Edgar Filing: KINDRED HEALTHCARE, INC

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Form 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 June 30, 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.

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 July 31, 2012
Common stock, $0.25 par value		52,965,232 shares

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 June 30, 2012 and 2011 and for the six months ended June 30, 2012 and 2011		3

	Condensed Consolidated Statement of Comprehensive Income (Loss)—for the three months ended June 30, 2012 and 2011 and for the six months ended June 30, 2012 and 2011		4

	Condensed Consolidated Balance Sheet—June 30, 2012 and December 31, 2011		5

	Condensed Consolidated Statement of Cash Flows—for the three months ended June 30, 2012 and 2011 and for the six months ended June 30, 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		38

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		68

Item 4.	Controls and Procedures		69

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings		70

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		70

Item 6.	Exhibits		71

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended June 30,						Six months ended June 30,
	2012			2011			2012			2011
Revenues	$	1,535,828		$	1,292,592		$	3,115,798		$	2,485,013

Salaries, wages and benefits		907,106			765,133			1,852,408			1,443,828
Supplies		108,238			96,718			219,533			186,740
Rent		107,541			95,677			215,509			187,130
Other operating expenses		312,995			287,132			623,959			546,501
Other income		(2,698	)		(2,880	)		(5,446	)		(5,665	)
Impairment charges		329			—			1,196			—
Depreciation and amortization		49,802			37,871			98,492			70,420
Interest expense		26,716			23,157			53,294			28,885
Investment income		(275	)		(257	)		(567	)		(752	)

		1,509,754			1,302,551			3,058,378			2,457,087

Income (loss) from continuing operations before income taxes		26,074			(9,959	)		57,420			27,926
Provision (benefit) for income taxes		10,797			(3,419	)		23,611			12,190

Income (loss) from continuing operations		15,277			(6,540	)		33,809			15,736
Income (loss) from discontinued operations, net of income taxes		(14	)		587			96			408

Net income (loss)		15,263			(5,953	)		33,905			16,144
(Earnings) loss attributable to noncontrolling interests		239			421			(212	)		421

Income (loss) attributable to Kindred	$	15,502		$	(5,532	)	$	33,693		$	16,565

Amounts attributable to Kindred stockholders:
Income (loss) from continuing operations	$	15,516		$	(6,119	)	$	33,597		$	16,157
Income (loss) from discontinued operations		(14	)		587			96			408

Net income (loss)	$	15,502		$	(5,532	)	$	33,693		$	16,565

Earnings (loss) per common share:
Basic:
Income (loss) from continuing operations	$	0.29		$	(0.14	)	$	0.64		$	0.39
Income (loss) from discontinued operations		—			0.01			—			0.01

Net income (loss)	$	0.29		$	(0.13	)	$	0.64		$	0.40

Diluted:
Income (loss) from continuing operations	$	0.29		$	(0.14	)	$	0.64		$	0.38
Income (loss) from discontinued operations		—			0.01			—			0.01

Net income (loss)	$	0.29		$	(0.13	)	$	0.64		$	0.39

Shares used in computing earnings (loss) per common share:
Basic		51,664			43,231			51,633			41,145
Diluted		51,675			43,231			51,657			41,661

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(In thousands)


	Three months ended June 30,						Six months ended June 30,
	2012			2011			2012			2011
Net income (loss)	$	15,263		$	(5,953	)	$	33,905		$	16,144
Other comprehensive income (loss):
Available-for-sale securities:
Change in net unrealized investment gains		(199	)		(116	)		1,003			438
Reclassification of net gains included in net income		(8	)		(1	)		(85	)		(159	)

Net change		(207	)		(117	)		918			279
Interest rate swaps:
Change in unrealized loss		(1,132	)		—			(1,263	)		—
Reclassification of losses included in net income, net of payments		—			—			201			—

Net change		(1,132	)		—			(1,062	)		—
Income tax expense related to items of other comprehensive income (loss)		588			41			168			(97	)

Other comprehensive income (loss)		(751	)		(76	)		24			182

Comprehensive income (loss)		14,512			(6,029	)		33,929			16,326
(Earnings) loss attributable to noncontrolling interests		239			421			(212	)		421

Comprehensive income (loss) attributable to Kindred	$	14,751		$	(5,608	)	$	33,717		$	16,747

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	June 30, 2012			December 31, 2011
ASSETS
Current assets:
Cash and cash equivalents	$	37,566		$	41,561
Cash—restricted		5,422			5,551
Insurance subsidiary investments		75,922			70,425
Accounts receivable less allowance for loss of $30,390—June 30, 2012 and $29,746—December 31, 2011		1,060,462			994,700
Inventories		31,248			31,060
Deferred tax assets		24,101			17,785
Income taxes		6,361			39,513
Other		35,438			32,687

		1,276,520			1,233,282

Property and equipment		2,108,365			1,975,063
Accumulated depreciation		(998,198	)		(916,022	)

