CAPELLA HEALTHCARE, INC. – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations

 The following discussion and analysis of financial condition and results of operations should be read in conjunction with (i) our condensed consolidated financial statements and accompany notes included elsewhere in this report and (ii) our consolidated financial statements and accompany notes and discussion and analysis of our financial condition and results of operations include in our Annual Report on Form 10-K for the year ended December 31, 2011 (the "2011 Annual Report on Form 10-K"). We intend for this discussion to provide information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from period to period, and the primary factors that accounted for those changes. Unless the context requires otherwise, Capella Healthcare, Inc. and its subsidiaries are referred to in this section as "Capella," the "Company," "we," "us" and "our."  This report and other materials the Company has filed or may file with the Securities and Exchange Commission, as well as information included in oral statements or other written statements made, or to be made, by senior management of the Company, contain, or will contain, disclosures that are "forward-looking statements," which are intended to be covered by the safe harbors created by federal securities laws. Forward-looking statements are those statements that are based upon management's current plans and expectations as opposed to historical and current facts and are often identified in this discussion by use of words, including but not limited to, "may," "believe," "will," "should," "expect," "estimate," "anticipate," "intend," and "plan." In this report, for example, we make forward-looking statements, including statements discussing our expectations about: our business strategy and operating philosophy, including efforts to provide high quality patient care and service excellence, investments in technology, recruitment and retention of physicians and nurses, expansion of service lines, and growth strategies for existing markets and for potential acquisitions; future financial performance and condition; industry and general economic trends, including the impact of the current economic environment, changes to reimbursement, patient volumes and related revenue; our compliance with new and existing laws and regulations, as well as costs and benefits associated with compliance; effects of competition and consolidation on our hospitals' markets; costs of providing care to our patients; the impact of bad debt expenses; anticipated revenue from Medicare and Medicaid electronic health records ("EHR") incentive payments; future liquidity and capital resources; existing and future debt; and the effects of inflation and changing prices.  These statements are based upon estimates and assumptions made by Capella's management that, although believed to be reasonable, are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected. There are several factors, some beyond our control, that could cause results to differ significantly from our expectations. Any factor described in this report and the 2011 Annual Report on Form 10-K could by itself, or together with one or more factors, adversely affect our business, results of operations and/or financial condition. There may be factors not described in this report or the 2011 Annual Report on Form 10-K that could also cause results to differ from our expectations. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our business or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied by any forward-looking statements. Except as required by law, we undertake no obligation to update publicly or to revise any forward-looking statements, whether as a result of new information, future events or otherwise.                                           22 

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

Table of Contents

EXECUTIVE OVERVIEW

  We are a provider of general and specialized acute care, outpatient and other medically necessary services in primarily non-urban communities. We provide these services through a portfolio of acute care hospitals and complementary outpatient facilities and clinics in seven states. As of June 30, 2012, on a consolidated basis, we operated 12 acute care hospitals (eleven of which we own and one of which we lease pursuant to a long-term lease) comprised of 1,529 licensed beds, excluding assets held for sale and included in discontinued operations. We are focused on enabling our facilities to maximize their potential to deliver high quality care in a patient-friendly environment. We invest our financial and operational resources to establish and support services that meet the needs of our communities. We seek to achieve our objectives by providing exceptional quality care to our patients, establishing strong local management teams, physician leadership groups and hospital boards, developing deep physician and employee relationships and working closely with our communities.  Effective April 30, 2012, we entered into a joint venture agreement with St. Thomas Health ("St. Thomas") in Tennessee. In exchange for a 6.49% minority ownership at our four Tennessee hospitals, St. Thomas contributed approximately $0.5 million in equipment. St. Thomas will co-brand our Tennessee hospitals as well as clinically support certain services and future growth opportunities. Our partnership with St. Thomas will be the exclusive development vehicle for a 60-county region in middle Tennessee and southern Kentucky.  Effective July 1, 2012, we executed a long-term lease agreement for Muskogee Community Hospital ("MCH"), a 45-licensed bed facility located in Muskogee, Oklahoma. As part of the transaction, we executed an asset purchase agreement in which we acquired specific components of net working capital, as defined, and certain intangible assets for $19.4 million. Of the purchase price, $8.4 million is in the form of a promissory note payable in fifteen equal installments beginning July 2013. We also executed a master lease agreement for the real property and certain equipment used in the operation of MCH. Under the master lease agreement, we will pay a monthly lease payment of $565,000 per month, which payment will be adjusted for inflation beginning in the third year of the lease. We have the option to purchase the leased real property and equipment at fair value on July 20, 2014 and again after the expiration of the initial lease term (15 years). We also have an option to renew the lease for an additional 15 years, after which we could also exercise a purchase option for fair value.  

Significant Industry Trends

  The following sections discuss recent trends that we believe are significant factors in our current and/or future operating results and cash flows. Certain of these trends apply to the entire hospital industry, while others may apply to us more specifically. These trends could be short-term in nature or could require long-term attention and resources. While these trends may involve certain factors that are outside of our control, the extent to which these trends affect our hospitals and our ability to manage the impact of these trends play vital roles in our current and future success. In many cases, we are unable to predict what impact, if any, these trends will have on us.  

