UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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FORM 10-Q

 

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(Mark One)

 

 

For the quarterly period ended June 30, 2015.

 

OR

 

 

For the transition period from              to             .

 

Commission file number: 001-33459

 

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Genesis Healthcare, Inc.

(Exact name of registrant as specified in its charter)

 

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(610) 444-6350

(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 ☒  No ☐

 

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

 

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

 

 

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

 

The number of shares outstanding of each of the issuer’s classes of common stock, as of the close of business on August 7, 2015, was:

Class A common stock, $0.001 par value – 73,591,665 shares

 

Class B common stock, $0.001 par value – 15,511,603 shares

 

Class C common stock, $0.001 par value – 64,449,380 shares

 

 

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Genesis Healthcare, Inc.

 

Form 10-Q

Index

 

 

 

 

 

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

 

GENESIS HEALTHCARE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

(UNAUDITED)

 

 

See accompanying notes to the unaudited consolidated financial statements.

 

 

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GENESIS HEALTHCARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE DATA)

(UNAUDITED)

 

 

 

See accompanying notes to the unaudited consolidated financial statements.

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GENESIS HEALTHCARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(IN THOUSANDS)

(UNAUDITED)

 

 

 

See accompanying notes to the unaudited consolidated financial statements.

 

 

 

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GENESIS HEALTHCARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)

(IN THOUSANDS)

(UNAUDITED)

 

 

 

See accompanying notes to the unaudited consolidated financial statements.

 

 

 

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GENESIS HEALTHCARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

 

 

 

See accompanying notes to the unaudited consolidated financial statements.

 

 

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(1)General Information

 

Description of Business

 

Genesis Healthcare, Inc. is a healthcare services company that through its subsidiaries (collectively, the Company) owns and operates skilled nursing facilities, assisted living facilities, hospices, home health providers and a rehabilitation therapy business.  The Company has an administrative service company that provides a full complement of administrative and consultative services that allows its affiliated operators and third-party operators with whom the Company contracts to better focus on delivery of healthcare services. The Company provides inpatient services through 514 skilled nursing, assisted living and behavioral health centers located in 34 states.  Revenues of the Company’s owned, leased and otherwise consolidated centers constitute approximately 85% of its revenues.

 

The Company provides a range of rehabilitation therapy services, including speech pathology, physical therapy, occupational therapy and respiratory therapy.  These services are provided by rehabilitation therapists and assistants employed or contracted at substantially all of the centers operated by the Company, as well as by contract to healthcare facilities operated by others.  After the elimination of intercompany revenues, the rehabilitation therapy services business constitutes approximately 12% of the Company’s revenues.

 

The Company provides an array of other specialty medical services, including management services, physician services, staffing services, hospice and home health services, and other healthcare related services, which comprise the balance of the Company’s revenues.

 

Basis of Presentation

 

The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP).  In the opinion of management, the consolidated financial statements include all necessary adjustments for a fair presentation of the financial position and results of operations for the periods presented.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q of Regulation S-X and do not include all of the disclosures normally required by U.S. GAAP or those normally required in annual reports on Form 10-K. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2014 filed with the Securities and Exchange Commission (the SEC) on Form 8-K on July 24, 2015. The accompanying consolidated balance sheet at December 31, 2014 was derived from audited consolidated financial statements, but does not include all disclosures required by U.S. GAAP.

 

Certain prior year amounts have been reclassified to conform to current period presentation, the effect of which was not material. The Company’s membership interest at December 31, 2014 has been recast as common stock and additional paid-in-capital.

 

The Company’s financial position at June 30, 2015 includes the impact of the Combination (as defined in Note 3 – “Significant Transactions and Events – The Combination with Skilled”), which has been accounted for as a reverse acquisition using the acquisition method effective February 2, 2015.

 

Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (the FASB) issued ASU No. 2014-09, Revenue from Contracts with Customers, (ASU 2014-09) which changes the requirements for recognizing revenue when entities enter into contracts with customers. Under ASU 2014-09, an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. It also requires

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more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The adoption of ASU 2014-09 is effective for annual and interim periods beginning after December 15, 2017 and early adoption is not permitted. The Company is still evaluating the effect, if any, ASU 2014-09 will have on the Company’s consolidated financial condition and results of operations.

 

In February 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810):  Amendments to the Consolidation Analysis (ASU 2015-02), which changes the way reporting enterprises evaluate whether (a) they should consolidate limited partnerships and similar entities, (b) fees paid to a decision maker or service provider are variable interests in a variable interest entity (VIE), and (c) variable interests in a VIE held by related parties of the reporting enterprise require the reporting enterprise to consolidate the VIE. It also eliminates the VIE consolidation model based on majority exposure to variability that applied to certain investment companies and similar entities. The new guidance excludes money market funds that are required to comply with Rule 2a-7 of the Investment Company Act of 1940 and similar entities from the U.S. GAAP consolidation requirements. The adoption of ASU 2015-02 is effective for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years, with early adoption permitted. If adopted in an interim period, this ASU must be reflected as of the beginning of the fiscal year that includes that interim period.  The adoption of ASU No. 2015-02 is not expected to have a material impact on the Company’s consolidated financial condition and results of operations.

