Edgar Filing: KINDRED HEALTHCARE, INC

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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 March 31, 2013

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

For the transition period from to .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)


Delaware		61-1323993
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

680 South Fourth Street Louisville, KY		40202-2412
(Address of principal executive offices)		(Zip Code)

(502) 596-7300

(Registrant’s telephone number, including area code)

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

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class of Common Stock		Outstanding at April 30, 2013
Common stock, $0.25 par value		54,037,557 shares

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX


		Page

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited):

	Condensed Consolidated Statement of Operations – for the three months ended March 31, 2013 and 2012		3

	Condensed Consolidated Statement of Comprehensive Income – for the three months ended March 31, 2013 and 2012		4

	Condensed Consolidated Balance Sheet – March 31, 2013 and December 31, 2012		5

	Condensed Consolidated Statement of Cash Flows – for the three months ended March 31, 2013 and 2012		6

	Notes to Condensed Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		34

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		61

Item 4.	Controls and Procedures		62

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings		63

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		63

Item 6.	Exhibits		63

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended March 31,
	2013			2012
Revenues	$	1,554,908		$	1,537,931

Salaries, wages and benefits		943,773			921,359
Supplies		105,808			108,533
Rent		105,978			104,313
Other operating expenses		305,503			296,365
Other income		(993	)		(3,143	)
Impairment charges		436			848
Depreciation and amortization		51,196			46,986
Interest expense		28,174			26,578
Investment income		(91	)		(288	)

		1,539,784			1,501,551

Income from continuing operations before income taxes		15,124			36,380
Provision for income taxes		5,620			14,765

Income from continuing operations		9,504			21,615
Discontinued operations, net of income taxes:
Loss from operations		(4,787	)		(1,803	)
Loss on divestiture of operations		(1,244	)		(1,170	)

Loss from discontinued operations		(6,031	)		(2,973	)

Net income		3,473			18,642
Earnings attributable to noncontrolling interests		(416	)		(451	)

Income attributable to Kindred	$	3,057		$	18,191

Amounts attributable to Kindred stockholders:
Income from continuing operations	$	9,088		$	21,164
Loss from discontinued operations		(6,031	)		(2,973	)

Net income	$	3,057		$	18,191

Earnings per common share:
Basic:
Income from continuing operations	$	0.17		$	0.40
Discontinued operations:
Loss from operations		(0.09	)		(0.03	)
Loss on divestiture of operations		(0.02	)		(0.02	)

Loss from discontinued operations		(0.11	)		(0.05	)

Net income	$	0.06		$	0.35

Diluted:
Income from continuing operations	$	0.17		$	0.40
Discontinued operations:
Loss from operations		(0.09	)		(0.03	)
Loss on divestiture of operations		(0.02	)		(0.02	)

Loss from discontinued operations		(0.11	)		(0.05	)

Net income	$	0.06		$	0.35

Shares used in computing earnings per common share:
Basic		52,062			51,603
Diluted		52,083			51,638

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)


	Three months ended March 31,
	2013			2012
Net income	$	3,473		$	18,642
Other comprehensive income:
Available-for-sale securities (Note 8):
Change in unrealized investment gains		1,613			1,202
Reclassification of (gains) losses realized in net income		119			(77	)

Net change		1,732			1,125
Interest rate swaps (Note 1):
Change in unrealized gains (losses)		844			(131	)
Reclassification of (gains) losses realized in net income, net of payments		(5	)		201

Net change		839			70
Income tax benefit related to items of other comprehensive income		(937	)		(420	)

Other comprehensive income		1,634			775

Comprehensive income		5,107			19,417
Earnings attributable to noncontrolling interests		(416	)		(451	)

Comprehensive income attributable to Kindred	$	4,691		$	18,966

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	March 31, 2013			December 31, 2012
ASSETS
Current assets:
Cash and cash equivalents	$	42,664		$	50,007
Cash—restricted		5,263			5,197
Insurance subsidiary investments		91,057			86,168
Accounts receivable less allowance for loss of $32,656 – March 31, 2013 and $23,959 – December 31, 2012		1,094,750			1,038,605
Inventories		32,057			32,021
Deferred tax assets		11,366			12,663
Income taxes		1,835			13,573
Other		39,781			35,532

		1,318,773			1,273,766
Property and equipment		2,202,083			2,226,903
Accumulated depreciation		(1,088,591	)		(1,083,777	)

		1,113,492			1,143,126
Goodwill		1,041,266			1,041,266
Intangible assets less accumulated amortization of $40,601 – March 31, 2013 and $34,854 – December 31, 2012		434,020			439,767
Assets held for sale		2,793			4,131
Insurance subsidiary investments		146,985			116,424
Other		220,330			219,466

