SUN HEALTHCARE GROUP INC - FORM 10-Q

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EX-32.1 - SUN HEALTHCARE GROUP INC	ex32-1.htm
EX-10.1 - SUN HEALTHCARE GROUP INC	ex10-1.htm
EX-31.1 - SUN HEALTHCARE GROUP INC	ex31-1.htm
EX-10.3 - SUN HEALTHCARE GROUP INC	ex10-3.htm
EX-32.2 - SUN HEALTHCARE GROUP INC	ex32-2.htm
EX-31.2 - SUN HEALTHCARE GROUP INC	ex31-2.htm
EX-10.2 - SUN HEALTHCARE GROUP INC	ex10-2.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 March 31, 2011

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	13-4230695
(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 May 4, 2011, there were 25,091,927 shares of the Registrant’s $.01 par value Common Stock outstanding.

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 March 31, 2011
	As of December 31, 2010

	Consolidated Income Statements (unaudited)	5
	For the three months ended March 31, 2011 and 2010

	Consolidated Statements of Cash Flows (unaudited)	6
	For the three months ended March 31, 2011 and 2010

	Notes to Consolidated Financial Statements (unaudited)	7-17

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	18-31

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31

Item 4.	Controls and Procedures	31

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	32

Item 1A.	Risk Factors	32

Item 6.	Exhibits	32

Signature		32

References throughout this document to the Company, “we,” “our” 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”) contain “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 outcome and costs of litigation, projected expenses and capital expenditures, growth opportunities, ability to refinance our indebtedness on favorable terms, plans and objectives of management for future operations, and compliance with and changes in governmental regulations. You can identify some of the forward-looking statements by the use of forward-looking words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “may” and other similar expressions, 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. You are urged to carefully review the disclosures we make concerning risks and other factors that may affect our business and operating results, including those made in our reports filed with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2010. 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. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document. 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.

_______________________

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS

(in thousands)

	March 31, 2011		December 31, 2010
			(Note 1)
Current assets:
Cash and cash equivalents	$	85,571	$	81,163
Restricted cash		17,274		15,329
Accounts receivable, net of allowance for doubtful accounts of $69,366
and $66,607 at March 31, 2011 and December 31, 2010, respectively		218,827		218,040
Prepaid expenses and other assets		20,510		16,859
Deferred tax assets		68,423		69,800

Total current assets		410,605		401,191

Property and equipment, net		141,211		139,860
Intangible assets, net		41,255		41,967
Goodwill		347,520		348,047
Restricted cash, non-current		351		350
Deferred tax assets		125,864		126,540
Other assets		50,027		23,803
Total assets	$	1,116,833	$	1,081,758

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

LIABILITIES AND STOCKHOLDERS’ EQUITY

(in thousands, except share data)

	March 31, 2011			December 31, 2010
				(Note 1)
Current liabilities:
Accounts payable	$	47,795		$	49,993
Accrued compensation and benefits		65,092			61,518
Accrued self-insurance obligations, current portion		55,314			52,093
Income taxes payable		478			-
Other accrued liabilities		53,451			53,945
Current portion of long-term debt and capital lease obligations		11,112			11,050

Total current liabilities		233,242			228,599

Accrued self-insurance obligations, net of current portion		159,146			133,405
Long-term debt and capital lease obligations, net of current portion		142,238			144,930
Unfavorable lease obligations, net		9,133			9,815
Other long-term liabilities		51,840			52,566

Total liabilities		595,599			569,315

Commitments and contingencies (Note 5)

Stockholders' equity:
Preferred stock of $.01 par value, authorized 3,333,333
shares, zero shares issued and outstanding as of
March 31, 2011 and December 31, 2010		-			-
Common stock of $.01 par value, authorized 41,666,667
shares, 25,088,409 and 24,973,693 shares issued and outstanding
as of March 31, 2011 and December 31, 2010, respectively		251			250
Additional paid-in capital		721,500			720,854
Accumulated deficit		(200,549	)		(208,661	)
Accumulated other comprehensive income, net		32			-
Total stockholders' equity		521,234			512,443
Total liabilities and stockholders' equity	$	1,116,833		$	1,081,758

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)

(in thousands, except per share data)

	For the
	Three Months Ended
	March 31, 2011			March 31, 2010

Total net revenues	$	483,897		$	470,415
Costs and expenses:
Operating salaries and benefits		272,101			265,087
Self-insurance for workers’ compensation and general and
professional liability insurance		15,262			14,441
Operating administrative expenses		13,280			12,289
Other operating costs		98,591			96,652
Center rent expense		36,912			18,547
General and administrative expenses		15,379			15,266
Depreciation and amortization		7,579			12,348
Provision for losses on accounts receivable		5,335			5,796
Interest, net of interest income of $59 and $90, respectively		5,000			11,890
Restructuring costs		136			-
Total costs and expenses		469,575			452,316

Income before income taxes and discontinued operations		14,322			18,099
Income tax expense		5,872			7,296
Income from continuing operations		8,450			10,803

Loss from discontinued operations, net of related taxes		(338	)		(605	)

Net income	$	8,112		$	10,198



Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.33		$	0.74
Loss from discontinued operations, net		(0.01	)		(0.05	)
Net income	$	0.32		$	0.69

Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.33		$	0.73
Loss from discontinued operations, net		(0.02	)		(0.04	)
Net income	$	0.31		$	0.69

Weighted average number of common and common
equivalent shares outstanding:
Basic		25,740			14,678
Diluted		25,838			14,828

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(in thousands)

	For the
	Three Months Ended
	March 31, 2011			March 31, 2010
Cash flows from operating activities:
Net income	$	8,112		$	10,198
Adjustments to reconcile net income to net cash provided by
operating activities, including discontinued operations:
Depreciation and amortization		7,681			12,446
Amortization of favorable and unfavorable lease intangibles		(484	)		(474	)
Provision for losses on accounts receivable		5,644			6,014
Stock-based compensation expense		1,449			1,393
Deferred taxes		2,032			4,936
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable		(5,393	)		(6,322	)
Restricted cash		(1,946	)		(1,156	)
Prepaid expenses and other assets		(249	)		4,283
Accounts payable		(1,919	)		(5,859	)
Accrued compensation and benefits		3,438			8,424
Accrued self-insurance obligations		(1,342	)		2,037
Income taxes payable		478			628
Other accrued liabilities		(731	)		2,470
Other long-term liabilities		(727	)		(955	)
Net cash provided by operating activities		16,043			38,063

Cash flows from investing activities:
Capital expenditures		(8,837	)		(17,058	)
Net cash used for investing activities		(8,837	)		(17,058	)

Cash flows from financing activities:
Principal repayments of long-term debt and capital lease obligations		(2,798	)		(20,941	)
Payment to non-controlling interest		-			(2,025	)
Distribution to non-controlling interest		-			(69	)
Net cash used for financing activities		(2,798	)		(23,035	)

Net increase (decrease) in cash and cash equivalents		4,408			(2,030	)
Cash and cash equivalents at beginning of period		81,163			104,483
Cash and cash equivalents at end of period	$	85,571		$	102,453

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(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” 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 199 healthcare centers in 25 states as of March 31, 2011.

