Genesis Healthcare Cp (GHCI) - Description of business


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Company Description
” concerning contract renewals, government regulations and the Medicare and Medicaid programs, reimbursement for services provided, demographic trends, strategy, competitive strengths, corporate integrity programs, insurance coverage and insurance reserves, environmental matters and legal proceedings;
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Statements contained in “Properties” concerning our anticipated level of capital expenditures in fiscal 2007;



 

statements contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the notes to our consolidated financial statements, such as demographic trends and our ability to take advantage of such demographic trends; the expected impact to our effective tax rate if certain credits are reinstated; our ability to meet our working capital requirements, debt service, and future cash needs; capital sources; estimated levels in fiscal 2007 of capital expenditures, stock-based compensation and expenses for asset retirement obligations; debt and lease requirements; our potential extension of credit to our joint venture partners; the expected changes in and effects of government legislation, regulation and funding on our business; estimates in our pro forma financial data and critical accounting policies, including the adequacy of our allowance for doubtful accounts, any anticipated impact of long-lived asset impairments and our ability to provide for outstanding losses and loss expenses for self-insured programs and legal proceedings; and the estimated impact of new accounting pronouncements upon their adoption;



 

statements contained in “Quantitative and Qualitative Disclosures About Market Risk;” and



 

statements contained in “Legal Proceedings” regarding the effects of litigation.



The forward-looking statements involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond our control. You are cautioned that these statements are not guarantees of future performance and that actual results and trends in the future may differ materially.

Factors that could cause actual results to differ materially include, but are not limited to, the following:

 

changes in the reimbursement rates or methods of payment from Medicare and Medicaid, including those described herein, or the implementation of other measures to reduce the reimbursement for our services;



 

the expiration of enactments providing for additional governmental funding;



 

the impact of federal and state regulations;



 

changes in case mix, payor mix and payment methodologies;



 

competition in our businesses;



 

the capital intensive nature of our inpatient services segment and the need for extensive capital expenditures in order to modernize and improve our physical infrastructure;



 

an increase in insurance costs and potential liability for losses not covered by, or in excess of, our insurance;



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competition for, and availability of, qualified staff in the healthcare industry, and risks of potential labor strikes;



 

our ability to control operating costs and generate sufficient cash flow to meet operational and financial requirements;



 

our ability, and the ability of our subsidiary guarantors, to fulfill debt obligations;



 

our covenants and restrictions contained in financing agreements which limit our discretion in the operation of our business and financing activities;



 

the economic condition of, or changes in the laws affecting, our business in those markets in which we operate;



 

our ability to realize tax benefits relating to our estimated net operating loss carryforwards;



 

the increasing cost of being a publicly owned company and our ability to provide reasonable assurance of the effectiveness of our internal controls over financial reporting;



 

the impact of new accounting pronouncements;



 

the impact of implementing new information systems;



 

the impact of acquisitions, and our ability to integrate acquired businesses, on our operations and finances;



 

our charter documents and the Pennsylvania Business Corporation Law of 1988, as amended, which could delay or prevent a change of control;



th e ability to implement and achieve certain performance improvement objectives in our rehabilitation therapy services segment;



 

the difficulty in evaluating certain of our financial information due to the spin-off;



 

federal income tax liabilities and indemnification obligations related to the spin-off; and



 

acts of God or public authorities, war, civil unrest, terrorism, fire, floods, earthquakes and other matters beyond our control.



In addition to these factors and any risks and uncertainties specifically identified in the text surrounding forward-looking statements, any statements in this report or the reports and other documents filed by us with the SEC that warn of risks or uncertainties associated with future results, events or circumstances also identify factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements.

We do not undertake any obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as may be required under applicable securities law.

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PART I

ITEM 1:      BUSINESS

Description of Our Business

Genesis HealthCare Corporation was incorporated in May 2003 as a Pennsylvania corporation. On December 1, 2003, NCI completed the distribution (the spin-off) of our common stock. Our common stock began trading publicly on the NASDAQ Global Market System on December 2, 2003 under the symbol “GHCI.”

We are one of the largest providers of healthcare and support services to the elderly in the United States. Within our network of geographically concentrated facilities, we offer services focusing on the primary medical, physical and behavioral issues facing the medically complex elderly population.

Our business is comprised of two primary business segments: inpatient services and rehabilitation therapy services. These segments are supported by complementary service capabilities.

Approximately 90% of our net revenues are generated through inpatient services. Our inpatient services are offered through a network of skilled nursing and assisted living centers primarily located in the eastern United States. We currently own, lease, manage or jointly own 210 eldercare facilities, consisting of 176 skilled nursing facilities, 26 assisted living facilities and 8 transitional care units collectively having 25,800 beds.

Our rehabilitation therapy services business, which represents approximately 8% of our net revenues, provides an extensive range of rehabilitation therapy services to the elderly, including speech pathology, physical therapy and occupational therapy principally in our inpatient market concentrations.

We also provide other complementary healthcare services, the revenues for which are included in all other services revenues in our segment financial information.

Inpatient Services Segment

Our eldercare centers are located in the following 12 states: Connecticut, Delaware, Maryland, Massachusetts, New Hampshire, New Jersey, North Carolina, Pennsylvania, Rhode Island, Vermont, Virginia and West Virginia. Approximately 80% of our beds are concentrated in the states of Pennsylvania, New Jersey, Maryland, Massachusetts and West Virginia.

Through our physicians, nurses, therapists and other members of our interdisciplinary medical care team, we apply a comprehensive approach to the complex needs facing the elderly, which we believe has resulted in above industry average occupancy levels and an enhanced level of Medicare, insurance and private paying patients. We receive higher rates of reimbursement from Medicare and private paying patients. For the twelve months ended September 30, 2006, the average occupancy level in our inpatient facilities was approximately 91%, and approximately 48% of our net revenues were from Medicare, insurance and private paying patients.

We employ physicians, physician assistants and nurse practitioners who are primarily involved in providing medical direction and/or direct patient care at each center. The emphasis on physician leadership is a strength that differentiates us from many other long-term care companies. In addition to physician executives, nursing center medical directors are administratively and clinically accountable for clinical care and quality improvement. The nursing center medical directors are dually accountable to the administrator and the physician executive. This medical staff structure allows for significant involvement of physicians at all levels of the organization thus ensuring that an emphasis on quality care is maintained. Directed by a senior nurse executive, we maintain a corporate quality improvement program to enhance and improve continuously the care provided in each center. In addition to clinical care, our centers provide our customers with dietary, housekeeping and laundry services, as well as social and recreational services.

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Our assisted living centers’ staff provides assistance with general activities of living such as medication management, bathing, dressing and meal preparation. Our assisted living centers offer a variety of daily social and therapeutic activities.

We have established and actively market programs for the elderly and other patients who require more complex levels of medical care. We focus on clinically complex elderly patients who need extensive therapies and treatments to stabilize health problems before returning home or transitioning into a permanent long-term care setting. Over 89% of patients come to our centers directly from an acute care hospital stay and have five or more health problems that affect their ability to carry out everyday activities. Half of the patients who enter our centers for post-acute care are discharged within 24 days while the average stay for a long-term care patient is 158 days. Private insurance companies and other third-party payors, including certain state Medicaid programs, have recognized that treating patients requiring complex medical care in centers such as those we operate is a cost-effective alternative to treatment in an acute care or rehabilitation hospital. We provide high acuity care at rates that we believe are substantially below the rates typically charged by acute care hospitals for comparable services.

The following table reflects our average number of beds in service and our average occupancy levels for the periods presented:

 

 

Year Ended September 30,

 

 

 

2006

 

2005

 

2004

 

Average Beds in Service:

 

 

 

 

 

 

 

Owned and leased facilities, including consolidated VIE’s

 

20,895

 

21,167

 

21,621

 

Managed and jointly-owned facilities, excluding consolidated VIE’s

 

4,983

 

5,482

 

4,870

 

Occupancy Based on Average Beds in Service:

 

 

 

 

 

 

 

Owned and leased facilities, including consolidated VIE’s

 

91

%

90

%

91

%



The following table reflects the payor mix of inpatient services revenues for the periods presented, and has been adjusted to exclude discontinued operations:

 

 

Year Ended September 30,

 

 

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

Medicaid

52

%

54

%

51

%

Medicare

 

29

%

27

%

29

%

Private pay and other

 

19

%

19

%

20

%

 

 

100

%

100

%

100

%



See “— Revenue Sources” and “— Government Regulation.”

Rehabilitation Therapy Services Segment

We provide an extensive range of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy in all of our inpatient market concentrations. These services are provided by

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approximately 4,900 licensed rehabilitation therapists and assistants employed or contracted by us at substantially all of the eldercare centers we operate, as well as by contract to healthcare facilities operated by others and through our 13 certified outpatient rehabilitation agencies. For the fiscal year ended September 30, 2006, approximately 61% of our rehabilitation therapy services revenue was generated under contracts with unrelated third parties.

Other Services

We provide management services to 34 independently and jointly owned eldercare centers and 8 transitional care units, which are the eldercare centers jointly owned and/or managed referred to in “ — Inpatient Services Segment” above, pursuant to management agreements that provide generally for the day-to-day responsibility for the operation and management of the centers. In turn, we receive management fees, depending on the agreement, computed as an overall fixed fee, a fixed fee per customer, a percentage of net revenues of the center plus an incentive fee, or a percentage of gross revenues of the center with some incentive clauses. The management agreements, including renewal option periods, are scheduled to terminate between 2006 and 2024, 23 of which are scheduled to terminate within the next twelve months. We expect to be able to renew a majority of the terminating contracts.

We also provide an array of other specialty medical services in certain parts of our eldercare network, including respiratory health services, physician services, hospitality services, staffing services and other related services.

Our Industry

The aging of the population and increased life expectancies are the primary driving forces behind the growth of the nursing and assisted living facilities market in the United States. According to the United States Census Bureau, in 2000, there were approximately 35 million Americans aged 65 or older, comprising approximately 13% of the total United States population. The number of Americans aged 65 or older is expected to climb to approximately 40 million by 2010 and to approximately 54 million by 2020. There are approximately 16,500 nursing homes with approximately 1.8 million total beds certified to provide Medicare and/or Medicaid services in the United States. On average, approximately 3.5 million people live in nursing homes during the course of a year. We believe that these demographic trends will support a growing demand for the services provided by nursing and assisted living facility operators that deliver the most efficient, responsive, cost-effective and highest quality eldercare services to support a full range of needs and acuity levels. We also believe that these demographic considerations will place increased pressure on healthcare providers to find innovative, efficient means of delivering healthcare services.

See “— Revenue Sources.”

