Edgar Filing: ENSIGN GROUP, INC

ENSG 9.30.12 10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_____________________________

FORM 10-Q



x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended September 30, 2012.



o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from to .

Commission file number: 001-33757

__________________________

THE ENSIGN GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)



Delaware	33-0861263
(State or Other Jurisdiction of	(I.R.S. Employer
Incorporation or Organization)	Identification No.)

27101 Puerta Real, Suite 450

Mission Viejo, CA 92691

(Address of Principal Executive Offices and Zip Code)

(949) 487-9500

(Registrant’s Telephone Number, Including Area Code)

N/A

(Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)

_____________________________

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

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

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



Large accelerated filer o	Accelerated filer x	Non-accelerated filer o	Smaller reporting company o
		(Do not check if a smaller reporting company)

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

As of November 5, 2012, 21,571,671 shares of the registrant’s common stock were outstanding.

THE ENSIGN GROUP, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012

TABLE OF CONTENTS



Part I. Financial Information

Item 1. Financial Statements (unaudited):	3

Condensed Consolidated Balance Sheets as of September 30, 2012 and December 31, 2011	3

Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2012 and 2011	4

Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2012 and 2011	5

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2011	6

Notes to Condensed Consolidated Financial Statements	7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	29

Item 3. Quantitative and Qualitative Disclosures About Market Risk	53

Item 4. Controls and Procedures	53

Part II. Other Information

Item 1. Legal Proceedings	54

Item 1A. Risk Factors	54

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	80

Item 3. Defaults Upon Senior Securities	80

Item 4. Mine Safety Disclosures	80

Item 5. Other Information	80

Item 6. Exhibits	81

Signatures	82

Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2
Exhibit 101

Table of Contents

Part I. Financial Information

Item 1. Financial Statements

THE ENSIGN GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par values)

(Unaudited)



	September 30, 2012			December 31, 2011
Assets
Current assets:
Cash and cash equivalents	$	32,028		$	29,584
Accounts receivable—less allowance for doubtful accounts of $13,628 and $12,782 at September 30, 2012 and December 31, 2011, respectively	98,072			86,311
Investments—current	4,254			—
Prepaid income taxes	3,232			5,882
Prepaid expenses and other current assets	7,985			7,667
Deferred tax asset—current	10,178			11,195
Total current assets	155,749			140,639
Property and equipment, net	439,233			403,862
Insurance subsidiary deposits and investments	18,149			16,752
Escrow deposits	—			175
Deferred tax asset	4,787			3,514
Restricted and other assets	12,385			10,418
Intangible assets, net	4,867			2,321
Goodwill	22,180			17,177
Other indefinite-lived intangibles	10,598			1,481
Total assets	$	667,948		$	596,339
Liabilities and equity
Current liabilities:
Accounts payable	$	23,211		$	21,169
Accrued wages and related liabilities	34,868			41,958
Accrued self-insurance liabilities—current	15,897			12,369
Other accrued liabilities	22,615			18,577
Current maturities of long-term debt	7,133			6,314
Total current liabilities	103,724			100,387
Long-term debt—less current maturities	192,299			181,556
Accrued self-insurance liabilities—less current portion	34,928			31,904
Fair value of interest rate swap	3,116			2,143
Deferred rent and other long-term liabilities	3,306			2,864
Total liabilities	337,373			318,854

Commitments and contingencies (Note 16)
Temporary equity - redeemable noncontrolling interest	11,511			—
Equity:
Ensign Group, Inc. stockholders' equity:
Common stock; $0.001 par value; 75,000 shares authorized; 22,107 and 21,550 shares issued and outstanding at September 30, 2012, respectively, and 21,575 and 21,179 shares issued and outstanding at December 31, 2011, respectively	22			22
Additional paid-in capital	84,881			77,257
Retained earnings	238,831			204,073
Common stock in treasury, at cost, 344 and 396 shares at September 30, 2012 and December 31, 2011, respectively	(2,347		)	(2,559		)
Accumulated other comprehensive loss	(1,901		)	(1,308		)
Total Ensign Group, Inc. stockholders' equity	319,486			277,485
Non-controlling interest	(422		)	—
Total equity	319,064			277,485
Total liabilities and equity	$	667,948		$	596,339

See accompanying notes to condensed consolidated financial statements.

Table of Contents

THE ENSIGN GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Revenue	$	207,150		$	196,346		$	613,618		$	565,615
Expense:
Cost of services (exclusive of facility rent, general and administrative and depreciation and amortization expenses shown separately below)	164,877			155,725			488,305			444,517
Facility rent—cost of services	3,374			3,331			10,063			10,380
General and administrative expense	8,099			7,195			23,933			22,188
Depreciation and amortization	7,179			6,179			21,145			16,784
Total expenses	183,529			172,430			543,446			493,869
Income from operations	23,621			23,916			70,172			71,746
Other income (expense):
Interest expense	(3,092		)	(5,323		)	(9,131		)	(10,789		)
Interest income	69			68			172			198
Other expense, net	(3,023		)	(5,255		)	(8,959		)	(10,591		)
Income before provision for income taxes	20,598			18,661			61,213			61,155
Provision for income taxes	7,562			7,063			23,070			23,835
Net income	13,036			11,598			38,143			37,320
Less: net loss attributable to noncontrolling interests	(258		)	—			(511		)	—
Net income attributable to The Ensign Group, Inc.	$	13,294		$	11,598		$	38,654		$	37,320
Net income per share:
Basic	$	0.62		$	0.55		$	1.81		$	1.78
Diluted	$	0.60		$	0.54		$	1.77		$	1.73
Weighted average common shares outstanding:
Basic	21,488			20,995			21,369			20,920
Diluted	22,010			21,570			21,899			21,571

See accompanying notes to condensed consolidated financial statements.

Table of Contents

THE ENSIGN GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Net income	$	13,036		$	11,598		$	38,143		$	37,320
Other comprehensive loss, net of tax:
Net unrealized loss on interest rate swap, net of tax of $154 and $380 for the three and nine months ended September 30, 2012, and $816 for both the three and nine months ended September 30, 2011.	(239		)	(1,274		)	(593		)	(1,274		)
Comprehensive income	12,797			10,324			37,550			36,046
Less: net loss attributable to noncontrolling interests	(258		)	—			(511		)	—
Comprehensive income attributable to The Ensign Group, Inc.	$	13,055		$	10,324		$	38,061		$	36,046

See accompanying notes to consolidated financial statements.

Table of Contents

THE ENSIGN GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



	Nine Months Ended September 30,
	2012			2011
Cash flows from operating activities:
Net income	$	38,143		$	37,320
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	21,145			16,784
Amortization of deferred financing fees and debt discount	620			518
Deferred income taxes	124			(1,843		)
Provision for doubtful accounts	6,195			5,982
Share-based compensation	2,484			2,614
Excess tax benefit from share-based compensation	(1,145		)	(991		)
Loss on extinguishment of debt	—			2,542
Loss on disposition of property and equipment	258			121
Change in operating assets and liabilities
Accounts receivable	(17,938		)	(17,510		)
Prepaid income taxes	2,650			(2,524		)
Prepaid expenses and other current assets	(306		)	(1,099		)
Insurance subsidiary deposits and investments	(5,651		)	(247		)
Accounts payable	1,143			4,216
Accrued wages and related liabilities	(7,090		)	1,642
Other accrued liabilities	4,853			3,378
Accrued self-insurance	5,796			3,041
Deferred rent liability	312			(699		)
Net cash provided by operating activities	51,593			53,245
Cash flows from investing activities:
Purchase of property and equipment	(26,755		)	(29,071		)
Cash payment for business acquisitions	(22,557		)	(86,539		)
Cash payment for asset acquisitions	(11,261		)	(16,583		)
Escrow deposits	—			(9,718		)
Escrow deposits used to fund business acquisitions	175			14,422
Cash proceeds from the sale of property and equipment	39			653
Restricted and other assets	(1,482		)	(34		)
Net cash used in investing activities	(61,841		)	(126,870		)
Cash flows from financing activities:
Proceeds from issuance of debt	21,525			75,000
Payments on long-term debt	(10,055		)	(44,698		)
Repurchase of shares of common stock	(174		)	—
Issuance of treasury stock upon exercise of options	386			623
Issuance of common stock upon exercise of options	3,996			1,282
Dividends paid	(3,873		)	(3,468		)
Excess tax benefit from share-based compensation	1,145			991
Payments of deferred financing costs	(258		)	(2,543		)
Net cash provided by financing activities	12,692			27,187
Net increase (decrease) in cash and cash equivalents	2,444			(46,438		)
Cash and cash equivalents beginning of period	29,584			72,088
Cash and cash equivalents end of period	$	32,028		$	25,650
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	9,220		$	10,613
Income taxes	$	19,116		$	27,352
Non-cash financing and investing activity:
Acquisition of redeemable noncontrolling interest	$	11,600		$	—
Accrued capital expenditures	$	899		$	621

See accompanying notes to condensed consolidated financial statements.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars and shares in thousands, except per share data)

(Unaudited)

1. DESCRIPTION OF BUSINESS

The Company - The Ensign Group, Inc., through its subsidiaries (collectively, Ensign or the Company), provides skilled nursing and rehabilitative care services through the operation of 107 facilities, six home health and four hospice operations as of September 30, 2012, located in Arizona, California, Colorado, Idaho, Iowa, Nebraska, Nevada, Oregon, Texas, Utah and Washington. The Company's operations, each of which strives to be the operation of choice in the community it serves, provide a broad spectrum of skilled nursing, assisted living, home health and hospice services, including physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. In the first quarter of 2012, the Company entered into a joint venture to develop and operate urgent care centers and related businesses. These walk-in clinics will offer daily access to healthcare for minor injuries and illnesses, including x-ray and lab services, all from convenient neighborhood locations with no appointments. The Company's facilities have a collective capacity of approximately 12,000 operational skilled nursing, assisted living and independent living beds. As of September 30, 2012, the Company owned 85 of its 107 facilities and operated an additional 22 facilities through long-term lease arrangements, and had options to purchase two of those 22 facilities.

The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenue. All of the Company’s skilled nursing, assisted living and home health and hospice operations are operated by separate, wholly-owned, independent subsidiaries, each of which has its own management, employees and assets. One of the Company’s wholly-owned subsidiaries, referred to as the Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other centralized services to the other operating subsidiaries through contractual relationships with such subsidiaries. The Company also has a wholly-owned captive insurance subsidiary (the Captive) that provides some claims-made coverage to the Company’s operating subsidiaries for general and professional liability, as well as coverage for certain workers’ compensation insurance liabilities.

Like the Company’s facilities, the Service Center and the Captive are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that The Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the Captive are operated by the same entity.

Other Information — The accompanying condensed consolidated financial statements as of September 30, 2012 and for the three and nine months ended September 30, 2012 and 2011 (collectively, the Interim Financial Statements), are unaudited. Certain information and note disclosures normally included in annual consolidated financial statements have been condensed or omitted, as permitted under applicable rules and regulations. Readers of the Interim Financial Statements should refer to the Company’s audited consolidated statements and notes thereto for the year ended December 31, 2011 which are included in the Company’s annual report on Form 10-K, File No. 001-33757 (the Annual Report) filed with the Securities and Exchange Commission (the SEC). Management believes that the Interim Financial Statements reflect all adjustments which are of a normal and recurring nature necessary to present fairly the Company’s financial position and results of operations in all material respects. The results of operations presented in the Interim Financial Statements are not necessarily representative of operations for the entire year.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation - The accompanying Interim Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The Company is the sole member or shareholder of various consolidated limited liability companies and corporations; each established to operate various acquired skilled nursing and assisted living facilities, and home health and hospice operations. Additionally, the Company's Interim Financial Statements include accounts of its majority owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation. The Company presents noncontrolling interest within the equity section of its condensed consolidated balance sheets. Noncontrolling interest that is redeemable at the option of the minority shareholder is presented outside of permanent equity in the mezzanine section as temporary equity in the Company's consolidated balance sheets. The Company presents the amount of consolidated net income that is attributable to The Ensign Group, Inc. and the noncontrolling interest in its condensed consolidated statements of income.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Estimates and Assumptions — The preparation of Interim Financial Statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The most significant estimates in the Company’s Interim Financial Statements relate to revenue, allowance for doubtful accounts, intangible assets and goodwill, impairment of long-lived assets, general and professional liability, worker’s compensation, and healthcare claims included in accrued self-insurance liabilities, interest rate swaps, and income taxes. Actual results could differ from those estimates.