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 March 31, 2011, and our consolidated results of operations and cash flows for the three-month periods ended March 31, 2011 and 2010, 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, 2010, which are included in our Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”).

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the 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

The Emerging Issues Task Force of the FASB issued an Accounting Standards Update in August 2010 regarding the balance sheet presentation of medical malpractice claims and similar contingent liabilities and related insurance recoveries. The updated guidance requires the insurance recovery receivable to be presented as a gross asset instead of netting it against the related liability. The updated presentation is effective for us beginning with our March 31, 2011 reporting, is reflected in the accompanying consolidated balance sheet and has resulted in insurance recovery assets as of March 31, 2011 of $2.1 million and $28.1 million for general and professional liabilities and workers’ compensation liabilities, respectively. There was no impact on our accumulated deficit due to adoption of this new standard. See the Insurance portion of Note 5 – “Commitments and Contigencies” for additional information.

Reclassifications

Certain reclassifications have been made to the prior period financial statements to conform to the 2010 financial statement presentation. We have reclassified the results of operations of the nurse practitioner services group and one skilled nursing center of our Inpatient Services segment (see Note 4 – “Discontinued Operations”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(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):

		March 31, 2011			December 31, 2010

Revolving loans	$	-		$	-
Mortgage notes payable due at various dates through 2042, interest at
rates from 6.7% to 8.5%, collateralized by the carrying values of
the real property totaling $7.1 million		7,794			7,979
Term loans		144,974			147,492
Capital leases		582			509
Total long-term obligations		153,350			155,980
Less amounts due within one year		(11,112	)		(11,050	)
Long-term obligations, net of current portion	$	142,238		$	144,930

The scheduled or expected maturities of long-term obligations as of March 31, 2011, were as follows (in thousands):

For the twelve months ending March 31:

2012	$	11,112
2013		11,033
2014		10,986
2015		10,290
2016		10,066
Thereafter		99,863
	$	153,350

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 also may enter into interest rate cap agreements that effectively limit the maximum interest rate that we pay on an agreed to notional principal amount. We use interest rate hedges 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 income. Ineffectiveness, if any, would be recognized in earnings.

Our credit agreement requires that 50% of our term loans be subject to at least a three-year hedging agreement. To satisfy this requirement, we executed two hedging instruments on January 18, 2011; a two-year interest rate cap and a two-year “forward starting” interest rate swap. The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012. This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 7.5% for two years. The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement. The two-year “forward starting” interest rate swap effectively converts the interest rate on $82.5 million of our term loans to a fixed rate from January 1, 2013 through December 31, 2014. LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 8.935% for this portion of the term loans. There was no fee for this swap agreement. Both arrangements qualify for hedge accounting treatment.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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

	Asset Derivatives
	March 31, 2011			December 31, 2010
	Balance Sheet			Balance Sheet
	Location		Fair Value	Location		Fair Value
Derivatives designated as
hedging instruments:
Interest rate hedging agreements	Other Assets	$	54	N/A	$	-

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

						Gain Reclassified from Accumulated
		Amount of Gain in				Other Comprehensive Income
		Other Comprehensive Income				to Income (ineffective portion)
		2011		2010		2011		2010
Derivatives designated as cash
flow hedges:
Interest rate hedging agreements	$	32	$	976	$	-	$	-

The amounts stated above for gain from changes in the fair value of our hedging agreements are our only sources of other comprehensive income, resulting in comprehensive income of $8.1 million for the three months ended March 31, 2011. Comprehensive income for the three months ended March 31, 2010 was $11.2 million.

(3) Fair Value of Financial Instruments

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

		March 31, 2011				December 31, 2010
		Carrying				Carrying
		Amount		Fair Value		Amount		Fair Value

Cash and cash equivalents	$	85,571	$	85,571	$	81,163	$	81,163
Restricted cash	$	17,274	$	17,274	$	15,679	$	15,679
Long-term debt and capital lease obligations,
including current portion	$	153,350	$	153,232	$	155,980	$	156,084
Interest rate hedging agreements	$	54	$	54	$	-	$	-

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At March 31, 2011 and December 31, 2010, the fair value of our long-term debt, including current maturities, and our interest rate hedging 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.

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 March 31, 2011 and December 31, 2010, respectively (in thousands):

		March 31, 2011
				Unadjusted Quoted		Significant Other
				Market Prices		Observable Inputs
		Total		(Level 1)		(Level 2)

Interest rate hedging agreements – asset	$	54	$	-	$	54

		December 31, 2010
				Unadjusted Quoted		Significant Other
				Market Prices		Observable Inputs
		Total		(Level 1)		(Level 2)

Restricted cash – money market funds	$	1,465	$	1,465	$	-

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.

During the three months ended March 31, 2011, we developed plans to dispose of a Maryland skilled nursing center in our Inpatient Services segment, whose results have been reclassified to discontinued operations for all periods presented in accordance with GAAP.

