Edgar Filing: KINDRED HEALTHCARE, INC

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 March 31, 2010

¨ 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 ¨ 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 ¨ Accelerated filer þ 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, 2010
Common stock, $0.25 par value		39,481,505 shares

1 of 43

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, 2010 and 2009	3
	Condensed Consolidated Balance Sheet — March 31, 2010 and December 31, 2009	4
	Condensed Consolidated Statement of Cash Flows — for the three months ended March 31, 2010 and 2009	5
	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40

Item 4.	Controls and Procedures	41

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	42

Item 6.	Exhibits	42

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended March 31,
	2010			2009
Revenues	$	1,089,837		$	1,069,474

Salaries, wages and benefits		627,175			615,218
Supplies		85,886			80,336
Rent		88,319			85,201
Other operating expenses		234,204			220,405
Other income		(3,084	)		(2,872	)
Depreciation and amortization		31,121			30,490
Interest expense		1,307			2,478
Investment income		(877	)		(1,475	)

		1,064,051			1,029,781

Income from continuing operations before income taxes		25,786			39,693
Provision for income taxes		10,631			16,352

Income from continuing operations		15,155			23,341
Discontinued operations, net of income taxes:
Loss from operations		(154	)		(581	)
Loss on divestiture of operations		(137	)		–

Net income	$	14,864		$	22,760

Earnings per common share:
Basic:
Income from continuing operations	$	0.38		$	0.60
Discontinued operations:
Loss from operations		–			(0.02	)
Loss on divestiture of operations		–			–

Net income	$	0.38		$	0.58

Diluted:
Income from continuing operations	$	0.38		$	0.60
Discontinued operations:
Loss from operations		–			(0.02	)
Loss on divestiture of operations		–			–

Net income	$	0.38		$	0.58

Shares used in computing earnings per common share:
Basic		38,626			38,184
Diluted		38,859			38,315

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	March 31, 2010			December 31, 2009
ASSETS
Current assets:
Cash and cash equivalents	$	14,675		$	16,303
Cash – restricted		6,421			5,820
Insurance subsidiary investments		64,253			106,834
Accounts receivable less allowance for loss of $19,053 – March 31, 2010 and $20,156 – December 31, 2009		663,654			610,959
Inventories		22,228			22,303
Deferred tax assets		46,391			42,791
Income taxes		–			17,447
Other		28,252			21,194

		845,874			843,651

Property and equipment		1,580,194			1,515,700
Accumulated depreciation		(790,577	)		(765,602	)

		789,617			750,098

Goodwill		81,382			81,223
Intangible assets less accumulated amortization of $2,868 – March 31, 2010 and $2,647 – December 31, 2009		66,489			64,491
Assets held for sale		8,773			8,806
Insurance subsidiary investments		110,028			100,223
Deferred tax assets		114,966			110,930
Other		64,266			62,802

	$	2,081,395		$	2,022,224

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	153,969		$	161,066
Salaries, wages and other compensation		266,548			287,772
Due to third party payors		26,589			28,261
Professional liability risks		43,742			47,076
Other accrued liabilities		77,279			78,358
Income taxes		12,189			–
Long-term debt due within one year		87			86

		580,403			602,619

Long-term debt		196,625			147,647
Professional liability risks		207,259			195,126
Deferred credits and other liabilities		114,278			110,238

Commitments and contingencies

Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 39,514 shares – March 31, 2010 and 39,104 shares – December 31, 2009		9,878			9,776
Capital in excess of par value		821,638			820,407
Accumulated other comprehensive loss		(224	)		(423	)
Retained earnings		151,538			136,834

		982,830			966,594

	$	2,081,395		$	2,022,224

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended March 31,
	2010			2009
Cash flows from operating activities:
Net income	$	14,864		$	22,760
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		31,121			30,805
Amortization of stock-based compensation costs		2,775			2,439
Provision for doubtful accounts		6,431			7,016
Deferred income taxes		(7,463	)		(2,179	)
Loss on divestiture of discontinued operations		137			–
Other		(163	)		204
Change in operating assets and liabilities:
Accounts receivable		(59,126	)		(86,415	)
Inventories and other assets		(11,245	)		(7,535	)
Accounts payable		(7,582	)		(12,264	)
Income taxes		29,286			43,223
Due to third party payors		(1,894	)		9,401
Other accrued liabilities		(11,137	)		(5,535	)

Net cash provided by (used in) operating activities		(13,996	)		1,920

Cash flows from investing activities:
Routine capital expenditures		(14,815	)		(26,924	)
Development capital expenditures		(7,567	)		(13,062	)
Acquisitions		(47,696	)		(15,604	)
Purchase of insurance subsidiary investments		(14,278	)		(36,257	)
Sale of insurance subsidiary investments		53,211			54,092
Net change in insurance subsidiary cash and cash equivalents		(5,575	)		20,458
Other		(28	)		(953	)

Net cash used in investing activities		(36,748	)		(18,250	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		389,600			390,800
Repayment of borrowings under revolving credit		(340,600	)		(371,600	)
Payment of deferred financing costs		(22	)		(309	)
Issuance of common stock		35			–
Other		103			94

Net cash provided by financing activities		49,116			18,985

Change in cash and cash equivalents		(1,628	)		2,655
Cash and cash equivalents at beginning of period		16,303			140,795

Cash and cash equivalents at end of period	$	14,675		$	143,450

Supplemental information:
Interest payments	$	875		$	2,070
Income tax refunds		11,412			25,170

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 hospitals, nursing and rehabilitation centers and a contract rehabilitation services business across the United States (collectively, the “Company”). At March 31, 2010, the Company’s hospital division operated 83 long-term acute care (“LTAC”) hospitals in 24 states. The Company’s nursing center division operated 222 nursing and rehabilitation centers in 27 states. The Company’s rehabilitation division provided rehabilitative services primarily in long-term care settings.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals and nursing centers to improve its future operating results. For accounting purposes, the operating results of these businesses and the losses associated with these transactions 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, 2010 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 2 for a summary of discontinued operations.

Recently issued accounting requirements

In January 2010, the Financial Accounting Standards Board (the “FASB”) issued authoritative guidance related to fair value measurements and disclosures. The provisions of the guidance require new disclosures related to transfers in and out of Levels 1 and 2 (as described in Note 10). The provisions also require a reconciliation of the activity in Level 3 recurring fair value measurements. Existing disclosures also were expanded to include Level 2 fair value measurement valuation techniques and inputs. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2009, except for the disclosures for Level 3 activity which is effective for fiscal years beginning after December 15, 2010. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

In June 2009, the FASB issued revised authoritative guidance related to the consolidation criteria for variable interest entities (“VIE”). The guidance, among other things, requires a qualitative rather than a quantitative analysis to determine the primary beneficiary of a VIE; requires continuous assessments of whether an enterprise is the primary beneficiary of a VIE; enhances disclosures regarding an enterprise’s involvement with a VIE; and amends certain guidance for determining whether an entity is a VIE. Under the guidance, a VIE must be consolidated if the enterprise has both (a) the power to direct the activities of the VIE that most significantly impact the entity’s economic performance, and (b) the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. The guidance was effective as of January 1, 2010. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

Upon adoption of the VIE guidance on January 1, 2010, the Company reassessed its three investment partnerships and its lease agreements under the new accounting guidance. Although the investment partnerships were determined to be VIEs, they do not require the Company to absorb losses or receive benefits that could potentially be significant to the VIE, nor can the Company direct the activities that most significantly impact the VIEs’ economic performance. As a result, the investment partnerships continue to be accounted for under the equity method of accounting and are not consolidated. The Company also determined that three of its lease agreements were considered VIEs; however, the Company is not the primary beneficiary as it lacks the power to direct activities of the lessor that most significantly impact economic performance. In addition, the Company’s investments and involvement in lease arrangements related to these VIEs were not significant to its accompanying unaudited condensed consolidated financial statements.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Comprehensive income

The following table sets forth the computation of comprehensive income (in thousands):


	Three months ended March 31,
	2010		2009
Net income	$	14,864	$	22,760
Net unrealized investment gains (losses), net of income taxes		199		(854	)

Comprehensive income	$	15,063	$	21,906

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, 2009 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K. The accompanying condensed consolidated balance sheet at December 31, 2009 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.

The Company reclassified $1.8 million of book overdrafts for the first quarter of 2009 from net cash used in financing activities to net cash used in operating activities in the accompanying unaudited condensed consolidated statement of cash flows to conform with the current period presentation. The reclassification had no impact on the Company’s business, financial position, results of operations or liquidity.

NOTE 2 – DISCONTINUED OPERATIONS

In accordance with the authoritative guidance for the impairment or disposal of long-lived assets, the divestiture 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 and the losses related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. At March 31, 2010, the Company held for sale one nursing center and two hospitals.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

A summary of discontinued operations follows (in thousands):


	Three months ended March 31,
	2010			2009
Revenues	$	3,802		$	16,112

Salaries, wages and benefits		2,505			9,110
Supplies		210			993
Rent		36			1,669
Other operating expenses		1,327			4,971
Depreciation		–			315
Interest expense		–			–
Investment income		(26	)		(1	)

		4,052			17,057

Loss from operations before income taxes		(250	)		(945	)
Income tax benefit		(96	)		(364	)

Loss from operations		(154	)		(581	)
Loss on divestiture of operations, net of income taxes		(137	)		–

	$	(291	)	$	(581	)

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


	Three months ended March 31,
	2010			2009
Revenues:
Hospital division	$	8		$	1,063
Nursing center division		3,794			15,049

	$	3,802		$	16,112

Operating income (loss):
Hospital division	$	(817	)	$	(850	)
Nursing center division		577			1,888

	$	(240	)	$	1,038

Rent:
Hospital division	$	31		$	90
Nursing center division		5			1,579

	$	36		$	1,669

Depreciation:
Hospital division	$	–		$	–
Nursing center division		–			315

	$	–		$	315

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


	March 31, 2010			December 31, 2009
Long-term assets:
Property and equipment, net	$	8,736		$	8,723
Other		37			83

		8,773			8,806
Current liabilities (included in other accrued liabilities)		(330	)		(422	)

	$	8,443		$	8,384

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – ACQUISITIONS

The following is a summary of the Company’s significant acquisition activities. The operating results of the acquired businesses have been included in the accompanying unaudited condensed consolidated financial statements of the Company from the respective acquisition dates. The purchase price of the acquired businesses and 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 businesses and real estate values. All of these acquisitions were financed through borrowings under the Company’s revolving credit facility. Unaudited pro formas related to acquired new businesses have not been presented because the acquisitions are not material, either individually or in the aggregate, to the Company’s consolidated financial statements.

