes the following: (1) current income tax expense of $2.1 million attributable to state income tax expense of subsidiaries which have separate state filing requirements, a reduction in the amount of state income tax refunds previously accrued, alternative minimum tax expense, and federal income taxes for subsidiaries not included in our federal consolidated income tax return and (2) deferred income tax expense of $0.4 million attributable to increases in basis differences of certain indefinite-lived assets.
 
Total remaining gross unrecognized tax benefits were $12.6 million as of December 31, 2010, all of which would affect our effective tax rate if recognized. Total accrued interest expense related to unrecognized tax benefits as of December 31, 2010 was $1.1 million. The amount of unrecognized tax benefits changed during the three months ended March 31, 2011 due to the settlement of federal income tax claims with the IRS for tax years 2007 and 2008 and the lapse of the applicable statute of limitations for certain federal and state claims. Total remaining gross unrecognized tax benefits were $9.3 million as of March 31, 2011, all of which would affect our effective tax rate if recognized. Total accrued interest expense related to unrecognized tax benefits as of March 31, 2011 was $0.1 million.
 
A reconciliation of the change in our unrecognized tax benefits from December 31, 2010 to March 31, 2011 is as follows (in millions):
 
   
Gross Unrecognized Income Tax Benefits
   
Accrued Interest and Penalties
 
Balance at December 31, 2010
  $ 12.6     $ 1.1  
Gross amount of increases in unrecognized tax
               
benefits related to prior periods
    23.5       -  
Decreases in unrecognized tax benefits relating
               
to settlements with taxing authorities
    (23.6 )     -  
Reductions to unrecognized tax benefits as a
               
result of a lapse of the applicable statute of
               
limitations
    (3.2 )     (1.0 )
Balance at March 31, 2011
  $ 9.3     $ 0.1  

Our continuing practice is to recognize interest and/or penalties related to income tax matters in income tax expense. For the three months ended March 31, 2011 and 2010, we recorded $1.6 million and $0.1 million, respectively, of net interest income as part of our income tax provision. Total accrued interest income was $0.3 million as of both March 31, 2011 and December 31, 2010.
 
HealthSouth and its subsidiaries’ federal and state income tax returns are periodically examined by various regulatory taxing authorities. In connection with such examinations, we have settled federal income tax examinations with the IRS for all tax years through 2008. At this time, we have no ongoing income tax audits by regulatory taxing authorities.
 
For the tax years that remain open under the applicable statutes of limitations, amounts related to unrecognized tax benefits have been considered by management in its estimate of our potential net recovery of prior years’ income taxes. However, at this time, we cannot estimate a range of the reasonably possible change that may occur.
 
 
We continue to actively pursue the maximization of our remaining state income tax refund claims and other tax benefits. Although management believes its estimates and judgments related to these claims are reasonable, depending on the ultimate resolution of these tax matters, actual amounts recovered could differ from management’s estimates, and such differences could be material.

 
13

HealthSouth Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements
 

8.
Earnings per Common Share
 
The calculation of earnings per common share is based on the weighted-average number of our common shares outstanding during the applicable period. The calculation for diluted earnings per common share recognizes the effect of all dilutive potential common shares that were outstanding during the respective periods, unless their impact would be antidilutive. The following table sets forth the computation of basic and diluted earnings per common share (in millions, except per share amounts):
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
Basic:
           
Numerator:
           
Income from continuing operations
  $ 77.1     $ 53.6  
Less: Net income attributable to noncontrolling
               
interests included in continuing operations
    (11.7 )     (9.8 )
Less: Convertible perpetual preferred stock dividends
    (6.5 )     (6.5 )
Income from continuing operations attributable
               
to HealthSouth common shareholders
    58.9       37.3  
Income (loss) from discontinued operations, net of tax,
               
attributable to HealthSouth common shareholders
    14.4       (3.1 )
Net income attributable to HealthSouth
               
common shareholders
  $ 73.3     $ 34.2  
                 
Denominator:
               