Business Segments — The Company has a single reportable segment — long-term care services, which includes the operation of skilled nursing and assisted living facilities, home health, hospice, urgent care and related ancillary services. The Company’s single reportable segment is made up of several individual operating segments grouped together principally based on their geographical locations within the United States. Based on the similar economic and other characteristics of each of the operating segments, management believes the Company meets the criteria for aggregating its operating segments into a single reportable segment.

Fair Value of Financial Instruments — The Company’s financial instruments consist principally of cash and cash equivalents, debt security investments, interest rate swap agreements, accounts receivable, insurance subsidiary deposits, accounts payable and borrowings. The Company believes all of the financial instruments’ recorded values approximate fair values because of their nature or respective short durations. The interest rate swap is carried at fair value on the balance sheet. The Company’s fixed-rate debt instruments do not actively trade in an established market. The fair values of this debt are estimated by discounting the principal and interest payments at rates available to the Company for debt with similar terms and maturities. See further discussion of debt security investments in Note 4, Fair Value Measurements.

Revenue Recognition — The Company recognizes revenue when the following four conditions have been met: (i) there is persuasive evidence that an arrangement exists; (ii) delivery has occurred or service has been rendered; (iii) the price is fixed or determinable; and (iv) collection is reasonably assured. The Company's revenue is derived primarily from providing healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis.

Revenue from the Medicare and Medicaid programs accounted for 73.6% and 73.7% of the Company’s revenue for the three and nine months ended September 30, 2012, and 75.0% and 75.3% for the three and nine months ended September 30, 2011, respectively. The Company records revenue from these governmental and managed care programs as services are performed at their expected net realizable amounts under these programs. The Company’s revenue from governmental and managed care programs is subject to audit and retroactive adjustment by governmental and third-party agencies. Consistent with healthcare industry accounting practices, any changes to these governmental revenue estimates are recorded in the period the change or adjustment becomes known based on final settlement. The Company recorded retroactive adjustments that (decreased) increased revenue by $(138) and $174 for the three and nine months ended September 30, 2012 and $40 and $881 for the three and nine months ended September 30, 2011, respectively.

The Company’s service specific revenue recognition policies are as follows:

Skilled Nursing Revenue

The Company’s revenue is derived primarily from providing long-term healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis. The Company records revenue from private pay patients, at the agreed upon rate, as services are performed.

Home Health and Hospice Revenue Recognition

Episodic Based Revenue —Net service revenue is typically recorded on a 60-day episode payment rate. The Company makes adjustments to revenue on completed episodes to reflect differences between estimated and actual payment amounts, an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. The Company records an estimate for the impact of such payment adjustments based on its historical experience. In addition to revenue recognized on completed episodes, the Company also recognizes a portion of revenue associated with episodes in progress. Episodes in progress are 60-day episodes of care that begin during the reporting period, but were not completed as of the end of the period. The Company estimates this revenue on a monthly basis based upon historical trends. The primary factors underlying

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

this estimate are the number of episodes in progress at the end of the reporting period, expected Medicare revenue per episode and the Company's estimate of the average percentage complete based on days completed of the episode of care.

Non-episodic Based Revenue — Revenue is recorded on an accrual basis based upon the date of service at amounts equal to our established or estimated per-visit rates, as applicable.

Hospice Revenue — Revenue is recorded on an accrual basis based upon the date of service at amounts equal to the estimated payment rates. The estimated payment rates are daily rates for each of the levels of care we deliver. The Company makes adjustments to revenue for an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. The Company estimates the impact of these adjustments based on its historical experience, which primarily includes historical collection rates on Medicare claims, and records it during the period services are rendered as an estimated revenue adjustment and as a reduction to its outstanding patient accounts receivable. Additionally, as Medicare hospice revenue is subject to an inpatient cap limit and an overall payment cap, the Company monitors its provider numbers and estimates amounts due back to Medicare if a cap has been exceeded. The Company records these adjustments as a reduction to revenue and increases other accrued liabilities.

Accounts Receivable and Allowance for Doubtful Accounts — Accounts receivable consist primarily of amounts due from Medicare and Medicaid programs, other government programs, managed care health plans and private payor sources. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.

In evaluating the collectability of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type and the status of ongoing disputes with third-party payors. On an annual basis, the historical collection percentages are reviewed by payor and by state and are updated to reflect the recent collection experience of the Company. In order to determine the appropriate reserve rate percentages which ultimately establish the allowance, the Company analyzes historical cash collection patterns by payor and by state. The percentages applied to the aged receivable balances are based on the Company’s historical experience and time limits, if any, for managed care, Medicare, Medicaid and other payors. The Company periodically refines its estimates of the allowance for doubtful accounts based on experience with the estimation process and changes in circumstances.

Equity Investment — The Company's majority-owned subsidiary has a non-marketable equity investment which is accounted for under the equity method. The investment is initially recorded at cost and the Company will adjust the carrying amount for its share of the earnings or losses of the investee after the date of investment. The investment is evaluated periodically for impairment. If it is determined that a decline of the investment is other than temporary, then the investment basis would be written down to fair value and the write-down would be included in earnings as a loss.

Property and Equipment — Property and equipment are initially recorded at their historical cost. Repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the depreciable assets (ranging from three to 30 years). Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the remaining lease term.

Impairment of Long-Lived Assets — The Company reviews the carrying value of long-lived assets that are held and used in the Company’s operations for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined based upon expected undiscounted future net cash flows from the operations to which the assets relate, utilizing management’s best estimate, appropriate assumptions, and projections at the time. If the carrying value is determined to be unrecoverable from future operating cash flows, the asset is deemed impaired and an impairment loss would be recognized to the extent the carrying value exceeded the estimated fair value of the asset. The Company estimates the fair value of assets based on the estimated future discounted cash flows of the asset. Management has evaluated its long-lived assets and has not identified any asset impairment during the nine months ended September 30, 2012 or 2011.

Intangible Assets and Goodwill — Definite-lived intangible assets consist primarily of favorable leases, lease acquisition costs, patient base, facility trade names and franchise relationships. Favorable leases and lease acquisition costs are amortized over the life of the lease of the facility, typically ranging from ten to 20 years. Patient base is amortized over a period of four to eight months, depending on the classification of the patients and the level of occupancy in a new acquisition on the acquisition date. Trade names at facilities are amortized over 30 years and franchise relationships are amortized over 25 years.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The Company's indefinite-lived intangible assets consist of trade names and home health and hospice Medicare licenses. The Company tests indefinite-lived intangible assets for impairment on an annual basis or more frequently if events or changes in circumstances indicate that the carrying amount of the intangible asset may not be recoverable.

Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill is subject to annual testing for impairment. In addition, goodwill is tested for impairment if events occur or circumstances change that would reduce the fair value of a reporting unit below its carrying amount. The Company defines reporting units as the individual facilities. The Company performs its annual test for impairment during the fourth quarter of each year. The Company did not record any impairment charges to goodwill during the nine months ended September 30, 2012 or 2011.

Self-Insurance — The Company is partially self-insured for general and professional liability up to a base amount per claim (the self-insured retention) with an aggregate, one-time deductible above this limit. Losses beyond these amounts are insured through third-party policies with coverage limits per occurrence, per location and on an aggregate basis for the Company. For claims made after April 1, 2012, the combined self-insured retention was $500 per claim with an aggregate $1,750 deductible limit. For all facilities, except those located in Colorado, the third-party coverage above these limits was $1,000 per occurrence, $3,000 per facility, with a $10,000 blanket aggregate and an additional state-specific aggregate where required by state law. In Colorado, the third-party coverage above these limits was $1,000 per occurrence and $3,000 per facility, which is independent of the $10,000 blanket aggregate applicable to our other 102 facilities.

The self-insured retention and deductible limits for general and professional liability and workers' compensation are self-insured through the Captive, the related assets and liabilities of which are included in the accompanying condensed consolidated balance sheets. The Captive is subject to certain statutory requirements as an insurance provider. These requirements include, but are not limited to, maintaining statutory capital. The Company’s policy is to accrue amounts equal to the actuarially estimated costs to settle open claims of insureds, as well as an estimate of the cost of insured claims that have been incurred but not reported. The Company develops information about the size of the ultimate claims based on historical experience, current industry information and actuarial analysis, and evaluates the estimates for claim loss exposure on a quarterly basis. Accrued general liability and professional malpractice liabilities recorded on an undiscounted basis, net of anticipated insurance recoveries, in the accompanying condensed consolidated balance sheets were $33,730 and $29,196 as of September 30, 2012 and December 31, 2011, respectively. In addition, in accordance with guidance provided by the Financial Accounting Standards Board (FASB) in August 2010, the Company has recorded an asset and equal liability of $3,570 and $2,814 at September 30, 2012 and December 31, 2011, respectively, in order to present the ultimate costs of malpractice claims and the anticipated insurance recoveries on a gross basis.

The Company’s operating subsidiaries are self-insured for workers’ compensation liability in California. To protect itself against loss exposure in California with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $500 for each claim. In Texas, the operating subsidiaries have elected non-subscriber status for workers’ compensation claims and, effective February 1, 2011, the Company has purchased individual stop-loss coverage that insures individual claims that exceed $750 for each claim. The Company’s operating subsidiaries in other states have third party guaranteed cost coverage. In California and Texas, the Company accrues amounts equal to the estimated costs to settle open claims, as well as an estimate of the cost of claims that have been incurred but not reported. The Company uses actuarial valuations to estimate the liability based on historical experience and industry information. Accrued workers’ compensation liabilities are recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets and were $11,201 and $9,827 as of September 30, 2012 and December 31, 2011, respectively.

The Company provides self-insured medical (including prescription drugs) and dental healthcare benefits to the majority of its employees. The Company is fully liable for all financial and legal aspects of these benefit plans. To protect itself against loss exposure with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $250 for each covered person with an aggregate individual stop loss deductible of $75. The Company’s accrued liability under these plans recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets was $2,324 and $2,436 at September 30, 2012 and December 31, 2011, respectively.

The Company believes that adequate provision has been made in the Financial Statements for liabilities that may arise out of patient care, workers’ compensation, healthcare benefits and related services provided to date. The amount of the Company’s reserves was determined based on an estimation process that uses information obtained from both company-specific and industry data. This estimation process requires the Company to continuously monitor and evaluate the life cycle of the claims. Using data obtained from this monitoring and the Company’s assumptions about emerging trends, the Company, with the assistance of an independent actuary, develops information about the size of ultimate claims based on the Company’s historical experience and other available industry information. The most significant assumptions used in the estimation process include determining the trend in costs, the expected cost of claims incurred but not reported and the expected costs to settle or pay damage awards with respect to unpaid claims. The self-insured liabilities are based upon estimates, and while management believes that the estimates

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

of loss are reasonable, the ultimate liability may be in excess of or less than the recorded amounts. Due to the inherent volatility of actuarially determined loss estimates, it is reasonably possible that the Company could experience changes in estimated losses that could be material to net income. If the Company’s actual liability exceeds its estimates of loss, its future earnings, cash flows and financial condition would be adversely affected.

Income Taxes —Deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities at tax rates in effect when such temporary differences are expected to reverse. The Company generally expects to fully utilize its deferred tax assets; however, when necessary, the Company records a valuation allowance to reduce its net deferred tax assets to the amount that is more likely than not to be realized.

For interim reporting purposes, the provision for income taxes is determined based on the estimated annual effective income tax rate applied to pre-tax income, adjusted for certain discrete items occurring during the period. In determining the effective income tax rate for interim financial statements, the Company must consider expected annual income, permanent differences between financial reporting and tax recognition of income or expense and other factors. When the Company takes uncertain income tax positions that do not meet the recognition criteria, it records a liability for underpayment of income taxes and related interest and penalties, if any. In considering the need for and magnitude of a liability for such positions, the Company must consider the potential outcomes from a review of the positions by the taxing authorities.