 

In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs, (ASU 2015-03). This ASU requires an entity to present debt issuance costs as a direct deduction from the carrying amount of the related debt liability, consistent with debt discounts.  The costs will continue to be amortized to interest expense using the effective interest method. The adoption of ASU 2015-03 is effective for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years, with early adoption permitted. This ASU requires retrospective application to all prior periods presented in the financial statements.  The adoption of ASU No. 2015-03 is not expected to have a material impact on the Company’s consolidated financial condition and results of operations.

 

 

(2)Certain Significant Risks and Uncertainties

 

Revenue Sources

 

The Company receives revenues from Medicare, Medicaid, private insurance, self-pay residents, other third-party payors and long-term care facilities that utilize its rehabilitation therapy and other services.  The Company’s inpatient services segment derives approximately 79% of its revenue from Medicare and various state Medicaid programs.

 

The sources and amounts of the Company’s revenues are determined by a number of factors, including licensed bed capacity and occupancy rates of inpatient facilities, the mix of patients and the rates of reimbursement among payors.  Likewise, payment for ancillary medical services, including services provided by the Company’s rehabilitation therapy services business, varies based upon the type of payor and payment methodologies.  Changes in the case mix of the patients as well as payor mix among Medicare, Medicaid and private pay can significantly affect the Company’s profitability.

 

It is not possible to quantify fully the effect of legislative changes, the interpretation or administration of such legislation or other governmental initiatives on the Company’s business and the business of the customers served by the Company’s rehabilitation therapy business.  The potential impact of reforms to the United States healthcare system, including potential material changes to the delivery of healthcare services and the reimbursement paid for such services by the government or other third party payors, is uncertain at this time.  Accordingly, there can be no assurance that the impact of any future healthcare legislation or regulation will not adversely affect the Company’s business.  There can be no assurance that payments under governmental and private third-party payor programs will be timely, will remain at

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levels similar to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for reimbursement pursuant to such programs.  The Company’s financial condition and results of operations are and will continue to be affected by the reimbursement process, which in the healthcare industry is complex and can involve lengthy delays between the time that revenue is recognized and the time that reimbursement amounts are settled.

 

Laws and regulations governing the Medicare and Medicaid programs, and the Company’s business generally, are complex and are often subject to a number of ambiguities in their application and interpretation. The Company believes that it is in substantial compliance with all applicable laws and regulations.  However, from time to time the Company and its affiliates are subject to pending or threatened lawsuits and investigations involving allegations of potential wrongdoing, some of which may be material or involve significant costs to resolve and/or defend against, or may lead to other adverse effects on the Company and its affiliates including, but not limited to, fines, penalties and exclusion from participation in the Medicare and/or Medicaid programs.  The Company business is subject to a number of other known and unknown risks and uncertainties, which are discussed in Item 1A (Risk Factors) of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2014, which was filed with the SEC on February 20, 2015.

 

(3)Significant Transactions and Events

 

The Combination with Skilled

 

On August 18, 2014, Skilled Healthcare Group, Inc., a Delaware corporation (Skilled) entered into a Purchase and Contribution Agreement with FC-GEN Operations Investment, LLC (FC-GEN) pursuant to which the businesses and operations of FC-GEN and Skilled were combined (the Combination). On February 2, 2015, the Combination was completed.

 

The following diagram depicts the organizational structure of the Company at the time of the Combination:

 

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Upon completion of the Combination, the Company began operating under the name Genesis Healthcare, Inc. and the Class A common stock of the combined company continues to trade on the NYSE under the symbol “GEN”.  Upon the closing of the Combination, the former owners of FC-GEN held 74.25% of the economic interests in the combined entity and the former shareholders of Skilled held the remaining 25.75% of the economic interests in the combined entity post-transaction, in each case on a fully-diluted, as-exchanged and as-converted basis.  Under applicable accounting standards, FC-GEN was the accounting acquirer in the Combination, which was treated as a reverse acquisition. The acquisition method has been applied to the accounts of Skilled based on Skilled’s stock price (level 1 valuation technique - quoted prices in active markets for identical assets or liabilities) as of the acquisition date. The consideration has been allocated to the legacy Skilled business that was acquired on the acquisition date with the excess consideration over the fair value of the net assets acquired recognized as goodwill. As of the effective date of the Combination, FC-GEN’s assets and liabilities remained at their historical costs.

Because FC-GEN’s pre-transaction owners held an approximately 58% direct controlling interest in Skilled and a 74.25% economic and voting interest in the combined company, FC-GEN is considered to be the acquirer of Skilled for accounting purposes. Following the closing of the Combination, the combined results of Skilled and FC-GEN are consolidated with approximately 42% direct noncontrolling economic interest shown as noncontrolling interest in the financial statements of the combined entity. The 42% direct noncontrolling economic interest is in the form of Class A common units of FC-GEN that are exchangeable on a 1 to 1 basis to public shares of the Company. The 42% direct noncontrolling economic interest will continue to decrease as Class A common units of FC-GEN are exchanged for public shares of the Company.