Basic weighted average common shares outstanding
    93.1       92.7  
                 
Basic earnings per common share:
               
Income from continuing operations attributable to
               
HealthSouth common shareholders
  $ 0.63     $ 0.40  
Income (loss) from discontinued operations, net of tax,
               
attributable to HealthSouth common shareholders
    0.16       (0.03 )
Net income attributable to HealthSouth
               
common shareholders
  $ 0.79     $ 0.37  
                 
Diluted:
               
Numerator:
               
Income from continuing operations
  $ 77.1     $ 53.6  
Less: Net income attributable to noncontrolling
               
interests included in continuing operations
    (11.7 )     (9.8 )
Income from continuing operations attributable
               
to HealthSouth common shareholders
    65.4       43.8  
Income (loss) from discontinued operations, net of tax,
               
attributable to HealthSouth common shareholders
    14.4       (3.1 )
Net income attributable to HealthSouth
               
common shareholders
  $ 79.8     $ 40.7  
                 
Denominator:
               
Diluted weighted average common shares outstanding
    109.0       108.0  
                 
Diluted earnings per common share:
               
Income from continuing operations attributable to
               
HealthSouth common shareholders
  $ 0.60     $ 0.40  
Income (loss) from discontinued operations, net of tax,
               
attributable to HealthSouth common shareholders
    0.13       (0.03 )
Net income attributable to HealthSouth
               
common shareholders
  $ 0.73     $ 0.37  

 
Diluted earnings per share report the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. These potential shares include dilutive stock options, restricted stock awards, restricted stock units, and convertible perpetual preferred stock. For the three months ended March 31, 2011 and 2010, the number of potential shares approximated 15.9 million and 15.3 million, respectively. For the three months ended March 31, 2011 and 2010, approximately 13.1 million of the potential shares related to our Convertible perpetual preferred stock. For the three months ended March 31, 2010, adding back the dividends for the Convertible perpetual preferred stock to our Income from continuing operations attributable to HealthSouth common shareholders causes a per share increase when calculating diluted earnings per common share resulting in an antidilutive per share amount. Therefore, basic and diluted earnings per common share are the same for the three months ended March 31, 2010.
 
Options to purchase approximately 1.2 million and 2.3 million shares of common stock were outstanding as of March 31, 2011 and 2010, respectively, but were not included in the computation of diluted weighted-average shares because to do so would have been antidilutive.
 
 See Note 11, Convertible Perpetual Preferred Stock, and Note 20, Earnings per Common Share, to the consolidated financial statements accompanying the 2010 Form 10-K for additional information related to common stock, common stock warrants, and convertible perpetual preferred stock.
 
9.
Settlements
 
On April 4, 2011, we entered into a definitive settlement and release agreement with the state of Delaware relating to a previously disclosed audit of unclaimed property conducted on behalf of Delaware and two other states by Kelmar Associates, LLC. While the terms of the settlement are confidential, the amount paid to Delaware was less than the amount previously accrued and included in the line item Accrued expenses and other current liabilities in our condensed consolidated balance sheet as of December 31, 2010. Accordingly, we recorded a $25.3 million pre-tax gain in connection with this settlement as part of our results of operations for the first quarter of 2011. Of this amount, $24.8 million is included in Income from discontinued operations, net of tax, as this gain primarily related to our previously divested divisions. The remainder is included in Net operating revenues in our condensed consolidated statement of operations for the three months ended March 31, 2011. See also Note 1, Summary of Significant Accounting Policies, “Refunds due Patients and Other Third-Party Payors,” to the consolidated financial statements accompanying the 2010 Form 10-K.
 
10.
Contingencies
 
We operate in a highly regulated and litigious industry. As a result, various lawsuits, claims, and legal and regulatory proceedings have been and can be expected to be instituted or asserted against us. The resolution of any such lawsuits, claims, or legal and regulatory proceedings could materially and adversely affect our financial position, results of operations, and cash flows in a given period.
 
