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RES CARE INC /KY/ - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

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Overview




This Management's Discussion and Analysis (MD&A) section is intended to help the
reader understand ResCare's financial performance and condition. MD&A is
provided as a supplement to, and should be read in conjunction with, our
Consolidated Financial Statements and the accompanying notes. All references in
this MD&A to "ResCare", "Company", "our company", "we", "us", or "our" mean
Res-Care, Inc. and, unless the context otherwise requires, its consolidated
subsidiaries. The individual sections of MD&A are:

† Onex Transaction - a description of the purchase of ResCare common stock by Onex.

†

†          Our Business-a general description of our business and revenue
sources.

†

† Application of Critical Accounting Policies- a discussion of accounting policies that require critical judgments and estimates.

† Results of Operations-an analysis of our consolidated results of operations for the periods presented including analysis of our operating segments.

† Financial Condition, Liquidity and Capital Resources- an analysis of cash flows, sources and uses of cash and financial position.

† Contractual Obligations and Commitments - a tabular presentation of our contractual obligations and commitments for future periods.



Onex Transaction


As more fully described in Note 2 of the Notes to Consolidated Financial Statements, on November 16, 2010, an affiliate of Onex Partners III LP (Purchaser) purchased 21,044,765 shares of ResCare common stock in a tender offer. Upon the completion of the tender offer, affiliates of Onex Corporation (the Onex Investors) beneficially owned 87.4% of the issued and outstanding shares of ResCare's common stock on an as-converted basis.




This change of control resulted in a new basis of accounting under the Financial
Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805,
Business Combinations (previously Statement of Financial Accounting Standards
No. 141R). This change creates many differences between reporting for ResCare
post-acquisition, as successor, and ResCare pre-acquisition, as predecessor. The
accompanying Consolidated Financial Statements and the Notes to Consolidated
Financial Statements reflect periods ended December 31, 2011 and December 31,
2010 as successor and November 15, 2010 and December 31, 2009 as predecessor.



As a result of the following transactions on December 22, 2010, ResCare became a
wholly owned subsidiary of Onex Rescare Holdings Corp. ("ResCare Holdings"),
which in turn, is owned by the Onex Investors, certain co-investors and members
of our management team:

†

†    ResCare entered into new senior secured credit facilities, comprised of a
new $170 million term loan facility and an amended and restated $275 million
revolving credit facility;

†

† ResCare issued $200 million of unsecured 10.75% Senior Notes due 2019 ("Notes") in a private placement under the Securities Act of 1933;

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†    ResCare repurchased $120 million (approximately 80%) aggregate principal
amount of its 7.75% Senior Notes due 2013 in a tender offer, and the $30 million
aggregate principal amount of 7.75% Senior Notes not tendered was satisfied and
discharged by delivering to the trustee amounts sufficient to pay the applicable
redemption price, plus accrued and unpaid interest up to the January 21, 2011
redemption date;

†

†    Purchaser completed the acquisition of all of the publicly held common
shares of ResCare through a second-step share exchange transaction, whereby each
outstanding share of ResCare common stock not currently held by Onex Investors
or by members of management was exchanged for the right to receive $13.25 in
cash (a total of $56.9 million);



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†    Purchaser redeemed preferred membership interests held by certain of the
Onex Investors for an amount equal to the contributions ($158.8 million) made by
them in respect of the purchase of such interests plus the accrued preferred
return ($0.8 million) on such interests through the redemption date; and

† The holders of equity interests in Purchaser and of ResCare stock contributed those holdings to ResCare Holdings in exchange for ResCare Holdings stock, and Purchaser was merged into ResCare, with ResCare as the surviving entity.




Our Business



We receive revenues primarily from the delivery of residential, training,
educational and support services to various populations with special needs. Our
programs include an array of services provided in both residential and
non-residential settings for adults and youths with intellectual, cognitive or
other developmental disabilities, and youths who have special educational or
support needs, are from disadvantaged backgrounds, or have severe emotional
disorders, including some who have entered the juvenile justice system. We also
offer, through drop-in or live-in services, personal care, meal preparation,
housekeeping, transportation and some skilled nursing care to the elderly in
their own homes. Additionally, we provide services to transition welfare
recipients, young people and people who have been laid off or have special
barriers to employment into the workforce and become productive employees.



Effective January 1, 2011, we changed our reportable operating segments to:
(i) Residential Services, (ii) ResCare HomeCare, (iii) Youth Services and
(iv) Workforce Services. Residential Services primarily includes services for
individuals with intellectual, cognitive or other developmental disabilities in
our community home settings. ResCare HomeCare primarily includes periodic
in-home care services to the elderly, as well as persons with disabilities.
Youth Services consists of our Job Corps centers, a variety of youth programs
including foster care, alternative education programs and charter schools.
Workforce Services is comprised of job training and placement programs that
assist welfare recipients and disadvantaged job seekers in finding employment
and improving their career prospects. We believe the changes in our segments
will allow us to serve our customers more efficiently and allow future growth
and long-term sustainability. Further information regarding our segments is
included in Note 10 of the Notes to Consolidated Financial Statements.



Revenues for our Residential Services operations are derived primarily from
state Medicaid programs, other government agencies, commercial insurance
companies and from management contracts with private operators, generally
not-for-profit providers, who contract with state government agencies and are
also reimbursed under the Medicaid program. Our services include social,
functional and vocational skills training, supported employment and emotional
and psychological counseling for individuals with intellectual or other
disabilities. We also provide respite, therapeutic and other services to
individuals with special needs and to older people in their homes. These
services are provided on an as-needed basis or hourly basis through our periodic
in-home services programs that are reimbursed on a unit-of-service basis.