Our Strategy

Our industry continues to experience significant change, as patients and payors seek higher quality health care while at the same time containing the overall costs of the healthcare system. We are an active participant in this evolutionary change in healthcare delivery, as we continue to provide more complex care to a higher acuity patient population at a lower cost setting. Our service model continues to increase our capabilities for meeting both the healthcare and personal needs of the short-stay patient requiring rehabilitation and recovery under skilled nursing care after an acute care episode. Additionally, we continue to improve both the appearance and amenities of our facilities which, coupled with our strength in clinical care, allows us to compete more effectively with market alternatives for residential services.

Implementation of our strategy requires us to:

Focus on quality care. We are focused on qualitative and quantitative clinical performance measures in order to enhance and improve continuously the care provided in our facilities. We continually seek to enhance our reputation for providing clinical capabilities and outcomes in patient care and rehabilitation. Among other things, we are increasing our professional nursing mix and are integrating nurse practitioners into our clinical model, we have incentivized our management team to improve clinical performance, and we employ physician executives who are administratively and clinically accountable for the quality of care.

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Focus on developing clinical specialties . We continue to develop our strong relationships with hospitals and physicians in our local markets, who increasingly seek skilled nursing facilities with demonstrated capabilities to accept and care for complex patients following an acute hospital stay. The market has also sought qualified and experienced providers of care for individuals with Alzheimer’s disease and other forms of dementia. We have developed and effectively implemented branded programs in certain markets and facilities to provide rehabilitation to expedite recovery and return to home for orthopedic and other disciplines after surgery, to care for those on dialysis or ventilator, and those who suffer from dementia, while assuring that core clinical services are provided at every facility.

Focus on developing our resources . We are focused on the improvement and development of both our physical plant as well as the implementation of information systems to grow revenue and better monitor and manage our business. These efforts include facility modernization to improve occupancy and quality mix, the development of an integrated clinical, operational and financial system to improve administrative efficiency and operational performance, and the implementation of tools for more effective management of purchasing and nursing staff scheduling to reduce the use of premium staffing, including temporary agency services and overtime.

Strengthen our presence in existing markets. Our significant presence in most of our markets has enhanced our specialty development capabilities, as facilities develop complementary capabilities and enhance our overall marketplace presence and reputation. Additionally, we seek to expand our presence in certain of our core markets through selective acquisitions of newer facilities which present growth opportunities through strategic as well as operational improvement. Expansion of existing facility clusters and creation of new clusters in local markets will allow us to leverage existing operations and to achieve greater operating efficiencies.

Our Competitive Strengths

We believe the following competitive strengths will enable us to continue to improve our profitability and cash flows:

Geographically focused network. We are regionally focused, and within our markets, we have developed strong referral networks with hospitals, physicians and discharge planners. Through these relationships, we have demonstrated the flexibility to design and customize our systems and services to meet the specific needs within our local markets. By concentrating our operations in specific and contiguous markets, with strong demographic trends for growth in our service population, we have achieved lower operating costs through greater purchasing power and operating efficiencies.

High acuity capabilities. We focus on clinically complex elderly patients who require extensive therapies and treatments to stabilize health problems before returning home or transitioning into a permanent long-term care setting. Over 89% of our patients come to our facilities directly from an acute care hospital and require assistance to perform daily activities. Private insurance companies and other third-party payors have recognized that treating patients requiring complex care in eldercare facilities, such as those we operate, is a cost-effective alternative to treatment in an acute care or rehabilitation hospital.

High quality eldercare services. We believe we have a reputation as a leading provider of high quality eldercare services. As a result, we believe we have excellent relationships with hospitals and discharge planners, our primary referral sources. We maintain a corporate compliance program to monitor and collect regulatory compliance data and to enhance and improve continuously the care provided in our facilities. We believe we have good relations with the state and federal agencies who regulate and provide oversight of our industry, and work effectively with them on both operational and strategic issues.

Significant facility ownership. We own rather than lease a majority of our eldercare facilities, unlike a number of our competitors. Excluding facilities held for sale, we own 137 facilities with 16,665 beds, which represents approximately 80% of the total number of beds we own or lease. We believe that owning properties increases our operating and financial flexibility by enabling us to control more directly our occupancy costs, divest facilities and exit markets at our discretion and refurbish or remodel facilities in order to satisfy market demand.

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Admissions and discharge planning. We believe we have developed a successful model to process admissions through the automated tracking of bed availability and specialty care capacity at each of our facilities. Our model utilizes a multifaceted approach including clinical care coordinators and toll-free phone lines to assist our marketing staff and direct referral sources. These efforts, we believe, have contributed to our achieving higher occupancy levels as compared to industry averages. For the twelve month period ended September 30, 2006, our occupancy level was approximately 91% compared to the industry median occupancy level of approximately 89%, as reported in the June 2006 Nursing Facility State Occupancy Rate and Median Facility Occupancy Rate for Certified Beds CMS OSCAR Data Current Surveys issued by the American Health Care Association.

Stable and experienced management team. While we operate in a healthcare sector which has historically experienced significant volatility due to a constantly changing reimbursement environment and varying ownership structures, our management team has remained substantially intact, with many years of operating experience working together. Our management team’s collective experience allows us to address effectively the continuing challenges facing the industry while providing the stability necessary to achieve meaningful operational and financial improvements.

Revenue Sources

We receive revenues from Medicare, Medicaid, private insurance, self-pay residents and other third-party payors. Our rehabilitation therapy services and other service related businesses also receive revenues from independent long-term care facilities that utilize our services.

The sources and amounts of our patient revenues will be determined by a number of factors, including licensed bed capacity and occupancy rates of our centers, the mix of patients and the rates of reimbursement among payors. Likewise, therapy services provided by our rehabilitation therapy services business will vary based upon payor and payment methodologies. Changes in the case mix of the patients as well as payor mix among private pay, Medicare and Medicaid will significantly affect our profitability.

Medicare and Medicaid

The Health Insurance for Aged and Disabled Act (Title XVIII of the Social Security Act), known as “Medicare,” has made available to nearly every United States citizen 65 years of age and older a broad program of health insurance designed to help the nation’s elderly meet hospital and other healthcare costs. The Medicare program consists of four parts: (i) Medicare Part A, which covers, among other things, inpatient hospital, skilled long-term care, home healthcare and certain other types of healthcare services; (ii) Medicare Part B, which covers physicians’ services, outpatient services, certain prescription drugs, and certain items and services provided by medical suppliers; (iii) a managed care option for beneficiaries who are entitled to Medicare Part A and enrolled in Medicare Part B, known as Medicare Advantage or Medicare Part C and (iv) a Medicare Part D benefit that became effective January 1, 2006 covering prescription drugs. The Medicare program is administered by the Centers for Medicare and Medicaid Services (CMS).

Medicaid (Title XIX of the Social Security Act) is a federal-state matching program, whereby the federal government, under a need based formula, matches funds provided by the participating states for medical assistance to “medically indigent” persons. The programs are administered by the applicable state welfare or social service agencies under federal rules. Although Medicaid programs vary from state to state, traditionally they have provided for the payment of certain expenses, up to established limits, at rates determined in accordance with each state’s regulations. For skilled nursing centers, most states pay prospective rates, and have some form of acuity adjustment. In addition to facility based services, most states cover an array of medical ancillary services. Payment methodologies for these services vary based upon state preferences and practices permitted under federal rules.

State Medicaid programs generally have long-established programs for reimbursement which have been revised and refined over time. Any future changes in such reimbursement programs or in regulations relating thereto, such as reductions in the allowable reimbursement levels or the timing of processing of payments, could adversely affect our business, results of operations, financial position and cash flows. The annual increase in the federally matched

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funds could vary from state to state based on a variety of factors. Additionally, any shift from Medicaid to state designated managed care plans could adversely affect our business, results of operations, financial position and cash flows.

Medicare and Medicaid are subject to statutory and regulatory changes, retroactive rate adjustments, administrative rulings and government funding restrictions, all of which may materially affect the timing and/or levels of payments to us for our services.

We are subject to periodic audits by the Medicare and Medicaid programs, which have various rights and remedies against us if they assert that we have overcharged the programs or failed to comply with program requirements. These rights and remedies may include requiring the repayment of any amounts alleged to be overpayments or in violation of program requirements, or making deductions from future amounts due to us. Such programs may also impose fines, criminal penalties or program exclusions. Other third-party payor sources also reserve rights to conduct audits and make monetary adjustments in connection with or inclusive of auditing activities.

Laws Affecting Medicare Revenues

Participating skilled nursing facilities are reimbursed under a prospective payment system for inpatient Medicare covered services. The prospective payment system commenced with a facility’s first cost reporting period beginning on or after July 1, 1998 and phased in over a three-year period following passage of the Balanced Budget Act in 1997. Under the prospective payment system, or PPS, skilled nursing facilities are paid a predetermined amount per patient, per day or “per diem” based on the anticipated costs of treating patients. The per diem rate is determined by classifying each patient into one of 53 Resource Utilization Groups (RUGs) based on the nature of the patient’s condition and care needs. Prior to January 1, 2006, there were 44 RUGs categories. There is a separate per diem rate for each of the RUG classifications. The per diem rate also covers rehabilitation and certain ancillary services.

As implemented by CMS, the prospective payment system initially had an adverse impact on the Medicare revenues of many skilled nursing facilities. In 1999 and 2000, refinements were made to the Balanced Budget Act that restored substantial Medicare funding to skilled nursing facilities that was originally eliminated in the initial implementation of the prospective payment system.

A number of refinements made in 1999 and 2000 providing additional funding for Medicare participating skilled nursing facilities expired on September 30, 2002, resulting in an approximate 10% reduction in the rates paid to us for providing services to Medicare patients. We refer to the expiration of the additional funding as the “skilled nursing facility Medicare cliff.” Effective October 1, 2002, Medicare rates adjusted for the skilled nursing facility Medicare cliff were increased by a 2.6% annual inflation update factor. For us, the net impact of the 10% rate reduction, offset by the annual inflation update factor, adversely impacted fiscal 2003 revenue and EBITDA approximately $24.8 million and net income approximately $15.1 million.

On July 28, 2005, CMS released the final fiscal 2006 skilled nursing facility prospective payment rules, including refinement to the RUG classification system (RUGs refinement). Effective January 1, 2006, the rules established nine new payment classifications, altered the case-mix weights for the remaining 44 RUG payment categories and adjusted upward the nursing component of most RUG payment categories. Excluding an additional 3.1% annual inflation factor, and after considering the distribution of our Medicare patient population under the new system, we previously expected RUGs refinement to reduce our Medicare payment rates approximately $9 per patient day beginning January 1, 2006. However, as a result of continuing shifts in the mix of our Medicare admissions toward higher acuity cases, and a higher percentage of patients qualifying for the new nine RUG categories than initially projected, our average Medicare payment rate increased approximately $5 per patient following the January 1, 2006 implementation of RUGs refinement.