Derivative Litigation—
 
All lawsuits purporting to be derivative complaints filed in the Circuit Court of Jefferson County, Alabama since 2002 have been consolidated and stayed in favor of the first-filed action captioned Tucker v. Scrushy and filed August 28, 2002. Derivative lawsuits in other jurisdictions have been stayed. The Tucker complaint named as defendants a number of our former officers and directors. Tucker also asserted claims on our behalf against Ernst & Young and various UBS entities, as well as against MedCenterDirect.com, Capstone Capital Corporation, now known as HR Acquisition I Corp., and G.G. Enterprises. When originally filed, the primary allegations in the Tucker case involved self-dealing by Mr. Scrushy and other insiders through transactions with various entities allegedly controlled by Mr. Scrushy. The complaint was amended four times to add additional defendants and include claims of accounting fraud, improper Medicare billing practices, and additional self-dealing transactions.
 
The Tucker derivative litigation, including a $2.9 billion judgment against Mr. Scrushy, and the related settlements to date are more fully described in “Litigation By and Against Richard M. Scrushy” below and Note 21, Settlements, “UBS Litigation Settlement,” and Note 22, Contingencies and Other Commitments, to the consolidated financial statements accompanying the 2010 Form 10-K. The settlements with UBS Securities and other defendants
 
 
do not release our claims against any non-settling defendants in the Tucker litigation, or against our former independent auditor, Ernst & Young, which remain pending in arbitration. The Tucker derivative claims against Ernst & Young and other defendants listed above remain pending and have moved through fact discovery on an expedited schedule that was coordinated with the federal securities claims by our former stockholders and bondholders against Mr. Scrushy, Ernst & Young, and UBS. We are no longer a party in the federal securities claims action described in Note 21, Settlements, “Securities Litigation Settlement,” to the consolidated financial statements accompanying the 2010 Form 10-K by our former stockholders and bondholders against Mr. Scrushy, Ernst & Young, and UBS and are not a party to or beneficiary of any settlements between the plaintiffs and the remaining defendants.
 
Litigation By and Against Richard M. Scrushy—
 
On December 9, 2005, Mr. Scrushy filed a complaint in the Circuit Court of Jefferson County, Alabama, captioned Scrushy v. HealthSouth. The complaint alleged that, as a result of Mr. Scrushy’s removal from the position of chief executive officer in March 2003, we owed him “in excess of $70 million” pursuant to an employment agreement dated as of September 17, 2002. On December 28, 2005, we counterclaimed against Mr. Scrushy, asserting claims for breaches of fiduciary duty and fraud arising out of Mr. Scrushy’s tenure with us, and seeking compensatory damages, punitive damages, and disgorgement of wrongfully obtained benefits. We also asserted that any employment agreements with Mr. Scrushy should be void and unenforceable. On July 7, 2009, we filed a motion for summary judgment on all claims by Mr. Scrushy based upon the Tucker court’s June 18, 2009 ruling that Mr. Scrushy’s employment agreements are void and rescinded. We understand that the court does not intend to rule on this motion at the present time.
 
On June 18, 2009, the Circuit Court of Jefferson County, Alabama ruled on our derivative claims against Mr. Scrushy presented during a non-jury trial held May 11 to May 26, 2009. The court held Mr. Scrushy responsible for fraud and breach of fiduciary duties and awarded us $2.9 billion in damages. On July 24, 2009, Mr. Scrushy filed a notice of appeal of the trial court’s decision, and the parties subsequently submitted their briefs to the Supreme Court of Alabama. On January 28, 2011, the Supreme Court upheld the trial court’s decision in its entirety. On April 15, 2011, the Supreme Court denied Mr. Scrushy’s application for a rehearing of the Supreme Court’s initial decision. At this time, we cannot predict when and to what extent this judgment can be collected. We will pursue collection aggressively and to the fullest extent permitted by law. We, in coordination with derivative plaintiffs’ counsel, are attempting to locate, in order to collect the judgment, Mr. Scrushy’s current assets and other assets we believe were improperly disposed. Part of this effort is a fraudulent transfer complaint filed on July 2, 2009 against Mr. Scrushy and a number of related entities by derivative plaintiffs for the benefit of HealthSouth in the Circuit Court of Jefferson County, Alabama, captioned Tucker v. Scrushy et al.
 