Reimbursement varies by state and service type, and may be based on a variety of
methods including flat-rate, cost-based reimbursement, per person per diem, or
unit-of-service basis. Rates are periodically adjusted based upon state budgets
or economic conditions and their impact on state budgets. At programs where we
are the provider of record, we are directly reimbursed under state Medicaid
programs for services we provide and such revenues are affected by occupancy
levels. At most programs that we operate pursuant to management contracts, the
management fee is negotiated with the provider of record. Through ResCare
HomeCare, we also provide in-home services to seniors on a private pay basis. We
are concentrating growth efforts in the home care private pay business to
further diversify our revenue streams.



We operate vocational training centers under the federal Job Corps program
administered by the Department of Labor (DOL) through our Youth Services
operations. Under Job Corps contracts, we are reimbursed for direct costs of
services related to Job Corps center operations, allowable indirect costs for
general and administrative costs, plus a predetermined management fee. The
management fee takes the form of a fixed contractual amount plus a computed
amount based on certain performance criteria. All of such amounts are reflected
as revenue, and all such direct costs are reflected as cost of services. Final
determination of amounts due under Job Corps contracts is subject to audit and
review by the DOL, and renewals and extension of Job Corps contracts are based
in part on performance reviews.



We operate job training and placement programs that assist disadvantaged job
seekers in finding employment and improving their career prospects through our
Workforce Services operations. These programs are administered under contracts
with local and state governments. We are typically reimbursed for direct costs
of services related to the job training centers, allowable indirect costs plus a
fee for profit. The fee can take the form of a fixed contractual amount (rate or
price) or be



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Executive Positions Available for Seasoned Marketers

computed based on certain performance criteria. The contracts are funded by federal agencies, including the DOL and Department of Health and Human Services.

Application of Critical Accounting Policies




Our discussion and analysis of the financial condition and results of operations
are based upon our Consolidated Financial Statements, which have been prepared
in accordance with U.S. GAAP. The preparation of these financial statements
requires us to make estimates and assumptions that affect the reported amounts
and related disclosures of commitments and contingencies. We rely on historical
experience and on various other assumptions that we believe to be reasonable
under the circumstances to make judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Actual results
could differ from those estimates.



We believe the following critical accounting policies involve the more
significant judgments and estimates used in the preparation of our Consolidated
Financial Statements. Management has discussed the development, selection, and
application of our critical accounting policies with our Audit Committee.



Valuation of Accounts Receivable




Accounts receivable consist primarily of amounts due from Medicaid programs,
other government agencies and commercial insurance companies. An estimated
allowance for doubtful accounts receivable is recorded to the extent it is
probable that a portion or all of a particular account will not be collected. In
evaluating the collectibility of accounts receivable, we consider a number of
factors, including historical loss rates, age of the accounts, changes in
collection patterns, the status of ongoing disputes with third-party payors,
general economic conditions and the status of state budgets. Complex rules and
regulations regarding billing and timely filing requirements in various states
are also a factor in our assessment of the collectibility of accounts
receivable. Actual collections of accounts receivable in subsequent periods may
require changes in the estimated allowance for doubtful accounts. Changes in
these estimates are charged or credited to the results of operations in the
period of the change of estimate.



Insurance Losses



We self-insure a substantial portion of our professional, general and automobile
liability, workers' compensation and health benefit risks. These liabilities are
necessarily based on estimates and, while we believe that the provision for loss
is adequate, the ultimate liability may be more or less than the amounts
recorded. Provisions for losses for workers' compensation risks are based upon
actuarially determined estimates and include an amount determined from reported
claims and an amount based on past experiences for losses incurred but not
reported. Estimates of workers' compensation claims reserves have been
discounted using a discount rate of 3% at December 31, 2012 and 2011,
respectively. The liabilities are reviewed quarterly and any adjustments are
reflected in earnings in the period known.



Legal Contingencies



We are party to numerous claims and lawsuits with respect to various matters.
The material legal proceedings in which ResCare is currently involved are
described in Item 3 of this report and Note 16 to the Consolidated Financial
Statements. We provide for costs related to contingencies when a loss is
probable and the amount is reasonably determinable. We confer with outside
counsel in estimating our potential liability for certain legal contingencies.
While we believe our provision for legal contingencies is adequate, the outcome
of legal proceedings is difficult to predict and we may settle legal claims or
be subject to judgments for amounts that exceed our estimates.



Valuation of Long-Lived Assets

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We regularly review the carrying value of long-lived assets with respect to any
events or circumstances that indicate a possible inability to recover their
carrying amount. Indicators of impairment include, but are not limited to, loss
of contracts, significant census declines, reductions in reimbursement levels,
significant litigation and impact of economic conditions on service demands and
levels. Our evaluation is based on cash flow, profitability and projections that
incorporate current or projected operating results, as well as significant
events or changes in the reimbursement and regulatory environment. If
circumstances suggest the recorded amounts cannot be recovered, the carrying
values of such assets are reduced to fair value based upon various techniques to
estimate fair value.



