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EXCEL - IDEA: XBRL DOCUMENT - SUN HEALTHCARE GROUP INCFinancial_Report.xls
EX-10.5 - SUN HEALTHCARE GROUP INCsunhexhibit105.htm
EX-31.1 - SUN HEALTHCARE GROUP INCsunhexhibit311.htm
EX-32.1 - SUN HEALTHCARE GROUP INCsunhexhibit321.htm
EX-10.1 - SUN HEALTHCARE GROUP INCsunhexhibit101.htm
EX-31.2 - SUN HEALTHCARE GROUP INCsunhexhibit312.htm
EX-32.2 - SUN HEALTHCARE GROUP INCsunhexhibit322.htm
EX-10.2 - SUN HEALTHCARE GROUP INCsunhexhibit102.htm
EX-10.3 - SUN HEALTHCARE GROUP INCsunhexhibit103.htm
EX-10.4 - SUN HEALTHCARE GROUP INCsunhexhibit104.htm

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

FORM 10-Q

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

For the quarterly period ended March 31, 2012

or

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

Commission File Number: 1-12040

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

Delaware
13-4230695
(State of Incorporation)
(I.R.S. Employer Identification No.)

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


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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  ý No   o

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

Large accelerated filer    o
Accelerated filer    ý
 
 
Non-accelerated filer    o
Smaller reporting company    o
(Do not check if a smaller reporting company)
 

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

As of May 7, 2012, there were 25,531,447 shares of the Registrant’s $.01 par value Common Stock outstanding.

1


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index
 
Page
Numbers
 
 
 
 
 
 
 
 
 
 
As of March 31, 2012
 
 
As of December 31, 2011
 
 
 
 
 
 
For the three months ended March 31, 2012 and 2011
 
 
 
 
 
 
For the three months ended March 31, 2012 and 2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

References throughout this document to the Company, “we,” “our” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Quarterly Report on Form 10-Q (this “Form 10-Q”) contain “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”) and the federal securities laws.  Any statements that do not relate to historical or current facts or matters are forward-looking statements. Examples of forward-looking statements include all statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, business strategy, budgets, the impact of reductions in reimbursements and other changes in government reimbursement programs,  the scope, timing and effectiveness of our efforts to mitigate the impact on our business of the CMS Final Rule (described below), the outcome and costs of litigation, projected expenses and capital expenditures, growth opportunities, ability to refinance our indebtedness on favorable terms, plans and objectives of management for future operations, and compliance with and changes in governmental regulations.  You can identify some of the forward-looking statements by the use of forward-looking words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “may” and other similar expressions, although not all forward-looking statements contain these identifying words.
 
The forward-looking statements are based on the information currently available and are applicable only as of the date of this report. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements.  You are urged to carefully review the disclosures we make concerning risks and other factors that may affect our business and operating results, including those made in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 and in our other reports filed with the Securities and Exchange Commission.  The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  We caution you that any forward-looking statements made in this Form 10-Q are not guarantees of future performance and that you should not place undue reliance on any of such forward-looking statements, which speak only as of the date of this document.  There may be additional risks of which we are presently unaware or that we currently deem immaterial.  We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.
_______________________

2


PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS
(in thousands)

 
March 31, 2012
 
December 31, 2011
Current assets:
 
 
 
Cash and cash equivalents
$
44,771

 
$
57,908

Restricted cash
14,325

 
15,706

Accounts receivable, net of allowance for doubtful accounts of $66,191
 

 
 

and $67,640 at March 31, 2012 and December 31, 2011, respectively
206,813

 
202,229

Prepaid expenses and other assets
28,022

 
29,075

Assets held for sale
4,537

 

Deferred tax assets
63,993

 
63,170

 
 
 
 
Total current assets
362,461

 
368,088

 
 
 
 
Property and equipment, net
146,033

 
148,298

Intangible assets, net
34,630

 
35,294

Goodwill
34,905

 
34,496

Restricted cash, non-current
353

 
353

Deferred tax assets
123,458

 
123,974

Other assets
42,825

 
45,163

Total assets
$
744,665

 
$
755,666


See accompanying notes.

3


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

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

 
March 31, 2012
 
December 31, 2011
Current liabilities:
 
 
 
Accounts payable
$
48,836

 
$
55,888

Accrued compensation and benefits
56,494

 
61,101

Accrued self-insurance obligations, current portion
59,687

 
57,810

Other accrued liabilities
44,746

 
43,139

Current portion of long-term debt and capital lease obligations
995

 
1,017

Total current liabilities
210,758

 
218,955

 
 
 
 
Accrued self-insurance obligations, net of current portion
152,921

 
157,267

Long-term debt and capital lease obligations, net of current portion
88,500

 
88,768

Unfavorable lease obligations, net
6,492

 
7,110

Other long-term liabilities
58,454

 
58,110

Total liabilities
517,125

 
530,210

 
 
 
 
Commitments and contingencies (Note 5)


 


 
 
 
 
Stockholders' equity:
 

 
 

Preferred stock of $.01 par value, authorized 3,333
 

 
 

shares, zero shares issued and outstanding as of
 

 
 

March 31, 2012 and December 31, 2011

 

Common stock of $.01 par value, authorized  41,667
 

 
 

shares, 25,272 and 25,146 shares issued and outstanding
 

 
 

as of March 31, 2012 and December 31, 2011, respectively
253

 
251

Additional paid-in capital
728,801

 
726,861

Accumulated deficit
(500,214
)
 
(500,427
)
Accumulated other comprehensive loss, net
(1,300
)
 
(1,229
)
Total stockholders' equity
227,540

 
225,456

Total liabilities and stockholders' equity
$
744,665

 
$
755,666


See accompanying notes.


4


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)
(in thousands, except per share data)
 
For the
Three Months Ended
 
March 31, 2012
 
March 31, 2011
 
 
 
 
Total net revenues
$
458,493

 
$
466,307

Costs and expenses:
 

 
 

Operating salaries and benefits
261,090

 
262,480

Self-insurance for workers’ compensation and general and
 

 
 

professional liability insurance
15,317

 
14,557

Operating administrative expenses
12,406

 
13,067

Other operating costs
96,566

 
91,135

Center rent expense
36,377

 
35,692

General and administrative expenses
16,041

 
15,379

Depreciation and amortization
8,430

 
7,449

Provision for losses on accounts receivable
4,808

 
5,176

Interest, net of interest income of $68 and $58, respectively
4,411

 
4,999

Restructuring costs

 
136

Total costs and expenses
455,446

 
450,070

 
 
 
 
Income before income taxes and discontinued operations
3,047

 
16,237

Income tax expense
1,188

 
6,619

Income from continuing operations
1,859

 
9,618

 
 
 
 
Loss from discontinued operations, net
(1,646
)
 
(1,506
)
 
 
 
 
Net income
$
213

 
$
8,112

 
 
 
 
Other comprehensive income, net of tax:





(Loss) gain from cash flow hedge, net of related tax (benefit) expense of ($47) and $22, respectively
(71
)

32

Other comprehensive income, net of tax
(71
)

32

 
 
 
 
Comprehensive income
$
142


$
8,144

 
 
 
 
Basic earnings per common and common equivalent share:
 

 
 

Income from continuing operations
$
0.07

 
$
0.37

Loss from discontinued operations, net
(0.06
)
 
(0.05
)
Net income
$
0.01

 
$
0.32

 
 
 
 
Diluted earnings per common and common equivalent share:
 

 
 

Income from continuing operations
$
0.07

 
$
0.37

Loss from discontinued operations, net
(0.06
)
 
(0.06
)
Net income
$
0.01

 
$
0.31

 
 
 
 
Weighted average number of common and common
 

 
 

equivalent shares outstanding:
 

 
 

Basic
26,207

 
25,740

Diluted
26,207

 
25,838


See accompanying notes.