On July 31, 2006, CMS released the final fiscal 2007 skilled nursing facility prospective payment rules effective October 1, 2006. The rate notice confirmed that the underlying fiscal 2007 rate methodology would not change, that per patient day payments would increase by a 3.1% annual inflation update factor and that a phased

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transition to revised labor market areas would occur. This latter change, a revision from standard metropolitan statistical areas to core-based statistical areas, is estimated to have a 0.4% negative impact on our fiscal 2007 Medicare payment rates, yielding net Medicare payment rate growth of approximately 2.7% effective October 1, 2006.

In February 2006, the Deficit Reduction Act of 2005 (DRA) was signed into law. Under the DRA, effective for cost report years beginning on or after October 1, 2005, the amount that Medicare reimburses skilled nursing facilities and other non-hospital providers for bad debts arising from uncollectible accounts receivable with non-government payors was reduced by 30%. The Congressional decision to differentiate between governmental and non-governmental bad debts minimizes the impact to us of this component of the DRA because most of our uncollectible Medicare coinsurance and deductibles are billed to state Medicaid programs. The impact of the final rule on our fiscal year 2006 EBITDA and net income was not material.

Included in the DRA is a provision that directed CMS to develop an exceptions process for medically necessary physical, speech and occupational therapy services for beneficiaries that exceed a $1,740 annual reimbursement cap. The provision establishes a 10-day exceptions request process. In connection with the DRA, on February 13, 2006 CMS issued three program transmittals instructing its contractors on implementing the exceptions process. Under the instructions, a two-tier process is established providing for automatic exceptions based upon diagnoses and patient condition, and a manual exceptions process for other claims that are not automatically exempt. These changes were retroactive to January 1, 2006. While initially there were delays in processing claims, most of the implementation issues were resolved. Generally, most nursing home therapy claims fell within the automatic exceptions group, and, therefore, we did not experience a disruption of services. However, the delayed communication and implementation of the exceptions process negatively impacted Medicare Part B therapy utilization during the three months ended March 31, 2006. There continues to be uncertainty regarding how the Medicare Part B therapy cap will be addressed in future reimbursement policy. CMS recently announced the proposed physician fee schedules and the implementation of the therapy caps effective January 1, 2007. The proposed rules suggest the therapy caps will increase from the current level of $1,740 to $1,780. On December 9, 2006, Congress passed legislation extending the existing exceptions process through December 31, 2007, removing a significant financial threat to our rehabilitation therapy business for the short term. No assurances can be made or given that Congress will extend the exceptions process beyond calendar year 2007, or enact other revisions.

By law, Medicare reimbursement for physician and non-physician professional services (including Medicare Part B physical therapy, speech pathology and occupational therapy services) is based on fee schedules. On August 22, 2006, CMS published in the Federal Register the proposed calendar year 2007 physician and non-physician fee schedule rules. In an accompanying press statement, CMS indicated that it anticipated calendar year 2007 physician fee schedules would be reduced by 5.1% effective January 1, 2007. On December 9, 2006, Congress passed legislation that negated the rate reduction and established a 1.5% bonus incentive to providers who report on quality measures in 2007.

Effective January 1, 2006, under the Medicare Modernization Act (MMA), Medicaid coverage of prescription drugs for Medicare beneficiaries who are also eligible for Medicaid have been shifted to the Medicare program (Medicare Part D). These residents are referred to as “dual eligibles.” This change has affected a significant percentage of residents in our nursing facilities. The final regulations and subsequent sub-regulatory guidance specifically require the new prescription drug plans and Medicare Advantage Plans that offer prescription drug coverage to provide convenient access to long-term care pharmacies and to offer standard contracts to all long-term care pharmacies within the plans’ service areas that meet performance standards specified by CMS. Currently, under contract, Omnicare, Inc., through its wholly owned subsidiary, provides services required for our residents. Under Medicare Part D, reimbursement for such services is provided through such plans as the primary payor for prescription drugs. Effective January 1, 2006, all dual eligible participants were automatically assigned to private prescription drug plans (PDPs). Our long-term care pharmacy provider, Omnicare, Inc. (Omnicare) negotiates its payment terms directly with the PDPs. It is important to note that, in its 2007 Work Plan, the Office of Inspector General stated that it will focus on whether skilled nursing facilities are properly passing through any benefits they receive through contracts with PDPs to their beneficiaries.

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Implementation of the new prescription drug benefit has been challenging; however, our residents have not experienced a significant disruption in receiving their necessary medication. Given the scale of the conversion, and the voluntary nature of Medicare Part D enrollment for other than dually eligible residents, there were complex implementation issues. CMS has been responsive to issues as they have been identified and transmitted. Additionally, in a number of states, special provisions are being considered or implemented under the state Medicaid plans to safeguard individuals automatically enrolled in the new Medicare Part D. Because of concerns that the MMA shifts prescription drug coverage from Medicaid to Medicare through private plans, CMS extended its initial 30-day transition period for those persons transitioning to the Part D program to 90 days. This transition period expired on April 1, 2006. Identifying nursing home residents and communicating formulary and coverage decisions continues to be challenging.

The second open enrollment for the Medicare Part D benefit began in mid-November, 2006 and will run through the end of the calendar year. Automatic plan selection changes may be required for some dual eligibles and low-income subsidized beneficiaries. There continues to be a risk that these changes and related issues with the implementation of Medicare Part D may disrupt pharmacy services to our facilities. Any such change or reduction in long-term care pharmacy services could create additional cost for us, reduce our ability to meet quality standards and disrupt service delivery to our residents.

The MMA covers most prescription drugs, insulin and certain insulin supplies, and approved vaccines. However, certain drugs are excluded from coverage under the new Medicare benefit in Part D, including several drugs that are commonly prescribed for nursing home and other long-term care residents. A number of states announced that they will continue to cover these excluded drugs under their Medicaid plans, however, there remains the possibility that certain physician ordered medications may fall outside of the PDPs’ and/or Medicaid’s formularies thereby requiring us to bear the cost of these drugs.

We have described only certain provisions of the MMA applicable to our business. There may be other provisions of the legislation that may impact our business by decreasing revenues or increasing operational expenses. The impact of this legislation depends upon a variety of factors, including patient mix and the implementing regulations. CMS continues to issue new regulations to implement the MMA, which we are in the process of reviewing. However, because of the broad scope and phased-implementation of key provisions in the MMA, we are not in a position to assess fully its impact on our business.

Laws Affecting Medicaid Revenues

Jointly financed by the federal and state governments, Medicaid is an essential part of the health coverage and financing system nationally and in every state. Combined federal and states’ Medicaid outlays are projected to approximate $347.0 billion in calendar year 2007 and account for nearly 15% of total national healthcare expenditures. Medicaid is the principal purchaser for approximately 45% of nursing home services purchased in the United States. Rapidly increasing Medicaid spending combined with slow state revenue growth and competing budgetary requirements has led many states to institute measures aimed at controlling spending growth. Historically, these budget pressures have translated into reductions in the rate of growth of state Medicaid spending. Budget constraints and other factors have caused some states to curb Medicaid reimbursement to nursing facilities and states may continue to curb or delay payments to nursing facilities in the future. The Balanced Budget Act of 1997 granted the states greater flexibility in establishing Medicaid managed care programs without the need to obtain a federal waiver. Although these waiver programs generally exempted institutional care, including nursing facility services, these programs could ultimately change the Medicaid reimbursement system for long-term care. These changes could include changing reimbursement for pharmacy services from fee-for-service, or payment per procedure or service rendered, to a fixed amount per person utilizing managed care negotiated or capitated rates. In each of the major states where we provide services, we are working with trade groups, consultants and government officials to address responsibly the particular funding issues.

The Benefits Improvement and Protection Act of 2000 enacted a phase out of intergovernmental transfer transactions by states whereby states would artificially inflate the payments to certain public facilities to increase federal matching funds. This action may have had the effect of reducing federal support for a number of state Medicaid programs. The reduced federal payments may impact aggregate available funds requiring states to further contain payments to providers. We operate in several of the states that have experienced or will experience a contraction of federal matching funds.

Medicaid funding is set annually. Most states have completed legislative actions on their fiscal year 2007 state budgets. In light of the changes to Medicaid payment rates, we expect our average Medicaid rate per patient day to increase between approximately 2.5% to 3.5% in our fiscal 2007. As part of the state budget process, a number of states have indicated a desire to divert individuals from placement in nursing homes through an expansion of home and community based services. Most of these efforts are being established under demonstration and waiver authority. To date, these alternative care programs have not significantly impacted nursing home admissions. The DRA also provided states greater flexibility to pursue alternative programs for the delivery of Medicaid services. During recent months, CMS has transmitted guidance letters to state Medicaid directors explaining how states can take advantage of the permissive authority

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provided under the new law to expand coverage for individuals with disabilities, increase access to home and community based services and re-design benefits. Many states are examining these options, weighing the full costs and benefits and the impact on vulnerable populations. We are unable to predict the outcome of these potential changes and their impact on resources necessary to sustain both facility-based and community-based services.

Among the alternative Medicaid funding approaches that states have explored, and in many states implemented, are nursing home provider assessments as tools for leveraging increased Medicaid matching funds. Such initiatives are authorized under the law. Provider assessment plans generate additional federal matching funds to the states for Medicaid reimbursement purposes, and implementation of a provider assessment plan requires approval by CMS in order to qualify for federal matching funds. These plans usually take the form of a bed tax or a quality assessment fee, which is imposed uniformly across classes of providers within the state. In turn, the state generally utilizes the additional federal matching funds generated by the tax to pay increased reimbursement rates to the providers, which often include a repayment of a portion of the provider tax based on the provider’s percentage of Medicaid patients. Nursing home provider assessments have been implemented in nine states where we operate (Massachusetts, West Virginia, Rhode Island, North Carolina, New Hampshire, Vermont, Pennsylvania, New Jersey and Connecticut). Of these nine states, all but one has provider assessment taxes of 6%. See Item 7 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Certain Transactions and Events” for a description of certain of the more material provider assessment programs recently implemented.

The President’s proposed fiscal 2007 federal budget recommended spending reductions for both Medicare and Medicaid. One of the specific changes advanced by the President is a request to phase-down the level of federal matching under Medicaid for provider assessments. Current regulations permit states to receive federally matched funds for up to 6% of aggregate outlays for state Medicaid nursing home services. On December 9, 2006, Congress passed legislation reducing the maximum federal matching under Medicaid provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in funding, which will become effective January 1, 2008, is expected to have an adverse effect on our business, results of operations, financial position and cash flows.