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Goodwill and Other Indefinite-Lived Intangible Assets




With respect to businesses we have acquired, we evaluate the costs of purchased
businesses in excess of net assets acquired (goodwill) for impairment at least
annually, unless significant changes in circumstances indicate a potential
impairment may have occurred sooner. Our annual impairment test date is
October 1. We are required to test goodwill on a reporting unit basis. We use a
fair value approach to test goodwill for impairment and recognize an impairment
charge for the amount, if any, by which the carrying amount of reporting unit
goodwill exceeds its implied fair value. Fair values for goodwill are typically
determined using an income approach (using discounted cash flow analysis method)
or a market approach (using the guideline company method or the guideline
transactions method), or it can be based on a weighted average of all or a
combination of these methods. Due to limited comparability to our reporting
units of the comparable guideline companies and limited financial information
available surrounding the transactions for companies sold, we utilized the
discounted cash flow analysis to establish fair values in our 2012 annual
impairment test. The goodwill impairment test is a two-part test. Step One of
the impairment test compares the fair values of each of our reporting units to
their carrying value. If the fair value is less than the carrying value for any
of our reporting units, Step Two must be completed. Fair values for
indefinite-lived intangible assets are measured using the cost approach.



Discounted cash flow computations depend on a number of key assumptions
including estimates of future market growth and trends, forecasted revenue and
costs, expected periods the assets will be utilized, appropriate discount rates
and other variables. We base our fair value estimates on assumptions we believe
to be reasonable, including recent historical performance and sales growth and
margin improvement that we believe a buyer would assume when determining a
purchase price for the reporting units. but which are unpredictable and
inherently uncertain. Actual future results may differ from those estimates. In
addition, we make certain judgments about the selection of comparable companies
used in determining market multiples in valuing our reporting units (not used in
2012 valuation due to limited comparability of companies to our reporting
units), as well as certain assumptions to allocate shared assets and liabilities
to calculate values for each of our reporting units.



At December 31, 2012, we had approximately $287.2 million of goodwill and $226.7
million of other indefinite-lived intangible assets. Goodwill at December 31,
2012, reflects the excess purchase price from the acquisition as described in
Note 2 of the Consolidated Financial Statements plus goodwill recorded from
acquisitions completed after the predecessor period ended November 15, 2010.
Other indefinite-lived intangible assets include licenses that are essential for
ResCare to operate its businesses in various states and other jurisdictions.
Goodwill and other indefinite-lived intangible assets are not amortized.



For our October 1, 2012 annual impairment test, we used a 2% long-term terminal
growth rate for all reporting units tested. We also used 13%, 14%, 17%, 16% and
13% for our Residential Services, ResCare HomeCare, Workforce Services, Youth
Services-Job Corps and Youth Services-Residential Youth reporting units,
respectively, for discount rates. All reporting units passed Step One. The Youth
Services-Residential Youth reporting unit only passed Step One with a fair value
that exceeded its carrying value by a 15 percent margin. The Youth
Services-Residential Youth reporting unit had a goodwill balance of $10.3
million as of October 1, 2012. A 100 basis point increase in the discount rate
for this reporting unit would decrease the fair value in excess of carrying
value to a 5 percent margin. A 100 basis point decrease in the long-term growth
rate would decrease the fair value in excess of carrying value to a 9 percent
margin for this reporting unit.



In February 2012, we were informed by the New York Human Resources
Administration that our Workforce Services' Wellness, Comprehensive Assessment,
Rehabilitation and Employment ("WeCARE") contract had been awarded to another
operator through the competitive bid process. Annual revenues for this contract
were approximately $28 million. Our formal protest was denied.  During the three
months ended March 31, 2012, we considered the loss of the WeCARE contract to be
an indicator of potential impairment and performed an interim analysis on the
Workforce Services reporting unit and concluded that its goodwill was not
impaired at March 31, 2012. However, the interim analysis did indicate that
Workforce Services' excess of fair value over its carrying value had decreased
to approximately a three percent margin.  During the three months ended June 30,
2012 and September 30, 2012, we continued to monitor this reporting unit.  While
operating results were still below original projected levels, margins had
improved since March 31, 2012 due to measures that had been implemented within
this reporting unit.  Based on our review, we concluded there were no impairment
indicators present and therefore, no impairment analysis was performed for the
quarters ended June 30, 2012 and September 30, 2012.



During the third quarter of 2010 (predecessor period), we updated our current
and future year forecasts. The updated revenues and profits in the forecasts
were significantly impacted by various contract losses, rate and service cuts by



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numerous states and other factors attributed to the general economic
environment. We concluded that these factors, when viewed together, were
indicators of possible impairment of goodwill, requiring an interim impairment
test during the quarter. We performed the interim test on all five reporting
units. As such, the Company recorded an estimated impairment charge during the
third quarter of 2010 of $65.6 million. Accordingly, the net carrying values of
goodwill in the Residential Services, ResCare HomeCare, Youth
Services-Residential Youth, Youth Services-Education and Workforce
Services-International reporting units were reduced $33.2 million, $11.4
million, $2.3 million, $4.9 million and $13.8 million, respectively. Step Two of
the goodwill impairment test was completed for these five reporting units in the
fourth quarter of 2010. Step Two required that we determine the implied fair
value of the reporting units' goodwill by allocating the reporting units' fair
value determined in Step One to the fair value of the reporting units' net
assets, including unrecognized intangible assets. The goodwill calculated in
Step Two is then compared to the recorded goodwill, with an impairment charge
recorded in the amount that the book value of goodwill exceeds the implied fair
value of goodwill calculated in this step. As such, we recorded an additional
impairment charge of $197.6 million related to goodwill in the period October 1,
2010 to November 15, 2010, including $140.9 million in the Residential Services,
$48.4 million in the ResCare HomeCare and $9.7 million in the Youth
Services-Residential Youth reporting units, $0.6 million reduction to the third
quarter charge recorded in the Youth Services-Education reporting unit and $0.8
million reduction to the third quarter charge recorded in the Workforce
Services-International reporting unit. The increase over the third quarter
estimate was due primarily to unrecognized intangibles that are utilized in the
Step Two computation.