		1,110,167			1,059,041

Goodwill		1,088,379			1,084,655
Intangible assets less accumulated amortization of $27,382—June 30, 2012 and $16,581—December 31, 2011		436,123			447,207
Assets held for sale		4,662			5,612
Insurance subsidiary investments		119,208			110,227
Other		207,471			198,469

Total assets	$	4,242,530		$	4,138,493

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	204,293		$	216,801
Salaries, wages and other compensation		382,150			407,493
Due to third party payors		26,367			37,306
Professional liability risks		46,458			46,010
Other accrued liabilities		134,037			130,693
Long-term debt due within one year		9,611			10,620

		802,916			848,923
Long-term debt		1,638,280			1,531,882

Professional liability risks		231,477			217,717
Deferred tax liabilities		7,557			17,955
Deferred credits and other liabilities		200,599			191,771

Noncontrolling interests-redeemable		9,373			9,704

Commitments and contingencies

Equity:
Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 52,965 shares—June 30, 2012 and 52,116 shares—December 31, 2011		13,241			13,029
Capital in excess of par value		1,138,825			1,138,189
Accumulated other comprehensive loss		(1,445	)		(1,469	)
Retained earnings		172,865			139,172

		1,323,486			1,288,921
Noncontrolling interests-nonredeemable		28,842			31,620

Total equity		1,352,328			1,320,541

Total liabilities and equity	$	4,242,530		$	4,138,493

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended June 30,						Six months ended June 30,
	2012			2011			2012			2011
Cash flows from operating activities:
Net income (loss)	$	15,263		$	(5,953	)	$	33,905		$	16,144
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		49,802			37,871			98,492			70,420
Amortization of stock-based compensation costs		3,077			3,462			4,879			6,106
Amortization of deferred financing costs		2,359			2,244			4,716			3,090
Payment of lender fees related to debt issuance		—			(46,232	)		—			(46,232	)
Provision for doubtful accounts		6,041			8,426			13,537			14,256
Deferred income taxes		(13,243	)		(1,959	)		(16,905	)		(2,689	)
Impairment charges		329			—			1,196			—
Other		1,919			(227	)		2,345			(703	)
Change in operating assets and liabilities:
Accounts receivable		(23,891	)		(43,935	)		(81,088	)		(80,575	)
Inventories and other assets		498			870			(15,407	)		(2,655	)
Accounts payable		(2,983	)		13,565			(12,533	)		1,217
Income taxes		229			(12,950	)		30,731			27,673
Due to third party payors		(1,963	)		6,577			(10,939	)		3,555
Other accrued liabilities		15,586			43,093			(3,331	)		41,681

Net cash provided by operating activities		53,023			4,852			49,598			51,288

Cash flows from investing activities:
Routine capital expenditures		(28,759	)		(33,950	)		(50,865	)		(58,668	)
Development capital expenditures		(12,376	)		(14,309	)		(22,998	)		(25,418	)
Acquisitions, net of cash acquired		(17,420	)		(651,952	)		(67,868	)		(659,979	)
Acquisition deposit		16,866			—			—			—
Sale of assets		—			—			1,110			1,714
Purchase of insurance subsidiary investments		(7,425	)		(9,220	)		(21,198	)		(17,037	)
Sale of insurance subsidiary investments		8,004			8,533			22,010			27,189
Net change in insurance subsidiary cash and cash equivalents		(1,363	)		(2,744	)		(14,486	)		(4,044	)
Change in other investments		182			—			451			1,000
Other		(255	)		(161	)		(1,004	)		(29	)

Net cash used in investing activities		(42,546	)		(703,803	)		(154,848	)		(735,272	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		449,300			654,900			964,700			1,100,100
Repayment of borrowings under revolving credit		(457,500	)		(814,900	)		(854,500	)		(1,275,100	)
Proceeds from issuance of senior unsecured notes		—			550,000			—			550,000
Proceeds from issuance of term loan, net of discount		—			693,000			—			693,000
Repayment of other long-term debt		(2,645	)		(345,666	)		(5,311	)		(345,688	)
Payment of deferred financing costs		(270	)		(6,443	)		(313	)		(6,860	)
Contribution made by noncontrolling interest		200			—			200			—
Cash distributed to noncontrolling interests		(2,133	)		—			(3,521	)		—
Issuance of common stock		—			1,604			—			3,019
Other		—			355			—			744

Net cash provided by (used in) financing activities		(13,048	)		732,850			101,255			719,215

Change in cash and cash equivalents		(2,571	)		33,899			(3,995	)		35,231
Cash and cash equivalents at beginning of period		40,137			18,500			41,561			17,168

Cash and cash equivalents at end of period	$	37,566		$	52,399		$	37,566		$	52,399

Supplemental information:
Interest payments	$	35,526		$	4,056		$	47,634		$	6,944
Income tax payments (refunds)		23,802			11,503			9,846			(13,283	)
Issuance of common stock in RehabCare acquisition		—			300,426			—			300,426
Financing costs paid in connection with RehabCare acquisition		—			13,074			—			13,074

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 June 30, 2012, the Company’s hospital division operated 118 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 June 30, 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 statements.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1—BASIS OF PRESENTATION (Continued)

Recently issued accounting requirements (Continued)

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.

