SKILLED HEALTHCARE GROUP, INC. – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Edgar Online, Inc.

 This Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not indicate future performance. Our forward-looking statements, which reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in Item 1A, "Risk Factors," of this report on Form 10-K. This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with "Selected Financial Data" in Item 6 of this report on Form 10-K and our consolidated financial statements and related notes included in this report. Certain prior year amounts have been reclassified to conform to current year presentation. Restatement On June 29, 2009, we restated our financial statements for the fiscal years ended December 31, 2006 through December 31, 2008, including the corresponding quarterly periods in 2007 and 2008, in our amended Form 10-K/A for the year ended December 31, 2008, and for the quarter ended March 31, 2009 in our amended Form 10-Q/A for the quarter then ended. The restatement principally related to an understatement of accounts receivable allowance for doubtful accounts for our long-term care, or LTC, operating segment, which was caused by improper dating of accounts receivable for that segment by a former senior officer of the LTC segment, referred to as the former employee. Management conducted a review of our accounts receivable allowance for doubtful accounts related to the LTC segment after the former employee left our employment following a disciplinary meeting on unrelated matters. Management determined that the former employee had acted in a manner inconsistent with our accounting and disclosure policies and practices. As a result of its review, management recommended to the Audit Committee that a restatement was required. The Audit Committee initiated and directed a special investigation regarding the accounting and reporting issues raised by the former employee's improper dating of accounts receivable. Under the oversight of the Audit Committee, internal audit personnel with the assistance of outside legal counsel and other advisors, investigated the matter and reviewed our internal controls related to accounts receivable allowance for doubtful accounts related to the LTC segment. Our investigation found no evidence that anyone else within our organization knew of or participated in the improper conduct. Business Overview We are a holding company with subsidiaries that operate skilled nursing facilities, assisted living facilities, hospices, home health providers and a rehabilitation therapy business. We have an administrative service company that provides a full complement of administrative and consultative services that allows our facility operators and third-party facility operators with whom we contract to better focus on delivery of healthcare services. We have one such service agreement with an unrelated facility operator. These subsidiaries focus on providing high-quality care to our patients and have a strong commitment to treating patients who require a high level of skilled nursing care and extensive rehabilitation therapy, whom we refer to as high-acuity patients. As of December 31, 2011, we operated 74 skilled nursing and 23 assisted living owned or leased facilities, together comprising 10,495 licensed beds. We also lease five skilled nursing facilities in California to an unaffiliated third party                                         32

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  operator. Our skilled nursing and assisted living facilities, approximately 76.5% of which we own, are located in California, Texas, Iowa, Kansas, Missouri, Nebraska, Nevada and New Mexico, and are generally clustered in large urban or suburban markets. For the twelve months ended December 31, 2011, we generated approximately 76.2% of our revenue from our skilled nursing facilities, including our integrated rehabilitation therapy services at these facilities. The remainder of our revenue is generated from our assisted living services, rehabilitation therapy services provided to third-party facilities, hospice care and home health services. Our revenue was $869.7 million and $820.2 million for the years ended December 31, 2011 and 2010, respectively. To increase our revenue, we focus on acquiring existing facilities and businesses, developing new facilities and businesses, and improving our occupancy (census) rate and our skilled mix, which is the number of Medicare and managed care patient days at our skilled nursing facilities divided by the total number of patient days at our skilled nursing facilities for any given period. Medicare and managed care payors typically provide higher reimbursement than other payors because patients in these programs typically require a greater level of care and service. We operate our business in three reportable operating segments: (1) long-term care services, which includes the operation of skilled nursing and assisted living facilities and is the most significant portion of our business; (2) therapy services, which includes our rehabilitation therapy services business; and (3) hospice and home health services, which includes our hospice and home health businesses. The "other" category includes general and administrative items. Our reporting segments are business units that offer different services, and that are managed separately due to the nature of services provided. Acquisitions, Developments, and Divestiture In March 2009, we admitted our first patients to our newly constructed skilled nursing facility in Dallas, Texas, the Dallas Center of Rehabilitation. The opening of the Dallas Center of Rehabilitation added 136 beds to our operations. In April 2009, we purchased a skilled nursing facility located in Des Moines, Iowa. This facility added 74 beds to our operations. In April 2009, we completed construction of Vintage Park at Tonganoxie, an assisted living facility in the Kansas City market. This facility added 41 units to our operations. In December 2009, we purchased a skilled nursing facility located in Davenport, Iowa. This facility added 118 beds to our operations. In May 2010, we acquired substantially all of the assets of five Medicare-certified hospice companies and four Medicare-certified home health companies located in Arizona, Idaho, Montana and Nevada, referred to herein as the Hospice/Home Health Acquisition. In July 2010, we admitted our first patients to our newly-constructed skilled nursing facility in Fort Worth, Texas, the Fort Worth Center of Rehabilitation. This facility added 136 beds to our operations. In December 2010, we sold our Westside Campus of Care skilled nursing facility and operations in Texas and purchased three previously leased facilities: St. Luke Healthcare and Rehabilitation Center and Woodland Care Center, located in California, and St. Joseph Transitional Rehabilitation Center in Nevada. We recorded a net gain of $1.8 million related to these transactions. In April 2011, five of our subsidiaries that operate skilled nursing facilities in northern California transferred their operations to an unaffiliated third party skilled nursing facility operator. Another subsidiary of ours retained ownership of the real estate where the operations are located, and signed a 10-year lease with two 10-year extension options with the new operator. We recorded $0.8 million in exit costs in connection with the foregoing transaction. In April 2011, a wholly owned subsidiary of our business, the Rehabilitation Center of Omaha, LLC ("RCO"), signed an operating lease for a skilled nursing and assisted living facility in Omaha, Nebraska for 10 years with two additional 5-year extensions. The lease also provides RCO with a purchase option and the landlord with a sale option, beginning in year six of the lease In July 2011, we acquired Altura Homecare & Rehab, a home health care agency serving the Albuquerque, New Mexico market. In July 2011, we acquired the real property and related operations of Willow Creek Memory Care at San Martin in Las Vegas, Nevada, which is currently licensed for 62 memory care assisted living beds. The newly acquired facility now operates as Vintage Park at San Martin. In October 2011, we acquired substantially all of the assets of Cornerstone Hospice, Inc., which provides hospice services in the Colton, California and Phoenix, Arizona areas. Key Financial Performance Indicators                                         33

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We manage the fiscal aspects of our business by monitoring certain key performance indicators that affect our revenue and profitability. The most important key performance indicators for our business are: • Average daily number of patients-the total number of patients at our

        skilled nursing facilities in a period divided by the number of days in        that period.   

• Average daily rates-revenue per patient per day for Medicare or managed

care, Medicaid and private pay and other, calculated as total revenue for

Medicare or managed care, Medicaid and private pay and other at our

skilled nursing facilities divided by actual patient days for that revenue

source for any given period.

• EBITDA-net (loss) income before depreciation, amortization and interest

expense (net of interest income) and the provision for income taxes.

Additionally, Adjusted EBITDA means EBITDA as adjusted for non-core

business items. See footnote 1 under Item 6 of this report, "Selected

Financial Data," for an explanation of the adjustments and a description

of our uses of, and the limitations associated with, EBITDA and Adjusted

EBITDA.

• EBITDAR-net (loss) income before depreciation, amortization and interest

expenses (net of interest income), the provision for income taxes and rent

cost of revenue. Additionally, Adjusted EBITDAR means EBITDAR as adjusted

for the non-core business items reflected in Adjusted EBITDA. See footnote

       2 under Item 6 of this report, "Selected Financial Data," for an        explanation of the adjustments and a description of our uses of, and the        limitations associated with, EBITDAR and Adjusted EBITDAR.  

• Number of facilities and licensed beds-the total number of skilled nursing

facilities and assisted living facilities that we own or operate and the

total number of licensed beds associated with our skilled nursing

facilities and the total number of units associated with our assisted

living facilities.

• Occupancy percentage-the average daily ratio during a measurement period

of the total number of patients occupying beds in a skilled nursing

facility to the number of available beds in the skilled nursing facility.

During any measurement period, the number of licensed beds in a skilled

       nursing facility that are actually available to us may be less than the        actual licensed bed capacity due to, among other things, bed        de-certifications.  

• Percentage of facilities owned-the number of skilled nursing facilities

and assisted living facilities that we own as a percentage of the total

number of facilities we operate. We believe that our success is positively

       influenced by the significant level of ownership of the facilities we        operate.  

• Quality mix-the amount of non-Medicaid revenue from each of our business

units as a percentage of total revenue. In most states, Medicaid rates are

generally the lowest of all payor types.

• Skilled mix-the number of Medicare and managed care patient days at our

skilled nursing facilities divided by the total number of patient days at

our skilled nursing facilities for any given period.

   The following tables summarize, for each of the periods indicated, our payor sources, quality mix, occupancy percentage, skilled mix, EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR and average daily rates and, at the end of the periods indicated, the number of facilities operated by us, the number of facilities that we own and lease, the total number of licensed beds and our total number of available beds:                                          34

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  Table of Contents                                                             Year Ended December 31,                                                      2011           2010            2009 Revenue from: Medicare                                               37.5 %          37.1 %          35.0 % Managed care, private pay, and other                   33.3            31.2            33.1 Quality mix                                            70.8            68.3            68.1 Medicaid                                               29.2            31.7            31.9 Total                                                 100.0 %         100.0 %         100.0 % Occupancy statistics (skilled nursing facilities): Available patient days                            3,249,449       3,391,343       3,324,757 Actual patient days                               2,698,994       2,819,609       2,784,033 Occupancy percentage                                   83.1 %          83.1 %          83.7 % Skilled mix                                            23.2 %          22.7 %          23.1 % Average daily number of patients                      7,395           7,725 

7,628

 EBITDA(1) (in thousands)                         $ (136,241 )   $    62,552     $   (60,164 ) Adjusted EBITDA(1) (in thousands)                $  131,310     $   121,524     $   110,887 EBITDAR(2) (in thousands)                        $ (117,842 )   $    81,590     $   (42,027 ) Adjusted EBITDAR(2) (in thousands)               $  149,709     $   140,562     $   129,024 Revenue per patient day (skilled nursing facilities prior to intercompany eliminations) LTC only Medicare (Part A)                       $      558     $       515     $       499 Medicare blended rate (Part A & B)                      619             578             557 Managed care                                            386             379             369 Medicaid                                                154             151             146 Private and other                                       178             169             162 Weighted-average                                 $      247     $       237     $       231                                                              As of December 31,                                                    2011          2010          2009 Facilities: Skilled nursing facilities: Owned                                                  52            57     

54

 Leased                                                 22            21     

24

 Total skilled nursing facilities                       74            78     

78

 Total licensed beds                                 9,183         9,566     

9,704

 Skilled nursing facilities leased to unaffiliated third party operator                       5             -             -  Assisted living facilities: Owned                                                  21            20            20 Leased                                                  2             2             2 Total assisted living facilities                       23            22            22 Total licensed beds                                 1,312         1,264         1,250 Total facilities                                      102           100           100 Available beds in service (SNF only)                8,809         9,156     

9,280

 Percentage of owned facilities                       76.5 %        77.0 %   

74.0 %

________________

(1) EBITDA and Adjusted EBITDA, as defined above, are supplemental measures of

our performance that are not required by, or presented in accordance with,

U.S. GAAP. See the reconciliation of net (loss) income to EBITDA and

Adjusted EBITDA, and a discussion of their uses and limitations, in Item 6

       of this report, "Selected Financial Data."                                           35

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(2) EBITDAR and Adjusted EBITDAR, as defined above, are supplemental measures

of our performance that are not required by, or presented in accordance

with, U.S. GAAP. See the reconciliation of net (loss) income to EBITDAR

and Adjusted EBITDAR, and a discussion of their uses and limitations, in

Item 6 of this report, "Selected Financial Data."