While these collection efforts continue, some of Mr. Scrushy’s assets have been seized and sold at auction pursuant to the state law procedure for collection of a judgment. Other assets will likewise be sold from time to time. Although we alone do not control the distribution, we anticipate that his assets that have been collected or seized, or the proceeds from their sale, will begin to be distributed to us this year after deducting attorneys’ fees and expenses associated with maintaining and selling those assets. However, no assurances as to the timing of these distributions can be provided. We are obligated to pay 35% of any recovery from Mr. Scrushy along with reasonable out-of-pocket expenses to the attorneys for the derivative shareholder plaintiffs. Under the Consolidated Securities Action settlement, we must also pay the federal plaintiffs 25% of any net recovery from Mr. Scrushy. After payment of these obligations and other amounts related to professional fees and expenses, we expect our recovery to be between 40% and 45% of any amounts collected.
 
Litigation By and Against Former Independent Auditor—
 
In March 2003, claims on behalf of HealthSouth were brought in the Tucker derivative litigation against Ernst & Young, alleging that from 1996 through 2002, when Ernst & Young served as our independent auditor, Ernst & Young acted recklessly and with gross negligence in performing its duties, and specifically that Ernst & Young failed to perform reviews and audits of our financial statements with due professional care as required by law and by its contractual agreements with us. The claims further allege Ernst & Young either knew of or, in the exercise of due care, should have discovered and investigated the fraudulent and improper accounting practices being directed by certain officers and employees, and should have reported them to our board of directors and the audit committee. The claims seek compensatory and punitive damages, disgorgement of fees received from us by
 
 
Ernst & Young, and attorneys’ fees and costs. On March 18, 2005, Ernst & Young filed a lawsuit captioned Ernst & Young LLP v. HealthSouth Corp. in the Circuit Court of Jefferson County, Alabama. The complaint alleges we provided Ernst & Young with fraudulent management representation letters, financial statements, invoices, bank reconciliations, and journal entries in an effort to conceal accounting fraud. Ernst & Young claims that as a result of our actions, Ernst & Young’s reputation has been injured and it has and will incur damages, expenses, and legal fees. On April 1, 2005, we answered Ernst & Young’s claims and asserted counterclaims related or identical to those asserted in the Tucker action. Upon Ernst & Young’s motion, the Alabama state court referred Ernst & Young’s claims and our counterclaims to arbitration pursuant to a clause in the engagement agreements between HealthSouth and Ernst & Young. On July 12, 2006, we and the derivative plaintiffs filed an arbitration demand on behalf of HealthSouth against Ernst & Young. On August 7, 2006, Ernst & Young filed an answering statement and counterclaim in the arbitration reasserting the claims made in state court. In August 2006, we and the derivative plaintiffs agreed to jointly prosecute the claims against Ernst & Young in arbitration.
 
We are vigorously pursuing our claims against Ernst & Young and defending the claims against us. The three-person arbitration panel that is adjudicating the claims and counterclaims in arbitration has been selected under rules of the American Arbitration Association (the “AAA”). The trial phase of the arbitration process began on July 12, 2010 and is continuing as schedules permit. However, pursuant to an order of the AAA panel, all aspects of the arbitration are confidential. Accordingly, we will not discuss the arbitration until there is a resolution. Based on the stage of arbitration, and review of the current facts and circumstances, we do not believe there is a reasonable possibility of a loss that might result from an adverse judgment or a settlement of this case.
 
