SUN HEALTHCARE GROUP INC – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Edgar Online, Inc.

Overview

  Our subsidiaries are providers of nursing, rehabilitative and related specialty healthcare services primarily to the senior population in the United States. Our core business is providing inpatient services, primarily through 158 skilled nursing centers, 13 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, 2 independent living centers and 7 mental health centers with 21,324 licensed beds located in 23 states as of September 30, 2012. Our subsidiaries also provide hospice services, rehabilitation therapy services and temporary medical staffing services to skilled nursing centers.  

Pending Merger with Genesis HealthCare LLC

  On June 20, 2012, we entered into an Agreement and Plan of Merger (the "Merger Agreement") with Genesis HealthCare LLC, a Delaware limited liability company ("Genesis"), and Jam Acquisition LLC, a Delaware limited liability company and an indirect wholly-owned subsidiary of Genesis ("Merger Sub"). The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Merger Sub will be merged with and into us, with us continuing as the surviving corporation and an indirect wholly-owned subsidiary of Genesis (the "Merger"). Pursuant to the terms of the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of our common stock, other than treasury shares, shares held by us (other than shares held in a fiduciary capacity that are beneficially owned by third parties), Genesis, Merger Sub or any wholly-owned subsidiary of Genesis or us and shares held by stockholders who perfect their appraisal rights under Delaware law, will be converted into the right to receive $8.50 in cash, without interest (the "Merger Consideration"). At the effective time of the Merger, outstanding equity awards with respect to shares of our common stock (whether vested or unvested) will be canceled and converted into the right to receive a cash amount equal to the difference between the Merger Consideration and the exercise price, if any, of such awards. We anticipate that the total amount of funds necessary to pay the aggregate Merger Consideration will be approximately $230 million, not including refinancing of our existing indebtedness or payment of related transaction fees and expenses.  In connection with the proposed Merger, the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 expired on August 8, 2012. Our stockholders approved the proposed Merger at a special stockholders meeting on September 5, 2012.  The transaction is expected to close in December 2012 subject to the satisfaction of customary closing conditions, including, among other things, (i) the receipt of remaining regulatory approvals, (ii) the absence of any law or order prohibiting the consummation of the Merger, (iii) subject to certain materiality exceptions, the accuracy of our representations and warranties in the Merger Agreement, (iv) the performance in all material respects of our covenants in the Merger Agreement, (v) the absence of any material adverse effect on us between June 20, 2012 and consummation of the Merger and (vi) compliance by us with our obligations under certain third party contracts.  2011 Asset Impairment  GAAP requires that goodwill, intangible assets and other long-lived assets be evaluated for potential impairment when a triggering event occurs during an interim time period. On July 29, 2011, CMS released its final rule for skilled nursing facilities for the 2012 federal fiscal year, which commenced on October 1, 2011 (the "CMS Final Rule"). After the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%, the prospective net decrease in Medicare reimbursement rates was 11.1%. Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that further reduced our revenues from the Medicare program and increased our costs of providing such services. We determined that the CMS Final Rule announcement constituted a triggering event for evaluating whether the recoverability of goodwill, intangible assets and other long-lived assets in the operating segments of our Inpatient Services reportable segment affected by the CMS Final Rule was impaired.  During the three months ended September 30, 2011, we recognized $317.1 million of non-cash loss on asset impairment for the healthcare facilities operating segments in our Inpatient Services reportable segment. The non-cash charges consisted of $314.7 million of goodwill impairment and $2.4 million of asset impairment for intangible assets for favorable lease obligations. See Note 8 - "Asset Impairment" to our consolidated financial statements included in this Form 10-Q for additional information.                                          25 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

2011 Restructuring

  On July 29, 2011, CMS released its final rule for skilled nursing facilities for the 2012 federal fiscal year, which commenced on October 1, 2011 (the "CMS Final Rule").  As a result of the expected negative impact of the CMS Final Rule on our business, we implemented a broad-based mitigation initiative, which included infrastructure cost reductions without affecting the quality of our patient care. These reductions in infrastructure costs were, and continue to be, necessary to mitigate the impact on our business and remain in compliance with financial covenants under our credit agreement. For additional information regarding the impact to us of the CMS Final Rule, please see "Medicare" below.  

Revenues from Medicare, Medicaid and Other Sources

  We receive revenues from Medicare, Medicaid, commercial insurance, self-pay residents, other third party payors and healthcare centers that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our centers, the acuity level of patients and the rates of reimbursement among payors. Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid, and pressures on federal and state budgets resulting from the current economic conditions in the United States may intensify these efforts. This focus has not been limited to skilled nursing centers, but includes specialty services provided by us, such as skilled therapy services, to third parties. We cannot at this time predict the extent to which proposals limiting federal or state expenditures will be adopted or, if adopted and implemented, what effect, if any, such proposals will have on us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.  The following table sets forth the total nonaffiliated revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the periods indicated (dollars in thousands):                                     For the Three Months Ended                              For the Nine Months Ended Sources of Revenues       September 30, 2012          September 30, 2011          September 30, 2012         September 30, 2011  Consolidated: Medicaid               $    195,441       42.4 %   $    184,754       39.4

% $ 570,734 41.5 % $ 541,977 38.6 % Medicare

                    128,180       27.8          149,147       31.8  

397,867 28.9 % 454,591 32.3 % Private pay and other

                       112,281       24.5          111,998       23.9  

336,193 24.4 % 339,857 24.2 % Managed care and commercial insurance 24,568 5.3

           22,777        4.9             71,311     5.2 %           69,133     4.9 % Total                  $    460,470      100.0 %   $    468,676      100.0 %   $    1,376,105   100.0 %   $    1,405,558   100.0 %  Inpatient Only: Medicaid               $    195,431       47.7 %   $    184,732       44.2 %   $      570,690    46.8 %   $      541,884    43.3 % Medicare                    123,940       30.2          144,210       34.5            384,286    31.5 %          440,528    35.2 % Private pay and other                        66,156       16.2           66,630       15.9 