Revenue

 Revenue by Service Offering In our long-term care services segment, we derive the majority of our revenue by providing skilled nursing care and integrated rehabilitation therapy services to residents in our affiliated of skilled nursing facilities. The remainder of our long-term care segment revenue is generated by our affiliated assisted living facilities. In our therapy services segment, we derive revenue by providing rehabilitation therapy services to third-party facilities. In our hospice and home health services segment, we derive revenue by providing hospice and home health services. The following table shows the revenue and percentage of our total revenue generated by each of our operating segments for the periods presented (dollars in thousands):                                                 Year Ended December 31,                             2011                        2010                        2009                     Revenue       Revenue       Revenue       Revenue       Revenue       Revenue             Percentage Change                     Dollars     Percentage      Dollars     Percentage      Dollars     Percentage     2011 vs. 2010      2010 vs. 2009 Long-term care services: Skilled nursing facilities        $ 662,638          76.2 %   $ 667,691          81.5 %   $ 640,080          84.7 %         (0.8 )%             4.3  % Assisted living facilities           27,593           3.2        25,585           3.1        24,442           3.2            7.8                4.7 Administration of third party facilities            1,144           0.1         1,125           0.1         2,278           0.3            1.7              (50.6 ) Leased facility revenue               2,239           0.3             -             -             -             -          100.0                N/A Total long-term care services       693,614          79.8       694,401          84.7       666,800          88.2           (0.1 )              4.1 Therapy services: Third-party rehabilitation therapy services     92,765          10.7        74,118           9.0        74,723           9.9           25.2               (0.8 ) Total therapy services             92,765          10.7        74,118           9.0        74,723           9.9           25.2               (0.8 ) Hospice & Home Health services: Hospice              65,509           7.5        41,221           5.0        14,542           1.9           58.9              183.5 Home Health          17,813           2.0        10,498           1.3             -             -           69.7              100.0 Total hospice & home health services             83,322           9.5        51,719           6.3        14,542           1.9           61.1              255.7 Total             $ 869,701         100.0 %   $ 820,238         100.0 %   $ 756,065         100.0 %          6.0  %             8.5  %    Sources of Revenue The following table sets forth revenue consolidated by state in dollars and as a percentage of total revenue for the periods presented (dollars in thousands):                                           36

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   Table of Contents                                        Year Ended December 31,                      2011                       2010                       2009             Revenue     Percentage     Revenue     Percentage     Revenue     Percentage             Dollars     of Revenue     Dollars     of Revenue     Dollars     of Revenue California $ 354,260         40.7 %   $ 343,984         41.9 %   $ 334,953         44.3 % Texas        187,108         21.5       190,607         23.2       190,587         25.2 New Mexico    92,617         10.6        86,029         10.5        81,061         10.7 Kansas        67,301          7.7        61,657          7.5        57,864          7.6 Missouri      60,738          7.0        57,539          7.0        57,141          7.6 Nevada        59,609          6.9        48,516          5.9        30,929          4.1 Montana       13,060          1.5         8,004          1.0             -            - Iowa          11,030          1.3         9,989          1.2         2,870          0.4 Arizona       12,086          1.4         7,928          1.0             -            - Idaho          9,420          1.1         5,937          0.7             -            - Nebraska       2,470          0.3             -            -             -            - Other              2            -            48          0.1           660          0.1 Total      $ 869,701        100.0 %   $ 820,238        100.0 %   $ 756,065        100.0 %    Long-Term Care Services Segment Skilled Nursing Facilities. Within our skilled nursing facilities, we generate our revenue from Medicare, Medicaid, managed care providers, insurers, private pay and other sources. We believe that our skilled mix is an important indicator of our success in attracting high-acuity patients because it represents the percentage of our patients who are reimbursed by Medicare and managed care payors, for whom we generally receive higher reimbursement rates. Most of our skilled nursing facilities include our Express RecoveryTM program. This program uses a dedicated unit within a skilled nursing facility to deliver a comprehensive rehabilitation and recovery regimen in accommodations specifically designed to serve high-acuity patients. The following table sets forth our Medicare, managed care, private pay/other and Medicaid patient days as a percentage of total patient days and the level of skilled mix for our skilled nursing facilities:                           Year Ended December 31,                         2011        2010      2009 Medicare                15.0 %      15.7 %    16.2 % Managed care             8.2         7.0       6.9 Skilled mix             23.2        22.7      23.1

Private pay and other 16.1 16.4 17.8 Medicaid

                60.7        60.9      59.1 Total                  100.0 %     100.0 %   100.0 %   Skilled mix increased to 23.2% in 2011 from 22.7% in 2010. While skilled mix increased in 2011 as compared to 2010, we experienced an increase in our managed care patient days and a decrease in Medicare patient days as more seniors elected managed Medicare. Our managed care PPD rates are lower than our Medicare PPD rates and our managed care patients historically have had a shorter length of stay than our Medicare patients. The following table sets forth our Medicare, managed care, private pay and Medicaid sources of revenue by percentage of total revenue and the level of quality mix for our company:                          Year Ended December 31,                         2011        2010      2009 Medicare                37.5 %      37.1 %    35.0 % Managed care            10.2         9.2       9.4 Private pay and other   23.1        22.0      23.7 Quality mix             70.8        68.3      68.1 Medicaid                29.2        31.7      31.9 Total                  100.0 %     100.0 %   100.0 %  

Assisted Living Facilities. Within our assisted living facilities, which are mostly in Kansas, we generate our revenue

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  primarily from private pay sources, with a small portion earned from Medicaid or other state-specific programs. Leased Facility Revenue. We lease five skilled nursing facilities in California to an unaffiliated third party operator. For a detailed discussion of the lease arrangement, see Note 8, "Property and Equipment." Therapy Services Segment As of December 31, 2011, we provided rehabilitation therapy services to a total of 186 healthcare facilities, including 64 of our facilities, as compared to 172 facilities, including 68 of our facilities, as of December 31, 2010. In addition, we have contracts to manage the rehabilitation therapy services for our 10 healthcare facilities in New Mexico. The net increase of 14 facilities serviced was comprised of 26 new facilities serviced, net of 12 cancellations. Rehabilitation therapy revenue derived from servicing our own facilities is included in our revenue from skilled nursing facilities. Our rehabilitation therapy business receives payment for services from the third-party skilled nursing facilities that it serves based on negotiated patient per diem rates or a negotiated fee schedule based on the type of service rendered. Hospice and Home Health Services Segment Hospice. As of December 31, 2011, we provided hospice care in Arizona, California, Idaho, Montana, Nevada, and New Mexico. We derive substantially all of the revenue from our hospice business from Medicare and managed care reimbursement. Federal law imposes a Medicare payment cap on hospice service programs. We monitor the impact of the Medicare cap on our hospice business by attempting to address our average length-of-stay on a market-by-market basis. A key component of this strategy is to analyze each hospice program's mix of patients and referral sources to achieve an appropriate balance of the types of patients and referral sources that we serve in each of our programs. Home Health. We provided home health care in Arizona, Nevada, Idaho, Montana, New Mexico and California as of December 31, 2011. We derive the majority of the revenue from our home health business from Medicare. Net service revenue is recorded under the Medicare payment program based on a 60-day episodic payment rate that is subject to downward adjustment based on certain variables. Regulatory and other Governmental Actions Affecting Revenue We derive a substantial portion of our revenue from government Medicare and Medicaid programs. In addition, our rehabilitation therapy services, for which we receive payment from private payors, is significantly dependent on Medicare and Medicaid funding, as those private payors are primarily funded by these programs. The following table summarizes the amount of revenue that we received from each of our payor classes by segment in the periods presented (dollars in thousands):                                                                                  Year Ended December 31,                                                2011                                                                                2010                                         Hospice & Home                                                                      Hospice & Home            Long-term       Therapy          Health                              Revenue        Long-term       Therapy          Health                              Revenue          Care Services     Services        Services        Total Revenue   

Percentage Care Services Services Services Total Revenue Percentage Medicare $ 250,236 $ - $ 75,975 $ 326,211

37.5 % $ 256,182 $ - $ 48,231 $ 304,413 37.1 % Medicaid 252,518

              -            1,209             253,727          29.2           259,334              -              749             260,083          31.7 Subtotal Medicare and Medicaid     502,754              -           77,184             579,938          66.7           515,516              -           48,980             564,496          68.8 Managed Care          86,727              -            1,938              88,665          10.2            75,206              -              451              75,657           9.2 

Private

 pay and other        104,133         92,765            4,200             201,098          23.1           103,679         74,118            2,288             180,085          22.0 Total    $   693,614     $   92,765     $     83,322     $       869,701         100.0 %     $   694,401     $   74,118     $     51,719     $       820,238         100.0 %                                           38

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  Table of Contents                                                                                  Year Ended December 31,                                                2010                                                                                2009                                         Hospice & Home                                                                      Hospice & Home            Long-term       Therapy          Health                              Revenue        Long-term       Therapy          Health                              Revenue          Care Services     Services        Services        Total Revenue   

Percentage Care Services Services Services Total Revenue Percentage Medicare $ 256,182 $ - $ 48,231 $ 304,413

37.1 % $ 251,019 $ - $ 13,575 $ 264,594 35.0 % Medicaid 259,334

              -              749             260,083          31.7           240,488              -              533             241,021          31.9 Subtotal Medicare and Medicaid     515,516              -           48,980             564,496          68.8           491,507              -           14,108             505,615          66.9 Managed Care          75,206              -              451              75,657           9.2            71,181              -                -              71,181           9.4 

Private

 pay and other        103,679         74,118            2,288             180,085          22.0           104,112         74,723              434             179,269          23.7 Total    $   694,401     $   74,118     $     51,719     $       820,238    

100.0 % $ 666,800$ 74,723$ 14,542 $ 756,065 100.0 %

Medicare. Medicare is a federal health insurance program for people age 65 or older, people under age 65 with certain disabilities, and people of all ages with End-Stage Renal Disease. Part A of the Medicare program includes hospital insurance that helps to cover hospital inpatient care and skilled nursing facility inpatient care under certain circumstances (e.g., up to 100 days of inpatient skilled nursing coverage following a 3-day qualifying hospital stay, and no custodial or long-term care). It also helps cover hospice care and some home health care. Skilled nursing facilities are paid on the basis of a prospective payment system, or PPS. The PPS payment rates are adjusted for case mix and geographic variation in wages and cover all costs of furnishing covered skilled nursing facilities services (routine, ancillary, and capital-related costs). The amount to be paid is determined by classifying each patient into a resource utilization group, or RUG, category, which is based upon each patient's acuity level. CMS generally evaluates and adjusts payment rates on an annual basis. Medicaid. Medicaid is a state-administered medical assistance program for the indigent, operated by the individual states with the financial participation of the federal government. Each state has relatively broad discretion in establishing its Medicaid reimbursement formulas and coverage of service, which must be approved by the federal government in accordance with federal guidelines. All states in which we operate cover long-term care services for individuals who are Medicaid eligible and qualify for institutional care. Providers must accept the Medicaid reimbursement level as payment in full for services rendered. Medicaid programs generally make payments directly to providers, except in cases where the state has implemented a Medicaid managed care program, under which providers receive Medicaid payments from managed care organizations (MCOs) that have subcontracted with the Medicaid program. All states in which we currently do business have all, or a portion of, their Medicaid population enrolled in a Medicaid MCO. Managed Care. Our managed care patients consist of individuals who are insured by a third-party entity, typically called a senior Health Maintenance Organization, or senior HMO plan, or are Medicare beneficiaries, or Hospice who assign their Medicare benefits to a senior HMO plan. Private Pay and Other. Private pay and other sources consist primarily of individuals or parties who directly pay for their services or are beneficiaries of the Department of Veterans Affairs.  Primary Expense Components Cost of Services Cost of services in our long-term care services segment primarily includes salaries and benefits, supplies, purchased services, ancillary expenses such as the cost of pharmacy and therapy services provided to patients and residents, and operating expenses of our skilled nursing and assisted living facilities, including professional and general liability insurance. Cost of services in our therapy services and hospice and home health services segments primarily includes salaries and benefits, supplies, purchased services, expenses for general and professional liability insurances and other operating expenses. General and Administrative General and administrative expenses are primarily salaries, bonuses and benefits and purchased services to operate our administrative service company. Also included in general and administrative expenses are expenses related to non-cash stock-based compensation and professional fees, including accounting, financial audit and legal fees. Performance Based Incentive Compensation                                         39