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
			March 31, 2011								March 31, 2010
			Inpatient								Inpatient
			Services			Other			Total		Services		Other		Total

Net operating revenues		$	2,556		$	-		$	2,556		2,841		-		2,841

Loss from discontinued operations, net (1)		$	(330	)	$	(8	)	$	(338	)	(593	)	(12	)	(605	)
	(1) Net of related tax benefit of $161 and $209, respectively

(5) Commitments and Contingencies

(a) 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 is 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

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 months ended March 31, 2011 and 2010 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		7,341			7,100			14,441
Current year provision, discontinued operations		43			54			97
Claims paid, continuing operations		(4,219	)		(4,555	)		(8,774	)
Claims paid, discontinued operations		(563	)		(633	)		(1,196	)
Amounts paid for administrative services and other		(850	)		(1,696	)		(2,546	)
Balance as of March 31, 2010	$	96,682		$	67,776		$	164,458

Balance as of January 1, 2011	$	111,871		$	68,485		$	180,356
Adjustment for anticipated insurance recoveries
(see Recent Accounting Pronouncements in Note 1 –
“Nature of Business”)		2,100			28,100			30,200
Current year provision, continuing operations		7,366			7,896			15,262
Current year provision, discontinued operations		75			71			146
Claims paid, continuing operations		(9,528	)		(4,701	)		(14,229	)
Claims paid, discontinued operations		(333	)		(332	)		(665	)
Amounts paid for administrative services and other		(809	)		(1,744	)		(2,553	)
Balance as of March 31, 2011	$	110,742		$	97,775		$	208,517

The anticipated insurance recoveries relate primarily to our workers’ compensation programs associated with policy years 1996 through 2001where the claim losses have exceeded the policies' aggregate retention limits. Obligations above these retention limits are covered by our excess insurance carriers, which all have carrier ratings of at least “A,” “XIV” or better.

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 March 31, 2011 and December 31, 2010 is as indicated below (in thousands):

		March 31, 2011							December 31, 2010
		Professional		Workers’			\|		Professional		Workers’
		Liability		Compensation		Total	\|		Liability		Compensation		Total
Assets:							\|
Restricted cash (1)							\|
Current	$	5,747	$	10,593	$	16,340	\|	$	3,659	$	10,864	$	14,523
Non-current		-		-		-	\|		-		-		-
	$	5,747	$	10,593	$	16,340	\|	$	3,659	$	10,864	$	14,523
							\|
Anticipated insurance recoveries (2)							\|
Current	$	-	$	3,900	$	3,900	\|	$	-	$	-	$	-
Non-current		2,100		24,200		26,300	\|		-		-		-
	$	2,100	$	28,100	$	30,200	\|	$	-	$	-	$	-

Total Assets	$	7,847	$	38,693	$	46,540	\|	$	3,659	$	10,864	$	14,523


Liabilities (3)(4):							\|
Self-insurance liabilities							\|
Current	$	24,616	$	24,755	$	49,371	\|	$	25,942	$	21,009	$	46,951
Non-current		86,126		73,020		159,146	\|		85,929		47,476		133,405
Total Liabilities	$	110,742	$	97,775	$	208,517	\|	$	111,871	$	68,485	$	180,356

(1)		Total restricted cash includes cash collateral deposits and other cash held by third parties. Total restricted cash above excludes $1,285 and $1,156 at March 31, 2011 and December 31, 2010, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD insured buildings.

(2)		Anticipated insurance recovery assets are presented as Other Assets (both current and long-term) in our consolidated balance sheet.

(3)		Total self-insurance liabilities above exclude $5,943 and $5,142 at March 31, 2011 and December 31, 2010, respectively, related to our employee health insurance liabilities.

(4)		Total self-insurance liabilities for workers’ compensation claims are collateralized, in addition to the restricted cash, by letters of credit of $56,761 as of March 31, 2011, and $59,066, as of December 31, 2010.

(b) 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. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, the industries in which we operate 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

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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.

In September 2010, a lawsuit was filed by a former employee of a subsidiary of our medical staffing company, alleging violation of various wage and hour provisions of the California Labor Code. We deny all of the allegations in the employee’s complaint. The lawsuit, which was filed as a purported class action on behalf of the former employee and all those similarly situated, has been settled. The terms of the settlement are confidential pending court approval. We believe our reserves are adequate for this matter.

In November 2010, a jury verdict was rendered in a Kentucky state court against us for $2.75 million in compensatory damages and $40 million in punitive damages. On February 25, 2011, the trial court judge reduced the punitive damage award to $24.75 million. The case involves claims for professional negligence resulting in wrongful death. We disagree with the jury’s verdict and believe that it is not supported by the facts of the case or applicable law. We have appealed this judgment to the Kentucky Court of Appeals. We believe our reserves are adequate for this matter.

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.

(6) Income Taxes

The provision for income taxes of $5.9 million for the three months ended March 31, 2011 results in an effective rate of approximately 41%. The provision for income taxes of $7.3 million for the three months ended March 31, 2010 resulted in an effective tax rate of approximately 40.3%. The rates for 2011 and 2010 differ from the statutory tax rate of 35% primarily due to state taxes.

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 $18.1 million at March 31, 2011 and December 31, 2010 relates primarily to state net operating loss (“NOL”) carryforwards and other deferred tax assets for which realization is uncertain.

After considering the transfer of substantially all of our real estate assets to Sabra Health Care REIT, Inc. in 2010 and utilization of NOL carryforwards through 2010, the Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $7.4 million. Accordingly, our NOL, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes. As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, there is approximately $58.1 million of NOLs which can be used to offset U.S. taxable income in 2011. Considering annual IRC Section 382 limitations and built-in gains, we have a total of $162.0 million of utilizable NOL carryforwards to offset taxable income in 2011 and future years.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(7) 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 13 – “Segment Information” and Note 2 – “Summary of Significant Accounting Policies” of our 2010 Form 10-K. 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
March 31, 2011
					Rehabilitation		Medical
		Inpatient			Therapy		Staffing						Intersegment
		Services			Services		Services			Corporate			Eliminations			Consolidated

Revenues from external customers	$	431,477		$	30,097	$	22,316		$	7		$	-		$	483,897

Intersegment revenues		-			32,694		623			-			(33,317	)		-

Total revenues		431,477			62,791		22,939			7			(33,317	)		483,897

Operating salaries and benefits		200,551			54,133		17,417			-			-			272,101

Self-insurance for workers’
compensation and general and
professional liability insurance		14,206			642		347			67			-			15,262

Other operating costs		126,878			2,169		2,861			-			(33,317	)		98,591

General and administrative expenses(1)		10,226			2,398		655			15,380			-			28,659

Provision (adjustment) for losses on
accounts receivable		5,112			324		(101	)		-			-			5,335

Segment operating income (loss)	$	74,504		$	3,125	$	1,760		$	(15,440	)	$	-		$	63,949

Center rent expense		36,612			127		173			-			-			36,912

Depreciation and amortization		6,336			226		187			830			-			7,579

Interest, net		(5	)		-		1			5,004			-			5,000

Net segment income (loss)	$	31,561		$	2,772	$	1,399		$	(21,274	)	$	-		$	14,458

Identifiable segment assets	$	712,605		$	15,890	$	20,541		$	346,930		$	20,867		$	1,116,833

Goodwill	$	342,912		$	75	$	4,533		$	-		$	-		$	347,520

Segment capital expenditures	$	6,507		$	729	$	53		$	1,548		$	-		$	8,837

______________________________________

(1) General and administrative expenses include operating administrative expenses.

