LifeCare Holdings, Inc. - FORM 10-Q

LifeCare Holdings, Inc. - FORM 10-Q - August 12, 2011

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EXCEL - IDEA: XBRL DOCUMENT - LifeCare Holdings, Inc.	Financial_Report.xls
EX-32.1 - EXHIBIT 32.1 - LifeCare Holdings, Inc.	dex321.htm
EX-31.2 - EXHIBIT 31.2 - LifeCare Holdings, Inc.	dex312.htm
EX-31.1 - EXHIBIT 31.1 - LifeCare Holdings, Inc.	dex311.htm
EX-32.2 - EXHIBIT 32.2 - LifeCare Holdings, Inc.	dex322.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2011.

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

For the transition period from to .

Commission File Number 333-133319

LIFECARE HOLDINGS, INC.

(Exact name of registrant as specified in its charter)


Delaware		51-0372090
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

5560 Tennyson Parkway Plano, Texas		75024
(Address of Principal Executive Offices)		(Zip Code)

(469) 241-2100

(Registrant’s telephone number, including area code)

None

(Former name, former address and former fiscal year, if changes since last report)

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 ¨

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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. Please see definition of “accelerated and large accelerated filer” in Rule 12b-2 of the Exchange Act.

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

As of August 12, 2011, the registrant had 100 shares of Common Stock, par value $0.01 per share, outstanding.

LIFECARE HOLDINGS, INC.

TABLE OF CONTENTS


PART I: FINANCIAL INFORMATION

ITEM 1.	CONSOLIDATED FINANCIAL STATEMENTS	3

	CONDENSED CONSOLIDATED BALANCE SHEETS	3

	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS	4

	CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDER’S DEFICIT	5

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	6

	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	7

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	21

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	30

ITEM 4.	CONTROLS AND PROCEDURES	31

PART II: OTHER INFORMATION		31

ITEM 1.	LEGAL PROCEEDINGS	31

ITEM 1A.	RISK FACTORS	31

ITEM 6.	EXHIBITS	31

SIGNATURES		32

PART 1: FINANCIAL INFORMATION

ITEM 1:

CONSOLIDATED FINANCIAL STATEMENTS

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

June 30, 2011 and December 31, 2010

(In thousands, except share data)

(unaudited)


	June 30, 2011			December 31, 2010
Assets
Current assets:
Cash and cash equivalents	$	19,922		$	54,570
Accounts receivable, net of allowance for doubtful accounts of $9,915 and $11,293, respectively		70,009			67,275
Other current assets		6,599			5,975

Total current assets		96,530			127,820
Property and equipment, net		74,586			76,832
Other assets, net		21,093			8,763
Identifiable intangibles, net		15,440			15,440
Goodwill		248,342			248,342

	$	455,991		$	477,197

Liabilities and Stockholder’s Deficit
Current liabilities:
Current installments of long-term debt	$	2,575		$	1,931
Current installments of obligations under capital leases		596			838
Current installment of lease financing obligation		499			480
Estimated third party payor settlements		3,073			4,318
Accounts payable		24,947			25,452
Accrued payroll		5,669			6,480
Accrued vacation		5,815			4,658
Accrued interest		8,938			6,377
Accrued other		4,788			4,321
Income taxes payable		383			282

Total current liabilities		57,283			55,137
Long-term debt, excluding current installments		377,561			393,981
Obligations under capital leases, excluding current installments		55			425
Lease financing obligation, excluding current installments		19,303			19,558
Accrued insurance		4,754			4,032
Other noncurrent liabilities		16,747			15,544

Total liabilities		475,703			488,677

Commitments and contingencies
Stockholder’s deficit:
Common stock, $0.01 par value, 100 shares authorized, issued and outstanding		—			—
Additional paid-in capital		175,441			175,441
Accumulated deficit		(195,153	)		(186,921	)

Total stockholder’s deficit		(19,712	)		(11,480	)

	$	455,991		$	477,197

See accompanying notes to condensed consolidated financial statements.

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

For the three and six months ended June 30, 2011 and 2010

(In thousands)

(Unaudited)


	Three Months					Six Months
	2011			2010		2011			2010
Net patient service revenue	$	95,992		$	90,633	$	190,911		$	185,593

Salaries, wages and benefits		45,014			42,669		89,414			84,170
Supplies		9,524			9,313		18,814			18,552
Rent		6,720			6,396		13,193			12,923
Other operating expenses		22,184			20,239		42,941			41,136
Provision for doubtful accounts		1,241			1,829		2,586			3,418
Loss on early extinguishment of debt		—			—		2,772			—
Depreciation and amortization		2,058			2,537		4,174			5,086
Interest expense, net		13,939			7,089		25,275			14,094

Total expenses		100,680			90,072		199,169			179,379

Operating income (loss)		(4,688	)		561		(8,258	)		6,214
Equity in income of joint venture		283			356		476			410

Income (loss) before income taxes		(4,405	)		917		(7,782	)		6,624
Provision for income taxes		225			225		450			400

Net income (loss)	$	(4,630	)	$	692	$	(8,232	)	$	6,224

See accompanying notes to condensed consolidated financial statements.

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholder’s Deficit

For the six months ended June 30, 2011

(In thousands)

(Unaudited)


	Common Stock		Additional Paid-in Capital		Accumulated Deficit			Total Stockholder’s Deficit
Balance, December 31, 2010	$	—	$	175,441	$	(186,921	)	$	(11,480	)
Net loss		—		—		(8,232	)		(8,232	)

Balance, June 30, 2011	$	—	$	175,441	$	(195,153	)	$	(19,712	)

See accompanying notes to condensed consolidated financial statements.

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

For the six months ended June 30, 2011 and 2010

(In thousands)

(Unaudited)


	2011			2010
Cash flows from operating activities:
Net income (loss)	$	(8,232	)	$	6,224
Adjustments to reconcile net income (loss) to net cash provided by operating activities:

Depreciation and amortization (including amortization of debt issuance cost)		7,348			6,235
Provision for doubtful accounts		2,586			3,418
Paid in kind interest		3,980			—
Equity compensation amortization		—			147
Loss on early extinguishment of debt		2,772			—
Equity in income of joint venture		(476	)		(410	)
Changes in operating assets and liabilities:
Accounts receivable		(5,320	)		(2,830	)
Income taxes		101			(275	)
Other current assets		(624	)		133
Other assets		85			334
Estimated third party payor settlements		(1,245	)		(5,130	)
Accounts payable and accrued expenses		2,869			(4,710	)
Other noncurrent liabilities		1,925			4,020

Net cash provided by operating activities		5,769			7,156

Cash flows from investing activities:
Purchases of property and equipment		(1,928	)		(1,355	)

Net cash used in investing activities		(1,928	)		(1,355	)

Cash flows from financing activities:
Deferred financing cost		(17,885	)		—
Payments under the line of credit		(35,000	)		—
Proceeds from long-term debt		257,500			—
Payments of long-term debt		(242,256	)		(1,275	)
Payments on obligations under capital leases		(612	)		(583	)
Payments on lease financing obligation		(236	)		(218	)

Net cash used in financing activities		(38,489	)		(2,076	)

Net increase (decrease) in cash and cash equivalents		(34,648	)		3,725
Cash and cash equivalents, beginning of period		54,570			46,681

Cash and cash equivalents, end of period	$	19,922		$	50,406

Supplemental disclosure of cash flow information:
Cash:
Interest paid	$	19,652		$	13,195
Net income taxes paid		349			676
Noncash:
Equipment purchased through capital lease financing		—			599

See accompanying notes to condensed consolidated financial statements.

LifeCare Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

(1) Basis of Presentation

LifeCare Holdings, Inc. (the “Company”) is a wholly owned subsidiary of LCI Holdco, LLC (“Holdco”). Holdco is a wholly owned subsidiary of LCI Intermediate Holdco, Inc. (“Intermediate Holdco”). Intermediate Holdco is a wholly owned subsidiary of LCI Holding Company, Inc. (“Holdings”), which is owned by an investor group that includes affiliates of The Carlyle Group and members of our senior management and board of directors. The investor group acquired Holdings pursuant to a merger that occurred on August 11, 2005 (the “Merger”).

The accompanying unaudited condensed consolidated financial statements and financial information have been prepared in accordance with generally accepted accounting principles, and reflect all adjustments that are, in the opinion of management, necessary for a fair presentation of the results of the interim periods. The accompanying financial statements for the three and six month periods ended June 30, 2011 and 2010 are not necessarily indicative of annualized financial results.

The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated audited financial statements and notes thereto for the year ended December 31, 2010 included in the Form 10-K we filed on March 30, 2011 with the Securities and Exchange Commission. Certain information and disclosures normally included in the notes to consolidated financial statements have been condensed or omitted as permitted by the rules and regulations of the Securities and Exchange Commission, although we believe the disclosure is adequate to make the information presented not misleading.

(2) Summary of Significant Accounting Policies

Use of Estimates

The preparation of the financial statements requires us to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual amounts could differ from those estimates.

Goodwill

We review our goodwill annually, or more frequently if circumstances warrant a more timely review, to determine if there has been an impairment. We review goodwill based upon one reporting unit, as our company is managed as one operating segment. In calculating the fair value of the reporting unit, we use various assumptions including estimated cash flows and discount rates. If estimated future cash flows decline from the current amounts projected by management, an impairment charge may be recorded.

Income Taxes

For the six months ended June 30, 2011, income tax expense recorded represents the estimated income tax liability for certain state income taxes. We believe that it is more likely than not that no benefit or expense will be realized during 2011 for federal income taxes based on estimated federal taxable losses for 2011. We anticipate that federal net operating losses generated during 2011 will be offset by an increase in the valuation allowance against net deferred tax assets.

