Genesis Healthcare Cp (GHCI) - Description of business

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; [/TABLE]

 

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. Back to Index 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. Back to Index 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 Back to Index 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. Back to Index 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. Back to Index 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 Back to Index 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 Back to Index 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. Back to Index 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 Back to Index 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