195,360 15.9 % 199,830 16.0 % Managed care and commercial insurance 24,223 5.9

           22,525        5.4             70,337     5.8 %           68,326     5.5 % Total                  $    409,750      100.0 %   $    418,097      100.0 %   $    1,220,673   100.0 %   $    1,250,568   100.0 %    Medicare  Medicare is available to nearly every United States citizen 65 years of age and older. It is a broad program of health insurance designed to help the nation's elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled or those having end-stage renal disease. Medicare is comprised of four related health insurance programs. Medicare Part A provides for inpatient services including hospital, skilled long-term care, hospice and home healthcare. Medicare Part B provides for outpatient services including physicians' services, diagnostic service, durable medical equipment, skilled therapy services and medical supplies. Medicare Part C is a managed care option ("Medicare Advantage") for beneficiaries who are entitled to Part A and enrolled in Part B. Medicare Part D is a benefit that provides prescription drug benefits for both Medicare and Medicare/Medicaid dually eligible patients.                                          26 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES  Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System ("PPS") as defined by the Balanced Budget Act of 1997 and subsequent legislative and rule changes. PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. Prior to October 1, 2010, the amount to be paid was determined by classifying each patient into one of 53 Resource Utilization Groups ("RUGs"), which were collectively referred to as "RUGs III". After October 1, 2010, the RUGs were expanded to 66 categories to provide further refinement and are referred to collectively as "RUGs IV". Each RUGs level represents the level of services required to treat the patient's condition or level of acuity.  The RUGs III system reimbursed for therapy service delivered concurrently, in a group or individually, at the same rate. The RUGs IV system changes maintain the same reimbursement methodology for group and individual therapy, but only considers concurrent therapy if it is delivered to two patients and divides the services between the two patients that receive the services. Changes were also made to the required qualifications for each RUGs level.  On July 29, 2011, CMS released the CMS Final Rule for skilled nursing facilities for the 2012 federal fiscal year that commenced on October 1, 2011. Pursuant to the CMS Final Rule, Medicare Part A payment rates were reduced by 12.6% (i.e., the Medicare rate parity adjustment) to correct what CMS perceived as a lack of parity between RUGs III and RUGs IV. The CMS Final Rule also changed the reimbursement rules associated with group therapy and introduced new change-of-therapy provisions as patients move through their post-acute stay. The CMS Final Rule therapy reimbursement changes resulted in further reductions in our revenues from the Medicare program (prior to implementation of our therapy mitigation plans) and also served to increase our costs of providing such therapy services. On October 1, 2011, we also received a net 1.7% market basket increase to our prospective Medicare rates. Based on operating results through the end of the third quarter of 2012, we continue to expect the impact of the CMS Final Rule on our full year 2012 operations to be a year-over-year reduction in income before income taxes of approximately $40.0 million to $45.0 million due to the ramp-up nature of many elements of our management mitigation plans.  

The following table sets forth the average amounts of inpatient Medicare Part A revenues per patient, per day, recorded by our healthcare centers for the periods indicated:

      For the Three Months Ended                 For the Nine Months Ended September 30, 2012   September 30, 2011   September 30, 2012   September 30, 2011      $465.80              $520.11              $463.52              $520.92    Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services. An automatic exception process has been in place for patients residing in skilled nursing centers. That exception process will continue through December 31, 2012. Beginning October 1, 2012, through December 31, 2012, a new provision for a manual medical review process has been added to request exceptions to the therapy caps for services above certain thresholds. Instructions regarding the manual medical review process have been released by CMS and we are in preliminary implementation of the first of three phases prescribed by CMS. We are not able to estimate the impact, if any, from this review process on future revenues.  CMS has notified providers that they would not issue a Notice of Proposed Rulemaking - SNF for the 2013 fiscal year, which commenced on October 1, 2012. They instead issued an Update Notice on July 27, 2012, which made the updates that are required by current law rather than implementing policy changes.  This Update Notice provides for a market basket increase of 2.5%, which is reduced by a productivity adjustment of 0.7%, generating a net increase of 1.8%.  We estimate that the net impact of this Update Notice on our skilled nursing operations will result in increased revenues of approximately $1.9 million per quarter.  Any additional changes for the 2013 federal fiscal year would require legislative action.  On February 17, 2012, Congress passed the Middle Class Tax Relief and Job Creation Act of 2011, which included a provision reducing the reimbursement of Medicare bad debts. Medicare bad debts are primarily generated when states do not reimburse the provider for co-insurance for Medicare/Medicaid dually eligible patients. Providers are not permitted to bill this co-insurance to any other party when Medicaid does not reimburse the provider cost of service. Prior to this legislation, Medicare reimbursed providers 100% for this uncollectable co-insurance associated with dually eligible patients. Under the newly enacted legislation, Medicare will now phase in a reduction in the percentage of reimbursement for uncollectable co-insurance starting with cost reports beginning in federal fiscal year 2013, which primarily impacts our cost reports beginning on January 1, 2013. It is not clear if states will reimburse for dually eligible patient co-insurance under the state Medicaid programs as a result of this new legislation. If states do not begin to reimburse for dually eligible patient co-insurance then we are projecting the result will be a reduction in our revenues from reimbursement of Medicare bad debts of approximately $2.3 million in 2013, $4.7 million in 2014 and $6.7 million in subsequent years. Fourteen of the twenty-three states in which we operate do not reimburse the Medicaid co-insurance for dually eligible patients.                                         27 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES   On August 2, 2011, Congress passed the Budget Control Act of 2011, which created The Joint Select Committee on Deficit Reduction.  This Committee was tasked to find $1.5 trillion in savings by November 23, 2011.  The Committee was unable to reach an agreement and as a result, sequestration as provided for in the Budget Control Act was triggered.  Sequestration will result in a 2% reduction in Medicare payments effective January 1, 2013, which we estimate will reduce our revenues by approximately $2.5 million per quarter in 2013.  

Historically we have been able to mitigate a portion of revenue reductions resulting from changes in CMS' reimbursement regulations.

We receive Medicare reimbursements for hospice care at daily or hourly rates based on the level of care furnished to the patient. Our ability to receive Medicare reimbursement for our hospice services is subject to two limitations:

· If inpatient days of care provided to all patients at a hospice exceed 20%

of the total days of hospice care provided by that hospice for an annual

period, then payment for days in excess of this limit are paid for at the

       lower routine home care rate.    ·      Overall payments made by Medicare on a per hospice program basis are

subject to a cap amount at the end of an annual period. The cap amount is

calculated by multiplying the number of first time Medicare hospice

beneficiaries during the year by the Medicare per beneficiary cap amount,

resulting in that hospice's aggregate cap, which is the allowable amount

of total Medicare payments that hospice can receive for that cap year. If

a hospice program exceeds its aggregate cap, then the hospice must repay

        the excess.    In July 2012, CMS issued its final rule for hospice services for the 2013 federal fiscal year. The rule includes an industry-wide rate net increase of 0.9%, which is comprised of a market basket increase of 1.6% and an offsetting 0.7% decrease resulting from a phase out of the wage index budget neutrality factor. We estimate that the net impact on our hospice service operations will be a net increase of 1.1% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.2 million per quarter.  

Medicaid

Medicaid is a state-administered program financed by state funds and federal matching funds. The program provides for medical assistance to the indigent and certain other eligible persons. Although administered under broad federal regulations, states are given flexibility to construct programs and payment methods. Each state in which we operate nursing and rehabilitation centers has its own unique Medicaid reimbursement system.  