Revenue Recognition



Overview: We recognize revenues as they are realizable and earned in accordance
with SEC Staff Accounting Bulletin No. 104, Revenue Recognition in Financial
Statements (SAB 104). SAB 104 requires that revenue can only be recognized when
persuasive evidence of an arrangement exists, services have been rendered, the
price is fixed or determinable and collectibility is reasonably assured.



Residential Services. Revenues are derived primarily from state Medicaid
programs, other government agencies, commercial insurance companies and from
management contracts with private operators, generally not-for-profit providers,
who contract with state agencies and are also reimbursed under the Medicaid
programs. Revenues are recorded at rates established at or before the time
services are rendered. Revenue is recognized in the period services are
rendered.



ResCare HomeCare. Revenues are derived from state Medicaid programs, other
government agencies, commercial insurance companies, long-term care insurance
policies, as well as private pay customers. Revenues are recorded at rates
established at or before the time services are rendered. Revenue is recognized
in the period services are rendered.



Youth Services. Revenues include amounts reimbursable under cost reimbursement
contracts with the DOL for operating Job Corps centers for education and
training programs. The contracts provide reimbursement for direct facility and
program costs related to operations, allowable indirect costs for general and
administrative costs, plus a predetermined management fee, normally a
combination of fixed and performance-based. Final determination of amounts due
under the contracts is subject to audit and review by the applicable government
agencies. Additional revenues are reimbursed from various state government
agencies including Medicaid programs as we operate our foster care programs,
residential youth programs and school programs in multiple states. Revenue is
recognized in the period associated costs are incurred and services are
rendered.



Workforce Services. Revenues are derived primarily through contracts with local and state governments funded by federal agencies. Revenue is generated from contracts which contain various pricing arrangements, including: (1) cost reimbursable, (2) performance-based, (3) hybrid and (4) fixed price.




With cost reimbursable contracts, revenue consists of the direct costs
associated with functions that are specific to the contract, plus an indirect
cost percentage that is applied to the direct costs, plus a profit. Revenue is
recognized in the period the associated costs are incurred and services are
rendered.



Under a performance-based contract, revenue is generally recognized as earned
based upon the attainment of a unit performance measure times the fixed unit
price for that specific performance measure. Typically, there are many different
performance measures that are stipulated in the contract that must be tracked to
support the billing and revenue recognition. Revenue may be recognized prior to
achieving a benchmark as long as reliable measurements of progress-to-date
activity can be obtained, indicating that it is probable that the benchmark will
be achieved. This requires judgment in determining what is considered to be a
reliable measurement.



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Revenues for hybrid contracts are generally recognized based on the specific
contract language. The most common type of hybrid contract is "cost-plus," which
provide for the reimbursement of direct and indirect costs with profit tied to
meeting certain performance measures. Revenues for cost-plus contracts are
generally recognized in the period the associated costs are incurred with an
estimate made for the performance-based portion, as long as reliable
measurements of progress-to-date activity can be obtained, indicating that it is
probable that the benchmark will be achieved. This requires judgment in
determining what is considered to be a reliable measurement.



Revenues for fixed price contracts are generally recognized in the period services are rendered. Certain of our long-term fixed price contracts may contain performance-based measures that can increase or decrease our revenue. Revenue is deferred in cases where the fixed price is not determinable as a result of these provisions.




Laws and regulations governing the government programs and contracts are complex
and subject to interpretation. As a result, there is at least a reasonable
possibility that recorded estimates could change by a material amount in the
near term. For each operating segment, expenses are subject to examination by
agencies administering the contracts and services. We believe that adequate
provisions have been made for potential adjustments arising from such
examinations. There were no material changes in the application of our revenue
recognition policies during the year.



Results of Operations



                                               SUCCESSOR                        PREDECESSOR       COMBINED
                              Year Ended      Year Ended      Nov-16, 2010      Jan-1, 2010      Year Ended
                               Dec-31,         Dec-31,            thru             thru           Dec-31,
                                 2012            2011         Dec-31, 2010     Nov-15, 2010       2010 (4)
                                                         (Dollars In thousands)
Revenues:
Residential Services         $    885,633    $    853,474    $      104,302    $     724,536    $    828,838
ResCare HomeCare                  336,968         321,832            39,522          266,544         306,066
Youth Services                    180,552         185,143            22,541          158,688         181,229
Workforce Services (1)            195,956         218,886            28,711          217,833         246,544
Consolidated                 $  1,599,109    $  1,579,335    $      195,076

$ 1,367,601$ 1,562,677


Operating income(loss):
Residential Services (2)     $    122,062    $    103,749    $       14,662    $     (93,623 )  $    (78,961 )
ResCare HomeCare(2)                22,799          22,915             2,893          (47,391 )       (44,498 )
Youth Services (2)                 13,696          14,899             2,303           (1,835 )           468
Workforce Services (1)             12,117          18,352             2,917           13,160          16,077
Corporate (3)                     (61,515 )       (56,015 )          (6,721 )        (64,870 )       (71,591 )
Consolidated (2) (3)         $    109,159    $    103,900    $       16,054    $    (194,559 )  $   (178,505 )

Operating margin:
Residential Services (2)             13.8 %          12.2 %            14.1 %          (12.9 )%         (9.5 )%
ResCare HomeCare(2)                   6.8 %           7.1 %             7.3 %          (17.8 )%        (14.5 )%
Youth Services (2)                    7.6 %           8.0 %            10.2 %           (1.2 )%          0.3 %
Workforce Services (1)                6.2 %           8.4 %            10.2 %            6.0 %           6.5 %
Corporate (3)                        (3.8 )%         (3.5 )%           (3.4 )%          (4.7 )%         (4.6 )%
Consolidated (2) (3)                  6.8 %           6.6 %             8.2 %          (14.2 )%        (11.4 )%



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(1) Excludes results for international operations, which were reclassified to discontinued operations for all periods presented.