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  Our performance based incentive compensation plan for each of our operating segments provides for cash bonus payments that are intended to reflect the achievement of key operating measures, including quality outcomes, customer satisfaction, cash collections, efficient resource utilization and operating budget goals. We accrue bonus expense based on the ratable achievement of these operating measures. Depreciation and Amortization Depreciation and amortization relates to the ratable write-off of assets such as our owned buildings and equipment over their estimated useful lives. Depreciation and amortization is computed using the straight-line method over the estimated useful lives of the assets as follows: Buildings and improvements   15-40 years                              Shorter of the lease term or estimated useful life, Leasehold improvements       generally 5-10 years Furniture and equipment      3-10 years    Rent Cost of Revenue Rent consists of the straight-line recognition of lease amounts payable to third-party owners of skilled nursing facilities and assisted living facilities that we operate but do not own.  Critical Accounting Policies and Estimates The preparation of our financial statements and related disclosures requires us to make judgments, 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 revenue and expenses during the reporting period. On an ongoing basis, we reevaluate our judgments and estimates, including those related to doubtful accounts, income taxes and loss contingencies. We base our estimates and judgments on our historical experience, knowledge of current conditions and our belief of what could occur in the future considering available information, including assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty and actual results could differ materially from the amounts reported based on these policies. The following represents a summary of our critical accounting policies, defined as those policies and estimates that we believe: (a) are the most important to the portrayal of our financial condition and results of operations and (b) require management's most subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain. Revenue recognition Our net patient service revenue is derived primarily from our skilled nursing facilities, which includes our integrated rehabilitation therapy services at these facilities, with the remainder generated by our post-acute related healthcare services. These other healthcare services consist of our rehabilitation therapy services provided to third-party facilities, as well as services provided by our assisted living facilities and by our hospice care and home health businesses. We record our net patient service revenue on an accrual basis as services are performed at their estimated net realizable value under these programs. Our revenue from governmental and managed care programs is subject to ongoing audit and retroactive adjustment by governmental and third-party agencies. Retroactive adjustments that are likely to result from ongoing and future audits by third-party payors are accrued on an estimated basis in the period the related services are performed. Consistent with accounting practices in the healthcare industry, we record any changes to these governmental revenue estimates in the period in which the change or adjustment becomes known based on final settlements. Because of the complexity of the laws and regulations governing Medicare and state Medicaid assistance programs, our revenue estimates may potentially change by a material amount. Allowance for doubtful accounts We maintain allowances for doubtful accounts related to estimated losses resulting from nonpayment of patient accounts receivable and third-party billings and notes receivable from customers. In evaluating the collectability of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection trends, the composition of patient accounts by payor, the status of ongoing disputes with third-party payors, underlying guarantees, and general industry conditions. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Our receivables from Medicare and Medicaid payor programs represent our only significant concentration of credit risk. We do not believe there to be significant credit risks associated with these governmental programs. If, at December 31, 2011, we were to recognize an increase of 10% in our allowance for doubtful accounts, our total current assets would decrease by $1.5 million, or 1.1%. There would be a corresponding increase in                                         40

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  operating expense. Patient liability risks Our professional liability and general liability reserve includes amounts for patient care related claims and incurred but not reported claims. Professional liability and general liability costs for healthcare services in many states continue to be expensive and difficult to estimate, although other states have implemented tort reform that has stabilized the costs. The amount of our reserves is determined based on an estimation process that uses information obtained from both company-specific and industry data. The estimation process requires us to continuously monitor and evaluate the life cycle of the claims. Using data obtained from this monitoring and our assumptions about emerging trends, we, along with an independent actuary, develop information about the size of ultimate claims based on our historical experience and other available industry information. The most significant assumptions used in the estimation process include determining the trend in costs, the expected number and cost of claims incurred but not reported and the expected costs to settle unpaid claims. Although we believe that our reserves are adequate, it is possible that this liability will require a material adjustment in the future. For example, an adverse professional liability judgment partially contributed to our predecessor's bankruptcy filing under Chapter 11 of the United States Bankruptcy Code in October 2001. If, at December 31, 2011, we were to recognize an increase of 10% in the reserve for professional liability and general liability, our total liabilities would be increased by $3.0 million, or 0.5%. There would be a corresponding increase in operating expense. We record our professional and general liability reserves on an undiscounted basis. Impairment of long-lived assets We periodically evaluate the carrying value of our long-lived assets other than goodwill, primarily consisting of our investments in real estate, for impairment indicators. If indicators of impairment are present, we evaluate the carrying value of the related real estate investments in relation to the future discounted cash flows of the underlying operations to assess recoverability of the assets. Measurement of the amount of the impairment, if any, may be based on independent appraisals, established market values of comparable assets or estimates of future cash flows expected. The estimates of these future cash flows are based on assumptions and projections believed by management to be reasonable and supportable. They require management's subjective judgments and take into account assumptions about revenue and expense growth rates. These assumptions may vary by type of long-lived asset. For property and equipment, major renovations or improvements are capitalized. Ordinary maintenance and repairs are expensed as incurred. Goodwill and Other Long-Lived Assets Goodwill is accounted for under the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 805, Business Combinations, and represents the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations accounted for as purchases. In accordance with FASB ASC Topic 350, "Intangibles - Goodwill and Other," goodwill is subject to periodic testing for impairment. Goodwill of a reporting unit is tested for impairment on an annual basis, or, if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying amount, between annual testing. We have selected October 1 as the date to test goodwill for impairment on an annual basis. However during 2011, as a result of the July 2011 announcement by CMS regarding reimbursement rate reductions and other changes that went into effect on October 1, 2011, which led to a significant decline in our stock price, we conducted an interim goodwill impairment analysis as of August 31, 2011. Our analysis and related conclusions are discussed below. Given the timing of the 2011 impairment test in relation to the reimbursement rate reductions effective date of October 1, 2011 and as there were no further indicators of impairment, an updated analysis was not required during the last four months of the year. Goodwill Impairment Testing We compare the fair value of each reporting unit to its carrying amount on an annual basis to determine whether there is potential goodwill impairment. If the fair value of the reporting unit is less than its carrying value, an impairment loss is recorded to the extent the fair value of goodwill is less than its carrying value. As of August 31, 2011, we compared the fair value of each reporting unit to its carrying value. We concluded that the carrying value of the long-term care and therapy services reporting units exceeded their fair value and that the fair value of the hospice and home health reporting units exceeded their carrying value. We assessed the fair value of the long-term care and therapy services reporting units for goodwill impairment based upon a combination of the discounted cash flow (income approach) and guideline public company method (market approach). The income and market approaches were given equal weighting. The discounted cash flow and market approach methodologies utilized in estimating the fair value of our reporting units for purposes of goodwill impairment testing requires various judgmental assumptions about revenues, EBITDA and operating                                         41

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  margins, growth rates, and working capital requirements. In determining those judgmental assumptions, we make a number of judgments regarding a variety of data, including for each reporting unit, the annual budget for the upcoming year, the longer-term business plan, economic projections, anticipated future cash flows, market data, and historical cash flow growth rates. As we had not yet prepared our budget for the year ended December 31, 2012, our then-current internal forecast was utilized for the August 31, 2011 impairment analysis. Long-Term Care Unit Testing Below are the key assumptions used to estimate the fair value for our long-term care reporting unit at the time of our August 31, 2011 goodwill impairment test using the income approach:  •A revenue reduction of 6.1% for the initial 12 month period following the valuation date as a result of the 11.1% Medicare rate reduction effective October 1, 2011; •2.0% long-term revenue growth rate beginning in 2012; •and a 9.5% discount rate Our long-term care reporting unit experienced an average annual compounded growth rate in external revenue from 2007 to 2010 of 7.7%. However, we selected a long term growth rate of 2.0% for the undiscounted cash flow analysis conducted as part of the impairment analysis because the historical growth rate includes acquisitions, new developments and the increase that resulted from RUGs IV being implemented on October 1, 2010. The 2.0% long-term growth rate is our expected long-term growth rate from a combination of reimbursement rate increases, occupancy and skilled mix increases. This growth rate was assumed to be 3.0% in the prior year analysis with a 2.5% growth rate in the terminal year. The reduction in the assumed revenue growth rate in the current year analysis is due to the increased pressure placed on the federal and state governments to limit and even reduce spending. The operating expenses projected under the discounted cash flow method were based upon our historical expenses as a percentage of long-term care revenue adjusted for known efficiencies or additional costs to be incurred. Capital expenditures were based upon expected expenditures per bed. The discount rate used to calculate the present value of cash flows under the discounted cash flow method is a significant assumption in the analysis. The discount rate was developed using the capital asset pricing model through which a weighted average cost of capital was derived. The cost of equity was assumed to be 15.6% and the pre-tax cost of debt was assumed to be 9.0%. Assuming a capital structure of 60% debt and 40% equity, the average cost of capital was determined to be 9.5%, which was used as the discount rate. A 0.5% decrease in the discount rate would increase the equity value of the long-term care reporting unit by approximately $48 million, or 38%, using the income approach. Increasing the long term revenue growth rate by 0.5% increases the equity value by approximately $38 million, or 30%, using the income approach, which would have resulted in approximately $30 million less of impairment charge. For the market approach, we compared ourselves to a peer group of other public companies. As several of our peers lease a higher percentage of their skilled nursing facilities than we do, the metric used was total invested capital, or TIC, divided by earnings before interest, tax, depreciation, amortization and rent, or EBITDAR. The average TIC divided by projected 2012 EBITDAR for the peer group, including us, was 6.1. For our market valuation a multiple of 6.5 was selected along with a control premium of 30%, based upon historical transactions. The market valuation multiple used was selected based upon company specific operating statistics as compared to the market participants. As the result of this evaluation indicated that the reporting unit's carrying value of equity exceeded the fair value of equity, we performed step two of the goodwill impairment analysis for the long-term care reporting unit. In this test, the carrying value of goodwill is adjusted to its fair value. Each asset and liability was ascribed a value based on fair value standards under U.S. GAAP. However, no change in book value for any assets or liabilities (other than goodwill) was recognized on our December 31, 2011 balance sheet as we have not elected the fair value option of reporting. We used forecasted occupancy rates, operating income, market rental rates and capitalization rates to calculate the fair value of the skilled nursing and assisted living facilities, the largest non-goodwill asset of the long-term care reporting unit. The assumptions varied by facility. We determined the fair value of the skilled healthcare facilities exceeded their carrying value in the aggregate. The fair value of the long-term care reporting unit was used for the equity value of the long-term care reporting unit in the step two analysis. The fair value of the remaining assets and liabilities (other than goodwill) was substantially equivalent to their carrying value. Upon completion of step two, we recorded a goodwill impairment charge of $243.2 million, or all of the goodwill, at our long-term care reporting unit. Therapy Unit Testing Below are the key assumptions used to estimate the fair value for our therapy reporting unit at the time of our August 31, 2011 goodwill impairment test using the income approach:                                         42