 

Consideration Price Allocation

 

The total Skilled consideration price of $348.1 million was allocated to Skilled’s net tangible and identifiable intangible assets based upon the estimated fair values at February 2, 2015.  The excess of the consideration price over the estimated fair value of the net tangible and identifiable intangible assets was recorded as goodwill.  The allocation of the consideration price to property, plant and equipment, identifiable intangible assets and deferred income taxes was based upon valuation data and estimates.  The Company has not finalized the analysis of the consideration price allocation and will continue its review during the measurement period.  The aggregate goodwill arising from the Combination is based upon the expected future cash flows of the Skilled operations.  Goodwill recognized from the Combination is the result of (i) the expected savings to be realized from achieving certain economies of scale and (ii) anticipated long-term improvements in Skilled’s core businesses.  The Company has estimated $79.8 million of pre-existing Skilled goodwill that is deductible for income tax purposes related to the Combination.

 

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The consideration price and related allocation are summarized as follows (in thousands): 

 

 

 

Pro forma information

 

The acquired business contributed net revenues of $382.6 million and net income of $9.5 million to the Company for the period from February 1, 2015 to June  30, 2015. The unaudited pro forma net effect of the Combination assuming the acquisition occurred as of January 1, 2014 is as follows (in thousands, except per share amounts):

 

 

The unaudited pro forma financial data have been derived by combining the historical financial results of the Company and the operations acquired in the Combination for the periods presented. The unaudited results of operations includes transaction and financing costs totaling $86.9 million incurred by both the Company and Skilled in connection with the Combination. These costs have been eliminated from the results of operations for the six months ended June 30, 2015 for purposes of the pro forma financial presentation.

 

Related Party Transactions

 

On March 31, 2015, the Company sold its investment in FC PAC Holdings, LLC (FC PAC), an unconsolidated joint venture in which it held an approximate 5.4% interest, for $26.4 million. The Company recognized a gain on sale of $8.4 million recorded as other income on the statement of operations. FC PAC ownership includes affiliates of Formation

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Capital (Formation), a private equity sponsor of the Company prior to the Combination, and also represented by members of the Company’s board of directors.

Acquisition from Revera

On June 15, 2015, the Company announced that it had signed an asset purchase agreement with Revera Assisted Living, Inc., a leading owner, operator and investor in the senior living sector, to acquire 24 of its skilled nursing facilities along with its contract rehabilitation business for $240 million.  The Company will acquire the real estate and operations of 20 of the skilled nursing facilities and enter into a long-term lease agreement with Health Care REIT, Inc., a publicly traded real estate investment trust, to operate the other four additional skilled nursing facilities.  The transaction is expected to close by this calendar year-end, subject to additional due diligence, regulatory and licensing approvals, and other customary conditions.

(4)Earnings (Loss) Per Share

 

The Company has three classes of common stock.  Classes A and B are identical in economic and voting interests.  Class C has a 1:1 voting ratio with the other two classes, representing the voting interests of the approximate 42% noncontrolling interest of the legacy FC-GEN owners. See Note 3 – “Significant Transactions and Events – the Combination with Skilled”. Class C common stock is a participating security; however, it shares in a de minimis economic interest and is therefore excluded from the denominator of the basic earnings per share calculation.

 

Basic net loss per share was computed by dividing net loss by the weighted-average number of outstanding common shares for the period. Diluted earnings per share is computed by dividing 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 computations of basic and diluted loss per share are consistent with any potentially dilutive adjustments to the numerator or denominator being anti-dilutive and therefore excluded from the dilutive calculation. A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per common share follows (in thousands, except per share data):

 

 

 

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The following were excluded from net income attributable to Genesis Healthcare, Inc. and the weighted-average diluted shares computation for the three and six months ended June 30, 2015 and 2014, as their inclusion would have been anti-dilutive (in thousands):

 

 

 

Because the Company is in a net loss position for the three and six months ended June  30, 2015, the combined impact of the assumed conversion of the approximate 42% noncontrolling interest to common stock and the related tax implications, are anti-dilutive to earnings per share (EPS).  As of June 30, 2015, there were 64,449,380 units attributed to the noncontrolling interests outstanding.  See Note 3 – “Significant Transactions and Events – the Combination with Skilled.”    There were no convertible instruments issued or outstanding as of June  30, 2014 that could be potentially dilutive to net loss for that period.  On June 3, 2015, the shareholders approved the 2015 Omnibus Equity Incentive Plan, which provided for the grant of 3,825,420 restricted stock units to employees and 198,020 restricted stock units to non-employee directors. Because the Company is in a net loss position for the three and six months ended June 30, 2015, the combined impact of the grant under the 2015 Omnibus Equity Incentive Plan to common stock and the related tax implications are anti-dilutive to EPS.    

 

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(5)Segment Information

 

The Company has three reportable operating segments: (i) inpatient services; (ii) rehabilitation therapy services; and (iii) other services. For additional information on these reportable segments see Note 1 – “General Information – Description of Business.”