We follow the threshold of more-likely-than-not for recognition of tax benefits of uncertain tax positions taken or expected to be taken in a tax return. We record accrued interest and penalties associated with uncertain tax positions, if any, as income tax expense in the condensed consolidated statement of operations.

The federal statute of limitations remains open for original tax returns filed for 2007 through 2010. State jurisdictions generally have statutes of limitations ranging from three to five years. The state income tax impact of federal income tax changes remains subject to examination by various states for a period up to one year after formal notification to the states.

Stock Compensation

We estimate the fair value of our equity-based compensation awards on the date of grant, or the date of award modification if applicable, using the Black-Scholes option pricing model. The weighted average fair value of options granted during the six months ended June 30, 2011 was nominal and was calculated based on the following assumptions: expected volatility of 40%, expected dividend yield of 0%, expected life of 6.25 years, and a risk-free interest rate of 3.00%. Expected volatility was derived using data drawn from other healthcare public companies for five to seven years prior to the date of grant. The expected life was computed utilizing the simplified method as permitted by the Securities and Exchange Commission’s Staff Accounting Bulletin No. 110, Share-Based Payment. The expected forfeiture rates are 50% and are based upon a review of our recent history and expectations. The risk-free interest rate is based on the approximate yield on seven-year United States Treasury Bonds as of the date of grant. There were 450,000 options granted during the six months ended June 30, 2011 (see note 6).

Reclassifications

Certain reclassifications have been made to the consolidated financial statements for prior periods to conform to the presentation of the 2011 condensed consolidated financial statements. Such reclassifications had no impact on net income or stockholder’s deficit.

(3) Net Patient Service Revenue

We recognize in our consolidated financial statements the impact of adjustments, if any, to Medicare reimbursement when the amounts can be reasonably determined. Net revenues for the three and six months ended June 30, 2011 included increases of $0.1 million and $0.1 million, respectively, related to changes in estimates and settlements on prior year cost reports filed with the Medicare program, compared to decreases of $3.5 million and $3.6 million for the three and six months ended June 30, 2010, respectively. Approximately 59.8% and 58.6% of our total net patient service revenue for the six months ended June 30, 2011 and 2010, respectively, came from Medicare reimbursement.

(4) Goodwill and Impairment Charges

The Merger agreement provided for additional purchase price considerations that were contingent upon the resolution of certain specific issues. During the three months ended June 30, 2010, goodwill was increased by $3.0 million due to distributions to the prior stockholders of our company from one of the escrow accounts, as the result of the resolution of a specific matter.

(5) Long-Term Debt

Long-term debt consists of the following (in thousands):


	June 30, 2011			December 31, 2010
Current senior secured credit facility—term loan	$	260,837		$	—
Previous senior secured credit facility—term loan		—			241,613
9 ¹/4% senior subordinated notes		119,299			119,299
Revolving credit facility		—			35,000

Total long-term debt		380,136			395,912
Current installments of long-term debt		(2,575	)		(1,931	)

Long-term debt, excluding current installments	$	377,561		$	393,981

New Senior Secured Credit Facility

As a result of the impending maturities and increasingly more restrictive covenant requirements under our existing senior secured credit facility, we entered into a new senior secured credit facility on February 1, 2011, that consisted of (a) an initial $257.5 million senior secured term loan (subject to paid in kind interest options as discussed below) and (b) a senior secured revolving credit facility providing for borrowings of up to $30.0 million (the “Credit Agreement”). Availability of borrowings under the revolving credit facility are reduced by outstanding letters of credit, which were $1.5 million as of June 30, 2011. The proceeds of this new Credit Agreement along with available cash on hand were utilized to pay off our existing senior secured credit facility, revolving credit facility and the fees and expenses associated with the new Credit Agreement.

The terms of the Credit Agreement also provide that we have the right to request additional term loan commitments of up to $50.0 million. The lenders are not required to provide such additional commitments, and any increase in commitments is subject to several conditions precedent and limitations specified in the Credit Agreement, including the consent of the lenders holding a majority of outstanding loans and undrawn commitments. See note 10 discussing the utilization of this right subsequent to June 30, 2011.

Borrowings under the term loan facility of the Credit Agreement bear interest at a rate per annum equal to an applicable margin plus, at our option, either (a) an alternate base rate determined by reference to the highest of (1) the prime rate of JPMorgan Chase Bank, N.A., (2) the federal funds rate in effect on such date plus 1/2 of 1% and (3) the LIBOR rate for a one month interest period plus 1% or (b) a LIBOR rate determined by reference to the cost of funds for U.S. dollar deposits for the relevant interest period adjusted for certain additional costs. The applicable margin percentage is 12.25% for term loans that are alternate base rate loans and 13.25% for term loans based on the LIBOR rate. For the term loans, we may, in our discretion, elect for the relevant interest period (a) to pay the entire amount of interest in cash or (b) to pay 5.50% of such interest “in-kind” by adding such interest to the outstanding principal of the term loans as of the applicable interest payment date. At June 30, 2011 and December 31, 2010, the interest rate applicable to the outstanding amounts under our term loan facility was 13.48% and 4.54%, respectively.

The applicable margin percentage is initially 6.75% for revolving loans that are alternate base loans and 7.75% for revolving loans that are based on the LIBOR rate, subject to quarterly adjustments based on our leverage ratio (as defined in the new senior secured credit agreement). In addition to paying interest on outstanding principal under the senior secured credit agreement, we are required to pay an initial commitment fee of 0.50% per annum in respect of the unutilized commitments under the revolving credit facility, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). We are also required to pay annual customary agency fees.

Beginning in June 2011, we are required to make scheduled quarterly payments under the senior secured term loan facility equal to 0.25% of the original principal amount of the term loan, with the balance payable on February 1, 2016. Additionally, we are required to prepay outstanding term loans under this agreement with (a) 100% of the net cash proceeds of any debt or equity issued by us or our restricted subsidiaries (with exceptions for certain debt permitted to be incurred or equity permitted to be issued under the agreement), (b) commencing with the year ending December 31, 2011, 75% (which percentage will be reduced to 50% if our senior secured leverage ratio (as defined in the Credit Agreement) is less than 4:00 to 1:00) of our annual excess cash flow (as defined in the Credit Agreement), and (c) 100% of the net cash proceeds of certain asset sales or other dispositions of property by us or our restricted subsidiaries, subject to reinvestment rights and certain other exceptions specified in the Credit Agreement. Mandatory prepayments of the term loans, subject to certain exceptions, are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such repayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014.

We may voluntarily prepay outstanding loans under the term loan facility and reduce the unutilized portion of the commitment amount in respect of the senior secured revolving credit facility at any time. Any such voluntary prepayments are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such prepayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014. Other than as described above, prepayments are not subject to any premium or penalty other than customary “breakage” costs with respect to loans based on the LIBOR rate.

The term loan and revolving credit facility under the Credit Agreement have scheduled maturity dates of February 1, 2016, and February 1, 2015, respectively. However, if our outstanding senior subordinated notes are not refinanced, purchased or defeased in full by May 15, 2013, then the term loan and the then outstanding balance under the revolving credit facility will be due in full on May 15, 2013.

The Credit Agreement also imposes certain financial covenants on us including: minimum consolidated EBITDA requirements beginning with the first fiscal quarter of 2011 through the end of the third fiscal quarter of 2011; a maximum ratio of total senior secured indebtedness to consolidated EBITDA tested quarterly, beginning on the last day of the fourth quarter of 2011; and a minimum ratio of consolidated EBITDA to consolidated cash interest expense, tested quarterly beginning on the last day of the fourth fiscal quarter of 2011. We believe we are currently in compliance with the covenants of our senior secured credit facility.

The Credit Agreement is secured by substantially all of our tangible and intangible assets, except for assets held by subsidiaries that have been designated as nonguarantor subsidiaries. The Credit Agreement also contains certain customary representations and warranties, affirmative covenants and events of default, including payment defaults, breach of representations and warranties, covenant defaults, cross defaults to certain material indebtedness, certain events of bankruptcy, certain events under ERISA, change of control, material judgments, failure of certain guaranty documents to be in full force and effect and failure of a lien to have the priority or otherwise be valid and perfected with respect to material collateral.

If we are unable to maintain compliance with the covenants and requirements contained in the Credit Agreement, an event of default could occur, unless we are able to obtain a waiver or enter into an amendment with the senior lenders to revise the covenants and requirements. If any such event of default occurs, the lenders under the Credit Agreement would be entitled to take various actions, including the acceleration of amounts due under the Credit Agreement, terminating access to our revolving credit facility, and all actions permitted to be taken by a secured creditor. If we are required to obtain a waiver or execute an amendment to the Credit Agreement, it is likely we will incur additional fees and expenses, and will be required to pay a higher interest margin on our outstanding indebtedness in subsequent periods. An event of default would have a material adverse effect on our financial position, results of operations and cash flow.

(6) Stock Options

At June 30, 2011, there were 2.9 million shares of common stock of Holdings available under the 2005 Equity Incentive Plan (“Plan”) for stock option grants and other incentive awards, including restricted stock units. Options granted generally have an exercise price equal to the fair market value of the shares on the date of grant and expire 10 years from the date of grant. A restricted stock unit is a contractual right to receive one share of Holdings common stock in the future. Options typically vest one-quarter on each of the first four anniversary dates of the grant and restricted stock units typically vest in three equal annual installments.

For the three months and six months ended June 30, 2011, there was no pre-tax compensation costs related to our stock-based compensation arrangements. Income for the three months and six months ended June 30, 2010 includes $0.1 million and $0.1 million, respectively, of pre-tax compensation costs related to our stock-based compensation arrangements.