In determining the need for a valuation allowance, the annual income tax rate for interim periods, or the need for and magnitude of liabilities for uncertain tax positions, the Company makes certain estimates and assumptions. These estimates and assumptions are based on, among other things, knowledge of operations, markets, historical trends and likely future changes and, when appropriate, the opinions of advisors with knowledge and expertise in certain fields. Due to certain risks associated with the Company’s estimates and assumptions, actual results could differ.

Noncontrolling Interest — The noncontrolling interest in a subsidiary is initially recognized at estimated fair value on the acquisition date and is presented within total equity in the Company's condensed consolidated balance sheets. The Company presents the noncontrolling interest and the amount of consolidated net income attributable to The Ensign Group, Inc. in its condensed consolidated statements of income and net income per share is calculated based on net income attributable to The Ensign Group, Inc.'s stockholders. The carrying amount of the noncontrolling interest is adjusted based on an allocation of subsidiary earnings based on ownership interest. Noncontrolling interest that has redemption features outside the Company's control is accounted for as redeemable noncontrolling interest and is recorded as temporary equity. Owners of noncontrolling interest in certain of the Company's subsidiaries have the right in certain circumstances to require it to purchase additional ownership interests at an amount as defined in the applicable agreement. The intent of the parties is to approximate fair value at the time of redemption by using a multiple of earnings that is consistent with generally accepted valuation practices. These contingent redemption rights are embedded in the equity security at issuance, are not free-standing instruments, do not represent a de facto financing and are not under the Company's control.

Stock-Based Compensation — The Company measures and recognizes compensation expense for all share-based payment awards made to employees and directors including employee stock options based on estimated fair values, ratably over the requisite service period of the award. Net income has been reduced as a result of the recognition of the fair value of all stock options and restricted stock awards issued, the amount of which is contingent upon the number of future grants and other variables.

Derivatives and Hedging Activities — The Company evaluates variable and fixed interest rate risk exposure on a routine basis and to the extent the Company believes that it is appropriate, it will offset most of its variable risk exposure by entering into interest rate swap agreements. It is the Company's policy to only utilize derivative instruments for hedging purposes (i.e. not for speculation). The Company formally designates its interest rate swap agreements as hedges and documents all relationships between hedging instruments and hedged items. The Company formally assesses effectiveness of its hedging relationships, both at the hedge inception and on an ongoing basis, then measures and records ineffectiveness. The Company would discontinue hedge accounting prospectively (i) if it is determined that the derivative is no longer effective in offsetting change in the cash flows of a hedged item, (ii) when the derivative expires or is sold, terminated or exercised, (iii) if it is no longer probable that the forecasted transaction will occur, or (iv) if management determines that designation of the derivative as a hedge instrument is no longer appropriate. The Company’s derivative is recorded on the balance sheet at its fair value.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Accumulated Other Comprehensive Loss and Total Comprehensive Income — Accumulated other comprehensive loss refers to revenue, expenses, gains, and losses that are recorded as an element of stockholders’ equity but are excluded from net income. The Company’s other comprehensive loss consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. As of September 30, 2012, accumulated other comprehensive losses were $3,116, recorded net of tax of $1,215, or $1,901, in stockholders' equity. As of December 31, 2011, accumulated other comprehensive losses were $2,143, net of tax of $835, or $1,308.

New Accounting Pronouncements — In July 2012, the FASB amended the guidance on testing indefinite-lived intangible assets, other than goodwill, for impairment. The amendment was issued in response to feedback on the amendments made to the goodwill impairment testing requirements by allowing an entity to perform a qualitative impairment assessment before proceeding to the two-step impairment test. Under the amended guidance, an entity testing an indefinite-lived intangible asset for impairment has the option of performing a qualitative assessment before calculating the fair value of the asset. Although this amendment revises the examples of events and circumstances that an entity should consider in interim periods, it does not revise the requirements to test (1) indefinite-lived intangible assets annually for impairment and (2) between annual tests if there is a change in events or circumstances. This amendment is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012; however, early adoption is permitted. The Company is evaluating whether it will adopt this amendment during its current fiscal year impairment analysis in the fourth quarter. The Company does not believe the adoption of this amendment will have a material effect on its financial statements.

In July 2012, the FASB clarified that an advance fee from a continuing care retirement community resident should be classified as deferred revenue if (1) the contract stipulates that this advance fee must be repaid when a room is reoccupied by a future resident and (2) the refundable amount is "limited to the proceeds from reoccupancy." If the refundable amount is not limited to the proceeds from reoccupancy, the advance fee must be reported as a liability. The above clarification is effective for fiscal periods beginning after December 15, 2012, however early adoption is permitted. The Company does not believe the adoption of this clarification will have a material effect on its financial statements.

Adoption of New Accounting Pronouncements — In December 2011, the FASB indefinitely deferred the provisions that required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which Other Comprehensive Income is presented (for both interim and annual financial statements). During the deferral period, entities will still need to comply with the existing U.S. GAAP requirements for the presentation of reclassification adjustments. The adoption of this amendment did not have a material effect on the Company's financial statements.

In July 2011, the FASB amended its standards on how health care entities present revenue and bad debt expense. Under the new guidance, health care entities are required to present bad debt expense related to patient service revenue as a reduction of patient service revenue (net of contractual allowances and discounts) on the statement of income for entities that do not assess a patient's ability to pay prior to rendering services. Further, it was determined, net presentation of bad debt expense in revenue would only apply to bad debts that are related to patient service revenue, to entities that provide services prior to assessing a patient's ability to pay, or to entities that recognize revenue prior to deciding that collection is reasonably assured. In addition, the final consensus requires health care entities to disclose information about the activity in the allowance for doubtful accounts, such as recoveries and write-offs, by using a mixture of qualitative and quantitative data. It will also require disclosure of the Company's policies for (i) assessing the timing and amount of uncollectible revenue recognized as bad debt expense; and (ii) assessing collectability in the timing and amount of revenue (net of contractual allowances and discounts). The Company adopted the disclosure requirements of this amendment during the first quarter of the current year. The Company determined the requirements for presentation of bad debt expense related to patient service revenue as a reduction of patient service revenue outlined in the amendment is not applicable as the Company assesses each patient's ability to pay prior to rendering services.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

3. COMPUTATION OF NET INCOME PER COMMON SHARE

Basic net income per share is computed by dividing net income attributable to Ensign Group, Inc. stockholders by the weighted average number of outstanding common shares for the period. The computation of diluted net income per share is similar to the computation of basic net income per share except that the denominator is increased to include contingently returnable shares and the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued.

A reconciliation of the numerator and denominator used in the calculation of basic net income per common share follows:



	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011
Numerator:
Net Income	$	13,036		$	11,598	$	38,143		$	37,320
Less: net loss attributable to the noncontrolling interests (2)	(258		)	—		(511		)	—
Net income attributable to The Ensign Group, Inc.	13,294			11,598		38,654			37,320
Denominator:
Weighted average shares outstanding for basic net income per share	21,488			20,995		21,369			20,920
Basic net income per common share	$	0.62		$	0.55	$	1.81		$	1.78

A reconciliation of the numerator and denominator used in the calculation of diluted net income per common share follows:



	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011
Numerator:
Net Income	$	13,036		$	11,598	$	38,143		$	37,320
Less: net loss attributable to the noncontrolling interests (2)	(258		)	—		(511		)	—
Net income attributable to The Ensign Group, Inc.	13,294			11,598		38,654			37,320
Denominator:
Weighted average common shares outstanding	21,488			20,995		21,369			20,920
Plus: incremental shares from assumed conversion (1)	522			575		530			651
Adjusted weighted average common shares outstanding	22,010			21,570		21,899			21,571
Diluted net income per common share	$	0.60		$	0.54	$	1.77		$	1.73


(1)	Options outstanding which are anti-dilutive and therefore not factored into the weighted average common shares amount above were 269 and 271 for the three and nine months ended September 30, 2012, respectively, and 49 and 41 for the three and nine months ended September 30, 2011, respectively.


(2)	See further discussion of noncontrolling interest at Note 14, Temporary Equity - Redeemable Noncontrolling Interest.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

4. FAIR VALUE MEASUREMENTS

Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted market prices in active markets; Level 2, defined as inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3, defined as observable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions.

The following table summarizes the financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011:



	September 30, 2012						December 31, 2011
	Level 1		Level 2		Level 3		Level 1		Level 2		Level 3
Cash and cash equivalents	$	32,028	$	—	$	—	$	29,584	$	—	$	—
Fair value of interest rate swap	$	—	$	3,116	$	—	$	—	$	2,143	$	—

Our non-financial assets, which include long-lived assets, including goodwill, intangible assets and property and equipment, are reported at carrying value and are not required to be measured at fair value on a recurring basis. However, on a periodic basis, or whenever events or changes in circumstances indicate that their carrying value may not be recoverable, we assess our long-lived assets for impairment. When impairment has occurred, such long-lived assets are written down to fair value. See Note 2 for further discussion of our significant accounting policies.

Debt Security Investments - Held to Maturity

At September 30, 2012 and December 31, 2011, the Company had approximately $22,403 and $16,466, respectively, in debt security investments which were held to maturity and carried at amortized cost. The carrying value of the debt securities approximates fair value. The Company has the intent and ability to hold these debt securities to maturity. Further, at September 30, 2012, $6,025 is held in AAA-rated debt securities backed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program, $6,376 is held in AA-rated debt securities and $10,002 is held in A-rated debt securities. These debt securities mature from December 2012 to August 2014.

Interest Rate Swap Agreement

In connection with the Senior Credit Facility with a five-bank lending consortium arranged by SunTrust and Wells Fargo (the Facility), in July 2011, the Company entered into an interest rate swap agreement in accordance with Company policy to reduce risk from volatility in the income statement due to changes in the LIBOR interest rate. The swap agreement, with a notional amount of $75,000, amortizing concurrently with the related term loan portion of the Facility, was five years in length and set to mature on July 15, 2016. The interest rate swap has been designated as a cash flow hedge and, as such, changes in fair value are reported in other comprehensive income in accordance with hedge accounting. Under the terms of this swap agreement, the net effect of the hedge was to record swap interest expense at a fixed rate of approximately 4.3%, exclusive of fees. Net interest paid under the swap was $240 and $710 for the three and nine months ended September 30, 2012, and $203 for both periods during the three and nine months ended September 30, 2011. In addition, based on the September 30, 2012 interest rate swap valuation, the Company expects to record swap interest expense of approximately $950 during the year ended December 31, 2012.

The Company assesses hedge effectiveness at inception and on an ongoing basis by performing a regression analysis. The regression analysis compares to the historical monthly changes in fair value of the interest rate swap to the historical monthly changes in the fair value of a hypothetically perfect interest rate swap over the trailing 30 months . The change in fair value of the hypothetical derivative is regarded as a proxy for the present value of the cumulative change in the expected future cash flows on the hedged transaction. The regression analysis serves as the Company's prospective and retrospective assessment of hedge effectiveness. Assuming the hedging relationship qualifies as highly effective, the actual swap will be recorded at fair value on the balance sheet and accumulated other comprehensive income (loss) will be adjusted to reflect the lesser of either the cumulative change in the fair value of the actual swap or the cumulative change in the fair value of the hypothetical derivative.

The interest rate swap agreement is recorded at fair value based upon valuation models which utilize relevant factors such as the contractual terms of the interest rate swap agreements, credit spreads for the contracting parties and interest rate curves. Based on this valuation method, the Company categorized the interest rate swap as Level 2 and recorded accumulated other comprehensive losses as of September 30, 2012 of $3,116, net of tax of $1,215, or $1,901, in stockholders' equity, compared to

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

$2,090, net of tax of $816, or $1,274 as of September 30, 2011. There are no amounts attributable to hedge ineffectiveness that were required to be recognized in earnings.