The DRA reduced projected Medicaid outlays by $6.9 billion over 5 years. The President signed this legislation into law on February 8, 2006. Among the provisions of the final legislation were requirements that extend the Medicaid look-back period for asset transfers from three years to five years, a change in the manner that annuities are considered and a change in the date for calculating the look-back penalty from the date of transfer to the date that Medicaid nursing home services are delivered. It is our understanding that CMS will be issuing specific guidance regarding the changes in the asset transfer rules. The DRA also implemented new penalties and rule changes to deter asset transfers individuals make to become Medicaid eligible. These changes may affect the number of people potentially eligible for Medicaid funding. We are unable to predict what impact this provision of the DRA will have on our financial condition, results of operations and cash flows, if any.

Under the DRA, states may be allowed to reduce the benefits provided to certain Medicaid enrollees, which could affect the services that states contract for with us. On July 12, 2006, CMS issued interim final regulations implementing the requirement that Medicaid recipients must be able to show proof of citizenship. We are unable to predict the outcome of these potential changes and their impact on our financial condition, results of operations and cash flows, if any.

Congress, during its fiscal year 2006, scaled back proposed Medicaid reductions through 2006. The final enactment is a compromise establishing a National Medicaid Commission authorized to make specific policy recommendations, while agreeing to defer Medicaid cuts during fiscal year 2006, and providing reconciliation instructions to Congress to make $10.0 billion in aggregate Medicaid reductions during fiscal years 2007 to 2011. Some of the ideas generated by the National Medicaid Commission were incorporated into the DRA. The National Medicaid Commission is mandated to deliver to the Congress a second report by the end of 2006 making specific recommendations for a comprehensive reform of the Medicaid program. These proposals may be considered in the coming 110 th Congress. No predictions can be made as to the ultimate outcome of these reform proposals. We cannot predict the extent of the impact that

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such decrease, if any, in spending by the federal government will have on our business, financial condition, results of operations and cash flows.

The federal government and state governments continue to focus on efforts to curb spending on healthcare programs such as Medicare and Medicaid. Among the ideas receiving active consideration in the Congress are revisions to the federal budget process that would establish an Entitlement Commission empowered to alter future outlays for all entitlement programs including Medicare and Medicaid. It is impossible to predict the outcome of the legislative and regulatory processes. We cannot at this time predict the extent to which these proposals will be adopted or, if adopted and implemented, what effect, if any, such proposals and existing new legislation and regulation will have on us. It is not possible to quantify fully the effect of legislative changes, the interpretation or administration of such legislation or other governmental initiatives on our business and the business of the customers served by our rehabilitation services business. Accordingly, there can be no assurance that the impact of any future healthcare legislation or regulation will not adversely affect our business. There can be no assurance that payments under governmental and private third-party payor programs will be timely, will remain at levels similar to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for reimbursement pursuant to such programs. Our financial condition and results of operations will be affected by the reimbursement process, which in the healthcare industry is complex and can involve lengthy delays between the time that revenue is recognized and the time that reimbursement amounts are settled.

Government Regulation

General

Our business is subject to extensive federal, state and, in some cases, local regulation with respect to, among other things, participation in the Medicare and Medicaid programs, licensure, certification and government reimbursement. For our eldercare centers, these regulations relate, among other things, to the adequacy of physical plant and equipment, qualifications of personnel, standards of care, government reimbursement and operational requirements. Compliance with such regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Failure to comply with current or future regulatory requirements could also result in the imposition of various remedies including fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of the facility or site of service.

Licensure, Certification and Regulation

Our eldercare centers and healthcare services, to the extent required, are currently licensed under applicable law. Our skilled nursing centers and healthcare services, or practitioners providing the services therein, are certified or approved as providers under one or more of the Medicaid and Medicare programs. Generally, assisted living centers are not eligible to be certified under Medicare or Medicaid. Licensing, certification and other applicable standards vary from jurisdiction to jurisdiction and are revised periodically. State and local agencies survey all skilled nursing centers on a regular basis to determine whether such centers are in compliance with governmental operating and health standards and conditions for participation in government sponsored third-party payor programs. We believe that our eldercare centers and other sites of service are in substantial compliance with the various Medicare, Medicaid and state regulatory requirements applicable to them. However, in the ordinary course of our business, we periodically receive notices of deficiencies for failure to comply with conditions of participation in the Medicare and Medicaid programs. We review such notices and take appropriate corrective action. In these cases, we submit our plan to bring the center into compliance with regulations which must be accepted by the reviewing agency prior to its implementation. In some cases, the reviewing federal or state agency may take various adverse actions against a provider, including but not limited to:

 

the imposition of fines;



 

suspension of payments for new or all admissions to the center; and



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in extreme circumstances, exclusion from participation in the Medicare or Medicaid programs and revocation of a center’s or service site’s license.



These actions may adversely affect a provider’s ability to continue to operate, ability to provide certain services, and/or eligibility to participate in the Medicare or Medicaid programs or to receive payments from other payors. Certain of our centers have received notices that, as a result of certain alleged deficiencies, federal and/or state agencies were taking steps to impose remedies. Additionally, actions taken by one center or service site may subject other centers or service sites under common control or ownership to adverse remedies.

All of our skilled nursing centers participate in the Medicare and Medicaid programs. Both initial and continuing qualifications of a skilled nursing center to participate in such programs depend upon many factors including accommodations, equipment, services, patient care, safety, personnel, physical environment, and adequate policies, procedures and controls.

Several states in which we operate, as well as states in which we may wish to operate in the future, have adopted certificate of need or similar laws which generally require that a state agency approve certain acquisitions and determine the need for certain bed additions, new services, and capital expenditures. State approvals are generally issued for a specified maximum expenditure and require implementation of the proposal within a specified period of time. Failure to obtain the necessary state approval can result in:

 

the inability to provide the service;



 

the inability to operate the centers;



 

the inability to complete the acquisition, addition or other change; and



 

the imposition of sanctions or adverse action on the center’s license and adverse reimbursement action.



In recent years it has become more difficult for nursing facilities to maintain licensure and certification. We have experienced and expect to continue to experience increased costs in connection with maintaining our licenses and certifications as well as increased enforcement actions. Failure to provide quality resident care may result in civil and/or criminal fines and penalties.

The operation of our eldercare centers is subject to federal and state laws prohibiting fraud by healthcare providers, including criminal provisions, which prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid, or failing to refund overpayments or improper payments. Violation of these criminal provisions is a felony punishable by imprisonment and/or fines. We may be subject to fines and treble damage claims if we violate the civil provisions that prohibit the knowing filing of a false claim or the knowing use of false statements to obtain payment.

State and federal governments are devoting increased attention and resources to anti-fraud initiatives against healthcare providers. HIPAA and the Balanced Budget Act expanded the penalties for healthcare fraud, including broader provisions for the exclusion of providers from the Medicaid program.

The DRA requires providers who make or receive over $5 million in payments from state health plans to establish policies and procedures detailing the Federal False Claims Act, state false claims acts (if applicable), state Whistleblower Protection Acts, and other state laws related to the reduction of fraud and abuse. This provision may require us to implement state-specific employee training based on these laws. Further, as a result of the DRA, certain states are contemplating the need for their own false claims acts which, if implemented, may impose stricter penalties than the federal statute and regulations.

While we believe that our business practices are consistent with Medicare and Medicaid criteria, those criteria are often vague and subject to change and interpretation. Determinations of alleged fraud could have an adverse effect on our business, results of operations, financial condition and cash flows.

Laws Affecting Billing and Business Practices

We are also subject to federal and state laws that govern financial and other arrangements between healthcare providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between healthcare providers that are designed to induce the referral of patients to, or the recommendation of, a particular provider for medical products and services. These laws include:

 

the “anti-kickback” provisions of the federal Medicare and Medicaid programs, which prohibit, among other things, knowingly and willfully soliciting, receiving, offering or paying any remuneration (including any kickback, bribe or rebate) directly or indirectly in return for or to induce the referral of an individual to a person for the furnishing or arranging for the furnishing of any item or service for which payment may be made in whole or in part under Medicare or Medicaid. Penalties may include imprisonment, fines, exclusion from participation in the Medicare and Medicaid programs and loss of license;



 

the “Stark laws” which prohibit, with limited exceptions, the referral of patients by physicians for certain services, including home health services, physical therapy and occupational therapy, to an entity in which the physician has a financial interest. Penalties may include denial of payment, mandatory refund of prior payment, civil monetary penalties and exclusion from participation in the Medicare and Medicaid programs; and

 

parallel state laws containing similar prohibitions and additional penalties.



In addition, some states restrict certain business relationships between physicians and other providers of healthcare services. Possible sanctions for violation of any of these restrictions or prohibitions include loss of licensure or eligibility to participate in reimbursement programs and/or civil and criminal penalties. These laws vary from state to state, are often complex and have seldom been interpreted by the courts or regulatory agencies. From time to time, we have sought guidance as to the interpretation of these laws; however, there can be no assurance that such laws will ultimately be interpreted in a manner consistent with our practices.

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There have also been a number of recent federal and state legislative and regulatory initiatives concerning reimbursement under the Medicare and Medicaid programs. During the past few years, DHHS has issued a series of voluntary compliance guidelines. These compliance guidelines provide guidance on acceptable practices. Skilled nursing facility services and durable medical equipment, prosthetics, orthotics, supplies, and supplier performance practices have been among the services addressed in these publications. Our Corporate Integrity Program is working to assure that our practices conform to regulatory requirements. DHHS also issues fraud alerts and advisory opinions. For example, directives concerning double billing, home health services, the provision of medical supplies to nursing facilities, and contractual joint venture relationships have been released. It is anticipated that areas addressed by these advisories may come under closer scrutiny by the government. While we have reviewed government guidance, we cannot predict accurately the impact of any such initiatives.

Laws Governing Health Information

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) requires us to comply with standards for the internal use of identifiable health information and the sharing of such information with third parties, such as payors, business associates, residents and patients. Among the standards that DHHS may adopt pursuant to HIPAA are standards for the following: electronic transactions and code sets, unique identifiers for providers, employers, health plans and individuals, security and electronic signatures, privacy, and enforcement.

DHHS has released three rules to date mandating the use and disclosure of new standards with respect to certain healthcare transactions and health information. The first rule establishes uniform standards for common healthcare transactions, including: healthcare claims information; plan eligibility, referral certification and authorization; claims status; plan enrollment and disenrollment; payment and remittance advice; plan premium payments; and coordination of benefits. Second, DHHS has released standards relating to the privacy of individually identifiable health information. These standards not only require our compliance with rules governing the use and disclosure of protected health information, but they also require us to impose those rules, by contract, on any business associate to whom we disclose information. Third, DHHS has released rules governing the security of health information maintained or transmitted in electronic form.