In March 2010, the Company acquired a combined nursing and rehabilitation center and assisted living facility for $16.6 million. Goodwill and identifiable intangible assets recorded in connection with the acquisition aggregated $2.4 million.

In January 2010, the Company acquired the real estate of two previously leased hospitals and two previously leased nursing and rehabilitation centers for $31.1 million in cash and $2.4 million in unamortized prepaid rent. Annual rents associated with these four facilities aggregated $2.9 million.

The fair value of each of the acquisitions completed during the first quarter of 2010 were measured using primarily discounted cash flow methodologies which is a Level 3 (as described in Note 10) measurement technique.

In March 2009, the Company acquired the real estate of a previously leased hospital for $15.6 million in cash and $1.6 million in unamortized prepaid rent. Annual rent associated with this facility aggregated $1.8 million. The fair value of the assets acquired were measured using Level 2 observable inputs, including replacement costs and direct sales comparisons of similar properties in the same geographic market or region.

NOTE 4 – 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,
	2010			2009
Medicare	$	472,472		$	462,729
Medicaid		265,975			266,145
Medicare Advantage		85,904			81,256
Other		342,176			329,968

		1,166,527			1,140,098
Eliminations		(76,690	)		(70,624	)

	$	1,089,837		$	1,069,474

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – 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. On January 1, 2009, the Company adopted 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,
	2010						2009
	Basic			Diluted			Basic			Diluted
Earnings:
Income from continuing operations:
As reported in Statement of Operations	$	15,155		$	15,155		$	23,341		$	23,341
Allocation to participating unvested restricted stockholders		(277	)		(275	)		(441	)		(440	)

Available to common stockholders	$	14,878		$	14,880		$	22,900		$	22,901

Discontinued operations, net of income taxes:
Loss from operations:
As reported in Statement of Operations	$	(154	)	$	(154	)	$	(581	)	$	(581	)
Allocation to participating unvested restricted stockholders		3			3			11			11

Available to common stockholders	$	(151	)	$	(151	)	$	(570	)	$	(570	)

Loss on divestiture of operations:
As reported in Statement of Operations	$	(137	)	$	(137	)	$	–		$	–
Allocation to participating unvested restricted stockholders		2			2			–			–

Available to common stockholders	$	(135	)	$	(135	)	$	–		$	–

Net income:
As reported in Statement of Operations	$	14,864		$	14,864		$	22,760		$	22,760
Allocation to participating unvested restricted stockholders		(272	)		(270	)		(430	)		(429	)

Available to common stockholders	$	14,592		$	14,594		$	22,330		$	22,331

Shares used in the computation:
Weighted average shares outstanding – basic computation		38,626			38,626			38,184			38,184

Dilutive effect of employee stock options					233						131

Adjusted weighted average shares outstanding – diluted computation					38,859						38,315

Earnings per common share:
Income from continuing operations	$	0.38		$	0.38		$	0.60		$	0.60
Discontinued operations:
Loss from operations		–			–			(0.02	)		(0.02	)
Loss on divestiture of operations		–			–			–			–

Net income	$	0.38		$	0.38		$	0.58		$	0.58

Number of antidilutive stock options excluded from shares used in the diluted earnings per common share computation					2,088						3,031

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA

At March 31, 2010, the Company operated three business segments: the hospital division, the nursing center division and the rehabilitation division. The hospital division operates LTAC hospitals. The nursing center division operates nursing and rehabilitation centers. The rehabilitation division provides rehabilitation services primarily in long-term care settings. 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 business segments excludes the allocation of corporate overhead.

Operating income for the three months ended March 31, 2010 included severance and retirement costs approximating $1.1 million for the hospital division, $0.5 million for the nursing center division and $1.3 million for corporate. Operating income for the three months ended March 31, 2010 also included transaction costs approximating $0.4 million for the hospital division and $0.4 million for the nursing center division.

The Company identifies its segments in accordance with the aggregation provisions of the authoritative guidance for segment reporting. This information is consistent with information used by the Company in managing its businesses and aggregates businesses with similar economic characteristics. The Company includes operating data for its hospice business in the rehabilitation division.

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


	Three months ended March 31,
	2010			2009
Revenues:
Hospital division	$	507,062		$	492,509
Nursing center division		539,321			529,942
Rehabilitation division		120,144			117,647

		1,166,527			1,140,098
Eliminations		(76,690	)		(70,624	)

	$	1,089,837		$	1,069,474

Income from continuing operations:
Operating income (loss):
Hospital division	$	95,033		$	100,899
Nursing center division		70,249			75,574
Rehabilitation division		14,635			15,453
Corporate:
Overhead		(33,781	)		(34,087	)
Insurance subsidiary		(480	)		(1,452	)

		(34,261	)		(35,539	)

Operating income		145,656			156,387
Rent		(88,319	)		(85,201	)
Depreciation and amortization		(31,121	)		(30,490	)
Interest, net		(430	)		(1,003	)

Income from continuing operations before income taxes		25,786			39,693
Provision for income taxes		10,631			16,352

	$	15,155		$	23,341

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA (Continued)


	Three months ended March 31,
	2010		2009
Rent:
Hospital division	$	37,415	$	36,445
Nursing center division		49,392		47,274
Rehabilitation division		1,475		1,451
Corporate		37		31

	$	88,319	$	85,201

Depreciation and amortization:
Hospital division	$	13,014	$	12,512
Nursing center division		12,113		11,685
Rehabilitation division		585		547
Corporate		5,409		5,746

	$	31,121	$	30,490

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division:
Routine	$	6,065	$	4,844
Development		5,774		9,486

		11,839		14,330
Nursing center division:
Routine		4,049		18,264
Development		1,793		3,576

		5,842		21,840
Rehabilitation division		267		190
Corporate:
Information systems		4,146		3,453
Other		288		173

	$	22,382	$	39,986


	March 31, 2010		December 31, 2009
Assets at end of period:
Hospital division	$	943,603	$	867,332
Nursing center division		584,382		566,592
Rehabilitation division		58,566		53,856
Corporate		494,844		534,444

	$	2,081,395	$	2,022,224

Goodwill:
Hospital division	$	68,577	$	68,577
Nursing center division		1,048		889
Rehabilitation division		11,757		11,757

	$	81,382	$	81,223

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – 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,
	2010			2009
Professional liability:
Continuing operations	$	17,270		$	14,888
Discontinued operations		(435	)		(130	)
Workers compensation:
Continuing operations	$	10,998		$	9,846
Discontinued operations		(759	)		(847	)

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, 2010						December 31, 2009
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	43,742	$	20,511	$	64,253	$	84,953	$	21,881	$	106,834
Reinsurance recoverables		89		–		89		89		–		89
Other		–		320		320		–		321		321

		43,831		20,831		64,662		85,042		22,202		107,244
Non-current:
Insurance subsidiary investments		49,903		60,125		110,028		43,272		56,951		100,223
Reinsurance and other recoverables		32,745		2,328		35,073		29,446		2,030		31,476
Deposits		5,000		1,410		6,410		5,000		1,410		6,410
Other		–		34		34		–		36		36

		87,648		63,897		151,545		77,718		60,427		138,145

	$	131,479	$	84,728	$	216,207	$	162,760	$	82,629	$	245,389

Liabilities:
Allowance for insurance risks:
Current	$	43,742	$	22,516	$	66,258	$	47,076	$	23,934	$	71,010
Non-current		207,259		60,547		267,806		195,126		58,188		253,314

	$	251,001	$	83,063	$	334,064	$	242,202	$	82,122	$	324,324

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – INSURANCE RISKS (Continued)

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 2% to 5% depending upon the policy year. The discount rate was 2% for the 2010 and 2009 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 $256.0 million at March 31, 2010 and $247.3 million at December 31, 2009.

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 8 – INSURANCE SUBSIDIARY INVESTMENTS

The Company maintains investments, consisting principally of cash and cash equivalents, debt securities, equities and commercial paper 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.