5. REVENUE AND ACCOUNTS RECEIVABLE

Revenue for the three and nine months ended September 30, 2012 and 2011 is summarized in the following table:



	Three Months Ended September 30,
	2012				2011
	Revenue		% of Revenue		Revenue		% of Revenue
Medicaid	$	76,709	37.0	%	$	70,967	36.1	%
Medicare	69,526		33.6		71,293		36.3
Medicaid — skilled	6,316		3.0		5,024		2.6
Total Medicaid and Medicare	152,551		73.6		147,284		75.0
Managed care	26,316		12.7		23,621		12.0
Private and other payors	28,283		13.7		25,441		13.0
Revenue	$	207,150	100.0	%	$	196,346	100.0	%



	Nine Months Ended September 30,
	2012				2011
	Revenue		% of Revenue		Revenue		% of Revenue
Medicaid	$	223,934	36.5	%	$	204,273	36.1	%
Medicare	209,715		34.2		207,897		36.8
Medicaid — skilled	18,590		3.0		13,730		2.4
Total Medicaid and Medicare	452,239		73.7		425,900		75.3
Managed care	77,738		12.7		71,938		12.7
Private and other payors	83,641		13.6		67,777		12.0
Revenue	$	613,618	100.0	%	$	565,615	100.0	%

Accounts receivable as of September 30, 2012 and December 31, 2011 is summarized in the following table:



	September 30, 2012			December 31, 2011
Medicaid	$	33,537		$	30,286
Managed care	25,501			22,068
Medicare	32,958			28,061
Private and other payors	19,704			18,678
	111,700			99,093
Less: allowance for doubtful accounts	(13,628		)	(12,782		)
Accounts receivable	$	98,072		$	86,311

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

6. ACQUISITIONS

The Company’s acquisition policy is generally to purchase or lease operations to complement the Company’s existing portfolio. The results of all the Company’s operations are included in the accompanying Interim Financial Statements subsequent to the date of acquisition. Acquisitions are typically paid for in cash and are accounted for using the acquisition method of accounting. Where the Company enters into facility lease agreements, the Company typically does not pay any material amount to the prior facility operator nor does the Company acquire any assets or assume any liabilities, other than rights and obligations under the lease and operations transfer agreement, as part of the transaction. Some leases include options to purchase the facilities. As a result, from time to time, the Company will acquire facilities that the Company has been operating under third-party leases.

During the nine months ended September 30, 2012, the Company acquired four stand-alone skilled nursing facilities, one stand-alone assisted living facility, two home health operations and one hospice operation. The aggregate purchase price of the eight business acquisitions was approximately $20,934, which was paid in cash. The Company also entered into a separate operations transfer agreement with the prior tenant as part of each transaction. The operations acquired during the nine months ended September 30, 2012 are as follows:


•	On February 1, 2012, the Company purchased an assisted living facility in Nevada for approximately $2,111, which was paid in cash. This acquisition added 60 operational assisted living units to the Company's operations.


•	On February 10, 2012, the Company acquired a home health operation in Oregon for approximately $530, which was paid in cash. The acquisition did not have an impact on the Company's operational bed count. The Company recognized $530 in other indefinite-lived intangible assets as part of this transaction.


•	On March 1, 2012, the Company acquired a skilled nursing facility in Idaho for approximately $2,780, which was paid in cash. This acquisition added 113 operational skilled nursing beds to the Company's operations.


•	On April 1, 2012, the Company acquired a home health and a hospice operation in Utah and Arizona for approximately $3,000, which was paid in cash. The acquisition did not have an impact on the Company's operational bed count. The Company recognized $2,279 in goodwill and $687 in other indefinite-lived intangible assets as part of this transaction.


•	On June 1, 2012, the Company acquired a skilled nursing facility in Texas for $8,002, which was paid in cash. This acquisition added 150 operational skilled nursing beds to the Company's operations.


•	On August 1, 2012, the Company acquired two skilled nursing facilities in Idaho for $4,511, which was paid in cash. One of the skilled nursing facilities acquired also offers assisted living services. These acquisitions added 94 skilled nursing beds and 24 assisted living units to the Company's operations.

The table below presents the allocation of the purchase price for the facilities acquired in business combinations during the nine months ended September 30, 2012 and 2011:



	September 30,
	2012		2011
Land	$	893	$	8,229
Building and improvements	15,303		69,883
Equipment, furniture, and fixtures	1,003		2,399
Assembled occupancy	239		1,010
Goodwill	2,279		4,209
Other indefinite-lived intangible assets	1,217		809
	$	20,934	$	86,539

In addition, during the nine months ended September 30, 2012, the Company purchased the underlying assets of three of its skilled nursing facilities in California which it previously operated under long-term lease agreements, which contained options to purchase, for $11,386, which was paid in cash. These acquisitions did not impact the Company's operational bed count.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In addition, in January 2012, the Company announced the formation of Immediate Clinic (IC), a majority owned subsidiary, to develop and operate urgent care facilities and related businesses. The first IC operated centers opened in the third quarter of 2012.


•	On February 15, 2012, IC purchased an equity investment in an urgent care software service provider for $1,400. See additional details in Note 10, Restricted and Other Assets.

•

On March 1, 2012, DRX Urgent Care LLC (DRX), a newly formed subsidiary of IC, purchased substantially all of the assets and assumed certain liabilities of Doctors Express Franchising LLC, a national urgent care franchise system for $2,000, adjusted for certain items at the time of close and redeemable noncontrolling interest. The noncontrolling interest was fair valued at the acquisition date at $11,600. The Company recognized intangible assets of $7,900 in trade name, $3,000 in franchise relationships and $2,724 in goodwill. See additional details in Note 9, Goodwill and Other Indefinite-Lived Intangible Assets - Net and Note 14, Temporary Equity - Redeemable Noncontrolling Interest.

On October 4, 2012, the Company committed to invest an additional $6,000 to IC in exchange for senior preferred stock, which will result in the Company holding approximately 96% of the outstanding interests in the joint venture on a fully-diluted basis.

The Company’s acquisition strategy has been focused on identifying both opportunistic and strategic acquisitions within its target markets that offer strong opportunities for return on invested capital. The facilities acquired by the Company are frequently underperforming financially and can have regulatory and clinical challenges to overcome. Financial information, especially with underperforming facilities, is often inadequate, inaccurate or unavailable. Consequently, the Company believes that prior operating results are not meaningful, representative of the Company’s current operating results or indicative of the integration potential of its newly acquired facilities. The businesses acquired during the nine months ended September 30, 2012 were not material acquisitions to the Company individually or in the aggregate. Accordingly, pro forma financial information is not presented. These acquisitions have been included in the September 30, 2012 condensed consolidated balance sheet of the Company, and the operating results have been included in the condensed consolidated statement of income of the Company since the dates the Company gained effective control.

7. PROPERTY AND EQUIPMENT

Property and equipment consist of the following:



	September 30, 2012			December 31, 2011
Land	$	70,267		$	67,179
Buildings and improvements	336,463			297,016
Equipment	77,048			66,483
Furniture and fixtures	8,750			8,731
Leasehold improvements	31,647			28,686
Construction in progress	7,627			8,213
	531,802			476,308
Less: accumulated depreciation	(92,569		)	(72,446		)
Property and equipment, net	$	439,233		$	403,862

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

8. INTANGIBLE ASSETS — Net



	Weighted	September 30, 2012							December 31, 2011
	Average Life	Gross Carrying		Accumulated					Gross Carrying		Accumulated
Intangible Assets	(Years)	Amount		Amortization			Net		Amount		Amortization			Net
Lease acquisition costs	15.5	$	684	$	(534	)	$	150	$	846	$	(604	)	$	242
Favorable lease	15.0	1,596		(399		)	1,197		1,596		(319		)	1,277
Assembled occupancy	0.5	2,205		(2,183		)	22		1,966		(1,750		)	216
Facility trade name	30.0	733		(165		)	568		733		(147		)	586
Franchise relationships	25.0	3,000		(70		)	2,930		—		—			—
Total		$	8,218	$	(3,351	)	$	4,867	$	5,141	$	(2,820	)	$	2,321

Amortization expense was $130 and $569 for the three and nine months ended September 30, 2012 and $339 and $1,045 for the three and nine months ended September 30, 2011, respectively. Of the $569 in amortization expense incurred during the nine months ended September 30, 2012, approximately $433 related to the amortization of patient base intangible assets at recently acquired facilities, which is typically amortized over a period of four to eight months, depending on the classification of the patients and the level of occupancy in a new acquisition on the acquisition date.

Estimated amortization expense for each of the years ending December 31 is as follows:



Year	Amount
2012 (remainder)	$	97
2013	295
2014	295
2015	275
2016	255
2017	255
Thereafter	3,395
	$	4,867

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

9. GOODWILL AND OTHER INDEFINITE-LIVED INTANGIBLE ASSETS

The Company performs its annual goodwill impairment analysis during the fourth quarter of each year for each reporting unit that constitutes a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment. The Company tests for impairment by comparing the net assets of each reporting unit to their respective fair values. The Company determines the estimated fair value of each reporting unit using a discounted cash flow analysis. In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value.

The following table represents activity in goodwill as of September 30, 2012 and December 31, 2011:



	Goodwill
January 1, 2012	$	17,177
Additions	5,003
Impairments	—
September 30, 2012	$	22,180

As of September 30, 2012, the Company anticipates that $19,456 in goodwill recognized will be fully deductible for tax purposes. The remaining goodwill balance of $2,724 may be fully deductible for tax purposes dependent on the noncontrolling interest holders exercising their right to require DRX to purchase additional ownership. Refer to additional details in Note 14, Temporary Equity - Redeemable Noncontrolling Interests.

Other indefinite-lived intangible assets consists of the following:



	September 30,		December 31,
	2012		2011
Trade name	$	8,000	$	66
Home health and hospice Medicare license	2,598		1,415
	$	10,598	$	1,481

During the nine months ended September 30, 2012, the Company recognized $7,900 in trade name intangible assets as part of the DRX acquisition on March 1, 2012. Additionally, the Company recorded $1,183 in home health and hospice Medicare license intangible assets as part of its acquisitions of two home health operations and one hospice operation during the nine months ended September 30, 2012.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

10. RESTRICTED AND OTHER ASSETS

Restricted and other assets consist primarily of capital reserves and capitalized debt issuance costs. Capital reserves are maintained as part of the mortgage agreements of the Company and certain of its landlords with the U.S. Department of Housing and Urban Development. These capital reserves are restricted for capital improvements and repairs to the related facilities.

Restricted and other assets consist of the following:



	September 30, 2012		December 31, 2011
Deposits with landlords	$	752	$	789
Capital improvement reserves with landlords and lenders	3,704		3,585
Debt issuance costs, net	2,959		3,230
Long-term insurance losses recoverable asset	3,570		2,814
Equity method investment	1,400		—
Restricted and other assets	$	12,385	$	10,418

Included in other assets, as of September 30, 2012, are anticipated insurance recoveries related to the Company's general and professional liability claims that are recorded on a gross rather than net basis in accordance with an Accounting Standards Update issued by the FASB and a non-marketable equity investment accounted for under the equity method. The investment is recorded at cost and is evaluated periodically for impairment.

11. OTHER ACCRUED LIABILITIES

Other accrued liabilities consist of the following:



	September 30, 2012		December 31, 2011
Quality assurance fee	$	3,732	$	3,912
Resident refunds payable	4,453		3,346
Deferred revenue	2,170		1,856
Cash held in trust for residents	1,586		1,648
Resident deposits	1,619		1,397
Dividends payable	1,306		1,283
Property taxes	3,540		2,224
Other	4,209		2,911
Other accrued liabilities	$	22,615	$	18,577

Quality assurance fee represents amounts payable to California, Utah, Idaho, Washington, Colorado, Iowa, and Nebraska in respect of a mandated fee based on resident days. Resident refunds payable includes amounts due to residents for overpayments and duplicate payments. Deferred revenue occurs when the Company receives payments in advance of services provided. Cash held in trust for residents reflects monies received from, or on behalf of, residents. Maintaining a trust account for residents is a regulatory requirement and, while the trust assets offset the liability, the Company assumes a fiduciary responsibility for these funds. The cash balance related to this liability is included in other current assets in the accompanying condensed consolidated balance sheets.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

12. INCOME TAXES

During the first quarter of 2012, the State of California initiated an examination of the Company's income tax returns for the 2008 and 2009 income tax years. The examination is primarily focused on the Captive and the treatment of related insurance matters. California has not proposed any adjustments. The Company is not currently under examination by any other major income tax jurisdiction. In the third quarter of 2012, the statute of limitations lapsed on the Company's 2008 Federal tax year without any impact on unrecognized tax benefits. The remainder of the Company's 2007 state tax years will lapse during the fourth quarter of 2012. The Company does not believe these lapses will significantly impact unrecognized tax benefits for any uncertain tax positions either. The Company does not believe the California examination or any other event will significantly impact the balance of unrecognized tax benefits in the next twelve months. The net balance of unrecognized tax benefits was not material to the Interim Financial Statements for the three or nine months ended September 30, 2012 or 2011.