Impact of Healthcare Reform

  The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the "Affordable Care Act") were signed into law on March 23, 2010 and March 30, 2010, respectively. The Affordable Care Act dramatically alters the United States healthcare system and is intended to decrease the number of uninsured Americans and reduce the overall cost of healthcare. The Affordable Care Act attempts to achieve these goals by, among other things, requiring most Americans to obtain health insurance, expanding Medicare and Medicaid eligibility, reducing Medicare disproportionate share ("DSH") payments and Medicaid payments to providers, expanding the Medicare program's use of value-based purchasing programs, tying hospital payments to the satisfaction of certain quality criteria, bundling payments to hospitals and other providers, and instituting certain private health insurance reforms. Although a majority of the measures contained in the Affordable Care Act do not take effect until 2014, certain of the reductions in Medicare spending, such as negative adjustments to the Medicare hospital inpatient and outpatient prospective payment system market basket updates and the incorporation of productivity adjustments to the Medicare program's annual inflation updates, became effective in 2010 and 2011 or will be implemented in 2012. On June 28, 2012, the United States Supreme Court upheld the "individual mandate" provision of the Affordable Care Act that generally requires all individuals to obtain healthcare insurance or pay a penalty. However, the Supreme Court also held that the provision of the Affordable Care Act that authorized the Secretary of Health and Human Services to penalize any state that chooses not to participate in the expansion of the Medicaid program by removing all of the states existing Medicaid funding was unconstitutional. In response to the ruling, a number of states have indicated that they will not expand their Medicaid programs, which would result in some low-income persons in those states not receiving coverage through the Affordable Care Act. Additionally, several bills have been and will likely continue to be introduced in Congress to repeal or amend all or significant provisions of the Affordable Care Act. It is difficult to predict the full impact of the Affordable Care Act on our revenue and results of operations due to its complexity, lack of implementing regulations and interpretive guidance, gradual and potentially delayed implementation, and possible repeal and/or amendment, as well as our inability to foresee how individuals and businesses will respond to the choices afforded them by the Affordable Care Act.                                           23 

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

Table of Contents

Adoption of Electronic Health Records

  The Health Information Technology for Economic and Clinical Health Act (the "HITECH Act"), which was enacted into law on February 17, 2009 as part of the American Recovery and Reinvestment Act of 2009 (the "ARRA"), includes provisions designed to increase the use of computerized physician order entry at hospitals and the use of EHR by both physicians and hospitals. We intend to comply with the EHR meaningful use requirements of the HITECH Act in time to qualify for the maximum available Medicare and Medicaid incentive payments. We will recognize income related to the Medicare or Medicaid incentive payments as we are able to satisfy all appropriate contingencies, which includes completing attestations as to our eligible hospitals adopting, implementing or demonstrating meaningful use of certified EHR technology, and additionally for Medicare incentive payments, deferring income until the related Medicare fiscal year has passed and cost report information used to determine the final amount of reimbursement is known. Our compliance has resulted in significant costs including professional services focused on successfully designing and implementing our EHR solutions along with costs associated with the hardware and software components of the project. We currently estimate that at a minimum the total costs incurred to comply with the HITECH Act will be recovered through EHR incentive payments. During the three and six months ended June 30, 2012, we recognized $0.4 million and $1.2 million, respectively, of other income related to estimated EHR incentive payments.  

Medicare and Medicaid Reimbursement

Medicare payment methodologies have been, and are expected to be, significantly revised based on cost containment and policy considerations. CMS has already begun to implement some of the Medicare reimbursement reductions required by the Affordable Care Act. These revisions will likely be more frequent and significant as more of the Affordable Care Act's changes and cost-saving measures become effective.  On May 11, 2012, CMS published its hospital inpatient prospective payment system ("IPPS") proposed rule for federal fiscal year ("FFY") 2013, which begins on October 1, 2012. Under the proposed rule, hospitals that successfully report the quality measures for the Hospital Inpatient Quality Reporting Program will receive a 2.3% rate increase and those that do not will receive a 0.3% rate increase in FFY 2013. The update is based on a proposed hospital market basket increase of 3.0%, which is reduced by a multi-factor productivity adjustment of 0.8% and an additional 0.1% as required by the Affordable Care Act and is increased by a documentation and coding adjustment of 0.2%.  On July 6, 2012, CMS issued the Medicare outpatient prospective payment system ("OPPS") proposed rule for calendar year ("CY") 2013. Under the proposed rule, hospitals that meet the reporting requirements of the Medicare Hospital Outpatient Quality Reporting Program will receive a rate increase of 2.1% in CY 2013 and those that do not will receive a 0.1% rate increase. The increase is based on the projected IPPS market basket percentage increase described above.  On July 6, 2012, CMS also issued a proposed rule to update Medicare ambulatory surgery center ("ASC") payment rates for CY 2013. The proposed rule provides for a 1.3% increase to ASC payment rates, which is comprised of a 2.2% increase in the consumer price index for urban consumers, less a multifactor productivity adjustment of 0.9%, as required by the Affordable Care Act.  In addition, many states in which we operate are facing budgetary challenges and have adopted, or may be considering, legislation that is intended to control or reduce Medicaid expenditures, enroll Medicaid recipients in managed care programs, and/or impose additional taxes on hospitals to help finance or expand their Medicaid programs. Budget cuts, federal or state legislation, or other changes in the administration or interpretation of government health programs by government agencies or contracted managed care organizations could have a material adverse effect on our financial position and results of operations.  