Indefinite-lived assets

In accordance with the authoritative guidance for goodwill and other intangible assets, the Company is required to perform an impairment test for indefinite-lived intangible assets at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired.

The Company’s indefinite-lived intangible assets consist of trade names, Medicare certifications and certificates of need. The fair values of the Company’s indefinite-lived intangible assets are derived from current market data and projections at a facility level which include management’s best estimates of economic and market conditions over the projected period including growth rates in the number of admissions, patient days, reimbursement rates, operating costs, rent expense and capital expenditures. Other significant estimates and assumptions include terminal value growth rates, changes in working capital requirements and weighted average cost of capital. Certificates of need intangible assets are estimated primarily using both a replacement cost methodology and an excess earnings method, a form of discounted cash flows, which is based upon the concept that net after-tax cash flows provide a return supporting all of the assets of a business enterprise.

As a result of the RehabCare Merger (as defined in Note 2 below), the Company acquired indefinite-lived intangible assets consisting of trade names ($115.4 million), Medicare certifications ($75.9 million) and certificates of need ($7.9 million). The annual impairment test for these indefinite-lived intangible assets was performed as of May 1, 2012. No impairment charges were recorded in connection with this annual impairment test.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1—BASIS OF PRESENTATION (Continued)

Equity

The following table sets forth the changes in equity attributable to noncontrolling interests and equity attributable to Kindred stockholders for the six months ended June 30, 2012 and 2011 (in thousands):


	Redeemable noncontrolling interests			Amounts attributable to Kindred stockholders			Nonredeemable noncontrolling interests			Total equity
For the six months ended June 30, 2012:
Balance at December 31, 2011	$	9,704		$	1,288,921		$	31,620		$	1,320,541
Comprehensive income (loss):
Net income (loss)		240			33,693			(28	)		33,665
Other comprehensive income		—			24			—			24

		240			33,717			(28	)		33,689
Shares tendered by employees for statutory tax withholdings upon issuance of common stock		—			(1,821	)		—			(1,821	)
Income tax provision in connection with the issuance of common stock under employee benefit plans		—			(2,210	)		—			(2,210	)
Stock-based compensation amortization		—			4,879			—			4,879
Contribution made by noncontrolling interest		—			—			200			200
Distributions to noncontrolling interests		(571	)		—			(2,950	)		(2,950	)

Balance at June 30, 2012	$	9,373		$	1,323,486		$	28,842		$	1,352,328


For the six months ended June 30, 2011:
Balance at December 31, 2010	$	—		$	1,031,759		$	—		$	1,031,759
Acquired noncontrolling interests		23,869			—			23,990			23,990
Comprehensive income (loss):
Net income (loss)		(28	)		16,565			(393	)		16,172
Other comprehensive income		—			182			—			182

		(28	)		16,747			(393	)		16,354
Issuance of common stock in connection with employee benefit plans		—			3,019			—			3,019
Shares tendered by employees for statutory tax withholdings upon issuance of common stock		—			(3,353	)		—			(3,353	)
Income tax benefit in connection with the issuance of common stock under employee benefit plans		—			608			—			608
Stock-based compensation amortization		—			6,106			—			6,106
Equity consideration for RehabCare Merger (see Note 2)		—			300,426			—			300,426

Balance at June 30, 2011	$	23,841		$	1,355,312		$	23,597		$	1,378,909

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 continue to be effective cash flow hedges at June 30, 2012. The fair value of the interest rate swaps recorded in other accrued liabilities was $2.1 million and $0.8 million at June 30, 2012 and December 31, 2011, respectively.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1—BASIS OF PRESENTATION (Continued)

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.

Operating results in the second quarter of 2011 included transaction costs totaling $19.1 million, financing costs totaling $11.8 million and severance costs totaling $14.9 million related to the RehabCare Merger. Operating results for the six months ended June 30, 2011 included transaction costs totaling $23.0 million, financing costs totaling $13.8 million and severance costs totaling $14.9 million related to the RehabCare Merger. In the accompanying unaudited condensed consolidated statement of operations, transaction costs were included in other operating expenses, financing costs were included in interest expense and severance costs were included in salaries, wages and benefits.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2—REHABCARE ACQUISITION (Continued)

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 with respect to the Term Loan Facility. 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 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 June 30, 2011		Six months ended June 30, 2011
Revenues	$	1,533,515	$	3,090,535
Income from continuing operations attributable to Kindred		25,501		62,027
Income attributable to Kindred		26,163		65,478
Earnings per common share:
Basic:
Income from continuing operations	$	0.49	$	1.19
Net income	$	0.50	$	1.26
Diluted:
Income from continuing operations	$	0.49	$	1.18
Net income	$	0.50	$	1.25

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, financing and severance costs totaling $74.5 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 were 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 $359.2 million and $33.7 million, respectively, in the second quarter of 2012, aggregated $723.7 million and $65.3 million, respectively, for the six months ended June 30, 2012 and aggregated $113.7 million and $9.0 million, respectively, in the second quarter of 2011.