13. DEBT

Long-term debt consists of the following:



	September 30, 2012			December 31, 2011
Promissory note with RBS, principal and interest payable monthly and continuing through March 2019, interest at a fixed rate, collateralized by real property, assignment of rents and Company guaranty.	$	21,198		$	—
Senior Credit Facility with SunTrust and Wells Fargo, principal and interest payable quarterly, balance due at July 15, 2016, secured by substantially all of the Company’s personal property.	80,313			88,125
Ten Project Note with GECC, principal and interest payable monthly; interest is fixed, balance due June 2016, collateralized by deeds of trust on real property, assignment of rents, security agreements and fixture financing statements.	50,363			51,185
Promissory note with RBS, principal and interest payable monthly and continuing through January 2018, interest at a fixed rate, collateralized by real property, assignment of rents and Company guaranty.	33,418			34,149
Promissory notes, principal, and interest payable monthly and continuing through October 2019, interest at fixed rate, collateralized by deed of trust on real property, assignment of rents and security agreement.	9,272			9,471
Mortgage note, principal, and interest payable monthly and continuing through February 2027, interest at fixed rate, collateralized by deed of trust on real property, assignment of rents and security agreement.	5,721			5,884
	200,285			188,814
Less current maturities	(7,133		)	(6,314		)
Less debt discount	(853		)	(944		)
	$	192,299		$	181,556

Promissory Note with RBS Asset Finance, Inc.

On February 17, 2012, two of the Company's real estate holding subsidiaries as Borrowers executed a promissory note in favor of RBS Asset Finance, Inc. (RBS) as Lender for an aggregate of $21,525 (the 2012 RBS Loan). The 2012 RBS Loan was secured by Commercial Deed of Trust, Security Agreement, Assignment of Leases and Rents and Fixture Filings on the properties owned by the Borrowers, and other related instruments and agreements, including without limitation a promissory note and a Company guaranty. The 2012 RBS Loan bears interest at a fixed rate of 4.75%. Amounts borrowed under the 2012 RBS Loan may be prepaid starting after the second anniversary of the note subject to certain prepayment fees. The term of the RBS Loan is for seven years, with monthly principal and interest payments commencing on April 1, 2012 and the balance due on March 1, 2019.

Among other things, under the RBS Loan the Company must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum debt service coverage ratio, an average occupancy rate and a minimum project yield. The Loan Documents also include certain additional affirmative and negative covenants, including limitations on the disposition of the Borrowers and the collateral and minimum average cash balance requirements. As of September 30, 2012, the Company was in compliance with all loan covenants.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

14. TEMPORARY EQUITY- REDEEMABLE NONCONTROLLING INTEREST

Owners of noncontrolling interests in certain of the Company's subsidiaries have the right in certain circumstances to require it to purchase additional ownership interests in DRX at an amount defined in the applicable agreements. The 25% noncontrolling interest is accounted for as redeemable noncontrolling interest as redemption is outside the Company's control. As such, the redeemable noncontrolling interest is reported in the mezzanine section in the Company's condensed consolidated balance sheets as temporary equity. The aggregate estimated maximum amount the Company could be required to pay in future periods is $13,500. As of September 30, 2012, the carrying amount of the redeemable noncontrolling interests is $11,511. The ultimate amount paid could be different as the redemption amount is primarily dependent on the future results of operations of the subject businesses, and the timing of the exercise of these rights.

15. OPTIONS AND AWARDS

Stock-based compensation expense consists of share-based payment awards made to employees and directors, including employee stock options and restricted stock awards, based on estimated fair values. As stock-based compensation expense recognized in the Company’s condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011 was based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. The Company estimates forfeitures at the time of grant and, if necessary, revises the estimate in subsequent periods if actual forfeitures differ.

The Company has three option plans, the 2001 Stock Option, Deferred Stock and Restricted Stock Plan (2001 Plan), the 2005 Stock Incentive Plan (2005 Plan) and the 2007 Omnibus Incentive Plan (2007 Plan), all of which have been approved by the stockholders. The total number of shares available under all of the Company’s stock incentive plans was 1,670 as of September 30, 2012.

The Company uses the Black-Scholes option-pricing model to recognize the value of stock-based compensation expense for all share-based payment awards. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. The Company develops estimates based on historical data and market information, which can change significantly over time. The Company granted 175 options and 114 restricted stock awards from the 2007 Plan during the nine months ended September 30, 2012.

The Company used the following assumptions for stock options granted during the three months ended September 30, 2012 and 2011:



Grant Year	Options Granted	Weighted Average Risk-Free Rate		Expected Life	Weighted Average Volatility		Weighted Average Dividend Yield
2012	83	0.84	%	6.5 years	55	%	0.93	%
2011	9	1.42	%	6.5 years	55	%	0.93	%

The Company used the following assumptions for stock options granted during the nine months ended September 30, 2012 and 2011:



Grant Year	Options Granted	Weighted Average Risk-Free Rate			Expected Life	Weighted Average Volatility		Weighted Average Dividend Yield
2012	175	0.84%	-	1.18%	6.5 years	55	%	0.93	%
2011	41	1.42%	-	2.53%	6.5 years	55	%	0.93	%

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

For the nine months ended September 30, 2012 and 2011, the following represents the exercise price and fair value displayed at grant date for stock option grants:



Grant Year	Granted	Weighted Average Exercise Price		Weighted Average Fair Value of Options
2012	175	$	27.04	$	12.44
2011	41	$	26.52	$	13.35

The weighted average exercise price equaled the weighted average fair value of common stock on the grant date for all options granted during the periods ended September 30, 2012 and 2011 and therefore, the intrinsic value was $0 at date of grant.

The following table represents the employee stock option activity during the nine months ended September 30, 2012:



	Number of Options Outstanding		Weighted Average Exercise Price		Number of Options Vested	Weighted Average Exercise Price of Options Vested
January 1, 2012	1,633		$	12.97	936	$	10.65
Granted	175		27.04
Forfeited	(38	)	16.74
Exercised	(272	)	11.05
September 30, 2012	1,498		$	14.87	838	$	11.32

The following summary information reflects stock options outstanding, vested and related details as of September 30, 2012:



								Stock Options Vested
	Stock Options Outstanding							Stock Options Vested
				Number Outstanding	Black-Scholes Fair Value		Remaining Contractual Life (Years)	Vested and Exercisable
Year of Grant	Exercise Price			Number Outstanding	Black-Scholes Fair Value		Remaining Contractual Life (Years)	Vested and Exercisable
2003	$0.67	-	0.81	4	*		1	4
2004	1.96	-	2.46	13	*		2	13
2005	4.99	-	5.75	85	*		3	85
2006	7.05	-	7.50	184	1,779		4	184
2008	9.38	-	14.87	482	2,622		6	336
2009	14.88	-	16.70	363	2,875		7	175
2010	17.47	-	18.16	103	918		8	33
2011	21.61	-	29.30	91	1,126		9	8
2012	24.04	-	28.82	173	2,280		10	—
Total				1,498	$	11,600		838

* The Company will not recognize the Black-Scholes fair value for awards granted prior to January 1, 2006 unless such awards are modified.

In addition to the above, during the three and nine months ended September 30, 2012, the Company granted 13 and 114 restricted stock awards, respectively. During the three and nine months ended September 30, 2011, the Company granted 33 and 115 restricted awards, respectively. All awards were granted at an exercise price of $0 and vest over five years.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

A summary of the status of the Company's nonvested restricted stock awards as of September 30, 2012, and changes during the nine-month period ended September 30, 2012 is presented below:



	Nonvested Restricted Awards		Weighted Average Grant Date Fair Value
Nonvested at January 1, 2012	210		$	22.32
Granted	114		26.55
Vested	(98	)	24.74
Forfeited	(9	)	22.41
Nonvested at September 30, 2012	217		$	22.76

Total share-based compensation expense recognized for the three and nine months ended September 30, 2012 and 2011 was as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Share-based compensation expense related to stock options	$	476	$	616	$	1,396	$	1,834
Share-based compensation expense related to restricted stock awards	292		196		809		448
Share-based compensation expense related to stock awards	$	102	$	124	$	1,639	$	680
Total	$	870	$	936	$	3,844	$	2,962

In future periods, the Company expects to recognize approximately $5,386 and $4,734 in share-based compensation expense for unvested options and unvested restricted stock awards, respectively, that were outstanding as of September 30, 2012. Future share-based compensation expense will be recognized over 3.3 and 3.8 weighted average years for unvested options and restricted stock awards, respectively. There were 661 unvested and outstanding options at September 30, 2012, of which 627 are expected to vest. The weighted average contractual life for options vested at September 30, 2012 was 6.2 years.

The aggregate intrinsic value of options outstanding, vested, expected to vest and exercised as of September 30, 2012 and December 31, 2011 is as follows:



Options	September 30, 2012		December 31, 2011
Outstanding	$	23,587	$	18,942
Vested	16,158		12,960
Expected to vest	6,790		5,374
Exercised	4,925		5,651

The intrinsic value is calculated as the difference between the market value of the underlying common stock and the exercise price of the options.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

16. COMMITMENTS AND CONTINGENCIES

Leases — The Company leases certain facilities and its administrative offices under non-cancelable operating leases, most of which have initial lease terms ranging from five to 20 years. The Company also leases certain of its equipment under non-cancelable operating leases with initial terms ranging from three to five years. Most of these leases contain renewal options, certain of which involve rent increases. Total rent expense, inclusive of straight-line rent adjustments, was $3,489 and $10,407 for the three and nine months ended September 30, 2012 and $3,446 and $10,725 for the three and nine months ended September 30, 2011, respectively.

Six of the Company’s facilities are operated under two separate three-facility master lease arrangements. Under these master leases, a breach at a single facility could subject one or more of the other facilities covered by the same master lease to the same default risk. Failure to comply with Medicare and Medicaid provider requirements is a default under several of the Company’s leases, master lease agreements and debt financing instruments. In addition, other potential defaults related to an individual facility may cause a default of an entire master lease portfolio and could trigger cross-default provisions in the Company’s outstanding debt arrangements and other leases. With an indivisible lease, it is difficult to restructure the composition of the portfolio or economic terms of the lease without the consent of the landlord.

In addition, a number of the Company’s individual facility leases are held by the same or related landlords, and some of these leases include cross-default provisions that could cause a default at one facility to trigger a technical default with respect to others, potentially subjecting certain leases and facilities to the various remedies available to the landlords under separate but cross-defaulted leases. The Company is not aware of any defaults as of September 30, 2012.

Regulatory Matters — Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. Compliance with such laws and regulations can be subject to future governmental review and interpretation, as well as significant regulatory action including fines, penalties, and exclusion from certain governmental programs. The Company believes that it is in compliance in all material respects with all applicable laws and regulations.

A significant portion of the Company’s revenue is derived from Medicaid and Medicare, for which reimbursement rates are subject to regulatory changes and government funding restrictions. Any significant future change to reimbursement rates or regulation on how services are provided could have a material effect on the Company’s operations.

Cost-Containment Measures — Both government and private pay sources have instituted cost-containment measures designed to limit payments made to providers of healthcare services, and there can be no assurance that future measures designed to limit payments made to providers will not adversely affect the Company.

Income Tax Examinations — During the first quarter of 2012, the State of California initiated an examination of the Company's income tax returns for the 2008 and 2009 income tax years. The examination is primarily focused on the Captive and the treatment of related insurance matters. California has not proposed any adjustments. The Company is not currently under examination by any other major income tax jurisdiction. The remainder of the Company's 2007 state tax years will lapse during the fourth quarter. The Company does not believe these lapses will significantly impact unrecognized tax benefits for any uncertain tax positions either. The Company does not believe the California examination or any other event will significantly impact the balance of unrecognized tax benefits in the next twelve months. See Note 12, Income Taxes.

