Genesis Healthcare, Inc. - FORM 10-Q - August 11, 2014

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)
þ
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2014.
OR
o
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from              to             .
Commission file number: 001-33459
 
Skilled Healthcare Group, Inc.
(Exact name of registrant as specified in its charter)
  
 
Delaware
 
20-3934755
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)
 
 
27442 Portola Parkway, Suite 200
 
 
Foothill Ranch, California
 
92610
(Address of principal executive offices)
 
(Zip Code)
(949) 282-5800
(Registrant’s telephone number, including area code)

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  þ    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  þ    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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
o
 
Accelerated filer
þ
 
 
 
 
 
Non-accelerated filer
o
(do not check if smaller reporting company)
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  þ
The number of shares outstanding of each of the issuer’s classes of common stock, as of the close of business on August 8, 2014, was:
Class A common stock, $0.001 par value – 24,615,157 shares
Class B common stock, $0.001 par value – 15,511,603 shares
 


Skilled Healthcare Group, Inc.
Form 10-Q
For the Quarterly Period Ended June 30, 2014
Index
 
 
 
Page
Number
Part I.
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
Part II.
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 



PART I — FINANCIAL INFORMATION
Item 1. Financial Statements.
Skilled Healthcare Group, Inc.
Condensed Consolidated Balance Sheets
(In thousands, except per share data)
 
June 30, 2014
 
December 31, 2013
 
(Unaudited)
 
(Audited)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
7,960

 
$
4,177

Accounts receivable, less allowance for doubtful accounts of $17,943 and $16,665 at June 30, 2014 and December 31, 2013, respectively
110,443

 
107,215

Deferred income taxes
11,845

 
9,876

Prepaid expenses
6,009

 
8,961

Other current assets
11,115

 
12,188

Total current assets
147,372

 
142,417

Property and equipment, less accumulated depreciation of $149,175 and $137,484 at June 30, 2014 and December 31, 2013, respectively
336,360

 
341,822

Leased facility assets, less accumulated depreciation of $4,674 and $4,432 at June 30, 2014 and December 31, 2013, respectively
9,174

 
9,416

Other assets:
 
 
 
Notes receivable
2,350

 
520

Deferred financing costs, net
8,600

 
9,189

Goodwill
68,983

 
69,065

Intangible assets, less accumulated amortization of $4,799 and $4,640 at June 30, 2014 and December 31, 2013, respectively
18,648

 
18,807

Deferred income taxes
7,029

 
9,472

Restricted Assets
30,246

 
26,965

Other assets
15,199

 
15,743

Total other assets
151,055

 
149,761

Total assets
$
643,961

 
$
643,416

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued liabilities
$
57,868

 
$
57,179

Employee compensation and benefits
41,385

 
32,979

Current portion of long-term debt
10,198

 
7,630

Total current liabilities
109,451

 
97,788

Long-term liabilities:
 
 
 
Insurance liability risks
29,232

 
29,534

Other long-term liabilities
12,471

 
12,367

Long-term debt, less current portion
400,036

 
411,495

Total liabilities
551,190

 
551,184

Commitments and contingencies — Note 8
 
 
 
Stockholders’ equity:
 
 
 
Class A common stock, 175,000 shares authorized, $0.001 par value per share; Issued and outstanding - 24,635 and 24,278 at June 30, 2014 and December 31, 2013, respectively
25

 
24

Class B common stock, 30,000 shares authorized, $0.001 par value per share; Issued and outstanding - 15,512 and 15,515 at June 30, 2014 and December 31, 2013 respectively
16

 
16

Additional paid-in-capital
380,808

 
378,756

Accumulated deficit
(288,078
)
 
(286,592
)
Accumulated other comprehensive income
—

 
28

Total stockholders’ equity
92,771

 
92,232

Total liabilities and stockholders’ equity
$
643,961

 
$
643,416

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

3

Skilled Healthcare Group, Inc.
Condensed Consolidated Statements of Operations
(In thousands, except per share data)
(Unaudited)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Revenue:
 
 
 
 
 
 
 
Net patient service revenue
$
206,172

 
$
209,405

 
$
412,685

 
$
423,702

Leased facility revenue
807

 
787

 
1,594

 
1,548

 
206,979

 
210,192

 
414,279

 
425,250

Expenses:
 
 
 
 
 
 
 
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)
178,529

 
182,815

 
358,838

 
369,084

Rent cost of revenue
4,922

 
4,685

 
9,696

 
9,354

General and administrative
7,287

 
6,837

 
13,371

 
13,292

Change in fair value of contingent consideration
(121
)
 
(2,244
)
 
(107
)
 
(2,161
)
Depreciation and amortization
6,034

 
5,902

 
12,120

 
11,800

Governmental investigation expense
6,000

 
—

 
6,000

 
—

Impairment of long-lived assets
82

 
—

 
82

 
—

Loss on disposal of asset
5

 
—

 
5

 
—

 
202,738

 
197,995

 
400,005

 
401,369

Other (expenses) income:
 
 
 
 
 
 
 
Interest expense
(7,945
)
 
(8,734
)
 
(15,984
)
 
(17,409
)
Interest income
302

 
112

 
345

 
224

Other income (expense), net
7

 
(32
)
 
60

 
(62
)
Equity in earnings of joint venture
92

 
472

 
638

 
960

Debt modification/retirement costs
(822
)
 
(1,088
)
 
(822
)
 
(1,088
)
Total other (expenses) income, net
(8,366
)
 
(9,270
)
 
(15,763
)
 
(17,375
)
(Loss) income from continuing operations before (benefit) provision for income taxes
(4,125
)
 
2,927

 
(1,489
)
 
6,506

(Benefit) provision for income taxes
(1,345
)
 
1,139

 
(3
)
 
1,384

(Loss) income from continuing operations
(2,780
)
 
1,788

 
(1,486
)
 
5,122

Loss from discontinued operations, net of tax
—

 
(265
)
 
—

 
(529
)
Net (loss) income
$
(2,780
)
 
$
1,523

 
$
(1,486
)
 
4,593

 
 
 
 
 
 
 
 
(Loss) earnings per share, basic:
 
 
 
 
 
 
 
(Loss) earnings per common share from continuing operations
$
(0.07
)
 
$
0.05

 
$
(0.04
)
 
$
0.13

Loss per share from discontinued operations
—

 
(0.01
)
 
—

 
(0.01
)
(Loss) earnings per share
$
(0.07
)
 
$
0.04

 
$
(0.04
)
 
$
0.12




 


 


 


(Loss) earnings per share, diluted:


 


 


 


(Loss) earnings per common share from continuing operations
$
(0.07
)
 
$
0.05

 
$
(0.04
)
 
$
0.13

Loss per share from discontinued operations
—

 
(0.01
)
 
—

 
(0.01
)
(Loss) earnings per share
$
(0.07
)
 
$
0.04

 
$
(0.04
)
 
$
0.12




 


 


 


Weighted-average common shares outstanding, basic
38,098

 
37,646

 
38,035

 
37,602

Weighted-average common shares outstanding, diluted
38,098

 
38,186

 
38,035

 
38,139

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


4

Skilled Healthcare Group, Inc.
Condensed Consolidated Statements of Comprehensive (Loss) Income
(In thousands)
(Unaudited)

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
Net (loss) income
$
(2,780
)
 
$
1,523

 
$
(1,486
)
 
$
4,593

Other comprehensive (loss) income:
 
 
 
 
 
 
 
Unrealized loss on investment available for sale - net of income tax benefit of $9 for the three months ended June 30, 2013; net of income tax benefit of $10 for the six months ended June 30, 2013.


 
(14
)
 


 
(16
)
Reclassification adjustments:
 
 
 
 
 
 
 
Gain realized in net loss on investments available for sale - net of income tax expense of $17 for the three and six months ended June 30, 2014.
(28
)
 
—

 
(28
)
 


Interest expense on interest rate swap - net of income tax expense of $56 and $107 for the three and six months ended June 30, 2013.
—

 
87

 
—

 
169

Other comprehensive (loss) income, net of tax
(28
)
 
73

 
(28
)
 
153

Comprehensive (loss) income
$
(2,808
)
 
$
1,596

 
(1,514
)
 
4,746


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


5

Skilled Healthcare Group, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
 
 
Six Months Ended June 30,
 
2014
 
2013
Cash Flows from Operating Activities
 
 
 
Net (loss) income
$
(1,486
)
 
$
4,593

Adjustments to reconcile net (loss) income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
12,120

 
12,266

Change in fair value of contingent consideration
(107
)
 
(2,161
)
Provision for doubtful accounts
6,625

 
6,097

Non-cash stock-based compensation
1,446

 
1,634

Loss on disposal of assets
5

 
—

Amortization of deferred financing costs
1,803

 
1,323

Debt modification/retirement costs
822

 
1,088

Deferred income taxes
474

 
4,080

Impairment of long lived assets
82

 
—

Amortization of discount on debt
282

 
475

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(12,643
)
 
(21,037
)
Payments on notes receivable
727

 
1,419

Other current and non-current assets
2,004

 
(1,642
)
Accounts payable and accrued liabilities
1,298

 
766

Employee compensation and benefits
5,739

 
(328
)
Insurance liability risks
1,812

 
4,271

Other long-term liabilities
211

 
945

Net cash provided by operating activities
21,214

 
13,789

Cash Flows from Investing Activities
 
 
 
Additions to property and equipment
(6,261
)
 
(5,981
)
Proceeds from maturity of investments
1,060

 
—

Net cash used in investing activities
(5,201
)
 
(5,981
)
Cash Flows from Financing Activities
 
 
 
Borrowings under line of credit
157,000

 
165,000

Repayments under line of credit
(163,057
)
 
(161,000
)
Repayments of long-term debt
(4,741
)
 
(9,121
)
Proceeds from exercise of stock options
948

 
—

Taxes paid related to net share settlement of equity awards
(343
)
 
(222
)
Payment of financing costs
(2,037
)
 
(2,449
)
Net cash used in financing activities
(12,230
)
 
(7,792
)
Increase in cash and cash equivalents
3,783

 
16

Cash and cash equivalents at beginning of period
4,177

 
2,003

Cash and cash equivalents at end of period
$
7,960

 
$
2,019

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

6

 
Six Months Ended June 30,
 
2014
 
2013
Supplemental cash flow information
 
 
 
Cash paid for:
 
 
 
Interest expense
$
13,073

 
$
15,684

Income taxes, net
$
(1,838
)
 
$
181

Non-cash activities:
 
 
 
Conversion of accounts receivable into notes receivable
$
2,782

 
$
—

Insurance premium financed
$
1,625

 
$
1,187

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

7
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


1. Description of Business

Current Business
Skilled Healthcare Group, Inc. ("Skilled") is a holding company that owns subsidiary companies that operate long-term care facilities and provides a wide range of post-acute care services, with a strategic emphasis on sub-acute specialty medical care. Skilled and its consolidated wholly-owned companies are collectively referred to as the "Company." As of June 30, 2014, the Company operated facilities in California, Iowa, Kansas, Missouri, Nevada, Nebraska, New Mexico and Texas, including 73 skilled nursing facilities ("SNFs"), which offer sub-acute care, rehabilitative, specialty healthcare, and skilled nursing care, and 22 assisted living facilities ("ALFs"), which provide room and board and assistance with activities of daily living. The Company leases five skilled nursing facilities in California to an unaffiliated third party operator. In addition, through its Hallmark Rehabilitation subsidiary ("Hallmark"), the Company provides a variety of rehabilitative services such as physical, occupational and speech therapy in Company-operated facilities and unaffiliated facilities. Furthermore, as of June 30, 2014, the Company provided hospice care and home health services in Arizona, California, Idaho, Montana, Nevada and New Mexico. The Company also provides private duty care services in Idaho, Montana, and Nevada. The Company has an administrative services company that provides a full complement of administrative and consultative services that allows affiliated operators and third-party operators with whom the Company contracts to better focus on delivery of healthcare services. The Company currently has one such service agreement with an unrelated skilled nursing facility operator. The Company also owns a 50% interest in an institutional pharmacy in Texas, which currently serves eight of the Company's SNFs as well as other facilities unaffiliated with the Company.
In June 2014, the Company commenced operations at its state-of-the-art skilled nursing facility in Kansas City, Kansas. The facility is co-located within the University of Kansas' acute rehabilitation hospital adjacent to the medical school. This facility added 96 licensed beds to the Company's long term care operations. As of June 30, 2014, the newly leased facility was not at full operation.

2. Discontinued Operations
On December 1, 2013, the Company disposed of two skilled nursing facilities, one owned facility in Texas and one leased facility in California. The results of operations of these facilities for all periods presented and the losses associated with the transaction have been classified as discontinued operations, net of tax, in the accompanying condensed consolidated statements of operations as the operations have been eliminated from the Company’s ongoing operations.

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


Three Months Ended June 30,
 
Six Months Ended June 30,

2014
 
2013
 
2014
 
2013
Net operating revenues
$
—

 
$
3,500

 
$
—

 
$
7,317

Operating expenses
—

 
3,932

 
—

 
8,180

Loss from discontinued operations
—

 
(432
)
 
—

 
(863
)
Income tax benefit
—

 
(167
)
 
—

 
(334
)
Loss from discontinued operations
$
—

 
$
(265
)
 
$
—

 
$
(529
)


3. Summary of Significant Accounting Policies

Basis of Presentation
The accompanying condensed consolidated financial statements as of June 30, 2014 and for the three and six months ended June 30, 2014 and 2013 (collectively, the "Interim Financial Statements"), are unaudited. Certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted, as permitted under applicable U.S. Securities and Exchange Commission rules and regulations. Readers of the Interim Financial Statements should refer to the Company's audited consolidated financial statements and notes thereto (as updated by Note 3, "Summary of Significant Accounting Policies," in this filing), for the year ended December 31, 2013, which are

8
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

included in the Company's 2013 Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC"). Management believes that the Interim Financial Statements reflect all adjustments that are of a normal and recurring nature necessary to fairly present the Company's financial information in all material respects as of the dates and for the periods presented. The results of operations presented in the Interim Financial Statements are not necessarily indicative of operations to be expected for the entire year or any other period.
The accompanying Interim Financial Statements include the accounts of Skilled and its consolidated wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation.
Estimates and Assumptions
The interim financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP"), which require the Company to consolidate company financial information and make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant estimates in the Company’s interim financial statements relate to revenue, allowance for doubtful accounts, self-insured liability risks, income taxes, governmental investigation, and valuation of contingent consideration.
Revenue and Accounts Receivables
Revenue and accounts receivable are recorded on an accrual basis as services are performed at their estimated net realizable value. The Company derives a majority of its revenue from funds under federal Medicare and state Medicaid assistance programs, the continuation of which are dependent upon governmental policies and are subject to audit risk and potential recoupment.
Overall payments made by Medicare for hospice services are subject to an annual cap amount on a per hospice agency basis. Total Medicare payments received for services rendered during the applicable Medicare hospice cap year by each Medicare-certified agency during this period are compared to the cap amount for the relevant period. Payments in excess of the cap are subject to recoupment by Medicare. For the three months ended June 30, 2014 and 2013, the Company recorded hospice Medicare cap reserves of $0.9 million and $1.4 million, respectively, as adjustments to revenue. Of the $0.9 million recorded in the three months ended June 30, 2014, $0.5 million was related to the 2014 cap year and $0.4 million was related to the 2013 cap year. Of the $1.4 million recorded in the three months ended June 30, 2013, $0.7 million was related to the 2013 cap year and $0.7 million was related to the 2012 cap year. For the six months ended June 30, 2014 and 2013, the Company recorded hospice Medicare cap reserves of $0.9 million and $2.9 million, respectively, as adjustments to revenue. Of the $0.9 million recorded in the six months ended June 30, 2014, $0.5 million was related to the 2014 cap year and$0.4 million was related to the 2013 cap year. Of the $2.9 million recorded in the six months ended June 30, 2013, $0.7 million was related to the 2013 cap year, $2.0 million was related to the 2012 cap year, and $0.2 million was related to the 2011 cap year.
Notes Receivable
As of June 30, 2014 and December 31, 2013, net notes receivable were approximately $4.1 million and $2.0 million, respectively, of which $1.7 million and $1.5 million was reflected as current assets as of June 30, 2014 and December 31, 2013, with the remaining balances reflected as long-term assets. Interest rates on these notes approximated market rates as of the date the notes were originated.
As of June 30, 2014, two customers of the Company's rehabilitation therapy services business were responsible for 100% of the net notes receivable balance. The notes receivable, as well as the receivables from these customers, are secured by the assets of the customers as well as a personal guaranty by the principal owners of the customers. Additionally, the customers represented $8.5 million, or 43.6% of the net accounts receivable for the Company's rehabilitation therapy services business and approximately $19.3 million, or 41.7%, of the external revenue of the rehabilitation therapy services business for the six months ended June 30, 2014.
The notes receivable balance is stated net of an allowance for uncollectibility. At June 30, 2014, there was no note receivable reserve balance.
Recent Accounting Pronouncement
In April 2014, the FASB issued ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, ("ASU 2014-08").  This ASU requires an entity to report disposed components or components held-for-sale in discontinued operations if such components represent a strategic shift that have or will have a significant effect on operations and financial results. Additionally, expanded disclosure about discontinued operations and disposals of significant components that do not qualify for discontinued operations presentation will be required. The adoption of ASU 2014-08 is effective prospectively for disposals that occur within annual periods beginning on or after December 15, 2014, with early adoption permitted. The Company is currently evaluating the impact to the consolidated financial statements.

9
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, ("ASU 2014-08").  This ASU requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve this core principle, the guidance provides that an entity should apply the following steps: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when, or as, the entity satisfies a performance obligation. The ASU is effective beginning in the first quarter of our fiscal year 2017. Early adoption is not permitted. The Company is currently evaluating the impact to the consolidated financial statements.

4. (Loss) Income Per Share
The Company computes (loss) income per share of Class A common stock and Class B common stock using the two-class method. The Company's Class A common stock and Class B common stock are identical in all respects, except with respect to voting rights and that each share of Class B common stock is convertible into one share of Class A common stock under certain circumstances. (Loss) income is allocated on a proportionate basis to each class of common stock in the determination of (loss) income per share.
Basic net (loss) income per share was computed by dividing net (loss) income by the weighted-average number of outstanding shares for the period. Diluted earnings per share is computed by dividing income (loss) plus the effect of assumed conversions (if applicable) by the weighted-average number of outstanding shares after giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase and convertible preferred stock, if any. The following table sets forth the computation of basic and diluted net (loss) income per share of Class A common stock and Class B common stock for the three and six months ended June 30, 2014 and June 30, 2013 (amounts in thousands, except per share data):
 
Three months ended June 30, 2014
 
Three months ended June 30, 2013
 
Six months ended June 30, 2014
 
Six months ended June 30, 2013
 
Class A
 
Class B
 
Total
 
Class A
 
Class B
 
Total
 
Class A
 
Class B
 
Total
 
Class A
 
Class B
 
Total
Net (loss) Income per share, basic
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Numerator:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allocation of (loss) income from continuing operations
$
(1,648
)
 
$
(1,132
)
 
$
(2,780
)
 
$
1,048

 
$
740

 
$
1,788

 
$
(880
)
 
$
(606
)
 
$
(1,486
)
 
$
3,000

 
$
2,122

 
$
5,122

Allocation of loss from discontinued operations
—

 
—

 
—

 
(155
)
 
(110
)
 
(265
)
 
—

 
—

 
—

 
(310
)
 
(219
)
 
(529
)
Allocation of net (loss) income
$
(1,648
)
 
$
(1,132
)
 
$
(2,780
)
 
$
893

 
$
630

 
$
1,523

 
$
(880
)
 
$
(606
)
 
$
(1,486
)
 
$
2,690

 
$
1,903

 
$
4,593

Net (loss) income per share, diluted
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Numerator:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allocation of (loss) income from continuing operations
$
(1,648
)
 
$
(1,132
)
 
$
(2,780
)
 
$
1,059

 
$
729

 
$
1,788

 
$
(880
)
 
$
(606
)
 
$
(1,486
)
 
$
3,030

 
$
2,092

 
$
5,122

Allocation of loss from discontinued operations
—

 
—

 
—

 
(157
)
 
(108
)
 
(265
)
 
—

 
—

 
—

 
(313
)
 
(216
)
 
$
(529
)
Allocation of net (loss) income
$
(1,648
)
 
$
(1,132
)
 
$
(2,780
)
 
$
902

 
$
621

 
$
1,523

 
$
(880
)
 
$
(606
)
 
$
(1,486
)
 
$
2,717

 
$
1,876

 
$
4,593

Denominator for basic and diluted (loss) income per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding, basic
22,585

 
15,513

 
38,098

 
22,070

 
15,576

 
37,646

 
22,521

 
15,514

 
38,035

 
22,026

 
15,576

 
37,602

Plus: incremental shares related to dilutive effect of stock options and restricted stock, if applicable
—

 
—

 
—

 
540

 
—

 
540

 
—

 
—

 
—

 
537

 
—

 
537

Adjusted weighted-average common shares outstanding, diluted
22,585

 
15,513

 
38,098

 
22,610

 
15,576

 
38,186

 
22,521

 
15,514

 
38,035

 
22,563

 
15,576

 
38,139

(Loss) earnings per share, basic:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Loss) earnings per common share from continuing operations
$
(0.07
)
 
$
(0.07
)
 
$
(0.07
)
 
$
0.05

 
$
0.05

 
$
0.05

 
$
(0.04
)
 
$
(0.04
)
 
$
(0.04
)
 
$
0.13

 
$
0.13

 
$
0.13

Loss per share from discontinued operations
—

 
—

 
—

 
(0.01
)
 
(0.01
)
 
(0.01
)
 
—

 
—

 
—

 
$
(0.01
)
 
$
(0.01
)
 
$
(0.01
)
(Loss) earnings per share
$
(0.07
)
 
$
(0.07
)
 
$
(0.07
)
 
$
0.04

 
$
0.04

 
$
0.04

 
$
(0.04
)
 
$
(0.04
)
 
$
(0.04
)
 
$
0.12

 
$
0.12

 
$
0.12

(Loss) earnings per share, diluted:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Loss) earnings per common share from continuing operations
$
(0.07
)
 
$
(0.07
)
 
$
(0.07
)
 
$
0.05

 
$
0.05

 
$
0.05

 
$
(0.04
)
 
$
(0.04
)
 
$
(0.04
)
 
$
0.13

 
$
0.13

 
$
0.13

Loss per share from discontinued operations
—

 
—

 
—

 
(0.01
)
 
(0.01
)
 
(0.01
)
 
—

 
—

 
—

 
$
(0.01
)
 
$
(0.01
)
 
$
(0.01
)
(Loss) earnings per share
$
(0.07
)
 
$
(0.07
)
 
$
(0.07
)
 
$
0.04

 
$
0.04

 
$
0.04

 
$
(0.04
)
 
$
(0.04
)
 
$
(0.04
)
 
$
0.12

 
$
0.12

 
$
0.12

The following were excluded from the weighted-average diluted shares computation for the three and six months ended June 30, 2014 and 2013, as their inclusion would have been anti-dilutive (shares in thousands):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Options to purchase common shares
338

 
585

 
492

 
585

Non-vested common shares
198

 
434

 
221

 
911

Total excluded
536

 
1,019

 
713

 
1,496

 

5. Business Segments
The Company has three reportable operating segments: (i) long-term care services ("LTC"), which includes the operation of SNFs and ALFs (which is the most significant portion of the Company's business), the Company's administrative services provided to an unrelated SNF operator, and the facility lease revenue from a third-party operator; (ii) the Company's rehabilitation therapy services business; and (iii) the Company's hospice and home health businesses. The "other" column in the table below includes general and administrative items, as well as joint venture equity earnings. The Company's reporting segments are business units that offer different services, and that are managed differently due to the nature of the services provided.
At June 30, 2014, LTC services included 73 wholly-owned SNF operating companies that offer post-acute, rehabilitative custodial and specialty skilled nursing care, as well as 22 wholly-owned ALF operating companies that provide room and board and social services. Therapy services included rehabilitative services such as physical, occupational and speech therapy provided in the Company's facilities and in unaffiliated facilities. Hospice and home health services were provided by the Company's wholly-owned subsidiaries to patients.
The Company evaluates performance and allocates capital resources to each segment based on an operating model that is designed to maximize the quality of care provided and profitability. Accordingly, earnings from operations before net interest, tax, depreciation and amortization, non-core expenses ("Adjusted EBITDA") and rent cost of revenue ("Adjusted EBITDAR") is used as the primary measure of each segment’s operating results because it does not include such costs as interest expense, income taxes, depreciation, amortization and rent cost of revenue which may vary from segment to segment depending upon various factors, including the method used to finance the original purchase of assets within a segment or the tax law of the states in which a segment operates. By excluding these items, the Company is better able to evaluate operating performance of the segment by focusing on more controllable measures. Adjusted EBITDA and Adjusted EBITDAR are non‑GAAP financial measures. For a full discussion of the definitions of these terms and the reasons why the Company utilizes such measures, see Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, of this filing. General and administrative expenses are not allocated to any segment for purposes of determining segment profit or loss, and are included in the "other" category in the selected segment financial data that follows. Intersegment sales and transfers are recorded at cost plus standard mark-up; intersegment transactions have been eliminated in consolidation.