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 was financed through operating cash flows or borrowings under the Company’s revolving credit facility.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3—OTHER ACQUISITIONS (Continued)

During the six months ended June 30, 2012, the Company acquired the real estate of two previously leased hospitals for $67.9 million. Annual rent associated with the hospitals aggregated $5.5 million. During the six months ended June 30, 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.

In April 2011, the Company acquired a home health company for $9.5 million, which included $0.1 million of property and equipment, $7.5 million of goodwill and $1.9 million of identifiable intangible assets.

The fair value of each of the acquisitions noted above was measured using discounted cash flow methodologies which are considered Level 3 inputs (as described in Note 12).

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 June 30, 2012, the Company held for sale two hospitals.

A summary of discontinued operations follows (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2012			2011			2012			2011
Revenues	$	254		$	208		$	334		$	177

Salaries, wages and benefits		(94	)		(160	)		(192	)		(316	)
Supplies		3			(1	)		3			(3	)
Rent		29			29			59			58
Other operating expenses (income)		339			(615	)		307			(225	)
Depreciation		—			—			—			—
Interest expense		—			—			—			—
Investment income		—			—			—			—

		277			(747	)		177			(486	)

Income (loss) from operations before income taxes		(23	)		955			157			663
Provision (benefit) for income taxes		(9	)		368			61			255

Income (loss) from operations	$	(14	)	$	587		$	96		$	408

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 June 30,						Six months ended June 30,
	2012			2011			2012			2011
Revenues:
Hospital division	$	183		$	11		$	201		$	(24	)
Nursing center division		71			197			133			201

	$	254		$	208		$	334		$	177

Operating income (loss):
Hospital division	$	(68	)	$	(282	)	$	(371	)	$	(698	)
Nursing center division		74			1,266			587			1,419

	$	6		$	984		$	216		$	721

Rent:
Hospital division	$	29		$	29		$	58		$	58
Nursing center division		—			—			1			—

	$	29		$	29		$	59		$	58

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


	June 30, 2012		December 31, 2011
Long-term assets:
Property and equipment, net	$	4,662	$	5,607
Other		—		5

		4,662		5,612
Current liabilities (included in other accrued liabilities)		—		(118	)

	$	4,662	$	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 June 30,						Six months ended June 30,
	2012			2011			2012			2011
Medicare	$	642,058		$	576,778		$	1,320,982		$	1,132,568
Medicaid		265,184			262,450			529,422			522,129
Medicare Advantage		118,566			98,074			236,979			193,455
Other		596,693			434,687			1,203,512			795,429

		1,622,501			1,371,989			3,290,895			2,643,581
Eliminations		(86,673	)		(79,397	)		(175,097	)		(158,568	)

	$	1,535,828		$	1,292,592		$	3,115,798		$	2,485,013

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6—EARNINGS (LOSS) PER SHARE

Earnings (loss) 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 (loss) per common share follows (in thousands, except per share amounts):


	Three months ended June 30,												Six months ended June 30,
	2012						2011						2012						2011
	Basic			Diluted			Basic			Diluted			Basic			Diluted			Basic			Diluted
Earnings (loss):
Amounts attributable to Kindred stockholders:
Income (loss) from continuing operations:
As reported in Statement of Operations	$	15,516		$	15,516		$	(6,119	)	$	(6,119	)	$	33,597		$	33,597		$	16,157		$	16,157
Allocation to participating unvested restricted stockholders		(372	)		(371	)		—			—			(633	)		(633	)		(296	)		(292	)

Available to common stockholders	$	15,144		$	15,145		$	(6,119	)	$	(6,119	)	$	32,964		$	32,964		$	15,861		$	15,865

Income (loss) from discontinued operations:
As reported in Statement of Operations	$	(14	)	$	(14	)	$	587		$	587		$	96		$	96		$	408		$	408
Allocation to participating unvested restricted stockholders		—			—			—			—			(2	)		(2	)		(7	)		(7	)

Available to common stockholders	$	(14	)	$	(14	)	$	587		$	587		$	94		$	94		$	401		$	401

Net income (loss):
As reported in Statement of Operations	$	15,502		$	15,502		$	(5,532	)	$	(5,532	)	$	33,693		$	33,693		$	16,565		$	16,565
Allocation to participating unvested restricted stockholders		(372	)		(371	)		—			—			(635	)		(635	)		(303	)		(299	)

Available to common stockholders	$	15,130		$	15,131		$	(5,532	)	$	(5,532	)	$	33,058		$	33,058		$	16,262		$	16,266

Shares used in the computation:
Weighted average shares outstanding—basic computation		51,664			51,664			43,231			43,231			51,633			51,633			41,145			41,145