(2)     Operating income and margin were negatively impacted in the predecessor
period for 2010 due to a goodwill impairment charge of $250.2 million, of which
$174.1 million related to our Residential Services segment, $59.8 million
related to our ResCare HomeCare segment and $16.3 million related to our Youth
Services segment.



(3)     Represents corporate general and administrative expenses, as well as
other operating (income) and expenses related to the corporate office. Expenses
related to the Onex transaction were $12.2 million in the 2010 predecessor
period, $0.2 million in the 2010 successor period and $1.7 million in the 2011
period.



(4)     The combined year ended December 31, 2010 sets forth the combined
successor and predecessor revenues, operating income (loss), operating expenses
and operating margins for comparison purposes. Our comments in the discussion
below will be referring to the 2010 combined period.



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Consolidated


Consolidated revenues increased $19.8 million, or 1.3% from 2011 to 2012, while 2011 increased $16.7 million, or 1.1%, over 2010. Revenues are more fully described in the segment discussions below.




Consolidated operating income increased $5.3 million, or 5.1%, to $109.2 million
in 2012 compared to $103.9 million in 2011.  Operating margin increased to 6.8%
in 2012 compared to 6.6% in 2011.  Consolidated operating income increased
$282.4 million to $103.9 million in 2011 compared to an operating loss of $178.5
million in 2010. Operating margin increased from (11.4%) in 2010 to 6.6% in
2011. The 2010 operating loss and negative margin primarily resulted from a
$250.2 million goodwill impairment charge and costs of $12.4 million associated
with the Onex transaction, partially offset by 2010 acquisitions in the
Residential Services and ResCare HomeCare segments.



Net interest expense decreased $6.8 million in 2012, compared to 2011 due
primarily to lower interest rates as a result of the new senior secured credit
facility which closed in April 2012, which was partially offset by $1.0 million
of additional interest expense related to our vehicle capital leases, as
disclosed in Note 13.  Net interest expense increased $22.8 million in 2011,
compared to 2010, due primarily to higher average debt balances and an increase
in interest rates arising from the refinancing of debt in December 2010 in which
the annual interest rate payable on our outstanding unsecured senior notes
increased from 7.75% to 10.75%.



Our effective income tax rates were 38.6%, 32.4% and 23.1% in 2012, 2011 and
2010, respectively. The 2011 to 2012 change in our effective rate was negatively
impacted by the expiration of jobs tax credits after 2011, an increase in our
reserve for uncertain tax positions and an adjustment associated with the going
private transaction costs (2011). The 2010 to 2011 change in our effective rate
was positively (increased benefit) impacted by adjustments associated with the
going private transaction costs and nondeductible goodwill impairments (2010).



Residential Services



Residential Services revenues in 2012 of $885.6 million increased $32.2 million,
or 3.8%, over the 2011 revenues of $853.5 million due primarily to acquisition
growth of $25.3 million and organic growth of $6.9 million. Operating margin
increased to 13.8% in 2012 from 12.2% in 2011 due primarily to growth and
effective management of labor and controllable costs.



Residential Services revenues increased 3.0% in 2011 over 2010 due primarily to
a $14.5 million increase in our pharmacy business revenue, as well as $13.5
million in acquisition growth. Operating margin increased to 12.2% in 2011 from
(9.5%) in 2010 due primarily to a $174.1 million goodwill impairment charge in
2010 and approximately $0.7 million of higher share-based compensation expense
in 2010, as well as savings and efficiencies in 2011 from our reorganization
efforts.



ResCare HomeCare



ResCare HomeCare revenues in 2012 of $337.0 million increased $15.1 million, or
4.7%, over 2011 revenues of $321.8 million.  This increase was due primarily to
$23.8 million from acquisition related growth which was partially offset by rate
and service cuts of $3.5 million and a $5.1 million reduction in organic
business across several states.  Operating margin decreased from 7.1% in 2011 to
6.8% in 2012 due primarily to rate and service cuts of $1.1 million, $1.6
million reduction in organic business across several states and $0.8 million
increase in bad debt expense, which were partially offset by $2.9 million impact
from acquisitions and $0.4 million in lower marketing costs..



ResCare HomeCare revenues increased 5.3% in 2011 over 2010 due primarily to
$31.3 million from acquisition related growth which was partially offset by
reductions from rate, service hour levels and reimbursement system changes of
$15 million. Operating margin increased to 7.3% in 2011 from (14.0%) in 2010 due
primarily to a $59.8 million goodwill impairment charge in 2010, as well as $3.7
million and $1.3 million of higher bad debt and amortization expenses,
respectively, in 2010.



Youth Services



Youth Services revenues decreased $4.6 million, or 2.5%, from 2011 to 2012 due
primarily to Job Corps contract loss and contract spending reductions of $1.3
million and $1.2 million, respectively, as well as a $2.0 million reduction due
to lower



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census in our Residential Youth reporting unit. Operating margin decreased from
8.0% in 2011 to 7.6% in 2012 due primarily to lower margins in our Residential
Youth reporting unit due to the lower census.



Youth Services revenues increased 2.5% in 2011 over 2010 due primarily to
increases in the Job Corps business, which was partially offset by a reduction
in our Residential Youth reporting unit revenues driven by lower census.
Operating margin increased to 7.6% in 2011 from (0.7%) in 2010 due primarily to
goodwill impairment charges in 2010 of $12.0 million and $4.3 million in our
Residential Youth and Education reporting units, respectively. Exclusive of the
2010 impairment charge, the operating income and margins for 2011 decreased from
2010 levels due primarily to lower margins in our Residential Youth reporting
unit.