 

A summary of the Company’s segmented revenues follows:

 

 

 

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A summary of the Company’s unaudited condensed consolidated statement of operations follows:

 

 

 

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The following table presents the segment assets as of June 30, 2015 compared to December 31, 2014 (in thousands):   

 

 

The following table presents segment goodwill as of June 30, 2015 compared to December 31, 2014 (in thousands):   

 

 

 

 

 

 

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(6)Property and Equipment

 

Property and equipment consisted of the following as of June 30, 2015 and December 31, 2014 (in thousands):

 

 

 

 

 

 

(7)Long-Term Debt

 

Long-term debt at June  30, 2015 and December 31, 2014 consisted of the following (in thousands):

 

 

 

Revolving Credit Facilities

 

In connection with the Combination, on February 2, 2015 the Company entered into new revolving credit facilities and terminated its former revolving credit facilities.  The new revolving credit facilities (the Revolving Credit Facilities) consist of a senior secured, asset-based revolving credit facility of up to $550 million under three separate tranches:  Tranche A-1, Tranche A-2 and FILO Tranche.  Interest accrues at a per annum rate equal to either (x) a base rate (calculated as the highest of the (i) prime rate, (ii) the federal funds rate plus 3.00%, or (iii) LIBOR plus the excess of the applicable margin between LIBOR loans and base rate loans) plus an applicable margin or (y) LIBOR plus an applicable margin.  The applicable margin is based on the level of commitments for all three tranches, and in regards to LIBOR loans (i) for Tranche A-1 ranges from 3.25% to 2.75%; (ii) for Tranche A-2 ranges from 3.00% to 2.50%; and (iii) for FILO Tranche is 5.00%.  The Revolving Credit Facilities mature on February 2, 2020, provided that if the Term Loan Facility (defined below) or the Real Estate Bridge Loan (defined below) is not refinanced with longer term debt or their terms not extended prior to their current maturities of December 4, 2017 and August 27, 2017, respectively, the Revolving Credit Facilities will mature 90 days prior to such maturity date, as applicable.  Borrowing levels under the Revolving Credit Facilities are limited to a borrowing base that is computed based upon the level of the Company’s eligible accounts receivable, as defined.  In addition to paying interest on the outstanding principal borrowed under the Revolving Credit Facilities, the Company is required to pay a commitment fee to the lenders for any unutilized

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commitments.  The commitment fee rate ranges from 0.375% per annum to 0.50% depending upon the level of unused commitment.

 

Borrowings and interest rates under the three tranches were as follows at June  30, 2015:

 

 

 

As of June  30, 2015, the Company had outstanding borrowings under the Revolving Credit Facilities of $293.0 million and had $108.5 million of drawn letters of credit securing insurance and lease obligations, leaving the Company with approximately $133.3 million of available borrowing capacity under the revolving credit facilities.

 

Term Loan Facility

 

Prior to the Combination, FC-GEN and certain of its subsidiaries became party to a five-year term loan facility (the Term Loan Facility).  The Term Loan Facility is secured by a first priority lien on the membership interests in the Company and on substantially all of the Company’s and its subsidiaries’ assets other than collateral held on a first priority basis by the Revolving Credit Facilities lender.  Borrowings under the Term Loan Facility bear interest at a rate per annum equal to the applicable margin plus, at the Company’s option, either (x) LIBOR or (y) a base rate determined by reference to the highest of (i) the lender defined prime rate, (ii) the federal funds rate effective plus one half of one percent and (iii) LIBOR described in subclause (x) plus 1.0%.  LIBOR based loans are subject to an interest rate floor of 1.5% and base rate loans are subject to a floor of 2.5%.  The Term Loan Facility matures on December 4, 2017.  On September 25, 2014, FC-GEN entered into an amendment to the Term Loan Facility providing for changes to the financial covenants and other provisions allowing for and accommodating the Combination.  On February 2, 2015, the amendment to the Term Loan Facility became effective.  The Term Loan Facility currently has an outstanding principal balance of $230.1 million.  Base rate borrowings under the Term Loan Facility bore interest of approximately 10.75% at June  30, 2015.  One-month LIBOR borrowings under the Term Loan Facility bore interest of approximately 10.0% at June 30, 2015.

 

Principal payments for the six months ended June  30, 2015 were $0.6 million.  The Term Loan Facility amortizes at a rate of 5% per annum.  The lenders have the right to elect ratable principal payments or defer principal recoupment until the end of the term.