At this time, we believe we are in substantial compliance with the HIPAA requirements that are currently in effect, and we continue to make good faith efforts to carry out compliance. As part of our Corporate Integrity Program, we monitor our compliance with HIPAA. Our compliance and privacy officer is responsible for administering the Corporate Integrity Program which includes HIPAA related compliance. Although HIPAA was ultimately intended to reduce administrative expenses and burdens faced within the healthcare industry, we believe that implementation of this law has resulted in additional costs. Sanctions for failing to comply with HIPAA health information practices provisions include criminal penalties and civil sanctions.

Corporate Integrity Program

Our Corporate Integrity Program was developed to assure that we strive to achieve our goal of providing a high level of care and service in a manner consistent with all applicable state and federal laws and regulations and our internal standard of conduct. This program is intended to allow personnel to prevent, detect and resolve any conduct or action that fails to satisfy all applicable laws and our standard of conduct.

We have a corporate compliance officer responsible for administering the Corporate Integrity Program. The corporate compliance officer, with the approval of the chief executive officer or the board of directors, may use any of our resources to evaluate and resolve compliance issues. The corporate compliance officer reports significant compliance issues to the board of directors.

We established the Corporate Integrity Program hotline, which offers a toll-free number available to all of our employees to report compliance issues, including any alleged privacy violations under HIPAA. All calls reporting alleged non-compliance are logged, investigated, addressed and remedied by appropriate company officials.

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The corporate integrity subcommittee was established to ensure a mechanism exists for us to monitor compliance issues. The corporate integrity subcommittee members are senior members of the finance, human resources, information systems, legal, clinical practices, internal audit and operations departments.

Periodically, we receive information from DHHS regarding individuals and providers that are excluded from participation in Medicare, Medicaid and other federal healthcare programs. Providers may include medical directors, attending physicians, vendors, consultants, therapists and other clinical staff. On a monthly basis, management compares the information provided by DHHS to databases containing providers and individuals doing business with us. Any potential matches are investigated and any necessary corrective action is taken to ensure we cease doing business with that provider and/or individual.

Personnel

We and our industry continue to experience shortages in qualified professional clinical staff. We compete with other healthcare providers and with non-healthcare providers for both professional and non-professional employees. As the demand for these services continually exceeds the supply of available and qualified staff, we and our competitors have been forced to offer more attractive wage and benefit packages to these professionals and to utilize outside contractors for these services at premium rates. Furthermore, the competitive arena for this shrinking labor market has created high turnover among clinical professional staff as many seek to take advantage of the supply of available positions, offering new and more attractive wage and benefit packages. In addition to the wage pressures inherent in this environment, the cost of training new employees amid the high turnover rates has created added pressure on our operating margins. Lastly, increased attention to the quality of care provided in skilled nursing facilities has caused several states to mandate and other states to consider mandating minimum staffing laws that further increase the gap between demand for and supply of qualified individuals and lead to higher labor costs. While we have been able to retain the services of an adequate number of qualified personnel to staff our facilities and sites of service appropriately and maintain our standards of quality care, there can be no assurance that continued shortages will not affect our ability to attract and maintain an adequate staff of qualified healthcare personnel in the future. A lack of qualified personnel at a facility could result in significant increases in labor costs and an increased reliance on expensive temporary agencies at such facility or otherwise adversely affect operations at such facility. Any of these developments could adversely affect our operating results or expansion plans.

In recognition of the competitive nature of clinical staff recruitment and retention, we have implemented the following reward, recognition and professional development programs:

 

An enhanced recruitment department focused on the recruitment of licensed nurses and therapists;



 

A new orientation process which includes extended training and mentoring for clinical employees; and



 

TAP (Tuition Assistance Program), a program designed to provide eligible employees with financial assistance to pursue education and training through defined degree and certified programs of study related to professional career growth. In 2006 and 2007, the majority of the expenditures for this program are for clinical education courses.



Our focus on recruitment and retention led us to consolidate our company-wide recruitment functions in fiscal 2006.

We employ approximately 35,500 people. We have 60 centers that have certified unions that have entered into collective bargaining agreements. The agreements expire at various dates through 2011 and cover approximately 5,300 employees. We believe that our relationship with our employees is generally good.

In fiscal 2004, we entered into an agreement with the Service Employees International Union (SEIU) to provide for one collective bargaining agreement which covers the six centers that were unionized SEIU buildings at that time and under which the SEIU was afforded the opportunity to organize 10 of our non-unionized centers in the State of New Jersey starting in September 2004. Consequently, seven of these non-unionized centers have elected to be

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represented by the SEIU, and one has elected not to be represented by the SEIU. To date, the two remaining centers have not held elections. The agreement emphasizes our positive relationship and common goals shared with the SEIU in the State of New Jersey. The agreement contains a formula which ties increases in employee wages and benefits to increases in the combined per patient day rates of the covered centers and protects us and our employees from lock-outs and/or strikes. The initial term of the agreement will expire in September 2008, with a successor agreement expiring in September 2011.

Marketing

Marketing for eldercare centers is focused at the local level and is conducted primarily by a dedicated regional marketing staff that calls on referral sources such as hospitals, hospital discharge planners, doctors and various community organizations. In addition to those efforts, our marketing objective is to maintain public awareness of our eldercare centers and their capabilities. We take advantage of our regional concentrations in our marketing efforts, where appropriate, through consolidated marketing programs, which benefit more than one center. Toll-free regional phone lines assist the marketing staff and direct referral sources, which speeds admissions by automated tracking of bed availability and specialty care capabilities for each of our centers and all of our affiliated centers.

We market our rehabilitation therapy services and other services through a direct sales force which primarily calls on eldercare centers, hospitals, clinics and home health agencies.

Historically, we operated our core business under the name Genesis ElderCare. Our logos, trademarks and service marks are featured in print advertisements in publications serving the regional markets in which we operate. We are using advertising, including our toll free Care Lines, to promote our brand names in trade, professional and business publications and to promote services directly to consumers.

Competition

We compete with a variety of other companies in providing healthcare services. Certain competing organizations have greater financial and other resources and may be more established in their respective communities than we are. Competing organizations may offer newer or different centers or services than us, including a variety of community based services, and may thereby attract our patients who are either presently residents of our eldercare centers or are otherwise receiving our healthcare services.

We operate eldercare centers in 12 states. In each market, our eldercare centers may compete for patients with rehabilitation hospitals, subacute units of hospitals, skilled or intermediate nursing centers, and personal care or residential centers. Certain of these providers are operated by not-for-profit organizations and similar businesses that can finance capital expenditures on a tax-exempt basis or receive charitable contributions unavailable to us. In competing for patients, a center’s local reputation is of paramount importance. Referrals typically come from acute care hospitals, physicians, religious groups, health maintenance organizations, the patient’s families and friends, and other community organizations.

Members of a patient’s family generally actively participate in the selection of an eldercare center. Competition for medically complex patients is intense among acute care hospitals with long-term care capability, rehabilitation hospitals and other specialty providers and is expected to remain so in the future. Important competitive factors include the reputation in the community, services offered, the appearance of a center, and the cost of services.

We compete in providing rehabilitation therapy services and other healthcare services with a variety of different companies. Generally, this competition is regional and local in nature. The primary competitive factors in these businesses are similar to those in the inpatient services business and include reputation, the cost of services, the quality of clinical services, responsiveness to patient needs, and the ability to provide support in other areas such as third-party reimbursement, information management and patient record-keeping.

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Insurance

The vast majority of our exposure to general and professional liability claims is insured by commercial insurers subject to per claim and aggregate retention limits. The retentions are insured by our wholly owned captive insurance company, Liberty Health Corporation, Ltd. (LHC). Growth in general and professional liability insurance premiums for coverage above our retention has risen in recent years. We have managed this increase by assuming additional retention through LHC and by more proactively managing claims. The vast majority of our exposure to workers’ compensation liability claims prior to May 1, 2006 is fully insured by LHC. After May 1, 2006, we are insured through a loss deposit fund with a large deductible workers’ compensation policy subject to per claim and aggregate retention limits.

We provide several health insurance options to our employees, including self-insured health plans and several fully-insured health maintenance organizations. Growth in health insurance premiums in the market rose sharply in recent years. Our business is a labor intensive business, and therefore health insurance costs represent a significant expense for us. In recent years, we have partially managed this increase with changes in program offerings. Continuing increases substantially in excess of inflation could have a negative impact on our profitability, as further shifts in responsibility for these cost increases to the employee may not be possible.

We believe that adequate reserves are in place to cover the ultimate liability related to general and professional liability, workers’ compensation and health insurance claims exposure. However, there can be no assurance that any current or future claims will not exceed applicable insurance reserves or that in the future such insurance will be available at a reasonable price or that we will be able to maintain adequate coverage.

Other

Environmental Matters

We are subject to various federal, state and local statutes and ordinances regulating the discharge of materials into the environment. Certain of our real estate assets contain asbestos. The asbestos is believed to be appropriately contained in accordance with environmental regulations. If these properties were demolished or subject to renovation activities that disturb the asbestos, certain environmental regulations are in place which specify the manner in which the asbestos must be handled and disposed. At September 30, 2006, we recognized a liability for the fair value of the related asset retirement obligation aggregating approximately $5.3 million, which amount is included in other long-term liabilities on our consolidated balance sheet. Management does not believe that we will be required to otherwise expend any material amounts in order to comply with environmental laws and regulations or that compliance will materially affect our capital expenditures, results of operations, financial condition and cash flows.

Reorganization

On June 22, 2000, NCI and certain of its direct and indirect subsidiaries filed for voluntary relief under Chapter 11 of the United States Code, referred to as the “Bankruptcy Code,” with the United States Bankruptcy Court for the District of Delaware, referred to as the “Bankruptcy Court.” On the same date, NCI’s 43.6% owned affiliate, The Multicare Companies, Inc., and certain of its direct and indirect subsidiaries and certain of its affiliates, referred to as “Multicare,” also filed for relief under Chapter 11 of the Bankruptcy Code with the Bankruptcy Court. A substantial majority of NCI and Multicare subsidiaries that became our subsidiaries following the spin-off filed for bankruptcy.

See Item 1A— “Risk Factors.”

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Available Information

Our internet address is www.GenesisHCC.com. We make available free of charge on www.GenesisHCC.com our registration statement on Form 10, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to such registration statement or reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

In addition, you may request a copy of these filings (excluding exhibits) at no cost by writing or telephoning us at the following address or telephone number:

Genesis HealthCare Corporation

101 East State Street

Kennett Square, PA 19348

Attention: Investor Relations

Telephone: (610) 925-2000

Information contained on our website is not part of this annual report on Form 10-K and is not incorporated by reference in this document. Our website is, and is only intended to be, an inactive textual reference.

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ITEM 1A:

RISK FACTORS



If any of the following risks and uncertainties develop into actual events, this could have a material adverse effect on our business, financial condition, results of operations and cash flows. In that case, the trading price of our common stock could decline.