Pay for Performance and Quality Related Reimbursement

  Many payors, including Medicare and several large managed care organizations, currently require hospital providers to report certain quality measures in order to receive the full amount of payment increases that were awarded automatically in the past. For FFY 2012, Medicare expanded the number of quality measures to be reported to 72, compared to 55 during FFY 2011. In addition, the Medicare 2013 Proposed Inpatient Prospective Payment System rule continues the focus on tying Medicare payments to value-based and quality-driven efforts. Medicare proposes to create a more streamlined set of 59 quality measures for FFY 2015 and 60 for FFY 2016. The proposed rule also would implement payment provisions related to CMS's effort to reduce the number of hospital readmissions. Many large managed care organizations have developed quality measurement criteria that are similar to or even more stringent than these Medicare requirements. While current Medicare guidelines and contracts with most managed care payors provide for reimbursement based upon the reporting of quality measures, we believe significant payors will utilize the quality measures to determine reimbursement rates for hospital services. We have developed key processes and infrastructure that we believe enable us to meet or exceed the current established quality guidelines. We plan to continue to invest in quality initiatives and technology in order to meet the quality demands of our payors in the future.  Physician Alignment  Our ability to attract skilled physicians to our hospitals is critical to our success. Coordination of care and alignment of care strategies between hospitals and physicians will become more critical as reimbursement becomes more episode-based. We have                                           24 

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

Table of Contents

  physician recruitment goals with primary emphasis on recruiting physicians specializing in family practice, internal medicine, general surgery, oncology, obstetrics and gynecology, cardiology, neurology, orthopedics, urology, otolaryngology and inpatient hospital care (hospitalists). To provide our patients access to the appropriate physician resources, we actively recruit physicians to the communities served by our hospitals through employment agreements, relocation agreements or physician practice acquisitions. We seek to invest in the infrastructure necessary to coordinate our physician alignment strategies and manage our physician operations. The costs associated with recruiting, integrating and managing a large number of new physicians will have a negative impact on our operating results and cash flows in the near term. However, we expect to realize improved clinical quality and service expansion capabilities from this initiative that will impact our operating results positively over the long term.  

HIPAA

  In January 2009, CMS published its 10th revision of International Statistical Classification of Diseases ("ICD-10"), which establishes an updated code set to be used for classifying health care diagnoses and procedures. Entities covered under HIPAA will be required to use the ICD-10, which contains significantly more diagnostic and procedural codes than the existing ICD-9 coding system. Because of the greater number of codes, the coding for the services provided in our facilities will require much greater specificity. Implementation of ICD-10 will require a significant investment in technology and training. We may experience delays in reimbursement while our facilities and the payors from which we seek reimbursement make the transition to ICD-10. HIPAA currently requires implementation of ICD-10 to be achieved by October 1, 2013. However, on April 9, 2012, CMS released a proposed rule that would delay the effective date of the ICD-10 transition to October 1, 2014. If any of our facilities fail to implement the new coding system by the deadline, the affected facility will not be paid for services. We are not able to predict the timeframe or the overall financial impact of the transition to ICD-10.  

Uncompensated Care

  Like others in the hospital industry, we continue to experience high levels of uncompensated care, including charity care and bad debts. These elevated levels are driven by the number of uninsured and under-insured patients seeking care at our hospitals and increasing healthcare costs and other factors beyond our control, such as increases in the amount of co-payments and deductibles as employers continue to pass more of these costs on to their employees. In addition, as a result of high unemployment and its continued impact on the economy, we believe that our hospitals may continue to experience high levels of and growth in bad debts and charity care. For the three months ended June 30, 2012, our same-facility uncompensated care as a percentage of revenue, which includes the impact of uninsured discounts and charity care, was 23.3%, compared to 20.3% during the same prior year period. For the six months ended June 30, 2012, our same-facility uncompensated care as a percentage of revenue was 21.7%, compared to 19.8% during the same prior year period.  

We anticipate that if we experience further growth in uninsured volume and revenue, including increased acuity levels and continued increases in co-payments and deductibles for insured patients, our uncompensated care will increase and our results of operations could be affected adversely.

                                       25

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

Table of Contents

  Similar to others in the hospital industry, we have a significant amount of self-pay receivables (including co-payments and deductibles from insured patients), and collecting these receivables may become more difficult if economic conditions worsen. The following table provides a summary of our accounts receivable payor class mix as of December 31, 2011 and June 30, 2012:      December 31, 2011         0-90 Days        91-180 Days        Over 180 Days        Total   Medicare(1)                     26.4 %              0.7 %                0.4 %       27.5 %   Medicaid(1)                      6.2                0.7                  0.6          7.5   Managed Care and Other          18.9                1.8                  1.1         21.8   Self-Pay(2)                     10.6                9.6                 23.0         43.2    Total                           62.1 %             12.8 %               25.1 %      100.0 %        June 30, 2012             0-90 Days        91-180 Days        Over 180 Days        Total   Medicare(1)                     27.1 %              0.8 %                0.7 %       28.6 %   Medicaid(1)                      6.3                0.7                  0.6          7.6   Managed Care and Other          18.9                1.9                  1.2         22.0   Self-Pay(2)                     11.1                9.9                 20.8         41.8    Total                           63.4 %             13.3 %               23.3 %      100.0 %     

(1) Includes receivables under managed Medicare or managed Medicaid programs.

(2) Includes both uninsured as well as estimated co-payment and deductible

amounts from insured patients.

   The volume of self-pay accounts receivable remains sensitive to a combination of factors including; price increases, acuity levels, higher insured patient co-payments and deductibles, economic factors and the increased difficulties of patients who do not qualify for charity care programs. We have implemented a number of practices to mitigate bad debt expense and increase collections including; increased focus on upfront cash collections, incentive plans for our hospitals' financial counselors and registration personnel, increased focus on payment plans with non-emergent patients, among other efforts. Despite these practices, we believe bad debts will remain a significant risk for us as well as the rest of the hospital industry.  