 

Real Estate Bridge Loan

 

In connection with the Combination on February 2, 2015, the Company entered into a $360.0 million real estate bridge loan (the Real Estate Bridge Loan), which is secured by a mortgage lien on the real property of 67 facilities and a second lien on certain receivables of the operators of such facilities.  The Real Estate Bridge Loan is subject to a 24-month term with two extension options of 90-days each and accrues interest at a rate equal to LIBOR, plus 6.75%, plus an additional margin that ranges up to 7.00% based on the aggregate number of days the Real Estate Bridge Loan is outstanding.  The interest rate is also subject to a LIBOR interest rate floor of 0.5%.  The Real Estate Bridge Loan bore interest of 7.25% at June  30, 2015.  The Real Estate Bridge Loan is subject to payments of interest only during the term with a balloon payment due at maturity, provided, that to the extent the subsidiaries receive any net proceeds from the sale and / or refinance of the underlying facilities such net proceeds are required to be used to repay the outstanding principal balance of the Real Estate Bridge Loan.   The proceeds of the Real Estate Bridge Loan were used to repay Skilled’s first lien senior secured term loan, repay Skilled’s mortgage loans and asset based revolving credit facility with

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MidCap Financial with excess proceeds used to fund direct costs of the Combination with the Company.  The Real Estate Bridge Loan has an outstanding principal balance of $360.0 million at June  30, 2015.

 

The Revolving Credit Facilities, the Term Loan and Real Estate Bridge Loan (collectively, the Credit Facilities) each contain a number of restrictive covenants that, among other things, impose operating and financial restrictions on the Company and its subsidiaries.  The Credit Facilities also require the Company to meet defined financial covenants, including interest coverage ratio, a maximum consolidated net leverage ratio and a minimum consolidated fixed charge coverage ratio, all as defined in the applicable agreements.  The Credit Facilities also contain other customary covenants and events of default.  At June  30, 2015, the Company was in compliance with its covenants. 

 

HUD Insured Loans

 

In connection with the Combination on February 2, 2015, the Company assumed certain obligations under 10 loans insured by HUD. The loans are secured by 10 of the Company's skilled nursing facilities that were acquired in the Combination. The HUD insured loans have an original amortization term of 30 to 35 years. On May 1, 2015, the Company acquired a facility in Texas and assumed its HUD insured loan totaling $8.4 million with a maturity date of January 1, 2049.  As of June 30, 2015 the HUD insured loans have a combined aggregate principal balance of $108.6 million including a $14.8 million debt premium established in purchase accounting in connection with the Combination.

 

These mortgages have an average remaining term of 31 years with fixed interest rates ranging from 3.4% to 4.6% and a weighted average interest rate of 4.3%. 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. 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, 2015, the Company has total escrow reserve funds of $5.5 million with the loan servicer that are reported within prepaid expenses. 

 

Other Debt

 

Mortgages and other secured debt (recourse). The Company carries two mortgage loans on two of its corporate office buildings.  The Company also has an outstanding note payable for an acquired facility.  The loans are secured by the underlying real property and have fixed or variable rates of interest ranging from 1.9% to 6.0% at June 30, 2015, with maturity dates ranging from 2018 to 2019. 

 

Mortgages and other secured debt (non-recourse). Loans are carried by certain of the Company’s consolidated joint ventures.  The loans consist principally of revenue bonds and secured bank loans.  Loans are secured by the underlying real and personal property of individual facilities and have fixed or variable rates of interest ranging from 2.5% to 21.9% at June  30, 2015, with maturity dates ranging from 2018 to 2036.  Loans are labeled “non-recourse” because neither the Company nor any of its wholly owned subsidiaries is obligated to perform under the respective loan agreements.

 

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The maturity of total debt of $1,044.5 million at June 30, 2015 is as follows (in thousands):

 

 

 

 

 

(8)Leases and Lease Commitments

 

The Company leases certain facilities under capital and operating leases.  Future minimum payments for the next five years and thereafter under such leases at June  30, 2015 are as follows (in thousands):

 

 

 

Capital Lease Obligations

 

The capital lease obligations represent the present value of minimum lease payments under such capital lease and cease use arrangements and bear imputed interest at rates ranging from 3.5% to 12.9% at June 30, 2015, and mature at dates ranging from 2015 to 2047.

 

Deferred Lease Balances

 

At June 30, 2015 and December 31, 2014, the Company had $61.7 million and $47.8 million, respectively, of favorable leases net of accumulated amortization, included in other identifiable intangible assets, and $39.0 million and $31.4 million, respectively, of unfavorable leases net of accumulated amortization included in other long-term liabilities on the consolidated balance sheet.  Favorable and unfavorable lease assets and liabilities, respectively, arise through the acquisition of leases in place which requires those contracts be recorded at their then fair value.  The fair value of a lease is determined through a comparison of the actual rental rate with rental rates prevalent for similar assets in similar markets.  A favorable lease asset to the Company represents a rental stream that is below market, and conversely an unfavorable lease is one with cost above market rates.  These assets and liabilities amortize as lease expense over the remaining term of the respective leases on a straight-line basis.  At June  30, 2015 and December 31, 2014, the Company

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had $24.0 million and $20.6 million, respectively, of deferred straight-line rent balances included in other long-term liabilities on the consolidated balance sheet.

 

Lease Covenants

 

Certain lease agreements contain a number of restrictive covenants that, among other things and subject to certain exceptions, impose operating and financial restrictions on the Company and its subsidiaries.  These leases also require the Company to meet defined financial covenants, including a minimum level of consolidated liquidity, a maximum consolidated net leverage ratio, a minimum consolidated fixed charge coverage and a minimum level of tangible net worth.  At June  30, 2015, the Company was in compliance with its covenants under its lease arrangements.