10
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


The following table sets forth selected interim financial data consolidated by business segment (dollars in thousands):
 
Long-Term
Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Other
 
Elimination
 
Total
Three months ended June 30, 2014
 
 
 
 
 
 
 
 
 
 
 
Net patient service revenue from external customers
$
162,264

 
$
23,076

 
$
20,832

 
$
—

 
$
—

 
$
206,172

Leased facility revenue
807

 
—

 
—

 
—

 
—

 
807

Intersegment revenue
503

 
14,066

 
—

 
—

 
(14,569
)
 
—

Total revenue
$
163,574

 
$
37,142

 
$
20,832

 
$
—

 
$
(14,569
)
 
$
206,979

Operating income (loss)
$
12,950

 
$
3,892

 
$
(5,192
)
 
$
(7,409
)
 
$
—

 
$
4,241

Interest expense, net of interest income
 
 
 
 
 
 
 
 
 
 
(7,643
)
Other income
 
 
 
 
 
 
 
 
 
 
7

Equity in earnings of joint venture
 
 
 
 
 
 
 
 
 
 
92

Debt modification/retirement costs
 
 
 
 
 
 
 
 
 
 
(822
)
Loss from continuing operations before benefit for income taxes
 
 
 
 
 
 
 
 
 
 
$
(4,125
)
Depreciation and amortization
$
5,520

 
$
165

 
$
227

 
$
122

 
$
—

 
$
6,034

Segment capital expenditures
$
2,469

 
$
18

 
$
53

 
$
171

 
$
—

 
$
2,711

Adjusted EBITDA
$
18,834

 
$
4,056

 
$
1,461

 
$
(6,074
)
 
$
—

 
$
18,277

Adjusted EBITDAR
$
23,297

 
$
4,056

 
$
1,920

 
$
(6,074
)
 
$
—

 
$
23,199

Three months ended June 30, 2013
 
 
 
 
 
 
 
 
 
 
 
Net patient service revenue from external customers
$
157,512

 
$
26,637

 
$
25,256

 
$
—

 
$
—

 
$
209,405

Leased facility revenue
787

 
—

 
—

 
—

 
—

 
787

Intersegment revenue
653

 
14,018

 
—

 
—

 
(14,671
)
 
—

Total revenue
$
158,952

 
$
40,655

 
$
25,256

 
$
—

 
$
(14,671
)
 
$
210,192

Operating income (loss)
$
12,608

 
$
2,705

 
$
3,879

 
$
(6,995
)
 
$
—

 
$
12,197

Interest expense, net of interest income
 
 
 
 
 
 
 
 
 
 
(8,622
)
Other expense
 
 
 
 
 
 
 
 
 
 
(32
)
Equity in earnings of joint venture
 
 
 
 
 
 
 
 
 
 
472

Debt modification/retirement costs
 
 
 
 
 
 
 
 
 
 
(1,088
)
Income from continuing operations before provision for income taxes
 
 
 
 
 
 
 
 
 
 
$
2,927

Depreciation and amortization
$
5,428

 
$
174

 
$
135

 
$
165

 
$
—

 
$
5,902

Segment capital expenditures
$
3,365

 
$
70

 
$
83

 
$
62

 
$
—

 
$
3,580

Adjusted EBITDA
$
18,237

 
$
2,879

 
$
2,017

 
$
(4,832
)
 
$
—

 
$
18,301

Adjusted EBITDAR
$
22,464

 
$
2,879

 
$
2,483

 
$
(4,840
)
 
$
—

 
$
22,986

Six months ended June 30, 2014
 
 
 
 
 
 
 
 
 
 
 
Net patient service revenue from external customers
$
322,850

 
$
46,143

 
$
43,693

 
$
—

 
$
—

 
$
412,685

Leased facility revenue
1,594

 
—

 
—

 
—

 
—

 
1,594

Intersegment revenue
954

 
27,901

 
—

 
—

 
(28,855
)
 
—

Total revenue
$
325,398

 
$
74,044

 
$
43,693

 
$
—

 
$
(28,855
)
 
$
414,279

Operating income (loss)
$
23,920

 
$
7,197

 
$
(3,208
)
 
$
(13,635
)
 
$
—

 
$
14,274

Interest expense, net of interest income
 
 
 
 
 
 
 
 
 
 
(15,639
)

11
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

 
Long-Term
Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Other
 
Elimination
 
Total
Other income
 
 
 
 
 
 
 
 
 
 
60

Equity in earnings of joint venture
 
 
 
 
 
 
 
 
 
 
638

Debt modification/retirement costs
 
 
 
 
 
 
 
 
 
 
(822
)
Loss from continuing operations before provision from income taxes
 
 
 
 
 
 
 
 
 
 
$
(1,489
)
Depreciation and amortization
$
11,061

 
$
333

 
$
462

 
$
264

 
$
—

 
$
12,120

Segment capital expenditures
$
5,307

 
$
54

 
$
107

 
$
793

 
$
—

 
$
6,261

Adjusted EBITDA
$
35,964

 
$
7,530

 
$
3,863

 
$
(11,227
)
 
$
—

 
$
36,130

Adjusted EBITDAR
$
44,735

 
$
7,530

 
$
4,788

 
$
(11,227
)
 
$
—

 
$
45,826

Six months ended June 30, 2013
 
 
 
 
 
 
 
 
 
 
 
Net patient service revenue from external customers
$
318,608

 
$
53,744

 
51,350

 
$
—

 
$
—

 
$
423,702

Leased facility revenue
1,548

 
—

 
—

 
—

 
—

 
1,548

Intersegment revenue
1,194

 
29,190

 
—

 
—

 
(30,384
)
 
—

Total revenue
$
321,350

 
$
82,934

 
51,350

 
$
—

 
$
(30,384
)
 
$
425,250

Operating income (loss)
$
25,289

 
$
5,659

 
6,583

 
$
(13,650
)
 
$
—

 
$
23,881

Interest expense, net of interest income
 
 
 
 
 
 
 
 
 
 
(17,185
)
Other expense
 
 
 
 
 
 
 
 
 
 
(62
)
Equity in earnings of joint venture
 
 
 
 
 
 
 
 
 
 
960

Debt modification/retirement costs
 
 
 
 
 
 
 
 
 
 
(1,088
)
Income from continuing operations before provision for income taxes
 
 
 
 
 
 
 
 
 
 
$
6,506

Depreciation and amortization
$
10,802

 
$
350

 
$
291

 
$
357

 
$
—

 
$
11,800

Segment capital expenditures
$
5,562

 
$
93

 
$
213

 
$
113

 
$
—

 
$
5,981

Adjusted EBITDA
$
36,987

 
$
6,010

 
$
5,219

 
$
(10,856
)
 
$
—

 
$
37,360

Adjusted EBITDAR
$
45,423

 
$
6,010

 
$
6,137

 
$
(10,856
)
 
$
—

 
$
46,714

    

12
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


A reconciliation of Adjusted EBITDA and Adjusted EBITDAR to net (loss) income is as follows (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Adjusted EBITDAR
$
23,199

 
$
22,986

 
$
45,826

 
$
46,714

Rent cost of revenue
(4,922
)
 
(4,685
)
 
(9,696
)
 
(9,354
)
Adjusted EBITDA
18,277

 
18,301

 
36,130

 
37,360

Depreciation and amortization
(6,034
)
 
(5,902
)
 
(12,120
)
 
(11,800
)
Interest expense
(7,945
)
 
(8,734
)
 
(15,984
)
 
(17,409
)
Interest income
302

 
112

 
345

 
224

Change in fair value of contingent consideration
121

 
2,244

 
107

 
2,161

Organization restructure costs
(631
)
 
(1,549
)
 
(1,071
)
 
(1,549
)
Exit costs related to divested facilities
27

 
—

 
(340
)
 
—

Losses at skilled nursing facility not at full operation
(133
)
 
—

 
(133
)
 
—

Governmental investigation expense
(6,000
)
 
—

 
(6,000
)
 
—

Professional fees related to non-routine matters
(1,205
)
 
(457
)
 
(1,519
)
 
(1,393
)
Debt modification/retirement costs
(822
)
 
(1,088
)
 
(822
)
 
(1,088
)
Impairment of long-lived assets
(82
)
 
—

 
(82
)
 
—

Discontinued operations, net of taxes
—

 
(265
)
 
—

 
(529
)
Benefit (provision) for income taxes
1,345

 
(1,139
)
 
3

 
(1,384
)
Net (loss) income
$
(2,780
)
 
$
1,523

 
$
(1,486
)
 
$
4,593

The following table presents the segment assets as of June 30, 2014 compared to December 31, 2013 (in thousands):  
 
Long-Term
Care  Services
 
Therapy Services
 
Hospice & Home Health Services
 
Other
 
Total
June 30, 2014:
 
 
 
 
 
 
 
 
 
Segment total assets
$
448,036

 
$
49,664

 
$
78,472

 
$
67,789

 
$
643,961

Goodwill and intangibles included in total assets
$
1,168

 
$
23,693

 
$
62,770

 
$
—

 
$
87,631

December 31, 2013:
 
 
 
 
 
 
 
 
 
Segment total assets
$
445,987

 
$
48,251

 
$
80,290

 
$
68,888

 
$
643,416

Goodwill and intangibles included in total assets
$
1,300

 
$
23,693

 
$
62,879

 
$
—

 
$
87,872


6. Property and Equipment
Property and equipment consisted of the following as of June 30, 2014 and December 31, 2013 (in thousands):

 
June 30, 2014
 
December 31, 2013
Land and land improvements
$
62,370

 
$
62,370

Buildings and leasehold improvements
324,121

 
320,923

Furniture and equipment
90,695

 
87,392

Construction in progress
8,349

 
8,621

 
485,535

 
479,306

Less accumulated depreciation
(149,175
)
 
(137,484
)
 
$
336,360

 
$
341,822


13
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


Leased facility assets consisted of the following as of June 30, 2014 and December 31, 2013 (in thousands):
 
June 30, 2014
 
December 31, 2013
Leased facility assets
$
13,848

 
$
13,848

Less accumulated depreciation
(4,674
)
 
(4,432
)
 
$
9,174

 
$
9,416


The Company began leasing five skilled nursing facilities in California to an unaffiliated third party operator in April 2011 and at that time signed a 10-year lease with two 10-year extension options exercisable by the lessee.

7. Income Taxes

For the three months ended June 30, 2014, the Company recorded an income tax benefit of $1.3 million representing an effective tax rate of 32.6% compared to an income tax expense of $1.1 million from continuing operations for the same period in 2013. The reduction in tax expense for the three months ended June 30, 2014 was primarily due to a $7.1 million decrease in pretax income, from $2.9 million for the three months ended June 30, 2013 to a loss from continuing operations of $4.1 million for the three months ended June 30, 2014, offset by $0.3 million of tax expense related to stock compensation for shares that vested at a lower price than the grant value.
For the six months ended June 30, 2014, the Company recorded an income tax expense of less than $0.1 million representing an effective tax rate of negative 0.2% compared to an income tax expense of $1.4 million from continuing operations for the same period in 2013. The reduction in tax expense for the six months ended was primarily due to a $8.0 million decrease in pretax income, from $6.5 million for the six months ended June 30, 2013 to a loss from continuing operations of $1.5 million for the six months ended June 30, 2014.  

14
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

8. Commitments and Contingencies
Legal Matters
General
Skilled and its subsidiaries are party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of business, including without limitation claims that their services have resulted in injury or death to patients who receive care from the Company's businesses and claims related to employment, staffing requirements and commercial and other matters. Although Skilled and its subsidiaries intend to vigorously defend themselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on the Company's results of operations and financial condition. The Company makes provisions for liabilities when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Such provisions are reviewed at least quarterly and adjusted to reflect the impact of settlement negotiations, judicial and administrative rulings, advice of legal counsel and other information and events pertaining to a particular case.
Skilled and its subsidiaries operate in a highly regulated industry. They are subject to ongoing regulatory oversight by state and federal regulatory authorities. Actual or alleged failure to comply with legal and regulatory requirements could subject Skilled and its subsidiaries to civil, administrative or criminal fines, penalties or restitutionary relief, and authorities could seek the suspension or exclusion of the offending provider or individual from participation in government healthcare programs and could lead to recoupment claims on prior payments by government healthcare programs. Adverse determinations in legal and regulatory investigations, actions and proceedings, whether currently asserted or arising in the future, could have a material adverse effect on the Company's financial position, results of operations and cash flows.
See also Part II, Item 1A -- Risk Factors, included elsewhere in this report, including without limitation the sections therein entitled "Significant legal actions, which are commonplace in our professions, could subject us to increased operating costs and substantial uninsured liabilities, which would materially and adversely affect our results of operations, liquidity and financial condition," "Revenue we receive from Medicare and Medicaid is subject to potential retroactive reduction or repayment," "We are subject to extensive and complex laws and government regulations. If we are not operating in compliance with these laws and regulations or if these laws and regulations change, we could be required to make significant expenditures or change our operations in order to bring our facilities and operations into compliance" and "We face reviews, audits and investigations under federal and state government programs and contracts. These audits could have adverse findings that may negatively affect our business."

Creekside Hospice Investigation
On August 2, 2013, the United States Attorney for the District of Nevada and the Civil Division of the U.S. Department of Justice (collectively, the “DOJ”) informed us that its Civil Division was investigating the Company, as well as its subsidiary, Creekside Hospice II, LLC, for possible violations of federal and state healthcare fraud and abuse laws and regulations. Those laws could have included the federal False Claims Act ("FCA") and the Nevada False Claims Act ("NFCA"). The FCA provides for civil and administrative fines and penalties, plus treble damages. The NFCA provides for similar fines and penalties, including treble damages. Violations of those federal or state laws could also subject the Company and/or its subsidiaries to exclusion from participation in the Medicare and Medicaid programs.
On or about August 6, 2014, in relation to the investigation the DOJ filed a notice of intervention in two pending qui tam proceedings filed by private party relators under the FCA and the NFCA and advised that it intends to take over the actions and file an amended complaint within 90 days, asserting that certain claims for hospice services provided by Creekside in the time period 2010 to 2013 did not meet Medicare requirements for reimbursement and are in violation of the civil False Claims Act. The Company believes that False Claims Act remedies will be pursued for an unspecified amount, with a request to treble provable damages and impose penalties per proved false claim in the amount ranging from $5,500 to $11,500 per claim. Additionally, alternative remedies such as overpayment, mistake or unjust enrichment may be sought.
While the Company denies the allegations and will defend this action, the Company has accrued $6.0 million as a contingent liability in connection with the matter, but it could ultimately cost more than that amount to settle or otherwise resolve it, including to satisfy any judgment that might be rendered against the Company or Creekside if the litigation defense were ultimately unsuccessful.


15
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Humboldt County Litigation

In connection with the September 2010 settlement of class action litigation against Skilled and certain of its subsidiaries related to, among other matters, alleged understaffing at certain California skilled nursing facilities operated by Skilled's subsidiaries (the "Humboldt County Action"), Skilled and its defendant subsidiaries (collectively, the "Defendants”) entered into settlement agreements with the plaintiffs and intervenor and agreed to an injunction. The settlement was approved by the Superior Court of California, Humboldt County on November 30, 2010. Under the terms of the settlement agreements, the defendant entities deposited a total of $50.0 million into escrow accounts to cover settlement payments to class members, notice and claims administration costs, reasonable attorneys' fees and costs and certain other payments, including $5.0 million to settle certain government agency claims and potential government claims that may arise. Of the $5.0 million provided for such government claims, $1.0 million was initially released by the court to the Humboldt County Treasurer-Tax Collector on behalf of the People of the State of California for their release of the Defendants. The remaining $4.0 million was available for the settlement and releases by the California Attorney General and certain other District Attorneys. However, in the event that any of these government authorities were to instead file certain actions against the Defendants by February 2013, the entire $4.0 million would have reverted to the Defendants upon their request to the Settlement Administrator. No such actions were filed, however, resulting in an additional $1.0 million distribution to the Humboldt County District Attorney's Office and the remaining $3.0 million was distributed to the class settlement fund, as required by the settlement agreement.
In addition to the payments to the Humboldt County Treasurer-Tax Collector on behalf of the People of the State of California, the court also approved payments from the escrow of up to approximately $24.8 million for plaintiff attorneys' fees and costs and $10,000 to each of the three named plaintiffs.  Pursuant to the injunction, the twenty-two Defendants that operated California nursing facilities were required to provide specified nurse staffing levels, comply with specified state and federal regulations governing staffing levels and posting requirements, and provide reports and information to a court-appointed auditor. The injunction was to remain in effect for a period of twenty-four months unless extended for additional three-month periods as to any Defendants who violated the injunction. Defendants demonstrating compliance for an eighteen-month period that ended September 30, 2012 were permitted to petition for early termination of the injunction. The Defendants were required to demonstrate over the term of the injunction that the costs of the injunction met a minimum threshold level pursuant to the settlement agreement, which level, initially $9.6 million, was reduced by the portion attributable to any Defendant in the case that no longer operated a skilled nursing facility during the injunction period.
In April 2011, five of the subsidiary Defendants transferred their operations to an unaffiliated third party skilled nursing facility operator (the “Former Humboldt County Facilities”). On November 14, 2012, the Defendants filed a motion to terminate the injunction and vacate the final judgment in the Humboldt County Action. Based upon compliance with the injunction through the requisite eighteen-month period, on December 21, 2012, the Superior Court of California, Humboldt County granted the Defendants' motion for early termination of the injunction, and the injunction has now ended with respect to the 17 California nursing facilities that the subsidiary Defendants still operate. In its order, the court determined that the injunction termination did not apply to the Former Humboldt County Facilities. However, the 2010 court-approved stipulation and order establishing the injunction provides that the injunction applies to the named defendants and any successor licensees of the applicable nursing facilities, but only if those successor licensees are affiliates of the named defendants. As noted above, the Former Humboldt County Facilities have been operated by an unaffiliated third party since April 2011. Therefore, under the terms of the injunction it does not apply to the Former Humboldt County Facilities unless an affiliate of the Defendants operates them. Pursuant to the BMFEA matter discussed below the California theories in this context were released in February 2013.
In the course of ongoing communications with the California Attorney General's Bureau of Medi-Cal Fraud & Elder Abuse ("BMFEA") related to the BMFEA matter discussed below, representatives of the California Attorney General and the U.S. Department of Justice ("DOJ") indicated an interest in pursuing an action under the False Claims Act ("FCA"). The DOJ expressed that it believes the company has FCA and other legal liabilities based upon the jury findings in the Humboldt County Action and otherwise related to staffing and perhaps other considerations related thereto. While the Company continues to cooperate with the government's evaluation of the matter, the Company views the government's apparent legal theories, including the False Claims Act theories, as lacking support in the established case law. The Company intends to vigorously defend any such action if brought.
BMFEA Matter
On April 15, 2009, two of Skilled's wholly-owned companies, Eureka Healthcare and Rehabilitation Center, LLC (“EHRC”), which at the time operated Eureka Healthcare and Rehabilitation Center (the "Facility"), and Skilled Healthcare, LLC (“SHC”), the administrative services provider for the Facility, were served with a search warrant that related to an investigation of the Facility by the BMFEA. The search warrant related to, among other things, records, property and information regarding certain enumerated patients of the Facility and covered the period from January 1, 2007 through the date

16
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

of the search. On October 31, 2012, the BMFEA filed a criminal complaint (the “BMFEA Action”) in California Superior Court, Humboldt County against EHRC, SHC and Skilled alleging elder endangerment in nine misdemeanor counts under Penal Code Section 368(c) and two felony counts under Penal Code Section 368(b)(1) related to the care of certain patients at the Facility in 2008. No individuals were named as defendants in the complaint. The Company disputed the BMFEA's theories of alleged criminal liability and vigorously defended the action. The charges filed by the BMFEA, if proven, would have carried fines of up to $6,000 for each of the two felony counts and $2,000 for each of the nine misdemeanor counts. Convictions could also lead to exclusion from participation in federal healthcare programs under federal laws such as the Federal False Claims Act and the Civil Monetary Penalty Law, which could be materially adverse to Skilled's business. EHRC transferred its operations in April 2011 to an unaffiliated third party skilled nursing facility operator, and has not had any ongoing operations since that time.
On February 15, 2013, the parties reached a mutually satisfactory settlement of the BMFEA Action. Pursuant to the settlement: (i) Skilled and SHC were dismissed from the case with prejudice; (ii) EHRC pled no contest to a single misdemeanor count of elder endangerment under Penal Code Section 368(c) and agreed to pay a statutory fine of $680, pay $145,000 to the California Attorney General for its costs of investigation, and to serve two (2) years of summary probation; and (iii) the California Attorney General granted Skilled, SHC, and twenty-five (25) of their affiliates who currently or formerly operated skilled nursing facilities in California, a release of any potential liability to the California Attorney General under certain civil statutes based upon conduct occurring through the effective date of the settlement (including the FCA theories discussed under Humboldt County Litigation above). The court accepted EHRC's misdemeanor plea and the other relevant terms of the settlement on February 15, 2013. Notwithstanding EHRC's no contest plea to the single misdemeanor charge, the Company, SHC and EHRC continue to deny any liability for the allegations in the BMFEA Action. The release granted by the California Attorney General may not apply to the DOJ should it choose to pursue action against us.

Pursuant to the settlement, Skilled, SHC and their twenty (20) affiliated current California skilled nursing facility operators also agreed to a 2-year staffing agreement (the “2013 Staffing Agreement”) with the California Attorney General that essentially continues the requirements of the staffing-related injunction that was in effect until December 2012 as a result of the September 2010 settlement of the Humboldt County Action. Similar to the former staffing-related injunction, the 2013 Staffing Agreement requires the applicable nursing facility operators to provide a minimum of 3.2 nursing hours per patient day as required by applicable California regulation and to adhere to related regulatory requirements, as well as to submit to periodic compliance audits of the same. Unlike the former staffing-related injunction, however, the 2013 Staffing Agreement does not provide for early termination based on demonstrated compliance and does not contain a minimum spend requirement. To date the 2013 Staffing Agreement has not, and the Company does not believe it will, require the Company or its affected affiliates to incur any material staffing or other costs beyond what they would otherwise incur in the ordinary course of business.
Insurance
The Company maintains various insurance and self insurance for property and casualty including workers' compensation and general and professional liability. The Company believes that its insurance programs are adequate and appropriate, and where there has not been a direct transfer of risk to the insurance carrier, the Company recognizes a liability in the consolidated financial statements.
Workers' Compensation. The Company has maintained workers' compensation insurance where statutorily required. The commercial workers' compensation insurance purchased is loss sensitive in nature. As a result, the Company is responsible for adverse loss development. The Company self-insures the first unaggregated $1.0 million per workers' compensation claim for all operations. The Company has elected not to carry workers' compensation insurance in Texas as a qualified non-subscriber and may be liable for negligence claims that are asserted against it by its Texas-based employees. The Company recognizes a liability in its financial statements for its estimated self-insured workers' compensation risks. Historically, estimated liabilities have been sufficient to cover actual claims. Effective January 1, 2014 the Company self-insures its workers compensation for all its business operations, other than those based in Texas, through its wholly-owned insurance company based on actuarily determined estimates.
General and Professional Liability. The Company's services subject it to certain liability risks. Malpractice and similar claims may be asserted against the Company if its services are alleged to have resulted in patient injury or other harm. The Company is subject to malpractice and similar claims and other litigation in the ordinary course of business.
The Company purchases excess liability policies for claims in excess of its unaggregated self insured retention for all businesses. The Company also self-insures professional liability claims through its wholly-owned insurance company.
The Company's Hospice and home health businesses are insured under a separate general and professional liability insurance policy. The excess liability coverage referenced above is also applicable to this policy.

17
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Actuarial Analysis. Changes in actuarial estimates are reviewed on a quarterly basis for professional and general liability claims and semi-annually for workers compensation claims. Variances in expected ultimate liabilities are recognized accordingly.
Employee Medical Insurance. Medical preferred provider option programs are offered as a component of the Company's employee benefits. The Company retains a self-insured amount up to a contractual stop loss amount of $0.25 million deductible for its preferred provider organization plan. All other employee medical plans are guaranteed cost plans.
A summary of the liabilities related to insurance risks are as follows (dollars in thousands):
 
As of June 30, 2014:
 
As of December 31, 2013
 
General and
Professional
 
Employee
Medical
 
Workers’
Compensation
 
Total
 
General and
Professional
 
Employee
Medical
 
Workers’
Compensation
 
Total
Current
$
7,620

(1) 
$
2,079

(2) 
$
6,213

(2) 
$
15,912

 
$
8,228

(1) 
$
2,446

(2) 
$
3,178

(2) 
$
13,852

Non-current
14,530

  
—

 
14,702

  
29,232

 
12,762

  
—

  
16,772

  
29,534

 
$
22,150

  
$
2,079

  
$
20,915

  
$
45,144

 
$
20,990

  
$
2,446

  
$
19,950

  
$
43,386


(1)
Included in accounts payable and accrued liabilities.
(2)
Included in employee compensation and benefits.
Hallmark Indemnification
Hallmark, the Company's rehabilitation services subsidiary, provides physical, occupational and speech therapy services to various unaffiliated skilled nursing facilities. These unaffiliated skilled nursing facilities are reimbursed for these services from the Medicare Program and other third-party payors. Hallmark has indemnified these unaffiliated skilled nursing facilities from a portion of certain disallowances of these services. Additionally, to the extent a Recovery Auditor ("RA") or other regulatory authority or contractor is successful in making a claim for recoupment of revenue from any of these skilled nursing facilities, Hallmark will typically be required to indemnify them against their charges associated with this loss. No material indemnification payments were required to be made in the three and six months ended June 30, 2014 or 2013.
Financial Guarantees
Substantially of all Skilled's wholly-owned subsidiaries guarantee the Company's first lien senior secured credit facility, excluding the subsidiaries that are pledged as collateral for the ten mortgage loans insured by the U.S. Department of Housing and Urban Development Program ("HUD") and the ten facilities pledged to MidCap Financial as collateral for the MidCap Financial credit facility. These loans are discussed in Note 11, "Debt", below. The aforementioned guarantees are full and unconditional and joint and several. Other subsidiaries of Skilled that are not guarantors are considered minor.

9. Stockholders' Equity
Accumulated Other Comprehensive Income
Accumulated other comprehensive income refers to gains and losses that are recorded as an element of stockholders' equity but are excluded from net (loss) income. The Company's other comprehensive (loss) income consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and gains and losses from investments available for sale. Details of other comprehensive (loss) income are included in the accompanying condensed consolidated Statements of Comprehensive (Loss) Income.
 
2007 Incentive Award Plan
During the six months ended June 30, 2014, the Company granted performance stock awards covering 512,475 shares of common stock. Each of the stock awards is subject to market-based vesting criteria. In order for the shares to vest, the Company must attain various average stock prices, each over a thirty-day period. There were no such market-based awards issued in the six months ended June 30, 2013.
During the year ended June 30, 2014, the following occurred with respect to restricted stock awards, restricted stock units, and performance stock awards under the Company’s existing plans (number of shares in thousands):

18
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

 
Number of
Shares
 
Weighted-
Average
Grant Date
Fair Value
Non-vested balance at January 1, 2014
2,256

 
$
6.42

Granted
872

 
4.75

Vested
(322
)
 
4.51

Forfeited
(582
)
 
5.44

Non-vested balance at June 30, 2014
2,224

 
$
6.30

As of June 30, 2014, there was approximately $5.4 million of total unrecognized compensation costs related to restricted stock awards, restricted stock units and performance stock awards. These costs have a weighted-average remaining recognition period of 1.9 years as of June 30, 2014. The total fair value of shares vested during the period ended June 30, 2014 was $1.5 million.
The following table summarizes stock option activity during the six months ended June 30, 2014 under the Skilled Healthcare Group, Inc. Amended and Restated 2007 Incentive Award Plan:
 
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term
(in years)
 
Aggregate
Intrinsic
Value
(in thousands)
Outstanding at January 1, 2014
794,645

 
$
8.54

 
 
 
 
Granted
—

 
$
—

 
 
 
 
Exercised
(160,548
)
 
$
5.91

 
 
 
 
Forfeited or cancelled
(157,083
)
 
$
9.55

 
 
 
 
Outstanding at June 30, 2014
477,014

 
$
9.09

 
4.65
 
$
—

Fully vested and expected to vest at June 30, 2014
475,956

 
$
9.10

 
4.65
 
$
—

Exercisable at June 30, 2014
456,491

 
$
9.15

 
4.53
 
$
—

As of June 30, 2014, there was $0.1 million of unrecognized compensation cost related to outstanding stock options, net of estimated forfeitures. This amount is expected to be recognized over a weighted-average period of 1.4 years. To the extent the forfeiture rate is different than the Company has anticipated, stock-based compensation related to these awards will be different from the Company's expectations.
Aggregate intrinsic value represents the value of Skilled's closing stock price on the New York Stock Exchange on the last trading day of the fiscal period in excess of the exercise price, multiplied by the number of options outstanding or exercisable.
 