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


	March 31, 2010									December 31, 2009
	Amortized cost		Unrealized gains		Unrealized losses			Fair value		Amortized cost		Unrealized gains		Unrealized losses			Fair value
Cash and cash equivalents (a)	$	101,718	$	–	$	–		$	101,718	$	96,143	$	–	$	–		$	96,143
Debt securities:
Corporate bonds		37,016		659		(85	)		37,590		47,528		770		(102	)		48,196
Debt securities issued by U.S. government agencies		15,078		88		(12	)		15,154		37,788		223		(43	)		37,968
U.S. Treasury notes		1,251		1		–			1,252		2,801		19		–			2,820
Debt securities issued by foreign governments		624		5		–			629		624		–		(5	)		619
Commercial mortgage-backed securities		591		27		–			618		610		27		–			637

		54,560		780		(97	)		55,243		89,351		1,039		(150	)		90,240
Equities by industry:
Financial services		1,284		217		(74	)		1,427		1,284		162		(155	)		1,291
Healthcare		1,573		20		(177	)		1,416		1,573		16		(171	)		1,418
Oil and gas		1,104		14		(274	)		844		1,257		8		(303	)		962
Real estate		148		2		(18	)		132		147		2		(24	)		125
Other		8,005		242		(949	)		7,298		8,470		80		(1,132	)		7,418

		12,114		495		(1,492	)		11,117		12,731		268		(1,785	)		11,214
Commercial paper		6,200		5		(2	)		6,203		9,449		14		(3	)		9,460

	$	174,592	$	1,280	$	(1,591	)	$	174,281	$	207,674	$	1,321	$	(1,938	)	$	207,057

(a)	Includes $0.7 million and $4.7 million of money market funds at March 31, 2010 and December 31, 2009, respectively.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE SUBSIDIARY INVESTMENTS (Continued)

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, 2010 and 2009 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 securities.

As a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary, the Company received distributions of $22 million and $34 million during the first quarter of 2010 and 2009, respectively, from its limited purpose insurance subsidiary in accordance with applicable regulations. These distributions had no impact on earnings and the proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

NOTE 9 – 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 loss 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 7.

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. In addition, the Company is a party to a tax matters agreement with PharMerica Corporation which sets forth the Company’s rights and obligations related to taxes for periods before and after the Company’s spin-off of its former institutional pharmacy business in 2007 and the related merger transaction which created PharMerica Corporation.

Litigation – The Company is a party to various legal actions (some of which are not insured), and regulatory and other government investigations in the ordinary course of business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory and other government investigations. These legal actions and investigations 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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9 – CONTINGENCIES (Continued)

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.

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 10 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

On January 1, 2008, the Company adopted 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 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 10 – 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, 2010:
Recurring:
Assets:
Available-for-sale debt securities:
Corporate bonds	$	–	$	37,590	$	–	$	37,590	$	–
Debt securities issued by U.S. government agencies		–		15,154		–		15,154		–
U.S. Treasury notes		1,252		–		–		1,252		–
Debt securities issued by foreign governments		–		629		–		629		–
Commercial mortgage-backed securities		–		618		–		618		–

		1,252		53,991		–		55,243		–

Available-for-sale equity securities		11,117		–		–		11,117		–
Commercial paper		–		6,203		–		6,203		–
Money market funds		686		–		–		686		–

Total available-for-sale investments		13,055		60,194		–		73,249		–

Deposits held in money market funds		959		3,000		–		3,959		–

	$	14,014	$	63,194	$	–	$	77,208	$	–

Liabilities	$	–	$	–	$	–	$	–	$	–

Non-recurring:
Assets	$	–	$	–	$	–	$	–	$	–

Liabilities	$	–	$	–	$	–	$	–	$	–

December 31, 2009:
Recurring:
Assets:
Available-for-sale debt securities:
Corporate bonds	$	–	$	48,196	$	–	$	48,196	$	–
Debt securities issued by U.S. government agencies		–		37,968		–		37,968		–
U.S. Treasury notes		2,820		–		–		2,820		–
Debt securities issued by foreign governments		–		619		–		619		–
Commercial mortgage-backed securities		–		637		–		637		–

		2,820		87,420		–		90,240		–

Available-for-sale equity securities		11,214		–		–		11,214		–
Commercial paper		–		9,460		–		9,460		–
Money market funds		4,692		–		–		4,692		–

Total available-for-sale investments		18,726		96,880		–		115,606		–

Deposits held in money market funds		351		3,000		–		3,351		–

	$	19,077	$	99,880	$	–	$	118,957	$	–

Liabilities	$	–	$	–	$	–	$	–	$	–

Non-recurring:
Assets:
Acquired previously leased hospital	$	–	$	18,000	$	–	$	18,000	$	–
Nursing centers available for sale		–		–		1,000		1,000		(21,870	)

	$	–	$	18,000	$	1,000	$	19,000	$	(21,870	)

Liabilities	$	–	$	–	$	–	$	–	$	–

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – 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 are comprised of debt securities, equities, commercial paper and money market funds. These available-for-sale investments and the insurance subsidiary’s cash and cash equivalents of $101.0 million as of March 31, 2010 and $91.5 million as of December 31, 2009, classified as insurance subsidiary investments, are maintained for the payment of claims and expenses related to professional liability and workers compensation risks.

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 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 commercial paper 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 to ensure prices are 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, 2010 or March 31, 2009.

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.


	March 31, 2010				December 31, 2009
(In thousands)	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	14,675	$	14,675	$	16,303	$	16,303
Cash–restricted		6,421		6,421		5,820		5,820
Insurance subsidiary investments		174,281		174,281		207,057		207,057
Tax refund escrow investments		215		215		215		215
Long-term debt, including amounts due within one year		196,712		196,694		147,733		147,724

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Cautionary Statement

This Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements regarding the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities, plans and objectives of management and statements containing words such as “anticipate,” “approximate,” “believe,” “plan,” “estimate,” “expect,” “project,” “could,” “should,” “will,” “intend,” “may” and other similar expressions, are forward-looking statements.

Such forward-looking statements are inherently uncertain, and stockholders and other potential investors must recognize that actual results may differ materially from the Company’s expectations as a result of a variety of factors, including, without limitation, those discussed below. Such forward-looking statements are based upon management’s current expectations and include known and unknown risks, uncertainties and other factors, many of which the Company is unable to predict or control, that may cause the Company’s actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements. These statements involve risks, uncertainties and other factors discussed below and detailed from time to time in the Company’s filings with the SEC. Factors that may affect the Company’s plans or results include, without limitation:

•

the impact of healthcare reform, which will initiate significant reforms to the United States healthcare system, including potential material changes to the delivery of healthcare services and the reimbursement paid for such services by the government or other third party payors. Healthcare reform will impact each of the Company’s businesses in some manner. Due to the substantial regulatory changes that will need to be implemented by CMS and others, and the numerous processes required to implement these reforms, the Company cannot predict which healthcare initiatives will be implemented at the federal or state level, the timing of any such reforms, or the effect such reforms or any other future legislation or regulation will have on the Company’s business, financial position, results of operations and liquidity,

•

changes in the reimbursement rates or the methods or timing of payment from third party payors, including the Medicare and Medicaid programs, changes arising from and related to the Medicare prospective payment system for LTAC hospitals (“LTAC PPS”), including potential changes in the Medicare payment rules, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, and changes in Medicare and Medicaid reimbursements for the Company’s nursing centers, and the expiration of the Medicare Part B therapy cap exception process,

•

the effects of additional legislative changes and government regulations, interpretation of regulations and changes in the nature and enforcement of regulations governing the healthcare industry,

•

the impact of the Medicare, Medicaid and SCHIP Extension Act of 2007 (the “SCHIP Extension Act”), including the ability of the Company’s hospitals to adjust to potential LTAC certification, medical necessity reviews and the moratorium on future hospital development,

•

the impact of the expiration of several moratoriums under the SCHIP Extension Act which could impact the short stay rules, the budget neutrality adjustment as well as implement the policy known as the “25 Percent Rule,” which would limit certain patient admissions,

•

failure of the Company’s facilities to meet applicable licensure and certification requirements,

•

the further consolidation and cost containment efforts of managed care organizations and other third party payors,

•

the Company’s ability to meet its rental and debt service obligations,

•

the Company’s ability to operate pursuant to the terms of its debt obligations and its master lease agreements with Ventas, Inc.,

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Cautionary Statement (Continued)

•

the condition of the financial markets, including volatility and deterioration in the equity, capital and credit markets, which could limit the availability and terms of debt and equity financing sources to fund the requirements of the Company’s businesses, or which could negatively impact the Company’s investment portfolio,

•

national and regional economic, financial, business and political conditions, including their effect on the availability and cost of labor, credit, materials and other services,

•

the Company’s ability to control costs, particularly labor and employee benefit costs,

•

increased operating costs due to shortages in qualified nurses, therapists and other healthcare personnel,

•

the Company’s ability to attract and retain key executives and other healthcare personnel,

•

the increase in the costs of defending and insuring against alleged professional liability claims and the Company’s ability to predict the estimated costs related to such claims, including the impact of differences in actuarial assumptions and estimates compared to eventual outcomes,

•

the Company’s ability to successfully reduce (by divestiture of operations or otherwise) its exposure to professional liability claims,

•

the Company’s ability to successfully pursue its development activities, including through acquisitions, and successfully integrate new operations, including the realization of anticipated revenues, economies of scale, cost savings and productivity gains associated with such operations,

•

the Company’s ability to successfully dispose of unprofitable facilities,

•

events or circumstances which could result in impairment of an asset or other charges,

•

changes in generally accepted accounting principles or practices, and

•

the Company’s ability to maintain an effective system of internal control over financial reporting.

Many of these factors are beyond the Company’s control. The Company cautions investors that any forward-looking statements made by the Company are not guarantees of future performance. The Company disclaims any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments.

General

The accompanying unaudited condensed consolidated financial statements, including the notes thereto, should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that through its subsidiaries operates hospitals, nursing and rehabilitation centers and a contract rehabilitation services business across the United States. At March 31, 2010, the Company’s hospital division operated 83 LTAC hospitals (6,580 licensed beds) in 24 states. The Company’s nursing center division operated 222 nursing and rehabilitation centers (27,523 licensed beds) in 27 states. The Company’s rehabilitation division provided rehabilitative services primarily in long-term care settings.