 

In connection with the Combination on February 2, 2015, the Company and certain of its lessors amended the existing lease agreements.  These amendments modified certain financial covenants to reflect the combined company.

 

(9)Financing Obligation

 

Future minimum payments for the next five years and thereafter under leases classified as financing obligations at June  30, 2015 are as follows (in thousands):

 

 

 

 

 

(10)Income Taxes

 

Upon completion of the Combination, the Company effectively owns 58% of FC-GEN, an entity taxed as a partnership for U.S. income tax purposes.  This is the Company’s only source of taxable income.  The transaction did not materially impact the amount of income subject to corporate tax.

 

For the three months ended June 30, 2015, the Company recorded an income tax benefit of $4.4 million from continuing operations, representing an effective tax rate of 11.7%, compared to an income tax benefit of $0.1 million from continuing operations, representing an effective tax rate of 0.3%, for the same period in 2014.

 

For the six months ended June 30, 2015, the Company recorded an income tax benefit of $10.1 million from continuing operations, representing an effective tax rate of 6.2%, compared to an income tax benefit of $2.9 million from continuing operations, representing an effective tax rate of 3.8%, for the same period in 2014.

 

The 11.4% and the 2.4% respective increase in the effective tax rate is attributable to the establishment of a valuation allowance against the insurance reserves deferred tax asset of its Cayman captive insurance company and the write-off of a portion of deferred tax assets on U.S. federal and state net operating losses.  The write-off is a result of a more restrictive change of ownership limitation under IRC Section 382 by which a taxpayer is limited to a certain

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amount of net operating losses it can utilize in a given tax year and the insolvency of certain corporate subsidiaries that were converted to limited liability companies that will be treated as partnerships for income tax purposes.

 

Exchange Rights and Tax Receivable Agreement

 

Following the Combination, the owners of FC-GEN will have the right to exchange their membership interests in FC-GEN for shares of Class A Common Stock of the Company or cash, at the Company’s option.  As a result of such exchanges, the Company’s membership interest in FC-GEN will increase and its purchase price will be reflected in its share of the tax basis of FC-GEN’s tangible and intangible assets.  Any resulting increases in tax basis are likely to increase tax depreciation and amortization deductions and, therefore, reduce the amount of income tax the Company would otherwise be required to pay in the future.  Any such increase would also decrease gain (or increase loss) on future dispositions of the effected assets. 

 

Concurrent with the Combination, the Company entered into a tax receivable agreement (TRA) with the owners of FC-GEN.  The agreement provides for the payment by the Company to the owners of FC-GEN of 90% of the cash savings, if any, in U.S. federal, state and local income tax that the Company actually realizes as a result of (i) the increases in tax basis attributable to the owners of FC-GEN and (ii) tax benefits related to imputed interest deemed to be paid by the Company as a result of the TRA.  Under the TRA, the benefits deemed realized by the Company as a result of the increase in tax basis attributable to the owners of FC-GEN generally will be computed by comparing the actual income tax liability of the Company to the amount of such taxes that the Company would have been required to pay had there been no such increase in tax basis.

 

Estimating the amount of payments that may be made under the TRA is by its nature imprecise, insofar as the calculation of amounts payable depends on a variety of factors. The actual increase in tax basis and deductions, as well as the amount and timing of any payments under the TRA, will vary depending upon a number of factors, including:

 

 

 

 

 

The TRA also provides that upon certain mergers, asset sales, other forms of business combinations or other changes of control, FC-GEN (or its successor’s) obligations under the TRA would be based on certain assumptions defined in the TRA. As a result of these assumptions, FC-GEN could be required to make payments under the TRA that are greater or less than the specified percentage of the actual benefits realized by the Company that are subject to the TRA.  In addition, if FC-GEN elects to terminate the TRA early, it would be required to make an early termination payment, which upfront payment may be made significantly in advance of the anticipated future tax benefits.

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Payments generally are due under the TRA within a specified period of time following the filing of FC-GEN’s U.S. federal and state income tax return for the taxable year with respect to which the payment obligation arises.  Payments under the TRA generally will be based on the tax reporting positions that FC-GEN will determine.  Although FC-GEN does not expect the IRS to challenge the Company’s tax reporting positions, FC-GEN will not be reimbursed for any overpayments previously made under the TRA, but any overpayments will reduce future payments.  As a result, in certain circumstances, payments could be made under the TRA in excess of the benefits that FC-GEN actually realizes in respect of the tax attributes subject to the TRA.

 

The term of the TRA generally will continue until all applicable tax benefits have been utilized or expired, unless the Company exercises its right to terminate the TRA and make an early termination payment.

 

In certain circumstances (such as certain changes in control, the election of the Company to exercise its right to terminate the agreement and make an early termination payment or an IRS challenge to a tax basis increase) it is possible that cash payments under the TRA may exceed actual cash savings.