Indemnities — From time to time, the Company enters into certain types of contracts that contingently require the Company to indemnify parties against third-party claims. These contracts primarily include (i) certain real estate leases, under which the Company may be required to indemnify property owners or prior facility operators for post-transfer environmental or other liabilities and other claims arising from the Company’s use of the applicable premises, (ii) operations transfer agreements, in which the Company agrees to indemnify past operators of facilities the Company acquires against certain liabilities arising from the transfer of the operation and/or the operation thereof after the transfer, (iii) certain lending agreements, under which the Company may be required to indemnify the lender against various claims and liabilities, (iv) agreements with certain lenders under which the Company may be required to indemnify such lenders against various claims and liabilities, and (v) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationships. The terms of such obligations vary by contract and, in most instances, a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, because no claims have been asserted, no liabilities have been recorded for these obligations on the Company’s balance sheets for any of the periods presented.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Litigation — The skilled nursing business involves a significant risk of liability given the age and health of the Company’s patients and residents and the services the Company provides. The Company and others in the industry are subject to an increasing number of claims and lawsuits, including professional liability claims, alleging that services have resulted in personal injury, elder abuse, wrongful death or other related claims. The defense of these lawsuits may result in significant legal costs, regardless of the outcome, and can result in large settlement amounts or damage awards.

In addition to the potential lawsuits and claims described above, the Company is also subject to potential lawsuits under the Federal False Claims Act and comparable state laws alleging submission of fraudulent claims for services to any healthcare program (such as Medicare) or payor. A violation may provide the basis for exclusion from federally-funded healthcare programs. Such exclusions could have a correlative negative impact on the Company’s financial performance. Some states, including California, Arizona and Texas, have enacted similar whistleblower and false claims laws and regulations. In addition, the Deficit Reduction Act of 2005 created incentives for states to enact anti-fraud legislation modeled on the Federal False Claims Act. As such, the Company could face increased scrutiny, potential liability and legal expenses and costs based on claims under state false claims acts in markets in which it does business.

In May 2009, Congress passed the Fraud Enforcement and Recovery Act (FERA) of 2009 which made significant changes to the Federal False Claims Act (FCA), expanding the types of activities subject to prosecution and whistleblower liability. Following changes by FERA, health care providers face significant penalties for the knowing retention of government overpayments, even if no false claim was involved. Health care providers can now be liable for knowingly and improperly avoiding or decreasing an obligation to pay money or property to the government. This includes the retention of any government overpayment. The government can argue, therefore, that a FCA violation can occur without any affirmative fraudulent action or statement, as long as it is knowingly improper. In addition, FERA extended protections against retaliation for whistleblowers, including protections not only for employees, but also contractors and agents. Thus, there is generally no need for an employment relationship in order to qualify for protection against retaliation for whistleblowing.

In July 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The Dodd-Frank Act establishes rigorous standards and supervision to protect the economy and American consumers, investors and businesses. Included under Section 922 of the Dodd-Frank Act, the Securities and Exchange Commission (SEC) will be required to pay a reward to individuals who provide original information to the SEC resulting in monetary sanctions exceeding $1,000 in civil or criminal proceedings. The award will range from 10 to 30 percent of the amount recouped and the amount of the award shall be at the discretion of the SEC. The purpose of this reward program is to “motivate those with inside knowledge to come forward and assist the Government to identify and prosecute persons who have violated securities laws and recover money for victims of financial fraud.”

Other companies in the Company's industry have been the subject of lawsuits alleging negligence, abuses and other causes of action which have, in some cases, resulted in large demand awards and settlements. In addition, there has been an increase in the number of class-action suits filed against the Company and other companies in its industry, which also have the potential to result in large damage awards and settlements. For example, a class action suit was previously filed against the Company in the State of California, alleging, among other things, violations of certain Health and Safety Code provisions and a violation of the Consumer Legal Remedies Act at certain of the Company’s California facilities. In 2007, the Company settled this class action suit, and the settlement was approved by the affected class and the Court.

Healthcare litigation is common and is filed based upon a wide variety of claims and theories, and we are routinely subjected to varying types of claims. One particular type of suit arises from alleged violations of state-established minimum staffing requirements for skilled nursing facilities. Failure to meet these requirements can, among other things, jeopardize a facility's compliance with conditions of participation under certain state and federal healthcare programs; it may also subject the facility to a notice of deficiency, a citation, civil money penalty, or litigation. These "staffing" suits have become more prevalent in the wake of a previous substantial jury award against one of the Company's competitors, and the Company expects the plaintiff's bar to become increasingly aggressive in their pursuit of these staffing and similar claims. The Company is currently defending one such staffing class-action claim filed in Los Angeles Superior Court, and has reached a tentative settlement with class counsel that is awaiting court approval. The total costs associated with the settlement, including attorney's fees, estimated class payout, and related costs and expenses, are projected to be $5,000, of which, $2,596 of this amount was recorded in the quarter ended June 30, 2012, with the balance having been expensed in prior periods. Assuming that the settlement is approved by the court, the settlement will not have a material ongoing adverse effect on the Company’s business, financial condition or results of operations.

Other claims and suits, including class actions, continue to be filed against us and other companies in our industry. If there were a significant increase in the number of these claims or an increase in amounts owing should plaintiffs be successful in their prosecution of these claims, this could materially adversely affect the Company’s business, financial condition, results of operations and cash flows.

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The Company has been, and continues to be, subject to claims and legal actions that arise in the ordinary course of business, including potential claims related to care and treatment provided at its facilities as well as employment related claims. The Company does not believe that the ultimate resolution of these actions will have a material adverse effect on the Company’s business, cash flows, financial condition or results of operations. A significant increase in the number of these claims or an increase in amounts owing should plaintiffs be successful in their prosecution of these claims, could materially adversely affect the Company’s business, financial condition, results of operations and cash flows.

Medicare Revenue Recoupments — The Company is subject to reviews relating to Medicare services, billings and potential overpayments. The Company had one operation subject to probe review during the nine months ended September 30, 2012. The Company anticipates that these probe reviews will increase in frequency in the future. Further, the Company currently has no facilities on prepayment review; however, others may be placed on prepayment review in the future. If a facility fails prepayment review, the facility could then be subject to undergo targeted review, which is a review that targets perceived claims deficiencies. The Company has no facilities that are currently undergoing targeted review.

Other Matters — In March 2007, the Company learned that the United States Attorney for the Central District of California (DOJ) had commenced an investigation of certain of its facilities and had issued an authorized investigative demand to the Company's bank seeking information pertaining to a total of 18 of its facilities. The DOJ also subsequently served a subpoena on the Company's independent external auditors in 2007, and in 2008 served search warrants and subpoenas on its Service Center and six of its Southern California skilled nursing facilities, seeking specific patient files and other information. Subsequent subpoenas issued to the Company covered additional documentation from the six facilities as well as eight of the other facilities. Based upon the issuance of the subpoenas and execution of the search warrants, the Company concluded that the government had undertaken parallel criminal and civil investigations. The Company pledged full cooperation to, and has been cooperating fully with, the government.

In September 2010 the Company's board of directors appointed a special committee consisting solely of independent directors to advance discussions with the DOJ regarding its investigation. The special committee retained independent counsel, and counsel has retained third party consultants, to facilitate its work. The Company and the special committee have continued cooperating with the DOJ, working to provide information necessary to aid the DOJ's investigation and move the matter toward resolution.

In December 2011, independent counsel for the Company's special committee received confirmation that the DOJ has closed its criminal investigation, although as a matter of course the DOJ reserves the right to reopen such inquiries if new facts come to light.

In January 2012, the DOJ indicated that the government would be seeking certain additional information in furtherance of the remaining civil investigation, and that it would formalize its request for that information in a new subpoena. In January 2012, the Office of the Inspector General of the United States Department of Health & Human Services (HHS) served the new subpoena, seeking specific patient records and documents from 2007 to 2011 from the six Southern California skilled nursing facilities that have been the subject of previous requests. HHS also issued a subpoena to the Company's independent external auditors requesting an update to the information requested in the 2007 subpoena to them, and a subpoena to the Company's independent internal auditors requesting similar information.

The Company has produced records called for in the January 2012 subpoena, and discussions between government representatives and counsel for the special committee are ongoing. The Company continues to cooperate with the government as part of an ongoing effort to move the matter to a resolution. In particular, while the Company seeks to address any questions the government may have after it completes its review of specific patient files requested, counsel for the special committee and counsel for the government are also attempting to develop a process to resolve, in advance of formal litigation, any civil claims the government may believe it has after concluding its investigation. In addition, the Company continues to make improvements to its compliance programs and systems.

The Company cannot predict or provide any assurance as to the possible outcome of the investigations or any possible related proceedings, or as to the possible outcome of any litigation. And although the Company believes there is a reasonable possibility that a loss may be incurred, it cannot estimate the possible loss or range of loss that may result from any such proceedings and, therefore, the Company has not recorded any related accruals. If any litigation were to proceed, and the Company is subjected to, alleged to be liable for, or agrees to a settlement of, claims or obligations under federal Medicare statutes, the federal False Claims Act, or similar state and federal statutes and related regulations, its business, financial condition and results of operations and cash flows could be materially and adversely affected and its stock price could be adversely impacted. Among other things, any settlement or litigation could involve the payment of substantial sums to settle any alleged civil violations, and may also include

Table of Contents

THE ENSIGN GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the Company's assumption of specific procedural and financial obligations going forward under a corporate integrity agreement and/or other arrangement with the government.

Concentrations

Credit Risk — The Company has significant accounts receivable balances, the collectability of which is dependent on the availability of funds from certain governmental programs, primarily Medicare and Medicaid. These receivables represent the only significant concentration of credit risk for the Company. The Company does not believe there are significant credit risks associated with these governmental programs. The Company believes that an appropriate allowance has been recorded for the possibility of these receivables proving uncollectible, and continually monitors and adjusts these allowances as necessary. The Company’s receivables from Medicare and Medicaid payor programs accounted for approximately 59.5% and 58.9% of its total accounts receivable as of September 30, 2012 and December 31, 2011, respectively. Revenue from reimbursement under the Medicare and Medicaid programs accounted for 73.6% and 73.7% of the Company’s revenue for the three and nine months ended September 30, 2012, and 75.0% and 75.3% for the three and nine months ended September 30, 2011, respectively.

Cash in Excess of FDIC Limits — The Company currently has bank deposits with financial institutions in the U.S. that exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. As of November 6, 2012, the Company had approximately $1,001 in uninsured cash deposits. All uninsured bank deposits are held at high quality credit institutions.

Table of Contents

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

You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission (SEC), including our Annual Report on Form 10-K (Annual Report), which discusses our business and related risks in greater detail, as well as subsequent reports we may file from time to time on Forms 10-Q and 8-K, for additional information. The section entitled “Risk Factors” contained in Part II, Item 1A of this Report, and similar discussions in our other SEC filings, also describe some of the important risk factors that may affect our business, financial condition, results of operations and/or liquidity. You should carefully consider those risks, in addition to the other information in this Report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.

This Report contains "forward-looking statements," within the meaning of the Private Securities Litigation Reform Act of 1995, which include, but are not limited to the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities and plans and objectives of management. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions, and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are listed under the section “Risk Factors” contained in Part II, Item 1A of this Report. These forward-looking statements speak only as of the date of this Report, and are based on our current expectations, estimates and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law. As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our” and “us” refer to The Ensign Group, Inc. and its consolidated subsidiaries. All of our skilled nursing, assisted living and home health and hospice operations, the Service Center and the Captive are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. The use of “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that any of our facilities, the Service Center or the Captive are operated by the same entity. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes included in the Annual Report.

Overview

We are a provider of skilled nursing and rehabilitative care services through the operation of 107 facilities, six home health and four hospice operations as of September 30, 2012, located in Arizona, California, Colorado, Idaho, Iowa, Nebraska, Nevada, Oregon, Texas, Utah and Washington. Our operations, each of which strives to be the service of choice in the community it serves, provide a broad spectrum of skilled nursing, assisted living, home health and hospice services, including physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. We recently entered into a joint venture to develop and operate urgent care facilities and related businesses. These walk-in clinics will offer daily access to healthcare for minor injuries and illnesses, including x-ray and lab services, all from convenient neighborhood locations with no appointments. As of September 30, 2012, we owned 85 of our 107 facilities and operated an additional 22 facilities under long-term lease arrangements, and had options to purchase two of those 22 facilities. The following table summarizes our facilities and operational skilled nursing, assisted living and independent living beds by ownership status as of September 30, 2012:



	Owned		Leased (with a Purchase Option)		Leased (without a Purchase Option)		Total
Number of facilities	85		2		20		107
Percent of total	79.4	%	1.9	%	18.7	%	100.0	%
Operational skilled nursing, assisted living and independent living beds	9,371		414		2,305		12,090
Percent of total	77.5	%	3.4	%	19.1	%	100.0	%

Table of Contents

The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenues. All of our skilled nursing, assisted living and home health and hospice operations are operated by separate, wholly-owned, independent subsidiaries, which have their own management, employees and assets. In addition, one of our wholly-owned independent subsidiaries, which we call our Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other services to each operating subsidiary through contractual relationships between such subsidiaries. In addition, we have the Captive that provides some claims-made coverage to our operating subsidiaries for general and professional liability, as well as for certain workers’ compensation insurance liabilities. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that The Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the Captive are operated by the same entity.