Dilutive effect of employee stock options					11						—						24						516

Adjusted weighted average shares outstanding—diluted computation					51,675						43,231						51,657						41,661

Earnings (loss) per common share:
Income (loss) from continuing operations	$	0.29		$	0.29		$	(0.14	)	$	(0.14	)	$	0.64		$	0.64		$	0.39		$	0.38
Income (loss) from discontinued operations		—			—			0.01			0.01			—			—			0.01			0.01

Net income (loss)	$	0.29		$	0.29		$	(0.13	)	$	(0.13	)	$	0.64		$	0.64		$	0.40		$	0.39

Number of antidilutive stock options excluded from shares used in the diluted earnings (loss) per common share computation					2,296						836						2,296						1,094

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 (1) hospitals, (2) skilled nursing and rehabilitation centers, (3) skilled nursing-based rehabilitation contract therapy services, (4) hospital-based rehabilitation contract therapy services and (5) 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 in the second quarter of 2012 included severance ($0.6 million) and other miscellaneous costs ($2.0 million) incurred in connection with the closing of two LTAC hospitals and the cancellation of a sub-acute unit project, and $5.0 million for employment-related lawsuits. Operating income for the hospital division for the six months ended June 30, 2012 included severance ($2.6 million) and other miscellaneous costs ($2.3 million) incurred in connection with the closing of a regional office and three LTAC hospitals and the cancellation of a sub-acute unit project, and $5.0 million for employment-related lawsuits.

Operating income for the nursing center division in the second quarter of 2012 and for the six months ended June 30, 2012 included employee retention costs of $0.7 million incurred in connection with the decision to allow leases to expire for 54 nursing and rehabilitation centers leased from Ventas, Inc. (“Ventas”).

Rent expense for the hospital division included $1.1 million and $2.9 million in the second quarter of 2012 and for the six months ended June 30, 2012, respectively, incurred in connection with the closing of three LTAC hospitals.

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 June 30,						Six months ended June 30,
	2012			2011			2012			2011
Revenues:
Hospital division	$	729,419		$	593,425		$	1,495,242		$	1,152,399
Nursing center division		535,644			568,199			1,079,963			1,135,671
Rehabilitation division:
Skilled nursing rehabilitation services		255,187			161,246			510,638			275,864
Hospital rehabilitation services		73,379			38,291			147,748			60,781

		328,566			199,537			658,386			336,645
Home health and hospice division		28,872			10,828			57,304			18,866

		1,622,501			1,371,989			3,290,895			2,643,581
Eliminations:
Skilled nursing rehabilitation services		(57,056	)		(57,587	)		(115,489	)		(114,668	)
Hospital rehabilitation services		(27,755	)		(20,706	)		(56,072	)		(41,931	)
Nursing and rehabilitation centers		(1,862	)		(1,104	)		(3,536	)		(1,969	)

		(86,673	)		(79,397	)		(175,097	)		(158,568	)

	$	1,535,828		$	1,292,592		$	3,115,798		$	2,485,013

Income (loss) from continuing operations:
Operating income (loss):
Hospital division	$	141,511		$	108,465		$	302,180		$	216,850
Nursing center division		71,005			93,532			136,538			180,882
Rehabilitation division:
Skilled nursing rehabilitation services		22,942			15,978			37,135			25,137
Hospital rehabilitation services		17,860			8,033			33,976			13,365

		40,802			24,011			71,111			38,502
Home health and hospice division		2,789			(447	)		5,130			(457	)
Corporate:
Overhead		(44,723	)		(43,801	)		(87,451	)		(82,116	)
Insurance subsidiary		(600	)		(420	)		(1,082	)		(1,022	)

		(45,323	)		(44,221	)		(88,533	)		(83,138	)
Impairment charges		(329	)		—			(1,196	)		—
Transaction costs		(597	)		(34,851	)		(1,082	)		(39,030	)

Operating income		209,858			146,489			424,148			313,609
Rent		(107,541	)		(95,677	)		(215,509	)		(187,130	)
Depreciation and amortization		(49,802	)		(37,871	)		(98,492	)		(70,420	)
Interest, net		(26,441	)		(22,900	)		(52,727	)		(28,133	)

Income (loss) from continuing operations before income taxes		26,074			(9,959	)		57,420			27,926
Provision (benefit) for income taxes		10,797			(3,419	)		23,611			12,190

	$	15,277		$	(6,540	)	$	33,809		$	15,736

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7—BUSINESS SEGMENT DATA (Continued)


	Three months ended June 30,				Six months ended June 30,
	2012		2011		2012		2011
Rent:
Hospital division	$	54,719	$	43,997	$	110,086	$	84,296
Nursing center division		50,229		49,562		100,167		98,946
Rehabilitation division:
Skilled nursing rehabilitation services		1,359		1,540		2,751		3,049
Hospital rehabilitation services		39		33		117		61

