NATIONAL HEALTHCARE CORP – 10-K/A – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

National HealthCare Corporation, which we also refer to as NHC or the Company, is a leading provider of long-term health care services.  At December 31, 2011 we operate or manage 75 long-term health care centers with 9,456 beds in 10 states and provide other services in one additional state.  These operations are provided by separately funded and maintained subsidiaries.  We provide long-term health care services to patients in a variety of settings including long-term nursing centers, managed care specialty units, sub-acute care units, Alzheimer's care units, hospice care, homecare programs, assisted living centers and independent living centers.  In addition, we provide management services, accounting services and insurance services to third party owners of long-term health care centers.                                               31  

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Executive Summary   Earnings   To monitor our earnings, we have developed budgets and management reports to monitor labor, census, and the composition of revenues.  Inflationary increases in our costs may cause net earnings from patient services to decline.   

Medicare Reimbursement Rate Changes

   In July 2011, CMS announced a final rule reducing Medicare skilled nursing facility PPS payments in fiscal year 2012 by $3.87 billion, or 11.1% lower than payments for fiscal year 2011.  We estimate the resulting decrease in revenue from the fiscal year 2012 Medicare rate changes will be approximately $24,000,000 annually or $6,000,000 quarterly.  Furthermore, changes in government requirements for providing therapy services are estimated to increase our operating costs by approximately $6,000,000 annually, or $1,500,000 per quarter.  We are examining cost saving measures to help mitigate a portion of the revenue decrease and cost increase, but we are also committed to maintaining the quality of care to our patients.   

Development and Growth

We are undertaking to expand our long-term care operations while protecting our existing operations and markets. The following table lists our recent construction and purchase activities.

  Type of Operation    Description         Size              Location         Placed in Service      Hospice         Acquisition        133 ADC       Aiken, Charleston,      January, 2009                                                        Columbia, Myrtle                                                       Beach and Sumter,                                                               SC  Skilled Nursing     New Facility      120 Beds          Bluffton, SC         January, 2010  Assisted Living     New Facility      45 Units          Mauldin, SC           March, 2010     Homecare         Acquisition        353 ADC         Columbia, Rock          May, 2010                                                           Hill, and                                                        Summerville, SC  Skilled Nursing     Acquisition       120 Beds           Macon, MO          December, 2010  Skilled Nursing     Acquisition       120 Beds        Osage Beach, MO       December, 2010  Skilled Nursing     Acquisition       120 Beds        Springfield, MO       December, 2010  Assisted Living     New Facility      75 Units          Columbia, SC           May, 2011  Assisted Living       Addition        46 Units          Franklin, TN          June, 2011      Hospice         Acquisition      Additional        Knoxville, TN        December, 2011                                      7.5% interest                                        in Caris                                      HealthCare LP   

Also, in 2012, we expect to begin construction on a 90-bed skilled nursing facility in Tullahoma, Tennessee, a 92-bed skilled nursing facility in Hendersonville, Tennessee and a 50-bed skilled nursing addition to NHC Lexington in Lexington, SC.

   During 2012, we will apply for Certificates of Need for additional beds in our markets and also evaluate the feasibility of expansion into new markets by building private pay health care centers or by the purchase of existing health care centers.                                               32  

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Accrued Risk Reserves

   Our accrued professional liability reserves, workers' compensation reserves and health insurance reserves totaled $98,732,000 at December 31, 2011 and are a primary area of management focus.  We have set aside restricted cash and marketable securities to fund our professional liability and workers' compensation reserves.   As to exposure for professional liability claims, we have developed for our centers performance certification criteria to measure and bring focus to the patient care issues most likely to produce professional liability exposure, including in-house acquired pressure ulcers, significant weight loss and numbers of falls. These programs for certification, which we regularly modify and improve, have produced measurable improvements in reducing these incidents. 

Our

experience is that achieving goals in these patient care areas improves both patient and employee satisfaction.

Application of Critical Accounting Policies

   The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates and cause our reported net income to vary significantly from period to period.   Our critical accounting policies that are both important to the portrayal of our financial condition and results and require our most difficult, subjective or complex judgments are as follows:   

Revenue Recognition - Third Party Payors

   Approximately 70% of our net patient revenues are derived from Medicare, Medicaid, and other government programs.  Amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries or their agents.  In our opinion, adequate provision has been made for any adjustments that may result from these reviews.  Any differences between our original estimates of reimbursements and subsequent revisions are reflected in operations in the period in which the revisions are made often due to final determination or the period of payment no longer being subject to audit or review.  We have made provisions of approximately $16,807,000 as of December 31, 2011 for various Medicare and Medicaid current and prior year cost reports and claims reviews.   