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

The term “net segment income (loss)” is defined as earnings before restructuring costs, income tax expense and discontinued operations.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Three Months Ended
March 31, 2010
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing						Intersegment
		Services		Services		Services			Corporate			Eliminations			Consolidated

Revenues from external customers	$	417,687	$	29,363	$	23,357		$	8		$	-		$	470,415

Intersegment revenues		-		21,154		143			-			(21,297	)		-

Total revenues		417,687		50,517		23,500			8			(21,297	)		470,415

Operating salaries and benefits		206,223		41,700		17,164			-			-			265,087

Self-insurance for workers’
compensation and general and
professional liability insurance		13,644		429		307			61			-			14,441

Other operating costs		112,663		1,818		3,468			-			(21,297	)		96,652

General and administrative expenses(1)		9,479		2,159		650			15,267			-			27,555

Provision for losses on accounts
receivable		5,497		259		40			-			-			5,796

Segment operating income (loss)	$	70,181	$	4,152	$	1,871		$	(15,320	)	$	-		$	60,884

Center rent expense		18,214		123		210			-			-			18,547

Depreciation and amortization		11,181		153		180			834			-			12,348

Interest, net		2,725		-		(1	)		9,166			-			11,890

Net segment income (loss)	$	38,061	$	3,876	$	1,482		$	(25,320	)	$	-		$	18,099


Identifiable segment assets	$	1,189,570	$	17,519	$	24,208		$	857,041		$	(528,438	)	$	1,559,900

Goodwill	$	333,756	$	75	$	4,533		$	-		$	-		$	338,364

Segment capital expenditures	$	16,136	$	119	$	113		$	690		$	-		$	17,058

______________________________________

(1) General and administrative expenses include operating administrative expenses.

The term “net segment income (loss)” is defined as earnings before restructuring costs, income tax expense and discontinued operations.

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
		March 31,
		2011		2010

Net segment income	$	14,458	$	18,099
Restructuring costs		136		-
Consolidated income before income taxes and
discontinued operations	$	14,322	$	18,099

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Our 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 163 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, two independent living centers and eight mental health centers with 22,916 licensed beds located in 25 states as of March 31, 2011. 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 (the “PPACA”) and the Health Care and Education Reconciliation Act of 2010 were signed into law. The combined laws create the Affordable Care Act (the “ACA”). 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.

2010 Restructuring

In November 2010, our former parent, Sun Healthcare Group, Inc. (“Old Sun”) completed a restructuring of its business by separating its real estate assets and its operating assets into two separate publicly traded companies. The restructuring consisted of certain key transactions including a reorganization, through a series of internal corporate restructurings, such that (i) substantially all of Old Sun’s owned real property and related mortgage indebtedness owed to third parties were transferred to or assumed by Sabra Health Care REIT, Inc. (“Sabra”), a Maryland corporation and a wholly owned subsidiary of Old Sun, or one or more subsidiaries of Sabra, and (ii) all of Old Sun’s operations and other assets and liabilities were transferred to or assumed by SHG Services, Inc., a Delaware corporation and a wholly owned subsidiary of Old Sun (“New Sun”), or one or more subsidiaries of New Sun.

In November 2010, Old Sun distributed to its stockholders on a pro rata basis all of the outstanding shares of New Sun common stock (the “Separation”), together with a pro rata cash distribution to Old Sun’s stockholders aggregating approximately $10 million. Old Sun then merged with and into Sabra, with Sabra surviving the merger and Old Sun’s stockholders receiving shares of Sabra common stock in exchange for their shares of Old Sun’s common stock (the “REIT Conversion Merger”). Immediately following the Separation and REIT Conversion Merger, New Sun changed its name to Sun Healthcare Group, Inc. Pursuant to master lease agreements that were entered into between subsidiaries of Sabra and of New Sun in connection with the Separation, subsidiaries of Sabra lease to subsidiaries of New Sun the properties that Sabra’s subsidiaries own following the REIT Conversion Merger.

The Separation was accounted for as a reverse spinoff where New Sun was designated as the “accounting” spinnor and Sabra was designated as the “accounting” spinnee. Accordingly, the assets and liabilities distributed were recorded based on their historical carrying values.

For accounting purposes, the historical consolidated financial statements of Old Sun became the historical consolidated financial statements of New Sun after the distribution on November 15, 2010. In this 10-Q, we discuss financial and other data of both Old Sun and of New Sun because New Sun has continued the business of Old Sun and is the successor issuer to Old Sun for purposes of the Securities Exchange of 1934, as amended (the “Exchange Act”). References to ‘we’, ‘us’ ‘our’ and the ‘Company’ refer to Old Sun and New Sun and their businesses.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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.

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

		For the
		Three Months Ended
Sources of Revenues		March 31, 2011				March 31, 2010

Consolidated:
Medicaid	$	184,678	38.2	%	$	187,306	39.8	%
Medicare		157,621	32.6			141,523	30.1
Private pay and other		117,130	24.2			117,193	24.9
Managed care and commercial insurance		24,468	5.0			24,393	5.2
Total	$	483,897	100.0	%	$	470,415	100.0	%

Inpatient Only:
Medicaid	$	184,628	42.8	%	$	187,269	44.8	%
Medicare		152,978	35.5			137,065	32.8
Private pay and other		69,672	16.1			69,239	16.6
Managed care and commercial insurance		24,199	5.6			24,114	5.8
Total	$	431,477	100.0	%	$	417,687	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, hospice and home healthcare. Medicare Part B provides for outpatient services including physicians’ services, diagnostic service, durable medical equipment, skilled therapy services and medical supplies. Medicare Part C is a managed care option (“Medicare Advantage”) for beneficiaries who are entitled to Part A and enrolled in Part B. Medicare Part D is a benefit that provides prescription drug benefits for both Medicare and Medicare/Medicaid dually eligible patients.