In recent years, the Company has completed several strategic divestitures to improve its future operating results. For accounting purposes, the operating results of these businesses and the losses associated with these transactions 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, 2010 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.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of commitments and contingencies. The Company relies on historical experience and on various other assumptions that management believes to be reasonable under the circumstances to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.

The Company believes the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue recognition

The Company has agreements with third party payors that provide for payments to each of its operating divisions. These payment arrangements may be based upon prospective rates, reimbursable costs, established charges, discounted charges or per diem payments. Net patient service revenue is recorded at the estimated net realizable amounts from Medicare, Medicaid, Medicare Advantage, other third party payors and individual patients for services rendered. Retroactive adjustments that are likely to result from future examinations by third party payors are accrued on an estimated basis in the period the related services are rendered and adjusted as necessary in future periods based upon new information or final settlements.

Collectibility of accounts receivable

Accounts receivable consist primarily of amounts due from the Medicare and Medicaid programs, other government programs, managed care health plans, commercial insurance companies and individual patients and customers. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.

In evaluating the collectibility of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type, the status of ongoing disputes with third party payors and general industry conditions. Actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of the change.

The provision for doubtful accounts totaled $6 million and $7 million for the first quarter of 2010 and 2009, respectively.

Allowances for insurance risks

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

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

of 2% to 5% depending upon the policy year. The discount rate was 2% for the 2010 and 2009 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. The allowance for professional liability risks aggregated $251 million at March 31, 2010 and $242 million at December 31, 2009. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $256 million at March 31, 2010 and $247 million at December 31, 2009.

Changes in the number of professional liability claims and the cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at March 31, 2010 would impact the Company’s operating income by approximately $3 million.

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $17 million and $14 million for the first quarter of 2010 and 2009, respectively.

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. The allowance for workers compensation risks aggregated $83 million at March 31, 2010 and $82 million at December 31, 2009. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $11 million and $10 million for the first quarter of 2010 and 2009, respectively.

Accounting for income taxes

The provision for income taxes is based upon the Company’s estimate of annual taxable income or loss for each respective accounting period. The Company recognizes an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. The Company also recognizes as deferred tax assets the future tax benefits from net operating and capital loss carryforwards. A valuation allowance is provided for these deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

The Company’s effective income tax rate was 41.2% in the first quarter of both 2010 and 2009.

There are significant uncertainties with respect to capital loss carryforwards that could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized and a valuation allowance is provided for deferred tax assets

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Accounting for income taxes (Continued)

to the extent that it is uncertain that the deferred tax asset will be realized. The Company recognized net deferred tax assets totaling $161 million at March 31, 2010 and $154 million at December 31, 2009.

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. While the Company believes its tax positions are appropriate, there can be no assurance that the various authorities engaged in the examination of its income tax returns will not challenge the Company’s positions.

Valuation of long-lived assets and goodwill

The Company regularly reviews the carrying value of certain long-lived assets and identifiable finite lived intangible assets with respect to any events or circumstances that indicate an impairment or an adjustment to the amortization period is necessary. If circumstances suggest that the recorded amounts cannot be recovered based upon estimated future undiscounted cash flows, the carrying values of such assets are reduced to fair value.

In assessing the carrying values of long-lived assets, the Company estimates future cash flows at the lowest level for which there are independent, identifiable cash flows. For this purpose, these cash flows are aggregated based upon the contractual agreements underlying the operation of the facility or group of facilities. Generally, an individual facility is considered the lowest level for which there are independent, identifiable cash flows. However, to the extent that groups of facilities are leased under a master lease agreement in which the operations of a facility and compliance with the lease terms are interdependent upon other facilities in the agreement (including the Company’s ability to renew the lease or divest a particular property), the Company defines the group of facilities under a master lease agreement as the lowest level for which there are independent, identifiable cash flows. Accordingly, the estimated cash flows of all facilities within a master lease agreement are aggregated for purposes of evaluating the carrying values of long-lived assets.

The Company’s other intangible assets with finite lives are amortized in accordance with the authoritative guidance for goodwill and other intangible assets using the straight-line method over their estimated useful lives ranging from one to ten years.

In accordance with the authoritative guidance for goodwill and other intangible assets, the Company is required to perform an impairment test for goodwill and 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 performs its annual goodwill impairment test at the end of each fiscal year for each of its reporting units. A reporting unit is either an operating segment or one level below the operating segment, referred to as a component. When the components within the Company’s operating segments have similar economic characteristics, the Company aggregates the components of its operating segments into one reporting unit. Accordingly, the Company has determined that its reporting units are hospitals, nursing centers, rehabilitation services and hospice. The carrying value of goodwill for each of our reporting units at March 31, 2010 and December 31, 2009 follows (in thousands):


	March 31, 2010		December 31, 2009
Hospitals	$	68,577	$	68,577
Nursing centers		1,048		889
Rehabilitation services		3,363		3,363
Hospice		8,394		8,394

	$	81,382	$	81,223

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Valuation of long-lived assets and goodwill (Continued)

The goodwill impairment test involves a two-step process. The first step is a comparison of each reporting unit’s fair value to its carrying value. If the carrying value of the reporting unit is greater than its fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss. Based upon the results of the step one impairment test for goodwill and the impairment test of indefinite lived intangible assets, no impairment charges were recorded in connection with the Company’s annual impairment tests at December 31, 2009. The Company did not believe that any of its reporting units were at risk for failing the step one impairment test at December 31, 2009.

Since quoted market prices for the Company’s reporting units are not available, the Company applies judgment in determining the fair value of these reporting units for purposes of performing the goodwill impairment test. The Company relies on widely accepted valuation techniques, including equally weighted discounted cash flows and market multiple analyses approaches, which capture both the future income potential of the reporting unit and the market behaviors and actions of market participants in the industry that includes the reporting unit. These types of analyses require management to make assumptions and estimates regarding future cash flows, industry-specific economic factors and the profitability of future business strategies. The discounted cash flow approach uses a projection of estimated operating results and cash flows that are discounted using a weighted average cost of capital. Under the discounted cash flow approach, the projection uses management’s best estimates of economic and market conditions over the projected period for each reporting unit 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. The market multiple analysis estimates fair value by applying cash flow multiples to the reporting unit’s operating results. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics to the reporting units.

The fair values of the Company’s indefinite lived intangible assets, primarily hospital certificates of need, are estimated using 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. The fair values of the Company’s indefinite lived intangible assets are derived from 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.

The Company has determined that during the first quarter of 2010 there were no events or changes in circumstances since December 31, 2009 requiring an interim impairment test. Although the Company has determined that there was no goodwill or other indefinite lived intangible asset impairments as of March 31, 2010 and December 31, 2009, adverse changes in the operating environment and related key assumptions used to determine the fair value of the Company’s reporting units and indefinite lived intangible assets or declines in the value of the Company’s common stock may result in future impairment charges for a portion or all of these assets. Specifically, if the rate of growth of government and commercial revenues earned by the Company’s reporting units were to be less than projected or if healthcare reforms were to negatively impact our business, an impairment charge for a portion or all of the assets may be required. An impairment charge could have a material adverse effect on the Company’s business, financial position and results of operations, but would not be expected to have an impact on the Company’s cash flows or liquidity.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Recently Issued Accounting Requirements

In January 2010, the FASB issued authoritative guidance related to fair value measurements and disclosures. The provisions of the guidance require new disclosures related to transfers in and out of Levels 1 and 2 (as described in Note 10). The provisions also require a reconciliation of the activity in Level 3 recurring fair value measurements. Existing disclosures also were expanded to include Level 2 fair value measurement valuation techniques and inputs. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2009, except for the disclosures for Level 3 activity which is effective for fiscal years beginning after December 15, 2010. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

In June 2009, the FASB issued revised authoritative guidance related to the consolidation criteria for VIEs. The guidance, among other things, requires a qualitative rather than a quantitative analysis to determine the primary beneficiary of a VIE; requires continuous assessments of whether an enterprise is the primary beneficiary of a VIE; enhances disclosures regarding an enterprise’s involvement with a VIE; and amends certain guidance for determining whether an entity is a VIE. Under the guidance, a VIE must be consolidated if the enterprise has both (a) the power to direct the activities of the VIE that most significantly impact the entity’s economic performance, and (b) the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. The guidance was effective as of January 1, 2010. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

Results of Operations – Continuing Operations

Hospital division

Revenues increased 3% in the first quarter of 2010 to $507 million compared to $493 million in the first quarter of 2009, primarily as a result of increased admissions and the development of new hospitals. Aggregate reported and same-facility admissions increased 3% in the first quarter of 2010 compared to the first quarter of 2009. Commercial same-facility admissions rose 12% in the first quarter of 2010 compared to the first quarter of 2009.

Hospital operating margins declined in the first quarter of 2010 as increased costs, particularly wage and benefit costs, exceeded the growth in overall revenues. Operating results for the first quarter of 2010 included approximately $2 million related to severance and transaction costs.

Hospital wage and benefit costs increased 4% to $228 million in the first quarter of 2010 from $218 million in the first quarter of 2009. Average hourly wage rates grew 1% in the first quarter of 2010 compared to the first quarter of 2009, while employee benefit costs increased 2% in the first quarter of 2010 compared to the same period last year.

Professional liability costs were $8 million and $6 million in the first quarter of 2010 and 2009, respectively.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Nursing center division

Revenues increased 2% in the first quarter of 2010 to $539 million compared to $530 million in the first quarter of 2009. Revenue growth in the first quarter was primarily attributable to reimbursement rate increases that reflected both inflationary adjustments and higher average patient acuity. Aggregate admissions grew 5% in the first quarter of 2010 compared to the first quarter of 2009. Aggregate patient days declined 1% in the first quarter of 2010 compared to the first quarter of 2009. Medicare patient days declined 2% while Medicare Advantage, private and other patient days were relatively unchanged in the first quarter of 2010 compared to the first quarter of 2009.