Revenue Recognition - Private Pay

    For private pay patients in skilled nursing or assisted living facilities, we bill room and board in advance for the current month with payment being due upon receipt of the statement in the month the services are performed.  Charges for ancillary, pharmacy, therapy and other services to private patients are billed in the month following the performance of services; however, all billings are recognized as revenue when the services are performed.   

Revenue Recognition - Subordination of Fees and Uncertain Collections

   We provide management services to certain long-term care facilities and to others we provide accounting and financial services.  We generally charge 6% to 7% of net revenues for our management services and a predetermined fixed rate per bed for the accounting and financial services.  Our policy is to recognize revenues associated with both management services and accounting and financial services on an accrual basis as the services are provided.  However, under the terms of our management contracts, payments for our management services are subject to subordination to other expenditures of the long-term care center being managed.  Furthermore, for certain of the third parties with whom we have contracted to provide services and which we have determined, based on insufficient historical collections and the lack of expected future collections, that collection is not reasonably assured, our policy is to recognize income only in the period in which the amounts are realized.  We may receive payment for the unpaid and unrecognized management fees in whole or in part in the future only if cash flows from the operating and investing activities of the centers or proceeds from the sale of the centers are sufficient to pay the fees. 

There can be no assurance that such future cash flows will occur. The realization of such previously unrecognized revenue could cause our reported net income to vary significantly from period to period.

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-------------------------------------------------------------------------------- We agree to subordinate our fees to the other expenses of a managed center because we believe we know how to improve the quality of patient services and finances of a long-term care center and because subordinating our fees demonstrates to the owner and employees of the managed center how confident we are of the impact we can have in making the center operations successful.  We may continue to provide services to certain managed centers despite not being fully paid currently so that we may be able to collect unpaid fees in the future from improved operating results and because the incremental savings from discontinuing services to a center may be small compared to the potential benefit.  Also, we may benefit from providing other ancillary services to the managed center.   

See Notes 2, 3 and 4 to the Consolidated Financial Statements regarding our relationships with National, NHI, and the recognition of management fees from long-term care centers owned by third parties.

Accrued Risk Reserves

   We are principally self-insured for risks related to employee health insurance, workers' compensation and professional and general liability claims.  Our accrued risk reserves primarily represent the accrual for self-insured risks associated with employee health insurance, workers' compensation and professional and general liability claims.  The accrued risk reserves include a liability for reported claims and estimates for incurred but unreported claims.  Our policy with respect to a significant portion of our workers' compensation and professional and general liability claims is to use an actuary to estimate our exposure for claims obligations (for both asserted and unasserted claims). 

Our health insurance reserve is based on our known claims incurred and an estimate of incurred but unreported claims determined by our analysis of historical claims paid. We reassess our accrued risk reserves on a quarterly basis.

   Professional liability remains an area of particular concern to us.  The entire long term care industry has seen a dramatic increase in personal injury/wrongful death claims based on alleged negligence by nursing homes and their employees in providing care to residents.  As of December 31, 2011, we and/or our managed centers are defendants in 30 such claims inclusive of years 2002 through 2011.  It remains possible that those pending matters plus potential unasserted claims could exceed our reserves, which could have a material adverse effect on our financial position, results of operations and cash flows.  It is also possible that future events could cause us to make significant adjustments or revisions to these reserve estimates and cause our reported net income to vary significantly from period to period.   We maintain insurance coverage for incidents occurring in all providers owned or leased by us, and most providers managed by us.  The coverages include both primary policies and excess policies.  In all years, settlements, if any, in excess of available insurance policy limits and our own reserves would be expensed by us.   Credit Losses   Certain of our accounts receivable from private paying patients and certain of our notes receivable are subject to credit losses.  We have attempted to reserve for expected accounts receivable credit losses based on our past experience with similar accounts receivable and believe our reserves to be adequate.   We continually monitor and evaluate the carrying amount of our notes receivable in accordance with ASC Topic 310, Receivables.  It is possible, however, that the accuracy of our estimation process could be materially impacted as the composition of the receivables changes over time.  We continually review and refine our estimation process to make it as reactive to these changes as possible.  However, we cannot guarantee that we will be able to accurately estimate credit losses on these balances.  It is possible that future events could cause us to make significant adjustments or revisions to these estimates and cause our reported net income to vary significantly from period to period.                                              34  

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Uncertain Tax Positions

    NHC continually evaluates for uncertain tax positions.  These uncertain positions may arise where tax laws may allow for alternative interpretations or where the timing of recognition of income is subject to judgment.  We believe we have adequate provisions for our uncertain tax positions including related penalties and interest.  However, because of uncertainty of interpretation by various tax authorities and the possibility that there are issues that have not been recognized by management, we cannot guarantee we have accurately estimated our tax liabilities.   