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequent revisions, the most recent of which was effective October 1, 2010. PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

patients indexed forward. The amount to be paid is determined by classifying each patient into one of 53 Resource Utilization Group (“RUGs”) categories prior to October 1, 2010 (“RUGs III”) and 66 RUGs categories after October 1, 2010 (“RUGs IV”). Each RUGs level represents the level of services required to treat the patient’s condition or level of acuity.

RUGs IV is part of CMS’s continuing effort to increase the correlation of the cost of services to the condition of individual patients. CMS created the system to be budget neutral, but actual results are expected to vary by provider.

Under the RUGs III system, CMS considered some services that were delivered in the hospital when determining the payment category, referred to as the “lookback.” Under the RUGs IV system CMS eliminated this consideration. The RUGs III system also reimbursed for therapy service delivered concurrently, in a group or individually at the same rate. The RUGs IV system changes maintain the same reimbursement methodology for group and individual therapy, but will only consider concurrent therapy if it is delivered to two patients and divides the services between the two patients that receive the services.

Changes were also made in the qualifications required to qualify for each RUGs level and additional levels were added to provider further refinement.

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
	Three Months Ended
	March 31, 2011		March 31, 2010
$	520.92	$	465.98

Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services. An automatic exception was in place for patients residing in skilled nursing centers. That exception will continue through December 31, 2011.

Effective January 1, 2011, changes were made in the payment methodology for Medicare Part B services received by patients in a skilled nursing facility setting. As part of the Physician Fee Schedule, CMS applied a Multiple Procedure Payment Reduction (“MPPR”). CMS previously applied an MPPR to diagnostic services and is now expanding it to include other Part B services. A portion of the payment for Part B services is related to activities that CMS contends are only delivered one time when multiple units of the same or related services are delivered on the same day. CMS reduced the portion of the rate that contains these services by 25%, which equates to a 7.2% reduction in the reimbursement rate for Part B therapy services provided by us. The change reduces the amount we are able to charge to internal and external customers. We estimate the impact to be a $6.5 million annual reduction in consolidated revenues.

In July 2010, CMS issued its final rule for skilled nursing facilities for the 2011 federal fiscal year, which commenced 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%.

On April 29, 2011, CMS released its proposed rule for skilled nursing facilities for the 2012 federal fiscal year, which commences on October 1, 2011. CMS did not specify the method that will be used to update rates, but presented two options. One is a standard update that includes a market basket increase of 2.7% and a productivity reduction of 1.2%. The second option attempts to correct what CMS perceives is a lack of parity between RUGs III and RUGs IV. We are reviewing the proposed rule, but cannot predict the impact to our revenues at this time.

The proposed rule also contains technical changes related to group therapy and Minimum Data Set 3.0 scheduling that may impact the categorization of patients and related payment rates. CMS has not estimated the impact related to these changes.

We receive Medicare reimbursements for hospice care at daily or hourly rates based on the level of care furnished to the patient. Our ability to receive Medicare reimbursement for our hospice services is subject to two limitations:

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

If inpatient days of care provided to all patients at a hospice exceed 20% of the total days of hospice care provided by that hospice for an annual period, then payment for days in excess of this limit are paid for at the lower routine home care rate. None of our hospice programs exceeded the payment limits on inpatient services for 2010 or 2009.

Overall payments made by Medicare on a per hospice program basis are subject to a cap amount at the end of an annual period. The cap amount is calculated by multiplying the number of first time Medicare hospice beneficiaries during the year by the Medicare per beneficiary cap amount, resulting in that hospice’s aggregate cap, which is the allowable amount of total Medicare payments that hospice can receive for that cap year. If a hospice program exceeds its aggregate cap, then the hospice must repay the excess.

In July 2010, CMS 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% decrease resulting from a phase out of the wage index budget neutrality factor. We estimate that the net impact on our hospice service operations of these two adjustments will be an increase of 2.2% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.2 million per quarter.

Also on April 29, 2011, CMS released its proposed rule for hospice providers for the 2012 federal fiscal year, which commences on October 1, 2011. This proposal contained an estimated market basket increase of 2.8%, which is reduced by 0.8% as a resultof the phase out of the wage index budget neutrality factor. We estimate the average increase in hospice payments for the federal fiscal year 2012 will be 2.3%. CMS also applied wage index updates. We expect to experience an increase of 1.9% in hospice revenues per quarter.

The proposed rule also includes a change in the methodology used to apply the aggregate hospice cap. This change is optional and we do not anticipate any impact on our hospice revenues.

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 skilled nursing centers. 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 skilled nursing centers 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 skilled nursing centers.

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
	Three Months Ended
	March 31, 2011		March 31, 2010
$	172.25	$	172.59

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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
	Three Months Ended
	March 31, 2011		March 31, 2010
$	157.62	$	159.08

Managed Care and Insurance

During the three months ended March 31, 2011, 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
	Three Months Ended
	March 31, 2011		March 31, 2010
$	367.47	$	363.84

Private Payors, Veterans and Other

During the three months ended March 31, 2011, we received 24.2% of our revenues from private payors, veterans’ coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors. These private and other payors are continuing their efforts to control healthcare costs. Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated:

	For the
	Three Months Ended
	March 31, 2011		March 31, 2010
$	196.59	$	189.59

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 either delay or 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 included in this Form 10-Q.

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
		March 31, 2011			March 31, 2010		March 31, 2011		March 31, 2010

Total net revenues	$	483,897		$	470,415		100.0	%	100.0	%
Costs and expenses:
Operating salaries and benefits		272,101			265,087		56.2		56.4
Self-insurance for workers’ compensation and
general and professional liabilities		15,262			14,441		3.2		3.1
Other operating costs (1)		111,871			108,941		23.1		23.2
Center rent expense		36,912			18,547		7.6		3.9
General and administrative expenses		15,379			15,266		3.2		3.2
Depreciation and amortization		7,579			12,348		1.6		2.6
Provision for losses on accounts receivable		5,335			5,796		1.1		1.2
Interest, net		5,000			11,890		1.0		2.5
Other		136			-		-		-
Income before income taxes and discontinued
operations		14,322			18,099		3.0		3.8
Income tax expense		5,872			7,296		1.2		1.6
Income from continuing operations		8,450			10,803		1.7		2.3
Loss from discontinued operations, net		(338	)		(605	)	0.1		0.1
Net income	$	8,112		$	10,198		1.7	%	2.2	%

Supplemental Financial Information (2):
EBITDA	$	26,901		$	42,337		5.6	%	9.0	%
Adjusted EBITDA	$	27,037		$	42,337		5.6	%	9.0	%
Adjusted EBITDAR	$	63,949		$	60,884		13.2	%	12.9	%

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

(2) 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 restructuring costs. 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 GAAP expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.