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   • 2.0% long-term growth rate; and • 12.5% discount rate Our therapy services reporting unit experienced an average annual compounded (negative) growth rate in external revenue from 2007 to 2010 of (2.1%). This decline in revenue was primarily the result of the loss of two customers in the fourth quarter of 2009. As such, we selected a long term growth rate of 2.0% for the discounted cash flow analysis conducted as part of the impairment analysis as the 2.0% long-term growth rate is our expected long-term growth rate from a combination of rate increases as well as occupancy and skilled mix increases at our third party customers. This growth rate was assumed to be 3.0% in the prior year analysis with a 2.5% growth rate in the terminal year. The reduction in the assumed revenue growth rate in the current year analysis is due to the increased pressure placed on the federal and state governments to limit and even reduce spending. The operating expenses projected under the discounted cash flow method were based upon our historical expenses as a percentage of therapy revenue adjusted for known efficiencies or additional costs to be incurred. Capital expenditures in the therapy services reporting unit have historically been negligible. The discount rate used to present value cash flows under the discounted cash flow method is a significant assumption in the analysis. The discount rate was developed using the capital asset pricing model through which a weighted average cost of capital was derived. The cost of equity was assumed to be 14.3% and the pre-tax cost of debt was assumed to be 10.0%. Assuming a capital structure of 25% debt and 75% equity, the average cost of capital was determined to be 12.5%, which was used as the discount rate. A 0.5% decrease in the discount rate would increase the equity value of the therapy reporting unit by approximately $2 million, or 8%, using the income approach. Increasing the long term revenue growth rate by 0.5% increases the equity value by approximately $1 million, or 4%, using the income approach. For the market approach, we compared ourselves to a peer group of other public companies. The metric used was total invested capital, or TIC, divided by earnings before interest, tax, depreciation and amortization, or EBITDA. The average TIC divided by projected 2012 EBITDAR for the peer group, including us, was 4.7. For our market valuation a multiple of 5.0 was selected along with a control premium of 30%, based upon historical transactions. As the result of this evaluation indicated that the reporting unit's carrying value of equity exceeded the fair value of equity, we performed step two of the goodwill impairment analysis for the therapy services reporting unit. In this test, the carrying value of goodwill is adjusted to its fair value. Each asset and liability was ascribed a value based on fair value standards under generally accepted accounting principles. As a result of this analysis, a $3.0 million impairment charge was recognized related to the Hallmark Rehabilitation business's trade name, a long-lived intangible asset. No other change in book value for any assets or liabilities (other than goodwill) was recognized on our December 31, 2011 balance sheet as we have not elected the fair value option of reporting. The fair value of the therapy services reporting unit was used for the equity value of the long-term care reporting unit in the step two analysis. The fair value of the remaining assets and liabilities (other than goodwill and the trade name) was substantially equivalent to their carrying value. Upon completion of step two, we recorded a goodwill impairment charge of $24.3 million at our therapy services reporting unit. Prior to the goodwill impairment charge, the therapy reporting unit had goodwill for $34.0 million. Our goodwill impairment analysis is subject to uncertainties due to uncontrollable events, including the strategic decisions made in response to economic or competitive conditions, the general economic environment, and material changes in Medicare and Medicaid reimbursement that could positively or negatively impact anticipated future operating conditions and cash flows. In addition, our goodwill impairment analysis is subject to current economic uncertainties. As of December 31, 2011, goodwill in the amount of $84.3 million was recorded in our consolidated balance sheet, of which $9.7 million related to the rehabilitation therapy unit, $53.7 million related to the hospice reporting unit and $20.9 million related to the home health reporting unit. Income Taxes Income taxes are accounted for under FASB ASC Topic 740, "Income Taxes." FASB ASC Topic 740 prescribes a recognition threshold and measurement criteria for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FASB ASC Topic 740 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition rules. As of December 31, 2011 and 2010, our accrual for unrecognized tax benefits including applicable interest and penalties was negligible. As prescribed by FASB ASC Topic 740, only the amounts reasonably expected to be paid within 12 months are recorded in taxes payable, while remaining amounts after 12 months are recorded in other non-current taxes payable. Significant judgment is required in determining our provision for income taxes. In the ordinary course of business, there are many transactions for which the ultimate tax outcome is uncertain. While we believe that our tax return positions are supportable, there are certain positions that may not be sustained upon review by tax authorities. While we believe that                                         43

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  adequate accruals have been made for such positions, the final resolution of those matters may differ from the amounts provided for in our historical income tax provisions and accruals. We recognize interest and penalties related to uncertain tax positions in the provision for income taxes line item of the consolidated statements of operations. As of December 31, 2011 and 2010, our accrued interest and penalties on unrecognized tax benefits was negligible. We are subject to taxation in the United States and in various state jurisdictions. Our tax years 2007 and forward are subject to examination by the United States Internal Revenue Service and from 2006 forward by our material state jurisdictions. The Internal Revenue Service completed the field audit portion of a limited scope examination of our 2007 through 2009 tax years and the results were negligible. We use the liability method of accounting for income taxes as set forth in FASB ASC Topic 740. We determine deferred tax assets and liabilities at the balance sheet date based upon the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Our temporary differences are primarily attributable to purchase adjustments related to intangible assets, depreciation, allowances for doubtful accounts, settlement costs, and accruals for professional and general liability expenses and workers' compensation, which are not deductible for tax purposes until paid. We assess the likelihood that our deferred tax assets will be recovered from future taxable income and available carryback potential and unless we believe that recovery is more likely than not, we establish a valuation allowance to reduce the deferred tax assets to the amounts expected to be realized. We make our judgments regarding deferred tax assets and the associated valuation allowance, based on among other things, expected future reversals of taxable temporary differences, available carryback potential, tax planning strategies and forecasts of future income. We periodically review for the requirement of a valuation allowance as necessary. As of December 31, 2011, we were in a three-year cumulative pre-tax loss position, which is considered significant negative evidence under FASB ASC Topic 740 and presumes a need for a valuation allowance. The cumulative pretax loss was attributable to 2009 and 2011 goodwill impairment charges which were primarily non-deductible for income tax purposes and did not affect taxable income. We have a history of generating taxable earnings and will report significant taxable income in 2011. Further, as our deferred tax assets are expected to reverse in subsequent years, any deferred tax asset could be utilized to carry back against prior year income. This significant positive evidence overcomes the presumption of a need for a valuation allowance. At December 31, 2011, we retained a valuation allowance for our state loss and credit carryforwards of $0.7 million as a result of certain restrictions regarding their utilization. Share-Based Payments Share-based payments are accounted for under the FASB ASC Topic 718, "Compensation-Stock Compensation," which requires all share-based payments, including stock option grants and restricted stock awards, to be recognized in our financial statements based upon their respective grant date fair values. Under FASB ASC Topic 718, the fair value of each employee's stock option is estimated on the date of grant using an option pricing model that meets certain requirements. We currently use the Black-Scholes option pricing model to estimate the fair value of our stock options. The Black-Scholes model meets the requirements of FASB ASC Topic 718, but the fair values generated by the model may not be indicative of the actual fair values of our equity awards as it does not consider certain factors important to those awards, such as continued employment and periodic vesting requirements as well as limited transferability. The determination of the fair value of share-based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. We estimated the expected volatility by examining the historical and implied volatilities of comparable publicly-traded companies due to our limited trading history and because we do not have any publicly traded options. We estimated the expected life of the stock options as the average of the contractual term and the weighted-average vesting term of the options. The risk-free interest rate assumption is based on the implied U.S. treasury rate for the expected life of the stock option. The dividend yield assumption is based on our history and expectation of no dividend payouts. The fair value of our restricted stock awards is based on the closing market price of our Class A common stock on the date of grant. We evaluate the assumptions used to value stock awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that we grant additional equity securities to employees, our stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants or acquisitions. As of December 31, 2011, there was approximately $4.0 million of total unrecognized compensation costs related to unvested stock awards, restricted stock units and performance stock awards. These costs are expected to have a weighted-average remaining recognition period of 2.7 years. As of December 31, 2011, the total compensation costs related to unvested stock option grants not yet recognized was $1.3 million. These costs are expected to have a weighted-average remaining                                         44

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  recognition period of 2.0 years. Accounting for Conditional Asset Retirement Obligations In accordance with FASB ASC Topic 410, "Asset Retirement and Environmental Obligations," we recorded a liability of $5.0 million effective December 31, 2005, substantially all of which related to estimated costs to remove asbestos that is contained within our facilities. Of this $5.0 million liability, $1.6 million was recorded as a cumulative effect of a change in accounting principle, net of tax benefit for the year ended December 31, 2005. We have determined that a conditional asset retirement obligation exists for asbestos remediation. Though not a current health hazard in our facilities, upon renovation, we may be required to take the appropriate remediation procedures in compliance with state law to remove the asbestos. The removal of asbestos-containing materials includes primarily floor and ceiling tiles from our pre-1980 constructed facilities. We determined the fair value of the conditional asset retirement obligation as the present value of the estimated future cost of remediation based on an estimated expected date of remediation. This computation is based on a number of assumptions which may change in the future based on the availability of new information, technology changes, changes in costs of remediation, and other factors. The determination of the asset retirement obligation is based upon a number of assumptions that incorporate our knowledge of the facilities, the asset life of the floor and ceiling tiles, the estimated time frames for periodic renovations which would involve floor and ceiling tiles, the current cost for remediation of asbestos and the current technology at hand to accomplish the remediation work. These assumptions to determine the asset retirement obligation may be imprecise or be subject to changes in the future. Any change in the assumptions can impact the value of the determined liability and impact our future earnings. If we were to experience a 10% increase in our estimated future cost of remediation, our recorded liability of $4.0 million would increase by $0.4 million. Operating Leases The information required by this item is incorporated herein by reference to Note 2, "Summary of Significant Accounting Policies," to the consolidated financial statements included elsewhere in this report. Recent Accounting Standards The information required by this item is incorporated herein by reference to Note 2, "Summary of Significant Accounting Policies," to the consolidated financial statements included elsewhere in this report.  Results of Operations The following table sets forth details of our revenue, expenses and earnings (loss) as a percentage of total revenue for the periods indicated:                                          45

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  Table of Contents                                                           Year Ended December 31,                                                     2011           2010           2009 Revenue                                             100.0  %       100.0  %       100.0  % Expenses: Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)                                               80.1           80.3           80.0 Rent cost of revenue                                  2.1            2.3            2.4 General and administrative                            3.0            3.1            3.3 Litigation settlement costs, (net of recoveries)                                          (0.5 )          6.5              - Depreciation and amortization                         2.9            3.1            3.1 Goodwill impairment charge                           31.1              -           22.6                                                     118.7           95.3          111.4 Other income (expenses): Interest expense                                     (4.5 )         (4.5 )         (4.4 ) Interest income                                       0.1            0.1            0.2 Equity in earnings of joint venture                   0.2            0.3            0.4 Other (expense) income                               (0.1 )          0.3              - Debt retirement costs                                   -           (0.8 )            - Total other (expenses) income, net                   (4.3 )         (4.6 )         (3.8 ) (Loss) income before provision for income taxes     (23.0 )          0.1          (15.2 ) Provision for income taxes                            0.4            0.3    

2.4

 Income from continuing operations                   (23.4 )         (0.2 )        (17.6 ) Loss from discontinued operations, net of tax           -              -           (0.1 ) Net (loss)                                          (23.4 )%        (0.2 )%       (17.7 )% EBITDA(1)                                           (15.7 )%         7.6  %        (8.0 )% Adjusted EBITDA(1)                                   15.1  %        14.8  %        14.7  % EBITDAR(2)                                          (13.5 )%         9.9  %        (5.6 )% Adjusted EBITDAR(2)                                  17.2  %        17.1  %        17.1  %    ________________

(1)    See footnote 1 to Item 6 of this report, "Selected Financial Data" for a        calculation of EBITDA and Adjusted EBITDA and for a description of our

uses of, and the limitations associated with, EBITDA and Adjusted EBITDA,

as well as an accompanying reconciliation of EBITDA and Adjusted EBITDA to

net income (loss).

(2) See footnote 2 to Item 6 of this report, "Selected Financial Data" for a

calculation of EBITDAR and Adjusted EBITDAR and for a description of our

uses of, and the limitations associated with, EBITDAR and Adjusted

EBITDAR, as well as an accompanying reconciliation of EBITDA and Adjusted

EBITDA to net income (loss).

DAR.