Compensation related to stock option grants and stock awards included in general and administrative expenses was $0.6 million and $0.1 million for the three months ended June 30, 2014 and 2013, respectively. The amount of compensation included in general and administrative expense was $1.2 million and $0.9 million for the six months ended June 30, 2014 and 2013, respectively. The amount of compensation included in cost of services was $0.2 million for both the three months ended June 30, 2014 and 2013, respectively. The amount of compensation included in cost of services was $0.2 million and $0.8 million for the six months ended June 30, 2014 and 2013.

10. Fair Value Measurements
Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions. The following table summarizes the valuation of the Company’s marketable securities and contingent consideration as of June 30, 2014 (dollars in thousands) and December 31, 2013:

19
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

 
June 30, 2014
 
December 31, 2013
 
Level 1
 
Level 2
 
Level 3
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
$
—

 
$
—

 
$
—

 
$
—

 
$
1,046

 
$
—

Trading securities
$
—

 
$
8,526

 
$
—

 
$
—

 
$
—

 
$
—

Contingent consideration – acquisitions
$
—

 
$
—

 
$
1,329

 
$
—

 
$
—

 
$
1,736

The Company's wholly-owned offshore captive insurance company is required by regulatory agencies to set aside assets to comply with the laws of the jurisdiction in which it operates. These assets consist of restricted cash and trading securities, which are included in restricted assets in the Company's consolidated June 30, 2014 condensed balance sheet. The unrealized holding gain included in (loss) income on the Company's trading securities was negligible for the three and six months ended June 30, 2014 and 2013.
On July 1, 2011, a wholly-owned subsidiary of the Company acquired Altura Homecare & Rehab ("Altura"). The acquisition included contingent earn-out consideration which can be earned based on the acquired business's achievement of an EBITDA threshold. The contingent consideration is up to $1.5 million over a period of 3 years following the closing. The fair value of the contingent consideration was estimated using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The fair value of the earn-out was $0.5 million at June 30, 2014 and December 31, 2013.
On October 24, 2011, a wholly-owned subsidiary of the Company acquired substantially all of the assets of Cornerstone Hospice, Inc. ("Cornerstone"). The acquisition included contingent earn-out consideration which can be earned based on the acquired business's achievement of an EBITDA threshold. The contingent consideration is up to $1.5 million over a period of 5 years following the closing. The fair value of the contingent consideration was estimated using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The fair value of the earn-out at December 31, 2013 was $1.1 million and at June 30, 2014 was $0.8 million which reflects payments of $0.3 million to the seller and a fair value adjustment of less than $0.1 million.
As discussed above, EBITDA is the basis for calculating the contingent consideration. The unobservable inputs to the determination of the fair value of the contingent consideration include assumptions as to the ability of the acquired businesses to meet their EBITDA targets and discount rates used in the calculation. Should the actual EBITDA generated by the acquired businesses increase or decrease as compared to our assumptions, the fair value of the contingent consideration obligations would increase or decrease, up to the contracted limit, as applicable. As the timing of contingent payments go further into the future, discount rate assumptions increase due to the increased uncertainty of the EBITDA that may be generated in those periods.
The Company's assumptions range from the acquired businesses achieving none, a portion, or all of the consideration, and discount rates range from 2%- 5%.
Below is a table listing the Level 3 rollforward as of June 30, 2014 (in thousands):
Level 3 Rollforward
 
Value at January 1, 2014
$
1,736

Change in fair value
(107
)
Payout
(300
)
Value at June 30, 2014
$
1,329

Long Term Debt
At June 30, 2014 and December 31, 2013, the aggregate fair value of the Company's term loan due 2016, the revolving credit facility due 2015, the HUD insured loans due in 2043 and 2048, the mortgage term loan due 2016, and the asset based revolving credit facility due 2016, using Level 2 inputs, approximated the carrying value. The carrying value of the debt was approximately $410.2 million and $419.1 million at June 30, 2014 and December 31, 2013 respectively. Fair value was estimated based on current yield rates plus the Company's estimated credit spread available for loan products with similar terms and maturities.



20
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

11. Debt
The Company’s long-term debt is summarized as follows (dollars in thousands):
 
 
As of June 30, 2014
 
As of December 31, 2013
Term Loan, due April 2016, interest rate based on LIBOR (subject to a 1.50% floor) plus 5.50%, or 7.00%, at June 30, 2014 and LIBOR (subject to a 1.50% floor) plus 5.25%, or 6.75%, at December 31, 2013; collateralized by substantially all assets of the Company excluding the skilled nursing facilities that collateralize the HUD insured mortgage loans and the skilled nursing facilities that collateralize the MidCap Financial credit facility
$
243,953

 
$
243,953

Term Loan original issue discount
(973
)
 
(1,254
)
Revolving Credit Facility due April 2015, interest rate comprised of the Prime rate of 3.25% plus 3.50%, or 6.75%, at December 31, 2013
—

 
11,000

Revolving Credit Facility due April 2016, interest rate comprised of LIBOR plus 5.50%, or 5.74%, at June 30, 2014
7,308

 
—

Revolving Credit Facility due April 2015, interest rate comprised of LIBOR plus 4.50%, or 4.74%, at June 30, 2014 and December 31, 2013
4,692

 
7,057

HUD insured loans due in 2043 and 2048, with a weighted average interest rate of 4.28% and 4.24% at June 30, 2014 and December 31, 2013, respectively
86,668

 
87,314

Term Loan, due December 2016, interest rate based on LIBOR rate (subject to a floor of 0.75%) plus 5.95%, or 6.70%, at June 30, 2014 and December 31, 2013; collateralized by 10 skilled nursing facilities
61,262

 
62,000

Revolving Credit Facility due December 2016, interest rate comprised of LIBOR (subject to a floor of 0.75%) plus 5.95%, or 6.70%, at June 30, 2014 and December 31, 2013; collateralized by the accounts receivable of 10 skilled nursing facilities
5,000

 
5,000

Note payable due December 2018, interest rate fixed at 6.50%, payable in monthly installments, collateralized by a first priority deed of trust
875

 
959

Insurance premiums financed
1,395

 
2,990

Other
54

 
106

Total long-term debt
410,234

 
419,125

Less amounts due within one year
(10,198
)
 
(7,630
)
Long-term debt, less current portion
$
400,036

 
$
411,495


Term Loan and Revolving Credit Facility
On April 9, 2010, the Company entered into an up to $360.0 million senior secured term loan and a $100.0 million revolving credit facility (the "Prior Credit Agreement") that amended and restated the senior secured term loan and revolving credit facility that were set to mature in June 2012. On April 12, 2012, the Company entered into an Amendment and Restatement and Additional Term Loan Assumption Agreement (“Restated Credit Agreement”) that amended and restated the Prior Credit Agreement and pursuant to which, among other things, the size of the Company's existing senior secured term loan was increased by $100.0 million (hereinafter referred to as the incremental senior secured term loan).
On June 6, 2013, the Company entered into an amendment to the Restated Credit Agreement that increased the maximum leverage ratio by 0.50 throughout the life of the Restated Credit Agreement. The amendment additionally permits the Company to make future offers to the lenders under the revolving credit facility to extend the maturity date of all or a portion of the revolving credit facility. The credit arrangements provided under the Restated Credit Agreement are collectively referred to herein as the Company's senior secured credit facility.
In connection with the June 2013 modification, the Company paid fees totaling $2.5 million, of which $1.1 million was recorded as debt modification costs in the consolidated statement of operations, and $1.4 million was recorded as other assets in the consolidated balance sheet. Substantially all of the Company's assets, except those skilled nursing facilities securing the HUD and MidCap mortgage loans, are pledged as collateral under the senior secured credit facility. Amounts borrowed under the senior secured term loan may be prepaid at any time without penalty, except for LIBOR breakage costs. The senior secured term loan matures on April 9, 2016.

21
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

On June 23, 2014, the Company entered into an Amendment No. 2 and Loan Modification Agreement ("Amendment No. 2") to our Fourth Amended and Restated Credit Agreement dated April 12, 2012, as previously amended on June 6, 2013. Amendment No. 2 increased the maximum leverage ratio to 5.25 and decreased the fixed charge coverage ratio to 1.85, both up to but not including June 30, 2015. Amendment No. 2 increased the interest rate by 0.25% to the London Interbank Offered Rate ("LIBOR") (subject to a floor of 1.50%) plus a margin of 5.50 or the prime rate (subject to a floor of 2.50%) plus a margin of 4.50%. Amendment No. 2 extended the maturity date of the revolving credit facility to April 9, 2016 and reduced the commitments of any extending revolving lenders by 25%. After giving effect to Amendment No. 2, the extended revolving credit facility commitments are $50.6 million and the non-extended revolving credit facility commitments are $32.5 million, for a total capacity of $83.1 million. The capacity of the revolving credit facility will decrease to $50.6 million on April 9, 2015 until its maturity. Lenders that take an assignment of non-extended commitments may subsequently agree to extend those commitments in accordance with Amendment No. 2. Amendment No. 2 also modified the interest rate for the extended revolving credit commitments to be, at the Company’s option, LIBOR plus a margin between 5.25% and 5.50% (based upon consolidated leverage) or the prime rate plus a margin between 4.25% and 4.50% (based upon consolidated leverage). The interest rates on the non-extended revolving credit facility commitments remain, at the Company’s option, at LIBOR plus a margin of between 4.25% and 4.50% (based upon consolidated leverage) or the prime rate plus a margin between 3.25% and 3.50% (based upon consolidated leverage). In connection with the June 2014 modification, the Company paid fees totaling $2.0 million of which $0.8 million were recorded as debt modification costs in the condensed consolidated statements of operations, and $1.2 million was recorded as other assets in the condensed consolidated balance sheet.
Pursuant to the Restated Credit Agreement, the quarterly term loan amortization payments increased to $2.6 million beginning June 30, 2012 compared to $0.9 million under the Prior Credit Agreement. Due to the principal reductions made in 2013 made in association with the HUD insured financings, no amortization payments are due until December 2014, at which time the quarterly principal payments due will be $1.6 million. Additionally, the maximum portion of the annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement) to be applied to term debt reductions increased to 75% from 50%, subject to stepdowns to 50% and 25% based on consolidated leverage. The Company has also increased its ability to refinance a portion of its credit facility with U.S. Department of Housing and Urban Development ("HUD") insured debt up to $250 million, subject to certain credit facility covenants. Any HUD insured borrowings beyond $250 million would necessitate either refinancing the senior secured credit facility in full or otherwise seeking a waiver or amendment from the senior secured lenders.
Under the senior secured credit facility, the Company must maintain compliance with specified financial covenants measured on a quarterly basis. The senior secured credit facility also includes certain additional affirmative and negative covenants, including limitations on the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Also under the senior secured credit facility, subject to certain exceptions and minimum thresholds, the Company is required to apply all of the proceeds from any issuance of debt, as much as half of the proceeds from any issuance of equity, as much as 75% of the Company's annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement), and amounts received in connection with any sale of the Company's assets to repay the outstanding amounts under the Restated Credit Agreement. The Company believes that it is in compliance with its debt covenants as of June 30, 2014. As of June 30, 2014, the fixed charge coverage ratio was 2.18, which compares to a minimum requirement of 1.85 and the leverage ratio was 4.72, as compared to an allowed maximum of 5.25.
HUD Insured Loans and Other Mortgage Loans
In 2013, the Company received funding of 10 loans insured by HUD. The loans have a combined aggregate original principal balance of $87.6 million and are secured by 10 skilled nursing facilities. The HUD insured loans have an average all in interest rate of approximately 5.3% and an amortization term of 30 to 35 years. As of June 30, 2014 the HUD insured loans have a combined aggregate principal balance of $86.7 million.
Accordingly, as of June 30, 2014, the Company has 10 mortgages insured by HUD, which are each secured by a skilled nursing facility. These mortgages have an average remaining term of 33 years with fixed interest rates ranging from 3.4% to 4.6% and a weighted average interest rate of 4.2%. Depending on the mortgage agreement, prepayments are generally allowed only after 12 months from the inception of the mortgage. Prepayments are subject to a penalty of 10% of the remaining principal balances in the first year and the prepayment penalty decreases each subsequent year by 1% until no penalty is required. As all $87.6 million of the HUD insured mortgage loans were originated in 2013, none of the loans could be prepaid at June 30, 2014. Any further HUD insured mortgages will require additional HUD approval.
All HUD-insured mortgages are non-recourse loans to the Company. All mortgages are subject to HUD regulatory agreements that require escrow reserve funds to be deposited with the loan servicer for mortgage insurance premiums, property taxes, insurance and for capital replacement expenditures. As of June 30, 2014, the Company has escrow reserve funds of $1.6 million with the loan servicer that are reported within other current assets, and replacement reserve funds of $3.0 million in

22
SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

other assets. The net proceeds of the HUD insured loans were required to be used to pay down term debt under the Restated Credit Agreement. In 2013, $87.6 million of HUD insured loan proceeds were used to pay down term debt.
As of June 30, 2014 the Company has 10 additional skilled nursing facilities securing a $61.3 million mortgage loan and a $5.0 million asset based revolving credit facility with MidCap Financial. Both loans have an interest rate of LIBOR plus a margin of 5.95% with a LIBOR floor of 0.75%. The mortgage loan amortizes over 25 years with the remaining principal due December 1, 2016. There are additional quarterly principal payments of $0.3 million beginning after six months, $0.4 million in year two and $0.5 million in year three. The mortgage loan has a debt service coverage ratio and a minimum debt coverage ratio, both of which were met at June 30, 2014. The asset based revolving credit facility is secured by the accounts receivable of the 10 skilled nursing facilities. In 2013, $65.0 million of mortgage loan and asset based revolving credit facility proceeds were used to pay down term debt.

12. Investment in Joint Venture
Since 1996, the Company had a 50% equity interest in APS - Summit Care Pharmacy, LLC, or APS - Summit Care, which is a company that serves the pharmaceutical needs of a limited number of the Company's affiliated Texas operations, as well as a number of other unaffiliated customers. The remaining 50% equity interest in APS - Summit Care is owned by an unaffiliated third party. APS - Summit Care operates a pharmacy in Austin, Texas, through which the Company's affiliated operations pay market value for prescription drugs and receives a 50% share of the net income related to the joint venture. The Company’s investment balance at June 30, 2014 and 2013 of $5.1 million and $6.0 million, respectively, is included in other assets in the accompanying condensed consolidated balance sheets. The following tables provide summarized information from the balance sheet and statement of earnings for APS - Summit Care as of June 30, 2014:
Statement of Earnings
(In thousands)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2014
 
2013
 
2014
 
2013
Sales, Net
 
$
3,391

 
$
4,267

 
$
6,082

 
$
6,941

Gross Profit
 
473

 
1,409

 
1,439

 
2,134

Net Income
 
$
75

 
$
897

 
$
802

 
$
1,563

Balance Sheet
(In thousands)
 
 
June 30, 2014
 
December 31, 2013
Current Assets
 
$
2,485

 
$
3,518

Non-Current Assets
 
1,088

 
1,078

Current Liabilities
 
129

 
96

Non-Current Liabilities
 
$
—

 
$
—


23


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition as of the dates and for the periods presented. Historical results may not indicate future performance. Our forward-looking statements, which reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2013 and our subsequent reports on Form 10-Q and Form 8-K filed with the Securities and Exchange Commission (the “SEC”). As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our,” and “us” refer to Skilled Healthcare Group, Inc. and its wholly-owned subsidiaries. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our condensed consolidated financial statements and related notes included in this report.
Our selected historical consolidated statements of operations have been recast to reflect our disposal of two skilled nursing facilities on December 1, 2013, as discontinued operations for the quarters ended June 30, 2014 and June 30, 2013. Please refer to the information set forth below in conjunction with other sections of this report, including our consolidated historical financial statements and related notes included elsewhere in this report.
Business Overview
Skilled Healthcare Group, Inc. ("Skilled") is a holding company that owns subsidiary companies that in turn own and operate skilled nursing facilities, assisted living facilities, hospices, home health providers and a rehabilitation therapy business. As used in this report, the terms "we," "us," "our" and the "Company," and similar terms, refer collectively to Skilled and its consolidated wholly-owned subsidiaries, unless the context requires otherwise. We have an administrative service company that provides a full complement of administrative and consultative services that allows our affiliated operators and third-party operators with whom we contract to better focus on delivery of healthcare services. We currently also have one such service agreement with an unaffiliated skilled nursing facility operator. All of our subsidiaries focus on providing high-quality care to the people we serve, and our skilled nursing facility subsidiaries, which comprise the largest portion of our consolidated business, have a strong commitment to treating patients who require a high level of skilled nursing care and extensive rehabilitation therapy, whom we refer to as high-acuity patients. As of June 30, 2014, we owned or leased 73 skilled nursing facilities and 22 assisted living facilities, together comprising 10,275 licensed beds. We also lease five skilled nursing facilities in California to an unaffiliated third party operator. Our skilled nursing and assisted living facilities are located in California, Texas, Iowa, Kansas, Missouri, Nebraska, Nevada and New Mexico, and are generally clustered in large urban or suburban markets. We owned 77% of these facilities as of June 30, 2014. As of June 30, 2014 we provided hospice and home health services in Arizona, California, Idaho, Montana, Nevada, and New Mexico. We also provided private duty care services in Idaho, Montana, and Nevada. For the six months ended June 30, 2014, we generated approximately 74% of our revenue from our skilled nursing facilities, including our integrated rehabilitation therapy services at these facilities. The remainder of our revenue is generated from our assisted living services, rehabilitation therapy services provided to third-party facilities, hospice care, home health, and private duty care services.
In June 2014, the Company commenced operations at its state-of-the-art skilled nursing facility in Kansas City, Kansas. The facility is co-located within the University of Kansas' acute rehabilitation hospital adjacent to the medical school. This facility added 96 licensed beds to the Company's long term care operations. As of June 30, 2014, the newly leased facility was not at full operation.

Industry Trends
Medicare and Medicaid Reimbursement
In an effort to mitigate the cost of providing healthcare benefits, third party payors including Medicare, Medicaid, managed care providers, insurance companies and others have increasingly encouraged the treatment of patients in lower-cost care settings. As a result, in recent years skilled nursing facilities, which typically have significantly lower cost structures than acute care hospitals and certain other post-acute care settings, have generally been serving larger populations of higher-acuity patients than in the past. Despite this growth in demand, uncertainty over Medicare and Medicaid reimbursement rates persists as rates have often been reduced or been increased in lesser amounts than expected. Medicare and Medicaid reimbursement rates are subject to change from time to time and, because revenue derived directly or indirectly from Medicare and Medicaid reimbursement has historically comprised the most significant portion of our consolidated revenue, a reduction or slow growth in rates could materially and adversely impact our revenue, particularly in times of increased regulation and related expenses.

24

Medicare reimburses our skilled nursing facilities under a prospective payment system ("PPS") for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, for certain services based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group ("RUG") category that is based upon each patient's acuity level. In October 2010, the number of RUG categories was expanded from 53 to 66 as part of the implementation of the RUGs IV system and the introduction of a revised and substantially expanded patient assessment tool called the minimum data set (MDS) version 3.0.
On July 1, 2014 CMS issued its proposed rule providing for a net decrease of 0.3% in PPS payments to home health agencies in calendar year 2015. The proposed decrease reflects the effects of the 2.2% home health payment update percentage and the rebasing adjustments to the national, standardized 60-day episode payment rate, the national per-visit payment rates, and the non-routine medical supplies conversion factor.
On July 31, 2014, CMS issued its final rule providing for, among other things, a net increase of 2.0% in PPS payments to skilled nursing facilities for CMS fiscal year 2015 (which begins October 1, 2014) as compared to the PPS payments in CMS fiscal year 2014 (which ends September 30, 2014). The 2.0% increase is on a net basis, after the application of a 2.5% market basket increase reduced by a 0.5% multi-factor productivity adjustment required by the PPACA. There was no forecast error adjustment.
On August 4, 2014 CMS issued its final rule providing for a net increase of 1.4% for payments to hospices serving Medicare beneficiaries for CMS' fiscal year 2015. The hospice payment increase would be the net result of a proposed payment update to the hospice per diem rates of 2.1% market basket increase less a 0.7% decrease in payments to hospices due to updated wage data and the sixth year of CMS' seven-year-phase-out of its wage index budget neutrality adjustment factor.
Should future changes in PPS include reduced rates or increased standards for reaching certain reimbursement levels (including as a result of automatic cuts tied to federal deficit cut efforts or otherwise), our Medicare revenues derived from our skilled nursing facilities (including rehabilitation therapy services provided at our skilled nursing facilities) could be reduced, with a corresponding adverse impact on our financial condition and results of operation. Furthermore, reimbursement rates could grow at a slower rate than our expenses increase. Our rehabilitation therapy, hospice and home health care businesses are also to a large degree directly or indirectly dependent on (and therefore affected by changes in) Medicare and Medicaid reimbursement rates. For example, our rehabilitation therapy business may have difficulty increasing or maintaining the rates it has negotiated with third party nursing facilities in light of the reduced PPS reimbursement rates that took effect on October 1, 2011 or future reductions in (or slow growth of) reimbursement rates.
We also derive a substantial portion of our consolidated revenue from Medicaid reimbursement, primarily through our skilled nursing business. Medicaid programs are administered by the applicable states and financed by both state and federal funds. Medicaid spending nationally has increased substantially in recent years, becoming an increasingly significant component of state budgets. This, combined with slower state revenue growth and other state budget demands, has led both the federal government and many states, including California and other states in which we operate, to institute measures aimed at controlling the growth of Medicaid spending (and in some instances reducing it).
Historically, adjustments to reimbursement under Medicare and Medicaid have had a significant effect on our revenue and results of operations. Recently enacted, pending and proposed legislation and administrative rulemaking at the federal and state levels could have similar effects on our business. Efforts to impose reduced reimbursement rates, greater discounts and more stringent cost controls by government and other payors are expected to continue for the foreseeable future and could adversely affect our business, financial condition and results of operations. Additionally, any delay or default by the federal or state governments in making Medicare and/or Medicaid reimbursement payments could materially and adversely affect our business, financial condition and results of operations.

Federal Health Care Reform
In addition to the matters described above affecting Medicare and Medicaid participating providers, PPACA enacted several reforms with respect to skilled nursing facilities, home health agencies and hospices, including payment measures to realize significant savings of federal and state funds by deterring and prosecuting fraud and abuse in both the Medicare and Medicaid programs. While some of the provisions of PPACA will not take effect for several years or are subject to further refinement through the promulgation of regulations, some key provisions of PPACA are presently effective.
•
Enhanced CMPs and Escrow Provisions. PPACA includes expanded civil monetary penalty ("CMP") and related provisions applicable to all Medicare and Medicaid providers. CMS rules adopted to implement applicable provisions of PPACA also provide that assessed CMPs may be collected and placed in whole or in part into an escrow pending final disposition of the applicable administrative and judicial appeals processes. To the extent our businesses are assessed large CMPs that are collected and placed into an escrow account pending lengthy appeals, such actions could adversely affect our liquidity and results of operations.
•
Nursing Home Transparency Requirements. In addition to expanded CMP provisions, PPACA imposes new transparency requirements for Medicare-participating nursing facilities. In addition to previously required

25

disclosures regarding a facility's owners, management and secured creditors, PPACA expanded the required disclosures to include information regarding the facility's organizational structure, additional information on officers, directors, trustees and "managing employees" of the facility (including their names, titles, and start dates of services), and information regarding certain parties affiliated with the facility. The transparency provisions could result in the potential for greater government scrutiny and oversight of the ownership and investment structure for skilled nursing facilities, as well as more extensive disclosure of entities and individuals that comprise part of skilled nursing facilities' ownership and management structure.
•
Face-to-Face Encounter Requirements. PPACA imposes new patient face-to-face encounter requirements on home health agencies and hospices to establish a patient's ongoing eligibility for Medicare home health services or hospice services, as applicable. A certifying physician or other designated health care professional must conduct the face-to-face encounters within specified timeframes, and failure of the face-to-face encounter to occur and be properly documented during the applicable timeframes could render the patient's care ineligible for reimbursement under Medicare.
•
Suspension of Payments During Pending Fraud Investigations. PPACA provides the federal government with expanded authority to suspend Medicare and Medicaid payments if a provider is investigated for allegations or issues of fraud. This suspension authority creates a new mechanism for the federal government to suspend both Medicare and Medicaid payments for allegations of fraud, independent of whether a state exercises its authority to suspend Medicaid payments pending a fraud investigation. To the extent the suspension of payments provision is applied to one of our businesses for allegations of fraud, such a suspension could adversely affect our liquidity and results of operations.
•
Overpayment Reporting and Repayment; Expanded False Claims Act Liability. PPACA enacted several important changes that expand potential liability under the federal False Claims Act. Overpayments related to services provided to both Medicare and Medicaid beneficiaries must be reported and returned to the applicable payor within specified deadlines, or else they are considered obligations of the provider for purposes of the federal False Claims Act. This new provision substantially tightens the repayment and reporting requirements generally associated with operations of health care providers to avoid False Claims Act exposure.
•
Home and Community Based Services. PPACA provides that states can provide home and community-based attendant services and supports through the Community First Choice State plan option. States choosing to provide home and community based services under this option must make them available to assist with activities of daily living, instrumental activities of daily living and health related tasks under a plan of care agreed upon by the individual and his/her representative. PPACA also includes additional measures related to the expansion of community and home based services and authorizes states to expand coverage of community and home-based services to individuals who would not otherwise be eligible for them. The expansion of home-and-community based services could reduce the demand for the facility based services that we provide.
•
Health Care-Acquired Conditions. PPACA provides that the Secretary of Health and Human Services must prohibit payments to states for any amounts expended for providing medical assistance for certain medical conditions acquired during the patient's receipt of health care services. The CMS regulation implementing this provision of PPACA prohibits states from making payments to providers under the Medicaid program for conditions that are deemed to be reasonably preventable. It uses Medicare's list of preventable conditions in inpatient hospital settings as the base (adjusted for the differences in the Medicare and Medicaid populations) and provides states the flexibility to identify additional preventable conditions and settings for which Medicaid payment will be denied.
•
Value-Based Purchasing. PPACA requires the Secretary of Health and Human Services to develop a plan to implement a value-based purchasing (“VBP”) program for payments under the Medicare program for skilled nursing facilities and to submit a report containing the plan to Congress. The intent of the provision is to potentially reconfigure how Medicare pays for health care services, moving the program towards rewarding better value, outcomes, and innovations, instead of volume. According to the plan submitted to Congress in June 2012, the funding for the VBP program could come from payment withholds from poor-performing skilled nursing facilities or by holding back a portion of the base payment rate or the annual update for all skilled nursing facilities. If a VBP program is ultimately implemented, it is uncertain what effect it would have upon skilled nursing facilities, but its funding or other provisions could negatively affect skilled nursing facilities.
•
Anti-Kickback Statute Amendments. PPACA amended the Anti-Kickback Statute so that (i) a claim that includes items or services violating the Anti-Kickback Statute also would constitute a false or fraudulent claim under the federal False Claims Act and (ii) the intent required to violate the Anti-Kickback Statute is