General Medicine Action—
 
On August 16, 2004, General Medicine, P.C. filed a lawsuit against us captioned General Medicine, P.C. v. HealthSouth Corp. seeking the recovery of allegedly fraudulent transfers involving assets of Horizon/CMS Healthcare Corporation, a former subsidiary of HealthSouth. The lawsuit was filed in the Circuit Court of Shelby County, Alabama, but was transferred to the Circuit Court of Jefferson County, Alabama on February 28, 2005 (the “Alabama Action”).
 
The underlying claim against Horizon/CMS originates from a services contract entered into in 1995 between General Medicine and Horizon/CMS whereby General Medicine agreed to provide medical director services to skilled nursing facilities owned by Horizon/CMS for a term of three years. Horizon/CMS terminated the agreement six months after it was executed, and General Medicine then initiated a lawsuit in the United States District Court for the Eastern District of Michigan in 1996 (the “Michigan Action”). General Medicine’s complaint in the Michigan Action alleged that Horizon/CMS breached the services contract by wrongfully terminating General Medicine. We acquired Horizon/CMS in 1997 and sold it to Meadowbrook Healthcare, Inc. in 2001 pursuant to a stock purchase agreement. In 2004, Meadowbrook consented to the entry of a final judgment in the Michigan Action in the amount of $376 million (the “Consent Judgment”) in favor of General Medicine against Horizon/CMS for the alleged wrongful termination of the contract with General Medicine. We were not a party to the Michigan Action or the settlement negotiated by Meadowbrook. The settlement agreement which was the basis for the Consent Judgment provided that Meadowbrook would pay only $0.3 million to General Medicine to settle the Michigan Action. The settlement agreement further provided that General Medicine would seek to recover the remaining balance of the Consent Judgment solely from us.
 
The complaint filed by General Medicine against us in the Alabama Action alleged that while Horizon/CMS was our wholly owned subsidiary and General Medicine was an existing creditor of Horizon/CMS, we caused Horizon/CMS to transfer its assets to us for less than a reasonably equivalent value or, in the alternative, with the actual intent to defraud creditors of Horizon/CMS, including General Medicine, in violation of the Alabama Uniform Fraudulent Transfer Act. General Medicine’s complaint requested relief including recovery of the unpaid amount of the Consent Judgment, the avoidance of the subject transfers of assets, attachment of the assets transferred to us, appointment of a receiver over the transferred properties, and a monetary judgment for the value of properties transferred. On September 2, 2008, General Medicine filed an amended complaint which alleged that we should be held liable for the Consent Judgment under two new theories: fraud and alter ego. Specifically, General Medicine alleged in its amended complaint that we, while Horizon’s parent from 1997 to 2001, failed to observe corporate formalities in its operation and ownership of Horizon, misused its control of Horizon, stripped assets from
 
 
Horizon, and engaged in other conduct which amounted to a fraud on Horizon’s creditors, including General Medicine.
 
In the Alabama Action, we filed an answer to General Medicine’s complaint, as amended, denying liability to General Medicine. We have also asserted counterclaims against General Medicine for fraud, injurious falsehood, tortious interference with business relations, conspiracy, unjust enrichment, abuse of process, and other causes of action. In our counterclaims, we alleged the Consent Judgment is the product of fraud, collusion and bad faith by General Medicine and Meadowbrook and, further, that these parties were guilty of a conspiracy to manufacture a lawsuit against HealthSouth in favor of General Medicine. The Alabama Action has now entered the discovery stage but is stayed subject to the outcome of the pending appeal in the Michigan Action discussed below. We intend to vigorously defend ourselves against General Medicine’s claim and to vigorously prosecute our counterclaims against General Medicine.
 