		1,398		1,573		2,868		3,110
Home health and hospice division		609		251		1,224		440
Corporate		586		294		1,164		338

	$	107,541	$	95,677	$	215,509	$	187,130

Depreciation and amortization:
Hospital division	$	22,866	$	16,572	$	45,469	$	30,850
Nursing center division		13,229		13,038		25,970		24,831
Rehabilitation division:
Skilled nursing rehabilitation services		2,724		1,221		5,352		1,875
Hospital rehabilitation services		2,323		819		4,647		916

		5,047		2,040		9,999		2,791
Home health and hospice division		925		118		1,823		223
Corporate		7,735		6,103		15,231		11,725

	$	49,802	$	37,871	$	98,492	$	70,420

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division:
Routine	$	9,095	$	11,809	$	19,440	$	23,953
Development		11,289		6,423		21,238		14,200

		20,384		18,232		40,678		38,153
Nursing center division:
Routine		3,417		8,000		7,646		16,155
Development		1,087		7,705		1,760		11,027

		4,504		15,705		9,406		27,182
Rehabilitation division:
Skilled nursing rehabilitation services:
Routine		569		179		895		414
Development		—		—		—		—

		569		179		895		414
Hospital rehabilitation services:
Routine		60		72		106		97
Development		—		—		—		—

		60		72		106		97
Home health and hospice division:
Routine		145		38		269		58
Development		—		181		—		191

		145		219		269		249
Corporate:
Information systems		15,195		13,641		22,059		17,573
Other		278		211		450		418

	$	41,135	$	48,259	$	73,863	$	84,086

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7—BUSINESS SEGMENT DATA (Continued)


	June 30, 2012		December 31, 2011
Assets at end of period:
Hospital division	$	2,130,276	$	2,056,103
Nursing center division		638,197		638,078
Rehabilitation division:
Skilled nursing rehabilitation services		452,726		425,499
Hospital rehabilitation services		343,185		347,491

		795,911		772,990
Home health and hospice division		110,488		104,374
Corporate		567,658		566,948

	$	4,242,530	$	4,138,493

Goodwill:
Hospital division	$	747,777	$	745,411
Rehabilitation division:
Skilled nursing rehabilitation services		107,899		107,026
Hospital rehabilitation services		168,019		167,753

		275,918		274,779
Home health and hospice division		64,684		64,465

	$	1,088,379	$	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 June 30,						Six months ended June 30,
	2012			2011			2012			2011
Professional liability:
Continuing operations	$	20,501		$	16,871		$	39,567		$	34,631
Discontinued operations		73			(942	)		(244	)		(821	)
Workers compensation:
Continuing operations	$	15,677		$	14,081		$	30,795		$	27,149
Discontinued operations		(141	)		(219	)		(288	)		(520	)

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):


	June 30, 2012						December 31, 2011
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	45,389	$	30,533	$	75,922	$	44,678	$	25,747	$	70,425
Reinsurance recoverables		2,033		—		2,033		323		—		323
Other		—		150		150		—		150		150

		47,422		30,683		78,105		45,001		25,897		70,898
Non-current:
Insurance subsidiary investments		54,223		64,985		119,208		39,048		71,179		110,227
Reinsurance and other recoverables		49,943		71,366		121,309		44,356		64,704		109,060
Deposits		3,977		1,574		5,551		3,643		1,623		5,266
Other		—		41		41		—		42		42

		108,143		137,966		246,109		87,047		137,548		224,595

	$	155,565	$	168,649	$	324,214	$	132,048	$	163,445	$	295,493

Liabilities:
Allowance for insurance risks:
Current	$	46,458	$	34,832	$	81,290	$	46,010	$	32,198	$	78,208
Non-current		231,477		147,079		378,556		217,717		138,489		356,206

	$	277,935	$	181,911	$	459,846	$	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 $280.6 million at June 30, 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):


	June 30, 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)	$	133,363	$	—	$	—		$	133,363	$	118,877	$	—	$	—		$	118,877
Debt securities:
Corporate bonds		21,454		118		(17	)		21,555		23,134		163		(48	)		23,249
Debt securities issued by U.S. government agencies		20,005		107		(1	)		20,111		18,173		120		(5	)		18,288
U.S. Treasury notes		2,607		4		—			2,611		3,867		10		—			3,877
Debt securities issued by foreign governments		624		4		—			628		625		8		—			633
Commercial mortgage-backed securities		—		—		—			—		137		6		—			143

		44,690		233		(18	)		44,905		45,936		307		(53	)		46,190

Equities by industry:
Consumer		2,171		631		(41	)		2,761		2,171		329		(45	)		2,455
Industrials		2,039		351		(54	)		2,336		2,039		248		(111	)		2,176
Technology		1,482		282		(88	)		1,676		1,482		215		(99	)		1,598
Healthcare		1,474		99		(46	)		1,527		1,474		77		(72	)		1,479
Financial services		1,419		171		(154	)		1,436		1,419		89		(227	)		1,281
Other		2,554		558		(213	)		2,899		2,554		345		(209	)		2,690