26

lowered such that a person need not have actual knowledge or specific intent to violate the Anti-Kickback Statute in order for a violation to be deemed to have occurred. These modifications of the Anti-Kickback Statute could expose us to greater risk of inadvertent violations of the statute and to related liability under the federal False Claims Act.
The provisions of PPACA discussed above are examples of recently enacted federal health reform provisions that we believe may have a material impact on the long-term care profession generally and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of PPACA. It is possible that other provisions of PPACA may be interpreted, clarified, or applied to our businesses in a way that could have a material adverse impact on our business, financial condition and results of operations. Similar federal and/or state legislation that may be adopted in the future could have similar effects.
Revenue
Revenue by Service Offering

We operate our business in three reportable operating segments: (i) long-term care services, which includes the operation of skilled nursing and assisted living facilities and is the most significant portion of our business; (ii) our rehabilitation therapy services business; and (iii) our hospice and home health businesses. Our reporting segments are business units that offer different services, and that are managed separately due to the nature of services provided.
In our long-term care services segment, we derive the majority of our revenue by providing skilled nursing care and integrated rehabilitation therapy services to residents in our affiliated skilled nursing facilities. The remainder of our long-term care segment revenue is generated by our assisted living facilities, by our administration of an unaffiliated third party skilled nursing facility, and from our leasing of five skilled nursing facilities to an unaffiliated third party operator. In our therapy services segment, we derive revenue by providing rehabilitation therapy services to third-party facilities. In our hospice and home health services segment, we provide hospice and home health services.
The following table shows the revenue and percentage of our total revenue generated by each of these segments for the periods presented (dollars in thousands):

 
Three Months Ended June 30,
 
 
 
2014
 
2013
 
 
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Increase/(Decrease)
Dollars
 
Percentage
Long-term care services:
 
 
 
 
 
 
 
 
 
 
 
Skilled nursing facilities
$
154,472

 
74.6
%
 
$
150,376

 
71.5
%
 
$
4,096

 
2.7
 %
Assisted living facilities
7,584

 
3.7

 
6,983

 
3.3

 
601

 
8.6

Administration of third party facility
208

 
0.1

 
153

 
0.1

 
55

 
35.9

Facility lease revenue
807

 
0.4

 
787

 
0.4

 
20

 
2.5

Total long-term care services
163,071

 
78.8

 
158,299

 
75.3

 
4,772

 
3.0

Therapy services:
 
 
 
 
 
 
 
 
 
 
 
Third-party rehabilitation therapy services
23,076

 
11.1

 
26,637

 
12.7

 
(3,561
)
 
(13.4
)
Total therapy services
23,076

 
11.1

 
26,637

 
12.7

 
(3,561
)
 
(13.4
)
Hospice & home health services:
 
 
 
 
 
 
 
 
 
 
 
Hospice
14,676

 
7.1

 
18,386

 
8.7

 
(3,710
)
 
(20.2
)
Home health
6,156

 
3.0

 
6,870

 
3.3

 
(714
)
 
(10.4
)
Total hospice & home health services
20,832

 
10.1

 
25,256

 
12.0

 
(4,424
)
 
(17.5
)
Total
$
206,979

 
100.0
%
 
$
210,192

 
100.0
%
 
$
(3,213
)
 
(1.5
)%

27

 
Six Months Ended June 30,
 
 
 
2014
 
2013
 
 
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Increase/(Decrease)
Dollars
 
Percentage
Long-term care services:
 
 
 
 
 
 
 
 
 
 
 
Skilled nursing facilities
$
307,634

 
74.3
%
 
$
304,187

 
71.5
%
 
$
3,447

 
1.1
 %
Assisted living facilities
14,872

 
3.6

 
14,109

 
3.3

 
763

 
5.4

Administration of third party facility
344

 
0.1

 
312

 
0.1

 
32

 
10.3

Facility lease revenue
1,594

 
0.3

 
1,548

 
0.4

 
46

 
3.0

Total long-term care services
324,444

 
78.3

 
320,156

 
75.3

 
4,288

 
1.3

Therapy services:
 
 
 
 
 
 
 
 
 
 
 
Third-party rehabilitation therapy services
46,143

 
11.1

 
53,744

 
12.7

 
(7,601
)
 
(14.1
)
Total therapy services
46,143

 
11.1

 
53,744

 
12.7

 
(7,601
)
 
(14.1
)
Hospice & home health services:
 
 
 
 
 
 
 
 
 
 
 
Hospice
30,882

 
7.5

 
37,370

 
8.7

 
(6,488
)
 
(17.4
)
Home health
12,811

 
3.1

 
13,980

 
3.3

 
(1,169
)
 
(8.4
)
Total hospice & home health services
43,693

 
10.6

 
51,350

 
12.0

 
(7,657
)
 
(14.9
)
Total
$
414,279

 
100.0
%
 
$
425,250

 
100.0
%
 
$
(10,971
)
 
(2.6
)%

Sources of Revenue
The following table sets forth revenue consolidated by state in dollars and as a percentage of total revenue for the periods presented (dollars in thousands):
 
Three Months Ended June 30,
 
2014
 
2013
 
Revenue Dollars
 
Percentage of
Revenue
 
Revenue Dollars
 
Percentage of
Revenue
California
$
86,135

 
41.6
%
 
$
86,144

 
41.0
%
Texas
38,994

 
18.8

 
41,214

 
19.6

New Mexico
24,949

 
12.1

 
24,199

 
11.5

Kansas
15,284

 
7.4

 
14,938

 
7.1

Missouri
15,269

 
7.4

 
14,520

 
6.9

Nevada
13,637

 
6.6

 
14,914

 
7.1

Montana
3,394

 
1.6

 
3,535

 
1.7

Iowa
2,677

 
1.3

 
2,213

 
1.1

Idaho
2,467

 
1.2

 
2,792

 
1.3

Arizona
2,425

 
1.2

 
3,793

 
1.8

Nebraska
1,748

 
0.8

 
1,461

 
0.7

Indiana
—

 
—

 
469

 
0.2

Total
$
206,979

 
100.0
%
 
$
210,192

 
100.0
%

28

 
Six Months Ended June 30,
 
2014
 
2013
 
Revenue Dollars
 
Percentage of
Revenue
 
Revenue Dollars
 
Percentage of
Revenue
California
$
168,269

 
40.6
%
 
$
173,427

 
40.8
%
Texas
80,898

 
19.5

 
84,099

 
19.8

New Mexico
49,278

 
11.9

 
48,473

 
11.4

Missouri
30,897

 
7.5

 
29,602

 
7.0

Kansas
30,355

 
7.3

 
30,343

 
7.1

Nevada
28,535

 
6.9

 
29,827

 
7.0

Montana
6,739

 
1.6

 
7,087

 
1.7

Arizona
5,651

 
1.4

 
8,181

 
1.9

Iowa
5,095

 
1.2

 
4,766

 
1.1

Idaho
4,971

 
1.2

 
5,524

 
1.3

Nebraska
3,591

 
0.9

 
2,942

 
0.7

Indiana
—

 
—

 
979

 
0.2

Total
$
414,279

 
100.0
%
 
$
425,250

 
100.0
%
Long-Term Care Services Segment
Skilled Nursing Facilities. Within our skilled nursing facilities, we generate our revenue from Medicare, Medicaid, managed care providers, insurers, private pay and other sources. We believe that our skilled mix, which we define as the number of Medicare and non-Medicaid managed care patient days at our skilled nursing facilities divided by the total number of patient days at our skilled nursing facilities for any given period, is an important indicator of our success in attracting high-acuity patients because it represents the percentage of our patients who are reimbursed by Medicare and managed care payors, for whom we receive higher reimbursement rates. Most of our skilled nursing facilities include our Express RecoveryTM program. This program uses a dedicated unit within a skilled nursing facility to deliver a comprehensive rehabilitation and recovery regimen in accommodations specifically designed to serve high-acuity patients.
Assisted Living Facilities. Within our assisted living facilities, which are mostly in Kansas, we generate our revenue primarily from private pay sources, with a small portion earned from Medicaid or other state-specific programs.
Leased Facility Revenue. We lease five skilled nursing facilities in California to an unaffiliated third party operator. For additional information on the lease arrangement, see Note 6 - "Property and Equipment," to the interim financial statements.
Therapy Services Segment
As of June 30, 2014, we provided rehabilitation therapy services to a total of 177 healthcare facilities, including 63 of our facilities, as compared to 194 facilities, including 64 of our facilities, as of June 30, 2013. In addition, we have contracts to manage the rehabilitation therapy services for our 10 healthcare facilities in New Mexico. The net decrease of 17 facilities serviced was comprised of 15 new facilities serviced, net of 32 cancellations. Rehabilitation therapy revenue derived from servicing patients at our own facilities is included in our revenue from skilled nursing facilities. Our rehabilitation therapy business receives payment for services from the third-party facilities that it serves based on negotiated patient per diem rates or a negotiated fee schedule based on the type of service rendered. As of June 30, 2014, we provided rehabilitation therapy services to facilities in California, Arizona, Nevada, Texas, Missouri, Nebraska, Iowa, and Kansas. CMS announced on February 18, 2014 that it is in the procurement process for the next round of Recovery Audit Program contracts and it will “pause” RA activities.  This “pause” in RA activities will allow the current RA contractors time to complete all outstanding claim reviews by the end of their specific contract dates. Since February 28, 2014, prepayment reviews have not been conducted; instead all claims will undergo post-payment reviews after the new contracts are in place. At this time CMS has not indicated when the new RAC contracts will be awarded.  However, when they are awarded, the new Recovery Auditor’s will be able to go back to March 2014 and conduct Part B MMR reviews on a Post Payment basis.  This means that the RACs will have the ability and jurisdiction to review claims that were paid during the Recovery Audit Pause. Going forward under the new Recovery Auditor’s contract MMR reviews will continue to be conducted on a post payment basis.
Hospice and Home Health Services Segment
Hospice. As of June 30, 2014, we provided hospice care in Arizona, California, Idaho, Montana, Nevada and New Mexico. We derive substantially all of the revenue from our hospice business from Medicare, Medicaid, and managed care reimbursement.

29

For a Medicare beneficiary to qualify for the Medicare hospice benefit, two physicians must certify that, in their best judgment, the beneficiary has less than six months to live, assuming the beneficiary’s disease runs its normal course. In addition, the Medicare beneficiary must affirmatively elect hospice care and waive any rights to other Medicare benefits related to his or her terminal illness. Each benefit period, a physician must re-certify that the Medicare beneficiary’s life expectancy is six months or less in order for the beneficiary to continue to qualify for and to receive the Medicare hospice benefit. The first two benefit periods are measured at 90-day intervals and subsequent benefit periods are measured at 60-day intervals. There is no limit on the number of periods that a Medicare beneficiary may be re-certified. A Medicare beneficiary may revoke his or her election at any time and begin receiving traditional Medicare benefits.
Medicare reimburses us for hospice care. We receive one of four predetermined daily or hourly rates based on the level of care we furnish to the beneficiary. These rates are subject to annual adjustments based on inflation and geographic wage considerations.
We are subject to two limitations on Medicare payments for hospice services. First, if inpatient days of care provided to patients at a hospice exceed 20% of the total days of hospice care provided for an annual period beginning on November 1st, then payment for days in excess of this limit are paid for at the routine home care rate. None of our hospice programs exceeded the payment limits on inpatient services for 2009 through June 30, 2014.
Second, overall payments made by Medicare to us on a per hospice program basis are also subject to a cap amount calculated by the Medicare fiscal intermediary at the end of the hospice cap period. The Medicare revenue paid to a hospice program from November 1 to October 31 may not exceed the annual aggregate cap amount. Up to the 2011 fiscal cap year, which began on November 1, 2010, this annual aggregate 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. This method is known as the streamlined method. Beginning with the 2011 fiscal cap year, unless an agency elected to stay with the streamlined method, the hospice cap amount is calculated under the proportional method, which spreads the hospice patient's cap allowance over the period for which the patient is under hospice care. For a hospice agency to estimate its cap exposure under the proportional method, the agency must estimate how long patients will stay on service. If a hospice exceeds its aggregate cap, then the hospice must repay the excess back to Medicare. The Medicare cap amount is reduced proportionately for patients who transferred in and out of our hospice services. The Medicare cap amount is adjusted annually for inflation, but is not adjusted for geographic differences in wage levels, although hospice per diem payment rates are wage indexed. For the six month periods ended June 30, 2014 and June 30, 2013 we estimated and recorded a cap reserve of $0.9 million and $2.9 million. See Item 1A of this report, “Risk Factors—We are subject to a Medicare cap amount for our hospice business. Our net patient service revenue and profitability could be adversely affected by limitations on Medicare payments.”
Home Health. We provided home health care in Arizona, Idaho, Montana, Nevada and New Mexico as of June 30, 2014. We derive the majority of the revenue from our home health business from Medicare. The payment is adjusted for the health condition and care needs of the beneficiary. The payment is also adjusted for the geographic differences in wages for home health agencies across the country. The adjustment for the health condition, or clinical characteristics, and service needs of the beneficiary is referred to as the case-mix adjustment. The home health PPS will provide home health agencies with payments for each 60-day episode of care for each beneficiary. If a beneficiary is still eligible for care after the end of the first episode, a second episode can begin. There are no limits to the number of episodes a beneficiary who remains eligible for the home health benefit can receive. While payment for each episode is adjusted to reflect the beneficiary’s health condition and needs, a special outlier provision exists to ensure appropriate payment for those beneficiaries that have the most expensive care needs.
Regulatory and Other Governmental Actions Affecting Revenue

We derive a substantial portion of our revenue from government Medicare and Medicaid programs. In addition, our rehabilitation therapy services, for which we receive payment from private payors, is significantly dependent on Medicare and Medicaid funding, as those private payors are primarily funded or reimbursed by these programs. The following table summarizes the amount of revenue that we received from each of our payor classes by segment in the periods presented (dollars in thousands):


30

 
Three Months Ended June 30,
 
2014
 
2013
 
Long-Term Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Total Revenue
 
Revenue Percentage
 
Long-Term Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Total Revenue
 
Revenue Percentage
Medicare Part A
$
39,791

 
$
—

 
$
17,049

 
$
56,840

 
27.5
%
 
$
40,096

 
$
—

 
$
21,658

 
$
61,754

 
29.4
%
Medicare Part B
3,994

 
—

 
—

 
3,994

 
1.9

 
3,345

 
—

 
—

 
3,345

 
1.6

Medicaid
67,408

 
—

 
1,082

 
68,490

 
33.1

 
64,470

 
—

 
726

 
65,196

 
31.0

Subtotal Medicare and Medicaid
111,193

 
—

 
18,131

 
129,324

 
62.5

 
107,911

 
—

 
22,384

 
130,295

 
62.0

Managed Care Part A
26,040

 
—

 
1,498

 
27,538

 
13.3

 
24,468

 
—

 
1,418

 
25,886

 
12.3

Managed Care Part B
541

 
—

 
—

 
541

 
0.3

 
586

 
—

 
—

 
586

 
0.3

Private pay and other
25,297

 
23,076

 
1,203

 
49,576

 
24.0

 
25,334

 
26,637

 
1,454

 
53,425

 
25.4

Total
$
163,071

 
$
23,076

 
$
20,832

 
$
206,979

 
100.0
%
 
$
158,299

 
$
26,637

 
$
25,256

 
$
210,192

 
100.0
%

 
Six Months Ended June 30,
 
2014
 
2013
 
Long-Term Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Total Revenue
 
Revenue Percentage
 
Long-Term Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Total Revenue
 
Revenue Percentage
Medicare Part A
$
78,948

 
$
—

 
$
36,276

 
$
115,224

 
27.8
%
 
$
83,401

 
$
—

 
$
44,323

 
$
127,724

 
30.0
%
Medicare Part B
7,802

 
—

 
—

 
7,802

 
1.9

 
7,652

 
—

 
—

 
7,652

 
1.8

Medicaid
133,501

 
—

 
1,942

 
135,443

 
32.7

 
128,265

 
—

 
1,383

 
129,648

 
30.5

Subtotal Medicare and Medicaid
220,251

 
—

 
38,218

 
258,469

 
62.4

 
219,318

 
—

 
45,706

 
265,024

 
62.3

Managed Care Part A
53,293

 
—

 
2,984

 
56,277

 
13.6

 
49,125

 
—

 
2,780

 
51,905

 
12.2

Managed Care Part B
1,011

 
—

 
—

 
1,011

 
0.2

 
1,150

 
—

 
—

 
1,150

 
0.3

Private pay and other
49,889

 
46,143

 
2,491

 
98,523

 
23.8

 
50,563

 
53,744

 
2,864

 
107,171

 
25.2

Total
$
324,444

 
$
46,143

 
$
43,693

 
$
414,280

 
100.0
%
 
$
320,156

 
$
53,744

 
$
51,350

 
$
425,250

 
100.0
%

Medicare. Medicare is a federal program that provides certain healthcare benefits to beneficiaries who are 65 years of age or older, blind, disabled or qualify for Medicare’s End Stage Renal Disease program. Medicare provides health insurance benefits in two primary parts for services that we provide:

•
Part A. Medicare Part A is hospital insurance, which provides reimbursement for inpatient services for hospitals, skilled nursing facilities, hospices, home health and certain other healthcare providers and patients requiring daily professional skilled nursing and other rehabilitative care. Coverage in a skilled nursing facility is limited for a period of up to 100 days, if medically necessary, after the individual has qualified for Medicare coverage as a result of a three-day or longer hospital stay. Medicare pays for the first 20 days of stay in a skilled nursing facility in full and the next 80 days, to the extent above a daily coinsurance amount. Covered services include supervised nursing care, room

31

and board, social services, pharmaceuticals and supplies as well as physical, speech and occupational therapies and other necessary services provided by nursing facilities. Medicare Part A also covers hospice care and some home health care. Skilled nursing facilities are paid under Medicare Part A on the basis of a prospective payment system, or PPS. The PPS payment rates are adjusted for case mix and geographic variation in wages and cover all costs of furnishing covered skilled nursing facilities services (routine, ancillary, and capital-related costs). The amount to be paid is determined by classifying each patient into a resource utilization group ("RUG"), category, which is based upon the patient's acuity level. CMS generally evaluates and adjusts payment rates on an annual basis.

•
Part B. Medicare Part B is supplemental medical insurance, which requires the beneficiary to pay monthly premiums, covers physician services, limited drug coverage and other outpatient services, such as physical, occupational and speech therapy services, enteral nutrition, certain medical items and X-ray services received outside of a Part A covered inpatient stay.
Medicaid. Medicaid is a state-administered medical assistance program for the indigent, operated by the individual states with the financial participation of the federal government. Each state has relatively broad discretion in establishing its Medicaid reimbursement formulas and coverage of service, which must be approved by the federal government in accordance with federal guidelines. All states in which we operate cover long-term care services for individuals who are Medicaid eligible and qualify for institutional care. Providers must accept the Medicaid reimbursement level as payment in full for services rendered. Medicaid programs generally make payments directly to providers, except in cases where the state has implemented a Medicaid managed care program, under which providers receive Medicaid payments from managed care organizations ("MCOs") that have subcontracted with the Medicaid program. PPACA provides for increased financial participation by the federal government in a state's Medicaid program if the state chooses to expand its Medicaid program as contemplated by PPACA. However, states are not required to expand their Medicaid programs and it is uncertain as to which states, including states in which we operate, will ultimately expand their programs.
Managed Care. Our managed care patients consist of individuals who are insured by a third-party entity, typically called a senior Health Maintenance Organization ("HMO") plan, or are Medicare beneficiaries who assign their Medicare benefits to a senior HMO plan.
Private Pay and Other. Private pay and other sources consist primarily of individuals or parties who directly pay for their services or are beneficiaries of the Department of Veterans Affairs. In addition, the revenue related to the five leased properties is also included as part of the other payor sources.
Critical Accounting Estimates
There has been no change in our critical accounting policies and estimates as included under "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, which we filed with the SEC on February 10, 2014.

32

Results of Operations
The following table summarizes some of our key performance indicators, along with other statistics, for each of the periods indicated:
 
Three Months Ended June 30,

Six Months Ended June 30,
 
2014

2013

2014

2013
Occupancy statistics (skilled nursing facilities):











     Available beds in service at end of period
8,670


8,587


8,670


8,587

     Available patient days(a)
780,542


782,151


1,552,882


1,556,123

     Actual patient days
637,981


641,656


1,274,873


1,283,427

     Occupancy percentage(a)
81.7
%

82.0
%

82.1
%

82.5
%
     Average daily number of patients
7,011


7,051


7,044


7,091





 






Hospice average daily census
1,032


1,324


1,058


1,330

Home health episodic-based admissions
1,921


2,091


4,160


4,333

Home health episodic-based recertifications
478


476


913


966





 






Revenue per patient day (skilled nursing facilities prior to intercompany eliminations)



 




     LTC only Medicare (Part A)
$
520


$
519


$
521


$
520

     Medicare blended rate (Part A & B)
572


563


572


568

     Managed care (Part A)
407


390


405


386

     Managed care blended rate (Part A & B)
415


400


413


395

     Medicaid
168


163


167


162

     Private and other
178


171


178


174

     Weighted-average for all
$
243


$
236


$
242


$
238





 






Patient days by payor (skilled nursing facilities):



 






Medicare
76,452


77,226


151,557


160,297

Managed care
64,051


62,680


131,668


127,149

Total skilled mix days
140,503


139,906


283,225


287,446

Private pay and other
96,509


105,690


190,972


206,516

Medicaid
400,969


396,060


800,676


789,465

Total days
637,981


641,656


1,274,873


1,283,427





 






Patient days as a percentage of total patient days (skilled nursing facilities):



 






Medicare
12.0
%

12.0
%

11.9
%

12.5
%
Managed care
10.0


9.8


10.3


9.9

Skilled Mix
22.0


21.8


22.2


22.4

Private pay and other
15.1


16.5


15.0


16.1

Medicaid
62.9


61.7


62.8


61.5

Total
100.0
%

100.0
%

100.0
%

100.0
%




 






Revenue for total company:



 





Medicare
29.4
%

31.0
%

29.7
%

31.8
%
Managed care, private pay, and other
37.6


38.0


37.6


37.7

Quality mix
67.0


69.0


67.3


69.5

Medicaid
33.0


31.0


32.7


30.5

Total
100.0
%

100.0
%

100.0
%

100.0
%












(a) Does not reflect available days related to newly open facility not at full operation.

33

The following table sets forth details of our revenue, expenses, and net income and other items as a percentage of total revenue for the periods indicated:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Expenses:
 
 
 
 

 

Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)
86.3

 
87.0

 
86.7

 
86.8

Rent cost of revenue
2.4

 
2.2

 
2.3

 
2.2

General and administrative
3.5

 
3.3

 
3.2

 
3.1

Change in fair value of contingent consideration
(0.1
)
 
(1.1
)
 
—

 
(0.5
)
Depreciation and amortization
2.9

 
2.8

 
2.9

 
2.8

Governmental investigation expense
2.9

 
—

 
1.4

 
—

Impairment of long-lived assets
—

 
—

 
—

 
—

Loss on disposal of asset
—

 
—

 
—

 
—

 
98.0

 
94.2

 
96.6

 
94.4

Other (expense) income:
 
 
 
 
 
 
 
Interest expense
(3.8
)
 
(4.2
)
 
(3.9
)
 
(4.1
)
Interest income
0.2

 
0.1

 
0.1

 
0.1

Other income (expense), net
—

 
—

 
—

 
—

Equity in earnings of joint venture
—

 
0.2

 
0.2

 
0.2

Debt modification/retirement costs
(0.4
)
 
(0.5
)
 
(0.2
)
 
(0.3
)
Total other (expenses) income, net
(4.0
)
 
(4.4
)
 
(3.8
)
 
(4.1
)
(Loss) income from continuing operations, before (benefit) provision for income taxes
(2.0
)
 
1.4

 
(0.4
)
 
1.5

(Benefit) provision for income taxes
(0.6
)
 
0.5

 
—

 
0.3

(Loss) income from continuing operations
(1.3
)%
 
0.8

 
(0.4
)%
 
1.2
 %
Loss from discontinued operations, net of tax
—
 %
 
(0.1
)
 
—
 %
 
(0.1
)%
Net (loss) income
(1.3
)%
 
0.7
 %
 
(0.4
)%
 
1.1
 %
 
 
 
 
 
 
 
 
Adjusted EBITDA(1)
8.8
 %
 
8.7
 %
 
8.7
 %
 
8.8
 %
Adjusted EBITDAR(2)
11.2
 %
 
10.9
 %
 
11.1
 %
 
11.0
 %
 
 
 
 
 
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Reconciliation from net (loss) income to EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR (in thousands):
 
 
 
 
 
 
 
Net (loss) income
$
(2,780
)
 
$
1,523

 
$
(1,486
)
 
$
4,593

Interest expense, net of interest income
7,643

 
8,622

 
15,639

 
17,185

(Benefit) provision for income taxes
(1,345
)
 
1,139

 
(3
)
 
1,384

Depreciation and amortization expense
6,034

 
5,902

 
12,120

 
11,800

EBITDA(1)
9,552

 
17,186

 
26,270

 
34,962

Rent cost of revenue
4,922

 
4,685

 
9,696

 
9,354

EBITDAR(2)
14,474

 
21,871

 
35,966

 
44,316

EBITDA(1)
9,552

 
17,186

 
26,270

 
34,962

Change in fair value of contingent consideration
(121
)
 
(2,244
)
 
(107
)
 
(2,161
)
Organization restructure costs
631

 
1,549

 
1,071

 
1,549

Exit costs related to divested facilities
(27
)
 