The following table summarizes stock option activity during the six months ended June 30, 2011:


	Number of Shares			Weighted average exercise price
Balance at December 31, 2010		2,277,500		$	2.50
Granted		450,000			2.50
Exercised		—			—
Forfeited		(1,000,000	)		2.50
Expired		(2,500	)		2.50

Balance at June 30, 2011		1,725,000		$	2.50

At June 30, 2011, the weighted average remaining contractual life of outstanding options was 7.1 years. There were 1.0 million stock options exercisable at June 30, 2011. At June 30, 2011, the weighted average exercise price of the vested stock options was $2.50, the remaining weighted average contractual life was 6.0 years and they had no intrinsic value. As of June 30, 2011, there was no unrecognized compensation costs related to stock options.

Restricted Stock Awards

In connection with the appointment of our new chairman and chief executive officer, on March 3, 2011, a restricted stock award covering 100,000 shares of our common stock was granted. There was determined to be no grant-date per share fair value for these awards. The shares vest in three equal annual installments beginning on March 24, 2010. On March 17, 2011, we entered into a separation agreement with our previous chief executive officer, which stated that subject to receipt of the release of claims, all of his restricted stock awards would vest upon his last day of employment in June 2011.

As of June 30, 2011, there was no unrecognized compensation costs related to restricted stock awards.

(7) Regulatory Matters

All healthcare providers are required to comply with a significant number of laws and regulations at the federal and state government levels. These laws are extremely complex, and in many instances, providers do not have the benefit of significant regulatory or judicial interpretation as to how to interpret and/or apply these laws and regulations. The U.S. Department of Justice and other federal and state agencies are increasing resources dedicated to regulatory investigations and compliance audits of healthcare providers. As a healthcare provider, we are subject to these regulatory efforts. Healthcare providers that do not comply with these laws and regulations may be subject to civil or criminal penalties, the loss of their licenses, or restriction in their ability to participate in various federal and state healthcare programs. We endeavor to conduct our business in compliance with applicable laws and regulations, including healthcare fraud and abuse laws.

As a result of our hospital’s state licensures and certifications under the Medicare and various Medicaid programs, we are subject to regular reviews, surveys, audits and investigations conducted by, or on the behalf of, the federal and state agencies, including the Centers for Medicare & Medicaid Services (“CMS”), that are responsible for the oversight of these programs. These agencies’ reviews may include reviews or surveys of our compliance with required conditions of participation regulations. The purpose of these surveys is to ensure that healthcare providers are in compliance with governmental requirements, including requirements such as adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse. These surveys may identify deficiencies with conditions of participation which require corrective actions to be made by the hospital within a given timeline. If a hospital is not successful in addressing the deficiencies and conditions in a timely manner, then CMS reserves the right to deem the hospital to be out of compliance with Medicare conditions of participation and may terminate the hospital from participation in the Medicare program. Termination of a hospital from the Medicare program would have a material adverse effect on our results of operations and cash flows.

(8) Commitments and Contingencies

matters all arose from a single event, process or condition. However, our insurance carrier sent reservation of rights letters which challenged, among other things, the application of one retention to the Hurricane Katrina related matters. On June 5, 2009, we reached an agreement with the insurance carrier regarding the reservation of rights matters whereby they would continue to pay all costs, indemnification and related expenses for the Hurricane Katrina claims in consideration for $1.0 million, which was paid by us in three equal installments, on July 1, 2009, March 31, 2010, and March 31, 2011.

We have certain other pending and threatened litigation and claims incurred in the ordinary course of business. We believe (based, in part, on the advice of legal counsel) that the probable resolution of such contingencies will not exceed our insurance coverage and will not materially affect our consolidated financial position, results of operations or liquidity.

(9) Fair Value of Financial Instruments

The carrying amount of cash and cash equivalents, accounts receivable, third-party payor settlements, and accounts payable and accrued expenses approximates fair value because of the short-term maturity of these instruments. The carrying amount of these obligations is a reasonable estimate of fair value.

We follow the guidance for the fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of subjective inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:

Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

Level 2 — Inputs (other than prices included in Level 1) are either directly or indirectly observable, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 — Inputs are unobservable and reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The Senior Secured Credit Facility and the Senior Subordinated Notes are traded in private institutional markets. The carrying amounts of the Senior Secured Credit Facility and the Senior Subordinated Notes were $260.8 million and $119.3 million, respectively, at June 30, 2011. Using available quoted market prices, the fair values of the Senior Secured Credit Facility and the Senior Subordinated Notes were approximately $264.7 million and $98.1 million, respectively, at June 30, 2011. The carrying amounts of the Senior Secured Credit Facility and the Senior Subordinated Notes were $241.6 million and $119.3 million, respectively, at December 31, 2010. Using available quoted market prices, the fair values of the Senior Secured Credit Facility and the Senior Subordinated Notes were approximately $233.8 million and $85.9 million, respectively, at December 31, 2010. The fair values are based on quoted market prices at each balance sheet date; however, these quoted market prices represent Level 2 inputs as the markets in which the Senior Secured Credit Facility and the Senior Subordinated Notes trade are not active. The revolving credit facility had a carrying value of $35.0 million at December 31, 2010. Using available quoted market prices for the Senior Secured Credit Facility as a basis, we estimated the fair market value of the revolving credit facility at $34.5 million at December 31, 2010. This valuation is categorized as a Level 2 in the valuation hierarchy.

(10) Acquisition

On August 1, 2011, we purchased five long-term acute care hospitals (the “Facilities”), which operate at seven locations, from HealthSouth Corporation and certain affiliates of HealthSouth Corporation (collectively, the “Sellers”), pursuant to an Asset Purchase Agreement (the “Purchase Agreement”). According to the Purchase Agreement, we acquired substantially all of the non-real estate assets (excluding accounts receivable and certain other components of working capital) in exchange for a cash purchase price of approximately $42.5 million less the value of working capital associated with the Facilities. We financed the acquisition with a combination of an incremental term loan from our existing senior secured credit facility and cash on hand. In addition, Health Care REIT, Inc. purchased the real estate assets associated with four of these Facilities from the Sellers for $75.0 million. We simultaneously entered into a lease with Health Care REIT, Inc. for these properties as discussed below.

On May 17, 2011, we entered into an amendment, (the “Incremental Amendment”), to our current credit agreement (the “Credit Agreement”), with JPMorgan Chase Bank, N.A., the lenders party thereto, and the other agents named therein. The Incremental Amendment provided for an additional $47.2 million in new senior secured term loans. Proceeds were restricted to (i) payment of consideration for the acquisition of the Facilities, (ii) payment of fees and expenses in connection with the acquisition of the Facilities and (iii) working capital purposes of the Company and its subsidiaries. The new senior secured term loans have the same terms as the outstanding senior secured term loans, including with respect to interest rate, amortization, maturity date and optional and mandatory prepayments. On August 1, 2011, in connection with the completion of the acquisition and the funding of the additional term loan proceeds, we paid a consent fee of $1.4 million to the lenders under the Credit Agreement for consenting to the Incremental Amendment.

On August 1, 2011, we entered into a Second Amended and Restated Master Lease Agreement (the “Second Amended and Restated Lease”) with Health Care REIT, Inc., which includes the real estate properties for two of our existing operations and the four new Facilities discussed previously. The Second Amended and Restated Lease became effective with respect to the hospitals on August 1, 2011 and its initial 15-year term ends on July 31, 2026. The Second Amended and Restated Lease contains an option to renew for one 14-year, 11-month renewal term. The rent for the hospitals under the Second Amended and Restated Lease is computed based upon the Health Care REIT, Inc.’s investment amount allocated to the hospitals multiplied by the greater of (i) the trading yield on the 10-year United States Treasury Note as of August 1, 2011 plus 5.0% or (ii) 9.71%, and is subject to an annual inflation adjustment. The Second Amended and Restated Lease is an “absolute net lease.” In addition, we paid a transaction fee of $750,000 to Health Care REIT, Inc., and an indirect parent of the Company granted a warrant to HealthCare REIT, Inc. to purchase 6.25% of the shares of Parent’s common stock on August 1, 2011, with an exercise price of $0.01 per share.

The Purchase Agreement includes customary representations, warranties and covenants. Under the Purchase Agreement, the Sellers have agreed, subject to certain exceptions, that they will not compete with our business for four (4) years following the closing by owning or having any other interest in long-term acute care hospitals within a 50 mile radius of any of the Facilities, and we have agreed not to convert any of the Facilities from long-term acute care hospitals to inpatient rehabilitation facilities for a period of four (4) years after closing. Subject to certain limitations and exceptions, the Sellers have agreed to indemnify us in respect of breaches of representations, warranties and covenants of the Sellers in the Purchase Agreement and liabilities that are not assumed us, and we have agreed to indemnify the Sellers in respect of breaches of representations, warranties and covenants of the Company in the Purchase Agreement and liabilities assumed us. We have agreed to guaranty our obligations under the Purchase Agreement and HealthSouth Corporation has agreed to guaranty the obligations of the Sellers under the Purchase Agreement.

The information for the proforma results of operation of the combined facilities and the assets acquired and liabilities assumed are not yet available for presentation. We will provide the required information, when available, in the Form 8-K.

The results of operations of the Facilities will be included in our consolidated results of operations beginning August 1, 2011. The assets acquired and liabilities assumed of the Facilities will be recognized at their acquisition date fair values. The allocation of the purchase price to the assets acquired and liabilities assumed of the Facilities (and the related estimated lives of depreciable tangible and identifiable intangible assets) will require a significant amount of judgment. Such allocation of the purchase price will be determined based upon analysis to be performed, which is expected to be completed no later than July 31, 2012. Any premium paid by us in this transaction is attributable to strategic benefits, including enhanced financial and operational scale, and market diversification. No goodwill associated with this transaction is deductible for income tax purposes.

(11) Financial Information for Subsidiary Guarantors and Nonguarantor Subsidiaries under the Senior Subordinated Notes

The senior subordinated notes are fully and unconditionally guaranteed by substantially all of our wholly-owned subsidiaries (the “Subsidiary Guarantors”), however, certain of our subsidiaries did not guarantee the senior subordinated notes (the Nonguarantor Subsidiaries”).