In the Michigan Action, we filed a motion on October 17, 2008 asking the court to set aside the Consent Judgment on grounds that it was the product of fraud on the court and collusion by the parties. On May 21, 2009, the court granted our motion to set aside the Consent Judgment on grounds that it was the product of fraud on the court. In its order setting aside the Consent Judgment, the court directed General Medicine and Horizon/CMS to confer with each other and the court’s case manager to determine what further proceedings are appropriate in the Michigan Action. On June 17, 2009, Horizon/CMS filed a motion for clarification requesting the court rule that Horizon/CMS has fully complied with its obligations under the settlement agreement and is therefore not required to participate in any further proceedings. On July 21, 2009, General Medicine filed a motion to compel Horizon/CMS to enter into a new consent judgment in favor of General Medicine. On February 25, 2010, the court granted Horizon/CMS’s motion, denied General Medicine’s motion, and ruled that no further proceedings were necessary in the litigation. On March 9, 2010, General Medicine filed an appeal of the court’s decision to the Sixth Circuit Court of Appeals. On March 25, 2010, we moved to intervene in General Medicine’s appeal, and on March 26, 2010, we moved to dismiss a portion of General Medicine’s appeal as untimely. On July 9, 2010, the Court of Appeals granted our motion to intervene but denied our motion to dismiss “at this time” on grounds that our argument is “inextricably intertwined” with the merits of General Medicine’s appeal. Accordingly, we reasserted this argument in our principal brief filed with the Court of Appeals on September 22, 2010. The appeal now has been fully briefed by the parties, but oral argument has not yet been scheduled. At this time, we do not know when the Court of Appeals will rule on the appeal.
 
Although both the Michigan Action and the Alabama Action remain pending and it is not possible to predict the outcome of either case, we do not believe, based on the stage of litigation, prior rulings in our favor, and review of the current facts and circumstances, there is a reasonable possibility of a loss that might result from an adverse judgment or settlement of this case.
 
Other Litigation—
 
We have been named as a defendant in a lawsuit filed March 28, 2003 by several individual stockholders in the Circuit Court of Jefferson County, Alabama, captioned Nichols v. HealthSouth Corp. The plaintiffs alleged that we, some of our former officers, and our former auditor engaged in a scheme to overstate and misrepresent our earnings and financial position. The plaintiffs are seeking compensatory and punitive damages. This case was consolidated with the Tucker case for discovery and other pretrial purposes and was stayed in the Circuit Court on August 8, 2005. The plaintiffs filed an amended complaint on November 9, 2010 to which we responded with a motion to dismiss based on lack of standing filed on December 22, 2010. We intend to vigorously defend ourselves in this case. Based on the stage of litigation and review of the current facts and circumstances, it is not possible to estimate with confidence the amount of loss, if any, or range of possible loss that might result from an adverse judgment or a settlement of this case.
 
We were named as a defendant in a lawsuit filed March 3, 2009 by an individual in the Court of Common Pleas, Richland County, South Carolina, captioned Sulton v. HealthSouth Corp, et al. The plaintiff alleged that certain treatment he received at a HealthSouth facility complicated a pre-existing infectious injury. The plaintiff sought recovery for pain and suffering, medical expenses, punitive damages, and other damages. On July 30, 2010, the jury in this case returned a verdict in favor of the plaintiff for $12.3 million in damages. On September 2, 2010, we filed a notice of appeal of this verdict with the South Carolina Court of Appeals, and we anticipate filing our
 
 
brief with the court in early May 2011. We intend to vigorously defend ourselves in this case. We believe the attending nurses acted both responsibly and professionally, and we will continue to support and defend them. Although we continue to believe in the merit of our defenses and counterarguments, we have recorded a liability of $12.3 million in Accrued expenses and other current liabilities in our condensed consolidated balance sheets as of March 31, 2011 and December 31, 2010 with a corresponding receivable of $7.7 million in Other current assets for the portion of the claim we expect to be covered through our excess insurance coverages, resulting in a net charge of $4.6 million to Other operating expenses in the second quarter of 2010. The $4.6 million portion of this claim would be a covered claim through our captive insurance subsidiary, HCS, Ltd. As a result of the verdict, during the third quarter of 2010, we made a $6.0 million payment through HCS, Ltd. to the Richland County Clerk as a deposit during the on-going appeal process. The deposit is a restricted asset included in Other current assets in our condensed consolidated balance sheets as of March 31, 2010 and December 31, 2010.
 