—

 
340

 
—

Professional fees related to non-routine matters
1,205

 
457

 
1,519

 
1,393

Governmental investigation expense
6,000

 
—

 
6,000

 
—

Debt modification/retirement costs
822

 
1,088

 
822

 
1,088

Losses at skilled nursing facility not at full operation
133

 
—

 
133

 
—


34

Impairment of long-lived assets
82

 
—

 
82

 
—

Discontinued Operations
—

 
265

 
—

 
529

Adjusted EBITDA(1)
18,277

 
18,301

 
36,130

 
37,360

Rent cost of revenue
4,922

 
4,685

 
9,696

 
9,354

Adjusted EBITDAR(2)
$
23,199

 
$
22,986

 
$
45,826

 
$
46,714


(1)
We define EBITDA as net (loss) income before depreciation, amortization and interest expense (net of interest income) and the (benefit) provision for income taxes. Adjusted EBITDA is EBITDA adjusted for non-core business items, such as change in fair value of contingent consideration, organization restructuring costs, debt modification/retirement costs, impairment of long lived assets, losses at skilled nursing facility not at full operation, legal expense for non-routine matters, or the exit costs related to divested facilities.
(2)
We define EBITDAR as net (loss) income before depreciation, amortization, interest expense (net of interest income), the (benefit) provision for income taxes and rent cost of revenue. Adjusted EBITDAR is EBITDAR adjusted for the non-core business items listed above for the definition of Adjusted EBITDA (each to the extent applicable in the appropriate period.)
We believe that the presentation of EBITDA, EBITDAR, 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 report of EBITDA, EBITDAR, 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, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are primary indicators management uses 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 expenses, revenues and gains (losses) that we believe are unrelated to the day-to-day performance of our business but are required to be reported in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). We also use EBITDA, EBITDAR, 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.
Management, including operating company based management, uses EBITDA, EBITDAR, 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 and segment level. Segment management uses these metrics to measure performance on a business unit by business unit basis. We typically use Adjusted EBITDA and Adjusted EBITDAR for these purposes on a consolidated basis as the adjustments to EBITDA and EBITDAR are not generally allocable to any individual business unit and we typically use EBITDA and EBITDAR to compare the operating performance of each skilled nursing facility, assisted living facility, or other business unit as well as to assess the performance of our operating segments. EBITDA, EBITDAR, 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, depreciation and amortization expense, rent cost of revenue (in the case of EBITDAR and Adjusted EBITDAR) and special charges, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a facility 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. We believe these types of charges are dependent on factors unrelated to the underlying business unit performance. As a result, we believe that the use of EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying business units between periods by eliminating certain items required by U.S. GAAP which have little or no significance to their day-to-day operations.
Finally, we use Adjusted EBITDA to determine compliance with our debt covenants and assess our ability to borrow additional funds and to finance or expand operations. Our senior secured credit facility uses a measure substantially similar to Adjusted EBITDA as the basis for determining compliance with our financial covenants, specifically our minimum interest coverage ratio and our maximum total leverage ratio, and for determining the interest rate of our first lien term loan. For example, the senior secured credit facility includes adjustments to EBITDA for (i) gain or losses on sale of assets, (ii) the write-off of deferred financing costs of extinguished debt, (iii) pro forma adjustments for acquisitions to show a full year of EBITDA and interest expense, (iv) sponsorship fees paid to Onex which totals $0.5 million annually, (v) non-cash stock compensation and (vi) impairment of long-lived assets. Our noncompliance with these financial covenants could lead to acceleration of amounts due under our senior secured credit facility.
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 individual business level basis, EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning

35

defined by U.S. GAAP. Therefore, our EBITDA, EBITDAR, 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 U.S. 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, and EBITDA and Adjusted EBITDA 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;
•
they do not reflect the impact on earnings of charges resulting from certain matters we consider not to be indicative of our ongoing operations; 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, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR only to supplement net income on a basis prepared in conformance with U.S. GAAP in order to provide a more complete understanding of the factors and trends affecting our business. Furthermore, the non-GAAP financial measures that we present may be different from the presentation of similar measures by other companies, so the comparability of the measures among companies may be limited. We strongly encourage investors to consider net income determined under U.S. GAAP as compared to EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR, and to perform their own analysis, as appropriate.
Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013
Revenue. Revenue decreased by $3.2 million, or 1.5%, to $207.0 million in the three months ended June 30, 2014 from $210.2 million in the three months ended June 30, 2013.
Long term care services 
 
Three Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Dollars
 
Percentage
 
(dollars in millions)
   Skilled nursing facilities
$
154.5

 
74.6
%
 
$
150.4

 
71.5
%
 
$
4.1

 
2.7
%
   Assisted living facilities
7.6

 
3.7

 
7.0

 
3.3

 
0.6

 
8.6

   Administration of third party facility
0.2

 
0.1

 
0.1

 
0.1

 
0.1

 
35.9

   Leased facility revenue
0.8

 
0.4

 
0.8

 
0.4

 
—

 
—

Total long-term care services
$
163.1

 
78.8
%
 
$
158.3

 
75.3
%
 
$
4.8

 
3.0
%

The $4.1 million increase in skilled nursing facilities revenue in the second quarter of 2014 as compared to the second quarter of 2013 was primarily due to an increase in our average revenue per patient day ("PPD") driven by an increase in payor rates. The overall increase in PPD resulted in increased revenue of $4.6 million in the second quarter 2014 as compared to the second quarter 2013. Also contributing to the increase to revenue in the second quarter of 2014 as compared to the second quarter of 2013 was an increase in census for both Medicaid and Managed Care representing $0.8 million and $0.6 million, respectively. The increase Medicaid and Managed Care census was partially offset by a volume decrease in Medicare, Private, and Other average daily census ("ADC") days, leading to declines in revenue of $0.5 million, $1.0 million, and $0.6 million, respectively, for the three months ended June 30, 2014. A $0.1 million increase in revenue was the result of the Company's participation in an inter-governmental payment program in the state of Texas that provides supplemental Medicaid payments with federal matching funds for skilled nursing facilities that are affiliated with county owned hospitals.  Company subsidiaries entered into transactions with county owned hospital districts to provide for the management of two Company-owned skilled nursing facilities under this program beginning June 2014, and presently twelve of the Company’s Texas facilities are participating in the program.  The Company expects to add additional nursing centers during the remainder of 2014. 
  

36


The increase of $0.6 million at our assisted living facilities in the second quarter of 2014 as compared to the second quarter of 2013 was due primarily to a rate and volume increase of $0.3 million and $0.3 million, respectively. Rates were increased during October 2013.
Therapy services
 
Three Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Dollars
 
Percentage
 
(dollars in millions)
Rehabilitation therapy services
$
37.1

 
17.9
 %
 
$
40.6

 
19.3
 %
 
$
(3.5
)
 
(8.6
)%
Intersegment elimination of services related to affiliated entities
(14.1
)
 
(6.8
)
 
(14.0
)
 
(6.7
)
 
(0.1
)
 
0.7

Third party therapy services
$
23.0

 
11.1
 %
 
$
26.6

 
12.7
 %
 
$
(3.6
)
 
(13.4
)%
    
Hallmark revenue for third party therapy services decreased by $3.6 million in the second quarter of 2014 as compared to the second quarter of 2013. $3.4 million of which was attributable to a net decrease of 17 third party contracts from June 30, 2013 to June 30, 2014 and approximately $0.2 million of which was attributable to two discontinued owned contracts.
Hospice & Home Health services
 
Three Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Dollars
 
Percentage
 
(dollars in millions)
Hospice
$
14.7

 
7.1
%
 
$
18.4

 
8.7
%
 
$
(3.7
)
 
(20.2
)%
Home Health
6.1

 
3.0

 
6.9

 
3.3

 
(0.7
)
 
(10.4
)
Total hospice & home health services
$
20.8

 
10.1
%
 
$
25.3

 
12.0
%
 
$
(4.4
)
 
(17.5
)%

The $3.7 million decrease in hospice revenue in the second quarter of 2014 as compared to the second quarter of 2013 was a result of a 23.4% reduction in ADC, leading to a revenue reduction of $4.2 million, partially offset by an increase in our average PPD of $0.5 million for the second quarter of 2014 as compared to the second quarter of 2013. Medicare sequestration, which went into effect on April 1, 2013, reduced rates by 2%, and negatively impacted revenue for the three months ended June 30, 2014. Revenue for the second quarter of 2014 and 2013 was net of $0.9 million and $1.4 million of hospice cap reserves, respectively. Of the $0.9 million recorded in the three months ended June 30, 2014, $0.5 million was related to the 2014 cap year and $0.4 million was related to the 2013 cap year. Of the $1.4 million recorded in the three months ended June 30, 2013, $0.7 million was related to the 2013 cap year and $0.7 million was related to the 2012 cap year. The hospice cap reserves recorded in the quarter ended June 30, 2014 were the result of a combination of continued long stay patients and a decline in admissions in the quarter.
 
The $0.7 million decrease in our home health revenue in the second quarter of 2014 as compared to the second quarter of 2013 was the result of a reduction in ADC of approximately $0.4 million and a reduction in our average rates of $0.3 million. For the quarter ended June 30, 2014 as compared to the quarter ended June 30, 2013, we experienced a reduction in episodic-based admissions of approximately 8%.








37

Cost of Services. Cost of services decreased $4.3 million, or 2.3%, to $178.5 million, or 86.3% of revenue, in the three months ended June 30, 2014, from $182.8 million, or 87.0% of revenue, in the three months ended June 30, 2013.

Long term care services
 
Three Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
 
 
Dollars
 
Percentage
 
(dollars in millions)
Skilled nursing facilities
$
130.9

 
84.7
%
 
$
126.5

 
84.1
%
 
$
4.4

 
3.5
 %
Assisted living facilities
5.2

 
69.1

 
5.1

 
72.6

 
0.2

 
3.3

Regional operations support
4.5

 
n/a

 
5.1

 
n/a

 
(0.6
)
 
(12.2
)
Total long-term care services
$
140.6

 
86.2
%
 
$
136.7

 
86.3
%
 
$
3.9

 
2.9
 %
    
Cost of services expenses at our skilled nursing facilities increased $4.4 million in the second quarter of 2014 as compared to the second quarter of 2013. The $4.4 million increase was primarily the result of an increase of $1.9 million in salaries and wages, incremental bad debt expense of $1.0 million, $0.1 million in exit costs related to divested facilities, and increased other expenses of $1.7 million comprised of increases in supplies, food, utilities, therapy, pharmacy, legal expense, insurance, and other expense. During April 2014, there was a one-time wage increase, which accounts for the change in salaries and wages in the second quarter of 2014 as compared to the second quarter of 2013. These increased expenses were partially offset by a decrease of $0.8 million in employee benefit costs, primarily due to lower than expected self-insured medical utilization.
 
Cost of services at our assisted living facilities increased $0.2 million in the second quarter of 2014 as compared to the second quarter of 2013. The increase was due to $0.1 million increase in salaries and wages and an increase in other expenses of $0.1 million.

Cost of services in regional operations support decreased $0.6 million in the second quarter of 2014 as compared to the second quarter of 2013 primarily due to headcount reductions effective in the third quarter of 2013.

Therapy services  
 
Three Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
(prior to
intersegment
eliminations)
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
Revenue
(prior to
intersegment
eliminations)
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
 
 
Dollars
 
Percentage
 
(dollars in millions)
Rehabilitation therapy services
$
37.1

 
$
33.0

 
88.9
%
 
$
40.6

 
$
37.8

 
93.1
%
 
$
(4.8
)
 
(12.7
)%
Total therapy services
$
37.1

 
$
33.0

 
88.9
%
 
$
40.6

 
$
37.8

 
93.1
%
 
$
(4.8
)
 
(12.7
)%
    
Rehabilitation therapy costs of services as a percentage of revenue decreased by 4.2 percentage points. The decrease was the result of improved efficiencies in labor management, decreased utilization of contract labor, and a decrease in employee benefit costs, primarily due to lower than expected self-insured medical utilization. The remainder of the decrease in costs of service is attributable to the decline in revenue from period to period.

Hospice and home health services

38

 
Three Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Cost of Service
Dollars
 
Percentage of Revenue
 
Cost of Service
Dollars
 
Percentage of Revenue
 
 
 
Dollars
 
Percentage
 
(dollars in millions)
Hospice
$
13.6

 
92.6
%
 
$
16.3

 
88.9
%
 
$
(2.7
)
 
(16.8
)%
Home Health
5.8

 
93.9

 
6.7

 
96.9

 
(0.9
)
 
(13.1
)
Total hospice & home health services
$
19.4

 
93.0
%
 
$
23.0

 
91.1
%
 
$
(3.6
)
 
(15.7
)%
Cost of services expenses related to our hospice business decreased $2.7 million in the second quarter of 2014 as compared to the second quarter of 2013, primarily due to the revenue reduction. PPD costs increased from $134.88 to $144.76, an increase of 7.3 percentage points, reflecting the time necessary for the Company to align labor costs to the decline in census.
Cost of services related to our home health business decreased $0.9 million in the second quarter of 2014 as compared to the second quarter of 2013. The decrease was primarily due to a decrease of $0.7 million in salaries and benefits for employees due to the decrease in census.
Rent Cost of Revenue. Rent cost of revenue increased $0.2 million, or 5.1%, to $4.9 million, or 2.4% of revenue, in the three months ended June 30, 2014 from $4.7 million, or 2.2% of revenue, in the three months ended June 30, 2013.
General and Administrative Services Expenses. Our general and administrative services expenses increased $0.5 million, or 6.6%, to $7.3 million, or 3.5% of revenue, in the three months ended June 30, 2014 from $6.8 million, or 3.3% of revenue, in the three months ended June 30, 2013. After adjusting for the effect of one-time restructuring charges of $1.5 million and $0.6 million for the second quarters of 2013 and 2014, respectively, general and administrative expense increased $1.4 million for the three months ended June 30, 2014. The $1.4 million increase was primarily related to an increase in stock compensation expense of $0.5 million, incentive compensation expense of $0.3 million, and professional fees related to non-routine matters of $0.6 million for the three months ended June 30, 2014.

Government Investigation Expense. In the three month period ended June 30, 2014, we accrued an estimated $6.0 million contingent liability in connection with discussions with the government to resolve their investigation of our Creekside Hospice agency in Las Vegas, Nevada. It could ultimately cost more than the accrued amount to resolve the matter. For additional information regarding the Creekside Hospice investigation, see Note 8, "Commitments and Contingencies", in Item 1 of this report.

Depreciation and Amortization. Depreciation and amortization increased $0.1 million to $6.0 million, or 2.9% of revenue, in the three months ended June 30, 2014 and 2.8% of revenue for the three months ended June 30, 2013.

Change in fair value of contingent consideration. The change in fair value of contingent consideration increased by $2.1 million, to negative $0.1 million in the three months ended June 30, 2014 from negative $2.2 million in the three months ended June 30, 2013. The increase is related to the change in fair value, during the three months ended June 30, 2013, of the contingent consideration related to the 2010 hospice and home health acquisition due to reductions in forecasted EBITDA, which reduces the likelihood of the business achieving their EBITDA target necessary for the earn-out to be paid in future periods.

Interest Expense. Interest expense decreased by $0.8 million, or 9.2%, to $7.9 million, or 3.8% of revenue, in the three months ended June 30, 2014 from $8.7 million, or 4.2% of revenue, in the three months ended June 30, 2013. The decrease is related to the decrease in average debt outstanding from $445.3 million for the three months ended June 30, 2013 to $420.1 million for the three months ended June 30, 2014. Also, our average interest rate reduced from 6.74% for the three months ended June 30, 2013 to 6.14% for the three months ended June 30, 2014.
Equity in Earnings of Joint Venture. Equity earnings of our pharmacy joint venture decreased $0.4 million, or 80.5%, from $0.5 million for the three months ended June 30, 2013 to $0.1 million for the three months ended June 30, 2014. The decrease was due to a decrease in the joint venture's net income.
(Benefit) Provision for Income Taxes. We recorded a tax benefit of $1.3 million, or 32.6% of pre-tax earnings, for the three months ended June 30, 2014, as compared to a tax expense of $1.1 million, or 38.9% of pre-tax earnings, for the three months ended June 30, 2013. The reduction in the tax expense was primarily due to the decrease in revenue for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, offset by $0.3 million of tax expense related to stock compensation for shares that vested at a lower price than the grant value.

39

Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013
Revenue. Revenue decreased by $11.0 million, or 2.6%, to $414.3 in the six months ended June 30, 2014 from $425.3 million in the six months ended June 30, 2013.
Long term care services 
 
Six Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Dollars
 
Percentage
 
(dollars in millions)
   Skilled nursing facilities
$
307.6

 
74.3
%
 
$
304.2

 
71.5
%
 
$
3.4

 
1.1
%
   Assisted living facilities
14.9

 
3.6

 
14.1

 
3.3

 
0.8

 
5.4

   Administration of third party facility
0.3

 
0.1

 
0.3

 
0.1

 
—

 
10.3

   Leased facility revenue
1.6

 
0.3

 
1.5

 
0.4

 
—

 
3.0

Total long-term care services
$
324.4

 
78.3
%
 
$
320.2

 
75.3
%
 
$
4.3

 
1.3
%

The $3.4 million increase in skilled nursing facilities revenue in the first six months of 2014 as compared to the first six months of 2013 was primarily due to an increase in Medicaid and Managed Care ADC resulting in an increase in revenue of $5.2 million and $4.2 million, respectively. A $0.1 million increase in revenue was the result of the Company's participation in an inter-governmental payment program in the state of Texas that provides supplemental Medicaid payments with federal matching funds for skilled nursing facilities that are affiliated with county owned hospitals.  Company subsidiaries entered into transactions with county owned hospital districts to provide for the management of two Company-owned skilled nursing facilities under this program beginning June 2014, and presently twelve of the Company’s Texas facilities are participating in the program.  The Company expects to add additional nursing centers during the remainder of 2014.  The increase in Medicaid and Managed Care ADC was partially offset by a decrease in Medicare volume, which resulted in a revenue reduction of $4.3 million. A decrease in Private and Other ADC resulted in a net decrease in revenue of $1.8 million. Additionally, our average revenue per patient day improved to $241.96 for the first six months of 2014 from $237.94 for the first six months of 2013 as the improved Medicare, Medicaid, and Managed Care rates offset the decrease in Medicare volume.

The increase of $0.8 million at our assisted living facilities in the first six months of 2014 as compared to the first six months of 2013 was due primarily to a 2.0% increase in ADC coupled with a 3.2% increase in the PPD rate.
Therapy services
 
Six Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Dollars
 
Percentage
 
(dollars in millions)
Rehabilitation therapy services
$
74.0

 
18.0
 %
 
$
82.9

 
19.5
 %
 
$
(8.9
)
 
(10.7
)%
Intersegment elimination of services related to affiliated entities
(27.9
)
 
(6.7
)
 
(29.2
)
 
(6.9
)
 
1.3

 
(4.5
)
Third party therapy services
$
46.1

 
11.2
 %
 
$
53.7

 
12.7
 %
 
$
(7.6
)
 
(14.0
)%
    
Hallmark revenue for third party therapy services decreased by $7.6 million for the first six months of 2014 as compared to the first six months of 2013. This decrease was related to a decrease in third party contracts from June 30, 2013 to June 30, 2014.
Hospice & Home Health services
 
Six Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Dollars
 
Percentage
 
(dollars in millions)
Hospice
$
30.9

 
7.5
%
 
$
37.4

 
8.7
%
 
$
(6.5
)
 
(17.4
)%
Home Health
12.8

 
3.1

 
14.0

 
3.3

 
(1.2
)
 
(8.4
)
Total hospice & home health services
$
43.7

 
10.6
%
 
$
51.4

 
12.0
%
 
$
(7.7
)
 
(14.9
)%

40


The $6.5 million decrease in hospice revenue in the first six months of 2014 as compared to the first six months of 2013 was a result of a reduction in ADC resulting in a decrease of approximately $8.4 million. The decrease in revenue was partially offset by an increase in our average PPD rate resulting in an increase of $1.5 million and an increase in revenue of $0.4 million from the addition of a new unit in the first six months of 2014 as compared to the first six months of 2013. Revenue in the first six months of 2014 and 2013 was net of $0.9 million and $2.9 million of hospice cap reserves, respectively. Of the $0.9 million recorded in the first six months ended June 30, 2014, $0.5 million was related to the 2014 cap year and $0.4 million was related to the 2013 cap year. Of the $2.9 million recorded in the six months ended June 30, 2013, $0.7 million was related to the 2013 cap year, $2.0 million was related to the 2012 cap year, and $0.2 million was related to the 2011 cap year. The hospice cap reserves recorded for the first six months ended June 30, 2014 were the result of a combination of continued long stay patients and a decline in admissions for the first six months ended June 30, 2014.
 
The $1.2 million decrease in our home health revenue in the first six months of 2014 as compared to the first six months of 2013 was the result of a volume decrease of $0.6 million coupled with a rate decrease of $0.6 million. For the first six months of 2014 we experienced a decrease in admissions of approximately 4.3%.
Cost of Services. Cost of services decreased $10.2 million, or 2.8%, to $358.8 million, or 86.6% of revenue, in the first six months ended June 30, 2014, from $369.1 million, or 86.8% of revenue, in the first six months ended June 30, 2013.

Long term care services
 
Six Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
 
 
Dollars
 
Percentage
 
(dollars in millions)
Skilled nursing facilities
$
261.7

 
85.1
%
 
$
255.4

 
84.0
%
 
$
6.4

 
2.5
 %
Assisted living facilities
10.8

 
72.3

 
10.2

 
72.0

 
0.6

 
6.2

Regional operations support
9.1

 
n/a

 
11.2

 
n/a

 
(2.1
)
 
(18.8
)
Total long-term care services
$
281.6

 
86.8
%
 
$
276.8

 
86.4
%
 
$
4.8

 
1.8
 %
    
Cost of services at our skilled nursing facilities increased $6.4 million in the first six months of 2014 as compared to the first six months of 2013. The increase was primarily the result of an increase of $3.1 million in salaries and wages, incremental bad debt expense of $1.6 million, $0.3 million in exit costs related to divested facilities, $0.1 million of expenses incurred at a facility not at full operation, and increased other expenses of $3.7 million comprised of increases in: supplies, food, utilities, purchased services, and other expense. This was partially offset by decreases in employee benefits expense of $0.6 million, professional liability and general liability insurance expense of $1.5 million, and tax expense of $0.3 million.
 
Cost of services at our assisted living facilities increased $0.6 million in the first six months of 2014 as compared to the first six months of 2013. The increase was due to $0.4 million increase in salaries and wages, an increase in utilities costs of $0.1 million, an increase in purchased services of $0.1 million, and increased other expenses of $0.2 million as compared to the first six months ended June 31, 2013.

Cost of services in regional operations support decreased $2.1 million in the first six months of 2014 as compared to the first six months of 2013 primarily due to headcount reductions effective in the third quarter of 2013.


41

Therapy services  
 
Six Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Revenue
(prior to
intersegment
eliminations)
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
Revenue
(prior to
intersegment
eliminations)
 
Cost of Service
Dollars
(prior to
intersegment
eliminations)
 
Percentage of Revenue
 
 
 
Dollars
 
Percentage
 
(dollars in millions)
Rehabilitation therapy services
$
74.0

 
$
66.5

 
89.9
%
 
$
82.9

 
$
76.9

 
92.8
%
 
$
(10.4
)
 
(13.5
)%
Total therapy services
$
74.0

 
$
66.5

 
89.9
%
 
$
82.9

 
$
76.9

 
92.8
%
 
$
(10.4
)
 
(13.5
)%
    
Rehabilitation therapy costs of services as a percentage of revenue decreased by $10.4 million or 13.5% for the six months ended June 30, 2014, as compared to the same period in 2013, commensurate with the revenue reduction.

Hospice and home health services
 
Six Months Ended June 30,
 
 
 
2014
 
2013
 
Increase/(Decrease)
 
Cost of Service
Dollars
 
Percentage of Revenue
 
Cost of Service
Dollars
 
Percentage of Revenue
 
 
 
Dollars
 
Percentage
 
(dollars in millions)
Hospice
$
27.4

 
88.8
%
 
$
32.5

 
87.0
%
 
$
(5.1
)
 
(15.6
)%
Home Health
12.1

 
94.9

 
13.2

 
94.6

 
(1.1
)
 
(8.3
)
Total hospice & home health services
$
39.5

 
90.5
%
 
$
45.7

 
89.0
%
 
$
(6.2
)
 
(13.5
)%
Cost of services related to our hospice business decreased $5.1 million or 15.6% in the first six months of 2014 as compared to the first six months of 2013, commensurate with the revenue reduction. PPD costs increased from $134.20 to $143.06, an increase of 6.6 percentage points, reflecting the time necessary for the Company to align labor costs to the decline in census.
Cost of services related to our home health business decreased $1.1 million in the first six months of 2014 as compared to the first six months of 2013, primarily due to the reduction in episodes.
Rent Cost of Revenue. Rent cost of revenue increased $0.3 million, or 3.7%, to $9.7 million, or 2.3% of revenue, in the six months ended June 30, 2014 from $9.4 million, or 2.2% of revenue, in the six months ended June 30, 2013.
General and Administrative Services Expenses. Our general and administrative services expenses increased $0.1 million, or 0.6%, to $13.4 million, or 3.2% of revenue, in the six months ended June 30, 2014 from $13.3 million, or 3.1% of revenue, in the six months ended June 30, 2013. After adjusting for the effect of one-time restructuring charges of $1.5 million and $1.1 million for the six months ended June 30, 2013 and June 30, 2014, respectively, general and administrative services expense increased $0.5 million for the first six months of 2014. The increase was primarily due to $0.6 million in professional fees related to non-routine matters offset by $0.1 million in headcount reductions.

Government Investigation Expense. In the three month period ended June 30, 2014, we accrued an estimated $6.0 million contingent liability in connection with discussions with the government to resolve their investigation of our Creekside Hospice agency in Las Vegas, Nevada. It could ultimately cost more than the accrued amount to resolve the matter. For additional information regarding the Creekside Hospice investigation, see Note 8, "Commitments and Contingencies", in Item 1of this report.

Depreciation and Amortization. Depreciation and amortization increased $0.3 million to $12.1 million, or 2.9% of revenue, in the six months ended June 30, 2014 compared to 2.8% of revenue for the six months ended June 30, 2013.

Change in fair value of contingent consideration. The change in fair value of contingent consideration increased $2.1 million, or 95.0%, to negative $0.1 million in the six months ended June 30, 2014 from negative $2.2 million in the six months

42

ended June 30, 2013. The increase is related to the change in fair value, during the six months ended June 30, 2013, of the contingent consideration related to the 2010 hospice and home health acquisition due to reductions in forecasted EBITDA, which reduces the likelihood of the business achieving their EBITDA target necessary for the earn-out to be paid in future periods.