 Year Ended December 31, 2011 Compared to Year Ended December 31, 2010 Revenue. Revenue increased $49.5 million, or 6.0%, to $869.7 million in 2011 from $820.2 million in 2010. Long Term Care Service                                         46

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   Table of Contents                                         Year Ended December 31,                                   2011                         2010                  Increase/(Decrease)                          Revenue        Revenue       Revenue        Revenue                          Dollars      Percentage      Dollars      Percentage       Dollars       Percentage                                                        (dollars in millions) Skilled nursing facilities             $    662.7         76.2 %    $    667.7         81.5 %    $     (5.0 )         (0.8 )% Assisted living facilities                   27.6          3.2            25.6          3.1             2.0            7.8 Administration of third party facilities        1.1          0.1             1.1          0.1               -              - Leased facility revenue                       2.2          0.3 %    $        -            -      $      2.2          100.0  % Total long-term care services               $    693.6         79.8 %    $    694.4         84.7 %    $     (3.0 )         (0.1 )%    Skilled nursing facilities revenue decreased by $5.0 million in 2011 as compared to 2010. Revenue increased by $19.4 million for skilled nursing facilities operated for all of 2010 and 2011, as a result of a $23.7 million increase to a higher weighted average per patient day ("PPD") rate, offset by a $4.3 million decrease due to a decline in occupancy rates, which occurred primarily at our Texas facilities. Additionally, there were increases of $6.6 million from the opening of the Fort Worth Center of Rehabilitation in June 2010 and $2.4 million from the acquisition of a lease by Rehabilitation Center of Omaha in April 2011, offset by a decreases of $10.6 million of revenue from the sale of Westside Campus of Care in December 2010 and $22.4 million from the transfer of operations of five skilled nursing facilities in northern California to an unaffiliated third party operator in April 2011. The reduction in revenue related to the transfer of operations of the five skilled nursing facilities was $20.2 million net of the $2.2 million of lease revenue that we received as a result of leasing the facilities to the third party operator. Skilled mix increased to 23.2% in 2011 from 22.7% in 2010. While skilled mix increased in 2011 as compared to 2010, we experienced an increase in our managed care patient days and a decrease in Medicare patient days as more seniors elected managed Medicare. Our managed care PPD rates are lower than our Medicare PPD rates and our managed care patients historically have had a shorter length of stay than our Medicare patients. Our average daily Part A Medicare rate increased 8.3% to $558 in 2011 from $515 in 2010, primarily due to the October 2010 implementation of RUGs IV. Our skilled nursing Medicare rates were decreased by 11.1% effective October 1, 2011 which has negatively impacted our skilled nursing revenues in the last quarter of 2011 and will continue to negatively impact our skilled nursing revenues in 2012 as compared to 2011. Our average daily Medicaid rate increased 2.0% to $154 in 2011 from $151 per day in 2010, primarily due to increased Medicaid rates in California, Kansas and New Mexico. These increases in Medicaid rates were substantially offset by increases in the provider taxes in those states. We expect overall Medicaid rates for the states we operate in to stay flat for the states' fiscal 2012 as compared to their fiscal 2011. However in July 2011, due to the economic downturn in California and the resultant budget deficit, California passed a budget that included a Medicaid payment reduction of 10%, effective June 1, 2011 through July 2012. The payments are to be restored retroactively to June 2011, sometime prior to the end of 2012, but in the meantime will contribute to a reduction in cash flows from operations in California. While same store admission volume has increased, we have experienced a decrease in our patients' average length of stay. We believe this to be primarily attributable to acuity and the economic factors affecting our business and the additional options patients have to return home. Of the $2.0 million increase at our assisted living facilities, $1.4 million was from assisted living facilities that operated for all of 2010 and 2011. Our revenue related to the administration of third party facilities remained consistent at $1.1 million in 2011 and 2010. Therapy Services                                           Year Ended December 31,                                    2011                          2010                      Increase/(Decrease)                           Revenue        Revenue        Revenue        Revenue                           Dollars      Percentage       Dollars      Percentage           Dollars         Percentage                                                             (dollars in millions) Rehabilitation therapy services                $   157.1         18.1  %     $   141.1         17.2  %     $     16.0                11.4 % Intersegment eliminations of services related to affiliated entities         (64.3 )       (7.4 )          (67.0 )       (8.2 )             2.7                 3.9 Total therapy services  $    92.8         10.7  %     $    74.1          9.0  %     $     18.7                25.2 %    Third party rehabilitation therapy services revenue increased $18.7 million in 2011 compared to 2010. Revenue increased $4.0 million at third party facilities serviced for all of 2011 and 2010, primarily as a result of the negotiated rate increase.                                         47

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  Revenue increased by $11.1 million from facilities for which service began since the beginning of 2010. The remainder of the difference is from facilities which used to be operated by our affiliates which have since been sold or leased to third party operators and are still serviced by Hallmark. Hospice and Home Health Services                                         Year Ended December 31,                                   2011                          2010                      Increase/(Decrease)                          Revenue        Revenue        Revenue        Revenue                          Dollars       Percentage      Dollars       Percentage          Dollars         Percentage                                                            (dollars in millions) Hospice                $     65.5          7.5 %           41.2          5.0 %           24.3                58.9 % Home Health                  17.8          2.0             10.5          1.3              7.3                69.7 Total hospice & home health services        $     83.3          9.5 %     $     51.7          6.3 %     $     31.6                61.1 %    Hospice and home health services revenue increased in 2011 compared to 2010, as a result of our completion of the Hospice/Home Health Acquisition in May 2010 and from an increase in the average daily census of our hospice businesses, which increased from 955 in 2010 to 1,269 in 2011. Cost of Services Expenses. Our cost of services expenses increased by $39.8 million, or 6.1%, to $697.3 million, or 80.1% of revenue, in 2011, from $657.5 million, or 80.3% of revenue, in 2010. Long Term Care Services                                                       Year Ended December 31,                                         2011                                        2010                           Increase/(Decrease)                            Cost of Service                             Cost of Service                                Dollars                                     Dollars                         (prior to intersegment       Revenue        (prior to intersegment       Revenue                             eliminations)           Percentage          eliminations)           Percentage       Dollars         Percentage                                                                       (dollars in millions) Skilled nursing facilities            $                  516.3          77.9 %    $                  519.3          77.8 %    $      (3.0 )          (0.6 )% Assisted living facilities                                19.8          71.7 %                        18.0          70.4 %            1.8             9.9  % Operations support                        23.5           n/a                          23.6           n/a             (0.1 )          (0.3 )% Total long-term care services              $                  559.6          80.7 %    $                  560.9          80.8 %    $      (1.3 )          (0.2 )%    Cost of services expenses at our skilled nursing facilities decreased by $3.0 million in 2011 compared to 2010. The change was substantially due to $4.9 million of additional expenses related to the Fort Worth Center of Rehabilitation which opened June 2010, $2.2 million of additional expenses due to the acquisition of a lease by the Rehabilitation Center of Omaha in April 2011, and $14.9 million of additional expenses from operating costs increasing at facilities acquired or developed prior to January 1, 2010. This $14.9 million increase resulted from an increase in operating costs of $6.91 PPD, or 3.8%, to $190.59 PPD in 2011 from $183.68 in 2010. The increase in cost of services expenses was offset by a decrease of $8.5 million of expenses due to the sale of Westside Campus of Care in December 2010 and a decrease of $17.4 million due to the transfer of operations of five skilled nursing facilities in northern <location value="LS/us.ca" idsrc="xmltag.org">California to an unaffiliated third party operator in April 2011. The $14.9 million increase in operating costs resulted from a $7.1 million increase in labor costs, which represented an increase of $3.40, or 3.2%, on a PPD basis. The increase in labor costs is attributable to an increase in personnel as well as salary and hourly wage increases. Additionally, the increase in operating costs resulted from a $3.8 million increase in taxes and licenses, which was primarily due to an increase in provider taxes, $1.7 million increase in expenses related to food and supplies, $1.7 million in expenses related to purchase services and $1.4 million increase in expenses related to pharmacy. In 2012, we expect pharmacy expenses to increase approximately $1.2 million resulting in a 3.0% increase in PPD. The increase in operating costs were offset by a decrease of approximately $0.8 million in insurance, bad debt, and other operating expenses. Cost of services expenses at our assisted living facilities increased $1.8 million in 2011 compared to 2010, $1.2 million of which was at assisted living facilities that operated for all 2010 and 2011. Therapy Services                                         48

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   Table of Contents                                                                     Year Ended December 31,                                             2011                                                             2010                                          Increase/(Decrease)                   Revenue Dollars         Cost of Service                          Revenue Dollars         Cost of Service                      (prior to           Dollars (prior to                            (prior to           Dollars (prior to                    intersegment            intersegment           Revenue           intersegment            intersegment           Revenue                    eliminations)           eliminations)         Percentage         eliminations)           eliminations)         Percentage            Dollars            Percentage                                                                                          (dollars in millions) Rehabilitation therapy services       $             157.1     $             138.9            88.4 %    $             141.1     $             121.9            86.4 %    $      17.0                     1.2 % Total therapy services       $             157.1     $             138.9            88.4 %    $             141.1     $             121.9            86.4 %    $      17.0                     1.2 %    Rehabilitation therapy costs as a percentage of revenue increased primarily due to changes related to concurrent therapy effective October 1, 2010, which has resulted in a requirement for more treatment time by licensed therapists. This, along with the loss of the ability to utilize rehabilitation aides to provide supervised treatments, created an increase in the demand for therapists which increased labor costs. As a result, labor and benefit costs per minute of service increased more than revenue per minute of service in 2011. These changes to providing concurrent therapy services created a more challenging operating environment and resulted in lower productivity in 2011 as compared to 2010. The negative impact to productivity from the concurrent therapy change was partially offset by third party customer rate increases and increasing group therapy treatments and an increase in volumes at both affiliated and non-affiliated facilities. However, CMS rulemaking effective for its fiscal year 2012 (which began October 1, 2011) effectively created a financial penalty for providing group therapy treatments in contrast to its policy which promoted such efficiencies in prior fiscal years. CMS also made changes effective October 1, 2011 which require additional therapy time to provide more frequent assessments of the patients we treat. These two factors have negatively impacted the margins of the therapy business during the fourth quarter of 2011 and will continue to have a negative impact to operating margins in future periods. Hospice and Home Health Services                                                  Year Ended December 31,                                        2011                                2010                          Increase/(Decrease)                           Cost of Service       Revenue       Cost of Service       Revenue                               Dollars          Percentage         Dollars          Percentage          Dollars           Percentage                                                                     (dollars in millions) Hospice                  $           48.5          74.1 %                33.4          81.1 %    $      15.1                 45.2 % Home Health                          16.6          93.1                   9.1          86.2 %            7.5                 83.2 Total hospice & home health services          $           65.1          78.1 %    $           42.5          82.1 %    $      22.6                 53.3 %    The increase in hospice and home health cost of services was primarily a result of our completion of the Hospice/Home Health Acquisition in May 2010 and the addition of hospice and home health facilities acquired in 2011. Cost of services as a percentage of revenue improved as the acquired hospice companies have higher operating margins than our legacy hospice operations, as well as from improved census in our legacy operations, which leverages fixed overhead costs. Rent Cost of Revenue. Rent cost of revenue decreased by $0.6 million, or 3.3%, to $18.4 million, or 2.1% of revenue, in 2011 from $19.0 million, or 2.3% of revenue, in 2010. The decrease is primarily related to the purchase of two previously leased facilities in December 2010. General and Administrative Services Expenses. Our general and administrative services expenses increased by $0.2 million, or 0.7%, to $25.7 million, or 3.0% of revenue, in 2011 from $25.5 million, or 3.1% of revenue, in 2010. The increase in our general and administrative expenses was primarily the result of an increase of $0.7 million related to the exploration of strategic alternatives and an increase of compensation costs offset by a $0.6 million reversal of stock compensation expense for performance stock awards for which the performance criteria are no longer expected to be met. Litigation Settlement Costs, net of Recoveries. Litigation settlement expense, net of recoveries for the year ended 2011 represented primarily insurance recoveries of $4.5 million related to the $53.5 million in litigation settlement expense that we recorded during the year ended 2010. Depreciation and Amortization. Depreciation and amortization increased by $0.2 million, or 0.7%, to $25.2 million in                                         49