Workforce Services



Workforce Services revenues decreased $22.9 million, or 10.5% from 2011 to 2012
due primarily to net contract losses of $14.1 million, contract amendments of
$2.4 million and contract performance issues of $6.0 million. Operating margins
decreased to 6.2% in 2012 from 8.4% in 2011 due primarily to net contract losses
of $3.0 million, contract performance issues of $5.2 million, which were
partially offset by overhead cost reductions of $0.8 million.  In February 2012,
we were informed by the New York City Human Resources Administration that our
WeCARE contract had been awarded to another operator through the competitive bid
process. Our performance continued under a contract extension until
December 2012. Annual revenues for this contract are $28 million.



Workforce Services revenues decreased 11.7% from 2010 to 2011 due primarily to
the loss of contracts in Texas and the absence of the American Recovery and
Investment Act (ARRA) funding in 2011. Operating margins increased to 8.5% in
2011 from 6.7% in 2010 due primarily to the absence of lower margin services
funded under ARRA.



Corporate



Total Corporate operating expenses represent corporate general and
administrative expenses, as well as other operating income and expenses.  Total
corporate operating expenses increased $5.5 million, or 9.8%, from 2011 to 2012
due primarily to increases in insurance costs of $2.6 million, share-based
compensation of $1.5 million and depreciation expense of $2.9 million, which
were partially offset by lower Onex transaction costs of $1.7 million.



Total corporate operating expenses decreased $15.6 million, or 21.8%, from 2010
to 2011 due primarily to decreases in depreciation of $3.2 million, insurance
costs of $1.9 million and Onex transaction costs of $10.7 million. The decrease
in depreciation is due to the valuation of fixed assets as required through
purchase price accounting for the Onex transaction described in Note 2 to the
Notes to Consolidated Financial Statements.



Discontinued Operations



The discontinued operations relate to the international Workforce Services
segment's closure of the operations in Germany and the Netherlands in the first
quarter of 2011 and the sale of the United Kingdom operations on July 1, 2011.
Total exit costs of $0.8 million were recorded in the first quarter of 2011. For
the sale of the operations in the United Kingdom, we recorded a charge in other
expenses of $2.2 million in the second quarter of 2011 to adjust assets and
liabilities to their net realizable value.



We had no net income or loss from discontinued operations in 2012.  Net income
from discontinued operations was $11.2 million for 2011 compared to net losses
of $18.1 million in 2010. The 2011 net income includes tax benefits of $19.8
million, while the 2010 net loss includes a $13 million goodwill impairment
charge. During the third quarter of 2011, a U.S. tax election was made which
changed the tax status and triggered the recognition of tax basis associated
with international operations.



Financial Condition, Liquidity and Capital Resources




Total assets increased $59.7 million, or 6.0%, in 2012 over 2011. This increase
was primarily related to $32.5 million of additional goodwill and intangible
assets from 2012 acquisitions, $16.5 million of revisions for vehicle capital
leases described in Note 13  and $24.5 million of additional cash and cash
equivalents, which were partially offset by an $11.4 million reduction in
refundable income taxes.



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Cash and cash equivalents were $50.1 million at December 31, 2012, compared to
$25.7 million at December 31, 2011.  Cash provided by operating activities for
2012 was $80.3 million compared to $72.6 million for 2011 and $85.3 million for
2010. The increase from 2011 to 2012 was primarily due to $6.1 million of higher
depreciation due to the revision for vehicle capital leases described in Note
13.  The decrease from 2010 to 2011 was primarily due to the change in trade
accounts payable.



Days revenue in net accounts receivable were 49 days at December 31, 2012,
December 31, 2011 and December 31, 2010. Net accounts receivable at December 31,
2012 increased to $228.4 million, compared to $221.1 million at December 31,
2011 and $215.9 million at December 31, 2010. The increase in net accounts
receivable from 2011 to 2012 and from 2010 to 2011 is primarily due to
acquisition growth.



Our capital requirements relate primarily to our plans to expand through
selective acquisitions and the development of new and expansion of existing
facilities and programs, and our need for sufficient working capital for general
corporate purposes. Since budgetary pressures and other forces are expected to
limit increases in reimbursement rates and service levels, our ability to
continue to grow at the current rate depends in large part on our acquisition
activity and our success in building additional home care brands, billing excess
capacity in our Residential and Youth Services lines and making appropriate
investments in complementary lines of business. We have historically satisfied
our working capital requirements, capital expenditures and scheduled debt
payments from our operating cash flow and borrowing under our revolving credit
facility.



Capital expenditures were $15.5 million for the year ended December 31, 2012,
compared to $13.5 million for the year ended December 31, 2011. We invested
$33.1 million ($30.7 million in cash and $2.4 million in seller notes) on
acquisitions in 2012. For 2011, we invested $27.9 million ($23.1 million in cash
and $2.1 million in seller notes and $2.7 million in forgiven seller obligations
to company) on acquisitions. We invested $32.5 million ($28.4 million in cash
and $4.1 million in seller notes) on acquisitions in 2010.



Our financing activities for 2012 included proceeds of $175 million related to
the new term loan (the "Term Loan A") and the payoff of $172.1 million related
to the old term loan (the "Term Loan B"), both of which are discussed below.
During 2012, we have paid $4.0 million in debt issuance costs resulting from the
new senior secured credit facility (the "Credit Agreement") we entered into on
April 5, 2012.  We also had $6.0 million of payments on capital leases
obligations, which were primarily related to the vehicle capital leases
disclosed in Note 13.