Presented below is condensed consolidating financial information for LifeCare Holdings, Inc., the Subsidiary Guarantors, and the Nonguarantor Subsidiaries for the three and six months ended at June 30, 2011 and 2010. The equity method has been used with respect to investments in subsidiaries. Separate financial statements of the Subsidiary Guarantors are not presented.

LifeCare Holdings, Inc.

Condensed Consolidating Balance Sheet

June 30, 2011

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated Totals
Assets
Current assets:
Cash and cash equivalents	$	—		$	19,921		$	1		$	—		$	19,922
Accounts receivable, net of allowance for doubtful accounts		—			65,858			4,151			—			70,009
Due to/from related parties		16,653			(12,471	)		(4,182	)		—			—
Other current assets		—			5,888			711			—			6,599

Total current assets		16,653			79,196			681			—			96,530
Investment in subsidiaries		341,563			—			—			(341,563	)		—
Property and equipment, net		—			53,688			20,898			—			74,586
Other assets, net		16,752			1,482			2,859			—			21,093
Identifiable intangibles, net		—			15,440			—			—			15,440
Goodwill		—			248,342			—			—			248,342

Total assets	$	374,968		$	398,148		$	24,438		$	(341,563	)	$	455,991


Liabilities and Stockholder’s Equity (Deficit)
Current liabilities:
Current installments of long-term debt	$	2,575		$	—		$	—		$	—		$	2,575
Current installments of obligations under capital leases		—			511			85			—			596
Current installments of lease financing obligation		—			—			499			—			499
Estimated third party payor settlements		—			257			2,816			—			3,073
Accounts payable		106			23,833			1,008			—			24,947
Accrued payroll		—			5,429			240			—			5,669
Accrued vacation		—			5,604			211			—			5,815
Accrued interest		8,938			—			—			—			8,938
Accrued other		—			4,639			149			—			4,788
Income taxes payable		—			389			(6	)		—			383

Total current liabilities		11,619			40,662			5,002			—			57,283

Long-term debt, excluding current installments		377,561			—			—			—			377,561
Obligations under capital leases, excluding current installments		—			44			11			—			55
Lease financing obligation, excluding current installments		—			—			19,303			—			19,303
Accrued insurance		—			4,754			—			—			4,754
Other noncurrent liabilities		5,500			11,247			—			—			16,747

Total liabilities		394,680			56,707			24,316			—			475,703

Stockholder’s equity (deficit):

Common stock		—			—			—			—			—
Additional paid-in capital		175,441			63			12,580			(12,643	)		175,441
Retained earnings (accumulated deficit)		(195,153	)		341,378			(12,458	)		(328,920	)		(195,153	)

Total stockholder’s equity (deficit)		(19,712	)		341,441			122			(341,563	)		(19,712	)

	$	374,968		$	398,148		$	24,438		$	(341,563	)	$	455,991

LifeCare Holdings, Inc.

Condensed Consolidating Balance Sheet

December 31, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated Totals
Assets
Current assets:
Cash and cash equivalents	$	—		$	54,569		$	1		$	—		$	54,570
Accounts receivable, net of allowance for doubtful accounts		—			61,661			5,614			—			67,275
Due to/from related parties		71,188			(65,528	)		(5,660	)		—			—
Other current assets		—			5,551			424			—			5,975

Total current assets		71,188			56,253			379			—			127,820
Investment in subsidiaries		321,277			—			—			(321,277	)		—
Property and equipment, net		—			55,338			21,494			—			76,832
Other assets, net		4,023			2,356			2,384			—			8,763
Identifiable intangibles, net		—			15,440			—			—			15,440
Goodwill		—			248,342			—			—			248,342

Total assets	$	396,488		$	377,729		$	24,257		$	(321,277	)	$	477,197


Liabilities and Stockholder’s Equity (Deficit)
Current liabilities:
Current installments of long-term debt	$	1,931		$	—		$	—		$	—		$	1,931
Current installments of obligations under capital leases		—			690			148			—			838
Current installments of lease financing obligation		—			—			480			—			480
Estimated third party payor settlements		—			2,058			2,260			—			4,318
Accounts payable		382			24,183			887			—			25,452
Accrued payroll		—			6,224			256			—			6,480
Accrued vacation		—			4,486			172			—			4,658
Accrued interest		6,377			—			—			—			6,377
Accrued other		—			4,170			151			—			4,321
Income taxes payable		(203	)		485			—			—			282

Total current liabilities		8,487			42,296			4,354			—			55,137

Long-term debt, excluding current installments		393,981			—			—			—			393,981
Obligations under capital leases, excluding current installments		—			399			26			—			425
Lease financing obligation, excluding current installments		—			—			19,558			—			19,558
Accrued insurance		—			4,032			—			—			4,032
Deferred income taxes		5,500			—			—			—			5,500
Other noncurrent liabilities		—			10,044			—			—			10,044

Total liabilities		407,968			56,771			23,938			—			488,677

Stockholder’s equity (deficit):

Common stock		—			—			—			—			—
Additional paid-in capital		175,441			63			12,580			(12,643	)		175,441
Retained earnings (accumulated deficit)		(186,921	)		320,895			(12,261	)		(308,634	)		(186,921	)

Total stockholder’s equity (deficit)		(11,480	)		320,958			319			(321,277	)		(11,480	)

	$	396,488		$	377,729		$	24,257		$	(321,277	)	$	477,197

LifeCare Holdings, Inc.

Condensed Consolidating Statement of Operations

For the Three Months Ended June 30, 2011

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated Totals

Net patient service revenue	$	—		$	91,059		$	4,933		$	—		$	95,992


Salaries, wages and benefits		3			42,907			2,104			—			45,014
Supplies		—			9,133			391			—			9,524
Rent		—			6,489			231			—			6,720
Other operating expenses		131			20,895			1,158			—			22,184
Provision for doubtful accounts		—			1,162			79			—			1,241
Depreciation and amortization		—			1,752			306			—			2,058
Intercompany (income) expenses		570			(902	)		332			—			—
Interest expense, net		13,546			(14	)		407			—			13,939


Total expenses		14,250			81,422			5,008			—			100,680


Operating income (loss)		(14,250	)		9,637			(75	)		—			(4,688	)
Earnings in investments in subsidiaries		(9,620	)		—			—			9,620			—
Equity in income of joint venture		—			—			283			—			283


Income (loss) before income taxes		(4,630	)		9,637			208			(9,620	)		(4,405	)
Provision for income taxes		—			225			—			—			225


Net income (loss)	$	(4,630	)	$	9,412		$	208		$	(9,620	)	$	(4,630	)

LifeCare Holdings, Inc.

Condensed Consolidating Statement of Operations

For the Six Months Ended June 30, 2011

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries		Eliminations			Consolidated Totals

Net patient service revenue	$	—		$	180,721		$	10,190	$	—		$	190,911


Salaries, wages and benefits		6			85,304			4,104		—			89,414
Supplies		—			18,057			757		—			18,814
Rent		—			12,752			441		—			13,193
Other operating expenses		373			40,082			2,486		—			42,941
Provision for doubtful accounts		—			2,423			163		—			2,586
Loss on early extinguishment of debt		2,772			—			—		—			2,772
Depreciation and amortization		—			3,549			625		—			4,174
Intercompany (income) expenses		1,668			(2,359	)		691		—			—
Interest expense, net		24,491			(20	)		804		—			25,275


Total expenses		29,310			159,788			10,071		—			199,169


Operating income (loss)		(29,310	)		20,933			119		—			(8,258	)
Earnings in investments in subsidiaries		(21,078	)		—			—		21,078			—
Equity in income of joint venture		—			—			476		—			476


Income (loss) before income taxes		(8,232	)		20,933			595		(21,078	)		(7,782	)
Provision for income taxes		—			450			—		—			450


Net income (loss)	$	(8,232	)	$	20,483		$	595	$	(21,078	)	$	(8,232	)

LifeCare Holdings, Inc. and Subsidiaries

Condensed Consolidating Statement of Operations

For the Three Months Ended June 30, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries		Eliminations			Consolidated Totals

Net patient service revenue	$	—		$	84,770		$	5,863	$	—		$	90,633


Salaries, wages and benefits		76			40,758			1,835		—			42,669
Supplies		—			8,983			330		—			9,313
Rent		—			6,174			222		—			6,396
Other operating expenses		272			18,726			1,241		—			20,239
Provision for doubtful accounts		—			1,728			101		—			1,829
Depreciation and amortization		—			2,212			325		—			2,537
Intercompany (income) expenses		3,697			(4,115	)		418		—			—
Interest expense, net		6,512			179			398		—			7,089


Total expenses		10,557			74,645			4,870		—			90,072


Operating income (loss)		(10,557	)		10,125			993		—			561
Earnings in investments in subsidiaries		(11,249	)		—			—		11,249			—
Equity in income of joint venture		—			—			356		—			356


Income (loss) before income taxes		692			10,125			1,349		(11,249	)		917
Provision for income taxes		—			225			—		—			225


Net income (loss)	$	692		$	9,900		$	1,349	$	(11,249	)	$	692

LifeCare Holdings, Inc. and Subsidiaries

Condensed Consolidating Statement of Operations

For the Six Months Ended June 30, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries		Eliminations			Consolidated Totals

Net patient service revenue	$	—		$	173,135		$	12,458	$	—		$	185,593


Salaries, wages and benefits		152			80,464			3,554		—			84,170
Supplies		—			17,759			793		—			18,552
Rent		—			12,472			451		—			12,923
Other operating expenses		546			38,150			2,440		—			41,136
Provision for doubtful accounts		—			3,205			213		—			3,418
Depreciation and amortization		—			4,421			665		—			5,086
Intercompany (income) expenses		3,847			(4,759	)		912		—			—
Interest expense, net		13,047			254			793		—			14,094


Total expenses		17,592			151,966			9,821		—			179,379


Operating income (loss)		(17,592	)		21,169			2,637		—			6,214
Earnings in investments in subsidiaries		(23,816	)		—			—		23,816			—
Equity in income of joint venture		—			—			410		—			410


Income (loss) before income taxes		6,224			21,169			3,047		(23,816	)		6,624
Provision for income taxes		—			400			—		—			400


Net income (loss)	$	6,224		$	20,769		$	3,047	$	(23,816	)	$	6,224

LifeCare Holdings, Inc.