5


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands)
 
For the
Three Months Ended
 
March 31, 2012
 
March 31, 2011
Cash flows from operating activities:
 
 
 
Net income
$
213

 
$
8,112

Adjustments to reconcile net income to net cash (used for) provided by operating activities, including discontinued operations:
 
 
 

Depreciation and amortization
8,582

 
7,681

Amortization of favorable and unfavorable lease intangibles
(513
)
 
(484
)
Provision for losses on accounts receivable
5,122

 
5,644

Stock-based compensation expense
2,232

 
1,449

Deferred taxes
(260
)
 
2,032

Changes in operating assets and liabilities, net of acquisitions:
 
 
 

Accounts receivable
(9,781
)
 
(5,393
)
Restricted cash
1,381

 
(1,946
)
Prepaid expenses and other assets
1,752

 
(249
)
Accounts payable
(6,036
)
 
(1,919
)
Accrued compensation and benefits
(4,607
)
 
3,438

Accrued self-insurance obligations
(2,469
)
 
(1,342
)
Income taxes payable

 
478

Other accrued liabilities
1,531

 
(731
)
Other long-term liabilities
227

 
(727
)
Net cash (used for) provided by operating activities
(2,626
)
 
16,043

 
 
 
 
Cash flows from investing activities:
 

 
 

Capital expenditures
(9,961
)
 
(8,837
)
Acquisitions, net of cash acquired
(260
)
 

Net cash used for investing activities
(10,221
)
 
(8,837
)
 
 
 
 
Cash flows from financing activities:
 

 
 

Principal repayments of long-term debt and capital lease
 

 
 

obligations
(290
)
 
(2,798
)
Net cash used for financing activities
(290
)
 
(2,798
)
 
 
 
 
Net (decrease) increase in cash and cash equivalents
(13,137
)
 
4,408

Cash and cash equivalents at beginning of period
57,908

 
81,163

Cash and cash equivalents at end of period
$
44,771

 
$
85,571

 
See accompanying notes.

6


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
(UNAUDITED)

(1)  Nature of Business

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

Business

Our subsidiaries provide long-term, post-acute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  Our continuing operations include 190 healthcare centers in 23 states as of March 31, 2012.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States (“GAAP”) for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at March 31, 2012, and our consolidated results of operations and cash flows for the three-month periods ended March 31, 2012 and 2011.  These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations of the Securities and Exchange Commission.  The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of only normal recurring items.  Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2011, which are included in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 Form 10-K”).

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of significant contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of impairment for goodwill and other long-lived assets, third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals and income taxes. Actual results could differ from those estimates.

Recent Accounting Pronouncements

The FASB issued an Accounting Standards Update in June 2011 regarding the presentation of comprehensive income within financial statements.  GAAP now requires that comprehensive income and its components of net income and other comprehensive income be presented in either (1) a single continuous statement of comprehensive income or (2) two separate but consecutive statements.  This new guidance is now effective for us and our accompanying consolidated financial statements have been presented with one single continuous statement of comprehensive income.

Reclassifications

Certain reclassifications have been made to the prior period financial statements to conform to the 2012 financial statement presentation.  We have reclassified the results of operations of nine skilled nursing centers of our Inpatient Services segment (see Note 4 – “Discontinued Operations”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.



7

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


(2)  Long-Term Debt, Capital Lease Obligations and Hedging Arrangements

Long-term debt and capital lease obligations consisted of the following as of the periods indicated (in thousands):
 
March 31, 2012
 
December 31, 2011
Revolving loans
$

 
$

Mortgage note payable due monthly through 2014, interest at
 

 
 

at a rate of 8.5%, collateralized by real property with
 

 
 

carrying values totaling $1.7 million
1,888

 
2,076

Term loans
87,358

 
87,389

Capital leases
249

 
320

Total long-term obligations
89,495

 
89,785

Less amounts due within one year
(995
)
 
(1,017
)
Long-term obligations, net of current portion
$
88,500

 
$
88,768



The scheduled or expected maturities of long-term obligations as of March 31, 2012, were as follows (in thousands):
For the twelve months ending March 31:
2013
$
995

2014
913

2015
229

2016

2017
87,358

 
$
89,495


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

Our credit agreement requires that at least 50% of our term loans be subject to at least a three-year hedging agreement. To satisfy this requirement, we executed two hedging instruments on January 18, 2011: a two-year interest rate cap and a two-year “forward starting” interest rate swap.  The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012.  This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 8.75% through December 31, 2012.  The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement.  The two-year “forward starting” interest rate swap effectively converts the interest rate on $82.5 million of our term loans to a fixed rate from January 1, 2013 through December 31, 2014.  LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 10.185% for this portion of the term loans.  There was no fee for this swap agreement.  Both arrangements qualify for hedge accounting treatment.


8

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


The fair values of our hedging agreements as presented in the consolidated balance sheets are as follows (in thousands):
 
Derivatives
 
March 31, 2012
 
December 31, 2011
 
Balance Sheet
Location
 
Fair Value
 
Balance Sheet
Location
 
Fair Value
Derivatives designated as hedging instruments:
Other Long-Term
 
 
 
Other Long-Term
 
 
Interest rate hedging agreements
Liabilities
 
$
2,167

 
Liabilities
 
$
2,049


The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the three months ended March 31 is as follows (in thousands):
 
Amount of (Loss)/Gain in
Other Comprehensive (Loss)/Income
 
Gain Reclassified from Accumulated
Other Comprehensive Income
to Income (ineffective portion)
 
2012
 
2011
 
2012
 
2011
Derivatives designated as cash flow hedges:
 
 
 
 
 
 
 
Interest rate hedging agreements
$
(71
)
 
$
32

 
$

 
$



(3)  Fair Value of Financial Instruments

The estimated fair values of our financial instruments were as follows (in thousands):
 
March 31, 2012
 
December 31, 2011
 
Carrying
Amount
 
Fair Value
 
Carrying
Amount
 
Fair Value
Cash and cash equivalents
$
44,771

 
$
44,771

 
$
57,908

 
$
57,908

Restricted cash
$
14,678

 
$
14,678

 
$
16,059

 
$
16,059

Long-term debt and capital lease obligations,
 

 
 

 
 

 
 

including current portion
$
89,495

 
$
86,492

 
$
88,785

 
$
74,545

Interest rate hedging agreements
$
2,167

 
$
2,167

 
$
2,049

 
$
2,049


The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At March 31, 2012 and December 31, 2011, the fair value of our long-term debt, including current maturities, and our interest rate hedging agreements was based on estimates using present value techniques that are significantly affected by the assumptions used concerning the amount and timing of estimated future cash flows and discount rates that reflect varying degrees of risk.

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

Level 1:     Unadjusted quoted market prices in active markets for identical assets or liabilities.

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

Level 3:    Unobservable inputs for the asset or liability.


9

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


We endeavor to utilize the best available information in measuring fair value.  The following tables summarize the valuation of our financial instruments by the above pricing levels as of March 31, 2012 and December 31, 2011, respectively (in thousands):
 
March 31, 2012
 
Total
 
Unadjusted Quoted
Market Prices
(Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Interest rate hedging agreements – liability
$2,167
 
$—
 
$2,167
 
December 31, 2011
 
Total
 
Unadjusted Quoted
Market Prices
(Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Interest rate hedging agreements - liability
$2,049
 
$—
 
$2,049

We currently have no other financial instruments subject to fair value measurement on a recurring basis. The fair value for our cash and cash equivalents and restricted cash disclosed above were determined by Level 1 valuation techniques and our long-term debt and capital lease obligations fair value above was determined by Level 2 valuation techniques.


(4) Discontinued Operations

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

During the three months ended March 31, 2012, we developed plans to dispose of nine skilled nursing centers in three different markets within our Inpatient Services segment, whose results have been reclassified to discontinued operations for all periods presented in accordance with GAAP.  As of March 31, 2012, assets held for sale for these nine centers of $4.5 million consisted of (i) a net carrying amount of $3.2 million of property and equipment, (ii) $0.8 million of other non-current assets and (iii) $0.5 million of prepaid expenses and other assets.