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with limited need for management's judgment in their application.

  There are also areas in which management's judgment in selecting any available alternative would not produce a materially different result.  See our audited consolidated financial statements and notes thereto which contain accounting policies and other disclosures required by generally accepted accounting principles.   Results of Operations  

The following table and discussion sets forth items from the consolidated statements of income as a percentage of net revenues for the audited years ended December 31, 2011, 2010 and 2009.

                             Percentage of Net Revenues                                                            Year Ended December 31,                                                         2011          2010    2009      Revenues:

              Net patient revenues                       92.5%        92.1%   92.3%               Other revenues                              7.5          7.9     7.7                       Net operating revenues            100.0        100.0   100.0

Costs and Expenses:

              Salaries, wages and benefits               55.4         55.5    55.1               Other operating                            25.7         27.3    27.9               Rent                                        5.1          5.3     5.5               Depreciation and amortization               3.7          3.8     3.8               Interest                                    0.1          0.1     0.1                       Total costs and expenses           90.0         92.0    92.4

     Income before non-operating income                  10.0          8.0 

7.6

     Non-operating income                                 2.7          3.3 

2.5

     Income before income taxes                          12.7         11.3 

  10.1      Income tax provision                               (4.4)        (4.0)   (4.1)      Net Income                                           8.3          7.3     6.0

     Dividends to preferred stockholders                (1.1)        (1.2) 

(1.3)

     Net income available to common stockholders          7.2          6.1     4.7                                                35  

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The following table sets forth the increase in certain items from the consolidated statements of income as compared to the prior period.

                         Period to Period Increase (Decrease)                                                    2011 vs. 2010       2010 vs. 2009 (dollars in thousands)                          Amount    Percent   Amount    Percent Revenues:

        Net patient revenues                   $ 51,860      7.8   $ 42,040      6.8         Other revenues                            1,024      1.8      5,411     10.5                 Net operating revenues           52,884      7.3     47,451      7.0

Costs and Expenses:

        Salaries, wages and benefits             28,402      7.1     29,562      8.0         Other operating                           1,423      0.7      8,871      4.7         Rent                                      1,650      4.3        754      2.0         Depreciation and amortization             1,760      6.5      1,712      6.7         Interest                                    (70)   (13.6)     

(203) (28.4)

                 Total costs and expenses         33,165      5.0     40,696 

6.5

 Income before non-operating income               19,719     34.2      6,755     13.3 Non-operating income                             (2,807)   (12.0)     6,556     39.1 Income before income taxes                       16,912     20.9     13,311     19.7 Income tax provision                              5,535     19.6        665      2.4 Net Income                                       11,377     21.6     12,646     31.6 Dividends paid to preferred stockholders             (2)        -         - 

-

Net income available to common stockholders $ 11,379 25.8 $ 12,646

40.3

    Our long-term health care services, including therapy and pharmacy services, provided 89.7%, 89.1% and 89.4% of net patient revenues in 2011, 2010, and 2009, respectively.  Homecare and hospice programs provided 10.3%, 10.9%, and 10.6% of net patient revenues in 2011, 2010, and 2009, respectively.   

The overall average census in owned and leased health care centers for 2011 was 90.6% compared to 92.0% in 2010 and 2009, respectively.

   Approximately 70% of our net patient revenues are derived from Medicare, Medicaid, and other government programs.  As discussed above in the Application of Critical Accounting Policies section, amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries.  See Application of Critical Accounting Policies for discussion of the effects that this revenue concentration and the uncertainties related to such revenues have on our revenue recognition policies.   

Government Program Financial Changes

   Cost containment will continue to be a priority for Federal and State governments for health care services, including the types of services we provide.  Government reimbursement programs such as Medicare and Medicaid prescribe, by law, the billing methods and amounts that health care providers may charge and be reimbursed to care for patients covered by these programs. Congress has passed a number of laws that have effected major changes in the Medicare and Medicaid programs. The Balanced Budget Act of 1997 sought to achieve a balanced federal budget by, among other things, reducing federal spending on Medicare and Medicaid to various providers.  The Balanced Budget Act of 1997 defined the Medicare Prospective Payment System ("PPS") and this System has subsequently been refined in 1999, 2000, 2005, 2006 and 2010.   