		11,139		2,092		(596	)		12,635		11,139		1,303		(763	)		11,679
Certificates of deposit		4,225		2		—			4,227		3,905		3		(2	)		3,906

	$	193,417	$	2,327	$	(614	)	$	195,130	$	179,857	$	1,613	$	(818	)	$	180,652

(a)	Includes $3.6 million and $2.2 million of money market funds at June 30, 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 June 30, 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 six months ended June 30, 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 six months ended June 30, 2011 from its limited purpose insurance subsidiary. These transactions were completed in accordance with applicable regulations. Neither the contribution nor the distribution had any impact on earnings.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10—LEASES

On April 27, 2012, the Company provided Ventas with notices to renew the master lease agreements for 19 nursing and rehabilitation centers and six LTAC hospitals (collectively, the “Renewal Facilities”) for an additional five years. The current lease term for the Renewal Facilities is scheduled to expire in April 2013.

Under its master lease agreements with Ventas, the Company had 73 nursing and rehabilitation centers and 16 LTAC hospitals within ten separate renewal bundles subject to lease renewals. Each renewal bundle contains both nursing and rehabilitation centers and LTAC hospitals. The master lease agreements require that the Company renew all or none of the facilities within a renewal bundle.

The Company has renewed three renewal bundles containing the Renewal Facilities. The Renewal Facilities contain 2,178 licensed nursing and rehabilitation center beds and 616 licensed hospital beds and generated revenues of approximately $434 million for the year ended December 31, 2011. The current annual rent for the Renewal Facilities approximates $46 million.

The Company did not renew seven renewal bundles containing 54 nursing and rehabilitation centers and ten LTAC hospitals. These facilities contain 6,140 licensed nursing and rehabilitation center beds and 1,066 licensed hospital beds and generated revenues of approximately $790 million for the year ended December 31, 2011. The current annual rent for these facilities approximates $77 million.

On May 24, 2012, the Company entered into a new master lease agreement with Ventas for the ten LTAC hospitals that the Company had previously announced it did not intend to renew. The new master lease agreement will be effective on May 1, 2013 and will have a term of ten years with three five-year renewal options. The annual rent for the new lease will be $28 million and is subject to annual increases based on the increase in the consumer price index (subject to an annual 4% cap). The current annual rent for these ten LTAC hospitals approximates $22 million. These ten LTAC hospitals contain 1,066 licensed hospital beds and generated revenues of approximately $276 million for the year ended December 31, 2011. The terms of the new master lease agreement are substantially similar to the terms of the other master lease agreements between Kindred and Ventas.

On May 24, 2012, the Company and Ventas also entered into a separate agreement to provide Ventas with more flexibility to accelerate the transfer of the 54 nursing and rehabilitation centers currently leased by the Company that are scheduled to expire on April 30, 2013. The Company will continue to operate these nursing and rehabilitation centers and include them in its results from continuing operations through the expiration of the lease term in April 2013.

NOTE 11—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.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11—CONTINGENCIES (Continued)

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 14.

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.

NOTE 12—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 12—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
June 30, 2012:
Recurring:
Assets:
Available-for-sale debt securities:
Corporate bonds	$	—	$	21,555		$	—	$	21,555		$	—
Debt securities issued by U.S. government agencies		—		20,111			—		20,111			—
U.S. Treasury notes		2,611		—			—		2,611			—
Debt securities issued by foreign governments		—		628			—		628			—

		2,611		42,294			—		44,905			—
Available-for-sale equity securities		12,635		—			—		12,635			—
Money market funds		7,226		—			—		7,226			—
Certificates of deposit		—		4,227			—		4,227			—

Total available-for-sale investments		22,472		46,521			—		68,993			—
Deposits held in money market funds		5,248		3,977			—		9,225			—

	$	27,720	$	50,498		$	—	$	78,218		$	—

Liabilities:
Interest rate swaps	$	—	$	(2,078	)	$	—	$	(2,078	)	$	—

Non-recurring:
Assets:
Property and equipment	$	—	$	—		$	132	$	132		$	(1,196	)

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 12—FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Recurring measurements

The Company’s available-for-sale investments held by its limited purpose insurance subsidiary 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 $129.8 million as of June 30, 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 $3.6 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 or six months ended June 30, 2012 or June 30, 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.


	June 30, 2012				December 31, 2011
(In thousands)	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	37,566	$	37,566	$	41,561	$	41,561
Cash–restricted		5,422		5,422		5,551		5,551
Insurance subsidiary investments		195,130		195,130		180,652		180,652
Tax refund escrow investments		207		207		211		211
Long-term debt, including amounts due within one year (excluding capital lease obligations totaling $2.3 million and $3.9 million at June 30, 2012 and December 31, 2011, respectively)		1,645,594		1,586,787		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 the Company’s operating results for the third quarter of 2011, the Company determined that the

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12—FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Non-recurring measurements (Continued)

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 $0.3 million and $1.2 million in the second quarter of 2012 and for the six months ended June 30, 2012, respectively, 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 13—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 13—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 June 30, 2012 and December 31, 2011, and the respective results of operations and cash flows for the three and six months ended June 30, 2012 and June 30, 2011.