Our financing activities for 2011 included payments of $38.9 million on long-term debt and capital lease obligations. We also received $1.4 million in funds contributed by co-investors.




As described further below, our financing activities for 2010 included a
refinancing in which our revolving credit facility was amended, adding a secured
term loan. We also redeemed substantially all of the existing senior notes and
issued new senior notes. In addition, the preferred shares were redeemed in
connection with the Onex transaction.



On December 22, 2010, we issued $200 million of 10.75% senior notes due
January 15, 2019 in a private placement to qualified institutional buyers under
the Securities Act of 1933. The 10.75% senior notes, which had an issue price of
100% of the principal amount, are unsecured obligations ranking equal to
existing and future debt and are subordinate to existing and future secured
debt. Proceeds were used to fund $120 million of our tendered 7.75% senior notes
due October 2013. The remaining $30 million of these senior notes that were not
repurchased were satisfied and discharged by delivering to the trustee amounts
sufficient to pay the applicable redemption price in January 2011. The 7.75%
senior notes were originally issued on October 3, 2005 for $150 million under a
private placement arrangement at an issue price of 99.261%. These securities
were unsecured obligations. In addition, proceeds from the $200 million issuance
of 10.75% senior notes were used to purchase outstanding shares of common stock
tendered by our shareholders and for general corporate purposes. The 10.75%
senior notes are jointly, severally, fully and unconditionally guaranteed by our
domestic subsidiaries.



On December 22, 2010, we amended our existing senior secured revolving credit
facility that originally had been scheduled to mature on July 28, 2013. The
aggregate amount available under that revolving credit facility was $275 million
until July 28, 2013, after which the revolving credit facility was to be
extended until December 22, 2015 for the extending revolving credit lenders. The
aggregate amount available under the extended revolving credit facility was $240
million. In addition, $175 million of additional borrowing capacity was
available for use to increase the revolving credit facility, or to increase
other certain senior secured indebtedness, subject to certain limitations and
conditions in our other debt agreements. The



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facility was to be used primarily for working capital purposes, letters of
credit required under our insurance programs and for acquisitions. The amended
and restated senior credit facility contains various financial covenants
relating to capital expenditures and rentals, and requires us to maintain
specified ratios with respect to interest coverage and leverage. The amendment
provided for the exclusion of charges incurred in connection with the resolution
of the matter described in Note 16 of the Notes to Consolidated Financial
Statements, as well as any non-cash impairment charges, in the calculation of
certain financial covenants. The amended and restated senior credit facility was
secured by a lien on all of our assets and, through secured guarantees, on our
domestic subsidiaries' assets.



On December 22, 2010, we issued a $170 million senior secured term loan (the
Term Loan B) due December 22, 2016, at a discounted price of 98% with realized
net proceeds of $166.6 million. Additional capacity of $175 million was
available for use to increase the Term Loan B, or to increase the revolving
credit facility, subject to certain limitations and conditions in our other debt
agreements. The Term Loan B was used primarily to repay the $159.6 million of
preferred equity plus accrued dividends from Purchaser, to various Onex
affiliates related to its acquisition and funding of tendered Company shares on
November 16, 2010. The Term Loan B contains various financial covenants similar
with respect to the amended and restated revolving credit facility. The Term
Loan B was an amortizing obligation, with principal payments of 1% of the
outstanding Term Loan B balance due annually. Pricing for the Term Loan B was
variable, at the London Interbank Offer Rate (LIBOR) plus 550 basis points.
LIBOR is defined as having a minimum rate of 1.75%. The Term Loan B was secured
by a lien on all of our assets and, through secured guarantees, on our domestic
subsidiaries' assets.



On April 5, 2012, we entered into a new senior secured credit facility (the
"Credit Agreement") in an aggregate principal amount of $375 million, which
replaced our 2010 senior secured revolving credit facility and the senior
secured term loan (the "Term Loan B"). The new Credit Agreement consists of a
new term loan (the "Term Loan A") in an aggregate principal amount of $175
million and a new revolving credit facility (the "Revolving Facility") in an
aggregate principal amount of $200 million. The Term Loan A and the Revolving
Facility each mature on April 5, 2017. The Term Loan A will amortize in an
aggregate annual amount equal to a percentage of the original principal amount
of the Term Loan A as follows: (i) 5% during each of the first two years after
funding, (ii) 10% during the third year after funding and (iii) 15% during each
of the final two years of the term. The balance of the Term Loan A is payable at
maturity. Pricing for the Term Loan A will be variable, at the London Interbank
Offer Rate (LIBOR) plus a spread, which is currently 275 basis points. LIBOR is
defined as having no minimum rate. The spread varies between 225 and 300 basis
points depending on our total leverage ratio.  The proceeds of the Term Loan A
were used to repay the Company's prior Term Loan B and pay certain related fees
and expenses. The proceeds of the Revolving Facility may be used for working
capital and for other general corporate purposes permitted under the Credit
Agreement, including certain acquisitions and investments. The Credit Agreement
also provides that, upon satisfaction of certain conditions, the Company may
increase the aggregate principal amount of loans outstanding thereunder by up to
$175 million, subject to receipt of additional lending commitments for such
loans. The loans and other obligations under the Credit Agreement are
(i) guaranteed by Onex Rescare Holdings Corp. ("Holdings") and substantially all
of its subsidiaries (subject to certain exceptions and limitations) and
(ii) secured by substantially all of the assets of the Company, Holdings and
substantially all of its subsidiaries (subject to certain exceptions and
limitations). The Credit Agreement contains various financial covenants relating
to capital expenditures and rentals, and requires us to maintain specific ratios
with respect to interest coverage and leverage. The new agreement continues to
provide for the exclusion of charges incurred with the resolution of certain
legal proceedings provided in Note 16 to Notes to the Consolidated Financial
Statements, as well as any non-cash impairment charges, in the calculation of
certain financial covenants.