A summary of the discontinued operations for the periods presented is as follows (in thousands):
 
For the Three Months Ended
 
March 31, 2012
 
March 31, 2011
 
Inpatient
Services
 
Other
 
Total
 
Inpatient
Services
 
Other
 
Total
Net operating revenues
$
16,746

 
$

 
$
16,746

 
$
20,145

 
$

 
$
20,145

 
 
 
 
 
 
 
 
 
 
 
 
Loss from discontinued operations, net (1)
$
(1,645
)
 
$
(1
)
 
$
(1,646
)
 
$
(1,498
)
 
$
(8
)
 
$
(1,506
)

(1) Net of related tax benefit of $1,052 and $981, respectively



10

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


(5)  Commitments and Contingencies

(a) Insurance

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

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

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

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

11

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


Activity in our professional liability and workers’ compensation self-insurance reserves as of and for the periods ended March 31, 2012 and 2011 is as follows (in thousands):
 
For the Three Months Ended
March 31, 2011
 
Professional
Liability
 
Workers’
Compensation
 
Total
Gross balance, beginning of period
$
113,971

 
$
96,585

 
$
210,556

Less: anticipated insurance recoveries
(2,100
)
 
(28,100
)
 
(30,200
)
Net balance, beginning of period
$
111,871

 
$
68,485

 
$
180,356

 
 
 
 
 
 
Current year provision, continuing operations
6,974

 
7,583

 
14,557

Current year provision, discontinued operations
467

 
384

 
851

Claims paid, continuing operations
(9,515
)
 
(4,667
)
 
(14,182
)
Claims paid, discontinued operations
(346
)
 
(366
)
 
(712
)
Amounts paid for administrative services and other
(809
)
 
(1,744
)
 
(2,553
)
 
 
 
 
 
 
Net balance, end of period
$
108,642

 
$
69,675

 
$
178,317

Plus: anticipated insurance recoveries
2,100

 
28,100

 
30,200

Gross balance, end of period
$
110,742

 
$
97,775

 
$
208,517


 
For the Three Months Ended
March 31, 2012
 
Professional
Liability
 
Workers’
Compensation
 
Total
Gross balance, beginning of period
$
120,857

 
$
87,242

 
$
208,099

Less: anticipated insurance recoveries
(2,390
)
 
(21,930
)
 
(24,320
)
Net balance, beginning of period
$
118,467

 
$
65,312

 
$
183,779

 
 
 
 
 
 
Current year provision, continuing operations
8,135

 
7,182

 
15,317

Current year provision, discontinued operations
467

 
326

 
793

Claims paid, continuing operations
(6,419
)
 
(4,828
)
 
(11,247
)
Claims paid, discontinued operations
(3,269
)
 
(370
)
 
(3,639
)
Amounts paid for administrative services and other
(1,145
)
 
(2,009
)
 
(3,154
)
 
 
 
 
 
 
Net balance, end of period
$
116,236

 
$
65,613

 
$
181,849

Plus: anticipated insurance recoveries
2,390

 
21,930

 
24,320

Gross balance, end of period
$
118,626

 
$
87,543

 
$
206,169

 

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


12

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


A summary of the assets and liabilities related to insurance risks at March 31, 2012 and December 31, 2011 is as indicated below (in thousands):
 
 
March 31, 2012
 
 
 
December 31, 2011
 
 
Professional
Liability
 
Workers’
Compensation
 
Total
 
|
|
 
Professional
Liability
 
Workers’
Compensation
 
Total
Assets:
 
 
 
 
 
 
 
|
 
 
 
 
 
 
Restricted cash (1)
 
 
 
 
 
|
 
 
 
 
 
 
Current
 
$
5,617

 
$
8,544

 
$
14,161

 
|
 
$
6,254

 
$
9,332

 
$
15,586

Non-current
 

 

 

 
|
 

 

 

 
 
$
5,617

 
$
8,544

 
$
14,161

 
|
 
$
6,254

 
$
9,332

 
$
15,586

 
 
 
 
 
 
 
 
|
 
 
 
 
 
 
Anticipated insurance recoveries (2)
 
 
 
|
 
 
 
 
 
 
Current
 
$
524

 
$
2,730

 
$
3,254

 
|
 
$
524

 
$
2,730

 
$
3,254

Non-current
 
1,866

 
19,200

 
21,066

 
|
 
1,866

 
19,200

 
21,066

 
 
$
2,390

 
$
21,930

 
$
24,320

 
|
 
$
2,390

 
$
21,930

 
$
24,320

Total Assets
 
$
8,007

 
$
30,474

 
$
38,481

 
|
 
$
8,644

 
$
31,262

 
$
39,906

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities (3)(4):
 
 
 
 
 
|
 
 
 
 
 
 
Self-insurance liabilities
 
 
 
 
 
|
 
 
 
 
 
 
Current
 
$
32,030

 
$
21,218

 
$
53,248

 
|
 
$
28,758

 
$
22,074

 
$
50,832

Non-current
 
86,596

 
66,325

 
152,921

 
|
 
92,099

 
65,168

 
157,267

Total Liabilities
 
$
118,626

 
$
87,543

 
$
206,169

 
|
 
$
120,857

 
$
87,242

 
$
208,099

 
(1)
Total restricted cash includes cash collateral deposits and other cash held by third parties.  Total restricted cash above excludes $517 and $473 at March 31, 2012 and December 31, 2011, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD-insured buildings.
(2)
Anticipated insurance recovery assets are presented as Other Assets (both current and long-term) in our March 31, 2012 and December 31, 2011 consolidated balance sheets.  
(3)
Total self-insurance liabilities above exclude $6,439 and $6,978 at March 31, 2012 and December 31, 2011, respectively, related to our employee health insurance liabilities.
(4)
Total self-insurance liabilities for workers’ compensation claims are collateralized, in addition to the restricted cash, by letters of credit of $57,538 as of March 31, 2012 and $55,335 as of December 31, 2011.


(b)  Litigation

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

We operate in an industry that is extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, the industries in which we operate are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief; and reimbursement authorities could also seek the suspension

13

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations or cash flows.
 
In November 2010, a jury verdict was rendered in a Kentucky state court against us for $2.75 million in compensatory damages and $40 million in punitive damages. On February 25, 2011, the trial court judge reduced the punitive damage award to $24.75 million. The case involves claims for professional negligence resulting in wrongful death. We disagree with the jury's verdict and believe that it is not supported by the facts of the case or applicable law. Our appeal is currently pending with the Kentucky Court of Appeals. We believe our reserves are adequate for this matter.

(c)  Other Inquiries

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

(6)  Income Taxes

The provision for income taxes of $1.2 million for the three months ended March 31, 2012 results in an effective tax rate of approximately 39%. The provision for income taxes of $6.6 million for the three months ended March 31, 2011 resulted in an effective tax rate of approximately 41%. The rates for 2012 and 2011 differ from the statutory tax rate of 35% primarily due to state taxes.

The realization of our deferred tax assets is dependent upon generation of taxable income during periods in which deductions and/or credits can be utilized.  As a result, we consider the level of historical taxable income, historical non-recurring credits and charges, the scheduled reversal of deferred tax liabilities, tax-planning strategies and projected future taxable income in determining the amount of the valuation allowance.  The valuation allowance of $17.9 million at March 31, 2012 and December 31, 2011 relates primarily to state net operating loss (“NOL”) carryforwards and other deferred tax assets for which realization is uncertain.

In evaluating the need to establish a valuation allowance on our net deferred tax assets, all items of positive evidence (e.g., future sources of taxable income, including the ability to reliably forecast and to continue our mitigation initiatives implemented in 2011) and negative evidence (e.g., impact of the Centers for Medicare and Medicaid Services ("CMS") final rule for skilled nursing facilities for the 2012 federal fiscal year, which commenced on October 1, 2011 (the "CMS Final Rule") and subsequent impairment of goodwill in 2011) were considered.  We were in a cumulative pre-tax book loss of approximately $217 million for the three-year period ended December 31, 2011.  However, because approximately $324 million of the book expenses (principally related to our 2011 non-cash loss on asset impairment for goodwill and other intangibles) were not deductible for tax purposes, we generated taxable income and utilized existing net operating loss carryforwards in each of the last three years.  As a result of the negative impact of the CMS Final Rule on our business, we commenced a broad based mitigation initiative in 2011, which includes infrastructure cost reductions. Our ability to generate sufficient future taxable income to realize our deferred tax assets is dependent on our ability to continue our mitigation initiatives. Based upon our current estimates of future taxable income, we believe that we will more likely than not realize our net deferred tax assets.  However, if we are unable to continue realizing enough savings through our mitigation initiative to offset the negative impact of the CMS Final Rule, we may be required to increase our valuation allowance in future periods.