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  2010 from $25.0 million in 2010. This increase is primarily a result of the change in fair value related to the contingent considerations due to the Hospice/Home Health Acquisition in May 2010, the Altura Homecare & Rehab acquisition in July 2011, the Willow Creek Memory Care at San Martin acquisition in July 2011, and the Cornerstone Hospice acquisition in October 2011, discussed in Note 3, "Fair Value Measurements" to our audited financial statements. Additionally, there was an increase in depreciation and amortization related to the opening of the Fort Worth Center of Rehabilitation in June 2010. In 2012, we expect intangible amortization to decrease $0.7 million and depreciation expense to increase primarily as a result of more assets being placed into service during 2011. Impairment of Long-Lived Assets. We recorded a goodwill impairment charge of $267.5 million and a $3.0 million impairment charge related to a long-lived asset for the year ended 2011. There was no comparable charge recorded for the year ended 2010. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Goodwill and Other Long-Lived Assets" for a more detailed discussion of the impairment charges. Interest Expense. Interest expense increased by $2.0 million, or 5.3%, to $39.0 million in 2011 from $37.0 million in 2010. The increase in our interest expense was primarily due to a higher "all-in" interest rate as the result of the refinancing of our credit facility in April 2010. The "all-in" interest rate inclusive of deferred financing fee amortization for 2011 was 7.8% compared to 7.4% for 2010. Average debt outstanding for 2011 was $499.4 million compared to $503.2 million in 2010. Interest Income. Interest income decreased by $0.2 million to $0.7 million in 2011 from $0.9 million in 2010 due to a decrease in average outstanding notes receivable. Equity in Earnings of Joint Venture. Equity earnings of our joint venture decreased by $0.6 million, or 23.8% to $2.0 million, or 0.2% of revenue, in 2011 from $2.6 million, or 0.3% of revenue, in 2010 primarily due to the decrease in number of facilities serviced by our pharmacy joint venture. Debt Retirement Cost. Debt retirement cost related to the April 2010 refinancing of our credit facility was $7.0 million for the year ended 2010 with no comparable amount for the year ended 2011 due to the expensing of deferred financing fees of $6.6 million and $0.4 million of interest rate swap termination costs as the swap was incompatible with the refinanced senior secured credit facility. Provision for Income Taxes. Our provision for income taxes in 2011 was $3.5 million, or 1.8% of pre-tax loss from continuing operations, as compared to $2.5 million, or 172.7% of pre-tax income from continuing operations in 2010. The change in effective tax rate in 2011 compared to 2010 was primarily due to the goodwill impairment charge recorded in 2011, most of which was not deductible for income tax purposes. Loss from Continuing Operations. Loss from continuing operations increased by $201.2 million to a loss of $199.8 million in 2011 from income from continuing operations of $1.4 million in 2010. The $201.2 million increase was related primarily to $270.5 million charge for impairment of long lived assets, $39.8 million increase in cost of services, and $2.0 million increase in interest expense, offset by an increase of $49.5 million in revenue, decrease in litigation settlement cost, net of recoveries, of $58.0 million, and $7.0 million decrease in debt retirement costs, all discussed above. EBITDA. EBITDA decreased by $198.8 million to a loss of $136.2 million in 2011 from $62.6 million in 2010. The $198.8 million decrease was primarily related to the $270.5 impairment of long-lived assets offset by the $58.0 million decrease in litigation settlement cost, net of recoveries and $7.0 million decrease in debt retirement costs, all discussed above. Year Ended December 31, 2010 Compared to Year Ended December 31, 2009 Revenue. Revenue increased by $64.7 million, or 8.5%, to $820.2 million in 2010 from $756.1 million in 2009. Long Term Care Services                                         Year Ended December 31,                                   2010                         2009                  Increase/(Decrease)                          Revenue        Revenue       Revenue        Revenue                          Dollars      Percentage      Dollars      Percentage       Dollars       Percentage                                                        (dollars in millions) Skilled nursing facilities             $    667.7         81.5 %    $    640.1         84.7 %    $     27.6            4.3  % Assisted living facilities                   25.6          3.1            24.4          3.2             1.2            4.7 Administrative of third party facilities        1.1          0.1             2.3          0.3            (1.2 )        (50.6 ) Total long-term care services               $    694.4         84.7 %    $    666.8         88.2 %    $     27.6            4.1  %   

Of the $27.6 million increase in skilled nursing facilities revenue, $13.8 million resulted primarily from the addition of

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  acquired and newly developed facilities since the beginning of 2009, which includes the opening of the Dallas Center of Rehabilitation, Fort Worth Center of Rehabilitation, and the acquisition of two facilities in Iowa. Additionally, revenue increased $12.1 million for skilled nursing facilities operated for all of 2009 and 2010 of which $17.1 million was due to a higher weighted average PPD rate from Medicare, Medicaid and managed care pay sources, offset by a $4.8 million decrease due to a decline in occupancy rates, which occurred primarily at our Texas facilities. Our revenue related to the administration of third party facilities decreased $1.2 million due to the reduction in number of facilities managed from four in 2009 to one in 2010. PPD rates were negatively impacted by the decrease in our skilled mix in 2010 as compared to 2009. We believe our skilled mix declined to 22.7% in 2010 from 23.1% in 2009 primarily due to new and re-admissions staying flat coupled by a decrease in overall average length of stay in most payor classes. We also faced competitive pressures related, to the development of new facilities in Texas near our existing facilities. Our average daily Part A Medicare rate increased 3.2% to $515 in 2010 from $499 primarily due to the Medicare rate increase effective October 1, 2010. Our average daily Medicaid rate increased 3.4% to $151 in 2010 from $146 in 2009, primarily due to increased Medicaid rates in Texas, Nevada and Missouri. Although average daily Medicare and, in some regions, Medicaid rates increased in 2010, the increase did not fully offset the impact of flat admissions. We have experienced net reductions in Medicaid rates in California and Kansas. Revenue at our assisted living facilities increased $1.2 million, primarily as a result of having a full year of operations at our facility in Tonganoxie, Kansas, which opened in April 2009. Therapy Services                                          Year Ended December 31,                                   2010                          2009                   Increase/(Decrease)                          Revenue        Revenue        Revenue        Revenue                          Dollars      Percentage       Dollars     

Percentage        Dollars       Percentage                                                         (dollars in millions) Rehabilitation therapy services to non-affiliated entities               $   141.1         17.2  %     $   141.2         18.7  %     $     (0.1 )         (0.1 )% Intersegment eliminations               (67.0 )       (8.2 )      $   (66.5 )       (8.8 )      $     (0.5 )         (0.7 ) Total therapy services $    74.1          9.0  %     $    74.7          9.9  %     $     (0.6 )         (0.8 )%   

Rehabilitation therapy services revenue stayed level as new contracts executed in 2010 offset contracts lost in the fourth quarter of 2009. Hospice and Home Health Services

                                          Year Ended December 31,                                   2010                          2009                     Increase/(Decrease)                          Revenue        Revenue        Revenue        Revenue                          Dollars       Percentage      Dollars       Percentage         Dollars         Percentage                                                           (dollars in millions) Hospice                $     41.2          5.0             14.5          1.9             26.7               183.5 Home Health                  10.5          1.3                -            -             10.5               100.0 Total hospice & home health services        $     51.7          6.3 %     $     14.5          1.9 %     $     37.2               255.7 %    Hospice and home health revenue increased in 2010 compared to 2009, as a result of the Hospice/Home Health Acquisition in May 2010. Cost of Services Expenses. Our cost of services expenses increased by $52.6 million, or 8.7%, to $657.5 million, or 80.2% of revenue, in 2010, from $604.9 million, or 80.0% of revenue, in 2009. Long Term Care Services                                           51

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  Table of Contents                                                               Year Ended December 31,                                                 2010                                        2009                              Increase/(Decrease)                                    Cost of Service                             Cost of Service                                        Dollars                                     Dollars                                 (prior to intersegment       Revenue        (prior to intersegment       Revenue                                     eliminations)           Percentage          eliminations)           Percentage          Dollars           Percentage                                                                                  (dollars in millions) Skilled nursing facilities    $                  519.3          77.8 %    $                  499.2          77.7 %    $      20.1                  4.0 % Assisted living facilities                        18.0          70.3                          17.0          69.7              1.0                  5.9 Operations support                                23.6           n/a                          21.3           n/a              2.3                 10.8 Total long-term care services $                  560.9          80.8 %    $                  537.5          80.6 %    $      23.4                  4.4 %    Cost of services expenses at our skilled nursing facilities increased by $20.1 million, $10.8 million of which was due to the addition of acquired and developed facilities since the beginning of 2009, which includes the opening of the <org>Dallas Center of Rehabilitation, Fort Worth Center of Rehabilitation, and the acquisition of two facilities in Iowa, $9.3 million of the increases resulted from operating costs increasing at facilities acquired or developed prior to January 1, 2009 by $4.70 per patient day, or 2.7%, to $183.1 per patient day in the year ended December 31, 2010 from $178 per patient day in the year ended December 31, 2009. The $9.3 million increase in operating costs resulted from a $5.1 million increase in labor costs, which represented an increase of $2.6, or 2.6%, on a per patient day basis. Additionally, the increase in operating costs resulted from a $3.2 million increase in taxes and licenses and a $1.2 million increase in expenses related to rehab/ancillaries. Cost of services expenses at our assisted living facilities increased $1.0 million, primarily due to our newly developed facility in Tonganoxie, Kansas, which opened in April 2009. In the next twelve months, we expect our cost of services expense to increase as we comply with the terms of the injunction related to the Humboldt County Action described in Note 12, "Commitments and Contingencies Litigation" to our audited financial statements. Therapy Services                                                                    Year Ended December 31,                                            2010                                                            2009                                           Increase/(Decrease)                  Revenue Dollars         Cost of Service                         Revenue Dollars         Cost of Service                     (prior to           Dollars (prior to                           (prior to           Dollars (prior to                    intersegment           intersegment           Revenue           intersegment           intersegment           Revenue                   eliminations)           eliminations)         Percentage        eliminations)           eliminations)         Percentage             Dollars             Percentage                                                                                          (dollars in millions) 

Rehabilitation

therapy

 services       $            141.1     $             121.9            86.4 %    $            141.2     $             120.5            85.3 %    $        1.4                      1.2 % Total therapy services       $            141.1     $             121.9            86.4 %    $            141.2     $             120.5            85.3 %    $        1.4                      1.2 %    Rehabilitation therapy costs as a percentage of revenue increased primarily because of flat revenue rates and salary, wages, and benefits increased as a percentage of total costs due to a decrease in third party facility contracts, as described above under "Revenue-Sources of Revenue-Therapy Services Segment." Hospice and Home Health Services                                                    Year Ended December 31,                                           2010                               2009                       Increase/(Decrease)                              Cost of Service       Revenue      Cost of Service       Revenue                                  Dollars         Percentage         Dollars         Percentage         Dollars         Percentage                                                                     (dollars in millions) Hospice                     $           33.4         81.1 %                15.9         109.7 %   $     17.5               110.1 % Home Health                              9.1         86.7                     -             -            9.1               100.0 Total hospice & home health services                    $           42.5         82.2 %    $           15.9         109.7 %   $     26.6               167.3 %                                            52