Healthcare-related legislation has significantly impacted our business, and future legislation and regulations may negatively affect our financial condition, results of operations and cash flows.

Our inpatient services business currently receives approximately 81% of its revenues from Medicare and Medicaid. The healthcare industry is experiencing a strong trend toward cost containment, as the government seeks to impose lower reimbursement and RUGs rates, limit the scope of covered services and negotiate reduced payment schedules with providers. These cost containment measures generally have resulted in a reduced rate of growth in the reimbursement for the services that we provide relative to the increase in our cost to provide such services. Prior reductions in governmental reimbursement rates contributed to our predecessor company’s subsidiaries’ bankruptcy filings under Chapter 11 of the United States Code on June 22, 2000. Additional reductions in reimbursement rates for our services may further negatively impact our business, results of operations, financial condition and cash flows.

Changes to Medicare and Medicaid reimbursement programs have limited, and are expected to continue to limit, payment increases under these programs. Also, the timing of payments made under the Medicare and Medicaid programs is subject to regulatory action and governmental budgetary constraints resulting in a risk that the time period between submission of claims and payment could increase. Further, within the statutory framework of the Medicare and Medicaid programs, a substantial number of areas are subject to administrative rulings and interpretations that may further affect payments.

It is not possible to quantify fully the effect of legislative changes, the interpretation or administration of such legislation or other governmental initiatives on our business and the business of the customers served by our rehabilitation services business. Accordingly, there can be no assurance that the impact of any future healthcare legislation or regulation will not adversely affect our business. There can be no assurance that payments under governmental and private third-party payor programs will be timely, will remain at levels similar to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for reimbursement pursuant to such programs. Our financial condition, results of operations and cash flows will be affected by the reimbursement process, which in the healthcare industry is complex and can involve lengthy delays between the time that revenue is recognized and the time that reimbursement amounts are settled. Any adverse impact of skilled nursing facility rate changes to the liquidity of our inpatient services segment, could require us to borrow in order to fund our working capital needs, and in turn, cause us to become more highly leveraged and further impact our results of operations and cash flows from increased interest expense.

Our revenues could be affected by changes to the Medicare program.

In February 2006, the DRA was signed into law. Included in the DRA is a provision that directed CMS to develop an exceptions process for medically necessary physical, speech and occupational therapy services for beneficiaries that exceed a $1,740 annual reimbursement cap. The provision establishes a 10-day exceptions request process. In connection with the DRA, on February 13, 2006 CMS issued three program transmittals instructing its contractors on implementing the exceptions process. Under the instructions, a two-tier process is established providing for automatic exceptions based upon diagnoses and patient condition, and a manual exceptions process for other claims that are not automatically exempt. These changes were retroactive to January 1, 2006. While initially there were delays in processing claims, most of the implementation issues were resolved. Generally, most nursing home therapy claims fell within the automatic exceptions group, and, therefore, we did not experience a disruption of services. However, the delayed communication and implementation of the exceptions process negatively impacted Medicare Part B therapy utilization during the three months ended March 31, 2006. There continues to be uncertainty regarding how the Medicare Part B therapy cap will be addressed in future reimbursement policy. CMS recently announced the proposed physician fee schedules and the implementation of the therapy caps effective January 1, 2007. The proposed rules suggest the therapy caps will increase from the current level of $1,740 to $1,780. On December 9, 2006, Congress passed legislation extending the existing exceptions process through December 31, 2007, removing a significant threat to our rehabilitation therapy business for the short term. No assurances can be made or given that Congress will extend the exceptions process beyond calendar year 2007, or enact other revisions.

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By law, Medicare reimbursement for physician and non-physician professional services (including Medicare Part B physical therapy, speech pathology and occupational therapy services) is based on fee schedules. On August 22, 2006, CMS published in the Federal Register the proposed calendar year 2007 physician and non-physician fee schedule rules. In an accompanying press statement, CMS indicated that it anticipated calendar year 2007 physician fee schedules would be reduced by 5.1% effective January 1, 2007. On December 9, 2006, Congress passed legislation that negated the rate reduction and established a 1.5% bonus incentive to providers who report on quality measures in 2007.

Effective January 1, 2006, under the MMA, Medicaid coverage of prescription drugs for Medicare beneficiaries who are also eligible for Medicaid have been shifted to the Medicare program (Medicare Part D). These residents are referred to as “dual eligibles.” This change has affected a significant percentage of residents in our nursing facilities. The final regulations and subsequent specific sub-regulatory guidance specifically require the new prescription drug plans and Medicare Advantage Plans that offer prescription drug coverage to provide convenient access to long-term care pharmacies and to offer standard contracts to all long-term care pharmacies within the plans’ service areas that meet performance standards specified by CMS. Currently, under contract, Omnicare, Inc., through its wholly owned subsidiary, provides services required for our residents. Under Medicare Part D, reimbursement for such services is provided through such plans as the primary payor for prescription drugs. Effective January 1, 2006, all dual eligible participants were automatically assigned to PDPs. Our long-term care pharmacy provider, Omnicare, negotiates its payment terms directly with the PDPs. It is important to note that, in its 2007 Work Plan, the Office of Inspector General stated that it will focus on whether skilled nursing facilities are properly passing through any benefits they receive through contracts with PDPs to their beneficiaries.

Implementation of the new prescription drug benefit has been challenging; however, our residents have not experienced a significant disruption in receiving their necessary medication. Given the scale of the conversion, and the voluntary nature of Medicare Part D enrollment for other than dually eligible residents, there were complex implementation issues. CMS has been responsive to issues as they have been identified and transmitted. Additionally, in a number of states, special provisions are being considered or implemented under the state Medicaid plans to safeguard individuals automatically enrolled in the new Medicare Part D. Because of concerns that the MMA shifts prescription drug coverage from Medicaid to Medicare through private plans, CMS extended its initial 30-day transition period for those persons transitioning to the Part D program to 90-days. This transition period expired on April 1, 2006. Identifying nursing home residents and communicating formulary and coverage decisions continues to be challenging.

The second open enrollment for the Medicare Part D benefit began in mid-November, 2006 and will run through the end of the calendar year. Automatic plan selection changes may be required for some dual eligibles and low-income subsidized beneficiaries. There continues to be a risk that these changes and related issues with the implementation of Medicare Part D may disrupt pharmacy services to our facilities. Any such change or reduction in long-term care pharmacy services could create additional cost for us, reduce our ability to meet quality standards and disrupt service delivery to our residents.

The MMA covers most prescription drugs, insulin and certain insulin supplies, and approved vaccines. However, certain drugs are excluded from coverage under the new Medicare benefit in Part D, including several drugs that are commonly prescribed for nursing home and other long-term care residents. A number of states announced that they will continue to cover these excluded drugs under their Medicaid plans, however, there remains the possibility that certain physician ordered medications may fall outside of the PDPs’ and/or Medicaid’s formularies thereby requiring us to bear the cost of these drugs.

We have described only certain provisions of the MMA applicable to our business. There may be other provisions of the legislation that may impact our business by decreasing revenues or increasing operational expenses. The impact of this legislation depends upon a variety of factors, including patient mix and the implementing regulations. CMS continues to issue new regulations to implement the MMA, which we are in the process of reviewing. However, because of the broad scope and phased-implementation of key provisions in the MMA, we are not in a position to assess fully its impact on our business.

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Our revenues could be impacted by federal and state changes to Medicaid.

Jointly financed by the federal and state governments, Medicaid is an essential part of the health coverage and financing system nationally and in every state. Combined federal and states’ Medicaid outlays are projected to approximate $347.0 billion in calendar year 2007 and account for nearly 15% of total national healthcare expenditures. Medicaid is the principal purchaser for approximately 45% of nursing home services purchased in the United States. Rapidly increasing Medicaid spending combined with slow state revenue growth and competing budgetary requirements has led many states to institute measures aimed at controlling spending growth. Historically, these budget pressures have translated into reductions in the rate of growth of state Medicaid spending. Budget constraints and other factors have caused some states to curb Medicaid reimbursement to nursing facilities, and states may continue to curb or delay payments to nursing facilities in the future. The Balanced Budget Act of 1997 granted the states greater flexibility in establishing Medicaid managed care programs without the need to obtain a federal waiver. Although these waiver programs generally exempted institutional care, including nursing facility services, these programs could ultimately change the Medicaid reimbursement system for long-term care. These changes could include changing reimbursement for pharmacy services from fee-for-service, or payment per procedure or service rendered, to a fixed amount per person utilizing managed care negotiated or capitated rates. In each of the major states where we provide services, we are working with trade groups, consultants and government officials to address responsibly the particular funding issues. Given that Medicaid outlays are a significant component of state budgets, we expect continuing cost containment pressures on Medicaid outlays for skilled nursing facilities in the states in which we operate, which could result in Medicaid rate adjustments that are below the average inflationary increase in our operating costs. States may be unable to continue to support financially growing Medicaid programs as currently structured and there is no assurance that federal assistance with the funding of these programs will continue.

The Benefits Improvement and Protection Act of 2000 enacted a phase out of intergovernmental transfer transactions by states whereby states would artificially inflate the payments to certain public facilities to increase federal matching funds. This action may have had the effect of reducing federal support for a number of state Medicaid programs. The reduced federal payments may impact aggregate available funds requiring states to further contain payments to providers. We operate in several of the states that have experienced or will experience a contraction of federal matching funds.

The President’s proposed fiscal 2007 federal budget recommended spending reductions for both Medicare and Medicaid. One of the specific changes advanced by the President is a request to phase-down the level of federal matching under Medicaid for provider assessments. Current regulations permit states to receive federally matched funds for up to 6% of aggregate outlays for state Medicaid nursing home services. On December 9, 2006, Congress passed legislation reducing the maximum federal matching to 5.5% of aggregate Medicaid outlays. This reduction in funding, which will become effective January 1, 2008, is expected to have an adverse effect on our business, results of operations, financial position and cash flows.

The DRA reduced projected Medicaid outlays by $6.9 billion over five years. The President signed this legislation into law on February 8, 2006. Among the provisions of the final legislation were requirements that extend the Medicaid look-back period for asset transfers from three years to five years, a change in the manner that annuities are considered and a change in the date for calculating the look-back penalty from the date of transfer to the date that Medicaid nursing home services are delivered. It is our understanding that CMS will be issuing specific guidance regarding the changes in the asset transfer rules. The DRA also implemented new penalties and rule changes to deter asset transfers individuals make to become Medicaid eligible. These changes may affect the number of people potentially eligible for Medicaid funding. We are unable to predict what impact this provision of the DRA will have on our financial condition, results of operations and cash flows, if any.