Condensed Consolidating Statement of Cash Flows

For the Six Months Ended June 30, 2011

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income (loss)	$	(8,232	)	$	20,483		$	595		$	(21,078	)	$	(8,232	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization (including amortization of debt issuance cost)		3,175			4,173			—			—			7,348
Provision for doubtful accounts		—			2,423			163			—			2,586
Paid in kind interest		3,980			—			—			—			3,980
Loss on early extinguishment of debt		2,772			—			—			—			2,772
Equity in income of joint venture		—			—			(476	)		—			(476	)
Changes in operating assets and liabilities:
Accounts receivable		—			(6,620	)		1,300			—			(5,320	)
Income taxes		—			101			—			—			101
Other current assets		—			(337	)		(287	)		—			(624	)
Change in investments in subsidiaries		(21,078	)		—			—			21,078			—
Other assets		—			85			—			—			85
Due to/from related parties		54,733			(52,456	)		(2,277	)		—			—
Estimated third party payor settlements		—			(1,801	)		556			—			(1,245	)
Accounts payable and accrued liabilities		2,291			434			144			—			2,869
Other noncurrent liabilities		—			1,925			—			—			1,925


Net cash provided by (used in) operating activities		37,641			(31,590	)		(282	)		—			5,769


Cash flows from investing activities:
Purchases of property and equipment		—			(2,524	)		596			—			(1,928	)


Net cash used in investing activities		—			(2,524	)		596			—			(1,928	)


Cash flows from financing activities:
Deferred financing costs		(17,885	)		—			—			—			(17,885	)
Payments under the line of credit		(35,000	)		—			—			—			(35,000	)
Proceeds from long-term debt		257,500			—			—			—			257,500
Payments of long-term debt		(242,256	)		—			—			—			(242,256	)
Payments on obligations under capital leases		—			(534	)		(78	)		—			(612	)
Payments on lease financing obligation		—			—			(236	)		—			(236	)


Net cash used in financing activities		(37,641	)		(534	)		(314	)		—			(38,489	)


Net decrease in cash and cash equivalents		—			(34,648	)		—			—			(34,648	)
Cash and cash equivalents, beginning of period		—			54,569			1			—			54,570


Cash and cash equivalents, end of period	$	—		$	19,921		$	1		$	—		$	19,922

LifeCare Holdings, Inc. and Subsidiaries

Condensed Consolidating Statement of Cash Flows

For the Six Months Ended June 30, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income (loss)	$	6,224		$	20,769		$	3,047		$	(23,816	)	$	6,224
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		1,149			4,421			665			—			6,235
Provision for doubtful accounts		—			3,205			213			—			3,418
Equity compensation amortization		146			—			—			—			146
Equity in income of joint venture		—			—			(410	)		—			(410	)
Changes in operating assets and liabilities:
Accounts receivable		—			(2,659	)		(171	)		—			(2,830	)
Income taxes		—			(276	)		—			—			(276	)
Prepaid expenses and other current assets		—			241			(108	)		—			133
Change in investments in subsidiaries		(23,816	)		—			—			23,816			—
Other assets		—			334			—			—			334
Due to/from related parties		17,775			(14,982	)		(2,793	)		—			—
Estimated third party payor settlements		—			(5,386	)		256			—			(5,130	)
Accounts payable and accrued expenses		(203	)		(4,268	)		(238	)		—			(4,709	)
Other liabilities		—			4,020			—			—			4,020


Net cash provided by operating activities		1,275			5,419			461			—			7,155


Cash flows from investing activities:
Purchases of property and equipment		—			(1,217	)		(138	)		—			(1,355	)


Net cash used in investing activities		—			(1,217	)		(138	)		—			(1,355	)


Cash flows from financing activities:
Payments of long-term debt		(1,275	)		—			—			—			(1,275	)
Payments on obligations under capital leases		—			(477	)		(106	)		—			(583	)
Payments on lease financing obligation		—			—			(217	)		—			(217	)


Net cash used in financing activities		(1,275	)		(477	)		(323	)		—			(2,075	)


Net increase in cash and cash equivalents		—			3,725			—			—			3,725

Cash and cash equivalents, beginning of period		—			46,680			1			—			46,681


Cash and cash equivalents, end of period	$	—		$	50,405		$	1		$	—		$	50,406

ITEM 2:

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

This discussion and analysis should be read in conjunction with our condensed consolidated financial statements and the accompanying notes.

Company Overview

We began operations in 1993 and have grown our business through developing and acquiring hospitals to become a leading operator of long-term acute care (“LTAC”) hospitals in the United States. As of June 30, 2011, we operated 20 hospitals located in nine states, consisting of eight “hospital within a hospital” facilities (27% of beds) and 12 freestanding facilities (73% of beds). Through these 20 long-term acute care hospitals, we operate a total of 1,057 licensed beds and employ approximately 3,400 people, the majority of whom are registered or licensed nurses and respiratory therapists. Additionally, we hold a 50% investment in a joint venture for a 51-bed LTAC hospital located in Muskegon, Michigan.

We believe we have developed a reputation for excellence in providing treatment for patients with complex medical needs requiring extended treatment. Our patients have serious medical conditions such as respiratory failure, chronic pulmonary disease, nervous system disorders, infectious diseases and severe wounds. They generally require a high level of monitoring and specialized care, yet may not require the continued services of an intensive care unit. Due to their serious medical conditions, our patients are generally not clinically appropriate for admission to a skilled nursing facility or inpatient rehabilitation facility. By combining general acute care services with a focus on long-term treatment, we believe that our hospitals provide medically complex patients with better and more cost-effective outcomes.

Recent Trends and Events

Hospital Openings and Closings

On October 16, 2010, we relocated an existing campus including 35 beds in our Pittsburgh market to a new location in the market, and on November 19, 2010, we opened a third hospital campus in Pittsburgh with 32 beds that we reallocated from our existing licensed and LTAC certified beds in the market.

Second Amended and Restated Lease is an “absolute net lease.” In addition, we paid a transaction fee of $750,000 to Health Care REIT, Inc., and an indirect parent of the Company granted a warrant to HealthCare REIT, Inc. to purchase 6.25% of the shares of Parent’s common stock on August 1, 2011, with an exercise price of $0.01 per share.

Upon the completion of the acquisition, we operated 27 hospitals located in ten states.

Regulatory Changes

Approximately 59.8% and 58.6% of our total net patient service revenue for the six months ended June 30, 2011 and 2010, respectively, came from Medicare reimbursement. Our industry is subject to extensive government regulation, including regulation of the Medicare reimbursement process. Changes in these regulations can have a material impact on the way we operate our business and on our results of operations.

The 2011 Final Rule

On August 1, 2011, the Centers for Medicare & Medicaid Services (“CMS”) published their annual payment update for LTAC hospitals for the 2012 rate year, which will become effective for all discharges on or after October 1, 2011 (the “2011 Final Rule”). The 2011 Final Rule includes a net increase in the standard federal rate of $623 to $40,222, or 1.6%, which is based on a market basket update of 2.9% less a 0.22% area wage level budget neutrality factor and the two adjustments required by the Patient Protection and Affordable Care Act: the multifactor productivity (“MFP”) adjustment of 1.0% and statutory payment rate reduction of 0.1%. The 2011 Final Rule also includes a decrease in the high-cost outlier fixed-loss amount to $17,931 from $18,785. Additionally, the 2011 Final Rule includes updates to the weighting of Medicare-Severity Diagnosis Related Groups (“MS-LTC-DRG”). CMS has estimated that the changes outlined above for the 2012 rate year, taken as a whole, will result in an increase of 2.5% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of the 2011 Final Rule depending upon their Medicare patient population and their specific base rate changes due to geographical location. The 2011 Final Rule also establishes a new quality reporting program for LTAC hospitals in accordance with provisions of the Affordable Care Act and clarifies CMS’ position that Medicare Advantage (“MA”) days, along with traditional Medicare fee-for-service program days, are to be included in the determination of whether an LTAC hospital meets the greater than 25 day average length of stay requirement. Furthermore, the 2011 Final Rule extends the application of the LTAC bed moratorium to LTAC hospitals developed under exceptions to the LTAC facility moratorium and proposes a rebasing of the market basket used by LTCH hospitals.

The 2010 Final Rule

On July 30, 2010, CMS published their annual payment update for LTAC hospitals for the 2011 rate year, which became effective for all discharges on or after October 1, 2010 (the “2010 Final Rule”). The 2010 Final Rule included a net decrease in the standard federal rate of $195, or 0.5%, to $39,600, which was based on a market basket update of 2.5% less an adjustment of 0.5% as required by the Patient Protection and Affordable Care Act (“PPACA”) of 2010, discussed below, and less an adjustment of 2.5% to account for changes in documentation and coding practices. The 2010 Final Rule also included an increase in the high-cost outlier fixed-loss amount to $18,785 from $18,615. Additionally, the 2010 Final Rule included updates to the weighting of MS-LTC-DRGs, which CMS indicated will be budget neutral for aggregate LTAC hospital payments. CMS also estimated that the changes for the 2011 rate year, taken as a whole, including changes to the area wage adjustments for the 2011 rate year, an increase in high-cost outlier

payments and an increase in short-stay outlier payments, would result in an increase of 0.5% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of the 2010 Final Rule depending upon their Medicare patient population and their specific base rate changes due to geographical location.