After consideration of the November 2010 restructuring of our former parent company, which, among other matters resulted in Sabra Health Care REIT, Inc. holding substantially all of our former parent’s owned real property, and utilization of NOL carryforwards through 2011, the Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $7.4 million. Accordingly, our NOL and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, we estimate there is approximately $47.6 million of NOLs which can be used to offset U.S. taxable income in 2012.  Considering annual IRC Section 382 limitations and built-in gains, we estimate a total of approximately $145.4 million of utilizable NOL carryforwards to offset taxable income in 2012 and future years.


14

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


(7)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.  Our reportable segments are composed of operating segments, which are aggregated, comprising strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  More complete descriptions and accounting policies of the segments are described in Note 13 – “Segment Information” and  Note 2 – “Summary of Significant Accounting Policies” of our 2011 Form 10-K.  The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):
As of and for the
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
 
 
 
 
 
 
 
 
 
 
 
March 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
Inpatient
Services
 
Rehabilitation
Therapy
Services
 
Medical
Staffing
Services
 
Corporate
 
Intersegment
Eliminations
 
Consolidated
 
 
 
 
 
 
 
 
 
 
 
 
Revenues from external customers
$
405,788

 
$
30,629

 
$
22,069

 
$
7

 
$

 
$
458,493

Intersegment revenues

 
33,464

 
831

 

 
(34,295
)
 

Total net revenues
405,788

 
64,093

 
22,900

 
7

 
(34,295
)
 
458,493

 
 
 
 
 
 
 
 
 
 
 
 
Operating salaries and benefits
189,707

 
53,896

 
17,487

 

 

 
261,090

Self-insurance for workers’ compensation and
 
 
 
 
 
 
 
 
 
 
 
general and professional liability insurance
14,289

 
609

 
355

 
64

 

 
15,317

Other operating costs
125,669

 
2,497

 
2,695

 

 
(34,295
)
 
96,566

General and administrative expenses(1)
9,260

 
2,530

 
615

 
16,042

 

 
28,447

Provision for losses on
 
 
 
 
 
 
 
 
 
 
 
accounts receivable
4,430

 
414

 
(36
)
 

 

 
4,808

Segment operating income (loss)
$
62,433

 
$
4,147

 
$
1,784

 
$
(16,099
)
 
$

 
$
52,265

 
 
 
 
 
 
 
 
 
 
 
 
Center rent expense
36,075

 
134

 
168

 

 

 
36,377

Depreciation and amortization
7,028

 
251

 
185

 
966

 

 
8,430

Interest, net
(19
)
 

 

 
4,430

 

 
4,411

Net segment income (loss)
$
19,349

 
$
3,762

 
$
1,431

 
$
(21,495
)
 
$

 
$
3,047

 
 
 
 
 
 
 
 
 
 
 
 
Identifiable segment assets
$
385,342

 
$
18,701

 
$
20,287

 
$
287,188

 
$
20,829

 
$
732,347

Goodwill
$
30,297

 
$
75

 
$
4,533

 
$

 
$

 
$
34,905

Segment capital expenditures
$
8,676

 
$
399

 
$
51

 
$
835

 
$

 
$
9,961

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

15

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)



As of and for the
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
 
 
 
 
 
 
 
 
 
 
 
March 31, 2011
 
 
 
 
 
 
 
 
 
 
 
 
Inpatient
Services
 
Rehabilitation
Therapy
Services
 
Medical
Staffing
Services
 
Corporate
 
Intersegment
Eliminations
 
Consolidated
 
 
 
 
 
 
 
 
 
 
 
 
Revenues from external customers
$
413,888

 
$
30,096

 
$
22,316

 
$
7

 
$

 
$
466,307

Intersegment revenues

 
32,694

 
623

 

 
(33,317
)
 

Total net revenues
413,888

 
62,790

 
22,939

 
7

 
(33,317
)
 
466,307

 
 
 
 
 
 
 
 
 
 
 
 
Operating salaries and benefits
190,931

 
54,132

 
17,417

 

 

 
262,480

Self-insurance for workers’ compensation and
 
 
 
 
 
 
 
 
 
 
 
general and professional liability insurance
13,501

 
642

 
347

 
67

 

 
14,557

Other operating costs
119,422

 
2,169

 
2,861

 

 
(33,317
)
 
91,135

General and administrative expenses(1)
10,014

 
2,398

 
655

 
15,379

 

 
28,446

Provision for losses on
 
 
 
 
 
 
 
 
 
 
 
accounts receivable
4,953

 
324

 
(101
)
 

 

 
5,176

Segment operating income (loss)
$
75,067

 
$
3,125

 
$
1,760

 
$
(15,439
)
 
$

 
$
64,513

 
 
 
 
 
 
 
 
 
 
 
 
Center rent expense
35,392

 
127

 
173

 

 

 
35,692

Depreciation and amortization
6,206

 
226

 
187

 
830

 

 
7,449

Interest, net
(6
)
 

 
1

 
5,004

 

 
4,999

Net segment income (loss)
$
33,475

 
$
2,772

 
$
1,399

 
$
(21,273
)
 
$

 
$
16,373

 
 
 
 
 
 
 
 
 
 
 
 
Identifiable segment assets
$
691,111

 
$
15,890

 
$
20,541

 
$
346,930

 
$
20,867

 
$
1,095,339

Goodwill
$
345,064

 
$
75

 
$
4,533

 
$

 
$

 
$
349,672

Segment capital expenditures
$
6,507

 
$
729

 
$
53

 
$
1,548

 
$

 
$
8,837

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


Measurement of Segment Income

We evaluate financial performance and allocate resources primarily based on income or loss from operations before income taxes, excluding any unusual items. The following table reconciles net segment income to consolidated income before income taxes and discontinued operations (in thousands):
 
For the Three Months Ended
March 31,
 
2012
 
2011
Net segment income
$
3,047

 
$
16,373

Restructuring costs

 
136

Consolidated income before income taxes
 
 
 
and discontinued operations
$
3,047

 
$
16,237






16


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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

Overview

Our subsidiaries are providers of nursing, rehabilitative and related specialty healthcare services primarily to the senior population in the United States. Our core business is providing inpatient services, primarily through 158 skilled nursing centers, 13 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, 2 independent living centers and 7 mental health centers with 21,414 licensed beds located in 23 states as of March 31, 2012. Our subsidiaries also provide hospice services, rehabilitation therapy services and temporary medical staffing services to skilled nursing centers.

2011 Restructuring

On July 29, 2011, the Centers for Medicare and Medicaid Services (“CMS”) released its final rule for skilled nursing facilities for the 2012 federal fiscal year, which commenced on October 1, 2011 (the “CMS Final Rule”).  As a result of the expected negative impact of the CMS Final Rule on our business, we implemented a broad-based mitigation initiative, which included infrastructure cost reductions without affecting the quality of our patient care. These reductions in infrastructure costs were, and continue to be, necessary to mitigate the impact on our business and remain in compliance with financial covenants under the Credit Agreement. For additional information regarding the impact to us of the CMS Final Rule, please see Item 2 - “Management's Discussion and Analysis of Financial Condition and Results of Operations - Medicare” below.

Revenues from Medicare, Medicaid and Other Sources

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

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

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


For the Three Months Ended
Sources of Revenues

March 31, 2012

March 31, 2011







Consolidated:






Medicaid

$
186,443

40.7
%

177,645

38.1
%
Medicare

136,288

29.7


151,251

32.4

Private pay and other

112,425

24.5


114,402

24.6

Managed care and commercial insurance

23,337

5.1


23,009

4.9

Total

$
458,493

100.0
%

466,307

100.0
%







Inpatient Only:






Medicaid

$
186,423

45.9
%

177,595

42.9
%
Medicare

131,517

32.4


146,608

35.4

Private pay and other

64,854

16.0


66,945

16.2

Managed care and commercial insurance

22,994

5.7


22,740

5.5

Total

$
405,788

100.0
%

413,888

100.0
%



17


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Medicare

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

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequent legislative and rule changes. PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. Prior to October 1, 2010, the amount to be paid was determined by classifying each patient into one of 53 Resource Utilization Groups (“RUGs”), which were collectively referred to as “RUGs III”. After October 1, 2010, the RUGs were expanded to 66 categories to provide further refinement and are referred to collectively as “RUGs IV”. Each RUGs level represents the level of services required to treat the patient's condition or level of acuity.