Impact of Current Economic Environment

  Similar to others in the industry, we continue to experience volume pressure based on reduced demand for inpatient healthcare services and increased competition for patients. The recent economic downturn impacted healthcare and many other industries negatively. While many healthcare services are considered non-discretionary in nature, certain services including elective procedures and other non-emergent services may be deferred or canceled by patients when they are suffering personal financial hardship or have a negative outlook on the general economy. Continually high unemployment results in high numbers of uninsured patients, and employer cost reduction programs may result in a higher level of co-pays and deductible limits for patients. Governmental payors and managed care payors may reduce reimbursement paid to hospitals and other healthcare providers to address economic and regulatory pressures. We believe a more severe economic downturn could have an adverse impact on our revenue whether in the form of payor mix shifts from managed care to uninsured or Medicaid, additional charity care, lower patient volumes, lower collection rates of patient co-pay and deductible balances or a combination of such factors.  

Revenue/Volume Trends

  Revenue for the three months ended June 30, 2012, increased 8.3% to $184.3 million, compared to $170.1 million in the same prior year period. Revenue for the six months ended June 30, 2012, increased 11.9% to $381.2 million, compared to $340.6 million in the same prior year period. Our revenue depends upon inpatient occupancy levels, outpatient procedures, ancillary services and therapy programs as well as our ability to negotiate appropriate payment rates for services with third-party payors and our ability to achieve quality metrics to maximize payment from our payors.  

Revenue

  The primary sources of our revenue before the provision for bad debts include various managed care payors, including managed Medicare and managed Medicaid programs, the traditional Medicare program, various state Medicaid programs, commercial health plans and patients themselves. We are typically paid less than our gross charges, regardless of the payor source, and report revenue before the provision for bad debts to reflect contractual adjustments and other allowances required by managed care providers and federal and state agencies. Our revenue for the six months ended June 30, 2012 was impacted by the following items.  Our Oklahoma facilities participate in the State of Oklahoma's Supplemental Hospital Offset Payment Program, or SHOPP. On January 17, 2012, CMS approved SHOPP with an effective date of July 1, 2011. The legislation related to SHOPP was signed into law                                           26 

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

Table of Contents

  by the Governor of Oklahoma on May 13, 2011, but subject to approval by CMS. SHOPP, with an initial term of three fiscal years, allows for the establishment of a hospital provider fee assessment on all non-exempt Oklahoma hospitals. The state plans to use revenue from this assessment to maintain hospital reimbursement from the SoonerCare Medicaid program and to secure additional matching Medicaid funds from the federal government. Since CMS approval of the program did not occur until, January 17, 2012, we recorded twelve months of revenue and expenses associated with SHOPP during the six months ended June 30, 2012. CMS approval was necessary to meet the revenue recognition criterion that persuasive evidence of an arrangement exists, pursuant to generally accepted accounting principles.  We also recorded revenue and expenses related to the rural floor provision settlement litigation during the six months ended June 30, 2012. The Balanced Budget Act of 1997, or BBA, established a rural floor provision, by which an urban hospital's wage index within a particular state could not be lower than the statewide rural wage index. The wage index reflects the relative hospital wage level compared to the applicable average hospital wage level. The BBA also made this provision budget neutral, meaning that total wage index payments nationwide before and after the implementation of this provision must remain the same. To accomplish this, CMS was required to increase the wage index for all affected urban hospitals, and to then calculate a rural floor budget neutrality adjustment to reduce other wage indexes in order to maintain the same level of payments. Litigation had been pending for several years contending that CMS miscalculated the neutrality adjustment from 1999 through 2011. The litigation, in which we and several other hospital companies participated, has now been settled with a settlement agreement signed on April 5, 2012. As a result of the agreement, we recorded revenue and expenses related to the rural floor provision settlement during the six months ended June 30, 2012.  

During the six months ended June 30, 2012, we recorded revenue and expenses related to the prior period SHOPP and rural floor provision settlement of $13.6 million and $5.1 million, respectively.

  Admissions increased 4.6% and 5.5%, respectively, for the three and six months ended June 30, 2012, compared to the same prior year periods. Adjusted admissions increased 11.6% and 11.8%, respectively, for the three and six months ended June 30, 2012, compared to the same prior year periods. On a same-facility basis, admissions decreased 0.1% and increased 0.6% for the three and six months ended June 30, 2012, compared to the same prior year periods, while adjusted admission increased 5.9% and 6.1%, respectively, for the three and six months ended June 30, 2012, compared to the same prior year periods.  On a same-facility basis, our inpatient volume was pressured by a decline in inpatient surgeries of 6.0% and 6.7%, respectively, for the three and six months ended June 30, 2012, compared to the same prior year periods. Also, our hospital volumes were impacted negatively, in part, by the impact of continued high unemployment and patient decisions to defer or cancel elective procedures, general primary care and other non-emergent healthcare procedures, all resulting from the impact of the current economic environment. We experienced an increase in same-facility outpatient surgeries of 3.1% and 9.8%, respectively, for the three and six months ended June 30, 2012, compared to the same prior year periods. The increase in outpatient surgeries is due, in part, to the addition of a surgery center at one of our hospitals and the continuing industry shift from an inpatient hospital setting to a more outpatient focused healthcare environment.  We believe our volumes over the long-term will grow as a result of our business strategies, including the continued investment in our physician alignment strategy, increased efforts to promote our commitment to patient care excellence and patient satisfaction, and the general aging of the population.                                           27

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

Table of Contents

  The following table sets forth the percentages of revenue after the provision for bad debts by payor for the three and six months ended June 30, 2011 and 2012:                                           Three Months                Six Months                                       Ended June 30,             Ended June 30,                                     2011        2012(2)        2011        2012(2)           Medicare(1)                 44.3 %        44.7 %       44.0 %        44.5           Medicaid(1)                 13.7          16.1         13.7          17.4           Managed Care and Other      41.5          38.5         41.3          36.8           Self-pay                     0.5           0.7          1.0           1.3            Total                      100.0 %       100.0 %      100.0 %       100.0 %     

(1) Includes revenue received under managed Medicare or managed Medicaid

programs.