Total assets	$	4,277,659		$	4,237,946

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	193,263		$	210,668
Salaries, wages and other compensation		390,701			389,009
Due to third party payors		34,392			35,420
Professional liability risks		67,859			54,088
Other accrued liabilities		152,241			137,204
Long-term debt due within one year		8,363			8,942

		846,819			835,331
Long-term debt		1,671,279			1,648,706
Professional liability risks		240,070			236,630
Deferred tax liabilities		10,588			9,764
Deferred credits and other liabilities		213,570			214,671
Commitments and contingencies (Note 9)

Equity:
Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 54,047 shares – March 31, 2013 and 53,280 shares – December 31, 2012		13,512			13,320
Capital in excess of par value		1,143,950			1,145,922
Accumulated other comprehensive loss		(248	)		(1,882	)
Retained earnings		101,509			98,799

		1,258,723			1,256,159
Noncontrolling interests		36,610			36,685

Total equity		1,295,333			1,292,844

Total liabilities and equity	$	4,277,659		$	4,237,946

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended March 31,
	2013			2012
Cash flows from operating activities:
Net income	$	3,473		$	18,642
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		52,954			48,690
Amortization of stock-based compensation costs		2,248			1,802
Amortization of deferred financing costs		2,613			2,357
Provision for doubtful accounts		11,266			7,496
Deferred income taxes		(344	)		(3,662	)
Impairment charges		436			867
Loss on divestiture of discontinued operations		1,244			1,170
Other		420			277
Change in operating assets and liabilities:
Accounts receivable		(67,411	)		(57,197	)
Inventories and other assets		(8,147	)		(15,905	)
Accounts payable		(15,790	)		(9,550	)
Income taxes		12,170			31,242
Due to third party payors		(1,028	)		(8,976	)
Other accrued liabilities		30,729			(20,678	)

Net cash provided by (used in) operating activities		24,833			(3,425	)

Cash flows from investing activities:
Routine capital expenditures		(22,370	)		(22,106	)
Development capital expenditures		(2,388	)		(10,622	)
Acquisitions, net of cash acquired		—			(50,448	)
Acquisition deposit		—			(16,866	)
Sale of assets		5,060			1,110
Purchase of insurance subsidiary investments		(10,836	)		(13,773	)
Sale of insurance subsidiary investments		10,002			14,006
Net change in insurance subsidiary cash and cash equivalents		(33,096	)		(13,123	)
Change in other investments		319			269
Other		(144	)		(749	)

Net cash used in investing activities		(53,453	)		(112,302	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		483,500			515,400
Repayment of borrowings under revolving credit		(459,200	)		(397,000	)
Repayment of other long-term debt		(2,666	)		(2,666	)
Payment of deferred financing costs		(202	)		(43	)
Distribution made to noncontrolling interests		(491	)		(1,388	)
Issuance of common stock		4			—
Other		332			—

Net cash provided by financing activities		21,277			114,303

Change in cash and cash equivalents		(7,343	)		(1,424	)
Cash and cash equivalents at beginning of period		50,007			41,561

Cash and cash equivalents at end of period	$	42,664		$	40,137

Supplemental information:
Interest payments	$	13,092		$	12,108
Income tax refunds		9,631			13,956

See accompanying notes.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. is a healthcare services company that through its subsidiaries operates transitional care (“TC”) hospitals, inpatient rehabilitation hospitals (“IRFs”), nursing centers, assisted living facilities, a contract rehabilitation services business and a home health and hospice business across the United States (collectively, the “Company” or “Kindred”). At March 31, 2013, the Company’s hospital division operated 116 TC hospitals (licensed as long-term acute care (“LTAC”) hospitals under the Medicare program) and six IRFs in 26 states. The Company’s nursing center division operated 204 nursing centers and six assisted living facilities in 26 states. The Company’s rehabilitation division provided rehabilitation services primarily in hospitals and long-term care settings. The Company’s home health and hospice division provided home health, hospice and private duty services from 101 locations in ten states.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals and nursing centers to improve its future operating results. For accounting purposes, the operating results of these businesses and the losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets held for sale at March 31, 2013 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 3 for a summary of discontinued operations.