The RUGs III system reimbursed for therapy service delivered concurrently, in a group or individually, at the same rate. The RUGs IV system changes maintain the same reimbursement methodology for group and individual therapy, but only considers concurrent therapy if it is delivered to two patients and divides the services between the two patients that receive the services. Changes were also made to the required qualifications for each RUGs level.

On July 29, 2011, CMS released its final rule for skilled nursing facilities for the 2012 federal fiscal year that commenced on October 1, 2011 (the "CMS Final Rule"). Pursuant to the CMS Final Rule, Medicare Part A payment rates were reduced by 12.6% (i.e., the Medicare rate parity adjustment) to correct what CMS perceived as a lack of parity between RUGs III and RUGs IV. The CMS Final Rule also changed the reimbursement rules associated with group therapy and introduced new change-of-therapy provisions as patients move through their post-acute stay. The CMS Final Rule therapy reimbursement changes resulted in further reductions in our revenues from the Medicare program (prior to implementation of our therapy mitigation plans) and also served to increase our costs of providing such therapy services. On October 1, 2011, we also received a net 1.7% market basket increase to our prospective Medicare rates. Based on operating results through the end of the first quarter of 2012, we continue to expect the impact of the CMS Final Rule on our full year 2012 operations to be a year-over-year reduction in income before income taxes of approximately $40.0 million to $45.0 million due to the ramp-up nature of many elements of our management mitigation plans.

The following table sets forth the average amounts of inpatient Medicare Part A revenues per patient, per day, recorded by our healthcare centers for the periods indicated:
For the Three Months Ended
March 31, 2012
 
March 31, 2011
$463.10
 
$522.11

Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services. An automatic exception was in place for patients residing in skilled nursing centers. That exception will continue through December 31, 2012.

CMS has notified providers that they will not issue a Notice of Proposed Rulemaking - SNF for the 2013 fiscal year which commences on October 1, 2012.  They will instead issue an Update Notice, prior to July 31, 2012.  This Notice will make updates that are required by current law rather than changes to the current system.  We anticipate the net impact of this Update to be an increase in rates of 1.8%.  Any additional changes prior to October 1, 2013 would require legislative action.

On February 17, 2012, Congress passed the Middle Class Tax Relief and Job Creation Act of 2011, which included a provision reducing the reimbursement of Medicare bad debts. Medicare bad debts are primarily generated when states do not reimburse the provider for co-insurance for Medicare/Medicaid dually eligible patients. Providers are not permitted to bill this co-insurance to any other party when Medicaid does not reimburse the provider cost of service. Prior to this legislation, Medicare reimbursed providers 100% for this uncollectable co-insurance associated with dually eligible patients. Under the newly enacted legislation, Medicare will now phase in a reduction in the percentage of reimbursement for uncollectable co-insurance starting with cost reports beginning in federal fiscal year 2013, which primarily impacts our cost reports beginning on January 1, 2013. It is not clear if

18


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

states will reimburse for dually eligible patient co-insurance under the state Medicaid programs as a result of this new legislation. If states do not begin to reimburse for dually eligible patient co-insurance then we are projecting the result will be a reduction in our revenues from reimbursement of Medicare bad debts of approximately $2.3 million in 2013, $4.7 million in 2014 and $6.7 million in subsequent years. Fourteen of the twenty-three states in which we operate do not reimburse the Medicaid co-insurance for dually eligible patients.

On August 2, 2011, Congress passed the Budget Control Act of 2011, which created The Joint Select Committee on Deficit Reduction.  This Committee was tasked to find $1.5 trillion in savings by November 23, 2011.  The Committee was unable to reach an agreement and as a result, sequestration as provided for in the Budget Control Act was triggered.  Sequestration will result in a 2% reduction in Medicare payments effective January 1, 2013, which we estimate will reduce our revenues by approximately $2.5 million per quarter in 2013.

Historically we have been able to mitigate a portion of revenue reductions resulting from changes in CMS' reimbursement regulations.

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

·
If inpatient days of care provided to all patients at a hospice exceed 20% of the total days of hospice care provided by that hospice for an annual period, then payment for days in excess of this limit are paid for at the lower routine home care rate.

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

In July 2011, CMS issued its final rule for hospice services for the 2012 federal fiscal year.  The rule includes a market basket increase of 3.0% and a 0.6% decrease resulting from a phase out of the wage index budget neutrality factor.  We estimate that the net impact on our hospice service operations of these two adjustments and updated wage index data will be an increase of 2.2% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.3 million per quarter.

Medicaid

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

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

Twenty-one of the states in which our Inpatient Services segment operates impose a provider tax on nursing homes as a method of increasing federal matching funds paid to those states for Medicaid.

The following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (excluding any impact of individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the periods indicated:
For the Three Months Ended
March 31, 2012
 
March 31, 2011
$178.64
 
$173.69


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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

For comparison purposes, the following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (including the impact from individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the periods indicated:
For the Three Months Ended
March 31, 2012
 
March 31, 2011
$161.61
 
$158.62

Managed Care and Insurance

During the three months ended March 31, 2012, we received 5.1% of our revenues from managed care and insurance, of which the Medicare Advantage program is the primary component.  As discussed above, Medicare Advantage is the managed care option for Medicare beneficiaries.  Medicare Advantage is administered by contracted third party payors.  The managed care and insurance payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers and increased utilization review.  These payors are increasingly demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated below. The increase in the average rate per patient, per day between the first quarter of 2011 and the first quarter of 2012 resulted from the unusually low prior year first quarter 2011 rate which included the negative impact of a $0.6 million prior year revenue reduction adjustment related to 2010 recorded in the first quarter of 2011 associated with a prior year managed care settlement payback. 
For the Three Months Ended
March 31, 2012
 
March 31, 2011
$381.54
 
$368.69

Private Payors, Veterans and Other

During the three months ended March 31, 2012, we received 24.5% of our revenues from private payors, veterans’ coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors. These private and other payors are continuing their efforts to control healthcare costs.  Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated below.  The decrease in the average rate per patient, per day between the first quarter of 2011 and the first quarter of 2012 resulted from a combination of the following:  (1) we experienced a proportionally larger amount of hospice and assisted living private pay customers in the first quarter of 2012 than in the prior year first quarter of 2011 and those hospice and private pay customers have a lower average per patient, per day private rate than our skilled nursing private pay customers thereby resulting in a lower blended inpatient services average per patient, per day private rate in 2012 as compared to 2011;  (2) the 2011 average rate per patient, per day included the positive benefit of $1.4 million greater prior year revenue increase adjustments recorded in the first quarter of 2011 than in the first quarter of 2012. 
For the Three Months Ended
March 31, 2012
 
March 31, 2011
$194.17
 
$199.38

Other Reimbursement Matters

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



20


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Recent Accounting Pronouncements

Discussion of recent accounting pronouncements can be found in the “Recent Accounting Pronouncements” portion of Note 1 – “Nature of Business” to our consolidated financial statements included in this Form 10-Q.

Results of Operations

The following tables set forth our unaudited historical consolidated income statements and certain percentage relationships for the periods presented (dollars in thousands): 
 
For the Three Months Ended
 
As a Percentage of Net Revenues
 
March 31, 2012
 
March 31, 2011
 
March 31, 2012
 
March 31, 2011
Total net revenues
$
458,493

 
$
466,307

 
100.0
 %
 
100.0
 %
Costs and expenses:
 

 
 

 
 
 
 
Operating salaries and benefits
261,090

 
262,480

 
56.9

 
56.3

Self-insurance for workers’ compensation and
 

 
 
 
 
 
 
general and professional liabilities
15,317

 
14,557

 
3.3

 
3.1

Other operating costs (1)
108,972

 
104,202

 
23.8

 
22.3

Center rent expense
36,377

 
35,692

 
7.9

 
7.7

General and administrative expenses
16,041

 
15,379

 
3.5

 
3.3

Depreciation and amortization
8,430

 
7,449

 
1.8

 
1.6

Provision for losses on accounts receivable
4,808

 
5,176

 
1.0

 
1.1

Interest, net
4,411

 
4,999

 
1.0

 
1.1

Other (2)

 
136

 

 

Income before income taxes and
        discontinued operations
3,047

 
16,237

 
0.7

 
3.5

Income tax expense
1,188

 
6,619

 
0.3

 
1.4

Income from continuing operations
1,859

 
9,618

 
0.4

 
2.1

Loss from discontinued operations, net
(1,646
)
 
(1,506
)
 
(0.4
)
 
(0.3
)
Net income
$
213

 
$
8,112

 
 %
 
1.7
 %
Supplemental Financial Information (3):
 

 
 

 
 
 
 
EBITDA
$
15,888

 
$
28,685

 
3.5
 %
 
6.2
 %
Adjusted EBITDA
$
15,888

 
$
28,821

 
3.5
 %
 
6.2
 %
Adjusted EBITDAR
$
52,265

 
$
64,513

 
11.4
 %
 
13.8
 %

(1) Operating administrative expenses are included in “other operating costs” above.
 