Other Matters—
 
The False Claims Act, 18 U.S.C. § 287, allows private citizens, called “relators,” to institute civil proceedings alleging violations of the False Claims Act. These qui tam cases are generally sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the presiding court. It is possible that qui tam lawsuits have been filed against us and that we are unaware of such filings or have been ordered by the presiding court not to discuss or disclose the filing of such lawsuits. We may be subject to liability under one or more undisclosed qui tam cases brought pursuant to the False Claims Act.
 
It is our obligation as a participant in Medicare and other federal healthcare programs to routinely conduct audits and reviews of the accuracy of our billing systems and other regulatory compliance matters. As a result of these reviews, we have made, and will continue to make, disclosures to the Office of Inspector General of the United States Department of Health and Human Services relating to amounts we suspect represent over-payments from these programs, whether due to inaccurate billing or otherwise. Some of these disclosures have resulted in, or may result in, HealthSouth refunding amounts to Medicare or other federal healthcare programs. See Note 21, Settlements, “The 2007 Referral Source Settlement,” to the consolidated financial statements accompanying the 2010 Form 10-K.
 
We also face certain financial risks and challenges relating to our 2007 divestiture transactions (see Note 18, Assets Held for Sale and Results of Discontinued Operations, to the consolidated financial statements accompanying the 2010 Form 10-K) following their closing. These include indemnification obligations, which in the aggregate could have a material adverse effect on our financial position, results of operations, and cash flows.
 
11.
Condensed Consolidating Financial Information
 
The accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X, Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” Each of the subsidiary guarantors is 100% owned by HealthSouth, and all guarantees are full and unconditional and joint and several. HealthSouth’s investments in its consolidated subsidiaries, as well as guarantor subsidiaries’ investments in non-guarantor subsidiaries and non-guarantor subsidiaries’ investments in guarantor subsidiaries, are presented under the equity method of accounting.
 
As described in Note 8, Long-term Debt, to the consolidated financial statements accompanying the 2010 Form 10-K, the terms of our credit agreement restrict us from declaring or paying cash dividends on our common stock unless: (1) we are not in default under our credit agreement and (2) the amount of the dividend, when added to the aggregate amount of certain other defined payments made during the same fiscal year, does not exceed certain maximum thresholds. However, as described in Note 11, Convertible Perpetual Preferred Stock, to the consolidated financial statements accompanying the 2010 Form 10-K, our preferred stock generally provides for the payment of cash dividends, subject to certain limitations.

 
19

HealthSouth Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements
 
Condensed Consolidating Statement of Operations
 


   
Three Months Ended March 31, 2011
 
   
HealthSouth Corporation
   
Guarantor Subsidiaries
   
Non Guarantor Subsidiaries
   
Eliminating Entries
   
HealthSouth Consolidated
 
   
(In Millions)
 
Net operating revenues
  $ 19.6     $ 380.3     $ 149.8     $ (11.6 )   $ 538.1  
Operating expenses:
                                       
Salaries and benefits
    12.1       178.4       72.0       (3.4 )     259.1  
Other operating expenses
    6.3       52.9       22.7       (5.2 )     76.7  
General and administrative expenses
    26.9       -       -       -       26.9  
Supplies
    1.5       20.9       7.5       -       29.9  
Depreciation and amortization
    2.9       13.3       4.1       -       20.3  
Occupancy costs
    1.1       9.5       4.7       (3.0 )     12.3  
Provision for doubtful accounts
    0.3       3.8       1.3       -       5.4  
Loss on disposal of assets
    -       0.1       0.1       -       0.2  
Professional fees—accounting,
                                       