2010 Healthcare Reform Law

On March 23, 2010, the President signed into law the PPACA. This act made dramatic changes to the Medicare and Medicaid programs by adopting numerous initiatives intended to improve the quality of healthcare, promote patient safety, reduce the cost of healthcare, increase transparency and reduce fraud and abuse of federal healthcare programs. Additionally, on March 30, 2010, the President signed the Health Care and Education Affordability Reconciliation Act of 2010, which made certain amendments to the law signed by the President on March 23, 2010.

The PPACA, together with the Health Care and Education Affordability Reconciliation Act of 2010, also made changes to the Medicare program relevant to the LTAC industry, including the following key provisions, among other things:

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a two-year extension of the LTAC provisions originally included in the Medicare, Medicaid and SCHIP Extension Act of 2007 (the “SCHIP Extension Act”),

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the implementation of quality reporting requirements for LTAC hospitals beginning in rate year 2014,

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reductions in the annual market basket rate increases of 0.25% for rate year 2010, and ranging from 0.1% to 0.75% for rate years beginning 2011 through 2019,

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additional reductions in the annual market basket rate increases as the result of productivity adjustments beginning in 2012, which are expected to approximate 1% annually, and

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the development of a new hospital wage index system to replace the current system of calculating the hospital wage index based on cost report data.

In addition, the PPACA created an “Independent Payment Advisory Board” to develop and submit proposals to the President and Congress designed to reduce Medicare spending, and provided for pilot programs to explore a bundled payment system for an episode of care that includes an inpatient stay in a hospital and post-acute care provided within 30 days after discharge.

The 2009 Final Rule

On July 31, 2009, CMS issued its final annual payment update for LTAC hospitals for the 2010 rate year, which became effective for all discharges on or after October 1, 2009 (the “2009 Final Rule”). The 2009 Final Rule included a net increase in the standard federal rate of $783 to $39,897, or 2.0%, which was based on a market basket update of 2.5% less an adjustment of 0.5% to account for changes in documentation and coding practices. The 2009 Final Rule also included a decrease in the high-cost outlier fixed-loss amount to $18,425 from $22,960. Additionally, the 2009 Final Rule included updates to the weighting of MS-LTC-DRGs, which CMS indicated will be budget neutral for aggregate LTAC hospital payments. CMS estimated that the changes for the 2010 rate year, taken as a whole, will result in an increase of 3.3% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of this rule depending upon their Medicare patient population and changes to their specific standard federal rate due to geographical location.

The 2009 Final Rule also finalized the interim final rule issued on June 3, 2009, as well as the June 3, 2009 supplement to the proposed rule previously published by CMS on May 1, 2009. This rule updated the rate year 2010 LTAC- Prospective Payment System (“PPS”) payments by revising the table of MS-LTC-DRG relative weights for the rate year 2010, which was based on the amended fiscal year 2009 weights. These changes have been taken into account in CMS’s impact calculations outlined above.

Regulatory Matters

Periodically CMS will conduct surveys of hospitals and other health care providers as a condition of participation in the Medicare program. The purpose of these surveys is to ensure that healthcare providers are in compliance with various governmental requirements related to adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse.

Sources of Revenue

We are reimbursed for our services provided to patients by a number of sources, including the federal Medicare program and commercial payors. Payment arrangements include prospectively determined rates per discharge, reimbursed costs, discounted charges and per diem rates. Our net patient service revenue consists of the amounts that we estimate to be reimbursable from each of the applicable non-governmental payors and the Medicare and Medicaid programs. We account for the differences between the estimated reimbursement rates and our standard billing rates as contractual adjustments, which are deducted from gross revenues to arrive at net revenues. We record accounts receivable resulting from such payment arrangements net of contractual allowances. Net patient service

revenues generated directly from the Medicare program approximated 59.8% and 58.6% of total net patient service revenue for the six months ended June 30, 2011 and 2010, respectively. Net patient service revenues generated from non-Medicare payors were substantially from commercial payors.

Laws and regulations governing provider reimbursement pursuant to the Medicare program are complex and subject to interpretation. The Medicare reimbursement amounts reported in our financial statements are based upon estimates and, as such, are subject to adjustment until such time as our billings and cost reports are filed and settled with the appropriate regulatory authorities. Federal regulations require that providers participating in the Medicare program submit annual cost reports associated with services provided to program beneficiaries. In addition, payments under LTAC hospital PPS are subject to review by the regulatory authorities, including enhanced medical necessity reviews pursuant to the SCHIP Extension Act and the Recovery Audit Contractor (“RAC”) program pursuant to the Tax Relief and Health Care Act of 2006. These reviews primarily focus on the accuracy of the MS-LTC-DRG assigned to each discharged patient and normally occur after the completion of the billing process.

The annual cost reports are subject to review and adjustment by CMS through its fiscal intermediaries. These reviews may not occur until several years after a provider files its cost reports and often results in adjustments to amounts reported by providers in their cost reports as a result of the complexity of the regulations and the inherent judgment that is required in the application of certain provisions of provider reimbursement regulations. Since these reviews of filed cost reports occur periodically, there is a possibility that recorded estimated Medicare reimbursement reflected in our consolidated financial statements and previously filed cost reports may change by a material amount in future periods. We recognize in our consolidated financial statements the impact of adjustments, if any, to estimated Medicare reimbursement when the amounts can be reasonably determined.

Total Expenses

Total expenses consist of salaries, wages and benefits, supplies, which includes expenses related to drug and medical supplies, rent, other operating expenses, provision for doubtful accounts, depreciation and amortization and interest expense. Other operating expenses include expenses such as contract labor, legal and accounting fees, insurance and contracted services purchased from host hospitals.

Other Operating Metrics

We use certain operating metrics in the management of our facility operations. These include:

Licensed beds. Licensed beds represent beds for which a facility has been granted approval to operate from the applicable state licensing agency. These licensed beds are used in the determination of average licensed beds and occupancy rates.

Average licensed beds. We compute average licensed beds by computing a weighted average based upon the number of licensed beds in place for each month within the reporting period.

Admissions. Admissions are the total number of patients admitted to our facilities during the reporting period.

Patient days. Patient days are the cumulative number of days that licensed beds are occupied in our facilities for the entire reporting period. We also refer to patient days as our census.

Average length of stay (days). We compute average length of stay in days by dividing patient days for discharged patients by discharges.

Occupancy rates. We compute our occupancy rate by determining the percentage of average licensed beds that are occupied for a 24-hour period during a reporting period. The occupancy rate provides a measure of the utilization of inpatient rooms.

Net patient service revenue per patient day. This measure is determined by dividing our total net patient service revenue by the number of patient days in a reporting period. We use this metric to provide a measure of the net patient service revenue generated for each patient day.

Critical Accounting Matters

This discussion and analysis of our financial condition and results of operation is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of those financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures. We rely on historical experience and other assumptions that we believe are reasonable at the time in forming the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts may differ from these estimates.

We believe that the following critical accounting policies as more fully described in our annual financial statements as of December 31, 2010 as filed in the Form 10-K, affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

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Revenue recognition

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Accounts receivable and allowance for doubtful accounts

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Insurance risks

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Impairment of long-lived assets

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Accounting for income taxes

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Goodwill

Results of Operations

The following table sets forth operating results for each of the periods presented (in thousands):


	Three Months Ended June 30					Six Months Ended June 30
	2011			2010		2011			2010
Net patient service revenue	$	95,992		$	90,633	$	190,911		$	185,593
Salaries, wages and benefits		45,014			42,669		89,414			84,170
Supplies		9,524			9,313		18,814			18,552
Rent		6,720			6,396		13,193			12,923
Other operating expenses		22,184			20,239		42,941			41,136
Provision for doubtful accounts		1,241			1,829		2,586			3,418
Loss on early extinguishment of debt		—			—		2,772			—
Depreciation and amortization		2,058			2,537		4,174			5,086
Interest expense, net		13,939			7,089		25,275			14,094

Total expenses		100,680			90,072		199,169			179,379

Operating income (loss)		(4,688	)		561		(8,258	)		6,214
Equity in income of joint venture		283			356		476			410

Income (loss) before income taxes		(4,405	)		917		(7,782	)		6,624
Provision for income taxes		225			225		450			400

Net income (loss)	$	(4,630	)	$	692	$	(8,232	)	$	6,224

Operating Statistics

The following table sets forth operating statistics for each of the periods presented.


	Three Months Ended June 30						Six Months Ended June 30
	2011			2010			2011			2010
Number of hospitals within hospitals (end of period)		8			8			8			8
Number of freestanding hospitals (end of period)		12			11			12			11
Number of total hospitals (end of period)		20			19			20			19
Licensed beds (end of period)		1,057			1,057			1,057			1,057
Average licensed beds ⁽¹⁾		1,057			1,058			1,057			1,058
Admissions		2,028			2,000			4,136			4,090
Patient days		59,859			57,996			119,894			117,248
Occupancy rate		62.2	%		60.2	%		62.7	%		61.2	%
Percent net patient service revenue from Medicare		59.7	%		56.0	%		59.8	%		58.6	%
Percent net patient service revenue from commercial payors and Medicaid ⁽²⁾		40.3	%		44.0	%		40.2	%		41.4	%
Net patient service revenue per patient day	$	1,604		$	1,563		$	1,592		$	1,583

(1)	The average licensed beds are only calculated on the beds at locations that were open for operations during the applicable periods.

(2)	The percentage of net patient service revenue from Medicaid is less than three percent for each of the periods presented.

Three Months Ended June 30, 2011 Compared to Three Months Ended June 30, 2010

Net Revenues

Our net patient service revenue of $96.0 million for the three months ended June 30, 2011, increased $5.4 million, or 5.9%, from $90.6 million in the comparable period in 2010. Patient days in the 2011 period were 1,863, or 3.2%, greater than the same period in 2010, while admissions were 28, or 1.4%, more than the same period in 2010.