Nursing center operating margins declined in the first quarter of 2010 compared to the first quarter of 2009 primarily as a result of 8% growth in ancillary expenses such as rehabilitation, pharmacy and outside services consistent with higher patient acuity levels. Operating results for the first quarter of 2010 included approximately $1 million related to severance and transaction costs.

Nursing center wage and benefit costs were relatively unchanged in the first quarter of 2010 compared to the first quarter of 2009. Average hourly wage rates grew 2% in the first quarter of 2010 compared to the first quarter of 2009, while employee benefit costs were relatively unchanged in the first quarter of 2010 compared to the same period last year.

Professional liability costs were $8 million in the first quarter of both 2010 and 2009.

Rehabilitation division

Revenues increased 2% in the first quarter of 2010 to $120 million compared to $117 million in the first quarter of 2009, primarily attributable to growth in the volume of services provided to existing customers. Revenues derived from unaffiliated customers aggregated $44 million and $45 million in the first quarter of 2010 and 2009, respectively.

Operating margins declined in the first quarter of 2010 compared to the first quarter of 2009 as growth in operating expenses exceeded revenue growth for the period. Revenue growth was slowed during the first quarter of 2010 as a result of pricing pressures associated with lower Medicare reimbursement growth rates experienced by existing customers.

Corporate overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $34 million in the first quarter of both 2010 and 2009. As a percentage of consolidated revenues, corporate overhead totaled 3.1% and 3.2% in the first quarter of 2010 and 2009, respectively. Operating results for the first quarter of 2010 included approximately $1 million related to retirement costs.

Corporate expenses included operating losses from the Company’s limited purpose insurance subsidiary of $0.4 million in the first quarter of 2010 compared to $1 million in the first quarter of 2009.

Capital costs

Rent expense increased 4% to $89 million in the first quarter of 2010 compared to $85 million in the first quarter of 2009, primarily from contractual inflation and contingent rent increases.

Depreciation and amortization expense increased 2% in the first quarter of 2010 to $31 million compared to $30 million in the first quarter of 2009, primarily a result of the Company’s ongoing capital expenditure program and hospital development.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Capital costs (Continued)

Interest expense declined to $1 million in the first quarter of 2010 from $2 million in the first quarter of 2009, primarily attributable to lower interest rates and lower borrowing levels under the Company’s revolving credit facility compared to the first quarter of 2009.

Investment income related primarily to the Company’s insurance subsidiary investments totaled $1 million in the first quarter of both 2010 and 2009. The Company considered the unrealized losses related to its insurance subsidiary investments at March 31, 2010 and 2009 to be temporary and did not record any impairment losses related to these investments in either period.

Consolidated results

Income from continuing operations before income taxes decreased 35% to $26 million in the first quarter of 2010 compared to $40 million in the first quarter of 2009. Income from continuing operations decreased 35% to $15 million in the first quarter of 2010 compared to $24 million in the first quarter of 2009.

Results of Operations – Discontinued Operations

Loss from discontinued operations aggregated $0.2 million in the first quarter of 2010 compared to $0.5 million in the first quarter of 2009.

The Company recorded a pretax loss of $0.2 million ($0.1 million net of income taxes) in the first quarter of 2010 related to the planned divestiture of discontinued operations.

Liquidity

Operating cash flows

Cash flows used in operations (including discontinued operations) aggregated $14 million in the first quarter of 2010 compared to cash flows provided by operations of $2 million in the first quarter of 2009. Operating cash flows in both periods were negatively impacted by the growth in accounts receivable. Operating cash flows in both periods were favorably impacted by federal income tax refunds of $10 million and $25 million for the first quarter of 2010 and 2009, respectively.

Cash and cash equivalents totaled $15 million at March 31, 2010 compared to $16 million at December 31, 2009. The Company’s long-term debt, comprised principally of borrowings under the Company’s revolving credit facility, aggregated $197 million at March 31, 2010 compared to $148 million at December 31, 2009. Based upon the Company’s existing cash levels, expected operating cash flows and the availability of borrowings under the Company’s revolving credit facility ($304 million at March 31, 2010), management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.

Revolving credit facility and financing activities

Under the terms of the Company’s revolving credit facility, the aggregate amount of the credit may be increased from $500 million to $600 million at the Company’s option subject to lender approval and certain other conditions. If the Company elects to expand the available credit, the existing lenders are likely to demand new terms, including increases in the effective interest rate. The term of the Company’s revolving credit facility expires in July 2012.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Liquidity (Continued)

Revolving credit facility and financing activities (Continued)

Interest rates under the Company’s revolving credit facility are based, at the Company’s option, upon (a) the London Interbank Offered Rate (“LIBOR”) plus the applicable margin or (b) the applicable margin plus the higher of the prime rate or 0.5% over the federal funds rate. The Company’s revolving credit facility is collateralized by substantially all of the Company’s assets including certain owned real property and is guaranteed by substantially all of the Company’s subsidiaries. The terms of the Company’s revolving credit facility include a certain defined fixed payment ratio covenant and covenants which limit acquisitions and annual capital expenditures. The Company was in compliance with the terms of its revolving credit facility at March 31, 2010.

Despite the recent instability within the financial markets both nationally and globally, the Company has not experienced any individual lender limitations to extend credit under its revolving credit facility. However, the obligations of each of the lending institutions in the Company’s revolving credit facility are separate and the availability of future borrowings under the Company’s revolving credit facility could be impacted by further volatility and disruptions in the financial credit markets or other events, including bankruptcy of a lending institution.

Capital Resources

Excluding acquisitions, routine capital expenditures totaled $15 million in the first quarter of 2010 compared to $27 million in the first quarter of 2009. Hospital development capital expenditures totaled $5 million in the first quarter of 2010 compared to $9 million in the first quarter of 2009. Nursing center development capital expenditures totaled $2 million in the first quarter of 2010 compared to $4 million in the first quarter of 2009. Excluding acquisitions, the Company anticipates that routine capital expenditures in 2010 will approximate $115 million to $120 million, hospital development capital expenditures should approximate $45 million to $50 million and nursing center development capital expenditures related to transitional care centers and units should approximate $25 million to $30 million. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. The Company’s capital expenditure program is financed generally through the use of internally generated funds. At March 31, 2010, the estimated cost to complete and equip construction in progress approximated $61 million.

In March 2010, the Company acquired a combined nursing and rehabilitation center and assisted living facility for approximately $17 million. This transaction was financed through borrowings under the Company’s revolving credit facility.

In January 2010, the Company acquired the real estate of two previously leased hospitals and two previously leased nursing and rehabilitation centers for approximately $31 million in cash and approximately $2 million in unamortized prepaid rent. Annual rents associated with these four facilities approximated $3 million. These transactions were financed through borrowings under the Company’s revolving credit facility.

In March 2009, the Company acquired the real estate of a previously leased hospital for approximately $16 million in cash and approximately $2 million in unamortized prepaid rent. Annual rent associated with this facility approximated $2 million. This transaction was financed through borrowings under the Company’s revolving credit facility.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Other Information

Effects of inflation and changing prices

The Company derives a substantial portion of its revenues from the Medicare and Medicaid programs. Congress and certain state legislatures have enacted or may enact additional significant cost containment measures limiting the Company’s ability to recover its cost increases through increased pricing of its healthcare services. Medicare revenues in LTAC hospitals and nursing centers are subject to fixed payments under the Medicare prospective payment systems.

Medicaid reimbursement rates in many states in which the Company operates nursing centers also are based upon fixed payment systems. Generally, these rates are adjusted annually for inflation. However, these adjustments may not reflect the actual increase in the costs of providing healthcare services. In addition, Medicaid reimbursement can be negatively impacted by state budgetary pressures.

Various healthcare reform provisions became law when the Patient Protection and Affordable Care Act (the “PPACA”) was enacted on March 23, 2010 and the Healthcare Education and Reconciliation Act (the “HCERA”) was enacted on March 30, 2010. The reforms contained in these bills will impact each of the Company’s businesses in some manner. Several of the reforms are very significant and could ultimately change the nature of the Company’s services, the methods of payment for the Company’s services and the underlying regulatory environment. The reforms include modifications to the conditions of qualification for payment, bundling payments to cover both acute and post-acute care and the imposition of enrollment limitations on new providers. In addition, a primary goal of healthcare reform is to reduce costs, which includes reductions in the reimbursement paid to the Company and other healthcare providers. Moreover, healthcare reform could negatively impact insurance companies, other third party payors, the Company’s customers, as well as other healthcare providers, which may in turn negatively impact the Company’s business. As such, these healthcare reforms or other similar healthcare reforms could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

The PPACA and the HCERA enacted a series of reductions to the annual market basket payment updates for LTAC hospitals. In addition to specific market basket reductions, Congress has mandated that the annual market basket payment update for a variety of providers, including both LTAC hospitals and skilled nursing facilities, be reduced for a “productivity adjustment” determined by CMS. These productivity adjustments may vary and will be determined annually by CMS. The productivity adjustments for LTAC hospitals and skilled nursing facilities are schedule to be implemented on October 1, 2011.

LTAC PPS maintains LTAC hospitals as a distinct provider type, separate from short-term acute care hospitals. Only providers certified as LTAC hospitals may be paid under this system. To maintain certification under LTAC PPS, the average length of stay of fee for service Medicare patients must be at least 25 days.