 

 

(11)Commitments and Contingencies

 

Loss Reserves For Certain Self-Insured Programs

 

General and Professional Liability and Workers’ Compensation

 

The Company self-insures for certain insurable risks, including general and professional liabilities and workers’ compensation liabilities through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary among states in which the Company operates, including wholly owned captive insurance subsidiaries, to provide for potential liabilities for general and professional liability claims and workers’ compensation claims. Policies are typically written for a duration of twelve months and are measured on a “claims made” basis. Regarding workers’ compensation, the Company self-insures to its deductible and purchases statutorily required insurance coverage in excess of its deductible. There is a risk that amounts funded by the Company’s self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Insurance reserves represent estimates of future claims payments. This liability includes an estimate of the development of reported losses and losses incurred but not reported. Provisions for changes in insurance reserves are made in the period of the related coverage. The Company also considers amounts that may be recovered from excess insurance carriers in estimating the ultimate net liability for such risks.

 

The Company’s management employs its judgment and periodic independent actuarial analysis in determining the adequacy of certain self-insured workers’ compensation and general and professional liability obligations recorded as liabilities in the Company’s financial statements. The Company evaluates the adequacy of its self-insurance reserves on a quarterly basis or more often when it is aware of changes to its incurred loss patterns that could impact the accuracy of those reserves. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. The foundation for most of these methods is the Company’s actual historical reported and/or paid loss data, over which it has effective internal controls. Any adjustments resulting therefrom are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

 

The Company utilizes third-party administrators (TPAs) to process claims and to provide it with the data utilized in its assessments of reserve adequacy. The TPAs are under the oversight of the Company’s in-house risk management and legal functions. These functions ensure that the claims are properly administered so that the historical data is reliable for

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estimation purposes. Case reserves, which are approved by the Company’s legal and risk management departments, are determined based on an estimate of the ultimate settlement and/or ultimate loss exposure of individual claims.

 

The reserves for loss for workers’ compensation risks are discounted based on actuarial estimates of claim payment patterns using a discount rate of approximately 1% for each policy period presented. The discount rate for the 2015 policy year is 0.78%. The discount rates are based upon the risk-free rate for the appropriate duration for the respective policy year. The removal of discounting would have resulted in an increased reserve for workers’ compensation risks of $5.4 million and $4.8 million as of June 30, 2015 and December 31, 2014, respectively. The reserves for general and professional liability are recorded on an undiscounted basis.

 

For the three months ended June 30, 2015 and 2014, the provision for general and professional liability risk totaled $45.4 million and $28.3 million, respectively.  The provision for general and professional liability risks totaled $71.6 million and $51.0 million for the six months ended June 30, 2015 and 2014, respectively. The reserves for general and professional liability were $346.7 million and $288.2 million as of June 30, 2015 and December 31, 2014, respectively.

 

For the three months ended June 30, 2015 and 2014, the provision for workers’ compensation risk totaled $13.9 million and $10.1 million, respectively.  The provision for loss for workers’ compensation risks totaled $31.8 million and $25.2 million for the six months ended June 30, 2015 and 2014, respectively. The reserves for workers’ compensation risks were $229.0 million and $198.0 million as of June 30, 2015 and December 31, 2014, respectively.

 

Health Insurance

 

The Company offers employees an option to participate in self-insured health plans.  Health insurance claims are paid as they are submitted to the plans’ administrators.  The Company maintains an accrual for claims that have been incurred but not yet reported to the plans’ administrators and therefore have not yet been paid.  The liability for the self-insured health plan is recorded in accrued compensation in the consolidated balance sheets.  Although management believes that the amounts provided in the Company’s consolidated financial statements are adequate and reasonable, there can be no assurances that the ultimate liability for such self-insured risks will not exceed management’s estimates.

 

Legal Proceedings

 

The Company is a party to litigation and regulatory investigations arising in the ordinary course of business.  Based on the Company’s evaluation of information currently available, with the exception of the specific matters noted below, management does not believe the results of such litigation and regulatory investigations would have a material adverse effect on the results of operations, financial position or cash flows of the Company.

 

Creekside Hospice Litigation

 

On August 2, 2013, the United States Attorney for the District of Nevada and the Civil Division of the U.S. Department of Justice (the DOJ) informed the Company that its Civil Division was investigating Skilled, 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. The DOJ filed its complaint in intervention on November 25, 2014, against Creekside, Skilled Healthcare Group, Inc., and Skilled Healthcare, LLC, asserting, among other things, that certain claims for hospice services

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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 DOJ is pursuing False Claims Act, NFCA, and federal common law claims remedies in 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 $11,000 per claim, as applicable.

 

While the Company denies the allegations and will vigorously defend this action, including any portion of the action that the private party relators may continue to pursue, the Company has accrued $7.5 million as a contingent liability in connection with the matter. However, it could ultimately cost more than that amount to settle or otherwise resolve the matter(s), including to satisfy any judgment that might be rendered against the Company or Creekside Hospice if the litigation defense were ultimately unsuccessful.  