Federal Health Care Reform

In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act ("PPACA") and the Health Care and Education Reconciliation Act of 2010 ("HCERA"), which represents

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-------------------------------------------------------------------------------- significant changes to the current U.S. health care system (collectively the "Acts"). The Acts affect aging services providers, our partners (employees) and our patients and residents in a multitude of ways.  We have evaluated the provisions of the Acts and anticipate many of the provisions may be subject to further clarification and modification through the rule-making process.  It is uncertain at this time the effect the modifications will have on our future results of operations or cash flows.   In December 2010, President Obama signed into law the Medicare and Medicaid Extenders Act ("MMEA").  This legislation affects numerous health care providers and makes several important technical corrections to the health reform laws enacted earlier in 2010.  An important item provided for in the MMEA legislation is for an immediate and retroactive updated methodology (Resource Utilization Group - Version Four, "RUG-IV") for determining Medicare payment rates to skilled nursing centers.  The MMEA allowed skilled nursing center rates determined by RUG-IV to be applied as of October 1, 2010.   In August 2011 and pursuant to the Budget Control Act of 2011, Congress created a 12-member bipartisan committee called the Joint Select Committee on Deficit Reduction, or the Joint Committee.  The Joint Committee was charged with issuing a formal recommendation by November 23, 2011 on how to reduce the federal deficit by at least $1.5 trillion over the next ten years.  The Committee concluded their work in November and was not able to make a bipartisan agreement before the Committee's deadline period.  This failure by the Committee is scheduled to trigger automatic reductions in discretionary and mandatory spending starting in 2013, including reductions of not more than 2% to payments to Medicare providers.  We are unable to predict the financial impact, if enacted, of the automatic payments cuts beginning in 2013.  However, such impact may be adverse and material to our future results of operations and cash flows.    Medicare   On July 29, 2011, CMS issued a final rule providing for, among other things, a net 11.1% reduction in PPS payments to skilled nursing facilities for CMS's fiscal year 2012 (which began October 1, 2011) as compared to PPS payments in CMS's fiscal year 2011 (which ended September 30, 2011).  The 11.1% reduction is on a net basis, after the application of a 2.7% market basket increase less a 1.0% multi-factor productivity adjustment required by the PPACA.  The final CMS rule also adjusts the method by which group therapy is counted for reimbursement purposes, and changes the timing in which patients who are receiving therapy must be reassessed for purposes of determining their RUG category.  We anticipate that, assuming other factors remain constant, CMS's reduced reimbursement rates and other changes effective for its fiscal year 2012 will have a significant and adverse effect on our results of operations when compared to the periods in CMS's fiscal year 2011.  We estimate the resulting decrease in revenue from the fiscal year 2012 Medicare rate changes will be approximately $24,000,000 annually, or $6,000,000 per quarter.  Furthermore, changes in government requirements for providing therapy services are estimated to increase our operating costs by approximately $6,000,000 annually, or $1,500,000 per quarter.  The effect of the rate changes on our revenues is dependent upon our census and the mix of our patients at the recalibrated PPS pay rates.  We are examining cost saving measures to help mitigate a portion of the revenue decrease and cost increase, but we are also committed to maintaining the quality of care to our patients. The PPS rates had a net market basket increase of 2.3% in 2010 and a net market basket decrease of 1.1% in 2009.   For 2011, our average Medicare per diem rate for skilled nursing facilities increased 13.5% compared to the same period in 2010.  No assurances can be given as to whether Congress will increase or decrease reimbursement in the future, the timing of any action or the form of relief, if any, that may be enacted.   On October 31, 2011 and effective January 1, 2012, CMS issued a final ruling for homecare programs which stated an approximate 2.4% rate reduction from the 2011 HH PPS rates.  The 2.4% rate reduction will impact individual providers unevenly.  CMS finalized significant changes by eliminating hypertension as a factor in the calculation, reducing the weights on therapy episodes, and increasing weights on non-therapy episodes.   Providers with high volume of therapy cases could see greater net rate reductions while others with non-therapy patients may see a negligible overall reduction in revenue or a slight increase.  We estimate the effect of the revenue decrease for NHC homecare programs to be approximately $2,600,000 annually, or $650,000 per quarter.   

Effective October 1, 2011, hospice agencies received Medicare payments which represented a 2.5% increase.

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Medicaid

No rate increases or decreases were implemented for the fiscal years beginning July 1, 2011 for Medicaid programs in the states of Tennessee and Missouri.