(2) Our percentage of revenue by payor for the three months ended June 30, 2012

has been impacted by SHOPP revenue recorded. Our percentages for the six

months ended June 30, 2012 have been impacted by the rural floor provision

settlement and prior period SHOPP described previously.

   Revenue per adjusted admission decreased 2.9% and increased 0.1%, respectively, for the three and six months ended June 30, 2012, compared to the same prior year periods. Same-facility revenue per adjusted admission decreased 1.6% and increased 1.7%, respectively, for the three and six months ended June 30, 2012, compared to the same prior year periods. Our revenue per adjusted admission for the six months ended June 30, 2012 was impacted by the revenue recognized from SHOPP and rural floor provision settlement discussed previously. Excluding the revenue related to SHOPP and the rural floor settlement, our same-facility revenue per adjusted admission declined 2.1% for the six months ended June 30, 2012, compared to the six months ended June 30, 2011. The decrease in our same-facility revenue per adjusted admission for the three and six months ended June 30, 2012 compared to the same prior year periods is primarily due to an increase in uncompensated care and the impact of service line rotation as we saw a higher number of lower reimbursement cases such as behavioral and urology combined with a decline of higher reimbursement cases such as orthopedics. We also have experienced moderating rates of pricing growth resulting from the impact of high unemployment and other industry pressures, including elevated levels of Medicaid and managed Medicaid, which typically result in lower reimbursement on a per adjusted admission basis. Also, the impact of state budgetary issues on Medicaid funding has resulted in some rate cuts to providers, which has caused a decline in pricing related to Medicaid and managed Medicaid volumes. As states continue to work through budgetary issues, any additional cuts to Medicaid funding would negatively impact our future pricing and earnings.  See "Item 1 - Business - Sources of Revenue" and "Item 1 - Business - Government Regulation and Other Factors", included in our 2011 Annual Report on Form 10-K, for a description of the types of payments we receive for services provided to patients enrolled in the traditional Medicare plan, managed Medicare plans, Medicaid plans, managed Medicaid plans and managed care plans. In those sections, we also discussed the unique reimbursement features of the traditional Medicare plan, including the annual Medicare regulatory updates published by CMS that impact reimbursement rates for services provided under the plan. The future potential impact to reimbursement for certain of these payors under the Affordable Care Act is also addressed in the 2011 Annual Report on Form 10-K.  

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts and related disclosures. We consider an accounting estimate to be critical if:

• it requires assumptions to be made that were uncertain at the time the

        estimate was made; and    

• changes in the estimate or different estimates that could have been made

could have a material impact on our consolidated results of operations or

financial condition.

   Our critical accounting estimates are more fully described in the 2011 Annual Report on Form 10-K. There have been no changes in the nature of our critical accounting policies or the application of those policies since December 31, 2011.                                           28 

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

Table of Contents

RESULTS OF OPERATIONS

The following table presents summaries of results of operations for the three and six months ended June 30, 2011 and 2012, respectively.

                                                         Three Months Ended                 Three Months Ended                 Six Months Ended                 Six Months Ended                                                         June 30, 2011                      June 30, 2012                     June 30, 2011                    June 30, 2012                                                   Amount         

Percentage Amount Percentage Amount Percentage Amount Percentage Revenue before provision for bad debts

           $   189.7              111.5 %     $   208.2              113.0 %     $  377.1             110.7 %     $  426.4             111.9 % Provision for bad debts                              (19.6 )            (11.5 )%        (23.9 )            (13.0 )%       (36.5 )           (10.7 )%       (45.2 )           (11.9 )%  Revenue                                              170.1              100.0 %         184.3              100.0 %        340.6             100.0 %        381.2             100.0 %  Costs and expenses: Salaries and benefits                                 82.1               48.3 %          85.8               46.6 %        165.8              48.7 %        176.6              46.3 % Supplies                                              28.0               16.5 %          28.7               15.6 %         55.7              16.4 %         57.8              15.2 % Other operating expenses                              36.2               21.2 %          46.4               25.2 %         72.2              21.2 %         93.3              24.5 % Other income                                          (1.9 )             (1.1 )%         (0.4 )             (0.2 )%        (1.9 )            (0.6 )%        (1.2 )            (0.3 )% Management fees                                        0.1                 -              0.1                 -             0.1                -             0.1                - Depreciation and amortization                          8.0                4.7 %           8.8                4.7 %         16.4               4.8 %         17.6               4.6 % Interest, net                                         12.7                7.5 %          12.9                7.0 %         25.4               7.5 %         25.9               6.8 %  Total costs and expense                              165.2               97.1 %         182.3               98.9 %        333.7              98.0 %        370.1              97.1 %  Income from continuing operations before income taxes                                           4.9                2.9 %           2.0                1.1 %          6.9               2.0 %         11.1               2.9 % Income taxes                                           0.9                0.5 %           0.9                0.5 %          1.8               0.5 %          1.8               0.5 %  Income from continuing operations                      4.0                2.4 %           1.1                0.6 %          5.1               1.5 %          9.3               2.4 % Loss from discontinued operations, net of taxes                                                 (0.3 )             (0.2 )%         (2.4 )             (1.3 )%        (0.4 )            (0.1 )%        (5.7 )            (1.5 )%  Net income (loss)                                $     3.7                2.2 %     $    (1.3 )             (0.7 )%    $    4.7               1.4 %     $    3.6               0.9 %  Less: Net income attributable to non-controlling interests                              0.4                0.2 %            -                  -             1.0               0.3 %          0.2                -  Net income (loss) attributable to Capella Healthcare, Inc.                                 $     3.3                2.0 %     $    (1.3 )             (0.7 )%    $    3.7               1.1 %     $    3.4               0.9 %                                             29 