Medicaid outlays are a significant component of state budgets, and there have been cost containment pressures on Medicaid outlays for nursing homes. The recent economic downturn has caused many states to institute freezes on or reductions in Medicaid spending to address state budget concerns.

  Twenty-one of the states in which our Inpatient Services segment operates impose a provider tax on nursing homes as a method of increasing federal matching funds paid to those states for Medicaid.  

The following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (excluding any impact of individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the periods indicated:

        For the Three Months Ended                  For the Nine Months

Ended September 30, 2012    September 30, 2011     September 30, 2012   September 30, 2011      $183.16         $             176.42         $180.65              $175.21                                            28

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For comparison purposes, the following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (including the impact from individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the periods indicated:

      For the Three Months Ended                 For the Nine Months Ended September 30, 2012   September 30, 2011   September 30, 2012   September 30, 2011      $165.95              $160.69              $163.50              $159.84    Excluded from the Medicaid revenue per patient, per day rates set forth in the tables above are Medicaid revenues we earned under certain supplemental Medicaid programs in the states of Idaho and Montana.  We classify those supplemental Medicaid revenues as other revenues.  The amounts of supplemental Medicaid revenue classified as other revenues totaled $2.7 million and $1.3 million for the three months ended September 30, 2012 and 2011, respectively, and $6.7 million and $4.5 million for the nine months ended September 30, 2012 and 2011, respectively.  Managed Care and Insurance  During the three months ended September 30, 2012, we received 5.3% of our revenues from managed care and insurance, of which the Medicare Advantage program is the primary component. As discussed above, Medicare Advantage is the managed care option for Medicare beneficiaries. Medicare Advantage is administered by contracted third party payors. The managed care and insurance payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers and increased utilization review. These payors are increasingly demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.  The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated below.        For the Three Months Ended                 For the Nine Months Ended September 30, 2012   September 30, 2011   September 30, 2012   September 30, 2011      $387.04              $384.33              $380.05              $377.69   

Private Payors, Veterans and Other

  During the three months ended September 30, 2012, we received 24.5% of our revenues from private payors, veterans' coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors. These private and other payors are continuing their efforts to control healthcare costs. Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.  The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated:        For the Three Months Ended                 For the Nine Months Ended September 30, 2012   September 30, 2011   September 30, 2012   September 30, 2011      $193.25              $190.58              $193.70              $193.89   

Other Reimbursement Matters

  Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may either delay or disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations.                                           29 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Recent Accounting Pronouncements

Discussion of recent accounting pronouncements can be found in the "Recent Accounting Pronouncements" portion of Note 1 - "Nature of Business" to our consolidated financial statements included in this Form 10-Q.

Results of Operations

The following tables set forth our unaudited historical consolidated income statements and certain percentage relationships for the periods presented (dollars in thousands):

                                        For the Three Months Ended           

As a Percentage of Net Revenues

                                September 30, 2012      September 30, 2011    September 30, 2012       September 30, 2011 Total net revenues            $         460,470       $          468,676             100.0  %                   100.0  % Costs and expenses: Operating salaries and benefits                                259,379                  263,932              56.3                       56.3 Self-insurance for workers' compensation and general and professional liabilities                              15,237                   14,545               3.3                        3.1 Other operating costs (1)               108,254                  106,667              23.5                       22.8 Center rent expense                      36,647                   35,952               8.0                        7.7 General and administrative expenses                                 14,447                   14,825               3.1                        3.2 Depreciation and amortization             8,654                    8,163               1.9                        1.7 Provision for losses on accounts receivable                       5,250                    4,604               1.1                        1.0 Interest, net                             4,458                    4,834               1.0                        1.0 Other (2)                                 1,223                  320,326               0.3                       68.3 Income (loss) before income taxes and      discontinued operations              6,921                 (305,172 )             1.5                      (65.1 ) Income tax expense                        2,932                    2,203               0.6                        0.5 Income (loss) from continuing operations                                3,989                 (307,375 )             0.9                      (65.6 ) Loss from discontinued operations, net                          (2,702 )                 (2,031 )            (0.6 )                     (0.4 ) Net income (loss)             $           1,287       $         (309,406 )             0.3  %                   (66.0 )% Supplemental Financial Information (3): EBITDA                        $          20,033       $         (292,175 )             4.4  %                   (62.3 )% Adjusted EBITDA               $          20,222       $           28,151               4.4  %                     6.0  % Adjusted EBITDAR              $          56,869       $           64,103              12.3  %                    13.7  %                                            30

--------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES                                          For the Nine Months Ended                As a Percentage of Net Revenues                                 September 30, 2012     September 30, 2011    September 30, 2012       September 30,                                                                                                           2011 Total net revenues             $        1,376,105     $        1,405,558             100.0  %             100.0  % Costs and expenses: Operating salaries and benefits                                  779,976                789,874              56.7                 56.2 Self-insurance for workers' compensation and general and professional liabilities                                43,744                 43,643               3.2                  3.1 Other operating costs (1)                 324,358                316,332              23.6                 22.5 Center rent expense                       109,546                107,394               8.0                  7.6 General and administrative expenses                                   46,537                 45,156               3.4                  3.2 Depreciation and amortization              25,588                 23,241               1.9                  1.7 Provision for losses on accounts receivable                        15,157                 14,198               1.1                  1.0 Interest, net                              13,297                 14,688               1.0                  1.0 Other (2)                                   3,060                320,628               0.2                 22.8 Income (loss) before income taxes and      discontinued operations               14,842               (269,596 )             1.1                (19.2 ) Income tax expense                          6,021                 16,715               0.4                  1.2 Income (loss) from continuing operations                                  8,821               (286,311 )             0.6                (20.4 ) Loss from discontinued operations, net                            (8,301 )               (5,036 )            (0.6 )               (0.4 ) Net income (loss)              $              520     $         (291,347 )               -  %             (20.7 )% Supplemental Financial Information (3): EBITDA                         $           53,727     $         (231,667 )             3.9  %             (16.5 )% Adjusted EBITDA                $           53,916     $           88,961               3.9  %               6.3  % Adjusted EBITDAR               $          163,462     $          196,355              11.9  %              14.0  %    

(1) Operating administrative expenses are included in "other operating costs" above.

(2) Other expenses consist of loss on sale of assets, net, transaction costs, restructuring costs, and loss on asset impairment.

  (3) We define EBITDA as net income before loss from discontinued operations, interest expense (net of interest income), income tax expense, depreciation and amortization. EBITDA margin is EBITDA as a percentage of revenue. Adjusted EBITDA is EBITDA adjusted for loss on sale of assets, restructuring costs and loss on asset impairment. Adjusted EBITDA margin is Adjusted EBITDA as a percentage of revenue. Adjusted EBITDAR is Adjusted EBITDA before center rent expense. Adjusted EBITDAR margin is Adjusted EBITDAR as a percentage of revenue.  We believe that the presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides useful information regarding our operational performance because they enhance the overall understanding of the financial performance and prospects for the future of our core business activities.  Specifically, we believe that a presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods. EBITDA, Adjusted EBITDA and Adjusted EBITDAR are three of the primary indicators we use for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of GAAP expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.  In addition to other financial measures, including net segment income, we use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated, segment and a center-by-center level. EBITDA, Adjusted EBITDA and Adjusted EBITDAR are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes and depreciation and amortization expense, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a center is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business unit operates. These types of charges are dependent on factors unrelated to our underlying business. The additional items we exclude from Adjusted EBITDA and Adjusted EBITDAR are also charges that we believe are unrelated to the operation of our underlying business. As a result, we believe that the use of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying business between periods by eliminating certain items required by GAAP which have little or no significance in our day-to-day operations.                                          31 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES  We also make capital allocations to each of our centers based on the centers' lease terms and their expected Adjusted EBITDA returns. We establish compensation and bonus programs for our center-level employees that are based upon the achievement of pre-established Adjusted EBITDA targets.  Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and facility level basis, EBITDA, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by GAAP. As the items excluded from EBITDA, Adjusted EBITDA and Adjusted EBITDAR are significant components in understanding and assessing our financial performance, EBITDA, Adjusted EBITDA and Adjusted EBITDAR should not be considered in isolation or as alternatives to net income, cash flows generated by or used in operating, investing or financing activities or other financial statement data presented in the consolidated financial statements included in this Form 10-Q as indicators of financial performance or liquidity. Therefore, our EBITDA, Adjusted EBITDA and Adjusted EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:  •      they do not reflect our cash expenditures, or future requirements for        capital expenditures, or contractual commitments;  

• they do not reflect changes in, or cash requirements for, our working

       capital needs;   •      they do not reflect the interest expense, or the cash requirements        necessary to service interest or principal payments, on our debt;  

• they do not reflect any income tax payments we may be required to make;

• although depreciation and amortization are non-cash charges, the assets

being depreciated and amortized will often have to be replaced in the

future in order to remain competitive in the market, and EBITDA, Adjusted

       EBITDA and Adjusted EBITDAR do not reflect any cash requirements for such        replacements;  

• they are not adjusted for all non-cash income or expense items that are

reflected in our consolidated statements of cash flows; and

• other companies in our industry may calculate these measures differently

than we do, which may limit their usefulness as comparative measures.

    We compensate for these limitations by using EBITDA, Adjusted EBITDA and Adjusted EBITDAR only to supplement net income on a basis prepared in conformance with GAAP in order to provide a more complete understanding of the factors and trends affecting our business. We strongly encourage investors to consider net income determined under GAAP as compared to EBITDA, Adjusted EBITDA and Adjusted EBITDAR, and to perform their own analysis, as appropriate.  The following table provides a reconciliation of our net income (loss), which is the most directly comparable financial measure presented in accordance with GAAP, to EBITDA, Adjusted EBITDA and Adjusted EBITDAR for the periods indicated (in thousands):                                For the Three Months Ended             For the Nine Months Ended                                      September 30,                          September 30,                                   2012            2011                   2012               2011 Net income (loss)            $      1,287     $  (309,406 )      $         520          $  (291,347 ) Plus: Loss from discontinued operations, net                     2,702           2,031                8,301                5,036 Income tax expense                  2,932           2,203                6,021               16,715 Interest expense, net               4,458           4,834               13,297               14,688 Depreciation and amortization                        8,654           8,163               25,588               23,241 EBITDA                       $     20,033     $  (292,175 )      $      53,727          $  (231,667 ) Plus: Loss on sale of assets                189             809                  189                  809 Restructuring costs                     -           2,426                    -                2,728 Loss on asset impairment                -         317,091                    -              317,091 Adjusted EBITDA              $     20,222     $    28,151        $      53,916          $    88,961 Plus: Center rent expense                36,647          35,952              109,546              107,394 Adjusted EBITDAR             $     56,869     $    64,103        $     163,462          $   196,355                                             32

--------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES  The following discussion of the "Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011" is based, in part, on the financial information presented in Note 7 - "Segment Information" in our consolidated financial statements included in this Form 10-Q.  

Three Months Ended September 30, 2012 Compared to Three Months Ended September

                                    30, 2011  The following summarizes our results of operations on a consolidated basis. A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under "Segment Information."  Total net revenues decreased $8.2 million, or 1.8%, to $460.5 million for the three months ended September 30, 2012 from $468.7 million for the three months ended September 30, 2011. We reported net income for the three months ended September 30, 2012 of $1.3 million and net loss of 309.4 million for the three months ended September 30, 2011.  The decrease in net revenues for the 2012 period included $8.3 million of reduced revenues in our Inpatient Services segment and a $0.5 million decrease in nonaffiliated revenues from our Rehabilitation Therapy Services segment which were partially offset by a $0.7 million increase in nonaffiliated revenues from our Medical Staffing segment.  Operating salaries and benefits decreased $4.6 million, or 1.7%, to $259.4 million (56.3% of net revenues) for the three months ended September 30, 2012 from $263.9 million (56.3% of net revenues) for the three months ended September 30, 2011. The decrease resulted primarily from decreased wages and benefits in our housekeeping and laundry departments following the outsourcing of the majority of our housekeeping and laundry services.  Self-insurance for workers' compensation and general and professional liability insurance expense increased $0.7 million, or 4.8%, to $15.2 million (3.3% of net revenues) for the three months ended September 30, 2012 from $14.5 million (3.1% of net revenues) for the three months ended September 30, 2011, which was primarily due to increased claims-related activity in our general and professional liability programs.  Other operating costs increased $1.6 million, or 1.5%, to $108.3 million (23.5% of net revenues) for the three months ended September 30, 2012 from $106.7 million (22.8% of net revenues) for the three months ended September 30, 2011. The increase was primarily due to increased provider taxes, coupled with increases in purchased services for housekeeping and laundry services.  Center rent expense increased $0.7 million, or 1.9%, to $36.6 million (8.0% of net revenues) for the three months ended September 30, 2012 from $36.0 million (7.7% of net revenues) for the three months ended September 30, 2011. The increase was primarily attributable to the scheduled inflationary increases in accordance with our lease agreements.  General and administrative expenses decreased $0.4 million, or 2.5%, to $14.4 million (3.1% of net revenues) for the three months ended September 30, 2012 from $14.8 million (3.2% of net revenues) for the three months ended September 30, 2011. The decrease was primarily due to decreased compensation and benefits.  Depreciation and amortization increased $0.5 million, or 6.0%, to $8.7 million (1.9% of net revenues) for the three months ended September 30, 2012 from $8.2 million (1.7% of net revenues) for the three months ended September 30, 2011. The increase was due to new property and equipment placed into service since September 30, 2011.  The provision for losses on accounts receivable increased $0.6 million, or 14.0%, to $5.3 million (1.1% of net revenues) for the three months ended September 30, 2012 from $4.6 million (1.0% of net revenues) for the three months ended September 30, 2011. The increase resulted primarily from higher reserves recorded on older accounts receivable balances.  Net interest expense decreased $0.4 million, or 7.8%, to $4.5 million (1.0% of net revenues) for the three months ended September 30, 2012 from $4.8 million (1.0% of net revenues) for the three months ended September 30, 2011 due to lower aggregate indebtedness.                                          33 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Segment Information

  The following table sets forth the amount and percentage of certain elements of total net revenues for the three months ended September 30, 2012 (dollars in thousands):                                          2012                     2011 Inpatient Services              $ 409,750      89.0  %   $ 418,097      89.2  % Rehabilitation Therapy Services    60,917      13.2         62,359      13.3 Medical Staffing Services          22,118       4.8         21,753       4.6 Corporate                               2         -             15         - Intersegment Eliminations         (32,317 )    (7.0 )      (33,548 )    (7.1 ) Total net revenues              $ 460,470     100.0  %   $ 468,676     100.0  %    Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations. The following table sets forth a summary of the intersegment revenues for the three months ended September 30 (in thousands):                                   2012        2011 Rehabilitation Therapy Services $ 31,885    $ 32,791 Medical Staffing Services            432         757 Total intersegment revenue      $ 32,317    $ 33,548   

The following table sets forth the amount of net segment income for the three months ended September 30 (in thousands):

                                        2012         2011 Inpatient Services                  $ 22,780     $ 32,352 

Rehabilitation Therapy Services 4,068 2,296 Medical Staffing Services

              1,238        1,221 Net segment income before Corporate   28,086       35,869 Corporate                            (19,942 )    (20,715 ) Net segment income                  $  8,144     $ 15,154    Our reportable segments are strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs. We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income. Net segment income is defined as earnings before income tax expense, restructuring costs and discontinued operations. Net segment income for the three months ended September 30, 2012 for (1) our Inpatient Services segment decreased $9.6 million, or 29.6%, to $22.8 million, (2) our Rehabilitation Therapy Services segment increased $1.8 million, or 77.2%, to $4.1 million and (3) our Medical Staffing Services segment remained flat at $1.2 million in comparison to the three months ended September 30, 2011, due to the factors discussed below for each segment. We use net segment income among other things to help identify opportunities for improvement and assist in allocating resources to each segment.                                          34 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient Services

  Total net revenues decreased $8.3 million, or 2.0%, to $409.8 million for the three months ended September 30, 2012 from $418.1 million for the three months ended September 30, 2011. The decrease was primarily the result of: 

- a $20.9 million decrease in Medicare revenues as a result of a $11.4

million decrease in revenues from lower Medicare Part A rates primarily

resulting from the CMS Final Rule parity rate adjustment and a $9.7 million

decrease due to a decreased customer base, offset in part by a $0.2 million

increase in Medicare Part B revenues; and

- a $1.5 million decrease in private revenues consisting of a $2.5 million

decrease related to customer base offset in part by a $1.0 million increase

     in rates;       Offset in part by: 

- a $10.6 million increase in Medicaid revenues consisting of $7.0 million

from an increase in rates and $3.6 million increase from a higher customer

base;

- a $1.7 million increase in managed care and commercial insurance revenues

driven by improved customer base;

- a $1.0 million increase in other revenue including from veterans' coverage

     and other various inpatient services; and   -   a $0.8 million increase in hospice revenues primarily due to organic      growth.     Operating salaries and benefits expenses decreased $2.4 million, or 1.2%, to $191.0 million for the three months ended September 30, 2012 from $193.4 million for the three months ended September 30, 2011. The decrease was attributable to the following: 

- a decrease of $3.7 million due to the outsourcing of housekeeping and

laundry services in many centers to a third party service provider; and

- a $0.3 million decrease in overtime for all staff;

Offset in part by:

- an increase of $1.6 million in staff compensation and benefits to remain

competitive in local markets.

    Self-insurance for workers' compensation and general and professional liability insurance expense increased $0.7 million, or 5.5%, to $14.2 million for the three months ended September 30, 2012 as compared to $13.5 million for the three months ended September 30, 2011, which was driven by increased claims related activity in our general and professional liability programs.  Other operating costs increased $3.0 million, or 2.4%, to $124.9 million for the three months ended September 30, 2012 from $121.9 million for the three months ended September 30, 2011. The increase was attributable to the following: 

- a $3.4 million increase in purchased services driven by a $3.7 million

increase related to outsourced housekeeping and laundry services, which was

partially offset by a $0.3 million decrease in other purchased services;

   -   a $2.1 million increase in taxes primarily due to increased provider tax       rates from a number of states in which we operate; and    -   a $0.5 million increase in miscellaneous administrative expenses;        Offset in part by:    -   a $1.7 million decrease in supplies of which $0.1 million relates to       housekeeping and laundry supplies now included in our outsourcing       arrangement discussed above; and 

- a $1.3 million decrease in contract labor mostly driven by reduced expense

      related to our affiliated therapy services because of lower skilled       customer base.    Operating administrative expenses decreased $1.6 million, or 15.7%, to $8.5 million for the three months ended September 30, 2012 compared to $10.1 million for the three months ended September 30, 2011, primarily due to lower salaries, benefits, contract labor, travel, utilities and office lease expense in accordance with our cost mitigation plans necessitated by the impact of the CMS Final Rule.                                          35

--------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES  Center rent expense increased $0.7 million, or 1.9%, to $36.3 million for the three months ended September 30, 2012 from $35.6 million for the three months ended September 30, 2011. The increase was primarily attributable to the scheduled inflationary increases in accordance with our lease agreements.  Depreciation and amortization increased $0.5 million, or 7.5%, to $7.3 million for the three months ended September 30, 2012 from $6.8 million for the three months ended September 30, 2011.  The increase was due to new property and equipment placed into service since September 30, 2011.  The provision for losses on accounts receivable increased $0.3 million, or 6.7%, to $4.8 million for the three months ended September 30, 2012 from $4.5 million for the three months ended September 30, 2011.  The increase in provision was related to higher reserves recorded on older accounts receivable balances.  

Rehabilitation Therapy Services

  Total net revenues from the Rehabilitation Therapy Services segment decreased $1.4 million, or 2.3%, to $60.9 million for the three months ended September 30, 2012 from $62.4 million for the three months ended September 30, 2011. The revenue decrease was the result of: 

- a decrease of $2.0 million attributable to decreased billable minutes, due

      to the loss of 5 contracts, net of new contracts; loss of two large       nonaffiliated chains in conjunction with a decrease in same store       affiliated business;        Offset in part by    -   an increase of $0.6 million attributable to an increase in revenue per       minute due to significant growth in Part B and other revenue as well as

nonaffiliated rate increases combined with an affiliated market basket

       rate increase.    Operating salaries and benefits expenses decreased $2.5 million, or 4.6%, to $51.8 million for the three months ended September 30, 2012 from $54.3 million for the three months ended September 30, 2011. The decrease is a reflection of staffing adjustments made to accommodate the decrease in volume in conjunction with increased productivity and decreased benefits costs, but partially offset by increases in wage rates to stay competitive with local markets.  

Operating administrative expenses decreased $0.8 million, or 34.4%, to $1.5 million for the three months ended September 30, 2012 compared to $2.3 million for the three months ended September 30, 2011, primarily due to lower professional fees and benefits in accordance with our cost mitigation plans necessitated by the impact of the CMS Final Rule.

Medical Staffing Services

  Total net revenues from the Medical Staffing Services segment increased $0.4 million, or 1.68%, to $22.1 million for the three months ended September 30, 2012 from $21.8 million for the three months ended September 30, 2011. The increase was primarily the result of: 

an increase of $0.6 million due to an increase in billable hours for nurse

- staffing; and

an increase of $0.1 million due to an increase in therapy and staffing

- hours;

Offset in part by

a decrease of $0.3 million due to lower fees earned from the temporary

- placement of physicians.

    Operating salaries and benefits expenses increased $0.3 million, or 1.8%, to $16.5 million for the three months ended September 30, 2012 as compared to $16.2 million for the three months ended September 30, 2011. The increase in operating salaries and benefits is due to increase in bill hours as well as wage rate increases to remain competitive in local markets.  

Corporate

  General and administrative expenses not directly attributed to segments decreased $0.4 million, or 2.5%, to $14.4 million for the three months ended September 30, 2012 from $14.8 million for the three months ended September 30, 2011. The decrease was primarily due to decreased professional and consultant fees.                                          36

--------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES  Interest expense not directly attributed to operating segments decreased $0.4 million, or 7.3%, to $4.5 million for the three months ended September 30, 2012 from $4.9 million for the three months ended September 30, 2011 due to lower aggregate indebtedness.   The following discussion of the "Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011" is based, in part, on the financial information presented in Note 7 - "Segment Information" in our consolidated financial statements included in this Form 10-Q.  

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30,

                                      2011  The following summarizes our results of operations on a consolidated basis. A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under "Segment Information."  Total net revenues decreased $29.5 million or 2.1%, to $1,376.1 million for the nine months ended September 30, 2012 from $1,405.6 million for the nine months ended September 30, 2011. We reported net income for the nine months ended September 30, 2012 of $0.5 million and net loss of $291.3 million for the nine months ended September 30, 2011.  The decrease in net revenues for the 2012 period included $29.9 million of reduced revenues in our Inpatient Services segment and a $0.8 million decrease in nonaffiliated revenues from our Rehabilitation Therapy Services, which were partially offset by a $1.3 million increase in nonaffiliated revenues from our Medical Staffing segment.  Operating salaries and benefits decreased $9.9 million, or 1.3%, to $780.0 million (56.7% of net revenues) for the nine months ended September 30, 2012 from $789.9 million (56.2% of net revenues) for the nine months ended September 30, 2011. The decrease resulted primarily from decreased wages and benefits in our housekeeping and laundry departments following the outsourcing of the majority of our housekeeping and laundry services.  Self-insurance for workers' compensation and general and professional liability insurance expense increased $0.1 million, or 0.2%, to $43.7 million (3.2% of net revenues) for the nine months ended September 30, 2012 from $43.6 million (3.1% of net revenues) for the nine months ended September 30, 2011. The increase resulted primarily from increased claims-related activity in our general and professional liability programs.  Other operating costs increased $8.0 million, or 2.5%, to $324.4 million (23.6% of net revenues) for the nine months ended September 30, 2012 from $316.3 million (22.5% of net revenues) for the nine months ended September 30, 2011. The increase was primarily due to increased provider taxes, coupled with increases in purchased services for housekeeping and laundry services.  Center rent expense increased $2.2 million, or 2.0%, to $109.5 million (8.0% of net revenues) for the nine months ended September 30, 2012 from $107.4 million (7.6% of net revenues) for the nine months ended September 30, 2011. The increase was primarily attributable to the scheduled inflationary increases in accordance with our lease agreements.  General and administrative expenses increased $1.4 million, or 3.1%, to $46.5 million (3.4% of net revenues) for the nine months ended September 30, 2012 from $45.2 million (3.2% of net revenues) for the nine months ended September 30, 2011. The increase was primarily due to increased benefits.  Depreciation and amortization increased $2.3 million, or 10.1%, to $25.6 million (1.9% of net revenues) for the nine months ended September 30, 2012 from $23.2 million (1.7% of net revenues) for the nine months ended September 30, 2011. The increase was due to new property and equipment placed into service since September 30, 2011.  The provision for losses on accounts receivable increased $1.0 million, or 6.8%, to $15.2 million (1.1% of net revenues) for the nine months ended September 30, 2012 from $14.2 million (1.0% of net revenues) for the nine months ended September 30, 2011. The increase resulted primarily from higher reserves recorded on older accounts receivable balances.  Net interest expense decreased $1.4 million, or 9.5%, to $13.3 million (1.0% of net revenues) for the nine months ended September 30, 2012 from $14.7 million (1.0% of net revenues) for the nine months ended September 30, 2011 due to lower aggregate indebtedness.                                          37

--------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the nine months ended September 30 (dollars in thousands):

                                           2012                       2011 Inpatient Services              $ 1,220,673      88.7  %   $ 1,250,568      89.0  % Rehabilitation Therapy Services     187,010      13.6          188,355      13.4 Medical Staffing Services            68,541       5.0           67,388       4.8 Corporate                                15         -               36         - Intersegment Eliminations          (100,134 )    (7.3 )       (100,789 )    (7.2 ) Total net revenues              $ 1,376,105     100.0  %   $ 1,405,558     100.0  %    Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations. The following table sets forth a summary of the intersegment revenues for the nine months ended September 30 (in thousands):                                    2012         2011 Rehabilitation Therapy Services $  98,152    $  98,710 Medical Staffing Services           1,982        2,079 Total intersegment revenue      $ 100,134    $ 100,789   

The following table sets forth the amount of net segment income for the nine months ended September 30 (in thousands):

                                        2012         2011 Inpatient Services                  $ 65,104     $ 101,196 

Rehabilitation Therapy Services 11,381 8,495 Medical Staffing Services

              4,345         4,082 Net segment income before Corporate   80,830       113,773 Corporate                            (62,928 )     (62,741 ) Net segment income                  $ 17,902     $  51,032    Our reportable segments are strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs. We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income. Net segment income is defined as earnings before income tax expense, restructuring costs and discontinued operations. Net segment income for the nine months ended September 30, 2012 for (1) our Inpatient Services segment decreased $36.1 million, or 35.7%, to $65.1 million, (2) our Rehabilitation Therapy Services segment increased $2.9 million, or 34.0%, to $11.4 million and (3) our Medical Staffing Services segment increased $0.3 million in comparison to the nine months ended September 30, 2011, due to the factors discussed below for each segment. We use net segment income among other things to help identify opportunities for improvement and assist in allocating resources to each segment.                                          38 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient Services

  Total net revenues decreased $29.9 million, or 2.4%, to $1,220.7 million for the nine months ended September 30, 2012 from $1,250.6 million for the nine months ended September 30, 2011. The decrease was primarily the result of: 

- a decrease of $58.9 million in Medicare revenues as a result of a $38.0

million decrease in revenues from lower Medicare Part A rates primarily

resulting from the CMS Final Rule parity rate adjustment, a $23.6 million

decrease due to a decreased customer base, offset in part by a $2.7 million

     increase in Medicare Part B revenues; and   -   a decrease of $6.0 million in private revenues mostly due to a lower      customer base;       Offset in part by: 

- a $28.6 million increase in Medicaid revenues consisting of $17.0 million

increase from higher rates and an $11.6 million increase related to higher

     customer base;   -   a $2.9 million increase in hospice revenues primarily due to organic      growth; 

- a $1.9 million increase in managed care and commercial insurance revenues

driven primarily by improved customer base; and

- a $1.6 million increase in other revenue including from veterans' coverage

     and other various inpatient services.     Operating salaries and benefits expenses decreased $7.0 million, or 1.2%, to $570.2 million for the nine months ended September 30, 2012 from $577.2 million for the nine months ended September 30, 2011. The decrease was attributable to the following: 

- a decrease of $11.8 million due to the outsourcing of housekeeping and

laundry services in many centers to a third party service provider; and

- a $1.9 million decrease in overtime for all staff;

Offset in part by:

- an increase of $6.7 million in staff compensation and benefits to remain

competitive in local markets.

    Self-insurance for workers' compensation and general and professional liability insurance expense increased $0.2 million, or 0.5%, to $40.7 million for the nine months ended September 30, 2012 as compared to $40.5 million for the nine months ended September 30, 2011, which was driven by increased claims related activity in our general and professional liability self-insurance programs.  Other operating costs increased $12.2 million, or 3.4%, to $374.3 million for the nine months ended September 30, 2012 from $362.2 million for the nine months ended September 30, 2011. The increase was attributable to the following: 

- a $10.1 million increase in purchased services driven by an $11.6 million

increase related to outsourced housekeeping and laundry services which was

partially offset by a $1.5 million decrease in other purchased services;

     and   -   a $7.7 million increase in taxes, primarily due to increased provider tax      rates from a number of states in which we operate;       Offset in part by:   -   a $3.2 million decrease in supplies of which $0.5 million relates to      housekeeping and laundry supplies now included in our outsourcing      arrangement discussed above; 

- a $2.2 million decrease in contract labor mostly driven by reduced expense

related to our affiliated therapy services because of our lower skilled

customer base as well as reduced contract labor in our nursing services;

     and   -   a $0.3 million decrease in miscellaneous administrative expenses.    Operating administrative expenses decreased $3.8 million, or 12.4%, to $26.6 million for the nine months ended September 30, 2012 compared to $30.4 million for the nine months ended September 30, 2011, primarily due to lower salaries, benefits, contract labor, supplies, travel, meals, meetings, utilities and office lease expense in accordance with our cost mitigation plans necessitated by the impact of the CMS Final Rule.                                          39 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES  Center rent expense increased $2.1 million, or 2.0%, to $108.6 million for the nine months ended September 30, 2012 from $106.5 million for the nine months ended September 30, 2011. The increase was primarily attributable to the scheduled inflationary increases in accordance with our lease agreements.  Depreciation and amortization increased $2.1 million, or 10.8%, to $21.4 million for the nine months ended September 30, 2012 from $19.3 million for the nine months ended September 30, 2011.  The increase was due to new property and equipment placed into service since September 30, 2011.  The provision for losses on accounts receivable increased $0.4 million, or 2.7%, to $13.8 million for the nine months ended September 30, 2012 from $13.4 million for the nine months ended September 30, 2011. The increase in provision was related to higher reserves recorded on older accounts receivable balances.  

Rehabilitation Therapy Services

  Total net revenues from the Rehabilitation Therapy Services segment decreased $1.3 million, or 0.7%, to $187.0 million for the nine months ended September 30, 2012 from $188.4 million for the nine months ended September 30, 2011. The revenue decrease was the result of:   -   a decrease of $2.7 million attributable to decreased billable minutes due       to the loss of 5 contracts, net of new contracts; loss of two large       nonaffiliated chains and four hospital contracts in conjunction with a       decrease in same store affiliated business;        Offset in part by: 

- an increase of $1.4 million attributable to increased revenue per minute

due to significant growth in Part B and other revenue as well as

nonaffiliated rate increases combined with an affiliated market basket

       rate increase.    Operating salaries and benefits expenses decreased $3.8 million, or 2.3%, to $158.2 million for the nine months ended September 30, 2012 from $161.9 million for the nine months ended September 30, 2011. The decrease was driven by the aforementioned decline in service volume coupled with productivity improvements and decreases in paid mileage, health insurance and paid time off.  

Operating administrative expenses decreased $0.9 million, or 12.0%, to $6.3 million for the nine months ended September 30, 2012 compared to $7.1 million for the nine months ended September 30, 2011, primarily due to lower professional fees and benefits in accordance with our cost mitigation plans necessitated by the impact of the CMS Final Rule.

Medical Staffing Services

  Total net revenues from the Medical Staffing Services segment increased $1.2 million, or 1.7%, to $68.5 million for the nine months ended September 30, 2012 from $67.4 million for the nine months ended September 30, 2011. The increase was primarily the result of: 

- an increase of $1.0 million due to an increase in billable hours for nurse

staffing; and

- an increase of $0.8 million due to an increase in therapy and staffing

      hours;        Offset in part by: 

- a decrease of due to lower fees earned from the temporary

placement of physicians.

    Operating salaries and benefits expenses increased $0.8 million, or 1.7%, to $51.6 million for the nine months ended September 30, 2012 as compared to $50.8 million for the nine months ended September 30, 2011. The increase is due to the increase in staffing hours referenced above.  

Corporate

General and administrative expenses not directly attributed to segments increased $1.4 million, or 3.1%, to $46.5 million for the nine months ended September 30, 2012 from $45.2 million for the nine months ended September 30, 2011. The increase was primarily due to increased benefits.

                                       40 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES  Interest expense not directly attributed to operating segments decreased $1.4 million, or 9.3%, to $13.4 million for the nine months ended September 30, 2012 from $14.8 million for the nine months ended September 30, 2011 due to lower aggregate indebtedness.  

Liquidity and Capital Resources

  For the three months ended and as of September 30, 2012, our net income was $1.3 million and our working capital was $159.3 million. As of September 30, 2012, we had cash and cash equivalents of $63.8 million, $60.0 million available on our revolving credit facility and $88.9 million in borrowings. As of September 30, 2012, we were in compliance with the covenants contained in the credit agreement governing our revolving credit facility and our term loan indebtedness as described under "Loan Agreements" below.  Based on current levels of operations, we believe that our operating cash flows, existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary) as discussed in our 2011 Form 10-K under "Capital Expenditures", scheduled debt service payments and our other commitments (as described in the table under "Obligations and Commitments" of our 2011 Form 10-K) at least through the next twelve months. We believe our long-term liquidity needs will be satisfied by these same sources, as well as borrowings as required to refinance indebtedness. Although our credit agreement, which is described under "Loan Agreements" below, contains restrictions on our ability to incur indebtedness, we currently believe that we will be able to refinance existing indebtedness or incur additional indebtedness, if needed. However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing debt or equity securities, on terms that are acceptable to us or at all.  Since April 2007, we have relied on our cash flows to provide for operational needs and capital expenditures, and have not relied on revolving credit borrowings. However, there can be no assurance that our operations will continue to provide sufficient cash flow or that refinancing sources will be available in the future, particularly given current economic conditions. We anticipate that we will be able to utilize our revolving credit facility if needed, as we expect to remain in compliance with the covenants contained in our credit agreement for at least the next twelve months. In December 2011, we voluntarily paid down $50 million of term loans in conjunction with amending our credit agreement.  The amendment increased our interest rate by 1.25% in return for greater flexibility to our financial covenants. As a result of the expected negative impact of the CMS Final Rule on our business, we implemented a broad-based mitigation initiative, which includes infrastructure cost reductions without affecting the quality of our patient care. These reductions in infrastructure costs were, and continue to be, necessary to mitigate the impact on our business and remain in compliance with financial covenants under our credit agreement.   While we do not anticipate that any of our lenders will be unable to lend under our revolving credit facility if we determine to borrow funds, no assurance can be given that one or more of our lenders will be able to fulfill their commitments. 

We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.

Cash Flows

  During the three months ended September 30, 2012, net cash provided by operating activities was $26.4 million as compared to $17.9 million during the three months ended September 30, 2011. The increase of $8.5 million was primarily due to decreased operating costs (excluding the non-cash loss on asset impairment of $317.1 million in the three months ended September 30, 2011) and decreased accounts receivable balances. For additional information, please see "Results of Operations" above.  During the nine months ended September 30, 2012, net cash provided by operating activities was $30.8 million as compared to $49.3 million during the nine months ended September 30, 2011.  The decrease of $18.5 million was primarily due to increased operating costs (excluding the non-cash loss on asset impairment of $317.1 million in the nine months ended September 30, 2011) and temporary cash usage from the impact of timing differences on scheduled payroll and accounts payable disbursement cycles.  For additional information, please see "Results of Operations" above. 

Net cash used for investing activities of $5.9 million for the three months ended September 30, 2012 and $24.0 million for the nine months ended September 30, 2012 were primarily for capital expenditures.

  Net cash used for financing activities was $0.3 million for the three months ended September 30, 2012 and $0.9 million for the nine months ended September 30, 2012, which were attributable to repayments of long-term debt and capital lease obligations.                                             41

--------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $6.7 million and $24.6 million for the three months and nine months ended September 30, 2012, respectively.

Loan Agreements

  In October 2010, we entered into a $285.0 million senior secured credit facility (the "Credit Agreement") with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent. The Credit Agreement provides for $150.0 million in term loans ($87.3 million was outstanding at September 30, 2012), a $60.0 million revolving credit facility ($30.0 million of which may be utilized for letters of credit) and a $75.0 million letter of credit facility funded by proceeds of additional term loans ($74.8 million was utilized at September 30, 2012). The revolving credit facility was undrawn on September 30, 2012. The final maturity date of the term loans and the letter of credit facility is October 18, 2016 and the revolving credit facility terminates on October 18, 2015.  Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test and a leverage covenant. The Credit Agreement contains customary events of default, such as a failure by us to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting certain actions, including incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments. Our obligations under the Credit Agreement are guaranteed by most of our subsidiaries and are collateralized by our assets and the assets of most of our subsidiaries.  In December 2011, we amended the Credit Agreement and the associated $50.0 million voluntary repayment effectively satisfied any required quarterly principal payments until the facility's maturity in 2016. Accrued interest is payable at the end of an interest period, but no less frequently than every three months. Upon amendment, borrowings under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at our option, either (a) the greater of 1.75% or LIBOR, adjusted for statutory reserves or (b) an alternative base rate determined by reference to the highest of (i) the prime rate announced by Credit Suisse, (ii) the federal funds rate plus 0.5%, and (iii) the greater of 1.75% or one-month LIBOR adjusted for statutory reserves plus 1%.  As of September 30, 2012, the applicable percentage for term loans and revolving loans was 6.00% for alternative base rate loans and 7.00% for LIBOR loans.  Each year, commencing in 2012, within 90 days of the prior fiscal year end, we are required to prepay a portion of the term loans in an amount based on the prior year's excess cash flows, if any, as defined in the Credit Agreement. In addition to paying interest on outstanding loans under the Credit Agreement, we are required to pay a facility fee of 0.50% per annum to the lenders under the revolving credit facility in respect of the unused revolving commitments.  The Credit Agreement requires that at least 50% of our term loans be subject to at least a three-year hedging agreement. To satisfy this requirement, we executed two hedging instruments on January 18, 2011: a two-year interest rate cap and a two-year "forward starting" interest rate swap. The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012. This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 8.75% through December 31, 2012. The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement. The two-year "forward starting" interest rate swap effectively converts the interest rate on $82.5 million of our term loans to a fixed rate from January 1, 2013 through December 31, 2014. LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 10.185% for this portion of the term loans. There was no fee for this swap agreement. Both arrangements qualify for hedge accounting treatment.                                           42 --------------------------------------------------------------------------------                    SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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