Under the DRA, states may be allowed to reduce the benefits provided to certain Medicaid enrollees, which could affect the services that states contract for with us. On July 12, 2006, CMS issued interim final regulations implementing the requirement that Medicaid recipients must be able to show proof of citizenship. We are unable to predict the outcome of these potential changes and their impact on our financial condition, results of operations and cash flows, if any.

Congress, during its fiscal year 2006, scaled back proposed Medicaid reductions through 2006. The final enactment is a compromise establishing a National Medicaid Commission authorized to make specific policy recommendations, while agreeing to defer Medicaid cuts during fiscal year 2006, and providing reconciliation instructions to Congress to make $10.0 billion in aggregate Medicaid reductions during fiscal years 2007 to 2011. Some of the ideas generated by the National Medicaid Commission were incorporated into the DRA. The National Medicaid Commission is mandated

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to deliver to the Congress a second report by the end of 2006 making specific recommendations for a comprehensive reform of the Medicaid program. These proposals may be considered in the coming 110 th Congress. No predictions can be made as to the ultimate outcome of these reform proposals. We cannot predict the extent of the impact that such decrease, if any, in spending by the federal government will have on our business, financial condition, results of operations and cash flows.

We conduct business in a heavily regulated industry, and changes in regulations and violations of regulations may result in increased costs or sanctions, including loss of licensure and decertification.

Our business is subject to extensive federal, state and, in some cases, local regulation with respect to, among other things, participation in the Medicare and Medicaid programs, licensure, certification and government reimbursement. For our eldercare centers, these regulations relate, among other things, to the adequacy of physical plant and equipment, qualifications of personnel, standards of care, government reimbursement and operational requirements. Compliance with these regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Because these regulations are amended from time to time and are subject to interpretation, we cannot predict when and to what extent liability may arise. Failure to comply with current or future regulatory requirements could also result in the imposition of various remedies including fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of a facility or site of service.

We are subject to periodic audits by the Medicare and Medicaid programs, which have various rights and remedies against us if they assert that we have overcharged the programs or failed to comply with program requirements. These rights and remedies may include requiring the repayment of any amounts alleged to be overpayments or in violation of program requirements, or making deductions from future amounts due to us. These programs may also impose fines, criminal penalties or program exclusions. Other third-party payor sources also reserve rights to conduct audits and make monetary adjustments in connection with or exclusive of audit activities.

In the ordinary course of our business, we periodically receive notices of deficiencies for failure to comply with conditions of participation in the Medicare and Medicaid programs. We review such notices and take appropriate corrective action. In these cases, we submit our plan to bring the center into compliance with regulations which must be accepted by the reviewing agency prior to its implementation. In some cases, the reviewing federal or state agency may take various adverse actions against a provider, including but not limited to:

 

the imposition of fines;



 

suspension of payments for new or all admissions to the center; and

 

in extreme circumstances, exclusion from participation in the Medicare or Medicaid programs and revocation of a center’s or service site’s license.



These actions may adversely affect a provider’s ability to continue to operate, the ability to provide certain services and/or eligibility to participate in the Medicare or Medicaid programs or to receive payments from other payors. Certain of our centers have received notices that, as a result of alleged deficiencies, federal and/or state agencies were taking steps to impose remedies. Additionally, actions taken against one center or service site may subject other centers or service sites under common control or ownership to adverse remedies.

We are also subject to federal and state laws that govern financial and other arrangements between healthcare providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between healthcare providers that are designed to induce the referral of patients to a particular provider for medical products and services. Possible sanctions for violation of any of these restrictions or prohibitions include loss of eligibility to participate in reimbursement programs and/or civil and criminal penalties. Furthermore, some states restrict certain business relationships between physicians and other providers of healthcare services. Many states prohibit business corporations from providing, or holding themselves out as providers of, medical care. From time to time, we may seek guidance as to the interpretation of these laws; however, there can be no assurance that such laws will ultimately be interpreted in a manner consistent with our practices.

In recent years it has become more difficult for nursing facilities to maintain licensure and certification. We have experienced and expect to continue to experience increased costs in connection with maintaining our licenses and certifications as well as increased enforcement actions. Failure to provide quality resident care may result in civil and/or criminal fines and penalties.

The operation of our eldercare centers is subject to federal and state laws prohibiting fraud by healthcare providers, including criminal provisions, which prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid, or failing to refund overpayments or improper payments. Violation of these criminal provisions is a felony punishable by imprisonment and/or fines. We may be subject to

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fines and treble damage claims if we violate the civil provisions that prohibit the knowing filing of a false claim or the knowing use of false statements to obtain payment.

State and federal governments are devoting increased attention and resources to anti-fraud initiatives against healthcare providers. HIPAA and the Balanced Budget Act expanded the penalties for healthcare fraud, including broader provisions for the exclusion of providers from the Medicaid program.

The DRA requires providers who make or receive over $5 million in payments from state health plans to establish policies and procedures detailing the Federal False Claims Act, state false claims acts (if applicable), state Whistleblower Protection Acts, and other state laws related to the reduction of fraud and abuse. This provision may require us to implement state-specific employee training based on these laws. Further, as a result of the DRA, certain states are contemplating the need for their own false claims acts which, if implemented, may impose stricter penalties than the federal statute and regulations.

While we believe that our business practices are consistent with Medicare and Medicaid criteria, those criteria are often vague and subject to change and interpretation. Determinations of alleged fraud could have an adverse effect on our business, results of operations, financial condition and cash flows.

HIPAA requires us to comply with standards for the internal use of identifiable health information and the sharing of such information with third parties, such as payors, business associates, residents and patients. The standards promulgated under HIPAA regulate the exchange of information in common healthcare transactions, the use of electronic signatures, the development of unique identifiers for providers, employers, health plans and individuals, the security and privacy of identifiable health information, and enforcement.

Sanctions for failing to comply with the HIPAA health information practices provisions include criminal penalties and civil sanctions that could have a material adverse effect on us.

State laws and regulations could affect our ability to grow.

Several states in which we operate our business, as well as states in which we may wish to operate in the future, have adopted certificate of need or similar laws that generally require that a state agency approve certain acquisitions and determine the need for certain bed additions, new services and capital expenditures. State approvals are generally issued for a specified maximum expenditure and require implementation of the proposal within a specified period of time. Failure to obtain the necessary state approval can result in the inability to provide the service, to operate the centers, to complete the acquisition, addition or other change, and can also result in the imposition of sanctions or adverse action on the center’s license and adverse reimbursement action. There can be no assurance that we will be able to obtain state approval for all future projects requiring such approval or that such approvals will be timely.

Possible changes in the case mix of patients as well as payor mix and payment methodologies may significantly affect our profitability.

The sources and amounts of our patient revenues will be determined by a number of factors, including licensed bed capacity and occupancy rates of our centers, the mix of patients and the rates of reimbursement among payors. Likewise, therapy services provided by our rehabilitation therapy services business will vary based upon payor and payment methodologies. Changes in the case mix of the patients as well as payor mix among private pay, Medicare and Medicaid will significantly affect our profitability. Particularly, any significant increase in our Medicaid population could have an adverse effect on our business, results of operations, financial condition and cash flows, especially if states operating these programs continue to limit, or more aggressively seek limits on, reimbursement rates.

We face intense competition in our business.

The healthcare industry is highly competitive. We compete with a variety of other organizations in providing healthcare services. Certain competing organizations have greater financial and other resources and may be more established in their respective communities than we are. Competing organizations may offer newer or different centers or services than us, including a variety of community based services, and may thereby attract patients or customers who are presently patients, customers or are otherwise receiving our services.

Our inpatient services segment is capital intensive, requiring us to direct continually financial resources to the maintenance and enhancement of our physical plant and equipment.

As of September 30, 2006, we wholly owned or leased 161 skilled nursing and assisted living centers. Our ability to maintain and enhance our physical plant and equipment in a suitable condition to meet regulatory standards, operate efficiently and remain competitive in our markets requires us to commit a substantial portion of our free cash flow to continued investment in our physical plant and equipment. Certain of our competitors may operate centers that are not as old as our centers, or may appear more modernized than our centers, and therefore may be more attractive to prospective customers. In addition, the cost to replace our existing centers through

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acquisition or construction is substantially higher than the carrying value of our centers. We are undertaking a process to allocate more aggressively capital spending within our owned and leased centers in an effort to address issues that arise in connection with an aging physical plant.

If factors, including factors indicated in these “Risk Factors” and other factors beyond our control, render us unable to direct the necessary financial and human resources to the maintenance, upgrade and modernization of our physical plant and equipment, our business, results of operations, financial condition and cash flows could be adversely impacted.

An increase in insurance costs may adversely affect us, and we may be liable for losses not covered by or in excess of our insurance.

We carry property, workers’ compensation insurance, general and professional liability coverage on our behalf and on behalf of our subsidiaries in amounts deemed adequate by management. However, there can be no assurance that any current or future claims will not exceed applicable insurance coverage.

Health insurance premiums in the market rose sharply in recent years. Our business is labor intensive, and therefore health insurance costs represent a significant expense for us. In recent years, we have partially managed the increase in insurance premiums with changes in program offerings. Continuing increases substantially in excess of inflation could have a negative impact on our profitability, as further shifts in responsibility for these cost increases to the employee may not be possible.

In addition, we are self-insured for a significant portion of our exposure for workers’ compensation insurance, general and professional liability claims and health insurance provided to our employees. Accordingly, we are liable for payments to be made. To the extent claims are greater than estimated, they could adversely affect our business, results of operations, financial condition and cash flows.

We could experience significant increases in our operating costs due to continued intense competition for qualified staff, minimum staffing laws in the healthcare industry and potential labor strikes.

We and our industry continue to experience shortages in qualified professional clinical staff. We compete with other healthcare providers and with non-healthcare providers for both professional and non-professional employees. As the demand for these services continually exceeds the supply of available and qualified staff, we and our competitors have been forced to offer more attractive wage and benefit packages to these professionals and to utilize outside contractors for these services at premium rates. Furthermore, the competitive arena for this shrinking labor market has created high turnover among clinical professional staff as many seek to take advantage of the supply of available positions offering new and more attractive wage and benefit packages. In addition to the wage pressures inherent in this environment, the cost of training new employees amid the high turnover rates has increased pressure on our operating margins. Lastly, increased attention to the quality of care provided in skilled nursing facilities has caused several states to mandate and other states to consider mandating minimum staffing laws that further increase the gap between demand for and supply of qualified individuals and lead to higher labor costs. While we have been able to retain the services of an adequate number of qualified personnel to staff our facilities appropriately and maintain our standards of quality care, there can be no assurance that continued shortages will not affect our ability to attract and maintain an adequate staff of qualified healthcare personnel in the future. A lack of qualified personnel at a facility could result in significant increases in labor costs and an increased reliance on expensive temporary professional staffing agencies at such facility or otherwise adversely affect operations at such facility. Any of these developments could adversely affect our business, results of operations, financial condition and cash flows.