In addition to other financial measures, including net segment income, we use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated, segment and a center-by-center level. EBITDA, Adjusted EBITDA and Adjusted EBITDAR are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes 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

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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 included in this Form 10-Q 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.

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
		March 31, 2011		March 31, 2010
Net income	$	8,112	$	10,198

Plus:
Loss from discontinued operations, net		338		605
Income tax expense		5,872		7,296
Interest expense, net		5,000		11,890
Depreciation and amortization		7,579		12,348
EBITDA	$	26,901	$	42,337

Plus:
Restructuring costs		136		-
Adjusted EBITDA	$	27,037	$	42,337

Plus:
Center rent expense		36,912		18,547
Adjusted EBITDAR	$	63,949	$	60,884

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following discussion of the “Three Months Ended March 31, 2011 Compared to Three Months Ended March 31, 2010” is based, in part, on the financial information presented in Note 7 – “Segment Information” in our consolidated financial statements included in this Form 10-Q.

Three Months Ended March 31, 2011 Compared to Three Months Ended March 31, 2010

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 $13.5 million, or 2.9%, to $483.9 million for the three months ended March 31, 2011 from $470.4 million for the three months ended March 31, 2010. We reported net income for the three month periods ended March 31, 2011 and 2010 of $8.1 million and $10.2 million, respectively.

The increase in net revenues for the 2011 period included $13.8 million of additional revenue in our Inpatient Services segment primarily due to higher Medicare revenue driven by increased Medicare Part A rates plus the December 2010 acquisition of a hospice company. A $0.7 million increase in nonaffiliated revenue from our Rehabilitation Therapy segment, due primarily to increases in billable minutes but partially offset by the negative impact of the implementation of MPPR, also contributed to the increase in net revenues. These increases were partially offset by a $1.0 million decrease in nonaffiliated 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 $7.0 million, or 2.6%, to $272.1 million (56.2% of net revenues) for the three months ended March 31, 2011 from $265.1 million (56.4% of net revenues) for the three months ended March 31, 2010. The increase resulted primarily from increased wage rates and benefits in all segments to remain competitive in local markets. Additionally, costs increased in our Inpatient Services segment due to the acquisition of a hospice company in December 2010 and in our Rehabiliation Therapy Services segment due to an increased nonaffiliated service volume.

Self-insurance for workers’ compensation and general and professional liability insurance increased $0.9 million, or 6.3%, to $15.3 million (3.2% of net revenues) for the three months ended March 31, 2011 from $14.4 million (3.1% of net revenues) for the three months ended March 31, 2010, primarily due to increased claims related activity in our workers’ compensation self-insurance.

Other operating costs increased $3.0 million, or 2.8%, to $111.9 million (23.1% of net revenues) for the three months ended March 31, 2011 from $108.9 million (23.2% of net revenues) for the three months ended March 31, 2010. The increase was primarily due to an increase in higher acuity patients requiring more rehabilitation therapy.

Center rent expense increased $18.4 million, or 99.5%, to $36.9 million (7.6% of net revenues) for the three months ended March 31, 2011 from $18.5 million (3.9% of net revenues) for the three months ended March 31, 2010. The increase is primarily attributable to the new lease agreements entered into in conjunction with the Separation.

General and administrative expenses increased $0.1 million, or 0.7%, to $15.4 million (3.2% of net revenues) for the three months ended March 31, 2011 from $15.3 million (3.2% of net revenues) for the three months ended March 31, 2010. The increase was primarily due to wage rate increases.

Depreciation and amortization decreased $4.7 million, or 38.2%, to $7.6 million (1.6% of net revenues) for the three months ended March 31, 2011 from $12.3 million (2.6% of net revenues) for the three months ended March 31, 2010. The decrease was attributable to the transfer of assets in conjunction with the Separation.

The provision for losses on accounts receivable decreased $0.5 million, or 8.6%, to $5.3 million (1.1% of net revenues) for the three months ended March 31, 2011 from $5.8 million (1.2% of net revenues) for the three months ended March 31, 2010. The decrease resulted from improving cash collections trends, which improved our accounts receivable aging, leading to a reduction in our provision for losses on accounts receivable for the three months ended March 31, 2011 when compared to the three months ended March 31, 2010.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Net interest expense decreased $6.9 million, or 58.0%, to $5.0 million (1.0% of net revenues) for the three months ended March 31, 2011 from $11.9 million (2.5% of net revenues) for the three months ended March 31, 2010 due to lower aggregate indebtedness resulting from the Separation.

Segment Information

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

		2011					2010

Inpatient Services	$	431,477		89.2	%	$	417,687		88.8	%
Rehabilitation Therapy Services		62,791		13.0			50,517		10.7
Medical Staffing Services		22,939		4.7			23,500		5.0
Corporate		7		-			8		-
Intersegment Eliminations		(33,317	)	(6.9	)		(21,297	)	(4.5	)
Total net revenues	$	483,897		100.0	%	$	470,415		100.0	%

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 March 31 (in thousands):

		2011		2010

Rehabilitation Therapy Services	$	32,694	$	21,154
Medical Staffing Services		623		143
Total intersegment revenue	$	33,317	$	21,297

The following table sets forth the amount of net segment income for the three months ended March 31 (in thousands):

		2011			2010

Inpatient Services	$	31,561		$	38,061
Rehabilitation Therapy Services		2,772			3,876
Medical Staffing Services		1,399			1,482
Net segment income before Corporate		35,732			43,419
Corporate		(21,274	)		(25,320	)
Net segment income	$	14,458		$	18,099

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, restructuring costs, loss on sale of assets and discontinued operations. Net segment income for the three months ended March 31, 2011 for (1) our Inpatient Services segment decreased $6.5 million, or 17.1%, to $31.6 million, (2) our Rehabilitation Therapy Services segment decreased $1.1 million, or 28.5%, to $2.8 million and (3) our Medical Staffing Services segment decreased $0.1 million, or 5.6%, to $1.4 million in comparison to the three months ended March 31, 2010, 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.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient Services

Net revenues increased $13.8 million, or 3.3%, to $431.5 million for the three months ended March 31, 2011 from $417.7 million for the three months ended March 31, 2010. The increase was primarily the result of:

-	an increase of $14.2 million in Medicare revenues as a result of a $13.4 million increase in revenues from higher Medicare Part A rates, a $0.3 million increase in Medicare Part B revenues and a $0.5 million increase in revenues due to an increased customer base;

-	a $2.9 million increase in hospice revenues due to internal growth of $0.6 million and an acquisition of a hospice company in December 2010, which contributed $2.3 million towards the hospice revenue growth;

-	a $0.9 million increase in other revenue including from veterans’ coverage and other various inpatient services; and

-	a $0.1 million increase in managed care and commercial insurance revenues driven primarily by improved rates;

	Offset in part by:

-	a $2.6 million decrease due to closure of operations in 2010;

-	a $1.5 million decrease in Medicaid revenues consisting of $0.8 million from a decrease in customer base and a $0.7 million decrease related to lower rates; and

-	a decrease of $0.2 million in revenues from private revenues primarily due to a lower customer base.