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  The increase in hospice cost of services was the result of the Hospice/Home Health Acquisition. Cost of services expense in our hospice business was challenged by labor inefficiencies in our California operations in 2009, which were remediated in 2010.   Hospice and home health costs of services included $0.7 million of acquisition related costs in the year ended December 31, 2010. Rent Cost of Revenue. Rent cost of revenue increased by $0.9 million, or 5.0%, to $19.0 million, or 2.3% of revenue, in 2010 from $18.1 million, or 2.4% of revenue, in 2009. General and Administrative Services Expenses. Our general and administrative services expenses increased $0.4 million, or 1.6%, to $25.5 million, or 3.1% of revenue, in 2010 from $25.1 million, or 3.3% of revenue, in 2009. The increase in our general and administrative expenses was primarily the result of an increase in compensation costs. Litigation Settlement Expense. Litigation settlement expense totaled $53.5 million for 2010 with no comparable amount for 2009. This was comprised of a $50.0 million cash settlement related to the Humboldt County Action described in Note 12, "Commitments and Contingencies- Litigation," to our audited financial statements included elsewhere in this report, $3.0 million of related legal expenses, and $0.5 million in costs related to a securities class action related to our initial public offering (which was settled in August 2010). Depreciation and Amortization. Depreciation and amortization increased by $1.7 million, or 7.3%, to $25.0 million in 2010 from $23.3 million in 2009. This increase primarily resulted from increased depreciation and amortization related to the opening of our developed skilled nursing facilities in Dallas and Fort Worth as well as other new assets placed in service during 2009 and 2010. Interest Expense. Interest expense increased by $4.0 million, or 12.1%, to $37.0 million in 2010 from $33.0 million in 2009. The increase in our interest expense was primarily due to an increase in the average interest rate on our debt from 5.9% in 2009 to 6.3% in 2010, which resulted in additional interest expense of $2.2 million. The increase in our cost of borrowing was due to the refinancing of our senior secured credit facility in April 2010. Average debt outstanding increased by $29.9 million, from $473.3 million in 2009 to $503.2 million in 2010 which resulted in additional interest expense of $1.8 million. The increase in average debt outstanding was primarily due to borrowings used to finance the Hospice/Home Health Acquisition and settlement costs. The all-in interest rate for the full year ended December 31, 2010 was 7.4%, as compared to 7.0% in 2009. Interest Income. Interest income decreased by $0.2 million to $0.9 million in 2010 from $1.1 million in 2009 due to a decrease in outstanding notes receivable. Equity in Earnings of Joint Venture. Equity earnings of our joint venture decreased by $0.2 million, or 7.1% to $2.6 million, or 0.3% of revenue, in 2010 from $2.8 million, or 0.4% of revenue, in 2009. These earnings relate primarily to our pharmacy joint venture. Debt Retirement Cost. Debt retirement cost was $7.0 million for 2010 with no comparable amount for 2009 due to the expensing of deferred financing fees of $6.6 million and $0.4 million of interest rate swap termination costs as the swap was incompatible with the refinanced senior secured credit facility. Provision for Income Taxes. Our provision for income taxes in 2010 was $2.5 million, or 172.7% of pre-tax income from continuing operations, as compared to $17.8 million, or 15.5% of pre-tax loss from continuing operations in 2009. The effective tax rate of 172.7% for 2010 was not meaningful due to the low level of pre-tax earnings from operations. Loss from Continuing Operations. Loss from continuing operations decreased by $131.7 million to a loss of $1.0 million in 2010 from a loss from continuing operations of $132.8 million in 2009. The $131.7 million decrease was related primarily to a$170.6 million goodwill impairment expense in 2009, $64.1 million increase in revenue, offset by the $53.5 million litigation settlement expense in 2010 and $52.6 million increase in cost of services, all discussed above. EBITDA. EBITDA increased by $122.7 million to $62.5 million in 2010 from a loss of $60.2 million in 2009. The $122.7 million increase was primarily related to the decrease of $170.6 million non-cash impairment charge in 2009 partially offset by the $53.5 million litigation settlement expense in 2010, all discussed above.                                              53

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  Quarterly Data The following is a summary of our unaudited quarterly results from operations for each of the years ended December 31, 2011 and 2010.                                                                         

Three Months Ended,

                  December 31,      September 30,      June 30,      March 31,     December 31,      September 30,      June 30,      March 31,                       2011               2011            2011          2011            2010               2010            2010          2010                                                               (In thousands, except per share data) Consolidated Statement of Operations Data Revenue          $     214,421     $      217,155     $ 215,547     $ 222,578     $     220,749     $      209,199     $ 200,971     $ 189,319 Expenses: Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)           177,021            173,548       171,249       175,461           175,224            168,579       162,007       151,705 Rent cost of revenue                  4,869              4,413         4,547         4,570             4,829              4,796         4,832         4,581 General and administrative           6,177              5,423         7,237         6,893             7,037              6,016         6,112         6,351 Litigation settlement costs (net of recoveries)                  -             (4,488 )           -             -                 -             53,505             -             - Depreciation and amortization             6,193              6,459         6,432         6,145             6,806              6,305         5,992         5,944 Impairment of long-lived assets                       -            270,478             -             -                 -                  -             -             -                        194,260            455,833       189,465       193,069           193,896            239,201       178,943       168,581 Other income (expenses): Interest expense        (9,675 )           (9,711 )      (9,662 )      (9,946 )         (10,487 )          (10,086 )      (9,164 )      (7,284 ) Interest income            161                170           208           175               263                260           196           228 Equity in earnings of joint venture              372                472           557           554               345                746           678           797 Other (expense) income                     (22 )             (123 )         (30 )        (324 )           1,744                  9           583            (4 ) Debt retirement costs                        -                  -             -             -                 -                  -        (7,010 )           - Total other expenses, net           (9,164 )           (9,192 )      (8,927 )      (9,541 )          (8,135 )           (9,071 )     (14,717 )      (6,263 ) Income (loss) before provision (benefit) for income taxes            10,997           (247,870 )      17,155        19,968            18,718            (39,073 )       7,311        14,475 Provision (benefit) for income taxes             4,067            (15,259 )       6,584         8,124             7,878            (13,766 )       2,766         5,594 Net income (loss)           $       6,930     $     (232,611 )   $  10,571     $  11,844     $      10,840     $      (25,307 )   $   4,545     $   8,881

Earnings (loss) per share, basic: Earnings (loss) per share        $        0.19     $        (6.26 )   $    0.28     $    0.32     $        0.29     $        (0.68 )   $    0.12     $    0.24 Earnings (loss) per share, diluted: Earnings (loss) per share        $        0.19     $        (6.26 )   $    0.28     $    0.32     $        0.29     $        (0.68 )   $    0.12     $    0.24 Weighted-average common shares outstanding, basic                   37,179             37,164        37,154        37,079            37,010             36,997        36,983        36,962 

Weighted-average

common shares outstanding, diluted                 37,285             37,164        37,354        37,326            37,150             36,997        37,084        37,037   

Liquidity and Capital Resources

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  The following table presents selected data from our consolidated statements of cash flows (in thousands):                                                            Twelve Months Ended December 31,                                                          2011             2010            2009 Cash Flows from Continuing Operations Net cash provided by operating activities           $    99,380       $    35,391     $   75,021 Net cash used in investing activities                   (39,917 )         (76,405 )      (46,168 ) Net cash (used in) provided by financing activities     (47,638 )          41,678        (27,762 ) Cash flows from discontinued operations                       -                 -            390 Net increase in cash and equivalents                     11,825               664          1,481 Cash and cash equivalents at beginning of period          4,192             

3,528 2,047 Cash and cash equivalents at end of period $ 16,017$ 4,192$ 3,528

   Based upon our current level of operations, we believe that cash generated from operations, cash on hand and borrowings available to us will be adequate to meet our anticipated debt service requirements, capital expenditures and working capital needs for at least the next 12 months. One element of our business strategy is to selectively pursue acquisitions and strategic alliances. Any acquisitions or strategic alliances may result in the incurrence of, or assumption by us, of additional indebtedness. We continually assess our capital needs and may seek additional financing through a variety of methods including through an extension of our senior secured credit facility or by accessing available debt and equity markets, as considered necessary to fund capital expenditures and potential acquisitions or for other purposes. Our future operating performance will be subject to future economic conditions and to financial, business, regulatory and other factors, many of which are beyond our control. For additional discussion, see "Other Factors Affecting Liquidity and Capital Resources" below.  Years Ended December 31, 2011 and 2010 Net cash provided by operating activities primarily consists of net loss adjusted for certain non-cash items including depreciation and amortization, provision for doubtful accounts, stock-based compensation, and goodwill impairment change, as well as the effect of changes in working capital and other activities. Cash provided by operating activities for the year ended December 31, 2011 was $99.4 million and consisted of net loss of $203.3 million, offset by adjustments for non-cash items of $299.8 million and $2.8 million provided by working capital and other activities. The majority of the $299.8 million of non-cash items was the result of the $270.5 million impairment of long-lived assets charge. Working capital and other activities primarily consisted of an increase in accounts receivable of $9.3 million and a decrease in insurance liability risks of $1.5 million offset by a $3.3 million increase of payments in notes receivable, $7.5 million decrease in other current and non-current assets, increase in accounts payable and accrued liabilities of $0.5 million, increase in employee compensation and benefits of $1.3 million and $1.0 million increase in other long-term liabilities. The increase in accounts receivable after considering the provision for doubtful accounts was $1.0 million. Days sales outstanding ("DSO") increased from 41.2 for the three months ended December 31, 2010 to 42.4 for the three months ended December 31, 2011. Investing activities used $39.9 million in 2011, as compared to $76.4 million in 2010. The primary use of funds in 2011 consisted of $24.0 million of cash consideration paid for acquisition of healthcare facilities and businesses and capital expenditures of $16.3 million offset by the cash proceeds of $0.4 million received from a sale of land. The capital expenditures consisted of $0.1 million for facility renovations, $1.4 million for expansion of our Express Recovery™ unit program and $14.8 million of routine capital expenditures. Net cash used by financing activities was $47.6 million in 2011, as compared to net cash provided by financing activities of $41.7 million in 2010. In 2011, net cash provided by financing activities primarily reflects net repayment of borrowings under our line of credit of $26.0 million as well as scheduled and voluntary repayment of long-term debt of $21.2 million. Years Ended December 31, 2010 and 2009 Net cash provided by operating activities primarily consists of net loss adjusted for certain non-cash items including depreciation and amortization, provision for doubtful accounts, and stock-based compensation as well as the effect of changes in working capital and other activities. Cash provided by operating activities for the year ended December 31, 2010 was $35.4 million and consisted of net loss of $1.0 million, adjustments for non-cash items of $46.8 million and $10.4 million used by working capital and other activities. Working capital and other activities primarily consisted of an increase in accounts receivable of $14.5 million, $8.1 million increase in other current and non-current assets, and decrease in insurance liability risks of $4.4 million offset by a $4.8 million increase of payments in notes receivable, increase in accounts payable and accrued liabilities of $1.8 million, increase in employee compensation and benefits of $9.2 million and $0.8 million increase in other long-term liabilities. The increase in accounts receivable was due primarily to an increase in revenue for the year ended December 31, 2010, as compared to the year ended December 31, 2009. DSO decreased from 47.0 for the three months ended December 31, 2009 to 41.2 for the three months ended December 31, 2010. The reduction in DSO offset the increase in sales,                                         55