Tennessee, however, has announced that it will implement a 4.25% rate reduction beginning January 1, 2012.  We estimate the resulting decrease in revenue in Tennessee will be approximately $2,600,000 annually, or $650,000 per quarter.   On April 7, 2011, effectively immediately, South Carolina implemented a three percent Medicaid rate reduction.  We estimate the resulting decrease in revenue is approximately $1,480,000 annually, or $370,000 per quarter.   Overall our average Medicaid per diem increased 0.5% in 2011 compared to 2010. We face challenges with respect to states' Medicaid payments, because many currently do not cover the total costs incurred in providing care to those patients. States will continue to control Medicaid expenditures and also look for adequate funding sources, including provider assessments.  The DRA includes several provisions designed to reduce Medicaid spending. These provisions include, among others, provisions strengthening the Medicaid asset transfer restrictions for persons seeking to qualify for Medicaid long-term care coverage, which could, due to the timing of the penalty period, increase facilities' exposure to uncompensated care. Other provisions could increase state funding for home and community-based services, potentially having an impact on funding for nursing facilities. There is no assurance that the funding for our services will increase or decrease in the future.   

2011 Compared to 2010

Results for 2011 compared to 2010 include a 7.3% increase in net operating revenues and a 20.9% increase in net income before income taxes.

   Net patient revenues increased $51,860,000 or 7.8% compared to the same period last year.  Medicare, Medicaid and private pay per diem rates increased 13.5%, 0.5% and 0.7%, respectively, in 2011 compared to 2010.  In combination with our per diem increases, the addition of our newly constructed or acquired businesses during the 2011 year helped increase net patient revenues approximately $18,589,000.  The new operations consisted of three skilled nursing facilities and two assisted living communities.   Other revenues this year increased $1,024,000 or 1.8% to $58,048,000.  Other revenues in 2011 include management and accounting service fees of $21,510,000 ($20,897,000 in 2010) and insurance services revenue of $15,657,000 ($17,068,000 in 2010).  Rental income of $19,124,000 in 2011 increased $1,749,000 compared to 2010.  NHC provided management services for 21 skilled nursing centers, four assisted living communities, and two independent living communities in 2011.  We also provided accounting and financial services to 28 healthcare facilities in 2011.  Rental income increased due to the renewed rental agreements of thirteen of our properties with third party operators.  See Application of Critical Accounting Policies, Revenue Recognition - Subordination of Fees and Uncertain Collections for a discussion of the factors that may cause management fee revenues to fluctuate from period to period.   Non-operating income in 2011 decreased $2,807,000 or 12.0% to $20,533,000.  The decrease in 2011 is due to the nonrecurring gain ($3,563,000) that was recorded in 2010 due to the acquisition of two Missouri long-term health care centers. 

The remaining increase is due to an increase in equity in earnings of our unconsolidated investments ($681,000).

   Total costs and expenses for 2011 increased $33,165,000 or 5.0% to $696,191,000 from $663,026,000 in 2010. Salaries, wages and benefits, the largest operating costs of this service company, increased $28,402,000 or 7.1% to $428,672,000 from $400,270,000.  Other operating expenses increased $1,423,000 or 0.7% to $198,439,000 for 2011 compared to $197,016,000 in 2010.  Rent expense increased $1,650,000 or 4.3% to $39,736,000.  Depreciation and amortization increased 6.5% to $28,901,000.  Interest costs decreased to $443,000.   Salaries, wages and benefits as a percentage of net operating revenue was 55.4% and 55.5% for the years ended December 31, 2011 and 2010, respectively.  The increases in salaries, wages and benefits are primarily due to increased staffing from the opening or acquisition of the three skilled nursing facilities and two assisted living                                            38  

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communities during 2011 ($9,880,000). We also had increased costs in our existing skilled nursing facilities ($9,754,000), increased costs for therapist services ($6,664,000) and inflationary wage increases.