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

Table of Contents

  The following table sets forth certain unaudited operating data for each of the periods presented.                                               Three Months Ended June 30,              Six Months Ended June 30,                                             2011                 2012               2011                2012 Continuing operations:(1)  Admissions(2)                                  10,661               11,156            21,559               22,738 Adjusted admissions(3)                         21,742               24,268            43,372               48,482

Revenue per adjusted admission $ 7,824 $ 7,594

    $      7,853       $        7,863 Inpatient surgeries                             2,550                2,483             5,036                4,891 Outpatient surgeries(4)                         5,323                5,659            10,098               11,424 Emergency room visits(5)                       49,767               58,636            98,746              115,466  Same-facility:(6)  Admissions(2)                                  10,661               10,646            21,559               21,694 Adjusted admissions(3)                         21,742               23,029            43,372               46,020

Revenue per adjusted admission $ 7,824 $ 7,695

    $      7,853       $        7,983 Inpatient surgeries                             2,550                2,396             5,036                4,699 Outpatient surgeries(4)                         5,323                5,488            10,098               11,088 Emergency room visits(5)                       49,767               54,601            98,746              107,632    

(1) Excludes all operations included in discontinued operations.

(2) Represents the total number of patients admitted to our hospitals and used by

management and investors as a general measure of inpatient volume.

(3) Adjusted admissions are used as a general measure of combined inpatient and

outpatient volume. We compute adjusted admissions by multiplying admissions

by the outpatient factor (the sum of gross inpatient revenue and gross

outpatient revenue and then dividing the result by gross inpatient revenue).

(4) Outpatient surgeries are surgeries that do not require admission to our

hospitals.

(5) Represents the total number of hospital-based emergency room visits.

(6) Excludes DeKalb Community Hospital and Stones River Hospital which were

acquired in July 2011 through our acquisition of a 60% interest in Cannon

County Hospital, LLC ("CCH").                                            30 

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

Table of Contents

Three Months Ended June 30, 2012 Compared to June 30, 2011

  Revenue. Revenue for the three months ended June 30, 2012 was $184.3 million, an increase of $14.2 million, or 8.3%, over the prior year quarter. The increase in revenue is due to the following items: (i) the acquisitions of DeKalb Community Hospital and Stones River Hospital, which became part of the Company in July 2011 through our acquisition of a 60% interest in Cannon County Hospital, LLC, and contributed approximately $7.2 million of revenue during the three months ended June 30, 2012, and (ii) an increase in same-facility adjusted admissions of 5.9%, offset by a decline in same-facility revenue per adjusted admission of approximately 1.6%.  Our revenue was impacted by an increase in our provision for bad debts, which was up $4.3 million, or 21.9% compared to the prior year period. The increase in bad debts was due to the growth in uninsured patient volume and revenue. On a same-facility basis, self-pay admissions were 6.8% of total admissions, which was an increase from 5.5% in the prior year. Self-pay gross revenue increased 19.2%, compared to the prior year period.  Salaries and benefits. Salaries and benefits for the three months ended June 30, 2012 were $85.8 million, or 46.6% of revenue, compared to $82.1 million, or 48.3% of revenue in the prior year quarter. We have reduced contract labor by approximately $1.2 million compared to the prior year quarter and continue to make labor productivity improvements that have favorably impacted our salaries and benefits expense margin.  Supplies. Supplies expense for the three months ended June 30, 2012 was $28.7 million, or 15.6% of revenue, compared to $28.0 million, or 16.5% of revenue in the prior year quarter. The improvement in our supplies margin was due to a decline in supply intensive in-patient surgical cases as well as our continued efforts to manage supply costs.  

Other operating expenses. Other operating expenses include, among other things, professional fees, repairs and maintenance, rents and leases, utilities, insurance, non-income taxes and physician income guarantee amortization.

  Other operating expenses for the three months ended June 30, 2012 was $46.4 million, or 25.2% of revenue, compared to $36.2 million, or 21.2% of revenue in the prior year quarter. The increase in our other operating expenses margin was due to the following items: a $3.3 million increase in contract services from the implementation of new service lines at our facilities, a $3.4 million increase in provider taxes and fees, a $1.7 million increase in professional fees due to the implementation of hospitalist programs at two of our hospitals, a $1.0 million increase in acquisition costs and an increase in information technology expenses due to meaningful use requirements as well as infrastructure build-outs in our growing physician practice clinics.  Other income. Other income includes EHR incentive payments, which represent those incentives under the HITECH Act for which the recognition criterion has been met. For the three months ended June 30, 2012, we recognized approximately $0.4 million of incentive reimbursements, compared to $1.9 million in the prior year.  Income taxes. Our effective tax rate from continuing operations was approximately 45.0% for the three months ended June 30, 2012 compared to 18.4% for the prior year quarter. The change in the effective tax rate is driven by changes in the level of pretax income combined with our net deferred tax liability position and related limitations with respect to deferred tax liabilities associated with indefinite-lived intangible assets.  