(2) Other expenses consist of restructuring costs.
 
(3) We define EBITDA as net income before loss from discontinued operations, interest expense (net of interest income), income tax expense, depreciation and amortization.  EBITDA margin is EBITDA as a percentage of revenue.  Adjusted EBITDA is EBITDA adjusted for restructuring costs.  Adjusted EBITDA margin is Adjusted EBITDA as a percentage of revenue.  Adjusted EBITDAR is Adjusted EBITDA before center rent expense.  Adjusted EBITDAR margin is Adjusted EBITDAR as a percentage of revenue.

We believe that the presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides useful information regarding our operational performance because they enhance the overall understanding of the financial performance and prospects for the future of our core business activities.

Specifically, we believe that a presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods.  EBITDA, Adjusted EBITDA and Adjusted EBITDAR are three of the primary indicators we use for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of GAAP expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.

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

21


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a center is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business
 
unit operates. These types of charges are dependent on factors unrelated to our underlying business. The additional items we exclude from Adjusted EBITDA and Adjusted EBITDAR are also charges that we believe are unrelated to the operation of our underlying business.  As a result, we believe that the use of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying business between periods by eliminating certain items required by GAAP which have little or no significance in our day-to-day operations.

We also make capital allocations to each of our centers based on the centers’ lease terms and their expected Adjusted EBITDA returns.  We establish compensation and bonus programs for our center-level employees that are based upon the achievement of pre-established Adjusted EBITDA targets.

Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and facility level basis, EBITDA, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by GAAP.  As the items excluded from EBITDA, Adjusted EBITDA and Adjusted EBITDAR are significant components in understanding and assessing our financial performance, EBITDA, Adjusted EBITDA and Adjusted EBITDAR should not be considered in isolation or as alternatives to net income, cash flows generated by or used in operating, investing or financing activities or other financial statement data presented in the consolidated financial statements included in this Form 10-Q as indicators of financial performance or liquidity.  Therefore, our EBITDA, Adjusted EBITDA and Adjusted EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP.  Some of these limitations are:

they do not reflect our cash expenditures, or future requirements for capital expenditures, or contractual commitments;
they do not reflect changes in, or cash requirements for, our working capital needs;
they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;
they do not reflect any income tax payments we may be required to make;
although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future in order to remain competitive in the market, and EBITDA, Adjusted EBITDA and Adjusted EBITDAR do not reflect any cash requirements for such replacements;
they are not adjusted for all non-cash income or expense items that are reflected in our consolidated statements of cash flows; and
other companies in our industry may calculate these measures differently than we do, which may limit their usefulness as comparative measures.

We compensate for these limitations by using EBITDA, Adjusted EBITDA and Adjusted EBITDAR only to supplement net income on a basis prepared in conformance with GAAP in order to provide a more complete understanding of the factors and trends affecting our business. We strongly encourage investors to consider net income determined under GAAP as compared to EBITDA, Adjusted EBITDA and Adjusted EBITDAR, and to perform their own analysis, as appropriate.

The following table provides a reconciliation of our net (loss) income, which is the most directly comparable financial measure presented in accordance with GAAP, to EBITDA, Adjusted EBITDA and Adjusted EBITDAR for the periods indicated (in thousands):
 
For the Three Months Ended
March 31,
 
2012
 
2011
Net income
$
213

 
$
8,112

Plus:
 

 
 

Loss from discontinued operations, net
(1,646
)
 
(1,506
)
Income tax expense
1,188

 
6,619

Interest expense, net
4,411

 
4,999

Depreciation and amortization
8,430

 
7,449

EBITDA
$
15,888

 
$
28,685

Plus:
 

 
 

Restructuring costs

 
136

Adjusted EBITDA
$
15,888

 
$
28,821

Plus:
 

 
 

Center rent expense
36,377

 
35,692

Adjusted EBITDAR
$
52,265

 
$
64,513




22


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following discussion of the “Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011” is based, in part, on the financial information presented in Note 7 – “Segment Information” in our consolidated financial statements included in this Form 10-Q.

Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011

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

Total net revenues decreased $7.8 million, or 1.7%, to $458.5 million for the three months ended March 31, 2012 from $466.3 million for the three months ended March 31, 2011.  We reported net income for the three months ended March 31, 2012 of $0.2 million and net income of $8.1 million for the three months ended March 31, 2011.

The decrease in net revenues for the 2012 period included $8.1 million of reduced revenues in our Inpatient Services segment and a $0.2 million decrease in nonaffiliated revenues from our Medical Staffing segment, which were partially offset by a $0.5 million increase in nonaffiliated revenues from our Rehabilitation Therapy Services segment.

Operating salaries and benefits decreased $1.4 million, or 0.5%, to $261.1 million (56.9% of net revenues) for the three months ended March 31, 2012 from $262.5 million (56.3% of net revenues) for the three months ended March 31, 2011.  The decrease resulted primarily from decreased wages and benefits in our housekeeping and laundry departments following the outsourcing of the majority of our housekeeping and laundry services.

Self-insurance for workers’ compensation and general and professional liability insurance expense increased $0.8 million, or 5.2%, to $15.3 million (3.3% of net revenues) for the three months ended March 31, 2012 from $14.6 million (3.1% of net revenues) for the three months ended March 31, 2011, which was primarily due to increased medical, legal and administrative costs associated with general and professional liability claims.
 
Other operating costs increased $4.8 million, or 4.6%, to $109.0 million (23.8% of net revenues) for the three months ended March 31, 2012 from $104.2 million (22.3% of net revenues) for the three months ended March 31, 2011.  The increase was primarily due to increased provider taxes, coupled with increases in purchased services for housekeeping and laundry services.

Center rent expense increased $0.7 million, or 1.9%, to $36.4 million (7.9% of net revenues) for the three months ended March 31, 2012 from $35.7 million (7.7% of net revenues) for the three months ended March 31, 2011.  The increase was primarily attributable to the scheduled inflationary increases in accordance with our lease agreements.

General and administrative expenses increased $0.7 million, or 4.3%, to $16.0 million (3.5% of net revenues) for the three months ended March 31, 2012 from $15.4 million (3.3% of net revenues) for the three months ended March 31, 2011.  The increase was primarily due to increased compensation and benefits.

Depreciation and amortization increased $1.0 million, or 13.2%, to $8.4 million (1.8% of net revenues) for the three months ended March 31, 2012 from $7.4 million (1.6% of net revenues) for the three months ended March 31, 2011.  The increase was due to new property and equipment placed into service since March 31, 2011.

The provision for losses on accounts receivable decreased $0.4 million, or 7.1%, to $4.8 million (1.0% of net revenues) for the three months ended March 31, 2012 from $5.2 million (1.1% of net revenues) for the three months ended March 31, 2011.  The decrease resulted primarily from decreased revenues associated with the CMS Final Rule that become effective October 1, 2011.

Net interest expense decreased $0.6 million, or 11.8%, to $4.4 million (1.0% of net revenues) for the three months ended March 31, 2012 from $5.0 million (1.1% of net revenues) for the three months ended March 31, 2011 due to lower aggregate indebtedness.