CMS is currently evaluating various certification criteria for designating a hospital as a LTAC hospital. If such certification criteria were developed and enacted into legislation, the Company’s hospitals may not be able to maintain their status as LTAC hospitals or may need to adjust their operations.

The SCHIP Extension Act became law on December 29, 2007. This legislation provides for, among other things:

(1)

a mandated study by the Secretary of Health and Human Services on the establishment of LTAC hospital certification criteria;

(2)

enhanced medical necessity review of LTAC hospital cases;

(3)

a three-year moratorium on the establishment of a LTAC hospital or satellite facility, subject to exceptions for facilities under development;

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

(4)

a three-year moratorium on an increase in the number of licensed beds at a LTAC hospital or satellite facility, subject to exceptions for states where there is only one other LTAC hospital and upon request following the closure or decrease in the number of licensed beds at a LTAC hospital within the state;

(5)

a three-year moratorium on the application of a one-time budget neutrality adjustment to payment rates to LTAC hospitals under LTAC PPS;

(6)

a three-year moratorium on very short-stay outlier payment reductions to LTAC hospitals initially implemented on May 1, 2007;

(7)

a three-year moratorium on the application of the policy known as the “25 Percent Rule” to freestanding LTAC hospitals;

(8)

a three-year period during which LTAC hospitals that are co-located with another hospital may admit up to 50% of their patients from their co-located hospital and still be paid according to LTAC PPS;

(9)

a three-year period during which LTAC hospitals that are co-located with an urban single hospital or a hospital that generates more than 25% of the Medicare discharges in a metropolitan statistical area (“MSA Dominant hospital”) may admit up to 75% of their patients from such urban single hospital or MSA Dominant hospital and still be paid according to LTAC PPS; and

(10)

the elimination of the July 1, 2007 market basket increase in the standard federal payment rate of 0.71%, effective for discharges occurring on or after April 1, 2008.

The PPACA revised certain provisions of the SCHIP Extension Act. The moratoriums on the establishment of new LTAC hospitals or satellites and bed increases at LTAC hospitals or satellites, the application of a one-time budget neutrality adjustment to rates, the payment reductions due to the very short-stay outlier provisions and application of the “25 Percent Rule” to freestanding hospitals have been extended from three years to five years. In addition, the periods during which LTAC hospitals may admit up to 50% of their patients from co-located hospitals and during which LTAC hospitals may admit up to 75% of their patients from a MSA Dominant hospital have been extended from three years to five years as well.

On May 1, 2007, CMS issued regulatory changes regarding Medicare reimbursement for LTAC hospitals (the “2007 Final Rule”). In the 2007 Final Rule, the policy known as the “25 Percent Rule” (described below) was expanded to all LTAC hospitals, regardless of whether they are co-located with another hospital. Under the 2007 Final Rule, all LTAC hospitals were to be paid LTAC PPS rates for admissions from a single referral source up to 25% of aggregate Medicare admissions. Patients reaching high cost outlier status in the short-term hospital were not to be counted when computing the 25% limit. Admissions beyond the 25% threshold were to be paid at a lower amount based upon short-term acute care hospital rates. However, as set forth above, the SCHIP Extension Act initially placed a three-year moratorium on the expansion of the “25 Percent Rule” to freestanding hospitals. That moratorium was extended to five years by the PPACA. In addition, the SCHIP Extension Act initially provided for a three-year period during which (1) LTAC hospitals may admit up to 50% of their patients from their co-located hospitals and still be paid according to LTAC PPS; and (2) LTAC hospitals that are co-located with an urban single hospital or a MSA Dominant hospital may admit up to 75% of their patients from such urban single or MSA Dominant hospital and still be paid according to LTAC PPS. Those periods also were extended to five years under the PPACA. The five-year moratorium of the “25 Percent Rule” threshold payment adjustment for freestanding hospitals and grandfathered hospitals with a host hospital (“HIH”) will expire for cost reporting periods beginning on or after July 1, 2012. The expansion of the admission limit to 50% for non-grandfathered, LTAC hospitals from their co-located hospital will expire for cost reports beginning on or after October 1, 2012, the same time at which the 75% limit for MSA Dominant hospitals will expire.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

On May 2, 2008, CMS issued regulatory changes regarding Medicare reimbursement for LTAC hospitals (the “2008 Final Rule”) that became effective for discharges occurring on or after July 1, 2008. The 2008 Final Rule projected an overall increase in payments to all Medicare certified LTAC hospitals of approximately 2.5%. Included in the 2008 Final Rule were (1) an increase to the standard federal payment rate of 2.7% (as compared to the adjusted federal rate for discharges occurring on or after April 1, 2008 by the SCHIP Extension Act); (2) adjustments to the wage index component of the federal payment resulting in projected reductions in payments of 0.1%; (3) an increase in the high cost outlier threshold per discharge to $22,960; and (4) an extension of the rate year cycle for one year to September 30, 2009, in order to be consistent thereafter with the federal fiscal year that begins October 1 of each year.

On April 19, 2010, CMS issued proposed regulations regarding Medicare reimbursement for LTAC hospitals for the fiscal year beginning October 1, 2010. Included in those proposed regulations is (1) a market basket increase to the standard federal payment rate of 2.4%; (2) an offset of 2.5% applied to the standard federal payment rate to account for the effect of documentation and coding changes; (3) adjustments to area wage indexes; and (4) an increase in the high cost outlier threshold per discharge to $18,692. CMS has projected the impact of these proposed changes to LTAC PPS to be an increase in payments of 0.8%.

CMS has regulations governing payments to LTAC hospitals that are co-located with another hospital, such as a HIH. The rules generally limit Medicare payments to the HIH if the Medicare admissions to the HIH from its co-located hospital exceed 25% of the total Medicare discharges for the HIH’s cost reporting period, the “25 Percent Rule.” There are limited exceptions for admissions from rural, urban single and MSA Dominant hospitals. Admissions that exceed this “25 Percent Rule” are paid using the short-term acute care inpatient payment system (“IPPS”). Patients transferred after they have reached the short-term acute care outlier payment status are not counted toward the admission threshold. Patients admitted prior to meeting the admission threshold, as well as Medicare patients admitted from a non co-located hospital, are eligible for the full payment under LTAC PPS. If the HIH’s admissions from the co-located hospital exceed the limit in a cost reporting period, Medicare will pay the lesser of (1) the amount payable under LTAC PPS; or (2) the amount payable under IPPS. At March 31, 2010, the Company operated 15 HIHs with 633 licensed beds.

On August 1, 2007, CMS issued final regulations regarding Medicare hospital inpatient payments to short-term acute care hospitals as well as certain provisions affecting LTAC hospitals. These regulations adopt a new system for LTAC hospitals for classifying patients into diagnostic categories called Medicare Severity Diagnosis Related Groups or more specifically, for LTAC hospitals, “MS-LTC-DRGs.” LTAC PPS is based upon discharged-based MS-LTC-DRGs similar to the system used to pay short-term acute care hospitals. This new MS-LTC-DRG system replaced the previous diagnostic related group system for LTAC hospitals and became effective for discharges occurring on or after October 1, 2007. The MS-LTC-DRG system created additional severity-adjusted categories for most diagnoses.

On July 31, 2008, CMS issued final regulations regarding the re-weighting of MS-LTC-DRGs for discharges occurring on or after October 1, 2008. CMS announced that this update was made in a budget neutral manner, and that estimated aggregate LTAC Medicare payments would be unaffected by these regulations. Based upon the Company’s experience under these final regulations, it appears that the re-weighting increased payments for the care of higher acuity patients.

On May 29, 2009, CMS issued an interim final rule that revised the October 1, 2008 payment weights. Effective June 3, 2009, CMS reduced MS-LTC-DRG payment weights by 3.9%, resulting in approximately a

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

0.9% reduction of the estimated total LTAC PPS payments in the federal fiscal year ending September 30, 2009. No retroactive adjustments to payments were made. On July 31, 2009, CMS finalized this interim rule.

On July 31, 2009, CMS issued final regulations regarding Medicare reimbursement for LTAC hospitals for the fiscal year beginning October 1, 2009. These final regulations include a recalibration of the MS-LTC-DRG payment weights as well as updates to the payment rates. CMS indicated that these changes will result in a 3.3% increase to average Medicare payments to LTAC hospitals. The 2.7% annualized reduction that resulted from a recalibration of MS-LTC-DRG payment weights on June 3, 2009 is incorporated into the final October 1, 2009 payment weights.

The Company cannot predict the ultimate long-term impact of LTAC PPS. This payment system is subject to significant change. Slight variations in patient acuity or length of stay could significantly change Medicare revenues generated under LTAC PPS. In addition, the Company’s hospitals may not be able to appropriately adjust their operating costs to changes in patient acuity and length of stay or to changes in reimbursement rates. In addition, there can be no assurance that LTAC PPS will not have a material adverse effect on revenues from commercial third party payors. Various factors, including a reduction in average length of stay, have negatively impacted revenues from commercial third party payors in recent years.

On July 31, 2009, CMS issued final regulations regarding Medicare reimbursement for nursing centers for the fiscal year beginning October 1, 2009. Included in these regulations are (1) a market basket increase to the federal payment rates of 2.2%, (2) updates to the wage indexes which adjust the federal payment, and (3) a reduction in the resource utilization grouping (“RUG”) indexes attributed to a CMS forecast error in a prior year, resulting in a 3.3% reduction in payments. CMS estimated that these changes will result in a net decrease in Medicare payments to nursing and rehabilitation centers of 1.1%.