Facility Acquisition History



	December 31,							September 30,
	2005	2006	2007	2008	2009	2010	2011	2012
Cumulative number of facilities	46	57	61	63	77	82	102	107
Cumulative number of operational skilled nursing, assisted living and independent living beds	5,585	6,667	7,105	7,324	8,948	9,539	11,702	12,090

The following table sets forth the location of our facilities and the number of operational beds located at our facilities as of September 30, 2012:



	CA	AZ	TX	UT	CO	WA	ID	NV	NE	IA	Total
Number of facilities	35	13	22	11	5	3	6	3	4	5	107
Operational skilled nursing, assisted living and independent living beds	3,864	1,902	2,812	1,342	463	274	477	304	296	356	12,090

On February 1, 2012, we acquired an assisted living facility in Nevada for approximately $2.1 million, which was paid in cash. This acquisition added 60 operational assisted living beds to our operation. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.

On February 10, 2012, we acquired a home health operation in Oregon for approximately $0.5 million, which was paid in cash. The acquisition did not have an impact on the Company's operational bed count. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.

On March 1, 2012, we acquired a skilled nursing facility in Idaho for approximately $2.8 million, which was paid in cash. This acquisition added 113 operational skilled nursing beds to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.

On April 1, 2012, we acquired a home health and hospice operation in Utah and Arizona for approximately $3.0 million, which was paid in cash. The acquisition did not have an impact on our operational bed count. We also entered into a separate operations transfer agreement with the prior owner as part of this transaction.

On June 1, 2012, we acquired a skilled nursing facility in Texas for $8.0 million, which was paid in cash. This addition added 150 operational skilled nursing beds to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.

On August 1, 2012, we acquired two skilled nursing facilities in Idaho for $4.5 million, which was paid in cash. One of the skilled nursing facilities acquired also offers assisted living services. This acquisition added 94 skilled nursing beds and 24 assisted living units to our operations.

In addition, during the nine months ended September 30, 2012, we purchased the underlying assets of three of our skilled nursing facilities in California which we previously operated under long-term lease agreements, which contained options to purchase, for $11.4 million, which was paid in cash. These acquisitions did not impact our operational bed count.

See further discussion of facility acquisitions in Note 6 in Notes to Condensed Consolidated Financial Statements.

Table of Contents

Recent Developments

Board of Directors — Effective June 15, 2012, Mr. Daren J. Shaw was appointed by the board of directors, at the recommendation of the nomination and corporate governance committee, to serve on the audit committee with Mr. John Nackel and Mr. Thomas Maloof (Chair). Mr. Shaw has also been appointed by the board of directors to serve on the nomination and corporate governance committee and the compensation committee. On July 26, 2012, the board of directors appointed Mr. Shaw to serve as the chair of the audit committee effective September 1, 2012.

Joint Venture - Urgent Care

Immediate Clinic (IC) — On January 10, 2012, we announced a joint venture to develop and operate urgent care facilities and related businesses. Immediate Clinic (IC) will offer daily access to healthcare for minor injuries and illnesses, including x-ray and lab services, all from convenient neighborhood locations with no appointments. Design and construction planning for several new locations is currently underway, and IC is also seeking opportunities to acquire existing urgent care operations across the United States. IC opened its first two operations during the third quarter of fiscal 2012. Dr. John Shufeldt resigned as Chief Executive Officer of IC effective September 12, 2012. In addition, on October 4, 2012, we committed to invest an additional $6.0 million to IC in exchange for senior preferred stock which will result in our holding approximately 96% of the outstanding interests in the joint venture on a fully-diluted basis. The proceeds of such investment will be used to continue the development of additional clinics in the Northwest.

On February 15, 2012, IC purchased an equity investment in an urgent care software service provider for $1.4 million. In addition, on March 1, 2012, DRX Urgent Care LLC (DRX), a newly formed subsidiary of IC, purchased substantially all of the assets and assumed certain liabilities of Doctors Express Franchising LLC, a national urgent care franchise system for $2.0 million, adjusted for certain items at the time of close and redeemable noncontrolling interest of $11.6 million. We recognized intangible assets of $7.9 million in trade name, $3.0 million in franchise relationships and $2.7 million in goodwill as part of this transaction.

Key Performance Indicators

We manage our skilled nursing business by monitoring key performance indicators that affect our financial performance. These indicators and their definitions include the following:

•

Routine revenue: Routine revenue is generated by the contracted daily rate charged for all contractually inclusive skilled nursing services. The inclusion of therapy and other ancillary treatments varies by payor source and by contract. Services provided outside of the routine contractual agreement are recorded separately as ancillary revenue, including Medicare Part B therapy services, and are not included in the routine revenue definition.

•

Skilled revenue: The amount of routine revenue generated from patients in our skilled nursing facilities who are receiving higher levels of care under Medicare, managed care, Medicaid, or other skilled reimbursement programs. The other skilled residents that are included in this population represent very high acuity residents who are receiving high levels of nursing and ancillary services which are reimbursed by payors other than Medicare or managed care. Skilled revenue excludes any revenue generated from our assisted living services.

•

Skilled mix: The amount of our skilled revenue as a percentage of our total routine revenue. Skilled mix (in days) represents the number of days our Medicare, managed care, or other skilled patients are receiving services at our skilled nursing facilities divided by the total number of days patients (less days from assisted living services) from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).

•

Quality mix: The amount of routine non-Medicaid revenue as a percentage of our total routine revenue. Quality mix (in days) represents the number of days our non-Medicaid patients are receiving services at our skilled nursing facilities divided by the total number of days patients from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).


•	Average daily rates: The routine revenue by payor source for a period at our skilled nursing facilities divided by actual patient days for that revenue source for that given period.


•	Occupancy percentage (operational beds): The total number of residents occupying a bed in a skilled nursing, assisted living or independent living facility as a percentage of the beds in a facility which are available for occupancy during the measurement period.


•	Number of facilities and operational beds: The total number of skilled nursing, assisted living and independent living facilities that we own or operate and the total number of operational beds associated with these facilities.

Table of Contents

Skilled and Quality Mix. Like most skilled nursing providers, we measure both patient days and revenue by payor. Medicare, managed care and other skilled patients, whom we refer to as high acuity patients, typically require a higher level of skilled nursing and rehabilitative care. Accordingly, Medicare and managed care reimbursement rates are typically higher than from other payors. In most states, Medicaid reimbursement rates are generally the lowest of all payor types. Changes in the payor mix can significantly affect our revenue and profitability.

The following table summarizes our overall skilled mix and quality mix for the periods indicated as a percentage of our total routine revenue (less revenue from assisted living services) and as a percentage of total patient days (less days from assisted living services):



	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Skilled Mix:
Days	25.2	%	24.9	%	25.8	%	25.8	%
Revenue	49.3	%	51.3	%	50.1	%	52.2	%
Quality Mix:
Days	38.4	%	38.2	%	39.0	%	38.2	%
Revenue	58.8	%	60.5	%	59.6	%	60.8	%

Occupancy. We define occupancy as the ratio of actual patient days (one patient day equals one resident occupying one bed for one day) during any measurement period to the number of beds in facilities which are available for occupancy during the measurement period. The number of licensed and independent living beds in a skilled nursing, assisted living or independent living facility that are actually operational and available for occupancy may be less than the total official licensed bed capacity. This sometimes occurs due to the permanent dedication of bed space to alternative purposes, such as enhanced therapy treatment space or other desirable uses calculated to improve service offerings and/or operational efficiencies in a facility. In some cases, three- and four-bed wards have been reduced to two-bed rooms for resident comfort, and larger wards have been reduced to conform to changes in Medicare requirements. These beds are seldom expected to be placed back into service. We define occupancy in operational beds as the ratio of actual patient days during any measurement period to the number of available patient days for that period. We believe that reporting occupancy based on operational beds is consistent with industry practices and provides a more useful measure of actual occupancy performance from period to period.

The following table summarizes our overall occupancy statistics for the periods indicated:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Occupancy:
Operational beds at end of period	12,090		11,461		12,090		11,461
Available patient days	1,108,622		1,032,478		3,256,086		2,882,973
Actual patient days	872,701		812,627		2,580,026		2,291,107
Occupancy percentage (based on operational beds)	78.7	%	78.7	%	79.2	%	79.5	%

Table of Contents

Revenue Sources

Our total revenue represents revenue derived primarily from providing services to patients and residents of skilled nursing facilities, and to a lesser extent from assisted living facilities and ancillary services. We receive service revenue from Medicaid, Medicare, private payors and other third-party payors, and managed care sources. The sources and amounts of our revenue are determined by a number of factors, including bed capacity and occupancy rates of our healthcare facilities, the mix of patients at our facilities and the rates of reimbursement among payors. Payment for ancillary services varies based upon the service provided and the type of payor. The following table sets forth our total revenue by payor source and as a percentage of total revenue for the periods indicated:



	Three Months Ended September 30,								Nine Months Ended September 30,
	2012				2011				2012				2011
	$		%		$		%		$		%		$		%
	(Dollars in thousands)
Revenue:
Medicaid	$	76,709	37.0	%	$	70,967	36.1	%	$	223,934	36.5	%	$	204,273	36.1	%
Medicare	69,526		33.6		71,293		36.3		209,715		34.2		207,897		36.8
Medicaid-skilled	6,316		3.0		5,024		2.6		18,590		3.0		13,730		2.4
Total	152,551		73.6		147,284		75.0		452,239		73.7		425,900		75.3
Managed Care	26,316		12.7		23,621		12.0		77,738		12.7		71,938		12.7
Private and Other(1)	28,283		13.7		25,441		13.0		83,641		13.6		67,777		12.0
Total revenue	$	207,150	100.0	%	$	196,346	100.0	%	$	613,618	100.0	%	$	565,615	100.0	%

______________________


(1)	Includes revenue from assisted living facilities, home health and hospice and franchise operations.

Critical Accounting Policies Update

There have been no significant changes during the nine-month period ended September 30, 2012 to the items that we disclosed as our critical accounting policies and estimates in our discussion and analysis of financial condition and results of operations in our Annual Report on Form 10-K filed with the SEC, except for the following:

Noncontrolling Interest

The noncontrolling interest in a subsidiary is initially recognized at estimated fair value on the acquisition date and is presented within total equity in our condensed consolidated balance sheets. We present the noncontrolling interest and the amount of consolidated net income attributable to The Ensign Group, Inc. in our condensed consolidated statements of income and net income per share is calculated based on net income attributable to The Ensign Group, Inc.'s stockholders. The carrying amount of the noncontrolling interest is adjusted based on an allocation of subsidiary earnings based on ownership interest. Noncontrolling interest that has redemption features outside our control is accounted for as redeemable noncontrolling interest and is recorded as temporary equity. Owners of noncontrolling interest in certain of our subsidiaries have the right in certain circumstances to require it to purchase additional ownership interests at an amount as defined in the applicable agreement. The intent of the parties is to approximate fair value at the time of redemption by using a multiple of earnings that is consistent with generally accepted valuation practices. These contingent redemption rights are embedded in the equity security at issuance, are not free-standing instruments, do not represent a de facto financing and are not under our control.

Equity Investment

Our majority-owned subsidiary has a non-marketable equity investment which is accounted for under the equity method. The investment is initially recorded at cost and we will adjust the carrying amount for its share of the earnings or losses of the investee after the date of investment. The investment is evaluated periodically for impairment. If it is determined that a decline of the investment is other than temporary, then the investment basis would be written down to fair value and the write-down would be included in earnings as a loss.