The increase in net patient service revenue of $5.4 million during the 2011 period was attributable to a favorable variance of $3.1 million as the result of the increase in patient days and a net increase of $3.4 million attributable to a decrease in adjustments related to changes in estimates and settlements on cost reports filed with the Medicare program, offset by an unfavorable variance of $1.1 million attributable to a decrease in net patient service revenue on a per patient day basis. During the three months ended June 30, 2011 and 2010, we recorded reductions in net patient service revenue of $0.1 million and $3.5 million, respectively, related to changes in estimates and settlements on cost reports filed with the Medicare program.

During the three months ended June 30, 2011 and 2010, our net patient service revenue per patient day was $1,604 and $1,563, respectively. However, exclusive of the cost report reimbursement adjustments, net patient service revenue per patient day for the three months ended June 30, 2011 and 2010 was $1,604 and $1,624, respectively, or a decrease of 1.2%, primarily a result of a marginal decrease in reimbursement from non-Medicare payors during the period.

Total Expenses

Total expenses increased by $10.6 million to $100.7 million for the three months ended June 30, 2011, as compared to the same period in 2010. This increase was primarily attributable to an increase of $6.9 million in net interest expense and an increase of $2.3 million in salary, wages and benefits. The increase in net interest expense was the result of the higher margin rate associated with the new senior secured credit agreement. The increase in salary, wages and benefits was primarily related to the increase in patient days during the period, the fixed staffing costs associated with our new hospital campus in Pittsburgh, higher group health benefit expenses during the period and annual inflationary increases.

Income Tax Expense

For the three months ended June 30, 2011, income tax expense recorded represents the estimated income tax liability for certain state income taxes. We believe that it is more likely than not that no benefit or expense will be realized during 2011 for federal income taxes based on estimated federal taxable losses for 2011. We anticipate that federal net operating losses generated during 2011 will be offset by an increase in the valuation allowance against net deferred tax assets.

Six Months Ended June 30, 2011 Compared to Six Months Ended June 30, 2010

Net Revenues

Our net patient service revenue of $190.9 million for the six months ended June 30, 2011, increased $5.3 million, or 2.9%, from $185.6 million in the comparable period in 2010. Patient days in the 2011 period were 2,646, or 2.3%, greater than the same period in 2010, while admissions were 46, or 1.1%, more than the same period in 2010.

The increase in net patient service revenue of $5.3 million during the 2011 period was attributable to a favorable variance of $4.3 million as the result of the increase in patient days and a net increase of $3.5 million attributable to a decrease in adjustments related to changes in estimates and settlements on cost reports filed with the Medicare program, offset by an unfavorable variance of $2.5 million attributable to a decrease in net patient service revenue on a per patient day basis. During the six months ended June 30, 2011 and 2010 we recorded reductions in net patient service revenue of $0.1 million and $3.6 million, respectively, related to changes in estimates and settlements on cost reports filed with the Medicare program.

During the six months ended June 30, 2011 and 2010, our net patient service revenue per patient day was $1,592 and $1,583, respectively. However, exclusive of the cost report reimbursement adjustments, net patient service revenue per patient day for the six months ended June 30, 2011 and 2010 was $1,593 and $1,614, respectively, or a decrease of 1.3%, primarily a result of a marginal decrease in reimbursement from non-Medicare payors during the period.

Total Expenses

Total expenses increased by $19.8 million to $199.2 million for the six months ended June 30, 2011, as compared to $179.4 million for the comparable period in 2010. This increase was primarily attributable to increases in net interest expense of $11.2 million and salaries, wages and benefits of $5.2 million and a $2.8 million loss related to the write-off of deferred financing cost as a result of the refinancing of the senior secured credit facility during the period. The increase in net interest expense was the result of the higher margin rate associated with the new senior secured credit agreement. The increase in salaries, wages and benefits primarily related to the increase in patient days during the period, the fixed staffing costs associated with our new hospital campus in Pittsburgh, higher group health benefit expenses during the period and annual inflationary increases.

Income Tax Expense

Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, expected cash flows generated by operations, and availability of borrowings under a revolving credit facility. Availability of borrowings under our revolving credit facility are generally dependent upon our ability to meet the maximum leverage ratio test included in the senior secured credit facility. Our primary liquidity requirements are for debt service on our senior secured credit facilities and the notes, capital expenditures and working capital.

As a result of the impending maturities and increasingly more restrictive covenant requirements under our previous senior secured credit facility, we completed a refinancing of our previous senior secured credit facility with a new senior secured credit facility that consisted of an initial $257.5 million senior secured term loan (subject to paid in kind interest options as discussed below) and a new $30.0 million senior secured revolving credit facility on February 1, 2011 (the “Credit Agreement”). The proceeds of this new Credit Agreement along with available cash on hand were utilized to pay off our existing senior secured credit facility and revolving credit facility and the fees and expenses associated with the new Credit Agreement.

The terms of the Credit Agreement also provide that we have the right to request additional term loan commitments of up to $50.0 million. The lenders are not required to provide such additional commitments, and any increase in commitments is subject to several conditions precedent and limitations specified in the Credit Agreement, including the consent of the lenders holding a majority of outstanding loans and undrawn commitments. This right was exercised in connection with the HealthSouth acquisition , which occurred on August 1, 2011, as previously discussed.

At June 30, 2011, our debt structure consisted of $119.3 million aggregate principal amount of senior subordinated notes, a senior secured credit facility, consisting of (i) a term loan facility in an outstanding principal amount of $260.8 million, which matures on February 1, 2016, and (ii) a $30.0 million revolving credit facility, subject to availability, of which none was outstanding, including sub-facilities for letters of credit, of which $1.5 million was outstanding, which matures on February 1, 2015. Availability of borrowings under the revolving credit facility are reduced by outstanding letters of credit. We also had capital lease obligations of $0.7 million with varying maturities. The full amount available under the initial term loan facility was used in connection with the February 1, 2011 refinancing.

Borrowings under the term loan facility of the Credit Agreement bear interest at a rate per annum equal to an applicable margin plus, at our option, either (a) an alternate base rate determined by reference to the highest of (1) the prime rate of JPMorgan Chase Bank, N.A., (2) the federal funds rate in effect on such date plus 1/2 of 1% and (3) the LIBOR rate for a one month interest period plus 1% or (b) a LIBOR rate determined by reference to the cost of funds for U.S. dollar deposits for the relevant interest period adjusted for certain additional costs. The applicable margin percentage is 12.25% for term loans that are alternate base rate loans and 13.25% for term loans based on the LIBOR rate. For the term loans, we may, in our discretion, elect for the relevant interest period (a) to pay the entire amount of interest in cash or (b) to pay 5.50% of such interest “in-kind” by adding such interest to the outstanding principal of the term loans as of the applicable interest payment date. At June 30, 2011, the interest rate applicable to the $260.8 million outstanding under our term loan facility was 13.48%.

The applicable margin percentages for the revolving loans are initially 6.75% for alternate base loans and 7.75% for loans that are based on the LIBOR rate, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). In addition to paying interest on outstanding principal under the senior secured credit agreement, we are required to pay an initial commitment fee of 0.50% per annum in respect of the unutilized commitments under the revolving credit facility, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). We are also required to pay annual customary agency fees.

We are required to make scheduled quarterly payments under the senior secured term loan facility equal to 0.25% of the original principal amount of the term loan, with the balance payable on February 1, 2016. Additionally, we are required to prepay outstanding term loans under this agreement with (a) 100% of the net cash proceeds of any debt or equity issued by us or our restricted subsidiaries (with exceptions for certain debt permitted to be incurred or equity permitted to be issued under the agreement), (b) commencing with the year ending December 31, 2011, 75% (which percentage will be reduced to 50% if our senior secured leverage ratio (as defined in the Credit Agreement) is less than 4:00 to 1:00) of our annual excess cash flow (as defined in the Credit Agreement), and (c) 100% of the net cash proceeds of certain asset sales or other dispositions of property by us or our restricted subsidiaries, subject to reinvestment rights and certain other exceptions specified in the Credit Agreement. Mandatory prepayments of the term loans, subject to certain

exceptions, are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such repayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014.

The Credit Agreement also imposes certain financial covenants on us including: minimum cumulative consolidated EBITDA requirements beginning with the first fiscal quarter of 2011 through the end of the third fiscal quarter of 2011; a maximum ratio of total senior secured indebtedness to consolidated EBITDA tested quarterly on a trailing 12 month basis, beginning on the last day of the fourth quarter of 2011; and a minimum ratio of consolidated EBITDA to consolidated cash interest expense, tested quarterly on a trailing 12 month basis beginning on the last day of the fourth fiscal quarter of 2011.

If we are unable to maintain compliance with the covenants and requirements contained in the Credit Agreement, an event of default could occur, unless we are able to obtain a waiver or enter into an amendment with the senior lenders to revise the covenants and requirements. If any such event of default occurs, the lenders under the Credit Agreement would be entitled to take various actions, including the acceleration of amounts due under the Credit Agreement, terminating access to our revolving credit facility, and all actions permitted to be taken by a secured creditor. An event of default would have a material adverse effect on our financial position, results of operations and cash flow. We believe we are currently in compliance with the covenants of our senior secured credit facility.

We believe that our cash on hand, expected cash flows from operations, and potential availability of borrowings under the revolving portion of our senior secured credit facilities will be sufficient to finance our operations, and meet our scheduled debt service requirements for at least the next twelve months, absent an acceleration of repayment due to an event of default as discussed in the previous paragraph.