Six Months Ended June 30, 2012 Compared to June 30, 2011

  Revenue. Revenue for the six months ended June 30, 2012 was $381.2 million, an increase of $40.6 million, or 11.9%, over the six months ended June 30, 2011. The increase in revenue was due to the following: (i) the acquisitions of DeKalb Community Hospital and Stones River Hospital, which contributed approximately $13.8 million of revenue during the six months ended June 30, 2012, (ii) the revenue recorded related to the prior period SHOPP and rural floor settlement which contributed approximately $13.6 million of revenue and (iii) an increase in same-facility adjusted admissions of 6.1%, offset by a decline in same-facility revenue per adjusted admission (excluding SHOPP and the rural floor settlement) of approximately 2.1%.  Our revenue was impacted by an increase in our provision for bad debts, which was up $8.7 million, or 23.8% compared to the six months ended June 30, 2011. The increase in bad debts was primarily due to the growth in uninsured patient volume and revenue. On a same-facility basis, self-pay admissions were 6.5% of total admissions, which increased from 5.5% during the six months ended June 30, 2011. Self-pay gross revenue increased 18.1%, compared to the prior year period.  Salaries and benefits. Salaries and benefits for the six months ended June 30, 2012 was $176.6 million, or 46.3% of revenue, compared to $165.8 million, or 48.7% of revenue during the six months ended June 30, 2011. Our salaries and benefits margin was impacted by the prior period SHOPP and rural floor settlement revenue discussed previously. Also, as a result of the rural floor provision settlement, we recorded an additional $2.2 million in incentive compensation for our employees in accordance with our incentive plan provisions during the six months ended June 30, 2012. On a same-facility basis, and excluding the revenue and expense related to the prior period SHOPP and rural floor settlement, salaries and benefits as a percentage of revenue was 47.0% for the six                                           31 

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

Table of Contents

  ended June 30, 2012, compared to 48.7% in the same prior year period. We have reduced same-facility contract labor by approximately $2.4 million compared to the prior year and continue to make labor productivity improvements that have favorably impacted our salaries and benefits expense margin.  Supplies.Supplies expense for the six months ended June 30, 2012 was $57.8 million, or 15.2% of revenue, compared to $55.7 million, or 16.4% of revenue for the six months ended June 30, 2012. Our supplies margin was impacted by the SHOPP program and rural floor settlement revenue discussed previously. On a same-facility basis, and excluding revenue related to the prior period SHOPP program and rural floor settlement, supplies expense as a percentage of revenue was 15.8%, compared to 16.4% in the prior year period. The improvement in our supplies margin was due to a decline in supply intensive in-patient surgical cases as well as our continued efforts to manage supply costs.  

Other operating expenses. Other operating expenses include, among other things, professional fees, repairs and maintenance, rents and leases, utilities, insurance, non-income taxes and physician income guarantee amortization.

  Other operating expenses for the six months ended June 30, 2012 was $93.3 million, or 24.5% of revenue, compared to $72.2 million, or 21.2% of revenue for the six months ended June 30, 2011. Our other operating expense margin was impacted by the SHOPP program and rural floor settlement discussed previously. On a same-facility basis, and excluding revenue and expenses related to the SHOPP program and rural floor settlement, other operating expenses as a percentage of revenue was 24.4%, compared to 21.1% in the prior year period. The increase in same-facility other operating expenses margin is due to a $5.4 million increase in provider taxes and fees, a $4.3 million increase in contract services from the implementation of new service lines at our facilities, a $2.4 million increase in professional fees due to the implementation of hospitalist programs at two of our hospitals, a $1.6 million increase in acquisition costs and an increase in information technology expenses due to meaningful use requirements as well as infrastructure build-outs in our growing physician practices.  Other income. Other income includes EHR incentive payments, which represent those incentives under the HITECH Act for which the recognition criteria have been met. For the six months ended June 30, 2012, we recognized approximately $1.2 million of incentive reimbursements, compared to $1.9 million for the six months ended June 30, 2012.  Income taxes. Our effective tax rate from continuing operations was approximately 16.2% for the six months ended June 30, 2012 compared to 26.1% for the six months ended June 30, 2011. The change in the effective tax rate is driven by changes in the level of pretax income combined with the Company's net deferred tax liability position and related limitations with respect to deferred tax liabilities associated with indefinite-live intangible assets.                                           32

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

Table of Contents

LIQUIDITY AND CAPITAL RESOURCES

  The following table shows a summary of our cash flows for the six months ended June 30, 2011 and 2012.                                                          Six Months Ended                                                           June 30,                                                       2011         2012                                                         (In millions)             Cash provided by operating activities   $   22.3      $  23.6             Cash used in investing activities          (42.1 )      (22.4 )             Cash used in financing activities           (0.5 )       (3.0 )  

Operating Activities

Cash provided by operating activities was $22.3 million for the six months ended June 30, 2011, compared to $23.6 million for the six months ended June 30, 2012.

  At June 30, 2012, we had working capital, excluding assets held for sale, of $114.4 million, including cash and cash equivalents of $40.6 million, compared to working capital at December 31, 2011 of $109.9 million, including cash and cash equivalents of $42.4 million.  