Interest Expense. Interest expense decreased by $1.4 million, or 8.2%, to $16.0 million, or 3.9% of revenue, for the six months ended June 30, 2014 from $17.4 million, or 4.1% of revenue, for the six months ended June 30, 2013. The decrease is related to the decrease in average debt outstanding from $447.0 million for the six months ended June 30, 2013 to $421.2 million for the six months ended June 30, 2014. Also, our average interest rate reduced from 6.74% for the six months ended June 30, 2013 to 6.20% for the six months ended June 30, 2014.
Equity in Earnings of Joint Venture. Equity earnings of our pharmacy joint venture decreased by $0.3 million, or 33.5%, to $0.6 million, or 0.2% of revenue, in the six months ended June 30, 2014 from $0.9 million, or 0.2%, for the six months ended June 30, 2013. The decrease was related due to a decrease in the joint venture's net income.
Provision for Income Taxes. We recorded a tax expense of less than $0.1 million, or 0.2% of pre-tax loss, for the six months ended June 30, 2014, as compared to a tax expense of $1.4 million, or 21.3% of pre-tax earnings, for the six months ended June 30, 2013. The reduction in the tax expense was primarily due to the decrease in pre-tax earnings offset by an increase to a shortfall resulting from stock compensation for the six month period June 30, 2014 as compared to the six month period June 30, 2013, the decrease in pre-tax earnings for the six month period June 30, 2014 as compared to the six month period June 30, 2013.
Liquidity and Capital Resources
The following table presents selected data from our condensed consolidated statements of cash flows (in thousands):
 
 
Six Months Ended June 30,
 
2014
 
2013
Cash Flows from Continuing Operations
 
 
 
Net cash provided by operating activities
$
21,214

 
$
13,789

Net cash used in investing activities
(5,201
)
 
(5,981
)
Net cash used in financing activities
(12,230
)
 
(7,792
)
Net increase in cash and cash equivalents
3,783

 
16

Cash and cash equivalents at beginning of period
4,177

 
2,003

Cash and cash equivalents at end of period
$
7,960

 
$
2,019

Based upon our current level of operations, we believe that cash generated from operations, cash on hand and borrowings available to us will be adequate to meet our anticipated debt service requirements, capital expenditures and working capital needs for at least the next twelve months. One element of our business strategy is to selectively pursue acquisitions and strategic alliances. Any acquisitions or strategic alliances may result in our incurrence or assumption of additional indebtedness. We assess our capital needs on an ongoing basis and may from time to time seek additional financing through a variety of methods, including through an extension of our senior secured credit facility, or by accessing available debt and equity markets, and participation in U.S. Department of Housing and Urban Development ("HUD") or other government insured loan programs, as considered necessary to fund capital expenditures and potential acquisitions, refinance existing debt, or for other purposes. Our future operating performance will be subject to future economic conditions and to financial, business, regulatory and other factors, many of which are beyond our control. For additional discussion, see "Other Factors Affecting Liquidity and Capital Resources" below.
Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013
At June 30, 2014, we had cash and cash equivalents of $8.0 million. Our available cash is held in accounts at third-party financial institutions. We have periodically invested in AAA-rated money market funds. To date, we have experienced no loss or lack of access to our invested cash or cash equivalents; however, we can provide no assurances that access to our invested cash or cash equivalents will not be impacted by adverse conditions in the financial markets.
Net cash provided by operating activities in the six months ended June 30, 2014 was $21.2 million, compared to $13.8 million in the six months ended June 30, 2013.  The increase in net cash provided by operating activities was primarily the result of a $14.8 million improvement in changes in operating assets and liabilities and a $1.2 million net decrease in adjustments for non-cash items offset by a decrease in net income of $6.1 million. The $14.8 million improvement in operating cash flows from operating assets and liabilities for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013 was the result of a decrease in the change in accounts receivable of $8.4 million, a $6.1 million increase in

43

employee compensation and benefits due to timing of payments, a decrease in other current and non-current assets of $3.6 million, and an increase in accounts payable and accrued liabilities of $0.5 million partially offset by a decrease in insurance liability risks of $2.5 million, a $0.7 million decrease in other long-term liabilities, and a $0.7 million decrease in notes receivable payments.
Net cash used in investing activities in the six months ended June 30, 2014 was $5.2 million, compared to $6.0 million in the six months ended June 30, 2013. The net change is primarily due to proceeds from maturity of investments of $1.1 million partially offset by a net increase in capital expenditures of $0.3 million for the six months ended June 30, 2014.
Net cash used in financing activities in the six months ended June 30, 2014 was $12.2 million, compared to the $7.8 million net cash used in the six months ended June 30, 2013. The change was primarily due to an increase in mandatory and voluntary repayments under the line of credit of $2.0 million and a reduction in cash provided by borrowings under the line of credit of $8.0 million. We continue to pay down debt and have incurred costs related to the June 2014 debt amendment and the origination of the MidCap insured loans in the six months ended June 30, 2014.
Principal Debt Obligations
Our primary sources of liquidity are our cash on hand, our cash flows from operations and borrowing under our senior secured credit facility, which is subject to the satisfaction of certain financial covenants therein. Our primary liquidity requirements are for debt service on our first lien senior secured term loan, capital expenditures and working capital.
We are significantly leveraged. As of June 30, 2014, we had $410.2 million in aggregate indebtedness outstanding, consisting of $243.0 million first lien senior secured term loan (net of the unamortized portion of the original issue discount ("OID") of $1.0 million), $12.0 million principal amount outstanding under our $83.1 million revolving credit facility, HUD insured loans of $86.7 million, $5.0 million outstanding under our asset based revolving credit facility, $61.3 million term debt mortgage loan, and other debt of approximately $2.3 million. Furthermore, we had $5.5 million in outstanding letters of credit against our $83.1 million revolving credit facility, leaving approximately $65.6 million of additional borrowing capacity under our senior secured credit facility as of June 30, 2014. Substantially all of our subsidiaries, except for the HUD insured loan subsidiaries and the skilled nursing facilities that collateralize the MidCap Financial credit facility, guarantee the first lien senior secured term loan and our revolving credit facility.
If our remaining ability to borrow under our revolving credit facility is insufficient for our capital requirements, we will be required to seek additional sources of financing, including issuing equity, which may be dilutive to our current stockholders, or incurring additional debt. Our ability to incur additional debt is subject to the restrictions in our senior secured credit facility. We cannot assure you that the restrictions contained in the senior secure credit facility will permit us to borrow the funds that we need to finance our operations, or that additional debt will be available to us on commercially reasonable terms or at all. If we are unable to obtain funds sufficient to finance our capital requirements, we may have to forego opportunities to expand our business, including the acquisition of additional facilities.
Term Loan and Revolving Credit Facility
On April 9, 2010, the Company entered into an up to $360.0 million senior secured term loan and a $100.0 million revolving credit facility (the "Prior Credit Agreement") that amended and restated the senior secured term loan and revolving credit facility that were set to mature in June 2012. On April 12, 2012, the Company entered into an Amendment and Restatement and Additional Term Loan Assumption Agreement (“Restated Credit Agreement”) that amended and restated the Prior Credit Agreement and pursuant to which, among other things, the size of the Company's existing senior secured term loan was increased by $100.0 million (hereinafter referred to as the incremental senior secured term loan).
On June 6, 2013, the Company entered into an amendment to the Restated Credit Agreement that increased the maximum leverage ratio by 0.50 throughout the life of the Restated Credit Agreement. The amendment additionally permits the Company to make future offers to the lenders under the revolving credit facility to extend the maturity date of all or a portion of the revolving credit facility. The credit arrangements provided under the Restated Credit Agreement are collectively referred to herein as the Company's senior secured credit facility.
In connection with the June 2013 modification, the Company paid fees totaling $2.5 million, of which $1.1 million was recorded as debt modification costs in the consolidated statement of operations, and $1.4 million was recorded as other assets in the consolidated balance sheet. Substantially all of the Company's assets, except those skilled nursing facilities securing the HUD and MidCap mortgage loans, are pledged as collateral under the senior secured credit facility. Amounts borrowed under the senior secured term loan may be prepaid at any time without penalty, except for LIBOR breakage costs. The senior secured term loan matures on April 9, 2016.
On June 23, 2014, the Company entered into an Amendment No. 2 and Loan Modification Agreement ("Amendment No. 2") to our Fourth Amended and Restated Credit Agreement dated April 12, 2012, as previously amended on June 6, 2013. Amendment No. 2 increased the maximum leverage ratio to 5.25 and decreased the fixed charge coverage ratio to 1.85, both up to but not including June 30, 2015. Amendment No. 2 increased the interest rate by 0.25% to the London Interbank Offered Rate

44

("LIBOR") (subject to a floor of 1.50%) plus a margin of 5.50 or the prime rate (subject to a floor of 2.50%) plus a margin of 4.50%. Amendment No. 2 extended the maturity date of the revolving credit facility to April 9, 2016 and reduced the commitments of any extending revolving lenders by 25%. After giving effect to Amendment No. 2, the extended revolving credit facility commitments are $50.6 million and the non-extended revolving credit facility commitments are $32.5 million, for a total capacity of $83.1 million. The capacity of the revolving credit facility will decrease to $50.6 million on April 9, 2015 until its maturity. Lenders that take an assignment of non-extended commitments may subsequently agree to extend those commitments in accordance with Amendment No. 2. Amendment No. 2 also modified the interest rate for the extended revolving credit commitments to be, at the Company’s option, LIBOR plus a margin between 5.25% and 5.50% (based upon consolidated leverage) or the prime rate plus a margin between 4.25% and 4.50% (based upon consolidated leverage). The interest rates on the non-extended revolving credit facility commitments remain, at the Company’s option, at LIBOR plus a margin of between 4.25% and 4.50% (based upon consolidated leverage) or the prime rate plus a margin between 3.25% and 3.50% (based upon consolidated leverage). In connection with the June 2014 modification, the Company paid fees totaling 2.0 of which $0.8 million were recorded as debt modification costs in the condensed consolidated statements of operations, and $1.2 million was recorded as other assets in the condensed consolidated balance sheet.
Pursuant to the Restated Credit Agreement, the quarterly term loan amortization payments increased to $2.6 million beginning June 30, 2012 compared to $0.9 million under the Prior Credit Agreement. Due to the principal reductions made in 2013 made in association with the HUD insured financings, no amortization payments are due until December 2014, at which time the quarterly principal payments due will be $1.6 million. Additionally, the maximum portion of the annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement) to be applied to term debt reductions increased to 75% from 50%, subject to stepdowns to 50% and 25% based on consolidated leverage. The Company has also increased its ability to refinance a portion of its credit facility with U.S. Department of Housing and Urban Development ("HUD") insured debt up to $250 million, subject to certain credit facility covenants. Any HUD insured borrowings beyond $250 million would necessitate either refinancing the senior secured credit facility in full or otherwise seeking a waiver or amendment from the senior secured lenders.
Under the senior secured credit facility, the Company must maintain compliance with specified financial covenants measured on a quarterly basis. The senior secured credit facility also includes certain additional affirmative and negative covenants, including limitations on the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Also under the senior secured credit facility, subject to certain exceptions and minimum thresholds, the Company is required to apply all of the proceeds from any issuance of debt, as much as half of the proceeds from any issuance of equity, as much as 75% of the Company's annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement), and amounts received in connection with any sale of the Company's assets to repay the outstanding amounts under the Restated Credit Agreement. The Company believes that it is in compliance with its debt covenants as of June 30, 2014. As of June 30, 2014, the fixed charge coverage ratio was 2.18, which compares to a minimum requirement of 1.85 and the leverage ratio was 4.72, as compared to an allowed maximum of 5.25.
HUD Insured and Other Mortgage Loans
In 2013, the Company received funding of 10 loans insured by HUD. The loans have a combined aggregate original principal balance of $87.6 million and are secured by 10 skilled nursing facilities. The HUD insured loans have an average all in interest rate of approximately 5.3% and amortization term 30 to 35 years. As of June 30, 2014 the HUD insured loans have a combined aggregate principal balance of $86.7 million.
Accordingly, as of June 30, 2014, the Company has 10 mortgages insured by HUD, which are each secured by a skilled nursing facility. These mortgages have an average remaining term of P33Y with fixed interest rates ranging from 3.4% to 4.6% and a weighted average interest rate of 4.23%. Depending on the mortgage agreement, prepayments are generally allowed only after 12 months from the inception of the mortgage. Prepayments are subject to a penalty of 10% of the remaining principal balances in the first year and the prepayment penalty decreases each subsequent year by 1% until no penalty is required. As all $87.6 million of the HUD insured mortgage loans were originated in 2013, none of the loans could be prepaid at June 30, 2014. Any further HUD insured mortgages will require additional HUD approval.
All HUD-insured mortgages are non-recourse loans to the Company. All mortgages are subject to HUD regulatory agreements that require escrow reserve funds to be deposited with the loan servicer for mortgage insurance premiums, property taxes, insurance and for capital replacement expenditures. As of June 30, 2014, the Company has escrow reserve funds of $1.6 million with the loan servicer that are reported within other current assets, and replacement reserve funds of $3.0 million in other assets. The net proceeds of the HUD insured loans were required to be used to pay down term debt under the Restated Credit Agreement. In 2013, $87.6 million of HUD insured loan proceeds were used to pay down term debt.
As of June 30, 2014 the Company has 10 additional skilled nursing facilities securing a $61.3 million mortgage loan and a $5.0 million asset based revolving credit facility with MidCap Financial. Both loans have an interest rate of LIBOR plus a margin of 5.95% with a LIBOR floor of 0.75%. The mortgage loan amortizes over 25 years with the remaining principal due December 1, 2016. There are additional quarterly principal payments of $0.3 million beginning after six months, $0.4 million in year two and $0.5 million in year three. The mortgage loan has a debt service coverage ratio and a minimum debt coverage

45

ratio, both of which were met at June 30, 2014. The asset based revolving credit facility is secured by the accounts receivable of the 10 skilled nursing facilities. In 2013, $65.0 million of mortgage loan and asset based revolving credit facility proceeds were used to pay down term debt.
Capital Expenditures
We intend to invest in the maintenance and general upkeep of our facilities on an ongoing basis. We also expect to perform renovations of our existing facilities every five to ten years to remain competitive. Combined, we expect that these activities will amount to approximately $1,500 per bed.
We anticipate that we will have capital expenditures in 2014 of approximately $14.0 million to $17.0 million. We will continue to assess our capital spending plans on an ongoing basis.
Other Factors Affecting Liquidity and Capital Resources
Medical and Professional Malpractice and Workers' Compensation Insurance. Our skilled nursing facilities and other businesses, like physicians, hospitals and other healthcare providers, are subject to a significant number of legal actions alleging malpractice, negligence or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we maintain professional liability and general liability as well as workers' compensation insurance in amounts and with deductibles that we believe to be sufficient for our operations. Historically, unfavorable pricing and availability trends emerged in the professional liability and workers' compensation insurance market and the insurance market in general that caused the cost of these liability coverages to generally increase dramatically. Many insurance underwriters became more selective in the insurance limits and types of coverage they would provide as a result of rising settlement costs and the significant failures of some nationally known insurance underwriters. As a result, we experienced substantial changes in our professional liability insurance program beginning in 2001. Specifically, we were required to assume substantial self-insured retentions for our professional liability claims. A self-insured retention is a minimum amount of damages and expenses (including legal fees) that we must pay for each claim. We use actuarial methods to estimate the value of the losses that may occur within this self-insured retention level and we are required under our workers' compensation insurance agreements to post a letter of credit or set aside cash in trust funds to securitize the estimated losses that we may incur. Because of the high retention levels, we cannot predict with certainty the actual amount of the losses we will assume and pay.
We estimate our self-insured general and professional liability reserves on a quarterly basis and our self-insured workers' compensation reserve on a semiannual basis, based upon actuarial analyses using the most recent trends of claims, settlements and other relevant data from our own and our industry's loss history. Based upon these analyses, at June 30, 2014, we had reserved $22.2 million net of $0.4 million in insurance recoveries for known or unknown or potential self-insured general and professional liability claims and $20.9 million for self-insured workers' compensation claims. Of these reserves, we estimate that a total of $13.8 million, consisting of approximately $7.6 million for self-insured general and professional liability claims based on historical experience and current claims activity and $6.2 million for self-insured workers' compensation claims, will be payable within 12 months; however, there are no set payment schedules and there can be no assurance that the payment amount in the next 12 months will not be significantly larger or smaller. To the extent that subsequent claims information varies from loss estimates, the liabilities will be adjusted to reflect current loss data. There can be no assurance that in the future general and professional liability or workers' compensation insurance will be available at a reasonable price and that we will not have to further increase our levels of self-insurance. For additional information on our general and professional liability and workers’ compensation reserve, see "Business — Insurance" in Part 1, Item 1 in our Annual Report on Form 10-K filed with the SEC on February 10, 2014.
Inflation. We derive a substantial portion of our revenue from the Medicare program. We also derive revenue from state Medicaid and similar reimbursement programs. Payments under these programs generally provide for reimbursement levels that are adjusted for inflation annually based upon the state's fiscal year for the Medicaid programs and in each October for the Medicare program. However, there can be no assurance that these adjustments will continue in the future and, if received, will reflect the actual increase in our costs for providing healthcare services.
Labor and supply expenses make up a substantial portion of our operating expenses. Those expenses can be subject to increase in periods of rising inflation and when labor shortages occur in the marketplace. To date, we have generally been able to implement cost control measures or obtain increases in reimbursement sufficient to offset increases in these expenses. We cannot assure you that we will be successful in offsetting future cost increases.
Recent Accounting Standards
The information required by this item is incorporated herein by reference to Note 3, "Summary of Significant Accounting Policies," to the unaudited condensed consolidated financial statements included under Part I, Item 1 of this report.
Off-Balance Sheet Arrangements
We had outstanding letters of credit of $5.5 million under our $83.1 million revolving credit facility as of June 30, 2014.


46

Item 3. Quantitative and Qualitative Disclosures About Market Risk
In the normal course of business, our operations are exposed to risks associated with fluctuations in interest rates. To the extent these interest rates increase, our interest expense will increase, which will make our interest payments and funding our other fixed costs more expensive, and our available cash flow may be adversely affected. We routinely monitor our risks associated with fluctuations in interest rates and consider the use of derivative financial instruments to hedge these exposures. We do not enter into derivative financial instruments for trading or speculative purposes nor do we enter into energy or commodity contracts.
Interest Rate Exposure—Interest Rate Risk Management
Our first lien credit agreement and our MidCap credit facility expose us to variability in interest payments due to changes in interest rates. Our HUD insured mortgage loans are fixed rate fully amortizing loans.
The table below presents the principal amounts, weighted-average interest rates and fair values by year of expected maturity to evaluate our expected cash flows and sensitivity to interest rate changes (dollars in thousands):
 
 
Twelve Months Ending June 30, (1)
 
 
 
 
 
 
 
2014
 
2015
 
2016
 
2017
 
2018
 
Thereafter
 
Total
 
Fair Value
Fixed-rate debt
$
2,958

 
$
1,576

 
$
1,646

 
$
1,720

 
$
1,684

 
$
79,408

 
$
88,992

 
$
89,642

Average interest rate
3.6
%
 
4.4
%
 
4.4
%
 
4.4
%
 
4.3
%
 
4.2
%
 
 
 
 
Variable-rate debt(2)
$
3,961

 
$
9,682

 
$
308,572

 
$
—

 
$
—

 
$
—

 
$
322,215

 
$
322,215

Average interest rate(1)
6.4
%
 
6.4
%
 
7.9
%
 
—
%
 
—
%
 
—
%
 
 
 
 
 
(1)
Based on implied forward three-month LIBOR rates in the yield curve as of June 30, 2014.
(2)
Excludes unamortized original issue discount of $1.0 million on our first lien senior secured term loan debt.

Item 4. Controls and Procedures
Disclosure Controls and Procedures
As required by Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report.
Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply its judgment in evaluating and implementing possible controls and procedures.
We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon their evaluation and subject to the foregoing, the Chief Executive Officer and Chief Financial Officer have concluded that, as of end of the period covered by this report, the disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Exchange Act is recorded, processed, summarized and reported as and when required.

Changes in Internal Control Over Financial Reporting
Management determined that there were no changes in our internal control over financial reporting that occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

47

Part II. Other Information

Item 1. Legal Proceedings
For information regarding certain pending legal proceedings to which we are a party or our property is subject, see Note 8, "Commitments and Contingencies—Legal Matters," to our consolidated financial statements included elsewhere in this report, which is incorporated herein by reference.

Item 1A. Risk Factors
Statements made by us in this report and in other reports and statements released by us that are not historical facts constitute "forward-looking statements" within the meaning of Section 21 of the Exchange Act. Statements that use words such as "believe," "anticipate," "estimate," "intend," "could," "plan," "expect," "project" or the negative of these, as well as similar expressions, are intended to identify forward-looking statements. These forward-looking statements are necessarily estimates and expectations reflecting the best judgment of our senior management based on our current estimates, expectations, forecasts and projections, and include comments that express our current opinions about trends and factors that may impact future operating results. Such statements rely on a number of assumptions concerning future events, many of which are outside of our control, and involve known and unknown risks and uncertainties that could cause our actual results, performance or achievements, or industry results, to differ materially from any future results, performance or achievements, expressed or implied by such forward-looking statements. Any such forward-looking statements, whether made in this report or elsewhere, should be considered in the context of the various disclosures made by us about our business and other matters including, without limitation, the risk factors discussed below. We expressly disclaim any duty to update the forward-looking statements and other information contained in this report, except as required by law.
We operate in a rapidly changing and highly regulated environment that involves a number of risks and uncertainties, some of which are highlighted below and others are discussed elsewhere in this report. These risks and uncertainties could materially and adversely affect our business, financial condition, prospects, operating results or cash flows. The following risk factors are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as employment relations, natural disasters, general economic conditions and geopolitical events. Further, additional risks not currently known to us or that we currently believe are immaterial may in the future materially and adversely affect our business, operations, liquidity and stock price.

Risks Related to Our Business
Reductions in Medicare reimbursement rates, or changes in the rules governing the Medicare program could have a material adverse effect on our revenue, financial condition and results of operations.
Medicare is our largest source of revenue, accounting for 29.4% of our consolidated revenue during the three month period ended June 30, 2014 and 31.0% in the same period for 2013. For the six months ended June 30, 2014 and 2013, Medicare revenue accounted for 29.7% and 31.8% of our consolidated revenue, respectively. In addition, many private payors base their reimbursement rates on the published Medicare rates or, in the case of our rehabilitation therapy services customers, are themselves reimbursed by Medicare for the services we provide. Accordingly, if Medicare reimbursement rates are reduced or fail to increase as quickly as our costs, or if there are changes in the rules governing the Medicare program that are disadvantageous to our business or industry, our business and results of operations will be adversely affected.
The Medicare program and its reimbursement rates and rules are subject to frequent change. These include statutory and regulatory changes, rate adjustments (including retroactive adjustments), administrative or executive orders and government funding restrictions, all of which may materially adversely affect the rates at which Medicare reimburses us for our services. For example, CMS implemented a net 11.1% reduction in its reimbursement rates to skilled nursing facilities effective October 1, 2011. Furthermore, due to the federal sequestration, an automatic 2% reduction in Medicare spending took effect beginning in April 2013 and will remain in effect unless Congress takes action to terminate the automatic reduction or authorize spending increases. Budget pressures often lead the federal government to reduce or place limits on reimbursement rates under Medicare. Implementation of these and other types of measures has in the past and could in the future result in substantial reductions in our revenue and operating margins. Prior reductions in governmental reimbursement rates partially contributed to our predecessor's bankruptcy filing under Chapter 11 of the United States Bankruptcy Code in October 2001.
In addition, the federal government often changes the rules governing the Medicare program, including those governing reimbursement. Changes that could adversely affect our business include:
•
administrative or legislative changes to base rates or the bases of payment;
•
limits on the services or types of providers for which Medicare will provide reimbursement;
•
changes in methodology for patient assessment and/or determination of payment levels;

48

•
the reduction or elimination of annual rate increases; or
•
an increase in co-payments or deductibles payable by beneficiaries.
Given the history of frequent revisions to the Medicare program and its reimbursement rates and rules, we may not continue to receive reimbursement rates from Medicare that sufficiently compensate us for our services or, in some instances, cover our operating costs. Limits on reimbursement rates or the scope of services being reimbursed could have a material adverse effect on our revenue, financial condition and results of operations. Additionally, any delay or default by the federal or state governments in making Medicare and/or Medicaid reimbursement payments could materially and adversely affect our business, financial condition and results of operations.
We expect the federal and state governments to continue their efforts to contain growth in Medicaid expenditures, which could adversely affect our revenue and profitability.
We receive a significant portion of our revenue from Medicaid, which accounted for 33.0% of our consolidated revenue for the three months ended June 30, 2014 compared to 31.0% for the same period in 2013. For the six months ended June 30, 2014 and 2013, Medicaid revenue accounted for 32.7% and 30.5% of our consolidated revenue, respectively. Medicaid is a state-administered program financed by both state funds and matching federal funds. Medicaid spending has increased rapidly in recent years, becoming a significant component of state budgets. This, combined with slower state revenue growth, has led both the federal government and many states (including California and Texas, where significant portions of our Medicaid-related business is located) to institute measures aimed at controlling the growth of Medicaid spending, and in some instances reducing aggregate Medicaid spending. We expect these state and federal efforts to continue for the foreseeable future. Furthermore, not all of the states in which we operate, most notably Texas, have elected to expand Medicaid as part of federal healthcare reform legislation. If Medicaid reimbursement rates are reduced or fail to increase as quickly as our costs, or if there are changes in the rules governing the Medicaid program that are disadvantageous to our businesses, our business and results of operations could be materially and adversely affected.
Recent federal government proposals could limit the states' use of provider tax programs to generate revenue for their Medicaid expenditures, which could result in a reduction in our reimbursement rates under Medicaid.
To generate funds to pay for the increasing costs of the Medicaid program, many states utilize financial arrangements commonly referred to as "provider taxes." Under provider tax arrangements, states collect taxes from healthcare providers and then use the revenue to pay the providers as a Medicaid expenditure, which allows the states to then claim additional federal matching funds on the additional reimbursements. Current federal law provides for a cap on the maximum allowable provider tax as a percentage of the provider's total revenue. There can be no assurance that federal law will continue to provide matching federal funds on state Medicaid expenditures funded through provider taxes, or that the current caps on provider taxes will not be reduced. Any discontinuance or reduction in federal matching of provider tax-related Medicaid expenditures could have a significant and adverse effect on states' Medicaid expenditures, and as a result could have a material and adverse effect on our financial condition and results of operations.
Revenue we receive from Medicare and Medicaid is subject to potential retroactive reduction or repayment.
Payments we receive from Medicare and Medicaid can be retroactively adjusted after examination during the claims settlement process or as a result of post-payment audits. Payors may disallow our requests for reimbursement, or recoup amounts previously reimbursed, based on determinations by the payors or their third-party audit contractors that certain costs are not reimbursable because either adequate or additional documentation was not provided or because certain services were not covered or deemed to not be medically necessary. Significant adjustments, recoupments or repayments of our Medicare or Medicaid revenue, and the costs associated with complying with investigative audits by regulatory and governmental authorities, could adversely affect our financial condition and results of operations.
Additionally, from time to time we become aware, either based on information provided by third parties and/or the results of internal audits, of payments from payor sources that were either wholly or partially in excess of the amount that we should have been paid for the service provided. Overpayments may result from a variety of factors, including insufficient documentation supporting the services rendered or medical necessity of the services, other failures to document the satisfaction of the necessary conditions of payment, or in some cases for providing services that are deemed to be worthless. We are required by law in most instances to refund the full amount of the overpayment after becoming aware of it, and failure to do so within requisite time limits imposed by the law could lead to significant fines and penalties being imposed on us. Furthermore, our initial billing of and payments for services that are unsupported by the requisite documentation and satisfaction of any other conditions of payment, regardless of our awareness of the failure at the time of the billing or payment, could expose us to significant fines and penalties, including pursuant to the Federal False Claims Act ("FFCA") and the Federal Civil Monetary Penalties Law ("FCMPL"). Violations of the FFCA could lead to any combination of a variety of criminal, civil and administrative fines and penalties. The FFCA provides for civil fines ranging from $5,500 to $11,000 per claim plus treble damages. The Civil Monetary Penalties Law similarly provides for civil monetary penalties of up to $10,000 per claim plus up

49

to treble damages. We and/or certain of our operating companies could also be subject to exclusion from participation in the Medicare or Medicaid programs in some circumstances as well, in addition to any monetary or other fines, penalties or sanctions that we may incur under applicable federal and/or state law. Our repayment of any such amounts, as well as any fines, penalties or other sanctions that we may incur, could be significant and could have a material and adverse effect on our results of operations and financial condition.
From time to time we are also involved in various external governmental investigations, audits and reviews. Reviews, audits and investigations of this sort can lead to government actions, which can result in the assessment of damages, civil or criminal fines or penalties, or other sanctions, including restrictions or changes in the way we conduct business, loss of licensure or exclusion from participation in government programs. For example, the Office of the Inspector General (“OIG”) conducts a variety of routine, regular and special investigations, audits and reviews across our industry. Failure to comply with applicable laws, regulations and rules could have a material and adverse effect on our results of operations and financial condition. Furthermore, becoming subject to these governmental investigations, audits and reviews can also require us to incur significant legal and document production expenses as we cooperate with the government authorities, regardless of whether the particular investigation, audit or review leads to the identification of underlying issues. For example, as discussed under “Creekside Hospice Investigation” in Note 8, "Commitments and Contingencies", included elsewhere in this report, the government has investigated and has elected to intervene in two pending qui tam actions that allege violations of the FFCA and the Nevada False Claims Act in connection with the operations of our affiliated Las Vegas, Nevada hospice. We have accrued $6.0 million as a contingent liability in connection with the matter, but it could ultimately cost more than that amount to settle or otherwise resolve it, including to satisfy any judgment that might be rendered against us if our litigation defense were ultimately unsuccessful.
Our success is dependent upon retaining key personnel.
Our senior management team has extensive experience in the healthcare industry. We believe that they have been instrumental in guiding our businesses, instituting valuable performance and quality monitoring, and driving innovation. Accordingly, our future performance is substantially dependent upon the continued services of our senior management team. The loss of the services of any of these persons could have a material adverse effect upon us.
Health reform legislation could adversely affect our revenue and financial condition.
In recent years, there have been numerous initiatives on the federal and state levels for comprehensive reforms affecting the payment for, the availability of and reimbursement for, healthcare services in the United States. These initiatives have ranged from proposals to fundamentally change federal and state healthcare reimbursement programs, including the provision of comprehensive healthcare coverage to the public under governmental funded programs, to minor modifications to existing programs. The PPACA was enacted in 2010 and is among the most comprehensive and notable of these legislative efforts. The impact of PPACA remains uncertain to a large degree due to various implementation, timing, cost and regulatory requirements imposed by the legislation. The content or timing of any future health reform legislation, and its impact on us is impossible to predict. However, it is likely that certain provisions in PPACA will impose significant costs on us or that will otherwise negatively affect our operations. For instance, the requirement to offer full time employees “affordable” healthcare insurance that meets specified coverage minimums (or alternatively pay a per-employee penalty to the federal government) will likely significantly increase our annual healthcare costs or could damage employee morale and/or cause other employee-related issues that are harmful to our operations. If significant reforms are made to the U.S. healthcare system, those reforms may have an adverse effect on our financial condition and results of operations.
In addition, we incur considerable administrative costs in monitoring the changes made within the various reimbursement programs in which we participate, determining the appropriate actions to be taken in response to those changes, and implementing the required actions to meet the new requirements and minimize the repercussions of the changes to our organization, reimbursement rates and costs
Annual caps that limit the amounts that can be paid for outpatient therapy services rendered to any Medicare beneficiary may negatively affect our results of operations.
Some of our rehabilitation therapy revenue is paid by the Medicare Part B program under a fee schedule. There are annual caps that limit, subject to certain exceptions, the amounts that can be paid (including deductible and coinsurance amounts) for rehabilitation therapy services rendered to any Medicare beneficiary under Medicare Part B. There is a combined cap for physical therapy and speech-language pathology and a separate cap for occupational therapy that apply subject to certain exceptions. The discontinuation or change in the current cap exception process or future modifications of the Medicare Part B cap structure could have an adverse effect on the revenue that we generate through our rehabilitation therapy business.  This could in turn have a negative effect on our financial condition and results of operations. For example, the Medicare Part B therapy pre-approval provisions (MMR) and multiple procedure payment reduction ("MPPR") rate reductions that took effect October 1, 2012, have continued to negatively impact our therapy business through the six months ended June 30, 2014.