   Other operating expense as a percentage of net operating revenues was 25.7% and 27.3% for the years ended December 31, 2011 and 2010, respectively.  The increases in other operating expenses are primarily due to the opening or acquisition of the new operations.  The three skilled nursing facilities and two assisted living communities increased other operating expenses $8,474,000.  Our existing skilled nursing facilities also increased other operating expenses approximately $4,394,000, but the increases in expenses were offset due to the favorable results within our accrued risk reserves of approximately $10,702,000.   Rent expense in 2011 increased by approximately $1,650,000 compared to the prior year due to increased percentage rent to National Health Investors, Inc. (NHI) of $1,847,000.  Percentage rent to NHI is equal to 4% of the increase in facility revenues over the 2007 revenues, the base year of the lease agreement.   Depreciation expense increased primarily due to the acquisition and construction of depreciable assets in the last year.  The increase in depreciation for the twelve months ended December 31, 2011 was $1,760,000.   The income tax provision for 2011 is $33,807,000 (an effective tax rate of 34.5%).  The income tax provision and effective tax rate for 2011 were favorably impacted by statute of limitations expirations resulting in a benefit to the provision of $3,992,000 or 4.1% of income before taxes in 2011.  The income tax provision and effective tax rate for 2011 were unfavorably impacted by adjustments to unrecognized tax benefits resulting in an increase in the tax provision of $85,000 composed of $351,000 tax and $(266,000) interest and penalties or 0.1% of income before taxes in 2011.   The income tax provision for 2010 is $28,272,000 (an effective tax rate of 34.9%).  The income tax provision and effective tax rate for 2010 were favorably impacted by statute of limitations expirations resulting in a benefit to the provision of $3,721,000 or 4.6% of income before taxes in 2010.  The income tax provision and effective tax rate for 2010 were unfavorably impacted by adjustments to unrecognized tax benefits resulting in an increase in the tax provision of $660,000 composed of $449,000 tax and $211,000 interest and penalties or 0.8% of income before taxes in 2010.   

The effective tax rate for 2012 is expected to be in the range of 35% to 39%.

   2010 Compared to 2009   

Results for 2010 compared to 2009 include a 7.0% increase in net operating revenues and a 19.7% increase in net income before income taxes.

   Net patient revenues increased $42,040,000 or 6.8% compared to the same period last year.  Medicare, Medicaid and private pay per diem rates increased 4.8%, 3.0% and 4.2%, respectively, in 2010 compared to 2009.  In combination with our per diem increases, the addition of our newly constructed or acquired businesses during the 2010 year helped increase net patient revenues approximately $11,208,000.  The new businesses consisted of four skilled nursing facilities, one assisted living community, and three homecare programs.   Other revenues in 2010 increased $5,411,000 or 10.5% to $57,024,000.  Other revenues in 2010 include management and accounting service fees of $20,897,000 ($17,845,000 in 2009) and insurance services revenue of $17,068,000 ($14,560,000 in 2009).  Rental income of $17,375,000 in 2010 decreased $370,000 compared to 2009.  NHC provided management services for 23 skilled nursing centers, four assisted living communities, three independent living communities, and accounting and financial services for 28 centers in 2010.  See Application of Critical Accounting Policies, Revenue Recognition - Subordination of Fees and Uncertain Collections for a discussion of the factors that may cause management fee revenues to fluctuate from period to period.   Non-operating income in 2010 increased $6,556,000 or 39.1% to $23,340,000.  The increase is primarily due to the amount of the recovery of assets ($3,563,000) in the acquisition of two Missouri long-term health care centers acquired on December 1, 2010.  We managed the facilities prior to our acquisition and had written certain assets down or off our balance sheet.  See Footnote 17 to our Consolidated Financial Statements for additional                                            39  

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disclosure regarding the acquisition. The remaining increase is due to an increase in interest and dividend income related to our marketable securities and restricted marketable securities ($2,679,000).

   Total costs and expenses for 2010 increased $40,696,000 or 6.5% to $663,026,000 from $622,330,000 in 2009. Salaries, wages and benefits, the largest operating costs of this service company, increased $29,562,000 or 8.0% to $400,270,000 from $370,708,000.  Other operating expenses increased $8,871,000 or 4.7% to $197,016,000 for 2010 compared to $188,145,000 in 2009.  Rent expense increased $754,000 or 2.0% to $38,086,000.  Depreciation and amortization increased 6.7% to $27,141,000.  Interest costs decreased to $513,000.   Salaries, wages and benefits as a percentage of net operating revenue was 55.5% and 55.1% for the years ended December 31, 2010 and 2009, respectively.  The increases in salaries, wages and benefits are primarily due to increased staffing from the opening or acquisition of the four skilled nursing facilities, one assisted living community, and three homecare programs during 2010 ($7,106,000).  We also had increased costs in our existing skilled nursing facilities ($9,165,000), increased costs for therapist services ($4,452,000), an increased provision for workers' compensation claims ($2,728,000), and inflationary wage increases.   Other operating expense as a percentage of net operating revenues was 27.3% and 27.9% for the years ended December 31, 2010 and 2009, respectively.  The increases in other operating expenses are primarily due to the opening or acquisition of the new operations.  The four skilled nursing facilities, one assisted living community, and three homecare programs increased other operating expenses $5,695,000.  Our existing skilled nursing facilities also increased other operating expenses approximately $3,691,000.   Rent expense in 2010 increased by approximately $754,000 compared to the prior year due to increased percentage rent to National Health Investors, Inc. (NHI) of $365,000.  Percentage rent to NHI is equal to 4% of the increase in facility revenues over the 2007 revenues, the base year of the lease agreement.   Depreciation expense increased primarily due to the acquisition and construction of depreciable assets in the last year.  The increase in depreciation for the twelve months ended December 31, 2010 was $1,712,000.   