Investing Activities

  Cash used in investing activities was $42.1 million for the six months ended June 30, 2011 compared to $22.4 million for the six months ended June 30, 2012. We spent approximately $6.5 million during the six months ended June 30, 2012 for our purchase of Artesian Cancer Center at Muskogee in Muskogee, Oklahoma. Capital expenditures for the six months ended June 30, 2011 were $13.0 million compared to $17.5 million for the six months ended June 30, 2012. During the six months ended June 30, 2012, we spent approximately $9.0 million on information technology, $2.7 million on routine capital and $5.8 million on growth capital. We also received proceeds for the divestiture of Hartselle Medical Center in Hartselle, Alabama of $1.6 million during the six months ended June 30, 2012.  

Financing Activities

  Cash flows used in financing activities was $0.5 million for the six months ended June 30, 2011 compared to $3.0 million for the six months ended June 30, 2012. Cash flows used in financing activities includes approximately $1.1 million in repurchases of non-controlling interests during the six months ended June 30, 2012.  Capital Resources  The Refinancing  In June 2010, we completed a comprehensive refinancing plan, or the Refinancing. Under the Refinancing, we issued $500.0 million of 9 1/4% senior unsecured notes due 2017, referred to as the 9 1/4% Notes, in a private placement offering and entered into a new senior secured asset based loan, or the ABL, consisting of a $100.0 million revolving credit facility maturing in December 2014, referred to as the 2010 Revolving Facility. The proceeds from the 9  1/4% Notes were used to repay the outstanding principal and interest related to our previous term loan facility and to pay fees and expenses relating to the Refinancing of approximately $21.7 million.  Effective November 4, 2011, in accordance with a registration rights agreement entered into by us in connection with the private placement offering of the 9 1/4% Notes, we completed the exchange of the 9  1/4% Notes for $500.0 million in registered 9  1/4% notes with substantially identical terms as the 9  1/4% Notes. We did not receive any proceeds from this exchange.  

Debt Covenants

  The indenture governing the 9  1/4% Notes contains a number of covenants that among other things, restrict, subject to certain exceptions, our ability and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, pay dividends and distributions or repurchase our capital stock, create liens on assets, make investments, engage in mergers or consolidations, and engage in certain transactions with affiliates. At December 31, 2011 and June 30, 2012, we were in compliance with all debt covenants that were subject to testing at such dates.  We expect that cash on hand, cash generated from our operations and cash expected to be available to us under the 2010 Revolving Facility will be sufficient to meet our working capital needs and planned capital expenditure programs for the next 12 months and into the foreseeable future. However, we cannot assure you that our operations will generate sufficient cash or that future borrowings under the Refinancing will be available to enable us to meet these requirements.                                           33 

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

Table of Contents

  We had $42.4 million and $40.6 million of cash and cash equivalents as of December 31, 2011 and June 30, 2012, respectively. We rely on available cash, cash flows generated by operations and available borrowing capacity under the 2010 Revolving Facility to fund our operations and capital expenditures. We invest our cash in accounts in high-quality financial institutions. We continually explore various options to increase the return on our invested cash while preserving our principal cash balances. However, the significant majority of our cash and cash equivalents are held in accounts that are not federally-insured and could be at risk in the event of a collapse of the financial institutions at which those accounts are held.  In addition, our liquidity and ability to fund our capital requirements are dependent on our future financial performance, which is subject to general economic, financial and other factors that are beyond our control. If those factors significantly change or other unexpected factors adversely affect us, our business may not generate sufficient cash flows from operations or we may not be able to obtain future financings to meet our liquidity needs. We anticipate that, to the extent additional liquidity is necessary to fund our operations, it would be funded through borrowings under our 2010 Revolving Facility, the incurrence of other indebtedness, additional note issuances or a combination of these potential sources of liquidity. We may not be able to obtain this additional liquidity when needed on terms acceptable to us.  We also intend to continue to pursue acquisitions or partnering arrangements, either in existing markets or new markets, which fit our growth strategies. To finance such transactions, we may draw upon cash on hand, amounts available under our revolving credit facility or seek additional funding sources. We continually assess our capital needs and may seek additional financing, including debt or equity, as considered necessary to fund potential acquisitions, fund capital projects or for other corporate purposes. We may be unable to raise additional equity proceeds from the investment funds affiliated with GTCR Golder Rauner II, L.L.C. (collectively, with GTCR Golder Rauner, L.L.C. and certain other affiliated entities, "GTCR"), which are our principal investors, or other investors should we need to obtain cash for any of these purposes. Our future operating performance, ability to service our debt and ability to draw upon other sources of capital will be subject to future economic conditions and other business factors, many of which are beyond our control.  

As market conditions warrant, we and our major equity holders, including GTCR, may from time-to-time repurchase debt securities issued by us, in privately negotiated or open market transactions, by tender offer or otherwise.

Obligations and Commitments

During the six months ended June 30, 2012, there were no material changes in our contractual obligations as presented in our 2011 Annual Report on Form 10-K.

Guarantees and Off-Balance Sheet Arrangements

We are a party to certain master lease agreements and other similar arrangements with non-affiliated entities.

We enter into physician income guarantees and other guarantee arrangements, including parent-subsidiary guarantees, in the ordinary course of business. We do not believe we have engaged in any transaction or arrangement with an unconsolidated entity that is reasonably likely to affect liquidity materially.

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Effects of Inflation and Changing Prices

  Various federal, state and local laws have been enacted that, in certain cases, limit our ability to increase prices. Revenue for acute hospital services rendered to Medicare patients is established under the federal government's prospective payment system. We believe that hospital industry operating margins have been, and may continue to be, under significant pressure because of changes in payor mix and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. In addition, as a result of increasing regulatory and competitive pressures, our ability to maintain operating margins through price increases to non-Medicare patients is limited.