 

Therapy Matters Investigation

 

In February 2015, representatives of the DOJ informed the Company that they are investigating and may pursue legal action against the Company and certain of its subsidiaries including Hallmark Rehabilitation GP, LLC for alleged violations of the federal and state healthcare fraud and abuse laws and regulations related to the provision of therapy services at certain Skilled Healthcare facilities from 2005 through 2013. These laws could include the FCA and similar state laws. As noted above, the FCA provides for civil and administrative fines and penalties, including civil fines ranging from $5,500 to $11,000 per claim plus treble damages. Applicable state laws provide for similar penalties. Violations of these federal or state laws could also subject the Company and/or its subsidiaries to exclusion from participation in the Medicare and Medicaid programs. Any damages, fines, penalties, other sanctions and costs that the Company may incur as a result of any federal and/or state suit could be significant and could have a material and adverse effect on its results of operations and financial condition. At this time, the Company cannot predict what effect, if any, the investigation or any potential claims arising under applicable federal or state laws and regulations could have on the Company. While the Company will continue to cooperate with the government’s investigation of the matter, the Company intends to vigorously defend against any legal action that may be brought in the matter. 

 

Staffing Matters Investigation

 

On February 10, 2015, the DOJ informed the Company that it intends to pursue legal action against the Company and certain of its subsidiaries related to staffing and certain quality of care allegations related to the issues adjudicated against the Company and those subsidiaries in a previously disclosed class action lawsuit that Skilled settled in 2010. The laws under which the DOJ could seek to pursue legal action could include the FCA and similar state laws. As noted above, violations of the FCA or similar state laws and regulations could subject the Company and/or its subsidiaries to severe monetary and other penalties and remedies. Any damages, fines, penalties, other sanctions and costs that the Company may incur as a result of any federal or state suit could be significant and could have a material and adverse effect on its results of operations and financial condition. At this time, the Company cannot predict what effect, if any, the investigation or any potential claims arising under applicable federal or state laws and regulations could have on the Company. While the Company will continue to cooperate with the government's evaluation of the matter, the Company intends to vigorously defend against any legal action that may be brought in the matter.

 

(12)Fair Value of Financial Instruments

 

The Company’s financial instruments consist primarily of cash and equivalents, restricted cash, trade accounts receivable, investments in marketable securities, accounts payable, short and long-term debt and derivative financial instruments.

 

The Company’s  financial instruments, other than its trade accounts receivable and accounts payable, are spread across a number of large financial institutions whose credit ratings the Company monitors and believes do not currently

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carry a material risk of non-performance.  Certain of the Company’s financial instruments, including its interest rate cap arrangements, contain an off-balance-sheet risk.

 

Recurring Fair Value Measures 

Fair value is defined as an exit price (i.e., the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date).  The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as shown below.  An instrument’s classification within the fair value hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

 

 

The tables below presents the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2015 and December 31, 2014, aggregated by the level in the fair value hierarchy within which those measurements fall (in thousands):

 

 

 

 

 

The Company places its cash and equivalents and restricted investments in marketable securities in quality financial instruments and limits the amount invested in any one institution or in any one type of instrument.  The Company has not experienced any significant losses on such investments.

 

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Debt Instruments 

 

The table below shows the carrying amounts and estimated fair values of the Company’s primary long-term debt instruments:

 

 

 

The fair value of debt is based upon market prices or is computed using discounted cash flow analysis, based on the Company’s estimated borrowing rate at the end of each fiscal period presented.  The Company believes that the inputs to the pricing models qualify as Level 2 measurements. 

 

Non-Recurring Fair Value Measures 

 

The Company recently applied the fair value measurement principles to certain of its non-recurring nonfinancial assets in connection with an impairment test.

 

The following table presents the Company’s hierarchy for nonfinancial assets measured at fair value on a non-recurring basis (in thousands):

 

 

 

The fair value of tangible and intangible assets is determined using a discounted cash flow approach, which is a significant unobservable input (Level 3).  The Company estimates the fair value using the income approach (which is a discounted cash flow technique).  These valuation methods required management to make various assumptions, including, but not limited to, future profitability, cash flows and discount rates.  The Company’s estimates are based upon

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historical trends, management’s knowledge and experience and overall economic factors, including projections of future earnings potential.

 

Developing discounted future cash flows in applying the income approach requires the Company to evaluate its intermediate to longer-term strategies, including, but not limited to, estimates of revenue growth, operating margins, capital requirements, inflation and working capital management.  The development of appropriate rates to discount the estimated future cash flows requires the selection of risk premiums, which can materially impact the present value of future cash flows. 

 

The Company estimated the fair value of acquired tangible and intangible assets using discounted cash flow techniques that included an estimate of future cash flows, consistent with overall cash flow projections used to determine the purchase price paid to acquire the business, discounted at a rate of return that reflects the relative risk of the cash flows.

 

The Company believes the estimates and assumptions used in the valuation methods are reasonable.

 

(13)Subsequent Events

 

On July 1, 2015, the Company acquired 22 rehabilitation outpatient clinics from Formation for a purchase price of $1.1 million.  The acquisition was financed entirely with a promissory note.