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The MMR requirement generally provides that, on a per beneficiary basis and subject to limited exceptions, services above $3,700 for physical therapy and speech-language pathology services combined and/or $3,700 for occupational therapy services are subject to manual medical review (typically on a pre-payment basis) by the applicable Medicare contractors.  Challenges in obtaining a timely response from the applicable contractors and other difficulties with the MMR system have added significant uncertainty as to whether beneficiary will have access to the applicable therapy services that are over the cap amount, and whether the provider will be reimbursed for those services.  Under the MPPR policy, when physical therapy, occupational therapy and speech-language pathology services are performed on the same day for the same patient and paid under Medicare Part B, then Medicare effectively makes a full reimbursement payment for only one of the procedures and the reimbursements for the other procedures are at a reduced rate.  The application of the MPPR policy has negatively affected our therapy business and will continue to do so as long as the policy is in effect.
We are subject to a Medicare cap amount for our hospice business. Our net patient service revenue and profitability could be adversely affected by limitations on Medicare payments.
Overall payments made by Medicare to us on a per hospice basis are subject to an annual cap amount. Total Medicare payments received for services rendered during the applicable Medicare hospice cap year by each of our Medicare-certified hospice programs during this period are compared to the cap amount for the relevant period. Payments in excess of the cap are subject to recoupment by Medicare.
We monitor the Medicare cap amount and seek to implement corrective measures as necessary. We maintain what we believe are adequate allowances in the event that our individual hospice agencies exceed the Medicare hospice cap in any given fiscal year. However, many of the variables involved in estimating the Medicare hospice cap contractual adjustment are beyond our control, and we cannot assure you that we will not increase or decrease our estimated contractual allowance in the future, or that we will not be required to surrender amounts we received from Medicare that were in excess of the Medicare hospice cap for any particular period(s).
For the three months ended June 30, 2014 and 2013, the Company recorded hospice Medicare cap reserves of $0.9 million and $1.4 million, respectively, as adjustments to revenue. Of the $0.9 million recorded in the three months ended June 30, 2014, $0.5 million was related to the 2014 cap year and $0.4 million was related to the 2013 cap year. Of the $1.4 million recorded in the three months ended June 30, 2013, $0.7 million was related to the 2013 cap year and $0.7 million was related to the 2012 cap year. For the six months ended June 30, 2014 and 2013, the Company recorded hospice Medicare cap reserves of $0.9 million and $2.9 million, respectively, as adjustments to revenue. Of the $0.9 million recorded in the six months ended June 30, 2014, $0.5 million was related to the 2014 cap year and$0.4 million was related to the 2013 cap year. Of the $2.9 million recorded in the six months ended June 30, 2013, $0.7 million was related to the 2013 cap year, $2.0 million was related to the 2012 cap year, and $0.2 million was related to the 2011 cap year. This adjustment related primarily to patients staying on service longer than estimated which results in the patients' cap allowances being stretched over multiple cap years. Our ability to comply with the cap limitation depends on a number of factors relating to a given hospice program, including number of admissions, average length of stay, mix in level of care and Medicare patients that transfer into and out of our hospice programs. Our revenue and profitability may be materially reduced if we are unable to comply with this and other Medicare payment limitations. We cannot assure you that our hospice programs will not exceed the cap amount in the future or that our estimate of the Medicare cap contractual adjustment will not differ materially from the actual Medicare cap amount.
We are subject to extensive and complex laws and government regulations. If we are not operating in compliance with these laws and regulations or if these laws and regulations change, we could be required to make significant expenditures or change our operations in order to bring our facilities and operations into compliance.
We, along with other companies in the healthcare industry, are required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things:
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licensure and certification;
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adequacy and quality of healthcare services;
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qualifications of healthcare and support personnel;
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quality of medical equipment;
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confidentiality, maintenance and security issues associated with medical records and claims processing;
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relationships with physicians and other referral sources and recipients;
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constraints on protective contractual provisions with patients and third-party payors;
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operating policies and procedures;
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addition of facilities and services; and
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billing for services.
Many of these laws and regulations are expansive, and we do not always have the benefit of significant regulatory or judicial interpretation of these laws and regulations. In addition, many of these laws and regulations evolve to include additional obligations and restrictions, and sometimes with retroactive effect. Certain other regulatory developments, such as

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revisions in the building code requirements for assisted living and skilled nursing facilities, mandatory increases in scope and quality of care to be offered to residents, revisions in licensing and certification standards, mandatory staffing levels, regulations regarding conditions for payment and regulations restricting those we can hire, could also have a material adverse effect on us. In the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs and operating expenses.
One development potentially restricting those we may hire was a decision on November 3, 2010 by the Physical Therapy Board of California ("PT Board") to rescind a 1990 PT Board resolution which determined that the offering of physical therapy services by a corporation, not organized as a professional corporation, was permitted by the Physical Therapy Practice Act, which is the California statute governing the provision of physical therapy within the state. This rescission purports to prohibit employment of a physical therapist to provide physical therapy services by any professional corporation except those owned by physical therapists and Naturopaths. Lay corporations that hold themselves out as physical therapy corporations would be similarly prohibited. We have a subsidiary that employs physical therapists in California, but is not owned by physical therapists. Our subsidiary contracts with nursing facilities to provide the facilities with personnel who are licensed to provide rehabilitation therapy services, including physical therapy, occupational therapy and/or speech language pathology services. Our therapists then provide rehabilitation therapy services to the nursing facilities' patients under the skilled nursing facilities' licenses that authorize the provision of physical therapy (and other rehabilitation therapy services, if applicable). In this relationship, the nursing facilities retain the patient relationship, remain professionally responsible for the healthcare services including therapy, and bill the patient and/or third party payors for the services rendered to their patients. We are unaware of any enforcement actions by the PT Board to date and it is not clear whether the applicable law would ultimately be interpreted to mean that our rehabilitation therapy subsidiary cannot employ and provide physical therapists to nursing facilities in California as it currently does.   Nevertheless, the PT Board could seek an enforcement action against our rehabilitation therapy subsidiary and its physical therapist employees and we may have to significantly restructure our California rehabilitation therapy operations to conform to the PT Board's revised interpretation of the law. 
In addition, federal and state government agencies have increased and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare companies, including skilled nursing facilities, home health agencies and hospice agencies. This includes investigations of:
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fraud and abuse;
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quality of care;
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financial relationships with referral sources; and
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the medical necessity of services provided.

We are unable to predict the future course of federal, state and local regulation or legislation, including Medicare and Medicaid statutes and regulations, the intensity of federal and state enforcement actions or the extent and size of any potential sanctions, fines or penalties. Changes in the regulatory framework, our failure to obtain or renew required regulatory approvals or licenses or to comply with applicable regulatory requirements, the suspension or revocation of our licenses or our disqualification from participation in federal and state reimbursement programs, or the imposition of other enforcement sanctions, fines or penalties could have a material adverse effect upon our results of operations, financial condition and liquidity. Furthermore, should we lose licenses or certifications for a number of our facilities or other businesses as a result of regulatory action, legal proceedings such as those described in Note 8, "Commitments and Contingencies-Legal Matters," or otherwise, we could be deemed to be in default under some of our agreements, including agreements governing outstanding indebtedness and the report of such issues at one of our facilities could harm our reputation for quality care and lead to a reduction in our patient referrals and ultimately our revenue and operating income.
We face reviews, audits and investigations under federal and state government programs and contracts. These audits could have adverse findings that may negatively affect our business.
As a result of our participation in the Medicare and Medicaid programs, we are subject to various governmental inspections, reviews, audits and investigations to verify our compliance with these programs and applicable laws and regulations. Managed care payors may also reserve the right to conduct audits. We also periodically conduct internal audits and reviews of our regulatory compliance. An adverse inspection, review, audit or investigation could result in:
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refunding amounts we have been paid pursuant to the Medicare or Medicaid programs or from managed care payors;
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state or federal agencies imposing fines, penalties and other sanctions on us;
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temporary suspension of payment for new patients to the facility or agency;
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decertification or exclusion from participation in the Medicare or Medicaid programs or one or more managed care payor networks;
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self-disclosure of violations to applicable regulatory authorities;

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damage to our reputation;
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the revocation of a facility's or agency's license; and
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loss of certain rights under, or termination of, our contracts with managed care payors.
We have in the past and will likely in the future be required to refund amounts we have been paid and/or pay fines and penalties, as a result of these inspections, reviews, audits and investigations. If adverse inspections, reviews, audits or investigations occur and any of the results noted above occur, it could have a material adverse effect on our business and operating results. Furthermore, the legal, document production and other costs associated with complying with these inspections, reviews, audits or investigations could be significant.

Significant legal actions, which are commonplace in our professions, could subject us to increased operating costs and substantial uninsured liabilities, which would materially and adversely affect our results of operations, liquidity and financial condition.
The long-term care profession has experienced an increasing trend in the number and severity of litigation claims involving punitive damages and settlements. We believe that this trend is endemic to the industry and is a result of a variety of factors, including the number of large judgments, including large punitive damage awards, against long-term care providers in recent years resulting in an increased awareness by plaintiffs' lawyers of potentially large recoveries. While some states have enacted tort reform legislation that limits plaintiffs' recoveries in some respects, should our professional liability and general liability increase significantly in the future, we may not be able to increase our revenue sufficiently to cover the cost increases, our operating income could suffer, and we may not be able to meet our obligations to repay our liabilities. For a discussion of recent litigation claims against us, including the Humboldt County Action, see Note 8, "Commitments and Contingencies-Legal Matters" in the notes to the consolidated financial statements included elsewhere in this report.
We also may be subject to lawsuits under the FFCA and comparable state laws for submitting allegedly fraudulent or otherwise inappropriate bills for services to the Medicare and Medicaid programs. These lawsuits, which may be initiated by regulatory authorities as well as private party whistleblowers, can involve significant monetary damages, fines, attorney fees and the award of bounties to private plaintiffs who successfully bring these suits, as well as to the government programs. In recent years, government oversight and law enforcement have become increasingly active and aggressive in investigating and taking legal action against potential fraud and abuse.
We may incur significant liabilities in conjunction with legal actions against us, including as a result of damages, fines and penalties that may be assessed against us, as well as a result of the sometimes significant commitments of financial and management resources that are often required to defend against such legal actions. The incurrence of such liabilities and related commitments of resources could materially and adversely affect our business, financial condition and results of operations.
We could face significant financial difficulties as a result of one or more of the risks discussed in this report, which could cause us to significantly alter our business and/or seek protection under bankruptcy laws or could cause our creditors or government authorities to have a receiver appointed on our behalf.
We could face significant financial difficulties if Medicare or Medicaid reimbursement rates are reduced, patient demand for our services is reduced or we incur unexpected liabilities or expenses, including in connection with legal actions, sanctions, penalties or fines or the other risks discussed in this report. This financial difficulty could cause us to significantly alter our business and/or seek protection under bankruptcy laws or could cause our creditors or government authorities to have a receiver appointed on our behalf.
A significant portion of our business is concentrated in certain geographical markets, and an economic downturn or changes in the laws affecting our business in those markets could have a material adverse effect on our operating results.
For the six months ended June 30, 2014, we received approximately 40.6% of our consolidated revenue from operations in California and 19.5% from Texas. We expect to continue to receive significant portions of our consolidated revenue from those states in the future as well. Accordingly, economic conditions and changes in state healthcare spending prevailing in either of these markets or other markets in which we have significant concentrations could affect the ability of our patients and third-party payors to reimburse us for our services, either through a reduction of the tax base used to generate state funding of Medicaid programs, an increase in the number of indigent patients eligible for Medicaid benefits, changes in state funding levels or healthcare programs or other factors. A continued or prolonged economic downturn, significant changes in state healthcare spending, or changes in the laws affecting our business in these markets could have a material adverse effect on our financial position, results of operations and cash flows.
Failure to maintain effective internal control over our financial reporting could have an adverse effect on our ability to report our financial results on a timely and accurate basis.

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We produce our consolidated financial statements in accordance with the requirements of accounting principles generally accepted in the United States of America ("U.S. GAAP"). Effective internal control over financial reporting is necessary for us to provide reliable financial reports, to help mitigate the risk of fraud and to operate successfully. We are required by federal securities laws to document and test our internal control procedures in order to satisfy the requirements of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal control over financial reporting.
Testing and maintaining our internal control over financial reporting can be expensive and divert our management's attention from other matters that are important to our business. We may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with applicable law, or our independent registered public accounting firm may not be able or willing to issue an unqualified attestation report if we conclude that our internal control over financial reporting is not effective. If we fail to maintain effective internal control over financial reporting, or our independent registered public accounting firm is unable to provide us with an unqualified attestation report on our internal control, we could be required to take costly and time-consuming corrective measures, be required to restate the affected historical financial statements, be subjected to investigations and/or sanctions by federal and state securities regulators, and be subjected to civil lawsuits by security holders. Any of the foregoing could also cause investors to lose confidence in our reported financial information and in our company and would likely result in a decline in the market price of our stock and in our ability to raise additional financing if needed in the future.
Changes in the acuity mix of patients as well as payor mix and payment methodologies may significantly reduce our profitability or cause us to incur losses.
Our revenue is affected by our ability to attract a favorable patient acuity mix, and by our mix of payment sources. Changes in the type of patients we attract, as well as our payor mix among private payors, managed care companies, Medicare (both traditional Medicare and "managed" Medicare/Medicare Advantage) and Medicaid, significantly affect our profitability because not all payors reimburse us at the same rates. Particularly, if we fail to maintain our proportion of high-acuity patients or if there is any significant increase in the percentage of our population for which we receive Medicaid reimbursement, our financial position, results of operations and cash flow may be adversely affected. Furthermore, in recent periods we have continued to see a shift from “traditional” fee-for-service Medicare patients to “managed” Medicare (Medicare Advantage) patients.  Reimbursement rates are generally lower for services provided to Medicare Advantage patients than they are for the same services provided traditional fee-for-service Medicare patients.  This trend may continue in future periods.  Our financial results have been negatively affected by this shift to date.  Our financial results will continue to be negatively affected if the trend towards Medicare Advantage continues, and particularly if it accelerates.

It can be difficult to attract and retain qualified nurses, therapists, healthcare professionals and other key personnel, which can increase our costs related to these employees

Our employees are our most important asset. We rely on our ability to attract and retain qualified nurses, therapists and other healthcare professionals. The market for these key personnel is highly competitive, and we could experience significant increases in our operating costs due to shortages in their availability. Like other healthcare providers, we have at times experienced difficulties in attracting and retaining qualified personnel, especially facility administrators, nurses, therapists, certified nurses' aides and other important healthcare personnel. We may continue to experience increases in our labor costs, primarily due to higher wages and greater benefits required to attract and retain qualified healthcare personnel, and such increases may adversely affect our profitability. Furthermore, while we attempt to manage overall labor costs in the most efficient way, our efforts to them through wage freezes and similar means may have limited effectiveness and may lead to increased turnover and other challenges

Tight labor markets and high demand for such employees can contribute to high turnover among clinical professional staff. A shortage of qualified personnel at a facility could result in significant increases in labor costs and increased reliance on overtime and expensive temporary staffing agencies, and could otherwise adversely affect operations at the affected facilities. If we are unable to attract and retain qualified professionals, our ability to adequately provide services to our residents and patients may decline and our ability to grow may be constrained.
If we are unable to comply with state minimum staffing requirements at one or more of our facilities, we could be subject to fines or other sanctions.
Increased attention to the quality of care provided in skilled nursing facilities has caused several states to mandate, and other states to consider mandating, staffing laws that require minimum nursing hours of direct care per resident per day. These minimum staffing requirements further increase the gap between demand for and supply of qualified professionals, and lead to higher labor costs.

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We operate a number of facilities in California, which enacted legislation aimed at establishing minimum staffing requirements for facilities operating in that state. This legislation required that the California Department of Public Health ("DPH"), promulgate regulations requiring each skilled nursing facility to provide a minimum of 3.2 nursing hours per patient day. The DPH finalized regulations in 2009 that required three 8-hour shifts for nurse-to-patient staffing, described documentation and notice requirements, and specified procedures for obtaining a waiver from per-shift staffing requirements at skilled nursing facilities. Although DPH finalized the regulations, initial implementation of the statute authorizing the regulations is contingent on an appropriation in the state's annual budged legislation or another statute. Because no appropriation was made and no additional statutes were enacted, the regulations did not become operational. Therefore, DPH will continue its practice of determining a facility's compliance with the 3.2 hour of nursing services per patient day measure in accordance with its internal policy and through on-site reviews conducted during periodic licensing and certification surveys and in response to complaints. If the DPH determines that a facility is out of compliance with this staffing measure, the DPH may issue a notice of deficiency, or a citation, depending on the impact on patient care. A citation carries with it the imposition of significant monetary fines. DPH has issued guidelines, implementing the provisions of newly enacted California laws, for state audits that verify compliance with the 3.2 nursing hours per patient day staffing requirements. If DPH determines under an audit that a facility has failed to meet the minimum staffing requirement for between 5% and 49% of the audited days, a significant administrative monetary penalty will be assessed. If DPH determines that a facility has failed to meet the minimum staffing requirement for more than 49% of the audited days, then a larger administrative monetary penalty will be assessed. The issuance of either a notice of deficiency or a citation requires the facility to prepare and implement an acceptable plan of correction. The Humboldt County Action included allegations that certain of our California skilled nursing facilities failed to meet state-mandated minimum staffing requirements. The Humboldt County Action resulted in a jury verdict against us and certain of our affiliated skilled nursing companies that awarded $677 million in damages. The case was ultimately settled in September 2010, pursuant to which we were required to deposit into escrow a total of $50 million to cover certain settlement costs. For more information regarding the Humboldt County Action and the settlement, as well as a description of our February 2013 settlement with the BMFEA which included a new staffing agreement and an ongoing investigation by the DOJ regarding related staffing considerations, see Note 8, "Commitments and Contingencies-Legal Matters" in the notes to the consolidated financial statements included elsewhere in this report.
Our ability to satisfy any minimum staffing requirements depends upon our ability to attract and retain qualified healthcare professionals, including nurses, certified nurse's assistants and other personnel. Attracting and retaining personnel is difficult, given a tight labor market for these professionals in many of the markets in which we operate. Furthermore, if states do not appropriate additional funds (through Medicaid program appropriations or otherwise) sufficient to pay for any additional operating costs resulting from minimum staffing requirements, our profitability may be materially adversely affected.
If we fail to attract patients and residents and to compete effectively with other healthcare providers, our revenue and profitability may decline and we may incur losses.
The healthcare services industry is highly competitive. Our skilled nursing facilities compete primarily on a local and regional basis with many long-term care providers, from national and regional chains to smaller providers owning as few as a single nursing center. We also compete under certain circumstances with inpatient rehabilitation facilities and long-term acute care hospitals. Our hospices and home health agencies also compete with local, regional and national companies. We anticipate additional competition in the future from accountable care organizations, as well as HMO's and similar healthcare systems that seek to provide a wider variety of healthcare services to their patients/members. Increased competition could limit our ability to attract and retain patients, maintain or increase rates and occupancy, or to expand our business. Our ability to compete successfully varies from location to location and depends on a number of factors, including the number of competitors in the local market, the types of services available, our local reputation for quality care of patients, achieve or maintain desired census levels, the commitment and expertise of our staff and physicians, our local service offerings and treatment programs, the cost of care in each locality, and the physical appearance, location, age and condition of our facilities. If we are unable to attract patients to our facilities and agencies, particularly high-acuity patients, then our revenue and profitability will be adversely affected. Some of our competitors may have greater recognition and be more established in their respective communities than we are, and may have greater financial and other resources than we have. Competing long-term care companies may also offer newer facilities or different programs or services than we do, which, combined with the foregoing factors, may result in our competitors being more attractive to our current patients, to potential patients and to referral sources. Furthermore, while we budget for routine capital expenditures at our facilities to keep them competitive in their respective markets, to the extent that competitive forces cause those expenditures to increase in the future our financial condition may be negatively affected.
Some of our competitors may accept lower profit margins than we do, which could present significant price competition, particularly for managed care and private pay patients. We believe we utilize a conservative approach in complying with laws prohibiting kickbacks and referral payments to referral sources. However, some of our competitors may use more aggressive methods than we do with this respect to obtaining patient referrals, and as a result competitors may from time to time obtain patient referrals that are not otherwise available to us.

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The primary competitive factors for our assisted living, rehabilitation therapy, hospice and home health care services are similar to those for our skilled nursing businesses and include reputation, the cost of services, the quality of services, responsiveness to patient/resident needs and the ability to provide support in other areas such as third-party reimbursement, information management and patient recordkeeping. Furthermore, given the relatively low barriers to entry and continuing healthcare cost containment pressures, we expect that the markets we service will become increasingly competitive in the future. Increased competition in the future could limit our ability to attract and retain patients and residents, maintain or increase our fees, or expand our business.
Insurance coverage may become increasingly expensive and difficult to obtain for health care companies, and our self-insurance may expose us to significant losses.
It may become more difficult and costly for us to obtain coverage for patient care liabilities and certain other risks, including property and casualty insurance. Insurance carriers may require health care companies to significantly increase their self-insured retention levels and/or pay substantially higher premiums for reduced coverage for most insurance coverages, including workers' compensation, employee healthcare and patient care liability.
We self-insure a significant portion of our potential liabilities for several risks, including certain types of professional and general liability, workers' compensation and employee healthcare benefits. Due to our self-insured retentions under many of our professional and general liability, workers' compensation and employee healthcare benefits programs, including our election to self-insure against workers' compensation claims in Texas, there is no limit on the maximum number of claims or amount for which we can be liable in any policy period. We base our loss estimates and related accruals on actuarial analyses, which determine expected liabilities on an undiscounted basis, including incurred but not reported losses, based upon the available information on a given date. It is possible, however, for the ultimate amount of losses to exceed our estimates and related accruals, as well as our insurance limits as applicable. In the event our actual liability exceeds our estimates for any given period, our results of operations and financial condition could be materially adversely impacted. Additionally, we may from time to time need to increase our accruals as a result of future actuarial reviews and claims that may develop. Such increases could have an adverse impact on our business and results of operations. An adverse determination in legal proceedings, whether currently asserted or arising in the future, could have a material adverse effect on our business and results of operations.
If our referral sources fail to view us as an attractive health care provider, our patient base would likely decrease.
We rely significantly on appropriate referrals from physicians, hospitals and other healthcare providers in the communities in which we deliver our services to attract the kinds of patients we target. Our referral sources are not obligated to refer business to us and generally also refer business to other healthcare providers. We believe many of our referral sources refer business to us as a result of the quality of our patient service and our efforts to establish and build a relationship with them. If we lose, or fail to maintain, existing relationships with our referral resources, fail to develop new relationships or if we are perceived by our referral sources for any reason as not providing high quality patient care, our volume of referrals would likely decrease, the quality of our patient mix could suffer and our revenue and results of operations could be adversely affected.
If we do not achieve or maintain a reputation for providing high quality of care, our business may be negatively affected.
Our ability to achieve and maintain a reputation for providing high quality of care to our patients at each of our skilled nursing and assisted living facilities, or through our rehabilitation therapy, hospice and home health businesses, is important to our ability to attract and retain patients, particularly high-acuity patients. In some instances, our referral sources are affiliated with health care systems that may have affiliated businesses that offer services that compete with ours, and the frequency of this occurring may increase in the future as accountable care organizations are formed in the markets we serve. We believe that the perception of our quality of care by a potential patient or potential patient's family seeking to contract for our services is influenced by a variety of factors, including doctor and other healthcare professional referrals, community information and referral services, newspapers and other print and electronic media, results of patient surveys, recommendations from family and friends, and quality care statistics or rating systems compiled and published by CMS or other industry data. Through our focus on retaining high quality staffing, reviewing feedback and surveys from our patients and referral sources to highlight areas of improvement and integrating our service offerings at each of our facilities, we seek to maintain and improve on the outcomes from each of the factors listed above in order to build and maintain a strong reputation at our facilities. If any of our companies fail to achieve or maintain a reputation for providing high-quality care, or is perceived to provide a lower quality of care than competitors within the same geographic area, our ability to attract and retain patients would be adversely affected. If our businesses fail to maintain a strong reputation in the areas in which we operate, our business, revenue and profitability could be adversely affected.
We may be unable to reduce costs to offset decreases in our patient census levels or other expenses completely.