Condensed Consolidating Statement of Operations and Comprehensive Income (Loss)


	Three months ended June 30, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,444,958		$	115,981		$	(25,111	)	$	1,535,828

Salaries, wages and benefits		1			866,151			40,954			—			907,106
Supplies		—			99,096			9,142			—			108,238
Rent		—			100,050			7,491			—			107,541
Other operating expenses		—			289,986			48,120			(25,111	)		312,995
Other income		—			(2,698	)		—			—			(2,698	)
Impairment charges		—			329			—			—			329
Depreciation and amortization		—			46,989			2,813			—			49,802
Management fees		—			(3,029	)		3,029			—			—
Intercompany interest (income) expense from affiliates		(28,340	)		25,120			3,220			—			—
Interest expense (income)		26,568			(4,878	)		5,026			—			26,716
Investment income		—			(65	)		(210	)		—			(275	)
Equity in net income of consolidating affiliates		(14,027	)		—			—			14,027			—

		(15,798	)		1,417,051			119,585			(11,084	)		1,509,754

Income (loss) from continuing operations before income taxes		15,798			27,907			(3,604	)		(14,027	)		26,074
Provision for income taxes		296			10,273			228			—			10,797

Income (loss) from continuing operations		15,502			17,634			(3,832	)		(14,027	)		15,277
Loss from discontinued operations, net of income taxes		—			(14	)		—			—			(14	)

Net income (loss)		15,502			17,620			(3,832	)		(14,027	)		15,263
Loss attributable to noncontrolling interests		—			—			239			—			239

Income (loss) attributable to Kindred	$	15,502		$	17,620		$	(3,593	)	$	(14,027	)	$	15,502

Comprehensive income (loss)	$	14,751		$	17,620		$	(3,967	)	$	(13,892	)	$	14,512

Comprehensive income (loss) attributable to Kindred	$	14,751		$	17,620		$	(3,728	)	$	(13,892	)	$	14,751

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Operations and Comprehensive Income (Loss) (Continued)


	Three months ended June 30, 2011
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,263,130		$	50,893		$	(21,431	)	$	1,292,592

Salaries, wages and benefits		145			751,748			13,240			—			765,133
Supplies		—			93,845			2,873			—			96,718
Rent		—			93,173			2,504			—			95,677
Other operating expenses		16			280,035			28,512			(21,431	)		287,132
Other income		—			(2,880	)		—			—			(2,880	)
Depreciation and amortization		—			36,483			1,388			—			37,871
Management fees		—			(1,158	)		1,158			—			—
Intercompany interest (income) expense from affiliates		(25,464	)		24,134			1,330			—			—
Interest expense (income)		23,075			(8	)		90			—			23,157
Investment (income) loss		—			(1,569	)		1,312			—			(257	)
Equity in net loss of consolidating affiliates		6,931			—			—			(6,931	)		—

		4,703			1,273,803			52,407			(28,362	)		1,302,551

Loss from continuing operations before income taxes		(4,703	)		(10,673	)		(1,514	)		6,931			(9,959	)
Provision (benefit) for income taxes		829			(4,310	)		62			—			(3,419	)

Loss from continuing operations		(5,532	)		(6,363	)		(1,576	)		6,931			(6,540	)
Income from discontinued operations, net of income taxes		—			587			—			—			587

Net loss		(5,532	)		(5,776	)		(1,576	)		6,931			(5,953	)
Loss attributable to noncontrolling interests		—			—			421			—			421

Loss attributable to Kindred	$	(5,532	)	$	(5,776	)	$	(1,155	)	$	6,931		$	(5,532	)

Comprehensive loss	$	(5,608	)	$	(5,776	)	$	(1,652	)	$	7,007		$	(6,029	)

Comprehensive loss attributable to Kindred	$	(5,608	)	$	(5,776	)	$	(1,231	)	$	7,007		$	(5,608	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13—CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Operations and Comprehensive Income (Loss) (Continued)


	Six months ended June 30, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries		Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	2,923,192		$	242,829	$	(50,223	)	$	3,115,798

Salaries, wages and benefits		70			1,767,564			84,774		—			1,852,408
Supplies		—			200,394			19,139		—			219,533
Rent		—			200,105			15,404		—			215,509
Other operating expenses		3			576,145			98,034		(50,223	)		623,959
Other income		—			(5,446	)		—		—			(5,446	)
Impairment charges		—			1,196			—		—			1,196
Depreciation and amortization		—			92,298			6,194		—			98,492
Management fees		—			(6,377	)		6,377		—			—
Intercompany interest (income) expense from affiliates		(56,247	)		49,397			6,850

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company