Operating salaries and benefits expenses decreased $5.6 million, or 2.7%, to $200.6 million for the three months ended March 31, 2011 from $206.2 million for the three months ended March 31, 2010. The decrease was attributable to the following:

-	a decrease of $8.5 million in therapist salaries due to their transfer from our Inpatient Services segment to our Rehabilitation Services segment;

	Offset in part by:

-	an increase in salaries and related benefits of $1.2 million related to an acquisition of a hospice company in December 2010; and

-	increases in compensation and related benefits and taxes of $1.7 million to remain competitive in local markets.

Self-insurance for workers’ compensation and general and professional liability insurance increased $0.6 million, or 4.4%, to $14.2 million for the three months ended March 31, 2011 as compared to $13.6 million for the three months ended March 31, 2010, which was driven by increased claims related activity in our workers’ compensation self-insurance.

Other operating costs increased $14.2 million, or 12.6%, to $126.9 million for the three months ended March 31, 2011 from $112.7 million for the three months ended March 31, 2010. The increase was attributable to the following:

-	an $11.0 million increase in contract labor driven by contracting with our Rehabilitation Therapy Services segment for therapists transferred from our Inpatient Services segment plus an increase in higher acuity patients requiring more rehabilitation therapy and an increase in Medicare Part B therapy;

-	a $1.8 million increase in purchased services primarily related to outsourced housekeeping contracts;

-	a $1.5 million increase in other supplies, principally food and oxygen;

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

-	a $1.0 million increase in provider taxes due to increased provider tax rates from a number of states in which we operate;

-	a $0.3 million increase in penalties and other fees; and

-	a $0.2 million increase in utility costs;

	Offset in part by:

-	an $0.8 million decrease in administrative costs to manage the therapists that transferred to our Rehabiliation Therapy Services segment;

-	a $0.4 million decrease in training and recruitment costs; and

-	a $0.4 million decrease in legal fees.

Operating administrative expenses increased at $0.7 million, or 7.4%, to $10.2 million for the three months ended March 31, 2011 compared to $9.5 million for the three months ended March 31, 2010, primarily due to higher salaries and benefits expense.

Center rent expense increased $18.4 million, or 101.1%, to $36.6 million for the three months ended March 31, 2011 from $18.2 million for the three months ended March 31, 2010. The increase is attributable to the new lease agreements entered into in conjunction with the Separation and other negotiated rent increases.

Depreciation and amortization decreased $4.9 million, or 43.8%, to $6.3 million for the three months ended March 31, 2011 from $11.2 million for the three months ended March 31, 2010. The decrease was attributable to the transfer of assets in conjunction with the Separation.

The provision for losses on accounts receivable decreased $0.4 million, or 7.3%, to $5.1 million for the three months ended March 31, 2011 from $5.5 million for the three months ended March 31, 2010. The decreased expense is due to improving cash collections trends.

Net interest expense decreased $2.7 million, or 100.0%, to $0.0 million for the three months ended March 31, 2011 from $2.7 million for the three months ended March 31, 2010. The decrease is the result of the transfer of mortgages for previously owned centers to Sabra in the Separation. Our remaining owned centers have no debt.

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $12.3 million, or 24.4%, to $62.8 million for the three months ended March 31, 2011 from $50.5 million for the three months ended March 31, 2010. The revenue increase was the result of:

-	an increase of $12.1 million attributable to increased billable minutes, due to the addition of 54 new contracts, net of lost contracts, 48 of which were affiliated contracts primarily resulting from the transfer of therapy employees from our Inpatient Services segment to our Rehabilitation Therapy Services segment;

-	revenue per minute was flat due to the negative impacts of the MPPR rule that was put in place January 2011 in the amount of $1.5 million, fully offset by nonaffiliated and affiliated rate increases as well as other Part B rate increases; and

-	an increase of $0.2 million in other revenue, primarily related to increased contract management fees.

Operating salaries and benefits expenses increased $12.4 million, or 29.7%, to $54.1 million for the three months ended March 31, 2011 from $41.7 million for the three months ended March 31, 2010. The increase was driven by the transfer of

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

therapists from our Inpatient Services segment to our Rehabilitation Therapy services segments associated with the 48 net affiliated contract growth, the increase in nonaffiliated service volume referenced above and wage rate increases.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $0.6 million, or 2.5%, to $22.9 million for the three months ended March 31, 2011 from $23.5 million for the three months ended March 31, 2010. The decrease was primarily the result of:

-	a decrease of $0.8 million due to lower fees earned from the temporary placement of physicians; and

-	a decrease of $0.6 million due to a decline for therapy and pharmacy staffing hours;

	Offset in part by:

-	an increase of $0.8 million due to an increase in billable hours for nurse staffing.

Operating salaries and benefits expenses increased $0.2 million, or 1.2%, to $17.4 million for the three months ended March 31, 2011 as compared to $17.2 million for the three months ended March 31, 2010. The increase in operating salaries and benefits is due to wage rate increases to remain competitive in local markets.

Corporate

General and administrative expenses not directly attributed to segments increased $0.1 million, or 0.7%, to $15.4 million for the three months ended March 31, 2011 from $15.3 million for the three months ended March 31, 2010. The increase was primarily due to wage rate increases in administrative salaries.

Interest expense not directly attributed to operating segments decreased $4.2 million, or 45.7%, to $5.0 million for the three months ended March 31, 2011 from $9.2 million for the three months ended March 31, 2010 due to lower aggregate indebtedness resulting from the Separation.