We actively seek to identify and evaluate potential acquisition candidates and, from time to time, we review potential acquisitions of businesses. Any acquisitions may require us to issue additional equity or incur additional indebtedness, subject to the limitations contained in our senior secured credit facility. We intend to seek opportunities to refinance our senior subordinated notes, subject to financial performance and market conditions, and we continue to explore various strategic transactions, including an acquisition, as a means to reduce our leverage and strengthen our operating and financial condition. However, there is no assurance that we will be able to refinance our senior subordinated notes on commercially reasonable terms or at all, or to complete an acquisition on desirable terms.

We and our subsidiaries, affiliates or significant stockholders may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors.

Capital Expenditures

We anticipate that we may incur capital expenditures of approximately $4.5 million during the remainder of 2011 based on our current plans of ongoing capital maintenance expenditure requirements at our facilities, including those related to the LTAC hospitals acquired after June 30, 2011, as previously discussed. We may enter into lease arrangements to finance a portion of these equipment expenditures.

Historical Cash Flow

The following table summarizes the net cash provided by (used in) the statement of cash flows (in thousands):


	Six Months Ended June 30
	2011			2010
Operating activities	$	5,769		$	7,156
Investing activities		(1,928	)		(1,355	)
Financing activities		(38,489	)		(2,076	)

For the six months ended June 30, 2011, operating activities provided $5.8 million of cash as compared to $7.2 million in cash for the comparable period in 2010. For the six months ended June 30, 2011, we had a net loss of $8.2 million as compared to net income of $6.2 million for the same period in 2010.

Accounts receivable increased by $5.3 million for the six months ended June 30, 2011 as compared to an increase of $2.8 million for the same period during 2010. Days of net patient service revenue in accounts receivable at June 30, 2011 had decreased to 66.2 as compared to 70.6 at December 31, 2010. Estimated third party payor settlements resulted in a net use of cash of $1.2 million as compared to a net use of cash of $5.1 million for the six months ended June 30, 2010. The use of cash during the 2010 period was principally due to the repayment to Medicare of amounts received as interim payments during 2009 in excess of revenues ultimately recognized.

Cash used in investing activities was $1.9 million for the six months ended June 30, 2011 as compared to $1.4 million in 2010. Cash used in investing activities during the 2011 and 2010 periods was principally for recurring maintenance capital expenditures.

Cash used by financing activities for the six months ended June 30, 2011 was $38.5 million as compared to $2.1 million for the same period in 2010. The six months ended June 30, 2011 included proceeds of $257.5 million from the new senior secured credit facility, offset by outflows to pay down the previous senior secured credit facility and scheduled payments on the current secured credit facility, consisting of $242.3 million in term debt. We also paid down the $35.0 million for the outstanding balance under the previous revolving line of credit. There were also payments of $17.9 million in deferred financing cost associated with the debt refinance.

Seasonality

Our business experiences seasonality resulting in variation in census levels, with the highest census historically occurring in the first quarter of the year and the lowest census occurring in the third quarter of the year.

Inflation

We derive a substantial portion of our revenue from the Medicare program. LTAC hospital PPS payments are subject to fixed payments that generally are adjusted annually for inflation. However, there can be no assurance that these adjustments, if received, will reflect the actual increase in our costs for providing healthcare services.

Labor and supply expenses make up a substantial portion of our operating expense structure. The expenses can be subject to increase in periods of rising inflation.

Forward Looking Statements

This quarterly report contains forward-looking statements regarding, among other things, our financial condition, results of operations, plans, objectives, future performance and business. All statements contained in this document other than historical information are forward-looking statements. Forward-looking statements include, but are not limited to, statements that represent our beliefs concerning future operations, strategies, financial results or other developments, and contain words and phrases such as “may,” “expects,” “believes,” “anticipates,” “estimates,” “should,” or similar expressions. Because these forward-looking statements are based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different. Although we believe that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, we cannot assure you that we will achieve or realize these plans, intentions or expectations. Forward-looking statements are inherently subject to risks, uncertainties and assumptions. Important factors that could cause actual results to differ materially from the forward-looking statements include, but are not limited to:

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the failure to maintain compliance with our financial covenants could be costly or have a material adverse effect on us;

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the amount of outstanding indebtedness and the restrictive covenants in the agreements governing our indebtedness may limit our operating and financial flexibility;

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the condition of the financial markets, including volatility and deterioration in the capital and credit markets, could have a material adverse effect on the availability and terms of financing sources;

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development or acquisition of new facilities may prove difficult or unsuccessful, use significant resources or expose us to unforeseen liabilities;

•

the failure to comply with the provisions of any of our Master Lease Agreements could materially adversely affect our financial position, results of operations and liquidity;

•

changes in government reimbursement for our services may have an adverse effect on our future revenues and profitability including, for example, the changes described under “Regulatory Changes”;

•

healthcare reform may have an adverse effect on our future revenues and profitability;

•

a government investigation or assertion that we have violated applicable regulations may result in increased costs or sanctions that reduce our revenues and profitability;

•

periodic reviews, surveys, audits and investigations by federal and state government agencies and private payors could result in adverse findings and may negatively impact our revenues and profitability;

•

actions that may be brought by individuals on the government’s behalf under the False Claims Act’s qui tam or whistleblower provisions may expose us to unforeseen liabilities;

•

the failure of our long-term acute care hospitals to maintain their qualification would cause our revenues and profitability to decline;

•

the failure of our “satellite” facilities to qualify for provider-based status with the applicable “main” facilities may adversely affect our results of operations;

•

private third party payors for our services may merge or undertake future cost containment initiatives that limit our future revenues and profitability;

•

an increase in uninsured and underinsured patients in our hospitals or the deterioration in the collectability of the accounts of such patients could harm our results of operations;

•

the failure to maintain established relationships with the physicians in our markets could reduce our revenues and profitability;

•

shortages in qualified nurses, therapists and other healthcare professionals or union activity may significantly increase our operating costs;

•

competition may limit our ability to grow and result in a decrease in our revenues and profitability;

•

the loss of key members of our management team could significantly disrupt our operations;

•

the geographic concentration of our facilities in Texas and Pennsylvania makes us sensitive to economic, regulatory, environmental and other developments in these states;

•

adverse changes in individual markets could significantly affect operating results;

•

the effect of legal actions asserted against us or lack of adequate available insurance could subject us to substantial uninsured liabilities;

•

an inability to ensure and maintain an effective system of internal controls over financial reporting could expose us to liability; and,

•

the failure to prevent damage or interruption to our systems and operations or to conform to regulatory standards for electronic health records could result in improper functioning, security breaches of our information systems, additional expenses or penalties.

Consequently, such forward-looking statements should be regarded solely as our current plans, estimates and beliefs. We do not intend, and do not undertake, any obligation to update any forward-looking statements to reflect future events or circumstances after the date of this report.

ITEM 3:

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At June 30, 2011, we had $260.8 million in senior term loans outstanding and a borrowing availability of $28.5 million under our revolving credit facility, each bearing interest at variable rates. Each 0.125% point change in interest rates would result in a $0.4 million annual change in interest expense on our term loans and revolving credit facility loans, assuming that our revolving credit facility is fully drawn.

ITEM 4:

CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered in this report. The disclosure controls and procedures are designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within required time periods, and include controls and disclosures designed to ensure that this information is accumulated and communicated to the company’s management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and principal financial officer have concluded that as of June 30, 2011 our disclosure controls and procedures were effective to provide reasonable assurance that information required to be included in our periodic Securities and Exchange Commission reports is recorded accurately, processed, summarized and reported within the time periods specified in the relevant Securities and Exchange Commission rules and forms.

In addition, we reviewed our internal controls, and there have been no changes in our internal controls over financial reporting identified in connection with an evaluation that occurred during the quarter ended June 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1:

LEGAL PROCEEDINGS

We are a party to several legal actions that arose in the ordinary course of business. The majority of these actions are related to malpractice claims that are covered under various insurance policies; however, there may be some actions which are not insured. We are unable to predict the ultimate outcome of pending litigation and government investigations, nor can there be any guarantee that the resolution of any litigation or investigation, either individually or in the aggregate, would not have a material adverse effect on our financial position, results of operations or liquidity. However, in our opinion, the outcome of these actions will not have a material adverse effect on the financial position, results of operations or liquidity of our company.

All claims raised in connection with Hurricane Katrina have been settled with no significant impact to us, except as follows. We maintained $15.0 million of general and professional liability insurance during this period, subject to a $1.0 million per claim retention. We believe that under our insurance policies, only one retention was applicable to the Hurricane Katrina matters since these matters all arose from a single event, process or condition. However, our insurance carrier sent reservation of rights letters which challenged, among other things, the application of one retention to the Hurricane Katrina related matters. On June 5, 2009, we reached an agreement with the insurance carrier regarding the reservation of rights matters whereby they would continue to pay all costs, indemnification and related expenses for the Hurricane Katrina claims in consideration for $1.0 million, which was paid by us in three equal installments, on July 1, 2009, March 31, 2010, and March 31, 2011.

ITEM 1A:

RISK FACTORS

No changes.

ITEM 6:

EXHIBITS

The exhibits to this report are listed in the Exhibit Index.

SIGNATURES

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.


LifeCare Holdings, Inc

By:		/S/ Phillip B. Douglas
		Phillip B. Douglas
		Chief Executive Officer

By:		/S/ CHRIS A. WALKER
		Chris A. Walker
		Chief Financial Officer

Dated: August 12, 2011

EXHIBIT INDEX


Exhibit		Description

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS		XBRL Instance Document*

101.SCH		XBRL Taxonomy Extension Schema Document*

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document*

101.LAB		XBRL Taxonomy Extension Label Linkbase Document*

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document*

101.DEF		XBRL Taxonomy Extension Definition Linkbase Document*

These interactive data files are being submitted electronically with this report and, in accordance with Rule 406T of Regulation S-T, are not deemed filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, are not deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

Large Accelerated Filer:

Accelerated Filer:

Non-Accelerated Filer:

Smaller Reporting Company: