Edgar Filing: KINDRED HEALTHCARE, INC

10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2012

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)


Delaware		61-1323993
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

680 South Fourth Street Louisville, KY		40202-2412
(Address of principal executive offices)		(Zip Code)

(502) 596-7300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer	þ	Accelerated filer	¨

Non-accelerated filer	¨	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class of Common Stock		Outstanding at April 30, 2012
Common stock, $0.25 par value		52,897,749 shares

1 of 67

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX


		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited):

	Condensed Consolidated Statement of Operations—for the three months ended March 31, 2012 and 2011		3

	Condensed Consolidated Statement of Comprehensive Income—for the three months ended March 31, 2012 and 2011		4

	Condensed Consolidated Balance Sheet—March 31, 2012 and December 31, 2011		5

	Condensed Consolidated Statement of Cash Flows—for the three months ended March 31, 2012 and 2011		6

	Notes to Condensed Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		34

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		63

Item 4.	Controls and Procedures		64

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings		65

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		65

Item 6.	Exhibits		66

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended March 31,
	2012			2011
Revenues	$	1,579,970		$	1,192,421

Salaries, wages and benefits		945,302			678,695
Supplies		111,295			90,022
Rent		107,968			91,453
Other operating expenses		310,964			259,369
Other income		(2,748	)		(2,785	)
Impairment charges		867			—
Depreciation and amortization		48,690			32,549
Interest expense		26,578			5,728
Investment income		(292	)		(495	)

		1,548,624			1,154,536

Income from continuing operations before income taxes		31,346			37,885
Provision for income taxes		12,814			15,609

Income from continuing operations		18,532			22,276
Income (loss) from discontinued operations, net of income taxes		110			(179	)

Net income		18,642			22,097
Earnings attributable to noncontrolling interests		(451	)		—

Income attributable to Kindred	$	18,191		$	22,097

Amounts attributable to Kindred stockholders:
Income from continuing operations	$	18,081		$	22,276
Income (loss) from discontinued operations		110			(179	)

Net income	$	18,191		$	22,097

Earnings per common share:
Basic:
Income from continuing operations	$	0.35		$	0.56
Income (loss) from discontinued operations		—			—

Net income	$	0.35		$	0.56

Diluted:
Income from continuing operations	$	0.35		$	0.55
Income (loss) from discontinued operations		—			—

Net income	$	0.35		$	0.55

Shares used in computing earnings per common share:
Basic		51,603			39,035
Diluted		51,638			39,543

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)


	Three months ended March 31,
	2012			2011
Net income	$	18,642		$	22,097
Other comprehensive income:
Available-for-sale securities:
Change in net unrealized investment gains		1,202			554
Reclassification of net gains included in net income		(77	)		(158	)

Net change		1,125			396
Interest rate swaps:
Change in unrealized loss		(131	)		—
Reclassification of losses included in net income		201			—

Net change		70			—
Income tax expense related to items of other comprehensive income		(420	)		(138	)

Other comprehensive income		775			258

Comprehensive income		19,417			22,355
Earnings attributable to noncontrolling interests		(451	)		—

Comprehensive income attributable to Kindred	$	18,966		$	22,355

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	March 31, 2012			December 31, 2011
ASSETS
Current assets:
Cash and cash equivalents	$	40,137		$	41,561
Cash—restricted		5,327			5,551
Insurance subsidiary investments		74,462			70,425
Accounts receivable less allowance for loss of $32,864—March 31, 2012 and $29,746—December 31, 2011		1,044,401			994,700
Inventories		31,155			31,060
Deferred tax assets		19,911			17,785
Income taxes		7,689			39,513
Other		40,186			32,687

		1,263,268			1,233,282

Property and equipment		2,053,326			1,975,063
Accumulated depreciation		(956,871	)		(916,022	)

		1,096,455			1,059,041

Goodwill		1,084,716			1,084,655
Intangible assets less accumulated amortization of $21,964—March 31, 2012 and $16,581—December 31, 2011		441,824			447,207
Assets held for sale		4,671			5,612
Insurance subsidiary investments		120,184			110,227
Other		222,054			198,469

Total assets	$	4,233,172		$	4,138,493

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	205,835		$	216,801
Salaries, wages and other compensation		380,981			407,493
Due to third party payors		28,330			37,306
Professional liability risks		45,257			46,010
Other accrued liabilities		131,339			130,693
Long-term debt due within one year		10,415			10,620

		802,157			848,923

Long-term debt		1,648,071			1,531,882
Professional liability risks		223,344			217,717
Deferred tax liabilities		17,313			17,955
Deferred credits and other liabilities		196,089			191,771

Noncontrolling interests-redeemable		9,532			9,704

Commitments and contingencies

Equity:
Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 52,900 shares—March 31, 2012 and 52,116 shares—December 31, 2011		13,225			13,029
Capital in excess of par value		1,135,917			1,138,189
Accumulated other comprehensive loss		(694	)		(1,469	)
Retained earnings		157,363			139,172

		1,305,811			1,288,921
Noncontrolling interests-nonredeemable		30,855			31,620

Total equity		1,336,666			1,320,541

Total liabilities and equity	$	4,233,172		$	4,138,493

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended March 31,
	2012			2011
Cash flows from operating activities:
Net income	$	18,642		$	22,097
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		48,690			32,549
Amortization of stock-based compensation costs		1,802			2,644
Amortization of deferred financing costs		2,357			846
Provision for doubtful accounts		7,496			5,830
Deferred income taxes		(3,662	)		(730	)
Impairment charges		867			—
Other		426			(476	)
Change in operating assets and liabilities:
Accounts receivable		(57,197	)		(36,640	)
Inventories and other assets		(15,905	)		(3,525	)
Accounts payable		(9,550	)		(12,348	)
Income taxes		30,502			40,623
Due to third party payors		(8,976	)		(3,022	)
Other accrued liabilities		(18,917	)		(1,412	)

Net cash provided by (used in) operating activities		(3,425	)		46,436

Cash flows from investing activities:
Routine capital expenditures		(22,106	)		(24,718	)
Development capital expenditures		(10,622	)		(11,109	)
Acquisitions		(50,448	)		(8,027	)
Acquisition deposit		(16,866	)		—
Sale of assets		1,110			1,714
Purchase of insurance subsidiary investments		(13,773	)		(7,817	)
Sale of insurance subsidiary investments		14,006			18,656
Net change in insurance subsidiary cash and cash equivalents		(13,123	)		(1,300	)
Change in other investments		269			1,000
Other		(749	)		132

Net cash used in investing activities		(112,302	)		(31,469	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		515,400			445,200
Repayment of borrowings under revolving credit		(397,000	)		(460,200	)
Repayment of other long-term debt		(2,666	)		(22	)
Payment of deferred financing costs		(43	)		(417	)
Cash distributed to noncontrolling interests		(1,388	)		—
Issuance of common stock		—			1,415
Other		—			389

Net cash provided by (used in) financing activities		114,303			(13,635	)

Change in cash and cash equivalents		(1,424	)		1,332
Cash and cash equivalents at beginning of period		41,561			17,168

Cash and cash equivalents at end of period	$	40,137		$	18,500

Supplemental information:
Interest payments	$	12,108		$	2,888
Income tax refunds		13,956			24,786

See accompanying notes.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1—BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. is a healthcare services company that through its subsidiaries operates long-term acute care (“LTAC”) hospitals, inpatient rehabilitation hospitals (“IRFs”), nursing and rehabilitation centers, assisted living facilities, a contract rehabilitation services business and a home health and hospice business across the United States (collectively, the “Company” or “Kindred”). At March 31, 2012, the Company’s hospital division operated 120 LTAC hospitals and six IRFs in 26 states. The Company’s nursing center division operated 224 nursing and rehabilitation centers and six assisted living facilities in 27 states. The Company’s rehabilitation division provided rehabilitation services primarily in hospitals and long-term care settings. The Company’s home health and hospice division provided home health, hospice and private duty services from 52 locations in eight states.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals and nursing and rehabilitation centers to improve its future operating results. For accounting purposes, the operating results of these businesses have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at March 31, 2012 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 4 for a summary of discontinued operations.

Recently issued accounting requirements

In September 2011, the Financial Accounting Standards Board (the “FASB”) issued authoritative guidance related to testing goodwill for impairment. The main provisions of the guidance state that an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step goodwill impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform Step 1 of the goodwill impairment test. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2011. The adoption of the guidance is not expected to have a material impact on the Company’s business, financial position, results of operations or liquidity.

In July 2011, the FASB issued authoritative guidance related to the presentation and disclosure of patient service revenue, provision for bad debts, and the allowance for doubtful accounts for certain healthcare entities. The provisions of the guidance require healthcare entities that recognize significant amounts of patient service revenue at the time services are rendered, even though they do not assess a patient’s ability to pay, to present the provision for bad debts related to those revenues as a deduction from patient service revenue (net of contractual allowances and discounts), as opposed to an operating expense. All other entities would continue to present the provision for bad debts as an operating expense. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2011. The adoption of the guidance did not have an impact on the Company’s business, financial position, results of operations or liquidity.

In June 2011, the FASB issued authoritative guidance related to the presentation of other comprehensive income. The provisions of the guidance state that an entity has the option to present the total of comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The statement(s) should be presented with equal prominence to the other primary financial

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1—BASIS OF PRESENTATION (Continued)

Recently issued accounting requirements (Continued)

statements. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2011. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

In December 2011, the FASB amended its authoritative guidance issued in June 2011 related to the presentation of other comprehensive income. The provisions indefinitely defer the requirement to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented, for both interim and annual financial statements. All other requirements of the June 2011 update were not impacted by the amendment which remains effective for all interim and annual reporting periods beginning after December 15, 2011. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

In May 2011, the FASB issued authoritative guidance related to fair value measurements. The provisions of the guidance result in applying common fair value measurement and disclosure requirements in both United States generally accepted accounting principles and International Financial Reporting Standards. The amendments primarily change the wording used to describe many of the requirements in generally accepted accounting principles for measuring and disclosing information about fair value measurements. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2011. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

Equity

The following table sets forth a reconciliation of the carrying amount of equity attributable to redeemable noncontrolling interests, equity attributable to Kindred stockholders, equity attributable to nonredeemable noncontrolling interests and total equity (in thousands):


	Redeemable noncontrolling interests			Amounts attributable to Kindred stockholders			Nonredeemable noncontrolling interests			Total equity
Balance at December 31, 2011	$	9,704		$	1,288,921		$	31,620		$	1,320,541
Comprehensive income:
Net income		155			18,191			296			18,487
Other comprehensive income		—			775			—			775

		155			18,966			296			19,262
Shares tendered by employees for statutory tax withholdings upon issuance of common stock		—			(1,796	)		—			(1,796	)
Income tax benefit in connection with the issuance of common stock under employee benefit plans		—			(2,082	)		—			(2,082	)
Stock-based compensation amortization					1,802			—			1,802
Distributions to noncontrolling interests		(327	)		—			(1,061	)		(1,061	)

Balance at March 31, 2012	$	9,532		$	1,305,811		$	30,855		$	1,336,666

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1—BASIS OF PRESENTATION (Continued)

Derivative financial instruments

In December 2011, the Company entered into two interest rate swap agreements to hedge its floating interest rate on an aggregate of $225.0 million of outstanding Term Loan Facility (as defined in Note 2 below) debt. The interest rate swaps have an effective date of January 9, 2012, and expire on January 11, 2016. The Company is required to make payments based upon a fixed interest rate of 1.8925% calculated on the notional amount of $225.0 million. In exchange, the Company will receive interest on $225.0 million at a variable interest rate that is based upon the three-month London Interbank Offered Rate (“LIBOR”), subject to a minimum rate of 1.5%. The Company determined the interest rate swaps were effective cash flow hedges at March 31, 2012. The fair value change of the interest rate swaps was $0.9 million and was recorded in other accrued liabilities at March 31, 2012.

Other information

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q of Regulation S-X and do not include all of the disclosures normally required by generally accepted accounting principles or those normally required in annual reports on Form 10-K. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2011 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K. The accompanying condensed consolidated balance sheet at December 31, 2011 was derived from audited consolidated financial statements, but does not include all disclosures required by generally accepted accounting principles.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the Company’s customary accounting practices. Management believes that financial information included herein reflects all adjustments necessary for a fair presentation of interim results and, except as otherwise disclosed, all such adjustments are of a normal and recurring nature.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include amounts based upon the estimates and judgments of management. Actual amounts may differ from those estimates.

Reclassifications

Certain prior period amounts have been reclassified to conform with the current period presentation.

NOTE 2—REHABCARE ACQUISITION

On June 1, 2011, the Company completed the acquisition of RehabCare Group, Inc. and its subsidiaries (“RehabCare”) (the “RehabCare Merger”). Upon consummation of the RehabCare Merger, each issued and outstanding share of RehabCare common stock was converted into the right to receive 0.471 of a share of Kindred common stock and $26 per share in cash, without interest (the “Merger Consideration”). Kindred issued approximately 12 million shares of its common stock in connection with the RehabCare Merger. The purchase price totaled $962.8 million and was comprised of $662.4 million in cash and $300.4 million of Kindred common stock at fair value. The Company also assumed $355.7 million of long-term debt in the RehabCare Merger, of which $345.4 million was refinanced on June 1, 2011. The operating results of RehabCare have been included in the accompanying unaudited condensed consolidated financial statements of the Company since June 1, 2011.

At the RehabCare Merger date, the Company acquired 32 LTAC hospitals, five IRFs, approximately 1,200 rehabilitation therapy sites of service and 102 hospital-based inpatient rehabilitation units.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2—REHABCARE ACQUISITION (Continued)

Operating results in the first quarter of 2012 included transaction costs totaling $0.2 million related to the RehabCare Merger. Operating results in the first quarter of 2011 included transaction costs totaling $3.9 million and financing costs totaling $2.0 million related to the RehabCare Merger. In the accompanying unaudited condensed consolidated statement of operations, transaction costs were included in other operating expenses and financing costs were included in interest expense.

In connection with the RehabCare Merger, the Company entered into a new $650 million senior secured asset-based revolving credit facility (the “ABL Facility”) and a new $700 million senior secured term loan facility (the “Term Loan Facility”) (collectively, the “New Credit Facilities”). The Company also successfully completed the private placement of $550 million of senior notes due 2019 (the “Notes”). The Company used proceeds from the New Credit Facilities and the Notes to pay the Merger Consideration, repay all amounts outstanding under the Company’s and RehabCare’s previous credit facilities and to pay transaction costs. The amounts outstanding under the Company’s and RehabCare’s former credit facilities that were repaid at the RehabCare Merger closing were $390.0 million and $345.4 million, respectively. The New Credit Facilities have incremental facility capacity in an aggregate amount between the two facilities of $200 million, subject to meeting certain conditions, including a specified senior secured leverage ratio. In connection with these new credit arrangements, the Company paid $46.2 million of lender fees related to debt issuance that were capitalized as deferred financing costs and paid $13.1 million of other financing costs that were charged to interest expense during the year of 2011.

Pro forma information

The unaudited pro forma net effect of the RehabCare Merger assuming the acquisition occurred as of January 1, 2010 is as follows (in thousands, except per share amounts):


	Three months ended March 31, 2011
Revenues	$	1,557,020
Income from continuing operations attributable to Kindred		36,526
Income attributable to Kindred		39,315
Earnings per common share:
Basic:
Income from continuing operations	$	0.71
Net income	$	0.76
Diluted:
Income from continuing operations	$	0.70
Net income	$	0.75

The unaudited pro forma financial data has been derived by combining the historical financial results of the Company and the operations acquired in the RehabCare Merger for the period presented. The unaudited pro forma financial data includes transaction and financing costs totaling $10.7 million incurred by both the Company and RehabCare in connection with the RehabCare Merger. These costs have been eliminated from the results of operations for 2011 and have been reflected as expenses incurred as of January 1, 2010 for purposes of the pro forma financial presentation. Revenues and earnings before interest, income taxes and transaction-related costs associated with RehabCare aggregated $364.5 million and $31.6 million, respectively, for the three months ended March 31, 2012.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3—OTHER ACQUISITIONS

The following is a summary of the Company’s other significant acquisition activities. The purchase price of the acquired leased facilities resulted from negotiations with each of the sellers that were based upon both the historical and expected future cash flows of the respective facilities and real estate values. Each of these acquisitions were financed through operating cash flows or borrowings under the Company’s revolving credit facility.

In March 2012, the Company acquired the real estate of a previously leased hospital for $50.4 million. Annual rent associated with the hospital aggregated $4.1 million.

In March 2011, the Company acquired the real estate of a previously leased hospital for $8.0 million. Annual rent associated with the hospital aggregated $0.9 million.

The fair value of each of the assets acquired were measured using discounted cash flow methodologies which are considered Level 3 inputs (as described in Note 11).

NOTE 4—DISCONTINUED OPERATIONS

In accordance with the authoritative guidance for the impairment or disposal of long-lived assets, the divestitures of unprofitable businesses discussed in Note 1 have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. At March 31, 2012, the Company held for sale two hospitals reported as discontinued operations.

A summary of discontinued operations follows (in thousands):


	Three months ended March 31,
	2012			2011
Revenues	$	80		$	(31	)

Salaries, wages and benefits		(98	)		(156	)
Supplies		—			(2	)
Rent		30			29
Other operating expenses (income)		(32	)		390
Depreciation		—			—
Interest expense		—			—
Investment income		—			—

		(100	)		261

Income (loss) from operations before income taxes		180			(292	)
Provision (benefit) for income taxes		70			(113	)

Income (loss) from operations	$	110		$	(179	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4—DISCONTINUED OPERATIONS (Continued)

The following table sets forth certain discontinued operating data by business segment (in thousands):


	Three months ended March 31,
	2012			2011
Revenues:
Hospital division	$	18		$	(35	)
Nursing center division		62			4

	$	80		$	(31	)

Operating income (loss):
Hospital division	$	(303	)	$	(416	)
Nursing center division		513			153

	$	210		$	(263	)

Rent:
Hospital division	$	29		$	29
Nursing center division		1			—

	$	30		$	29

A summary of the net assets held for sale follows (in thousands):


	March 31, 2012		December 31, 2011
Long-term assets:
Property and equipment, net	$	4,659	$	5,607
Other		12		5

		4,671		5,612
Current liabilities (included in other accrued liabilities)		—		(118	)

	$	4,671	$	5,494

NOTE 5—REVENUES

Revenues are recorded based upon estimated amounts due from patients and third party payors for healthcare services provided, including anticipated settlements under reimbursement agreements with Medicare, Medicaid, Medicare Advantage and other third party payors.

A summary of revenues by payor type follows (in thousands):


	Three months ended March 31,
	2012			2011
Medicare	$	678,924		$	555,790
Medicaid		264,238			259,679
Medicare Advantage		118,413			95,381
Other		606,819			360,742

		1,668,394			1,271,592
Eliminations		(88,424	)		(79,171	)

	$	1,579,970		$	1,192,421

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6—EARNINGS PER SHARE

Earnings per common share are based upon the weighted average number of common shares outstanding during the respective periods. The diluted calculation of earnings per common share includes the dilutive effect of stock options. The Company follows the provisions of the authoritative guidance for determining whether instruments granted in share-based payment transactions are participating securities, which requires that unvested restricted stock that entitles the holder to receive nonforfeitable dividends before vesting be included as a participating security in the basic and diluted earnings per common share calculation pursuant to the two-class method.

A computation of earnings per common share follows (in thousands, except per share amounts):


	Three months ended March 31,
	2012						2011
	Basic			Diluted			Basic			Diluted
Earnings:
Income from continuing operations:
As reported in Statement of Operations	$	18,081		$	18,081		$	22,276		$	22,276
Allocation to participating unvested restricted stockholders		(247	)		(247	)		(428	)		(423	)

Available to common stockholders	$	17,834		$	17,834		$	21,848		$	21,853

Income (loss) from discontinued operations, net of income taxes:
As reported in Statement of Operations	$	110		$	110		$	(179	)	$	(179	)
Allocation to participating unvested restricted stockholders		(1	)		(1	)		3			3

Available to common stockholders	$	109		$	109		$	(176	)	$	(176	)

Net income:
As reported in Statement of Operations	$	18,191		$	18,191		$	22,097		$	22,097
Allocation to participating unvested restricted stockholders		(248	)		(248	)		(425	)		(420	)

Available to common stockholders	$	17,943		$	17,943		$	21,672		$	21,677

Shares used in the computation:
Weighted average shares outstanding—basic computation		51,603			51,603			39,035			39,035

Dilutive effect of employee stock options					35						508

Adjusted weighted average shares outstanding—diluted computation					51,638						39,543

Earnings per common share:
Income from continuing operations	$	0.35		$	0.35		$	0.56		$	0.55
Income (loss) from discontinued operations		—			—			—			—

Net income	$	0.35		$	0.35		$	0.56		$	0.55

Number of antidilutive stock options excluded from shares used in the diluted earnings per common share computation					2,562						1,164

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7—BUSINESS SEGMENT DATA

The Company is organized into four operating divisions: the hospital division, the nursing center division, the rehabilitation division and the home health and hospice division. The expansion of the Company’s home health and hospice operations and changes to the Company’s organizational structure have led the Company to segregate its home health and hospice business into a separate division. The Company’s home health and hospice division was previously included in the rehabilitation division. Based upon the authoritative guidance for business segments and after giving consideration to the Company’s business segments after the RehabCare Merger, the operating divisions represent five reportable operating segments, including (i) hospitals, (ii) skilled nursing and rehabilitation centers, (iii) skilled nursing-based rehabilitation contract therapy services, (iv) hospital-based rehabilitation contract therapy services and (v) home health and hospice services. These reportable operating segments are consistent with information used by the Company’s Chief Executive Officer and Chief Operating Officer to assess performance and allocate resources. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies. Prior period segment information has been restated to conform with the current period presentation.

For segment purposes, the Company defines operating income as earnings before interest, income taxes, depreciation, amortization and rent. Operating income reported for each of the Company’s operating segments excludes impairment charges, transaction costs and the allocation of corporate overhead.

Operating income for the hospital division for the three months ended March 31, 2012 included severance ($2.0 million) and other miscellaneous costs ($0.3 million) incurred in connection with the closing of a regional office and a LTAC hospital.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7—BUSINESS SEGMENT DATA (Continued)

The following table sets forth certain data by business segment (in thousands):


	Three months ended March 31,
	2012			2011
Revenues:
Hospital division	$	765,823		$	558,974
Nursing center division		544,319			567,472
Rehabilitation division:
Skilled nursing rehabilitation services		255,451			114,618
Hospital rehabilitation services		74,369			22,490

		329,820			137,108
Home health and hospice division		28,432			8,038

		1,668,394			1,271,592
Eliminations:
Skilled nursing rehabilitation services		(58,433	)		(57,081	)
Hospital rehabilitation services		(28,317	)		(21,225	)
Nursing and rehabilitation centers		(1,674	)		(865	)

		(88,424	)		(79,171	)

	$	1,579,970		$	1,192,421

Income from continuing operations:
Operating income (loss):
Hospital division	$	160,669		$	108,385
Nursing center division		65,533			87,350
Rehabilitation division:
Skilled nursing rehabilitation services		14,193			9,159
Hospital rehabilitation services		16,116			5,332

		30,309			14,491
Home health and hospice division		2,341			(10	)
Corporate:
Overhead		(42,728	)		(38,315	)
Insurance subsidiary		(482	)		(602	)

		(43,210	)		(38,917	)
Impairment charges		(867	)		—
Transaction costs		(485	)		(4,179	)

Operating income		214,290			167,120
Rent		(107,968	)		(91,453	)
Depreciation and amortization		(48,690	)		(32,549	)
Interest, net		(26,286	)		(5,233	)

Income from continuing operations before income taxes		31,346			37,885
Provision for income taxes		12,814			15,609

	$	18,532		$	22,276

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7—BUSINESS SEGMENT DATA (Continued)


	Three months ended March 31,
	2012		2011
Rent:
Hospital division	$	55,367	$	40,299
Nursing center division		49,938		49,384
Rehabilitation division:
Skilled nursing rehabilitation services		1,392		1,509
Hospital rehabilitation services		78		28

		1,470		1,537
Home health and hospice division		615		189
Corporate		578		44

	$	107,968	$	91,453

Depreciation and amortization:
Hospital division	$	22,603	$	14,278
Nursing center division		12,741		11,793
Rehabilitation division:
Skilled nursing rehabilitation services		2,628		654
Hospital rehabilitation services		2,324		97

		4,952		751
Home health and hospice division		898		105
Corporate		7,496		5,622

	$	48,690	$	32,549

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division:
Routine	$	10,345	$	12,144
Development		9,949		7,777

		20,294		19,921
Nursing center division:
Routine		4,229		8,155
Development		673		3,322

		4,902		11,477
Rehabilitation division:
Skilled nursing rehabilitation services:
Routine		326		235
Development		—		—

		326		235
Hospital rehabilitation services:
Routine		46		25
Development		—		—

		46		25
Home health and hospice division:
Routine		751		20
Development		—		10

		751		30
Corporate:
Information systems		6,237		3,932
Other		172		207

	$	32,728	$	35,827

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7—BUSINESS SEGMENT DATA (Continued)


	March 31, 2012		December 31, 2011
Assets at end of period:
Hospital division	$	2,121,862	$	2,056,103
Nursing center division		641,637		638,078
Rehabilitation division:
Skilled nursing rehabilitation services		441,294		425,499
Hospital rehabilitation services		342,795		347,491

		784,089		772,990
Home health and hospice division		107,340		104,374
Corporate		578,244		566,948

	$	4,233,172	$	4,138,493

Goodwill:
Hospital division	$	745,450	$	745,411
Rehabilitation division:
Skilled nursing rehabilitation services		107,036		107,026
Hospital rehabilitation services		167,765		167,753

		274,801		274,779
Home health and hospice division		64,465		64,465

	$	1,084,716	$	1,084,655

NOTE 8—INSURANCE RISKS

The Company insures a substantial portion of its professional liability risks and workers compensation risks through its wholly owned limited purpose insurance subsidiary. Provisions for loss for these risks are based upon management’s best available information including actuarially determined estimates.

The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of, or less than, the amounts recorded. To the extent that expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited.

The provision for loss for insurance risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, follows (in thousands):


	Three months ended March 31,
	2012			2011
Professional liability:
Continuing operations	$	19,066		$	17,760
Discontinued operations		(317	)		121
Workers compensation:
Continuing operations	$	15,118		$	13,068
Discontinued operations		(147	)		(301	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8—INSURANCE RISKS (Continued)

A summary of the assets and liabilities related to insurance risks included in the accompanying unaudited condensed consolidated balance sheet follows (in thousands):


	March 31, 2012						December 31, 2011
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	44,096	$	30,366	$	74,462	$	44,678	$	25,747	$	70,425
Reinsurance recoverables		60		—		60		323		—		323
Other		—		150		150		—		150		150

		44,156		30,516		74,672		45,001		25,897		70,898
Non-current:
Insurance subsidiary investments		55,853		64,331		120,184		39,048		71,179		110,227
Reinsurance and other recoverables		47,916		69,546		117,462		44,356		64,704		109,060
Deposits		3,977		1,574		5,551		3,643		1,623		5,266
Other		—		42		42		—		42		42

		107,746		135,493		243,239		87,047		137,548		224,595

	$	151,902	$	166,009	$	317,911	$	132,048	$	163,445	$	295,493

Liabilities:
Allowance for insurance risks:
Current	$	45,257	$	35,043	$	80,300	$	46,010	$	32,198	$	78,208
Non-current		223,344		142,635		365,979		217,717		138,489		356,206

	$	268,601	$	177,678	$	446,279	$	263,727	$	170,687	$	434,414

Provisions for loss for professional liability risks retained by the Company’s limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 1% to 5% depending upon the policy year. The discount rate was 1% for the 2012 and 2011 policy years. The discount rates are based upon the risk free interest rate for the respective year. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $271.3 million at March 31, 2012 and $266.5 million at December 31, 2011.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually.

NOTE 9—INSURANCE SUBSIDIARY INVESTMENTS

The Company maintains investments, consisting principally of cash and cash equivalents, debt securities, equities and certificates of deposit for the payment of claims and expenses related to professional liability and workers compensation risks. These investments have been categorized as available-for-sale and are reported at fair value.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9—INSURANCE SUBSIDIARY INVESTMENTS (Continued)

The amortized cost and estimated fair value of the Company’s insurance subsidiary investments follows (in thousands):


	March 31, 2012									December 31, 2011
	Amortized cost		Unrealized gains		Unrealized losses			Fair value		Amortized cost		Unrealized gains		Unrealized losses			Fair value
Cash and cash equivalents (a)	$	132,000	$	—	$	—		$	132,000	$	118,877	$	—	$	—		$	118,877
Debt securities:
Corporate bonds		21,841		156		(19	)		21,978		23,134		163		(48	)		23,249
Debt securities issued by U.S. government agencies		19,021		119		(4	)		19,136		18,173		120		(5	)		18,288
U.S. Treasury notes		3,111		6		(1	)		3,116		3,867		10		—			3,877
Debt securities issued by foreign governments		625		6		—			631		625		8		—			633
Commercial mortgage-backed securities		134		5		—			139		137		6		—			143

		44,732		292		(24	)		45,000		45,936		307		(53	)		46,190
Equities by industry:
Healthcare		1,474		83		(56	)		1,501		1,474		77		(72	)		1,479
Financial services		1,150		246		(45	)		1,351		1,150		89		(120	)		1,119
Oil and gas		921		202		(110	)		1,013		921		131		(117	)		935
Other		7,594		1,561		(232	)		8,923		7,594		1,006		(454	)		8,146

		11,139		2,092		(443	)		12,788		11,139		1,303		(763	)		11,679
Certificates of deposit		4,855		3		—			4,858		3,905		3		(2	)		3,906

	$	192,726	$	2,387	$	(467	)	$	194,646	$	179,857	$	1,613	$	(818	)	$	180,652

(a)	Includes $2.7 million and $2.2 million of money market funds at March 31, 2012 and December 31, 2011, respectively.

The Company’s investment policy governing insurance subsidiary investments precludes the investment portfolio managers from selling any security at a loss without prior authorization from the Company. The investment managers also limit the exposure to any one issue, issuer or type of investment. The Company intends, and has the ability, to hold insurance subsidiary investments for a long duration without the necessity of selling securities to fund the underwriting needs of its insurance subsidiary. This ability to hold securities allows sufficient time for recovery of temporary declines in the market value of equity securities and the par value of debt securities as of their stated maturity date.

The Company considered the severity and duration of its unrealized losses at March 31, 2012 and 2011 for various investments held in its insurance subsidiary investment portfolio and determined that these unrealized losses were temporary and did not record any impairment losses related to these investments.

As a result of deterioration in professional liability and workers compensation underwriting results of the Company’s limited purpose insurance subsidiary in 2011, the Company made a capital contribution of $8.6 million during the first quarter of 2012 to its limited purpose insurance subsidiary. Conversely, as a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary in 2010, the Company received a distribution of $3.5 million during the first quarter of 2011 from its limited purpose insurance subsidiary. Both were completed in accordance with applicable regulations. The contribution and distribution had no impact on earnings.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10—CONTINGENCIES

Management continually evaluates contingencies based upon the best available information. In addition, allowances for losses are provided currently for disputed items that have continuing significance, such as certain third party reimbursements and deductions that continue to be claimed in current cost reports and tax returns.

Management believes that allowances for losses have been provided to the extent necessary and that its assessment of contingencies is reasonable.

Principal contingencies are described below:

Revenues—Certain third party payments are subject to examination by agencies administering the various reimbursement programs. The Company is contesting certain issues raised in audits of prior year cost reports.

Professional liability risks—The Company has provided for losses for professional liability risks based upon management’s best available information including actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Note 8.

Income taxes—The Company is subject to various federal and state income tax audits in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties.

Litigation—The Company is a party to various legal actions (some of which are not insured), and regulatory and other governmental audits and investigations in the ordinary course of business. The Company cannot predict the ultimate outcome of pending litigation and regulatory and other governmental audits and investigations. These matters could potentially subject the Company to sanctions, damages, recoupments, fines and other penalties. The U.S. Department of Justice (the “DOJ”), the Centers for Medicare and Medicaid Services (“CMS”) or other federal and state enforcement and regulatory agencies may conduct additional investigations related to the Company’s businesses in the future which may, either individually or in the aggregate, have a material adverse effect on the Company’s business, financial position, results of operations and liquidity. See Note 13.

Other indemnifications—In the ordinary course of business, the Company enters into contracts containing standard indemnification provisions and indemnifications specific to a transaction, such as a disposal of an operating facility. These indemnifications may cover claims related to employment-related matters, governmental regulations, environmental issues and tax matters, as well as patient, third party payor, supplier and contractual relationships. Obligations under these indemnities generally are initiated by a breach of the terms of a contract or by a third party claim or event.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11—FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The Company follows the provisions of the authoritative guidance for fair value measurements, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles.

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The guidance related to fair value measures establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:


Level 1		Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as certain U.S. Treasury, other U.S. Government and agency asset backed debt securities that are highly liquid and are actively traded in over-the-counter markets.

Level 2		Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3		Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11—FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

The Company’s assets and liabilities measured at fair value on a recurring and non-recurring basis and any associated losses are summarized below (in thousands):


	Fair value measurements							Assets/liabilities at fair value			Total losses
	Level 1		Level 2			Level 3		Assets/liabilities at fair value			Total losses
March 31, 2012:
Recurring:
Assets:
Available-for-sale debt securities:
Corporate bonds	$	—	$	21,978		$	—	$	21,978		$	—
Debt securities issued by U.S. government agencies		—		19,136			—		19,136			—
U.S. Treasury notes		3,116		—			—		3,116			—
Debt securities issued by foreign governments		—		631			—		631			—
Commercial mortgage-backed securities		—		139			—		139			—

		3,116		41,884			—		45,000			—
Available-for-sale equity securities		12,788		—			—		12,788			—
Money market funds		6,529		—			—		6,529			—
Certificates of deposit		—		4,858			—		4,858			—

Total available-for-sale investments		22,433		46,742			—		69,175			—
Deposits held in money market funds		351		3,977			—		4,328			—

	$	22,784	$	50,719		$	—	$	73,503		$	—

Liabilities:
Interest rate swaps	$	—	$	(945	)	$	—	$	(945	)	$	—

Non-recurring:
Assets:
Property and equipment	$	—	$	—		$	97	$	97			(867	)

Liabilities	$	—	$	—		$	—	$	—		$	—

December 31, 2011:
Recurring:
Assets:
Available-for-sale debt securities:
Corporate bonds	$	—	$	23,249		$	—	$	23,249		$	—
Debt securities issued by U.S. government agencies		—		18,288			—		18,288			—
U.S. Treasury notes		3,877		—			—		3,877			—
Debt securities issued by foreign governments		—		633			—		633			—
Commercial mortgage-backed securities		—		143			—		143			—

		3,877		42,313			—		46,190			—
Available-for-sale equity securities		11,679		—			—		11,679			—
Money market funds		6,263		—			—		6,263			—
Certificates of deposit		—		3,906			—		3,906			—

Total available-for-sale investments		21,819		46,219			—		68,038			—
Deposits held in money market funds		353		3,643			—		3,996			—

	$	22,172	$	49,862		$	—	$	72,034		$	—

Liabilities:
Interest rate swaps	$	—	$	(815	)	$	—	$	(815	)	$	—

Non-recurring:
Assets:
Hospital available for sale	$	—	$	—		$	1,200	$	1,200		$	(1,490	)
Property and equipment		—		—			6,604		6,604			(22,836	)
Goodwill—nursing and rehabilitation centers		—		—			—		—			(6,080	)
Goodwill—skilled nursing rehabilitation services		—		—			107,026		107,026			(45,999	)
Intangible assets—certificates of need		—		—			1,000		1,000			(54,366	)

	$	—	$	—		$	115,830	$	115,830		$	(130,771	)

Liabilities	$	—	$	—		$	—	$	—		$	—

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11—FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Recurring measurements

The Company’s available-for-sale investments are held by its limited purpose insurance subsidiary and consist of debt securities, equities, money market funds and certificates of deposit. These available-for-sale investments and the insurance subsidiary’s cash and cash equivalents of $129.3 million as of March 31, 2012 and $116.7 million as of December 31, 2011, classified as insurance subsidiary investments, are maintained for the payment of claims and expenses related to professional liability and workers compensation risks.

The Company also has available-for-sale investments totaling $3.8 million related to a deferred compensation plan that is maintained for certain of the Company’s current and former employees.

The fair value of actively traded debt and equity securities and money market funds are based upon quoted market prices and are generally classified as Level 1. The fair value of inactively traded debt securities and certificates of deposit are based upon either quoted market prices of similar securities or observable inputs such as interest rates using either a market or income valuation approach and are generally classified as Level 2. The Company’s investment advisors obtain and review pricing for each security. The Company is responsible for the determination of fair value and as such the Company reviews the pricing information from its advisors in determining reasonable estimates of fair value. Based upon the Company’s internal review procedures, there were no adjustments to the prices during the three months ended March 31, 2012 or March 31, 2011.

The Company’s deposits held in money market funds consist primarily of cash and cash equivalents held for general corporate purposes.

The fair value of the derivative liability associated with the interest rate swaps is estimated using industry-standard valuation models, which are Level 2 measurements. Such models project future cash flows and discount the future amounts to a present value using market-based observable inputs, including interest rate curves.

The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments. The carrying value is equal to fair value for financial instruments that are based upon quoted market prices or current market rates. The Company’s long-term debt is based upon Level 2 inputs.


	March 31, 2012				December 31, 2011
(In thousands)	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	40,137	$	40,137	$	41,561	$	41,561
Cash–restricted		5,327		5,327		5,551		5,551
Insurance subsidiary investments		194,646		194,646		180,652		180,652
Tax refund escrow investments		209		209		211		211
Long-term debt, including amounts due within one year (excluding capital lease obligations totaling $3.1 million and $3.9 million at March 31, 2012 and December 31, 2011, respectively)		1,655,376		1,551,820		1,538,557		1,406,751

Non-recurring measurements

On July 29, 2011, CMS issued final rules which, among other things, significantly reduced Medicare payments to nursing centers and changed the reimbursement for the provision of group rehabilitation therapy services to Medicare beneficiaries beginning October 1, 2011 (the “2011 CMS Rules”). In connection with the preparation of

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11—FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Non-recurring measurements (Continued)

the Company’s operating results for the third quarter of 2011, the Company determined that the impact of the 2011 CMS Rules was a triggering event in the third quarter of 2011 and accordingly tested the recoverability of its nursing and rehabilitation centers reporting unit goodwill, intangible assets and property and equipment asset groups impacted by the reduced Medicare payments. The Company recorded pretax impairment charges aggregating $0.9 million in the first quarter of 2012 for necessary property and equipment expenditures in impaired nursing and rehabilitation center asset groups. These charges reflected the amount by which the carrying value of certain assets exceeded their estimated fair value. The fair value of property and equipment was measured using Level 3 inputs such as replacement costs factoring in depreciation, economic obsolesce and inflation trends.

NOTE 12—CONDENSED CONSOLIDATING FINANCIAL INFORMATION

The accompanying unaudited condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X, Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The Company’s Notes issued on June 1, 2011 are fully and unconditionally guaranteed, subject to certain customary release provisions, by substantially all of the Company’s domestic 100% owned subsidiaries. The equity method has been used with respect to the parent company’s investment in subsidiaries.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

The following unaudited condensed consolidating financial data presents the financial position of the parent company/issuer, the guarantor subsidiaries and the non-guarantor subsidiaries as of March 31, 2012 and December 31, 2011, and the respective results of operations and cash flows for the three months ended March 31, 2012 and 2011.

Condensed Consolidating Statement of Operations and Comprehensive Income


	Three months ended March 31, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,478,234		$	126,848		$	(25,112	)	$	1,579,970

Salaries, wages and benefits		69			901,413			43,820			—			945,302
Supplies		—			101,298			9,997			—			111,295
Rent		—			100,055			7,913			—			107,968
Other operating expenses		3			286,159			49,914			(25,112	)		310,964
Other income		—			(2,748	)		—			—			(2,748	)
Impairment charges		—			867			—			—			867
Depreciation and amortization		—			45,309			3,381			—			48,690
Management fees		—			(3,348	)		3,348			—			—
Intercompany interest (income) expense from affiliates		(27,907	)		24,277			3,630			—			—
Interest expense (income)		26,293			(4,762	)		5,047			—			26,578
Investment income		—			(27	)		(265	)		—			(292	)
Equity in net income of consolidating affiliates		(17,218	)		—			—			17,218			—

		(18,760	)		1,448,493			126,785			(7,894	)		1,548,624

Income from continuing operations before income taxes		18,760			29,741			63			(17,218	)		31,346
Provision for income taxes		569			12,138			107			—			12,814

Income (loss) from continuing operations		18,191			17,603			(44	)		(17,218	)		18,532
Income from discontinued operations, net of income taxes		—			110			—			—			110

Net income (loss)		18,191			17,713			(44	)		(17,218	)		18,642
Earnings attributable to noncontrolling interests		—			—			(451	)		—			(451	)

Income (loss) attributable to Kindred	$	18,191		$	17,713		$	(495	)	$	(17,218	)	$	18,191

Comprehensive income	$	18,966		$	17,713		$	688		$	(17,950	)	$	19,417

Comprehensive income attributable to Kindred	$	18,966		$	17,713		$	237		$	(17,950	)	$	18,966

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Operations and Comprehensive Income (Continued)


	Three months ended March 31, 2011
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,192,066		$	21,285		$	(20,930	)	$	1,192,421

Salaries, wages and benefits		126			678,569			—			—			678,695
Supplies		—			90,022			—			—			90,022
Rent		3			91,450			—			—			91,453
Other operating expenses		31			258,735			21,533			(20,930	)		259,369
Other income		—			(2,785	)		—			—			(2,785	)
Depreciation and amortization		—			32,549			—			—			32,549
Intercompany interest (income) expense from affiliates		(9,474	)		9,474			—			—			—
Interest expense		5,699			29			—			—			5,728
Investment income		—			(22	)		(473	)		—			(495	)
Equity in net income of consolidating affiliates		(19,874	)		—			—			19,874			—

		(23,489	)		1,158,021			21,060			(1,056	)		1,154,536

Income from continuing operations before income taxes		23,489			34,045			225			(19,874	)		37,885
Provision for income taxes		1,392			14,125			92			—			15,609

Income from continuing operations		22,097			19,920			133			(19,874	)		22,276
Loss from discontinued operations, net of income taxes		—			(179	)		—			—			(179	)

Net income	$	22,097		$	19,741		$	133		$	(19,874	)	$	22,097

Comprehensive income	$	22,355		$	19,741		$	391		$	(20,132	)	$	22,355

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Balance Sheet


	As of March 31, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries		Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
ASSETS
Current assets:
Cash and cash equivalents	$	—		$	23,587	$	16,550		$	—		$	40,137
Cash—restricted		—			5,327		—			—			5,327
Insurance subsidiary investments		—			—		74,462			—			74,462
Accounts receivable, net		—			971,176		73,225			—			1,044,401
Inventories		—			28,269		2,886			—			31,155
Deferred tax assets		—			19,911		—			—			19,911
Income taxes		—			7,333		356			—			7,689
Other		—			37,700		2,486			—			40,186

		—			1,093,303		169,965			—			1,263,268

Property and equipment, net		—			1,045,897		50,558			—			1,096,455
Goodwill		—			815,816		268,900			—			1,084,716
Intangible assets, net		—			415,085		26,739			—			441,824
Assets held for sale		—			4,671		—			—			4,671
Insurance subsidiary investments		—			—		120,184			—			120,184
Investment in subsidiaries		282,730			—		—			(282,730	)		—
Other		50,314			114,320		57,420			—			222,054

	$	333,044		$	3,489,092	$	693,766		$	(282,730	)	$	4,233,172

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	8		$	187,586	$	18,241		$	—		$	205,835
Salaries, wages and other compensation		212			341,231		39,538			—			380,981
Due to third party payors		—			28,330		—			—			28,330
Professional liability risks		—			3,872		41,385			—			45,257
Other accrued liabilities		945			124,054		6,340			—			131,339
Long-term debt due within one year		7,000			98		3,317			—			10,415

		8,165			685,171		108,821			—			802,157
Long-term debt		1,643,483			435		4,153			—			1,648,071
Intercompany		(2,624,049	)		2,292,070		331,979			—			—
Professional liability risks		—			107,385		115,959			—			223,344
Deferred tax liabilities		(366	)		29,672		(11,993	)		—			17,313
Deferred credits and other liabilities		—			136,641		59,448			—			196,089
Noncontrolling interests-redeemable		—			—		9,532			—			9,532
Commitments and contingencies
Equity:
Stockholders’ equity		1,305,811			237,718		45,012			(282,730	)		1,305,811
Noncontrolling interests-nonredeemable		—			—		30,855			—			30,855

		1,305,811			237,718		75,867			(282,730	)		1,336,666

	$	333,044		$	3,489,092	$	693,766		$	(282,730	)	$	4,233,172

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Balance Sheet (Continued)


	As of December 31, 2011
(In thousands)	Parent company/ issuer			Guarantor subsidiaries		Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
ASSETS
Current assets:
Cash and cash equivalents	$	—		$	21,825	$	19,736		$	—		$	41,561
Cash—restricted		—			5,551		—			—			5,551
Insurance subsidiary investments		—			—		70,425			—			70,425
Accounts receivable, net		—			908,100		86,600			—			994,700
Inventories		—			28,220		2,840			—			31,060
Deferred tax assets		—			17,785		—			—			17,785
Income taxes		—			39,513		—			—			39,513
Other		—			30,489		2,198			—			32,687

		—			1,051,483		181,799			—			1,233,282

Property and equipment, net		—			1,007,187		51,854			—			1,059,041
Goodwill		—			815,787		268,868			—			1,084,655
Intangible assets, net		—			420,468		26,739			—			447,207
Assets held for sale		—			5,612		—			—			5,612
Insurance subsidiary investments		—			—		110,227			—			110,227
Investment in subsidiaries		266,817			—		—			(266,817	)		—
Other		52,623			92,231		53,615			—			198,469

	$	319,440		$	3,392,768	$	693,102		$	(266,817	)	$	4,138,493

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	102		$	196,326	$	20,373		$	—		$	216,801
Salaries, wages and other compensation		43			371,022		36,428			—			407,493
Due to third party payors		—			37,306		—			—			37,306
Professional liability risks		—			3,582		42,428			—			46,010
Other accrued liabilities		—			121,959		8,734			—			130,693
Income taxes		—			329		(329	)		—			—
Long-term debt due within one year		7,000			96		3,524			—			10,620

		7,145			730,620		111,158			—			848,923
Long-term debt		1,526,583			460		4,839			—			1,531,882
Intercompany		(2,503,209	)		2,169,985		333,224			—			—
Professional liability risks		—			108,853		108,864			—			217,717
Deferred tax liabilities		—			30,342		(12,387	)		—			17,955
Deferred credits and other liabilities		—			130,466		61,305			—			191,771
Noncontrolling interests-redeemable		—			—		9,704			—			9,704
Commitments and contingencies
Equity:
Stockholders’ equity		1,288,921			222,042		44,775			(266,817	)		1,288,921
Noncontrolling interests-nonredeemable		—			—		31,620			—			31,620

		1,288,921			222,042		76,395			(266,817	)		1,320,541

	$	319,440		$	3,392,768	$	693,102		$	(266,817	)	$	4,138,493

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Cash Flows


	Three months ended March 31, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Net cash provided by (used in) operating activities	$	2,431		$	(12,603	)	$	6,747		$	—		$	(3,425	)

Cash flows from investing activities:
Routine capital expenditures		—			(20,940	)		(1,166	)		—			(22,106	)
Development capital expenditures		—			(9,703	)		(919	)		—			(10,622	)
Acquisitions		—			(50,448	)		—			—			(50,448	)
Acquisition deposit		—			(16,866	)		—			—			(16,866	)
Sale of assets		—			1,110			—			—			1,110
Purchase of insurance subsidiary investments		—			—			(13,773	)		—			(13,773	)
Sale of insurance subsidiary investments		—			—			14,006			—			14,006
Net change in insurance subsidiary cash and cash equivalents		—			—			(13,123	)		—			(13,123	)
Change in other investments		—			269			—			—			269
Capital contribution to insurance subsidiary		—			(8,600	)		—			8,600			—
Other		—			(749	)		—			—			(749	)

Net cash used in investing activities		—			(105,927	)		(14,975	)		8,600			(112,302	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		515,400			—			—			—			515,400
Repayment of borrowings under revolving credit		(397,000	)		—			—			—			(397,000	)
Repayment of other long-term debt		(1,750	)		(23	)		(893	)		—			(2,666	)
Payment of deferred financing costs		(43	)		—			—			—			(43	)
Cash distributed to noncontrolling interests		—			—			(1,388	)		—			(1,388	)
Change in intercompany accounts		(119,038	)		120,315			(1,277	)		—			—
Capital contribution to insurance subsidiary		—			—			8,600			(8,600	)		—

Net cash provided by (used in) financing activities		(2,431	)		120,292			5,042			(8,600	)		114,303

Change in cash and cash equivalents		—			1,762			(3,186	)		—			(1,424	)
Cash and cash equivalents at beginning of period		—			21,825			19,736			—			41,561

Cash and cash equivalents at end of period	$	—		$	23,587		$	16,550		$	—		$	40,137

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Cash Flows (Continued)


	Three months ended March 31, 2011
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Net cash provided by operating activities	$	3,761		$	44,544		$	1,631		$	(3,500	)	$	46,436

Cash flows from investing activities:
Routine capital expenditures		—			(24,718	)		—			—			(24,718	)
Development capital expenditures		—			(11,109	)		—			—			(11,109	)
Acquisitions		—			(8,027	)		—			—			(8,027	)
Sale of assets		—			1,714			—			—			1,714
Purchase of insurance subsidiary investments		—			—			(7,817	)		—			(7,817	)
Sale of insurance subsidiary investments		—			—			18,656			—			18,656
Net change in insurance subsidiary cash and cash equivalents		—			—			(1,300	)		—			(1,300	)
Change in other investments		—			1,000			—			—			1,000
Other		—			132			—			—			132

Net cash provided by (used in) investing activities		—			(41,008	)		9,539			—			(31,469	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		445,200			—			—			—			445,200
Repayment of borrowings under revolving credit		(460,200	)		—			—			—			(460,200	)
Repayment of other long-term debt		—			(22	)		—			—			(22	)
Payment of deferred financing costs		(417	)		—			—			—			(417	)
Issuance of common stock		1,415			—			—			—			1,415
Change in intercompany accounts		9,852			(2,182	)		(7,670	)		—			—
Insurance subsidiary distribution		—			—			(3,500	)		3,500			—
Other		389			—			—			—			389

Net cash used in financing activities		(3,761	)		(2,204	)		(11,170	)		3,500			(13,635	)

Change in cash and cash equivalents		—			1,332			—			—			1,332
Cash and cash equivalents at beginning of period		—			17,168			—			—			17,168

Cash and cash equivalents at end of period	$	—		$	18,500		$	—		$	—		$	18,500

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13—LEGAL AND REGULATORY PROCEEDINGS

The Company provides services in a highly regulated industry and has been subject to various legal actions (some of which are not insured) and regulatory and other governmental audits and investigations from time to time. These matters could (1) require the Company to pay substantial damages, fines, penalties or amounts in judgments or settlements, which individually or in the aggregate could exceed amounts, if any, that may be recovered under the Company’s insurance policies where coverage applies and is available; (2) cause the Company to incur substantial expenses; (3) require significant time and attention from the Company’s management; (4) subject the Company to sanctions including possible exclusions from the Medicare and Medicaid programs; and (5) cause the Company to close or sell one or more facilities or otherwise modify the way the Company conducts business. The ultimate resolution of these matters, whether as a result of litigation or settlement, could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

In accordance with authoritative accounting guidance related to loss contingencies, the Company records an accrued liability for litigation and regulatory matters that are both probable and can be reasonably estimated. Additional losses in excess of amounts accrued may be reasonably possible. The Company reviews loss contingencies that are reasonably possible and determines whether an estimate of the possible loss or range of loss, individually or in aggregate, can be disclosed in the Company’s consolidated financial statements. These estimates are based upon currently available information for those legal and regulatory proceedings in which the Company is involved, taking into account the Company’s best estimate of losses for those matters for which such estimate can be made. The Company’s estimates involve significant judgment, given that (1) these legal and regulatory proceedings are in early stages; (2) discovery is not completed; (3) damages sought in these legal and regulatory proceedings can be unsubstantiated or indeterminate; (4) the matters present legal uncertainties or evolving areas of law; (5) there are often significant facts in dispute; and (6) there is a wide range of possible outcomes. Accordingly, the Company’s estimated loss or range of loss may change from time to time, and actual losses may be more or less than the current estimate. At this time, no estimate of the possible loss or range of loss, individually or in the aggregate, in excess of the amounts accrued, if any, can be made regarding the matters described below.

Set forth below are descriptions of the Company’s significant legal proceedings.

Medicare and Medicaid payment reviews, audits and investigations—as a result of the Company’s participation in the Medicare and Medicaid programs, the Company faces and is currently subject to various governmental reviews, audits and investigations to verify the Company’s compliance with these programs and applicable laws and regulations. The Company is routinely subject to audits under various government programs, such as the CMS Recovery Audit Contractor program, in which third party firms engaged by CMS conduct extensive reviews of claims data and medical and other records to identify potential improper payments to healthcare providers under the Medicare program. In addition, the Company, like other hospital and nursing center operators and rehabilitation therapy service contractors, is subject to ongoing investigations by the U.S. Department of Health and Human Services Office of Inspector General into the billing of rehabilitation services provided to Medicare patients and general compliance with conditions of participation in the Medicare and Medicaid programs. Private pay sources such as third party insurance and managed care entities also often reserve the right to conduct audits. The Company’s costs to respond to and d

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