Liquidity and Capital Resources

For the three months ended March 31, 2011, our net income was $8.1 million. As of March 31, 2011, our working capital was $177.4 million and we had cash and cash equivalents of $85.6 million, $153.4 million in borrowings and $60.0 million available under our revolving credit facility. As of March 31, 2011, we were in compliance with the covenants contained in the credit agreement governing the revolving credit facility and our term loan indebtedness as described under “Loan Agreements” below.

Based on current levels of operations, we believe that our operating cash flows (which were $16.0 million for the three months ended March 31, 2011), existing cash reserves and availability for borrowing under our $60.0 million revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary), scheduled debt service payments and our other commitments described in our 2010 Form 10-K in the table under “Obligations and Commitments” at least through the next twelve months, notwithstanding the negative impact of the multi-year economic downturn on our ability to collect certain of our accounts receivable. 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.

Since 2007, 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

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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.

Cash Flows

During the three months ended March 31, 2011, net cash provided by operating activities decreased by $22.0 million as compared to the same period last year. In addition to decreased net income of $2.1 million, the decrease in cash flows from operating activities was the result of (i) our quarter-over-quarter decrease in working capital changes of $11.9 million, driven by changes in accounts receivable, accounts payable, accrued compensation and benefits and other accrued liabilities and (ii) a $8.0 million decrease in non-cash adjustments to net income, principally related to depreciation and amortization expense (as a result of the transfer of substantially all of our real estate to Sabra in the Separation) and deferred taxes. Increased center rent expense of $18.4 million and reduced interest expense of $6.9 million, which also resulted primarily from the Separation, contributed to the decrease in net cash provided by operating activities. All of these factors are discussed in “Results of Operations” above.

Net cash used for investing activities of $8.8 million for the three months ended March 31, 2011 were for capital expenditures.

Net cash used for financing activities was $2.8 million for the three months ended March 31, 2011, which was driven by repayments of long-term debt and capital lease obligations.

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $8.8 million and $17.1 million for the three months ended March 31, 2011 and 2010, respectively.

Loan Agreements

In October 2010, we entered into a $285.0 million senior secured credit facility (the “Credit Agreement”) with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent. The Credit Agreement provides for $150.0 million in term loans ($145.0 million outstanding at March 31, 2011), a $60.0 million revolving credit facility ($30.0 million of which may be utilized for letters of credit) and a $75.0 million funded letter of credit facility funded by proceeds of additional term loans, which was fully utilized at March 31, 2011. The revolving credit facility remains undrawn (and was not utilized for letters of credit) through March 31, 2011. If, however, we require additional letters of credit in the future, we will need to utilize availability under the revolving credit facility. The final maturity date of the term loans and the letter of credit facility is October 18, 2016 and the revolving credit facility terminates on October 18, 2015.

Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test and a leverage covenant. The Credit Agreement contains customary events of default, such as a failure by us 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. Our obligations under the Credit Agreement are guaranteed by most of our subsidiaries and are collateralized by our assets and the assets of most of our subsidiaries.

Amounts borrowed under the term loan facility are due in quarterly installments of $2.5 million, 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. Borrowings 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) the greater of 1.75% or LIBOR, adjusted for statutory reserves or (b) an alternative base rate determined by reference to the highest of (i) the prime rate announced by Credit Suisse, (ii) the federal funds rate plus one-half of 1.0%, and (iii) the greater of 1.75% or one-month LIBOR adjusted for statutory reserves plus 1%. The applicable percentage for term loans and revolving loans is 4.75% for alternative base rate loans and 5.75% for LIBOR loans. Each year, commencing in 2012, 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

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

any, as defined in the Credit Agreement. In addition to paying interest on outstanding loans under the Credit Agreement, we are required to pay a facility fee of 0.50% per annum to the lenders under the revolving credit facility in respect of the unused revolving commitments.

The Credit Agreement requires that 50% of our term loans be subject to at least a three-year hedging arrangement. To satisfy this requirement, we executed two hedging instruments on January 18, 2011; a two-year interest rate cap and a two-year “forward starting” interest rate swap. The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012. This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 7.5% for two years. The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement. The two-year “forward starting” interest rate swap effectively converts the interest rate on $82.5 million of our term loans to fixed rate from January 1, 2013 through December 31, 2014. LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 8.935% for this portion of the term loans. There was no fee for this swap agreement. Both arrangements qualify for hedge accounting treatment.

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																				March 31,			December 31,
		2012			2013				2014			2015			2016			Thereafter			Total		2011 (1)		2010 (1)
							(Dollars in thousands)
Long-term debt:
Fixed rate debt	$	1,112		$	1,033			$	986		$	290		$	66		$	4,888		$	8,375	$	8,257	$	8,584
Rate		7.5	%		7.3	%			7.0	%		6.8	%		6.7	%		6.7	%

Variable rate debt	$	10,000		$	10,000			$	10,000		$	10,000		$	10,000		$	94,975		$	144,975	$	144,975	$	147,500
Rate		11.4	%		7.5	%			7.5	%		7.5	%		7.5	%		7.5	%

Interest rate hedges:																						$	54	$	-
Cap	$	82,500		$	82,500			$	-		$	-		$	-		$	-
Maximum rate		1.75	%		1.75	%			-			-			-			-
Variable to fixed	$	-		$	-			$	82,500		$	82,500		$	-		$	-
Average pay rate		-			-				3.185	%		3.185	%		-			-
Average receive rate		-			-				1.75	%		1.75	%		-			-

(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.

ITEM 4. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures defined in Rule 13a-15(e) under the Exchange Act 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, William A. Mathies, 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 March 31, 2011.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

There were no changes in our internal control over financial reporting that 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 5(b) – “Commitments and Contingencies – Litigation” of our consolidated financial statements included in this 10-Q, which is incorporated by reference to this item.

ITEM 1A. RISK FACTORS

There have been no material changes in our assessment of our risk factors from those set forth in our 2010 Form 10-K.

ITEM 6. EXHIBITS

10.1	Sun Healthcare Group, Inc. Executive Bonus Plan

10.2	2011 Incentive Plan for President of SunBridge Healthcare, LLC

10.3	2011 Incentive Plan for President of SunDance Rehabilitation Corporation

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)

May 4, 2011

SUN HEALTHCARE GROUP INC - FORM 10-Q - May 5, 2011

Attached files

SUN HEALTHCARE GROUP INC Reports