In addition, for the fiscal year beginning October 1, 2010, CMS finalized provisions that would increase the number of RUG categories for nursing centers from 53 to 66 (i.e., RUGs IV) and amend the criteria, including the provision of therapy services, currently used to classify patients into these categories. CMS has indicated that these changes will be enacted in a budget neutral manner. However, the PPACA enacted a delay in the implementation of RUGs IV until October 1, 2011, while maintaining the provisions related to concurrent therapy and look-back periods set forth in the July 31, 2009 final payment rule. These changes may impair the ability of CMS to implement the changes finalized on July 31, 2009 in a budget neutral manner. While the Company is unable to estimate the impact of these changes, the operating results of its contract rehabilitation services business may be adversely affected.

Medicare Part B provides reimbursement for certain physician services, limited drug coverage and other outpatient services, such as therapy and other services, outside of a Medicare Part A covered patient stay. Since 2006, federal legislation has provided for an annual Medicare Part B outpatient therapy cap. In succeeding years, CMS subsequently increased the amount of the therapy cap. Legislation also was passed that required CMS to implement a broad process for reviewing medically necessary therapy claims, creating an exception to the cap. Legislation has annually extended the Medicare Part B outpatient therapy cap. The Medicare Improvements for Patients and Providers Act of 2008, enacted on July 15, 2008, extended the therapy cap exception process from July 1, 2008 to December 31, 2009. The PPACA provided that the exception process remain in effect from January 1, 2010 through December 31, 2010.

The Company believes that its operating margins may continue to be under pressure as the growth in operating expenses, particularly professional liability, labor and employee benefits costs, exceeds payment increases from third party payors. In addition, as a result of competitive pressures, the Company’s ability to maintain operating margins through price increases to private patients is limited.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)


	2009 Quarters												Year			First Quarter 2010
	First			Second			Third			Fourth			Year			First Quarter 2010
Revenues	$	1,069,474		$	1,073,054		$	1,057,488		$	1,069,991		$	4,270,007		$	1,089,837

Salaries, wages and benefits		615,218			620,830			629,077			617,961			2,483,086			627,175
Supplies		80,336			83,912			82,400			86,408			333,056			85,886
Rent		85,201			86,882			88,081			88,084			348,248			88,319
Other operating expenses		220,405			221,755			221,524			222,521			886,205			234,204
Other income		(2,872	)		(2,823	)		(2,870	)		(2,947	)		(11,512	)		(3,084	)
Depreciation and amortization		30,490			31,355			31,992			31,893			125,730			31,121
Interest expense		2,478			2,229			1,741			1,432			7,880			1,307
Investment income		(1,475	)		(1,033	)		(746	)		(1,159	)		(4,413	)		(877	)

		1,029,781			1,043,107			1,051,199			1,044,193			4,168,280			1,064,051

Income from continuing operations before income taxes		39,693			29,947			6,289			25,798			101,727			25,786
Provision for income taxes		16,352			12,409			901			9,453			39,115			10,631

Income from continuing operations		23,341			17,538			5,388			16,345			62,612			15,155
Discontinued operations, net of income taxes:
Income (loss) from operations		(581	)		(897	)		13			2,396			931			(154	)
Gain (loss) on divestiture of operations		–			(24,051	)		52			567			(23,432	)		(137	)

Net income (loss)	$	22,760		$	(7,410	)	$	5,453		$	19,308		$	40,111		$	14,864

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.60		$	0.45		$	0.14		$	0.42		$	1.61		$	0.38
Discontinued operations:
Income (loss) from operations		(0.02	)		(0.02	)		–			0.06			0.02			–
Gain (loss) on divestiture of operations		–			(0.62	)		–			0.01			(0.60	)		–

Net income (loss)	$	0.58		$	(0.19	)	$	0.14		$	0.49		$	1.03		$	0.38

Diluted:
Income from continuing operations	$	0.60		$	0.45		$	0.14		$	0.42		$	1.60		$	0.38
Discontinued operations:
Income (loss) from operations		(0.02	)		(0.02	)		–			0.06			0.02			–
Gain (loss) on divestiture of operations		–			(0.62	)		–			0.01			(0.60	)		–

Net income (loss)	$	0.58		$	(0.19	)	$	0.14		$	0.49		$	1.02		$	0.38

Shares used in computing earnings (loss) per common share:
Basic		38,184			38,307			38,398			38,465			38,339			38,626
Diluted		38,315			38,415			38,524			38,693			38,502			38,859

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Operating Data

(Unaudited)

(In thousands)


	2009 Quarters												Year			First Quarter 2010
	First			Second			Third			Fourth			Year			First Quarter 2010
Revenues:
Hospital division	$	492,509		$	487,145		$	468,069		$	485,169		$	1,932,892		$	507,062
Nursing center division		529,942			537,545			539,217			543,638			2,150,342			539,321
Rehabilitation division		117,647			120,450			122,625			114,316			475,038			120,144

		1,140,098			1,145,140			1,129,911			1,143,123			4,558,272			1,166,527
Eliminations		(70,624	)		(72,086	)		(72,423	)		(73,132	)		(288,265	)		(76,690	)

	$	1,069,474		$	1,073,054		$	1,057,488		$	1,069,991		$	4,270,007		$	1,089,837

Income from continuing operations:
Operating income (loss):
Hospital division	$	100,899		$	91,027		$	78,674		$	93,211		$	363,811		$	95,033	(a,b)
Nursing center division		75,574			79,522			73,383			77,111			305,590			70,249	(a,b)
Rehabilitation division		15,453			13,599			10,912			10,628			50,592			14,635
Corporate:
Overhead		(34,087	)		(33,586	)		(33,843	)		(33,120	)		(134,636	)		(33,781	)(a)
Insurance subsidiary		(1,452	)		(1,182	)		(1,769	)		(1,782	)		(6,185	)		(480	)

		(35,539	)		(34,768	)		(35,612	)		(34,902	)		(140,821	)		(34,261	)

Operating income		156,387			149,380			127,357			146,048			579,172			145,656
Rent		(85,201	)		(86,882	)		(88,081	)		(88,084	)		(348,248	)		(88,319	)
Depreciation and amortization		(30,490	)		(31,355	)		(31,992	)		(31,893	)		(125,730	)		(31,121	)
Interest, net		(1,003	)		(1,196	)		(995	)		(273	)		(3,467	)		(430	)

Income from continuing operations before income taxes		39,693			29,947			6,289			25,798			101,727			25,786
Provision for income taxes		16,352			12,409			901			9,453			39,115			10,631

	$	23,341		$	17,538		$	5,388		$	16,345		$	62,612		$	15,155

(a)	Includes severance and retirement costs approximating $1.1 million for the hospital division, $0.5 million for the nursing center division and $1.3 million for corporate.

(b)	Includes transaction costs approximating $0.4 million for the hospital division and $0.4 million for the nursing center division.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)

(In thousands)


	2009 Quarters								Year		First Quarter 2010
	First		Second		Third		Fourth		Year		First Quarter 2010
Rent:
Hospital division	$	36,445	$	36,834	$	37,062	$	37,153	$	147,494	$	37,415
Nursing center division		47,274		48,565		49,471		49,525		194,835		49,392
Rehabilitation division		1,451		1,459		1,495		1,373		5,778		1,475
Corporate		31		24		53		33		141		37

	$	85,201	$	86,882	$	88,081	$	88,084	$	348,248	$	88,319

Depreciation and amortization:
Hospital division	$	12,512	$	13,018	$	13,275	$	13,127	$	51,932	$	13,014
Nursing center division		11,685		12,038		12,408		12,500		48,631		12,113
Rehabilitation division		547		549		584		611		2,291		585
Corporate		5,746		5,750		5,725		5,655		22,876		5,409

	$	30,490	$	31,355	$	31,992	$	31,893	$	125,730	$	31,121

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division:
Routine	$	4,844	$	5,335	$	10,226	$	6,311	$	26,716	$	6,065
Development		9,486		12,395		10,884		9,606		42,371		5,774

		14,330		17,730		21,110		15,917		69,087		11,839
Nursing center division:
Routine		18,264		10,495		5,774		5,130		39,663		4,049
Development		3,576		1,451		597		63		5,687		1,793

		21,840		11,946		6,371		5,193		45,350		5,842
Rehabilitation division		190		172		269		412		1,043		267
Corporate:
Information systems		3,453		8,838		6,152		9,998		28,441		4,146
Other		173		210		73		1,231		1,687		288

	$	39,986	$	38,896	$	33,975	$	32,751	$	145,608	$	22,382

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Condensed Consolidating Statement of Operations

(Unaudited)

(In thousands)


	First Quarter 2010
	Hospital division			Nursing center division			Rehabilitation division			Corporate			Eliminations			Consolidated
Revenues	$	507,062		$	539,321		$	120,144		$	–		$	(76,690	)	$	1,089,837

Salaries, wages and benefits		227,641			273,242			100,512			25,780			–			627,175
Supplies		57,934			27,128			687			137			–			85,886
Rent		37,415			49,392			1,475			37			–			88,319
Other operating expenses		126,454			168,702			4,310			11,428			(76,690	)		234,204
Other income		–			–			–			(3,084	)		–			(3,084	)
Depreciation and amortization		13,014			12,113			585			5,409			–			31,121
Interest expense		2			31			–			1,274			–			1,307
Investment income		(1	)		(18	)		(1	)		(857	)		–			(877	)

		462,459			530,590			107,568			40,124			(76,690	)		1,064,051

Income from continuing operations before income taxes	$	44,603		$	8,731		$	12,576		$	(40,124	)	$	–			25,786

Provision for income taxes																	10,631

Income from continuing operations																$	15,155

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Condensed Consolidating Statement of Operations (Continued)

(Unaudited)