The decrease in interest costs is primarily due to the Company paying off the revolving credit facility during the fourth quarter of 2009.

   The income tax provision for 2010 is $28,272,000 (an effective tax rate of 34.9%).  The income tax provision and effective tax rate for 2010 were favorably impacted by statute of limitations expirations resulting in a benefit to the provision of $3,721,000 or 4.6% of income before taxes in 2010.  The income tax provision and effective tax rate for 2010 were unfavorably impacted by adjustments to unrecognized tax benefits resulting in an increase in the tax provision of $660,000 composed of $449,000 tax and $211,000 interest and penalties or 0.8% of income before taxes in 2010.   The income tax provision for 2009 was $27,607,000 (an effective tax rate of 40.8%).  The income tax provision and effective tax rate for 2009 were favorably impacted by statute of limitations expirations and adjustment to unrecognized tax benefits resulting in a benefit to the provision of $1,553,000 or 2.3% of income before taxes in 2009.  The income tax provision and effective tax rate for 2009 were unfavorably impacted by adjustments to unrecognized tax benefits resulting in an increase in the tax provision of $4,179,000 composed of $2,589,000 tax and $1,591,00 interest and penalties or 6.2% of income before taxes in 2009.   

Liquidity, Capital Resources and Financial Condition

Sources and Uses of Funds

   Our primary sources of cash include revenues from the healthcare and senior living facilities we operate, homecare operations, hospice operations, insurance services, management services and accounting services.  Our primary uses of cash include salaries, wages and other operating costs of our home office and the facilities we operate, the cost of additions to and acquisitions of real property, rent expenses, and dividend distributions.  These sources and uses of cash are reflected in our Consolidated Statements of Cash Flows and are discussed in further detail below.  The following is a summary of our sources and uses of cash flows (dollars in thousands):                                Year Ended            One Year Change       Year Ended      Two Year Change                         12/31/11     12/31/10         $         %         12/31/09          $         % Cash and cash equivalents at beginning of period   $  28,478    $  39,022    $  (10,544)   (27.0)   $    49,033    $  (20,555)   (41.9)  

Cash provided from

operating activities 80,654 62,404 18,250 29.2 85,150 (4,496) (5.3)

Cash used in investing activities (31,746) (46,351) 14,605 31.5 (39,185) 7,439 19.0

  Cash provided from (used in) financing activities              (16,378)     (26,597)       10,219     38.4        

(55,976) 39,598 70.7

  Cash and cash equivalents at end of period                $  61,008    $  28,478    $   32,530    114.2    $    39,022    $   21,986     56.3    Operating Activities   Net cash provided by operating activities for the year ended December 31, 2011 was $80,654,000 as compared to $62,404,000 and $85,150,000 for the years ended December 31, 2010 and 2009, respectively.  Cash provided by operating activities consisted of net income of $64,072,000, adjustments for non-cash items of $36,472,000, and $19,890,000 used for working capital and other activities.  Working capital primarily consisted of an increase in restricted cash and cash equivalents of $7,830,000, a decrease in accrued risk reserves of $6,817,000, and an increase in federal income taxes receivable of $3,779,000.   The increase in restricted cash and cash equivalents is from NHC and other healthcare facilities paying insurance premiums into NHC insurance companies, which restrict the cash payment.  The decrease in accrued risk reserves is due from the favorable results during the 2011 fiscal year.   

Investing Activities

   Cash used in investing activities totaled $31,746,000 for the year ended December 31, 2011, as compared to $46,351,000 and $39,185,000 for the years ended December 31, 2010 and 2009, respectively.  Cash used for property and equipment additions was $23,597,000, $32,838,000, and $44,064,000 for the years ended December 31, 2011 and 2010 and 2009, respectively.  Cash in the amount of $7,500,000 was used in the December 31, 2011 acquisition of an additional 7.5% limited partnership interest in Caris.  Purchases and sales of marketable securities resulted in a net use of cash of $2,096,000.  Investments in notes receivable totaled $650,000 in 2011 compared to $-0- in 2010.  Cash provided by collections of notes receivable was $1,872,000 in 2011 compared to $1,300,000 in 2010.   Construction costs included in additions to property and equipment in 2011 include $5,369,000 for the completion of a 75-unit assisted living facility in Columbia, South Carolina and a 46-unit assisted living addition to our Franklin, Tennessee community.   