23


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the three months ended March 31 (dollars in thousands):
 
2012
 
2011
Inpatient Services
$
405,788

 
88.5
 %
 
$
413,888

 
88.8
 %
Rehabilitation Therapy Services
64,093

 
14.0

 
62,790

 
13.5

Medical Staffing Services
22,900

 
5.0

 
22,939

 
4.9

Corporate
7

 

 
7

 

Intersegment Eliminations
(34,295
)
 
(7.5
)
 
(33,317
)
 
(7.2
)
Total net revenues
$
458,493

 
100.0
 %
 
$
466,307

 
100.0
 %

Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the three months ended March 31 (in thousands):
 
2012
 
2011
Rehabilitation Therapy Services
$
33,464

 
$
32,694

Medical Staffing Services
831

 
623

Total intersegment revenue
$
34,295

 
$
33,317


The following table sets forth the amount of net segment income for the three months ended March 31 (in thousands):
 
2012
 
2011
Inpatient Services
$
19,349

 
$
33,475

Rehabilitation Therapy Services
3,762

 
2,772

Medical Staffing Services
1,431

 
1,399

Net segment income before Corporate
24,542

 
37,646

Corporate
(21,495
)
 
(21,273
)
Net segment income
$
3,047

 
$
16,373


Our reportable segments are strategic business units that provide different products and services.  They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income.  Net segment income is defined as earnings before income tax expense, restructuring costs and discontinued operations.  Net segment income for the three months ended March 31, 2012 for (1) our Inpatient Services segment decreased $14.1 million, or 42.2%, to $19.3 million, (2) our Rehabilitation Therapy Services segment increased $1.0 million, or 35.7%, to $3.8 million and (3) our Medical Staffing Services segment remained unchanged at $1.4 million in comparison to the three months ended March 31, 2011, due to the factors discussed below for each segment.  We use net segment income among other things to help identify opportunities for improvement and assist in allocating resources to each segment. 


24


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient Services

Total net revenues decreased $8.1 million, or 2.0%, to $405.8 million for the three months ended March 31, 2012 from $413.9 million for the three months ended March 31, 2011.  The decrease was primarily the result of:
-
a $16.1 million decrease in Medicare revenues due to a $13.6 million decrease in revenues related to Medicare Part A rates primarily resulting from the CMS Final Rule parity rate adjustment, and a $3.9 million decrease due to a lower customer base, offset in part by a $1.4 million increase in Medicare Part B revenues; and
 
 
-
a $2.9 million decrease in private revenues driven by lower customer base and rates;
 
 
 
Offset in part by:
 
 
-
an $8.8 million increase in Medicaid revenues consisting of $5.1 million from an increase in rates and a $3.7 million increase related to higher customer base;
 
 
-
a $1.0 million increase in hospice revenues due primarily to growth in customer base;
 
 
-
a $0.9 million increase in other revenues, including veterans' coverage and other various inpatient services; and
 
 
-
a $0.2 million increase in managed care and commercial insurance revenues driven by improved rates but partially offset by a decrease in customer base.
 

Operating salaries and benefits expenses decreased $1.2 million, or 0.6%, to $189.7 million for the three months ended March 31, 2012 from $190.9 million for the three months ended March 31, 2011.  The decrease was attributable to the following:
-
a decrease of $4.1 million due to the outsourcing of housekeeping and laundry services in many centers to a third party service provider; and
 
 
-
a $0.9 million decrease in overtime for all staff;
 
 
 
Offset in part by:
 
 
-
an increase of $3.8 million in staff compensation and benefits to remain competitive in local markets.
 
Self-insurance for workers’ compensation and general and professional liability insurance expense increased $0.8 million, or 5.8%, to $14.3 million for the three months ended March 31, 2012 as compared to $13.5 million for the three months ended March 31, 2011, which was primarily due to increased medical, legal and administrative costs associated with general and professional liability claims.

Other operating costs increased $6.2 million, or 5.2%, to $125.7 million for the three months ended March 31, 2012 from $119.4 million for the three months ended March 31, 2011.  The increase was attributable to the following:
-
a $3.6 million increase in purchased services, driven by a $4.1 million increase related to outsourced housekeeping and laundry services, which was partially offset by a $0.5 million decrease in other purchased services;
 
 
-
a $2.9 million increase in taxes, consisting primarily of provider taxes;
 
 
-
a $0.3 million increase in contract labor, principally driven by affiliated therapy services; and
 
 
-
a $0.2 million decrease in vendor rebates;
 
 
 
Offset in part by:
 
 
-
a $0.5 million decrease in supplies, of which $0.2 million relates to housekeeping and laundry supplies now included in our outsourcing arrangement discussed above; and
 
 
-
a $0.3 million decrease in administrative costs including advertising, legal fees, community awareness and other miscellaneous expenses.

Operating administrative expenses decreased $0.8 million, or 7.5%, to $9.3 million for the three months ended March 31, 2012 compared to $10.0 million for the three months ended March 31, 2011, primarily due to lower salaries, benefits and contract labor expense in accordance with our cost mitigation plans necessitated by the impact of the CMS Final Rule.


25


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Center rent expense increased $0.7 million, or 1.9%, to $36.1 million for the three months ended March 31, 2012 from $35.4 million for the three months ended March 31, 2011.  The increase was primarily attributable to the scheduled inflationary increases in accordance with our lease agreements.

Depreciation and amortization increased $0.8 million, or 13.2%, to $7.0 million for the three months ended March 31, 2012 from $6.2 million for the three months ended March 31, 2011.  The increase was due to new property and equipment placed into service since March 31, 2011.

The provision for losses on accounts receivable decreased $0.5 million, or 10.6%, to $4.4 million for the three months ended March 31, 2012 from $5.0 million for the three months ended March 31, 2011.   The decrease resulted primarily from decreased revenues associated with the CMS Final Rule that became effective October 1, 2011.

Rehabilitation Therapy Services

Total net revenues from the Rehabilitation Therapy Services segment increased $1.3 million, or 2.1%, to $64.1 million for the three months ended March 31, 2012 from $62.8 million for the three months ended March 31, 2011. The revenue increase was the result of:
-
an increase of $0.8 million attributable to increased billable minutes, primarily due to increased therapist productivity, and growth in Medicare Part B volume; and
 
 
-
an increase of $0.6 million due to a higher revenue per minute resulting from nonaffiliated rate increases combined with an affiliated market basket rate increase effective October 1, 2011;
 
 
 
Offset in part by:
 
 
-
a decrease in other revenue of $0.1 million primarily due to non-recurring personnel buy-outs received in the three months ended March 31, 2011 but not recurring in the three months ended March 31, 2012.

Operating salaries and benefits expenses decreased $0.2 million, or 0.4%, to $53.9 million for the three months ended March 31, 2012 from $54.1 million for the three months ended March 31, 2011.  The decrease was driven primarily by reduced health insurance and other benefits but partially offset by wage rate increases to remain competitive in local markets.

Medical Staffing Services

Total net revenues from the Medical Staffing Services segment were flat at $22.9 million for the three months ended March 31, 2012 compared to the three months ended March 31, 2011.  

Operating salaries and benefits expenses increased $0.1 million, or 0.4%, to $17.5 million for the three months ended March 31, 2012 as compared to $17.4 million for the three months ended March 31, 2011. The increase in operating salaries and benefits is due to wage rate increases to remain competitive in local markets.

Corporate

General and administrative expenses not directly attributed to segments increased $0.7 million, or 4.3%, to $16.0 million for the three months ended March 31, 2012 from $15.4 million for the three months ended March 31, 2011.  The increase was primarily due to increased compensation and benefits.

Interest expense not directly attributed to operating segments decreased $0.6 million, or 11.5%, to $4.4 million for the three months ended March 31, 2012 from $5.0 million for the three months ended March 31, 2011 due to lower aggregate indebtedness.

Liquidity and Capital Resources

For the three months ended and as of March 31, 2012, our net income was $0.2 million and our working capital was $151.7 million. As of March 31, 2012, we had cash and cash equivalents of $44.8 million, $60.0 million available on our revolving credit facility and $89.5 million in borrowings. As of March 31, 2012, we were in compliance with the covenants contained in the credit agreement governing the revolving credit facility and our term loan indebtedness as described under "Loan Agreements" below.

Based on current levels of operations, we believe that our operating cash flows (which were an outflow of $2.6 million during

26


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

the three months ended March 31, 2012, but were an inflow of $83.0 million for the year ended December 31, 2011), existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary) as discussed in our 2011 Form 10-K under “Capital Expenditures”, scheduled debt service payments and our other commitments (as described in the table under “Obligations and Commitments” of our 2011 Form 10-K) at least through the next twelve months. We believe our long-term liquidity needs will be satisfied by these same sources, as well as borrowings as required to refinance indebtedness. Although our credit agreement, which is described under “Loan Agreements” below, contains restrictions on our ability to incur indebtedness, we currently believe that we will be able to refinance existing indebtedness or incur additional indebtedness, if needed. However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing debt or equity securities, on terms that are acceptable to us or at all.