(In thousands)


	First Quarter 2009
	Hospital division			Nursing center division			Rehabilitation division			Corporate			Eliminations			Consolidated
Revenues	$	492,509		$	529,942		$	117,647		$	–		$	(70,624	)	$	1,069,474

Salaries, wages and benefits		218,245			272,482			98,196			26,295			–			615,218
Supplies		54,145			25,552			487			152			–			80,336
Rent		36,445			47,274			1,451			31			–			85,201
Other operating expenses		119,220			156,334			3,511			11,964			(70,624	)		220,405
Other income		–			–			–			(2,872	)		–			(2,872	)
Depreciation and amortization		12,512			11,685			547			5,746			–			30,490
Interest expense		–			40			–			2,438			–			2,478
Investment income		(7	)		(58	)		(2	)		(1,408	)		–			(1,475	)

		440,560			513,309			104,190			42,346			(70,624	)		1,029,781

Income from continuing operations before income taxes	$	51,949		$	16,633		$	13,457		$	(42,346	)	$	–			39,693

Provision for income taxes																	16,352

Income from continuing operations																$	23,341

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Operating Data

(Unaudited)


	2009 Quarters								Year		First Quarter 2010
	First		Second		Third		Fourth		Year		First Quarter 2010
Hospital data:
End of period data:
Number of hospitals		82		82		82		83				83
Number of licensed beds		6,520		6,520		6,520		6,580				6,580

Revenue mix %:
Medicare		56		55		55		56		55		56
Medicaid		10		10		11		9		10		9
Medicare Advantage		10		11		9		9		10		10
Commercial insurance and other		24		24		25		26		25		25

Admissions:
Medicare		7,421		7,117		6,875		7,283		28,696		7,432
Medicaid		1,052		1,053		1,165		984		4,254		997
Medicare Advantage		1,094		1,091		926		919		4,030		1,129
Commercial insurance and other		1,921		1,869		1,969		2,280		8,039		2,262

		11,488		11,130		10,935		11,466		45,019		11,820

Admissions mix %:
Medicare		65		64		63		63		64		63
Medicaid		9		9		11		9		9		8
Medicare Advantage		9		10		8		8		9		10
Commercial insurance and other		17		17		18		20		18		19

Patient days:
Medicare		197,377		197,203		188,712		196,067		779,359		202,882
Medicaid		50,868		50,485		53,585		47,352		202,290		47,813
Medicare Advantage		35,229		36,806		29,912		30,315		132,262		34,524
Commercial insurance and other		65,509		61,960		65,717		74,253		267,439		75,483

		348,983		346,454		337,926		347,987		1,381,350		360,702

Average length of stay:
Medicare		26.6		27.7		27.4		26.9		27.2		27.3
Medicaid		48.4		47.9		46.0		48.1		47.6		48.0
Medicare Advantage		32.2		33.7		32.3		33.0		32.8		30.6
Commercial insurance and other		34.1		33.2		33.4		32.6		33.3		33.4
Weighted average		30.4		31.1		30.9		30.3		30.7		30.5

Revenues per admission:
Medicare	$	37,262	$	37,748	$	37,105	$	37,620	$	37,436	$	38,078
Medicaid		45,160		45,759		43,640		43,314		44,465		45,738
Medicare Advantage		46,387		46,950		47,597		47,807		47,141		45,187
Commercial insurance and other		61,286		63,716		59,957		54,662		59,647		56,344
Weighted average		42,872		43,769		42,805		42,314		42,935		42,899

Revenues per patient day:
Medicare	$	1,401	$	1,362	$	1,352	$	1,397	$	1,378	$	1,395
Medicaid		934		954		949		900		935		954
Medicare Advantage		1,440		1,392		1,473		1,449		1,436		1,478
Commercial insurance and other		1,797		1,922		1,796		1,678		1,793		1,688
Weighted average		1,411		1,406		1,385		1,394		1,399		1,406

Medicare case mix index (discharged patients only)		1.22		1.23		1.19		1.18		1.21		1.21

Average daily census		3,878		3,807		3,673		3,782		3,785		4,008
Occupancy %		66.0		64.7		63.6		64.3		64.7		68.2

Annualized employee turnover %		21.3		22.1		22.8		22.1				21.8

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)


	2009 Quarters								Year		First Quarter 2010
	First		Second		Third		Fourth		Year		First Quarter 2010
Nursing center data:
End of period data:
Number of nursing centers:
Owned or leased		218		218		218		218				218
Managed		4		4		4		4				4

		222		222		222		222				222

Number of licensed beds:
Owned or leased		27,138		27,138		27,086		27,038				27,038
Managed		485		485		485		485				485

		27,623		27,623		27,571		27,523				27,523

Revenue mix %:
Medicare		35		35		34		33		34		35
Medicaid		41		41		42		43		42		41
Medicare Advantage		6		6		6		6		6		6
Private and other		18		18		18		18		18		18

Patient days (excludes managed facilities):
Medicare		374,853		375,140		360,009		353,443		1,463,445		369,102
Medicaid		1,326,654		1,323,157		1,357,596		1,368,198		5,375,605		1,312,517
Medicare Advantage		80,352		82,652		84,322		86,449		333,775		87,692
Private and other		403,320		415,510		415,467		403,166		1,637,463		397,550

		2,185,179		2,196,459		2,217,394		2,211,256		8,810,288		2,166,861

Patient day mix %:
Medicare		17		17		16		16		17		17
Medicaid		61		60		61		62		61		61
Medicare Advantage		4		4		4		4		4		4
Private and other		18		19		19		18		18		18

Revenues per patient day:
Medicare Part A	$	457	$	459	$	464	$	466	$	461	$	470
Total Medicare (including Part B)		497		500		508		510		503		513
Medicaid		165		167		166		170		167		168
Medicare Advantage		380		392		398		405		394		398
Private and other		235		232		234		239		235		238
Weighted average		243		245		243		246		244		249

Average daily census		24,280		24,137		24,102		24,035		24,138		24,076
Admissions (excludes managed facilities)		18,166		18,456		17,803		18,376		72,801		19,026
Occupancy %		89.3		88.9		88.9		88.9		89.0		89.0
Medicare average length of stay		34.8		35.5		36.3		35.1		35.4		33.7

Annualized employee turnover %		37.9		39.9		40.2		38.9				36.7

Rehabilitation data:
Revenue mix %:
Company-operated		61		60		59		64		61		64
Non-affiliated		39		40		41		36		39		36

Sites of service (at end of period)		661		659		660		622				619
Revenue per site	$	177,984	$	182,775	$	185,797	$	183,789	$	730,345	$	194,094

Therapist productivity %		84.8		84.8		83.5		83.8		84.2		83.8

Annualized employee turnover %		10.9		11.6		13.1		12.8				12.6

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion of the Company’s exposure to market risk contains “forward-looking statements” that involve risks and uncertainties. Given the unpredictability of interest rates as well as other factors, actual results could differ materially from those projected in such forward-looking information.

The Company’s exposure to market risk relates to changes in the prime rate, federal funds rate and LIBOR which affect the interest paid on certain borrowings.

The following table provides information about the Company’s financial instruments that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted average interest rates by expected maturity date.

Interest Rate Sensitivity

Principal Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)


	Expected maturities																				Fair value 3/31/10
	2010			2011			2012			2013			2014			Thereafter			Total		Fair value 3/31/10
Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate	$	65		$	91		$	96		$	102		$	109		$	249		$	712	$	694	(a)
Average interest rate		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%
Variable rate (b)	$	–		$	–		$	196,000		$	–		$	–		$	–		$	196,000	$	196,000

(a)	Calculated based upon the net present value of future principal and interest payments using a discount rate of 6%.

(b)

Interest on borrowings under the Company’s revolving credit facility is payable, at the Company’s option, at (1) LIBOR plus an applicable margin ranging from 1.25% to 2.00% or (2) the applicable margin ranging from 0.25% to 1.00% plus the higher of the prime rate or 0.5% over the federal funds rate. The applicable margin is based upon the Company’s average daily excess availability as defined in the Company’s revolving credit facility.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures and Changes in Internal Control Over Financial Reporting

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of March 31, 2010, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended March 31, 2010, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings

The Company is a party to various legal actions (some of which are not insured), and regulatory and other government investigations in the ordinary course of business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory and other government investigations. These legal actions and investigations could potentially subject the Company to sanctions, damages, recoupments, fines and other penalties. The DOJ, 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.

Item 6.

Exhibits



10.1		Termination of Lease and Notice of Lease dated as of January 22, 2010 by and among HCRI Massachusetts Properties Trust, HCRI Massachusetts Properties Trust II and Kindred Hospitals East, L.L.C.

10.2		Termination of Lease and Notice of Lease dated as of January 22, 2010 by and among HCRI Massachusetts Properties Trust, HCRI Massachusetts Properties Trust II, Kindred Hospitals East, L.L.C. and KND Real Estate 26, L.L.C.

10.3		Employment Agreement dated as of March 30, 2010 by and between Kindred Healthcare Operating, Inc. and Benjamin A. Breier. Exhibit 10.1 to the Company’s Current Report on Form 8-K dated March 30, 2010 (Comm. File No. 001-14057) is hereby incorporated by reference.

31		Rule 13a-14(a)/15d-14(a) Certifications.

32		Section 1350 Certifications.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		KINDRED HEALTHCARE, INC.

Date: May 7, 2010		/s/ PAUL J. DIAZ
		Paul J. Diaz
		President and Chief Executive Officer

Date: May 7, 2010		/s/ RICHARD A. LECHLEITER
		Richard A. Lechleiter
		Executive Vice President and Chief Financial Officer