The purchases of marketable securities were funded primarily from restricted cash and cash equivalents to earn a better rate of return.

Financing Activities

Net cash used in financing activities totaled $16,378,000, $26,597,000 and $55,976,000 for the years ended December 31, 2011, 2010, and 2009, respectively.

  Dividends paid to common stockholders for the 2011 year were $15,952,000 compared to $14,780,000 in 2010.  Dividends paid to preferred stockholders were $8,671,000 in 2011 compared to $8,673,000 in 2010.  Proceeds from the issuance of common stock, primarily from the exercise of stock options, totaled $8,392,000 in 2011 compared to $2,655,000 in the prior year.  In August 2010, the Company repurchased 182,900 shares of common stock, which used $5,944,000 of cash.                                             41  

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Table of Contractual Cash Obligations

   Our contractual cash obligations for periods subsequent to December 31, 2011 are as follows (in 000's):                                                  Less than    1-3      3-5      After                                       Total     1 year     Years    Years    5 Years Long-term debt principal           $  10,000 $         - $      - $      - $  10,000 Long-term debt - interest              1,656         276      552      552       276 Operating leases                     337,000      33,700   67,400   67,400   168,500

Total Contractual Cash Obligations $ 348,656$ 33,976$ 67,952 67,952

178,776

    Income taxes payable for uncertain tax positions under ASC 740 of $4,457,000 attributable to permanent differences, at December 31, 2011 has not been included in the above table because of the inability to estimate the period in which payment is expected to occur.  See Note 13 of the Consolidated Financial Statements for a discussion on income taxes.   

Short-term liquidity

   Effective October 26, 2011, we extended the maturity of our $75,000,000 revolving credit agreement to October 25, 2012.  At December 31, 2011, we do not have any funds borrowed against the credit agreement.  The entire amount of $75,000,000 is available to be drawn for general corporate purposes, including working capital and acquisitions.   We expect to meet our short-term liquidity requirements primarily from our cash flows from operating activities. In addition to cash flows from operations, our current cash on hand of $61,008,000, marketable securities of $85,051,000 and as needed, our borrowing capacity, are expected to be adequate to meet our contractual obligations and to finance our operating requirements and our growth and development plans in the next twelve months.   

Long-term liquidity

   Our $75,000,000 revolving credit agreement matures on October 25, 2012.  We currently anticipate renewing the credit agreement at that time.  While we have had no indication from the lender there is any question about renewal, there has been no commitment at this time.  We entered into this loan originally on October 30, 2007, and have renewed the loan four times, with a one year maturity.  At the inception and at each renewal, the lender offered alternative notes with longer maturities, but the Company chose a one-year maturity because of the terms.  If we have an outstanding balance and are not able to refinance our debt as it matures, we will be required to use our cash and marketable securities to meet our debt obligations.  This will limit our ability to fund future growth opportunities.   Our ability to refinance the credit agreement, to meet our long-term contractual obligations and to finance our operating requirements, growth and development plans will depend upon our future performance, which will be affected by business, economic, financial and other factors, including potential changes in state and federal government payment rates for healthcare, customer demand, success of our marketing efforts, pressures from competitors, and the state of the economy, including the state of financial and credit markets.   

Guarantees and Contingencies

   We started paying quarterly dividends in the second quarter of 2004.  Although we intend to declare and pay regular quarterly cash dividends, there can be no assurance that any dividends will be declared, paid or increased in the future.    

At December 31, 2011, we have no agreements to guarantee the debt obligations of other parties.

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-------------------------------------------------------------------------------- We have no outstanding letters of credit.  We may or may not in the future elect to use financial derivative instruments to hedge interest rate exposure in the future. At December 31, 2011, we did not participate in any such financial investments.   Impact of Inflation   Inflation has remained relatively low during the past three years.  However, rates paid under the Medicare and Medicaid programs do not necessarily reflect all inflationary changes and are subject to cuts unrelated to inflationary costs.  Therefore, there can be no assurance that future rate increases will be sufficient to offset future inflation increases in our labor and other health care service costs.   Other Matters   On July 24, 2009, the Company received a civil investigative demand from the Tennessee Attorney General's Office, requesting production of documents related to NHC's business relationships with non-profit entities.  The Company has responded to the demand and complied as required with the terms of the demand.   

New Accounting Pronouncements

See Note 1 to the Consolidated Financial Statements for the impact of new accounting standards.