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We depend on implementing adequate cost management initiatives in response to fluctuations in levels of patient census in our businesses in order to maintain our current cash flow and earnings levels. Fluctuation in our patient census levels may become more common as we continue our emphasis in our skilled nursing facilities on patients with shorter stays but higher acuities. A decline in patient census levels would likely result in decreased revenue. If we are unable to put in place corresponding reductions in costs in response to decreases in our patient census or other revenue shortfalls, our financial condition and operating results could be adversely affected.
We may not be fully reimbursed for all services that our skilled nursing facilities are able to bill through Medicare's consolidated billing requirements.
Skilled nursing facilities are required to bill Medicare on a consolidated basis for certain items and services that they furnish to patients and residents, regardless of the amount or costs of services that the patients and residents actually receive. The consolidated billing requirement essentially confers on the skilled nursing facility itself the Medicare billing responsibility for the entire package of care that its residents receive in these situations. Federal law also requires that post-hospitalization skilled nursing services be “bundled” into the hospital's Diagnostic Related Group ("DRG") payment in certain circumstances. Where this rule applies, the hospital and the skilled nursing facility must, in effect, divide the payment which otherwise would have been paid to the hospital alone for the patient's treatment, and no additional funds are paid by Medicare for skilled nursing care of the patient. This requirement may, in instances where it is applicable, have a negative effect on skilled nursing facility utilization/census and payments, either because hospitals may find it difficult to place patients in skilled nursing facilities which will not be paid as they previously were, or because hospitals are reluctant to discharge patients to skilled nursing facilities and lose a portion of the payment that the hospital would otherwise receive. This bundling requirement could be extended to more DRGs in the future, which could exacerbate the potentially negative impact on skilled nursing facility utilization/census and payments. As a result of the bundling requirements we may not be fully reimbursed for all services that a facility bills through consolidated billing, which could adversely affect our results of operations and financial condition.
Consolidation of managed care organizations and other third-party payors or reductions in reimbursement from these payors may adversely affect our revenue and income or cause us to incur losses.

Managed care organizations and other third-party payors have in many instances consolidated in order to enhance their ability to influence the delivery of healthcare services. Consequently, the healthcare needs of a large percentage of the United States population are increasingly served by a small number of managed care organizations. These organizations generally enter into service agreements with a limited number of providers for needed services. These organizations have become an increasingly important source of revenue and referrals for us. To the extent that such organizations terminate us as a preferred provider or engage our competitors as a preferred or exclusive provider, our business could be materially adversely affected.
In addition, private third-party payors, including managed care payors, are continuing their efforts to control healthcare costs through direct contracts with healthcare providers, increased utilization reviews, or reviews of the propriety of, and charges for, services provided, and greater enrollment in managed care programs and preferred provider organizations. As these private payors increase their purchasing power, they are demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk associated with the provision of care. Significant reductions in reimbursement from these sources could materially adversely affect our business and financial condition.
Delays in reimbursement may cause liquidity problems.
If we have information systems problems or payment or other issues arise with Medicare, Medicaid or other payors that affect the amount or timeliness of reimbursements, we may encounter delays in our payment cycle. Any significant payment timing delay could cause us to experience working capital shortages. As a result, working capital management, including prompt and diligent billing and collection, is an important factor in our consolidated results of operations and liquidity. Our working capital management procedures may not successfully mitigate the effects of any delays in our receipt of payments or reimbursements. Accordingly, such delays could have an adverse effect on our liquidity and financial condition.
Our rehabilitation and other related healthcare services are also subject to delays in reimbursement, as we act as vendors to other providers who in turn must wait for reimbursement from other third-party payors. Each of these customers is therefore subject to the same potential delays to which our nursing homes are subject, meaning any such delays would further delay the date we would receive payment for the provision of our related healthcare services. To the extent we grow and expand the rehabilitation and other complementary services that we offer to third parties, we may incur increasing delays in payment for these services, and these payment delays could have an adverse effect on our liquidity and financial condition. We may also experience delays in reimbursement related to change of ownership applications for our acquired facilities, as well as changes in fiscal intermediaries.
Future acquisitions may use significant resources, may be unsuccessful and could expose us to unforeseen liabilities.
We intend to selectively pursue acquisitions of skilled nursing facilities, assisted living facilities, home health companies, hospice agencies and other related healthcare operations. Acquisitions may involve significant cash expenditures,

57

debt incurrence, operating losses and additional expenses that could have a material adverse effect on our financial position, results of operations and liquidity. Acquisitions involve numerous risks, including:
•
difficulties integrating acquired operations, personnel and accounting and information systems, or in realizing projected efficiencies and cost savings;
•
diversion of management's attention from other business concerns;
•
potential loss of key employees or customers of acquired companies;
•
entry into markets in which we may have limited or no experience;
•
increasing our indebtedness and limiting our ability to access additional capital when needed;
•
assumption of unknown liabilities or regulatory issues of acquired companies, including failure to comply with healthcare regulations or to establish internal financial controls; and
•
straining of our resources, including internal controls relating to information and accounting systems, regulatory compliance, logistics and others.
 Furthermore, certain of the foregoing risks could be exacerbated when combined with other growth measures that we may pursue.
Global economic conditions may impact our ability to obtain additional financing on commercially reasonable terms or at all and our ability to expand our business may be harmed.
Global market and economic conditions continue to be very challenging. Ongoing concerns about the systemic impact of potential long-term and widespread economic recession or stagnation, energy costs, geopolitical issues, sovereign debt issues, the availability and cost of credit, and the global real estate and mortgage markets have contributed to increased market volatility, uncertainty and liquidity issues for both borrowers and investors. These conditions, combined with volatile prices for energy, food and other commodities, unstable business and consumer confidence, and significant unemployment, have contributed to pronounced economic volatility.
As a result of these market conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets, interest rate fluctuations and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide credit to businesses and consumers. These factors have led to a decrease in spending by businesses and consumers alike, and a corresponding decrease in global infrastructure spending. Continued turbulence in the U.S. and international markets and economies and prolonged declines or stagnation in business and consumer spending may adversely affect our liquidity and financial condition, and the liquidity and financial condition of our customers, including our ability to refinance maturing liabilities and access the capital markets to meet liquidity needs. If we are not able to timely retire or refinance our senior secured credit facility on acceptable terms at or before its stated maturity, due to market conditions or otherwise, our liquidity, financial condition, business and operating results could be materially and adversely affected.
If our ability to borrow under our senior secured credit facility is insufficient for our capital requirements, we will be required to seek additional sources of financing, including issuing equity, which may be dilutive to our current stockholders or incurring additional debt. Our ability to incur additional debt is subject to the restrictions in our senior secured credit facility. There can be no assurance that the restrictions contained in our senior secured credit facility will permit us to borrow the funds that we need to finance our operations, or that additional debt will be available to us on commercially reasonable terms or at all. Furthermore, market conditions may impede our ability to secure additional sources of financing, whether through the extension of our existing senior secured credit facility or by accessing the debt and/or equity markets. If we are unable to obtain funds sufficient to finance our capital requirements, we may have to forego opportunities to expand our business, including the acquisition or development of additional or expanded facilities.
Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our financial obligations.
We have now and will for the foreseeable future continue to have a significant amount of indebtedness. At June 30, 2014, our total indebtedness was approximately $410.2 million. Our substantial indebtedness could have important consequences. For example, it could:
•
increase our vulnerability to adverse economic and industry conditions;
•
require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes;
•
limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;
•
place us at a competitive disadvantage compared to our competitors that have less debt;
•
increase the cost or limit the availability of additional financing, if needed or desired, to fund future working capital, capital expenditures and other general corporate requirements, or to carry out other aspects of our business plan;
•
require us to maintain debt coverage and financial ratios at specified levels, reducing our financial flexibility; and

58

•
limit our ability to make strategic acquisitions and develop new or expanded facilities.
In addition, if we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required debt payments, or if we fail to comply with the various covenants and requirements of our senior secured credit facility or other existing or future indebtedness, we would be in default, which could permit the holders of our indebtedness, including our senior secured credit facility, to accelerate the maturity of indebtedness, as the case may be. Any default under our senior secured credit facility, or our other existing or future indebtedness, as well as any of the above-listed factors, could have a material adverse effect on our business, operating results, liquidity and financial condition.

59

Despite our substantial indebtedness, we may still be able to incur more debt. This could intensify the risks associated with this indebtedness.
The terms of our senior secured credit facility contain restrictions on our ability to incur additional indebtedness. These restrictions are subject to a number of important qualifications and exceptions, and the indebtedness incurred in compliance with these exceptions could be substantial. Accordingly, we could incur significant additional indebtedness in the future. The more we become leveraged, the more we become exposed to the risks described above under “Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our financial obligations.”
Floating rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase.
Borrowings under our senior secured credit facility are subject to floating rates of interest over an interest rate floor of 1.5%. If interest rates increase over the floor, our debt service obligations on our variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows would correspondingly decrease. As of April 12, 2012, we increased the size of the term loan by $100.0 million. On June 23, 2014, the Company entered into an Amendment No. 2 and Loan Modification Agreement ("Amendment No. 2") to our Fourth Amended and Restated Credit Agreement dated April 12, 2012, as previously amended on June 6, 2013; further explained in "Debt" note contained elsewhere. Amendment No. 2 also modified the interest rate for the extended revolving credit facility commitments to be, at the Company’s option, LIBOR plus a margin between 5.25% and 5.50% (based upon consolidated leverage) or the prime rate plus a margin between 4.25% and 4.50% (based upon consolidated leverage). The interest rates on the non-extended revolving credit facility commitments remain at, at the Company’s option, LIBOR plus a margin of between 4.25% and 4.50% (based upon consolidated leverage) or the prime rate plus a margin between 3.25% and 3.50% (based upon consolidated leverage). The incremental term loan bears interest at LIBOR (subject to a floor of 1.50%) plus a margin of 5.50%. As part of the refinancing, the interest rate on the existing term loan was amended to match the interest rate of the incremental term loan.
Our operations are subject to environmental and occupational health and safety regulations, which could subject us to fines, penalties and increased operational costs.
We are subject to a wide variety of federal, state and local environmental and occupational health and safety laws and regulations. Regulatory requirements faced by healthcare providers such as us include those relating to air emissions, wastewater discharges, air and water quality control, occupational health and safety (such as standards regarding blood-borne pathogens and ergonomics), management and disposal of low-level radioactive medical waste, biohazards and other wastes, management of explosive or combustible gases, such as oxygen, specific regulatory requirements applicable to asbestos, lead-based paints, polychlorinated biphenyls and mold, other occupational hazards associated with our workplaces, and providing notice to employees and members of the public about our use and storage of regulated or hazardous materials and wastes. Failure to comply with these requirements could subject us to fines, penalties and increased operational costs. Moreover, changes in existing requirements or more stringent enforcement of them, as well as discovery of currently unknown conditions at our owned or leased facilities, could result in additional cost and potential liabilities, including liability for conducting cleanup, and there can be no guarantee that such increased expenditures would not be significant.
A portion of our workforce is unionized and our operations may be adversely affected by work stoppages, strikes or other collective actions.
As of June 30, 2014, approximately 570 of our approximately14,950 active employees were represented by unions and covered by collective bargaining agreements. In addition, certain labor unions have publicly stated that they are concentrating their organizing efforts within the long-term healthcare industry. We cannot predict the effect that continued union representation or future organizational activities will have on our business or future operations. There can be no assurance that we will not experience a material work stoppage in the future.
Disasters and similar events may seriously harm our business.
Natural and man-made disasters and similar events, including terrorist attacks and acts of nature such as hurricanes, tornados, earthquakes, floods and wildfires, may cause damage or disruption to us, our employees and our facilities, which could have an adverse impact on our patients and our business. In order to provide care for our patients, we are dependent on consistent and reliable delivery of food, pharmaceuticals, utilities and other goods to our facilities, and the availability of employees to provide services at our facilities and other locations. If the delivery of goods or the ability of employees to reach our facilities and patients were interrupted in any material respect due to a natural disaster or other reasons, it would have a significant impact on our business. For example, in connection with Hurricane Katrina in New Orleans, several nursing home operators unaffiliated with us were accused of not properly caring for their residents, which resulted in, among other things, criminal charges being filed against the proprietors of those facilities. Furthermore, the impact, or impending threat, of a natural disaster has in the past and may in the future require that we evacuate one or more facilities, which would be costly and would involve risks, including potentially fatal risks, for the patients and employees. The impact of disasters and similar events is inherently uncertain. Such events could harm our patients and employees, severely damage or destroy one or more of our

60

facilities, harm our business, reputation and financial performance, or otherwise cause our business to suffer in ways that we currently cannot predict.
The operation of our business is dependent on effective and secure information systems.
We depend on several information technology systems for the efficient functioning of our business. The software programs supporting these systems are licensed to us by independent software developers. Our inability or the inability of these developers, to continue to maintain and upgrade these information systems and software programs could disrupt or reduce the efficiency of our operations. In addition, costs and potential problems and interruptions associated with the implementation of new or upgraded systems and technology or with maintenance or adequate support of existing systems could also disrupt or reduce the efficiency of our operations. Furthermore, while we budget for the changes and upgrades to our information technology systems that we anticipate needing over time, it is possible that we may underestimate the actual costs of those changes and upgrades. Failure to make necessary changes and upgrades due to financial or other concerns could negatively impact the effectiveness of our information technology systems, as well as our operations and financial performance.
Additionally, we maintain information necessary to conduct our business, including confidential and proprietary information as well as personal information regarding our patients, employees and others with whom we do business, in digital form. Data maintained in digital form is subject to the risk of tampering, theft and unauthorized access. We develop and maintain systems to prevent this from occurring, but the development and maintenance of these systems is costly and requires ongoing monitoring and updating as technologies change and efforts to overcome security measures become more sophisticated. Moreover, despite our efforts, the possibility of tampering, theft and other unauthorized access cannot be eliminated entirely, and risks associated with each of these remain. If our information technology systems are compromised and personal or other protected information regarding patients, employees or others with whom we do business is stolen, tampered with or otherwise improperly accessed, our ability to conduct our business and our reputation may be impaired. If personal or other protected information of our patients, employees or others with whom we do business is tampered with, stolen or otherwise improperly accessed, and we may incur significant costs to remediate possible injury to the affected persons, compensate the affected persons, pay any applicable fines, or take other action with respect to judicial or regulatory actions arising out of the incident, including under HIPAA or the HITECH Act, as applicable.

Risks Related to Ownership of Our Class A Common Stock
We are controlled by Onex Corporation, whose interests may conflict with yours.
Our Class A common stock has one vote per share, while our Class B common stock has ten votes per share, on all matters voted on by our stockholders. As of June 30, 2014, Onex Corporation, its affiliates and certain of our directors and members of our senior management who are party to a voting agreement with an affiliate of Onex Corporation owned shares of common stock representing over 75.0% of the combined voting power of our outstanding common stock. Accordingly, Onex Corporation generally has the power to control the outcome of matters on which stockholders are entitled to vote. Such matters include the election and removal of directors, the adoption or amendment of our certificate of incorporation and bylaws, possible mergers, corporate control contests and significant transactions. Through its control of elections to our board of directors, Onex Corporation may also have the ability to appoint or replace our senior management and cause us to issue additional shares of our common stock or repurchase common stock, declare dividends or take other actions. Onex Corporation may make decisions regarding our company and business that are opposed to our other stockholders’ interests or with which they disagree. Onex Corporation may also delay or prevent a change of control of us, even if the change of control would benefit our other stockholders, which could deprive our other stockholders of the opportunity to receive a premium for their Class A common stock. The significant concentration of stock ownership and voting power may also adversely affect the trading price of our Class A common stock due to investors’ perception that conflicts of interest may exist or arise. To the extent that the interests of our public stockholders are harmed by the actions of Onex Corporation, the price of our Class A common stock may be harmed.
Additionally, Onex Corporation is in the business of making investments in companies and currently holds, and may from time to time in the future acquire, controlling interests in businesses engaged in the healthcare industries that complement or directly or indirectly compete with certain portions of our business. Further, if it pursues such acquisitions in the healthcare industry, those acquisition opportunities may not be available to us.
If our stock price is volatile, purchasers of our Class A common stock could incur substantial losses.
Our stock price has been and is likely to continue to be volatile. The stock market in general often experiences substantial volatility that is seemingly unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our Class A common stock. The price for our Class A common stock may be influenced by many factors, including:


61

•
the depth and liquidity of the market for our Class A common stock;
•
developments generally affecting the healthcare industry;
•
investor perceptions of us and our business;
•
actions by institutional or other large stockholders;
•
strategic actions, such as acquisitions or restructurings, or the introduction of new services by us or our competitors;
•
new laws or regulations or new interpretations of existing laws or regulations applicable to our business;
•
litigation and governmental investigations;
•
changes in accounting standards, policies, guidance, interpretations or principles;
•
adverse conditions in the financial markets, state and federal government or general economic conditions, including those resulting from statewide, national or global financial and deficit considerations, overall market conditions, war, incidents of terrorism and responses to such events;
•
sales of Class B common stock by Onex, us or members of our management team;
•
additions or departures of key personnel; and
•
our results of operations, financial performance and future prospects.
These and other factors may cause the market price and demand for our Class A common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of Class A common stock and may otherwise negatively affect the liquidity of our Class A common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending or settling the lawsuit. Such a lawsuit could also divert the time and attention of our management from our business.
If securities or industry analysts do not publish research or reports about our business, if they change their recommendations regarding our stock adversely or if our operating results do not meet their expectations, our stock price and trading volume could decline.
The trading market for our Class A common stock is significantly influenced by the research and reports that industry or securities analysts publish about us or our business. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, if one or more of the analysts who cover us downgrade our stock or if our operating results do not meet their expectations, our stock price could decline.
We do not intend to pay dividends on our common stock.
We do not anticipate paying any cash dividends on our common stock in the foreseeable future. We currently anticipate that we will retain all of our available cash, if any, for use as working capital and for other general purposes, including to service or repay our debt and to fund the operation and expansion of our business. Any payment of future dividends will be at the discretion of our board of directors and will depend on, among other things, our earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends and other considerations that our board of directors deems relevant.
We are a “controlled company” within the meaning of NYSE rules and, as a result, qualify for and rely on exemptions from certain corporate governance requirements.
Onex Corporation and its affiliates control a majority of the voting power of our outstanding common stock. Under the NYSE rules, a company of which more than 50% of the voting power is held by another person or group of persons acting together is a “controlled company” and may elect not to comply with certain NYSE corporate governance requirements, including the requirements that:

•
a majority of the board of directors consist of independent directors;
•
the nominating and corporate governance committee be entirely composed of independent directors with a written charter addressing the committee’s purpose and responsibilities;
•
the compensation committee be entirely composed of independent directors with a written charter addressing the committee’s purpose and responsibilities; and
•
there be an annual performance evaluation of the nominating and corporate governance and compensation committees.
We elect to be treated as a controlled company and thus utilize some of these exemptions. In addition, although we currently have a board composed of a majority of independent directors and have adopted charters for our audit, corporate governance, quality and compliance and compensation committees, and intend to conduct annual performance evaluations for these committees, none of these committees are composed entirely of independent directors, except for our audit committee. Accordingly, you may not have the same protections afforded to stockholders of companies that are subject to all of NYSE corporate governance requirements.

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Our amended and restated certificate of incorporation, bylaws and Delaware law contain provisions that could discourage transactions resulting in a change in control, which may negatively affect the market price of our Class A common stock.
In addition to the effect that the concentration of ownership and voting power in our significant stockholders may have, our amended and restated certificate of incorporation and our amended and restated bylaws contain provisions that may enable our management to resist a change in control. These provisions may discourage, delay or prevent a change in the ownership of our company or a change in our management, even if doing so might be beneficial to our stockholders. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our Class A common stock. The provisions in our amended and restated certificate of incorporation or amended and restated bylaws include:

•
our board of directors is authorized, without prior stockholder approval, to create and issue preferred stock, commonly referred to as “blank check” preferred stock, with rights senior to those of our Class A common stock and Class B common stock;
•
advance notice requirements for stockholders to nominate individuals to serve on our board of directors or to submit proposals that can be acted upon at stockholder meetings; provided, that prior to the date that the total number of outstanding shares of our Class B common stock is less than 10% of the total number of shares of common stock outstanding, which we refer to as the "Transition Date," no such requirement is required for holders of at least 10% of our outstanding Class B common stock;
•
our board of directors is classified so not all of the members of our board of directors are elected at one time, which may make it more difficult for a person who acquires control of a majority of our outstanding voting stock to replace our directors;
•
following the Transition Date, stockholder action by written consent will be prohibited;
•
special meetings of the stockholders are permitted to be called only by the chairman of our board of directors, our chief executive officer or by a majority of our board of directors;
•
stockholders are not permitted to cumulate their votes for the election of directors;
•
newly created directorships resulting from an increase in the authorized number of directors or vacancies on our board of directors will be filled only by majority vote of the remaining directors;
•
our board of directors is expressly authorized to make, alter or repeal our bylaws; and
•
stockholders are permitted to amend our bylaws only upon receiving at least 66 2/3% of the votes entitled to be cast by holders of all outstanding shares then entitled to vote generally in the election of directors, voting together as a single class.
After the Transition Date, we will also be subject to the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our amended and rested certificate of incorporation, amended and restated bylaws and Delaware law could discourage acquisition proposals and make it more difficult or expensive for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by our then-current board of directors, including delaying or impeding a merger, tender offer or proxy contest involving us. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our Class A common stock to decline.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The table below sets forth information with respect to purchases of our Class A common stock made by us or on our behalf during the quarter ended June 30, 2014:
Period
 
Total Number of Shares Purchased (1)
 
Average Price Paid per Share
 
Total Number of Shares Purchase as Part of Publicly Announced Plans or Programs
 
Maximum Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
April 1 - 30, 2014
 
—

 
$
—

 
n/a
 
n/a
May 1 - 31, 2014
 
1,694

 
$
5.08

 
n/a
 
n/a
June 1 - 30, 2014
 
 
 
 
 
 
 
 
Total:
 
1,694

 
$
5.08

 
n/a
 
n/a

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(1) Reflects shares forfeited to us upon the vesting of restricted stock granted to participants in our 2007 Incentive Award Plan, to satisfy applicable tax withholding obligations with respect to such vesting. We did not have any publicly announced plans or programs to purchase our Class A common stock in the quarter ended June 30, 2014.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
None.
Item  5. Other Information
None.

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Item 6. Exhibits
(a)
Exhibits.
 
 
 
Number
 
Description
 
 
 
10.1*
 
Employment Agreement, dated April 10, 2014, with Paxton L. Wiffler
 
 
 
10.2*
 
Restricted Stock Agreement, dated May 8, 2014, with Paxton L. Wiffler
 
 
 
10.3
 
Amendment No. 2 and Loan Modification Agreement, dated as of June 23, 2014, to the Fourth Amended and Restated Credit Agreement, dated as of April 12, 2012, by and among Skilled Healthcare Group, Inc., certain subsidiary guarantors , Credit Suisse AG, Cayman Islands Branch, as administrative agent, Credit Suisse Securities (USA) LLC, as amendment arranger, and certain lenders and other parties thereto (Incorporated by reference to Exhibit 10.1 of our Current Report on Form 8-K filed with the SEC on June 27, 2014)
 
 
 
31.1
 
Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
31.2
 
Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
32**
 
Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
101
 
The following financial information from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2014 as filed with the SEC on August 11, 2014, formatted in Extensible Business Reporting Language (XBRL): (i) the condensed consolidated balance sheets at June 30, 2014 and December 31, 2013, and (ii) the condensed consolidated statements of operations for the three and six months ended June 30, 2014 and June 30, 2013, and (iii) the condensed consolidated statements of comprehensive income for the three and six months ended June 30, 2014 and June 30, 2013, and (iv) the condensed consolidated statements of cash flows the six months ended June 30, 2014 and June 30, 2013, and (v) the Notes to Condensed Consolidated Financial Statements.


 *    Management contract or compensatory plan or arrangement.
**
Furnished herewith and not "filed" for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.



65

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
SKILLED HEALTHCARE GROUP, INC.
 
 
 
 
Date:
August 11, 2014
By
/S/    ROBERT H. FISH        
 
 
 
Robert H. Fish
 
 
 
Chief Executive Officer
 
 
 
 
Date:
August 11, 2014
By
/S/ CHRISTOPHER N. FELFE
 
 
 
Christopher N. Felfe
 
 
 
Chief Financial Officer
 
 
 
(Principal Financial Officer, Principal Accounting Officer, and Authorized Signatory)


66

EXHIBIT INDEX
 
Number
 
Description
 
 
10.1*
 
Employment Agreement, dated April 10, 2014, with Paxton L. Wiffler
 
 
 
10.2*
 
Restricted Stock Agreement, dated May 8, 2014, with Paxton L. Wiffler
 
 
 
10.3
 
Amendment No. 2 and Loan Modification Agreement, dated as of June 23, 2014, to the Fourth Amended and Restated Credit Agreement, dated as of April 12, 2012, by and among Skilled Healthcare Group, Inc., certain subsidiary guarantors , Credit Suisse AG, Cayman Islands Branch, as administrative agent, Credit Suisse Securities (USA) LLC, as amendment arranger, and certain lenders and other parties thereto (Incorporated by reference to Exhibit 10.1 of our Current Report on Form 8-K filed with the SEC on June 27, 2014)
 
 
 
31.1
 
Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
31.2
 
Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
32**
 
Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
101
 
The following financial information from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2014 as filed with the SEC on August 11, 2014, formatted in Extensible Business Reporting Language (XBRL): (i) the condensed consolidated balance sheets at June 30, 2014 and December 31, 2013, and (ii) the condensed consolidated statements of operations for the three and six months ended June 30, 2014 and June 30, 2013, and (iii) the condensed consolidated statements of comprehensive income for the three and six months ended June 30, 2014 and June 30, 2013, and (iv) the condensed consolidated statements of cash flows the six months ended June 30, 2014 and June 30, 2013, and (v) the Notes to Condensed Consolidated Financial Statements.
*        Management contract or compensatory plan or arrangement.        
 **
Furnished herewith and not "filed" for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

67

Genesis Healthcare, Inc. Reports