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  resulting in the net $14.5 million increase in accounts receivable. The aforementioned legal settlement expense negatively impacted cash flows from operations of $35.3 million by $53.5 million for the year ended December 31, 2010, as compared to cash flows from operations of $75.0 million in 2009. Investing activities used $76.4 million in 2010, as compared to $46.2 million in 2009. The primary use of funds in 2010 consisted of $45.4 million of cash consideration paid for the Hospice/Home Health Acquisition in May 2010, $18.0 million cash paid for the purchase of previously leased facilities, capital expenditures of $27.7 million, offset by the cash proceeds of $14.7 million received from our sale of the Westside Campus Care in December 2010. The capital expenditures consisted of $7.9 million for construction of new healthcare facilities, $5.6 million for expansion of our Express Recovery™ unit program and $14.3 million of routine capital expenditures. Net cash provided by financing activities was $41.7 million in 2010, as compared to net cash used in financing activities of $27.7 million in 2009. In 2010, net cash provided by financing activities primarily reflects net repayment of borrowings under our line of credit of $46.0 million and repayment of long-term debt of $259.3 million, offset by the $357.3 million of proceeds from issuance of long-term debt and additions to deferred financing fees of $10.2 million, associated with the refinancing of our senior secured credit facility in April 2010. Principal Debt Obligations Our primary sources of liquidity are our cash on hand, our cash flows from operations and our senior secured credit facility, which is subject to the satisfaction of certain financial covenants therein. Our primary liquidity requirements are for debt service on our first lien senior secured term loan and our 2014 Notes, capital expenditures and working capital. We are significantly leveraged. As of December 31, 2011, we had $475.5 million in aggregate indebtedness outstanding, consisting of $129.8 million principal amount of our 2014 Notes (net of the unamortized portion of the original issue discount of $0.2 million), a $341.8 million first lien senior secured term loan (net of the unamortized portion of the original issue discount of $1.9 million), and other debt of approximately $3.9 million. Furthermore, we had $4.4 million in outstanding letters of credit against our $100.0 million revolving credit facility, leaving approximately $95.6 million of additional borrowing capacity under our "senior secured credit facility" as of December 31, 2011. Substantially all of our subsidiaries guarantee our 2014 Notes, the first lien senior secured term loan and our revolving credit facility For 2011, 2010, and 2009, our interest expense, net of interest income, was $38.3 million, $36.1 million, and $31.9 million, respectively. For 2011, we had no capitalized interest expense compared to $0.3 million and $0.4 million, respectively, in 2010, and 2009, related to new facilities that were developed. If our remaining ability to borrow under our revolving credit facility is insufficient for our capital requirements, we will be required to seek additional sources of financing, including issuing equity, which may be dilutive to our current stockholders, or incurring additional debt. Our ability to incur additional debt is subject to the restrictions in the indenture governing our 2014 Notes and our senior secured credit facility. We cannot assure you that the restrictions contained in these agreements will permit us to borrow the funds that we need to finance our operations, or that additional debt will be available to us on commercially reasonable terms or at all. If we are unable to obtain funds sufficient to finance our capital requirements, we may have to forego opportunities to expand our business, including the acquisition of additional facilities.  Term Loan and Revolving Loan On April 9, 2010, we entered into an up to $360.0 million term loan and a $100.0 million revolving credit facility (the "Restated Credit Agreement") that replaced the senior secured term loan and revolving credit facility that were set to mature in June 2012. The new revolving credit facility was undrawn at closing. We refer to the senior secured term loan and revolving credit facility provided under the Restated Credit Agreement as our senior secured credit facility. The senior secured term loan requires principal payments of 0.25% of the original principal amount, or $0.9 million on the last business day of each of March, June, September and December, commencing on June 30, 2010, with the balance due April 9, 2016. Amounts borrowed under the term loan may be prepaid at any time without penalty except for breakage costs. Commitments under the revolving credit facility terminate on April 9, 2015. However, if any of our 2014 Notes remain outstanding on October 14, 2013, then the maturity date of the senior secured term loan and revolving credit facility will be October 14, 2013. Amounts borrowed pursuant to the Restated Credit Agreement are secured by substantially all of our assets. Substantially all of our subsidiaries guarantee our senior secured credit facility. Under the Restated Credit Agreement, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum fixed charge coverage ratio (with a range of 1.5:1 to 2:1 as set forth in further detail in the Restated Credit Agreement) as well as a maximum leverage ratio (with a range of 5.5:1 to 4:1 as set forth in further detail in the Restated Credit Agreement). The Restated Credit Agreement also includes certain additional affirmative and negative covenants, including limitations on the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Also under the Restated Credit Agreement, subject to certain exceptions and minimum thresholds, we are required to apply all of the proceeds from any issuance of debt, half of the proceeds from any issuance of equity, half (or one                                         56

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  quarter if our Consolidated Leverage Ratio, as defined in the Restated Credit Agreement, for such fiscal year is less than 3:1) of our annual Consolidated Excess Cash Flow, as defined in the Restated Credit Agreement, and, subject to permitted reinvestments, all amounts received in connection with any sale of our assets and casualty insurance and condemnation or eminent domain proceedings, in each case to repay the outstanding amounts under the Restated Credit Agreement. We believe that we were in compliance with our debt covenants as of December 31, 2011. As of December 31, 2011, our fixed charge coverage ratio was 3.6 which compares to a minimum requirement of 1.6 and our leverage ratio was 3.3 compared to a maximum of 5.0. Loans outstanding under the Restated Credit Agreement bear interest, at our election, either at the prime rate plus an initial margin of 2.75% or the London Interbank Offered Rate ("LIBOR") plus an initial margin of 3.75%. Under the terms of the Restated Credit Agreement there is a LIBOR floor of 1.50%. We have a 0.5% commitment fee on the unused portion of the revolving line of credit. The interest rate margin on the loans can be reduced by 0.25% based on our Consolidated Leverage Ratio, as defined in the Restated Credit Agreement, for the applicable four-quarter period. Furthermore, we have the right to increase our borrowings under the term loan and/or the revolving loan up to an aggregate amount of $150.0 million provided that we are in compliance with the Restated Credit Agreement, that the additional debt would not cause any covenant violation of the Restated Credit Agreement, and that existing or new lenders within the Restated Credit Agreement or new lenders agree to increase their commitments.  Senior Subordinated Notes Our 11.0% senior subordinated notes, which we sometimes refer to as the 2014 Notes, were issued in December 2005 in the aggregate principal amount of $200.0 million, with an interest rate of 11.0% per annum. The 11.0% senior subordinated notes were issued at a discount of $1.3 million. Interest is payable semiannually in January and July of each year. The 11% senior subordinated notes mature on January 15, 2014. The 11.0% senior subordinated notes are unsecured senior subordinated obligations and rank junior to all of our existing and future senior indebtedness, including indebtedness under our senior secured credit facility. The 11.0% senior subordinated notes are guaranteed on a senior subordinated basis by substantially all of our current and future subsidiaries. There was $130.0 million aggregate principal amount of our 11.0% senior subordinated notes outstanding as of December 31, 2011. Substantially all of our subsidiaries guarantee our 11.0% senior subordinated notes. As of January 15, 2011, we became entitled to redeem all or a portion of the remaining $130.0 million aggregate principal amount of our 11% senior subordinated notes upon not less than 30 nor more than 60 days notice, at a redemption price (expressed in percentages of principal amount on the redemption date) of 102.75% effective January 15, 2011 and 100.0% effective January 15, 2012. Capital Expenditures We intend to invest in the maintenance and general upkeep of our facilities on an ongoing basis. We also expect to perform renovations of our existing facilities every five to ten years to remain competitive. Combined, we expect that these activities will amount to approximately $1,500 per bed. In addition, we are continuing with the expansion of our Express Recovery™ units. These units cost, on average, between $0.4 million and $0.6 million each. We completed one Express Recovery™ unit in 2011. We are in the process of developing two additional Express Recovery™ units in 2012. We anticipate that we will have capital expenditures in 2012 of approximately $17.0 million to $20.0 million. We will continue to assess our capital spending plans on an ongoing basis. Other Factors Affecting Liquidity and Capital Resources Medical and Professional Malpractice and Workers'Compensation Insurance. Our skilled nursing facilities and other businesses, like physicians, hospitals and other healthcare providers, are subject to a significant number of legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we maintain professional liability and general liability as well as workers' compensation insurance in amounts and with deductibles that we believe to be sufficient for our operations. Historically, unfavorable pricing and availability trends emerged in the professional liability and workers' compensation insurance market and the insurance market in general that caused the cost of these liability coverages to generally increase dramatically. Many insurance underwriters became more selective in the insurance limits and types of coverage they would provide as a result of rising settlement costs and the significant failures of some nationally known insurance underwriters. As a result, we experienced substantial changes in our professional liability insurance program beginning in 2001. Specifically, we were required to assume substantial self-insured retentions for our professional liability claims. A self-insured retention is a minimum amount of damages and expenses (including legal fees) that we must pay for each claim. We use actuarial methods to estimate the value of the losses that may occur within this self-insured retention level and we are required under our workers' compensation insurance agreements to post a letter of credit or set aside cash in trust funds to securitize the estimated losses that we may incur. Because of the high retention levels, we cannot predict with certainty the actual amount of the losses we will                                         57

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  assume and pay. We estimate our self-insured general and professional liability reserves on a quarterly basis and our self-insured workers' compensation reserve on a semiannual basis, based upon actuarial analyses using the most recent trends of claims, settlements and other relevant data from our own and our industry's loss history. Based upon these analyses, at December 31, 2011, we had reserved $18.2 million net of $5.8 million in insurance recoveries for known or unknown or potential self-insured general and professional liability claims and $15.9 million for self-insured workers' compensation claims. Of these reserves, we estimate that approximately $3.5 million net of $1.5 million in current insurance recoveries for self-insured general and professional liability claims and $4.4 million for self-insured workers' compensation claims for a total of $7.9 million will be payable within 12 months; however, there are no set payment schedules and there can be no assurance that the payment amount in the next 12 months will not be significantly larger or smaller. To the extent that subsequent claims information varies from loss estimates, the liabilities will be adjusted to reflect current loss data. There can be no assurance that in the future general and professional liability or workers' compensation insurance will be available at a reasonable price and that we will not have to further increase our levels of self-insurance. Inflation. We derive a substantial portion of our revenue from the Medicare program. We also derive revenue from state Medicaid and similar reimbursement programs. Payments under these programs generally provide for reimbursement levels that are adjusted for inflation annually based upon the state's fiscal year for the Medicaid programs and in each October for the Medicare program. However, there can be no assurance that these adjustments will continue in the future and, if received, will reflect the actual increase in our costs for providing healthcare services. Labor and supply expenses make up a substantial portion of our operating expenses. Those expenses can be subject to increase in periods of rising inflation and when labor shortages occur in the marketplace. To date, we have generally been able to implement cost control measures or obtain increases in reimbursement sufficient to offset increases in these expenses. We cannot assure you that we will be successful in offsetting future cost increases. Global Market and Economic Conditions. Recent global market and economic conditions have been unprecedented and challenging with tight credit conditions and recession or slow growth in most major economies expected to continue through 2012 and possibly longer. As a result of these market conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide credit to borrowers. These factors have led to a decrease in spending by businesses and consumers alike, and a corresponding decrease in global infrastructure spending. Continued turbulence in the U.S. and international markets and economies and prolonged declines in business and consumer spending may adversely affect our liquidity and financial condition. Furthermore, if the U.S. federal government were to default on its obligations (or have the rating on government debt lowered by credit rating agencies), our business, liquidity and financial condition could be materially and adversely affected. Although we recently were able to extend the maturity of our revolving loan commitments and maintain existing interest rate spreads on that Restated Credit Facility (see "Principal Debt Obligations and Capital Expenditures" above), if these market conditions continue or worsen, they may impact our ability in the future to timely replace maturing liabilities, access the capital markets to meet liquidity needs, and service or refinance our 11.0% senior subordinated notes and our senior secured credit facilities, resulting in an adverse effect on our financial condition, including liquidity, capital resources and results of operations.  Off Balance Sheet Arrangements We had outstanding letters of credit of $4.4 million under our $100.0 million revolving credit facility as of December 31, 2011.  Contractual Obligations The following table sets forth our contractual obligations as of December 31, 2011 (in thousands):                                          58

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  Table of Contents                                                       Less Than                                   More than                                         Total          1 Yr.        1-3 Yrs.      3-5 Yrs.        5 Yrs. Long-term debt obligations 11% senior subordinated notes        $ 130,000     $         -     $ 130,000     $       -     $         - Senior secured credit facility(1)(2)   343,700           3,600         7,200       332,900               - Other long-term debt obligations         3,900             814         2,297           371             418 Operating lease obligations(3)         102,834          18,702        30,502        22,880          30,750                                      $ 580,434     $    23,116     $ 169,999     $ 356,151     $    31,168   ________________

(1)    Based on implied forward one-month LIBOR rates in the yield curve as of        December 31, 2011.   (2)    If the 11% senior subordinated notes remain outstanding on October 14,

2013, then the maturity date of the senior secured credit facility will be

October 14, 2013.

(3) We lease some of our facilities under noncancelable operating leases. The

leases generally provide for our payment of property taxes, insurance and

       repairs, and have rent escalation clauses, principally based upon the        Consumer Price Index or other fixed annual adjustments. The amounts shown        reflect the future minimum rental payments under these leases.

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