We recorded a loss on extinguishment of debt of $7.1 million in the three months
ended June 30, 2012 associated with termination of the 2010 senior secured
revolving credit facility and the Term Loan B prepayment. Loss on extinguishment
of debt consists principally of write-offs of unamortized deferred debt issuance
costs and original issue discount.



Our obligations under capital leases are $17.7 million as of  December 31, 2012,
due primarily to vehicle capital leases which are disclosed further in Note 13.
The current portion of these lease obligations was $6.0 million.



As of December 31, 2012, we had irrevocable standby letters of credit in the
principal amount of $59 million issued primarily in connection with our
insurance programs. As of December 31, 2012, we had $141 million available under
the amended and restated revolving credit facility, with no outstanding balance.
Outstanding balances bear interest at 2.75% over the LIBOR at our option. As of
December 31, 2012, the weighted average interest rate was not applicable as
there were no outstanding borrowings. Letters of credit had a borrowing rate of
2.88% as of December 31, 2012. The commitment fee on the unused balance was
0.50%. The margin over LIBOR and the commitment fee is determined quarterly
based on our leverage ratio, as defined by the revolving credit facility.



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Our credit facility contains a total leverage ratio and an interest coverage
ratio. As of December 31, 2012, the maximum leverage ratio allowed under the
facility was 4.50. That maximum allowable leverage steps down to 4.25 at
March 31, 2014, to 4.00 at September 30, 2015 and to 3.75 at March 31, 2016 and
the end of each fiscal quarter thereafter. As of December 31, 2012, the minimum
interest coverage ratio allowed under the facility was 2.25. That minimum
allowable interest coverage steps up to 2.5 at March 31, 2014, to 2.75 at
September 30, 2015 and to 3.00 at December 31, 2016 and the end of each fiscal
quarter thereafter. As of December 31, 2012, our leverage ratio was 2.2 and our
interest coverage ratio was 4.7. We believe we will continue to be in compliance
with our debt covenants over the next twelve months. Our ability to achieve the
thresholds provided for in the financial covenants largely depends upon the
maintenance of continued profitability and/or reductions of amounts borrowed
under the facility, and continued cash collections.



Operating funding sources for 2012 were approximately 66% through Medicaid
reimbursement, 8% from the DOL and 26% from other payors. We believe our sources
of funds through operations and available through our credit facility will be
sufficient to meet our working capital, planned capital expenditure and
scheduled debt repayment requirements for the next twelve months.



As described in Item 3. Legal Proceedings on Page 31 of this report, a jury
returned a verdict of approximately $53.9 million in damages against the
Company, consisting of approximately $4.7 million in compensatory damages and
$49.2 million in punitive damages, which was entered as a judgment in
December 2009. On February 19, 2010, the New Mexico trial court judge ruled on
post-trial motions reducing the jury award to $15.5 million, which consists of
approximately $10.8 million in punitive damages and $4.7 million in compensatory
damages. We believe the parent company is not liable for the actions of its
subsidiary (Res-Care New Mexico, Inc.) or its employees and that both the
compensatory and punitive amounts awarded are excessive and contrary to United
States Supreme Court and New Mexico Supreme Court precedent which would warrant
a new trial or, in the alternative, would reduce the judgment amount. We, as
well as the plaintiffs, have appealed. Oral arguments before the Court of
Appeals were held on November 15, 2011, and we anticipate a ruling from the
Court of Appeals in the near future.  We will continue to defend this matter
vigorously. Although we have made provisions in our condensed consolidated
financial statements for this self-insured matter, the amount of our legal
reserve is less than the original amount of the damages awarded, plus accrued
interest. The ultimate outcome of this matter could have a material adverse
effect on our financial condition, results of operations or cash flows.



Contractual Obligations and Commitments




Information concerning our contractual obligations and commercial commitments
follows (in thousands):



                                                     Payments Due by Period
                                                Twelve Months Ending December 31,
                                                                                       2018 and
Contractual Obligations           Total        2013       2014-2015     2016-2017      Thereafter
Long-term Debt                  $ 373,115    $  14,695    $   35,748    $  122,672    $    200,000
Capital Lease Obligations          17,684        6,052         5,841         5,791               †
Operating Leases                  197,855       59,837        85,098        38,464          14,456
Fixed interest payments on
Long-term Debt and Capital
Lease Obligations(1)              132,035       21,793        43,501        43,448          23,293
Total Contractual
Obligations(2)                  $ 720,689    $ 102,377    $  170,188    $  210,375    $    237,749



--------------------------------------------------------------------------------

(1)   Excludes any interest payments on our variable rate debt.


(2) This amount excludes $2.2 million of unrecognized tax benefits, as we are unable to reasonably estimate the timing of these cash flows.

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                                                       Amount of

Commitments Expiring per Period

                                  Total                    Twelve Months Ending December 31,
                                Amounts                                                          2018 and
Other Commercial Commitments    Committed           2013           
2014-2015      2016-2017    Thereafter
Standby Letters-of-Credit      $    59,099   $           59,099              †              †             †
Surety Bonds                   $    30,130   $           30,081     $       30     $       19   $         -



We had no significant off-balance sheet transactions or interests in 2012.

New Accounting Pronouncements Not Yet Adopted

See Note 1 to the Notes to Consolidated Financial Statements.

Wordcount: 8162



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