Table of Contents

Industry Trends

The skilled nursing industry has evolved to meet the growing demand for post-acute and custodial healthcare services generated by an aging population, increasing life expectancies and the trend toward shifting of patient care to lower cost settings. The skilled nursing industry has evolved in recent years, which we believe has led to a number of favorable improvements in the industry, as described below:

•

Shift of Patient Care to Lower Cost Alternatives. The growth of the senior population in the United States continues to increase healthcare costs, often faster than the available funding from government-sponsored healthcare programs. In response, federal and state governments have adopted cost-containment measures that encourage the treatment of patients in more cost-effective settings such as skilled nursing facilities, for which the staffing requirements and associated costs are often significantly lower than acute care hospitals, inpatient rehabilitation facilities and other post-acute care settings. As a result, skilled nursing facilities are generally serving a larger population of higher-acuity patients than in the past.


•	Significant Acquisition and Consolidation Opportunities. The skilled nursing industry is large and highly fragmented, characterized predominantly by numerous local and regional providers. We believe this fragmentation provides significant acquisition and consolidation opportunities for us.


•	Improving Supply and Demand Balance. The number of skilled nursing facilities has declined modestly over the past several years. We expect that the supply and demand balance in the skilled nursing industry will continue to improve due to the shift of patient care to lower cost settings, an aging population and increasing life expectancies.

•

Increased Demand Driven by Aging Populations and Increased Life Expectancy. As life expectancy continues to increase in the United States and seniors account for a higher percentage of the total U.S. population, we believe the overall demand for skilled nursing services will increase. At present, the primary market demographic for skilled nursing services is primarily individuals age 75 and older. According to the 2010 U.S. Census, there were over 40 million people in the United States in 2010 that are over 65 years old. The 2010 U.S. Census estimates this group is one of the fastest growing segments of the United States population and is expected to more than double between 2000 and 2030.

We believe the skilled nursing industry has been and will continue to be impacted by several other trends. The use of long-term care insurance is increasing among seniors as a means of planning for the costs of skilled nursing services. In addition, as a result of increased mobility in society, reduction of average family size, and the increased number of two-wage earner couples, more seniors are looking for alternatives outside the family for their care.

Effects of Changing Prices — Medicare reimbursement rates and procedures are subject to change from time to time, which could materially impact our revenue. Medicare reimburses our skilled nursing facilities under a prospective payment system (PPS) for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group (RUG) category that is based upon each patient’s acuity level. As of October 1, 2010, the RUG categories were expanded from 53 to 66 with the introduction of minimum data set (MDS) 3.0. Should future changes in skilled nursing facility payments reduce rates or increase the standards for reaching certain reimbursement levels, our Medicare revenues could be reduced, with a corresponding adverse impact on our financial condition or results of operations.

Centers for Medicare and Medicaid Services (CMS) Rulings — On July 27, 2012, the CMS announced a final rule updating Medicare skilled nursing facility PPS payments in fiscal year 2013. The update, a 1.8% or $670 million increase, reflects a 2.5% market basket increase, reduced by a 0.7% multi-factor productivity (MFP) adjustment mandated by the Patient Protection and Affordable Care Act (PPACA). This increase will be offset by the 2% sequestration reduction, discussed below, which will become effective January 1, 2013.

On July 6, 2012, CMS announced its proposed rule for the Home Health Prospective Payment System (PPS) increasing payments to home health service organizations by $20.0 million. The proposed home health rule provides a net increase of 0.1% in Medicare payments, made up of a 2.5% market basket increase, offset by mandatory cuts under the Patient Protection and Affordable Care Act. If finalized, the proposed rule will be effective beginning January 1, 2013.

In July 2012, CMS issued its final rule for hospice services for its 2013 fiscal year. The rule includes a market basket increase of 2.6% less 0.3% reduction in the market basket as a result of the PPACA and a 0.7% reduction due to productivity adjustment.

Should future changes in PPS include further reduced rates or increased standards for reaching certain reimbursement levels, our Medicare revenues derived from our skilled nursing facilities (including rehabilitation therapy services provided at our skilled nursing facilities) could be reduced, with a corresponding adverse impact on our financial condition or results of operations.

Table of Contents

Medicare Part B Therapy Cap — Some of our rehabilitation therapy revenue is paid by the Medicare Part B program under a fee schedule. Congress has established annual caps that limit the amounts that can be paid (including deductible and coinsurance amounts) for rehabilitation therapy services rendered to any Medicare beneficiary under Medicare Part B. The Deficit Reduction Act of 2005 (DRA) added Sec. 1833(g)(5) of the Social Security Act and directed the Centers for Medicare and Medicaid Services to develop a process that allows exceptions for Medicare beneficiaries to therapy caps when continued therapy is deemed medically necessary.

The therapy cap exception was reauthorized in a number of subsequent laws, most recently in the Middle Class Tax Relief and Job Creation Act of 2012 which extends the exceptions process through December 31, 2012. The statutory Medicare Part B outpatient therapy cap for occupational therapy and the combined cap for physical therapy and speech-language pathology services are $1,880, respectively, for 2012. These amounts represent annual per beneficiary therapy caps determined for each calendar year. Similar to the therapy cap, Congress established a threshold of $3,700 for physical therapy and speech-language pathology services combined and a separate threshold of $3,700 for occupational therapy services. All therapy services rendered above this limit are subject to medical review and certain providers will be required to submit a request for an exception. Beginning October 1, 2012 some therapy providers are required to submit requests for exceptions. Prior to October 1, 2012 there was no requirement for an exception request when the threshold was exceeded.

The application of annual caps, or the discontinuation of exceptions to the annual caps, could have an adverse effect on our rehabilitation therapy revenue. Additionally, the exceptions to these caps may not be extended beyond December 31, 2012, which could also have an adverse effect on our revenue after that date.

Medicare Coverage Settlement Agreement — A proposed federal class action settlement was filed in federal district court on October 16, 2012 that would end the Medicare coverage standard for skilled nursing, home health and outpatient therapy services that a beneficiary's condition must be expected to improve. The proposed settlement would require the Centers for Medicare and Medicaid Services to issue guidance stating that skilled nursing, home health and outpatient therapy services can be covered under Medicare so long as the beneficiary's clinical condition required skilled care in order to maintain the beneficiary's current condition or to prevent or slow further deterioration. Implementation of the provisions of this settlement agreement could impact reimbursement for our services favorably.

Federal Regulations — On August 2, 2011, the President signed into law the Budget Control Act of 2011 (Budget Control Act), which raised the debt ceiling and put into effect a series of actions for deficit reduction. The Budget Control Act creates a Congressional Joint Select Committee on Deficit Reduction (the Committee) that was tasked with proposing additional deficit reduction of at least $1.5 trillion over ten years. As the Committee was unable to achieve its targeted savings, this regulation triggered automatic reductions in discretionary and mandatory spending starting in 2013, including reductions of not more than 2% to payments to Medicare providers. The Budget Control Act also requires Congress to vote on an amendment to the Constitution that would require a balanced budget.

State Regulations — On March 24, 2011, the governor of California signed Assembly Bill 97 (AB 97), the budget trailer bill on health, into law. AB 97 outlines significant cuts to state health and human services programs. Specifically, the law reduces provider payments by 10% for physicians, pharmacies, clinics, medical transportation, certain hospitals, home health, and nursing facilities. AB X1 19 Long Term Care was subsequently approved by the governor on June 28, 2011. AB X1 19 limits the 10% payment reduction to skilled-nursing providers to 14 months for the services provided on June 1, 2011 through July 31, 2012, with a promise to repay by December 31, 2012. Federal approval was obtained on October 27, 2011. There can be no assurance that the reduction in provider payments will not lead to material adverse consequences in the future.

Federal Health Care Reform — On March 23, 2010, President Obama signed PPACA into law, which contained several sweeping changes to America’s health insurance system. Among other reforms contained in PPACA, many Medicare providers received reductions in their market basket updates. Unlike for some other Medicare providers, PPACA makes no reduction to the market basket update for skilled nursing facilities in fiscal years 2010 or 2011. However, under PPACA, the skilled nursing facility market basket update will be subject to a full productivity adjustment beginning in fiscal year 2012. In addition, PPACA enacted several reforms with respect to skilled nursing facilities and hospice organizations, including payment measures to realize significant savings of federal and state funds by deterring and prosecuting fraud and abuse in both the Medicare and Medicaid programs. While many of the provisions of PPACA will not take effect for several years or are subject to further refinement through the promulgation of regulations, some key provisions of PPACA are:


•	Enhanced CMPs and Escrow Provisions — PPACA included expanded civil monetary penalty (CMP) provisions applicable to all Medicare and Medicaid providers. PPACA provided for the imposition of CMPs of up to $50,000 and, in some cases, treble damages, for actions relating to alleged false statements to the federal government.

Table of Contents

•

Nursing Home Transparency Requirements — In addition to expanded CMP provisions, PPACA imposed substantial new transparency requirements for Medicare-participating nursing facilities. Existing law required Medicare providers to disclose to CMS: (1) any person or entity that owns directly or indirectly an ownership interest of five percent or more in a provider; (2) officers and directors (if a corporation) and partners (if a partnership); and (3) holders of a mortgage, deed of trust, note or other obligation secured by the entity or the property of the entity. PPACA expanded the information required to be disclosed to include: (4) the facility’s organizational structure; (5) additional information on officers, directors, trustees, and “managing employees” of the facility (including their names, titles, and start dates of services); and (6) information on any “additional disclosable party” of the facility. CMS has not yet promulgated regulations to implement these provisions.

•

Face-to-Face Encounter Requirements — PPACA imposed new patient face-to-face encounter requirements on home health agencies and hospices to establish a patient's ongoing eligibility for Medicare home health services or hospice services, as applicable. Effective for patients with home health starts of care on or after January 1, 2011 and for hospice patients with a third or later benefit period on or after January 1, 2011, a certifying physician or other designated health care professional must conduct and properly document the face-to-face encounters with the Medicare beneficiary within a specified timeframe, and failure of the face-to-face encounter to occur and be properly documented during the applicable timeframe could render the patient's care ineligible for reimbursement under Medicare.

•

Suspension of Payments During Pending Fraud Investigations — PPACA also provided the federal government with expanded authority to suspend payment if a provider is investigated for allegations or issues of fraud. Section 6402 of the PPACA provides that Medicare and Medicaid payments may be suspended pending a “credible investigation of fraud,” unless the Secretary of Health and Human Services determined that good cause exists not to suspend payments. “Credible investigation of fraud” is undefined, although the Secretary must consult with the Office of the Inspector General (OIG) in determining whether a credible investigation of fraud exists. This suspension authority created a new mechanism for the federal government to suspend both Medicare and Medicaid payments for allegations of fraud, independent of whether a state exercised its authority to suspend Medicaid payments pending a fraud investigation. To the extent the Secretary applied this suspension of payments provision to one or more of our facilities for allegations of fraud, such a suspension could adversely affect our revenue, cash flow, financial condition and results of operations. OIG promulgated regulations making these provisions effective as of March 25, 2011.

•

Overpayment Reporting and Repayment; Expanded False Claims Act Liability — PPACA also enacted several important changes that expand potential liability under the federal False Claims Act. PPACA provided that overpayments related to services provided to both Medicare and Medicaid beneficiaries must be reported and returned to the applicable payor within the later of sixty days of identification of the overpayment, or the date the corresponding cost report (if applicable) is due. Any overpayment retained after the deadline is considered an “obligation” for purposes of the federal False Claims Act.

•

Skilled Nursing Facility Value-Based Purchasing Program — PPACA required the U.S. Department of Health and Human Services (HHS) to develop a plan to implement a value-based purchasing program for Medicare payments to skilled nursing facilities. HHS delivered a report to Congress outlining its plans for implementing this value-based purchasing program. The value-based purchasing program would provide payment incentives for Medicare-participating skilled nursing facilities to improve the quality of care provided to Medicare beneficiaries. Among the most relevant factors in HHS' plans to implement value-based purchasing for skilled nursing facilities is the current Nursing Home Value-Based Purchasing Demonstration Project, which will conclude in December 2012. HHS indicates it will complete an evaluation of the demonstration program in the autumn of 2013, and any permanent value-based purchasing program for skilled nursing facilities will be implemented after that evaluation.