tax, and legal
    3.8       -       -       -       3.8  
Total operating expenses
    54.9       278.9       112.4       (11.6 )     434.6  
Interest expense and amortization of
                                       
debt discounts and fees
    32.5       2.2       0.7       (0.3 )     35.1  
Other income
    (0.1 )     -       (0.8 )     0.3       (0.6 )
Equity in net income of nonconsolidated
                                       
affiliates
    (0.8 )     (1.7 )     -       -       (2.5 )
Equity in net income of consolidated
                                       
affiliates
    (53.6 )     (2.2 )     (0.5 )     56.3       -  
Management fees
    (23.9 )     18.6       5.3       -       -  
Income from continuing operations
                                       
before income tax (benefit) expense
    10.6       84.5       32.7       (56.3 )     71.5  
Provision for income tax (benefit) expense
    (54.0 )     40.2       8.2       -       (5.6 )
Income from continuing operations
    64.6       44.3       24.5       (56.3 )     77.1  
Income (loss) from discontinued operations,
                                       
net of tax
    15.2       (0.9 )     0.1       -       14.4  
  Net Income
    79.8       43.4       24.6       (56.3 )     91.5  
Less: Net income attributable to
                                       
noncontrolling interests
    -       -       (11.7 )     -       (11.7 )
Net income attributable
                                       
   to HealthSouth
  $ 79.8     $ 43.4     $ 12.9     $ (56.3 )   $ 79.8  

 
20

HealthSouth Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements
 
Condensed Consolidating Statement of Operations
 


   
Three Months Ended March 31, 2010
 
   
HealthSouth Corporation
   
Guarantor Subsidiaries
   
Non Guarantor Subsidiaries
   
Eliminating Entries
   
HealthSouth Consolidated
 
   
(In Millions)
 
Net operating revenues
  $ 17.3     $ 345.0     $ 138.8     $ (10.1 )   $ 491.0  
Operating expenses:
                                       
Salaries and benefits
    11.7       165.7       67.6       (3.1 )     241.9  
Other operating expenses
    4.4       46.0       20.9       (4.4 )     66.9  
General and administrative expenses
    26.3       -       -       -       26.3  
Supplies
    1.4       19.6       7.3       -       28.3  
Depreciation and amortization
    2.5       12.2       3.6       -       18.3  
Occupancy costs
    1.1       8.6       4.4       (2.5 )     11.6  
Provision for doubtful accounts
    0.4       4.8       1.7       -       6.9  
Loss (gain) on disposal of assets
    -       0.1       (0.1 )     -       -  
Professional fees—accounting,
                                       
tax, and legal
    2.9       -       -       -       2.9  
Total operating expenses
    50.7       257.0       105.4       (10.0 )     403.1  
Loss on early extinguishment of debt
    0.3       -       -       -       0.3  
Interest expense and amortization of
                                       
debt discounts and fees
    28.1       2.2       0.7       (0.5 )     30.5  
Other income
    (0.2 )     -       (1.0 )     0.5       (0.7 )
Loss on interest rate swaps
    4.3       -       -       -       4.3  
Equity in net income of nonconsolidated
                                       
affiliates
    (0.7 )     (1.9 )     -       -       (2.6 )
Equity in net income of consolidated
                                       
affiliates
    (47.9 )     (1.8 )     (0.7 )     50.4       -  
Management fees
    (21.7 )     17.0       4.7       -       -  
Income from continuing operations
                                       
before income tax (benefit)
                                       
expense
    4.4       72.5       29.7       (50.5 )     56.1  
Provision for income tax (benefit)
                                       
expense
    (38.2 )     33.0       7.7       -       2.5  
Income from continuing operations
    42.6       39.5       22.0       (50.5 )     53.6  
Loss from discontinued operations,
                                       
net of tax
    (1.9 )     (0.5 )     (0.7 )     -       (3.1 )
  Net Income
    40.7       39.0       21.3