In addition, certain of our centers have certified unions that have entered into collective bargaining agreements. If one or more of these centers experience a lock-out or strike it could create a disruption in our business and increase our operating costs.

If we are unable to control operating costs and generate sufficient cash flow to meet operational and financial requirements, including servicing our indebtedness, our business operations may be adversely affected.

Cost containment and lower reimbursement levels relative to inflationary increases in cost by third-party payors, including federal and state governments, have had a significant impact on the healthcare industry as a whole and on our cash flows. Our operating margins continue to be under pressure because of continuing regulatory requirements and scrutiny and growth in operating expenses, such as labor costs and insurance premiums. In

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addition, as a result of competitive pressures, our ability to maintain operating margins through price increases to private patients is limited.

Our ability to make payments on our existing and future debt and to pay our expenses will depend on our ability to generate cash in the future. Our ability to generate cash is subject to various risks and uncertainties, including those disclosed in this section and prevailing economic, regulatory and other conditions beyond our control.

The agreements that govern our financing agreements contain various covenants that limit our discretion in the operation of our business.

The agreements and instruments that govern our financing arrangements contain various restrictive covenants that, among other things, require us to comply with or maintain certain financial tests and ratios and restrict our ability to:

 

incur more debt;



 

pay dividends, purchase company stock or make other distributions;



 

make payments in respect of subordinated debt;



 

make certain investments;



 

create liens;



 

enter into transactions with affiliates;



 

make acquisitions;



 

merge or consolidate; and



 

transfer or sell assets.



Our ability to comply with these covenants is subject to various risks and uncertainties. In addition, events beyond our control could affect our ability to comply with and maintain the financial tests and ratios. Any failure by us to comply with and maintain all applicable financial tests and ratios and to comply with all applicable covenants could result in an event of default with respect to, and the acceleration of the maturity of, and the termination of the commitments to make further extension of credit under, a substantial portion of our debt. If we were unable to repay debt to our senior lenders, these lenders could proceed against the collateral securing that debt. Even if we are able to comply with all applicable covenants, the restrictions on our ability to operate our business in our sole discretion could harm our business by, among other things, limiting our ability to take advantage of financing, mergers, acquisitions and other corporate opportunities.

A significant portion of our business is concentrated in certain markets and the respective economic conditions or changes in the laws affecting our business in those markets could have a material adverse effect on our operating results.

As of September 30, 2006, we receive approximately 80% of our inpatient services revenue from operations in Pennsylvania, New Jersey, Maryland, Massachusetts and West Virginia. The economic condition of these markets could affect the ability of our patients and third-party payors to reimburse us for our services through a reduction of disposable household income or the ultimate reduction of the tax base used to generate state funding of their respective Medicaid programs. An economic downturn, or changes in the laws affecting our business in these markets and in surrounding markets, could have an adverse effect on our business, results of operations, financial condition and cash flows.

Realization of the tax benefit relating to our net operating loss carryforward is subject to numerous risks.

We estimate our net operating loss carryforward is approximately $83.2 million at September 30, 2006 after giving effect to NCI’s consolidated federal tax return completed for the period ended September 30, 2004. However, such net operating loss carryforward may further need to be adjusted pending settlement of any federal tax audit of tax years ending on or before that date which could materially reduce, or even eliminate, our estimated net operating loss carryforward. The amount and timing of any realized tax benefit resulting from the utilization of the net operating loss carryforward is a function of future taxable income, multiple change of ownership limitations

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imposed by Section 382 of the Internal Revenue Code of 1986, as amended, contractual limitations imposed by the tax sharing agreement with NCI, and the term of the carryforward period.

Recent legislation and the increasing costs of being publicly owned are likely to impact our future financial position and results of operations.

In connection with the Sarbanes-Oxley Act of 2002, we are subject to rules requiring our management to report on the effectiveness of our internal controls over financial reporting, and further requiring our independent registered public accounting firm to attest similarly to such effectiveness. If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information which could, in turn, have an adverse effect on our business, results of operations, financial condition and cash flows.

Significant regulatory changes, including the Sarbanes-Oxley Act and rules and regulations promulgated as a result of the Sarbanes-Oxley Act, have increased, and in the future are likely to further increase, general and administrative costs. In order to comply with the Sarbanes-Oxley Act of 2002, the listing standards of the NASDAQ Global Market, and rules implemented by the Securities and Exchange Commission (SEC), we have had to hire additional personnel and utilize additional outside legal, accounting and advisory services, and may continue to require such additional resources. Moreover, in the rapidly changing regulatory environment in which we now operate, there is significant uncertainty as to what will be required to comply with many of the new rules and regulations. As a result, we may be required to spend substantially more than we currently estimate, and may need to divert resources from other activities, as we develop our compliance plans.

New accounting pronouncements or new interpretations of existing standards could require us to make adjustments in our accounting policies that could affect our consolidated financial statements.

The Financial Accounting Standards Board (FASB), the SEC, or other accounting organizations or governmental entities issue new pronouncements or new interpretations of existing accounting standards that sometimes require us to change our accounting policies and procedures. Future pronouncements or interpretations could require us to change our policies or procedures and have a significant impact on our consolidated financial statements.

Implementation of new information systems could negatively affect us.

We are in the process of implementing certain new information systems to enhance operating efficiencies and provide more effective management of our business. Implementation of new systems carries risks such as project cost overruns and business interruptions. If we experience a material business interruption as a result of the implementation of new information systems or are unable to obtain the projected benefits of new systems, it could have an adverse effect on our business, results of operations, financial condition and cash flows.

We may make acquisitions that could subject us to a number of operating risks.

We have made and may make additional acquisitions of, investments in, and strategic alliances with complementary businesses utilizing cash or debt financing to enable us to capitalize on our position in the geographic markets in which we operate and to expand our businesses geographically. Implementation of this strategy entails a number of risks, including:

 

inaccurate assessment of undisclosed liabilities;



 

diversion of management’s attention from our existing operations;



 

difficulties in assimilating the operations of an acquired business or in realizing projected revenue synergies, efficiencies and cost savings; and



 

increase in our indebtedness and a limitation on our ability to access additional capital when needed.



Certain changes may be necessary to integrate the acquired businesses into our operations, to assimilate new employees and to implement reporting, monitoring, compliance and forecasting policies and procedures.

Provisions in Pennsylvania law and our corporate documents could delay or prevent a change in control.

As a Pennsylvania corporation, we are governed by the Pennsylvania Business Corporation Law of 1988, as amended, referred to as “Pennsylvania corporation law.” Pennsylvania corporation law provides that the board of directors of a corporation in discharging its duties, including its response to a potential merger or takeover, may consider the effect of any action upon employees, shareholders, suppliers, patients, customers and creditors of the

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corporation, as well as upon communities in which offices or other establishments of the corporation are located and all other pertinent factors. In addition, under Pennsylvania corporation law, subject to certain exceptions, a business combination between us and a beneficial owner of more than 20% of our common stock may be accomplished only if certain conditions are met.

Our articles of incorporation contain certain provisions that may affect a person’s decision to initiate a takeover of us, including the following provisions:

 

a classified board of directors;



 

a provision confirming that we are subject to the restrictions in the Pennsylvania corporation law on certain business combinations involving us that are not approved by the board or directors; and



 

the authority to issue preferred stock with rights to be designated by the board of directors.



Our articles of incorporation also confirm that we are subject to the provisions of Pennsylvania corporation law that deny our shareholders the right to act by partial written consent without a meeting.

Additionally, our board of directors adopted a shareholder rights plan, which makes it difficult for any person or group to acquire a significant interest in our common stock without advance approval of our board of directors.

The overall effect of the foregoing provisions may be to deter a future tender offer or other offers to acquire us or our shares. Shareholders might view such an offer to be in their best interest if the offer includes a substantial premium over the market price of the common stock at that time. In addition, these provisions may assist our management in retaining its position and place it in a better position to resist changes that the shareholders may want to make if dissatisfied with the conduct of our business.

Our future profitability could be impacted by our ability to achieve certain performance improvement objectives in our rehabilitation therapy services segment.

Beginning in fiscal 2004 and throughout fiscal 2006, we and the rehabilitation therapy services sector have experienced a shortage of qualified rehabilitation therapists. As the demand for these services continues to exceed the supply of available therapists, we and our competitors have been forced to offer more attractive wage and benefit packages to these professionals while utilizing outside contractors for these services at premium rates. We have undertaken a series of actions intended to improve the operating performance of our rehabilitation therapy services segment. If we are unsuccessful in achieving our performance improvement objectives, it could have an adverse effect on our business, results of operations, financial condition and cash flows.

Portions of our historical financial information and our pro forma financial information may not be representative of our results as a separate company.

Prior to our spin-off on December 1, 2003, our operations were conducted as part of the consolidated NCI entity and not as a stand-alone entity. Accordingly, the financial information included or incorporated by reference in this annual report as of dates prior to the spin-off may not reflect the results of operations, financial condition and cash flows that would have been achieved had our company been operated independently during such periods and as of such dates presented.

Prior to December 1, 2003, costs related to our corporate functions, including legal support, treasury administration, insurance administration, human resource management, internal audit, corporate accounting and income tax administration, which are not directly and solely related to our operations, were allocated to us prior to the spin-off based upon various methodologies deemed reasonable by management. Prior to December 1, 2003, certain assets and liabilities relating to our business were managed and controlled by NCI on a centralized basis. Such assets and liabilities reflected in our financial statements as of dates prior to December 1, 2003 were also allocated to us based upon various methodologies deemed reasonable by management. Although our management believes that the methods used to allocate and estimate such assets, liabilities and expenses are reasonable, there can be no assurance that such financial information is comparable to financial information for periods after the December 1, 2003 spin-off.

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We may be required to satisfy certain indemnification obligations to NCI, or may not be able to collect on indemnification rights from NCI.

Under the terms of a separation and distribution agreement, we and NCI each agreed to indemnify each other from and after the distribution with respect to the indebtedness, liabilities and obligations that are retained by our respective companies. These indemnification obligations could be significant, and we cannot presently determine the amount of indemnification obligations for which we will be liable or for which we will seek payment from NCI. Our ability to satisfy these indemnities, if we are called upon to do so, will depend upon our future financial performance. Similarly, NCI’s ability to satisfy any such obligations to us will depend on NCI’s future financial performance. We cannot assure you that we will have the ability to satisfy any substantial indemnification obligations to NCI. We also cannot assure you that if NCI is required to indemnify us for any substantial obligations, NCI will have the ability to satisfy those obligations.

ITEM 1B:   UNRESOLVED STAFF COMMENTS

None.

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