Since April 2007, we have relied on our cash flows to provide for operational needs and capital expenditures, and have not relied on revolving credit borrowings. However, there can be no assurance that our operations will continue to provide sufficient cash flow or that refinancing sources will be available in the future, particularly given current economic conditions. We anticipate that we will be able to utilize our revolving credit facility if needed, as we expect to remain in compliance with the covenants contained in our credit agreement for at least the next twelve months. In December 2011, we voluntarily paid down $50 million of term loans in conjunction with amending the Credit Agreement.  The amendment increased our interest rate by 1.25% in return for greater flexibility to our financial covenants. As a result of the expected negative impact of the CMS Final Rule on our business, we implemented a broad-based mitigation initiative, which includes infrastructure cost reductions without affecting the quality of our patient care. These reductions in infrastructure costs were, and continue to be, necessary to mitigate the impact on our business and remain in compliance with financial covenants under the Credit Agreement.   While we do not anticipate that any of our lenders will be unable to lend under our revolving credit facility if we determine to borrow funds, no assurance can be given that one or more of our lenders will be able to fulfill their commitments.  We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.

Cash Flows

During the three months ended March 31, 2012, net cash provided by operating activities decreased by $18.7 million as compared to the same period last year as we used $2.7 million of net cash in our operating activities for the three months ended March 31, 2012.  In addition to decreased net income of $7.9 million, the decrease in cash flows from operating activities was primarily the result of (i) our period-over-period increase in working capital needs of $9.6 million, driven principally by increased accounts receivable balances coupled with temporary cash usage from the impact of timing differences on scheduled payroll and accounts payable disbursement cycles and (ii) a period-over-period decrease of $1.2 million in non-cash adjustments to net income.  For additional information, please see “Results of Operations” above.

Net cash used for investing activities of $10.2 million for the three months ended March 31, 2012 was for capital expenditures and payments related to a February 2012 hospice acquisition.

Net cash used for financing activities was $0.3 million for the three months ended March 31, 2012, which was attributable to repayments of long-term debt and capital lease obligations.

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $10.0 million for the three months ended March 31, 2012.

Loan Agreements

In October 2010, we entered into a $285.0 million senior secured credit facility (the “Credit Agreement”) with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent. The Credit Agreement provides for $150.0 million in term loans ($87.4 million was outstanding at March 31, 2012), a $60.0 million revolving credit facility ($30.0 million of which may be utilized for letters of credit) and a $75.0 million letter of credit facility funded by proceeds of additional term loans ($74.8 million was utilized at March 31, 2012). The revolving credit facility was undrawn on March 31, 2012. The final maturity date of the term loans and the letter of credit facility is October 18, 2016 and the revolving credit facility terminates on October 18, 2015.

Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test and a leverage covenant. The Credit Agreement contains customary events of default, such as a failure by

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

us to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting certain actions, including incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments. Our obligations under the Credit Agreement are guaranteed by most of our subsidiaries and are collateralized by our assets and the assets of most of our subsidiaries.

In December 2011, we amended the Credit Agreement and the associated $50.0 million voluntary repayment effectively satisfied any required quarterly principal payments until the facility's maturity in 2016. Accrued interest is payable at the end of an interest period, but no less frequently than every three months. Upon amendment, borrowings under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at our option, either (a) the greater of 1.75% or LIBOR, adjusted for statutory reserves or (b) an alternative base rate determined by reference to the highest of (i) the prime rate announced by Credit Suisse, (ii) the federal funds rate plus 0.5%, and (iii) the greater of 1.75% or one-month LIBOR adjusted for statutory reserves plus 1%.  As of March 31, 2012, the applicable percentage for term loans and revolving loans was 6.00% for alternative base rate loans and 7.00% for LIBOR loans.  Each year, commencing in 2012, within 90 days of the prior fiscal year end, we are required to prepay a portion of the term loans in an amount based on the prior year's excess cash flows, if any, as defined in the Credit Agreement. In addition to paying interest on outstanding loans under the Credit Agreement, we are required to pay a facility fee of 0.50% per annum to the lenders under the revolving credit facility in respect of the unused revolving commitments.

The Credit Agreement requires that at least 50% of our term loans be subject to at least a three-year hedging agreement. To satisfy this requirement, we executed two hedging instruments on January 18, 2011: a two-year interest rate cap and a two-year “forward starting” interest rate swap.  The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012.  This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 8.75% through December 31, 2012.  The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement.  The two-year “forward starting” interest rate swap effectively converts the interest rate on $82.5 million of our term loans to a fixed rate from January 1, 2013 through December 31, 2014.  LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 10.185% for this portion of the term loans.  There was no fee for this swap agreement.  Both arrangements qualify for hedge accounting treatment.


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk because we have issued debt that is sensitive to changes in interest rates. We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates of interest on our debt. The following table provides information regarding our market sensitive financial instruments and constitutes a forward-looking statement.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value
 
Fair Value
 
Expected Maturity Dates - the Twelve Months Ending March 31,
 
March 31,
 
  December 31,
 
2013
 
2014
 
2015
 
2016
 
2017
 
Thereafter
 
Total
 
2012 (1)
 
2011 (1)
 
(Dollars in thousands)
 
 
 
 
Long-term debt:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate debt
$
995

 
$
913

 
$
229

 
$

 
$

 
$

 
$
2,137

 
$
2,191

 
$
2,450

Rate
8.7
%
 
8.6
%
 
8.6
%
 

 

 

 
 

 
 

 
 

Variable rate debt
$

 
$

 
$

 
$

 
$
87,358

 
$

 
$
87,358

 
$
84,301

 
$
72,096

Rate

 

 

 

 
8.75
%
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate hedges:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
$
2,167

 
$
2,049

Cap
$
82,500

 
$

 
$

 
$

 
$

 
$

 
 

 
 

 
 

Maximum rate
1.75
%
 

 

 

 

 

 
 

 
 

 
 

Variable to fixed
$

 
$
82,500

 
$
82,500

 
$

 
$

 
$

 
 

 
 

 
 

Average pay rate

 
3.185
%
 
3.185
%
 

 

 

 
 

 
 

 
 

Average receive rate

 
1.75
%
 
1.75
%
 

 

 

 
 

 
 

 
 

 
(1)
    The fair value of fixed and variable rate debt was determined based on the current rates offered for debt with similar risks and maturities.



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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 4.  CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as controls and procedures that are designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated  and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding  required disclosure.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of management, including our Chief Executive Officer, William A. Mathies, and our Chief Financial Officer, L. Bryan Shaul, of the effectiveness of the Company’s disclosure controls and procedures.  Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2012.

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

PART II. OTHER INFORMATION


ITEM 1.  LEGAL PROCEEDINGS

For a description of our legal proceedings, see Note 5(b) – “Commitments and Contingencies – Litigation” of our consolidated financial statements included in this Form 10-Q, which is incorporated by reference to this item.


ITEM 1A. RISK FACTORS

There have been no material changes in our assessment of our risk factors from those set forth in our 2011 Form 10-K.



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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 6. EXHIBITS

10.1
Sun Healthcare Group, Inc. 2012 Cash Bonus Plan
 
 
10.2
Sun Healthcare Group, Inc. Non-Employee Director Compensation Policy
 
 
10.3
Sun Healthcare Group, Inc. 2011 Executive Bonus Retention Plan
 
 
10.4
Form of Stock Unit Agreement for Employees
 
 
10.5
Form of Restricted Stock Agreement
 
 
31.1
Section 302 Sarbanes-Oxley Certification by Chief Executive Officer
 
 
31.2
Section 302 Sarbanes-Oxley Certification by Chief Financial Officer
 
 
32.1
Section 906 Sarbanes-Oxley Certification by Chief Executive Officer
 
 
32.2
Section 906 Sarbanes-Oxley Certification by Chief Financial Officer
 
 
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


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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


SIGNATURE

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

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

May 8, 2012

31