Recently issued accounting requirements

In February 2013, the Financial Accounting Standards Board (the “FASB”) amended its authoritative guidance issued in December 2011 related to the deferral of the requirement to present reclassification adjustments out of accumulated other comprehensive income in both the statement in which net income is presented and the statement in which other comprehensive income is presented. The amended provisions require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under United States generally accepted accounting principles to be reclassified to net income in its entirety in the same reporting period. For all other amounts, an entity is required to cross-reference to other disclosures that provide additional details about these amounts. All other requirements of the original June 2011 update were not impacted by the amendment which became effective for all interim and annual reporting periods beginning after December 15, 2012. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Equity

The following table sets forth the changes in equity attributable to noncontrolling interests and equity attributable to Kindred stockholders for the three months ended March 31, 2013 and 2012 (in thousands):


For the three months ended March 31, 2013:	Redeemable noncontrolling interests			Amounts attributable to Kindred stockholders			Nonredeemable noncontrolling interests			Total equity
Balance at December 31, 2012	$	—		$	1,256,159		$	36,685		$	1,292,844
Comprehensive income:
Net income		—			3,057			416			3,473
Other comprehensive income		—			1,634			—			1,634

		—			4,691			416			5,107
Issuance of common stock in connection with employee benefit plans		—			4			—			4
Shares tendered by employees for statutory tax withholdings upon issuance of common stock		—			(2,810	)		—			(2,810	)
Income tax provision in connection with the issuance of common stock under employee benefit plans		—			(1,569	)		—			(1,569	)
Stock-based compensation amortization		—			2,248			—			2,248
Distribution made to noncontrolling interests		—			—			(491	)		(491	)

Balance at March 31, 2013	$	—		$	1,258,723		$	36,610		$	1,295,333


For the three months ended March 31, 2012:
Balance at December 31, 2011	$	9,704		$	1,288,921		$	31,620		$	1,320,541
Comprehensive income:
Net income		155			18,191			296			18,487
Other comprehensive income		—			775			—			775

		155			18,966			296			19,262
Shares tendered by employees for statutory tax withholdings upon issuance of common stock		—			(1,796	)		—			(1,796	)
Income tax provision in connection with the issuance of common stock under employee benefit plans		—			(2,082	)		—			(2,082	)
Stock-based compensation amortization		—			1,802			—			1,802
Distribution made to noncontrolling interests		(327	)		—			(1,061	)		(1,061	)

Balance at March 31, 2012	$	9,532		$	1,305,811		$	30,855		$	1,336,666

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Derivative financial instruments

In December 2011, the Company entered into two interest rate swap agreements to hedge its floating interest rate on an aggregate of $225 million of outstanding senior secured term loan facility debt (the “Term Loan Facility”) entered into in June 2011. The interest rate swaps have an effective date of January 9, 2012, and expire on January 11, 2016. The Company is required to make payments based upon a fixed interest rate of 1.8925% calculated on the notional amount of $225 million. In exchange, the Company will receive interest on $225 million at a variable interest rate that is based upon the three-month London Interbank Offered Rate (“LIBOR”), subject to a minimum rate of 1.5%. The Company determined the interest rate swaps continue to be effective cash flow hedges at March 31, 2013. The fair value of the interest rate swaps recorded in other accrued liabilities was $1.8 million and $2.6 million at March 31, 2013 and December 31, 2012, respectively.

Other information

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q of Regulation S-X and do not include all of the disclosures normally required by generally accepted accounting principles or those normally required in annual reports on Form 10-K. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2012 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K. The accompanying condensed consolidated balance sheet at December 31, 2012 was derived from audited consolidated financial statements, but does not include all disclosures required by generally accepted accounting principles.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the Company’s customary accounting practices. Management believes that financial information included herein reflects all adjustments necessary for a fair presentation of interim results and, except as otherwise disclosed, all such adjustments are of a normal and recurring nature.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include amounts based upon the estimates and judgments of management. Actual amounts may differ from those estimates.

Reclassifications

Certain prior period amounts have been reclassified to conform with the current period presentation.

NOTE 2 – ACQUISITION

In March 2012, the Company acquired the real estate of a previously leased hospital for $50.4 million. Annual rent associated with the hospital aggregated $4.1 million. The fair value of the asset acquired was measured using discounted cash flow methodologies which are considered Level 3 inputs (as described in Note 10).

The purchase price of this hospital resulted from negotiations with the landlord that were based upon both the historical and expected future cash flows of the hospital and real estate values. This acquisition was financed through operating cash flows and borrowings under the Company’s revolving credit facility.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS

In accordance with the authoritative guidance for the impairment or disposal of long-lived assets, the divestitures of unprofitable businesses discussed in Note 1 have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the losses associated with these transactions have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. At March 31, 2013, the Company held for sale one hospital.

On April 27, 2012, the Company announced that it would not renew seven renewal bundles containing 54 nursing centers (the “Expiring Facilities”) under operating leases with Ventas, Inc. (“Ventas”) that expire on April 30, 2013. The Expiring Facilities contain 6,140 licensed nursing center beds and generated revenues of approximately $475 million for the year ended December 31, 2012. The current annual rent for these facilities approximates $57 million. The Company has also entered into an agreement with Ventas to provide Ventas with more flexibility to accelerate the transfer of the Expiring Facilities, as well as to extend the term of the leases as necessary to facilitate these transfers. The Company may be required to pay for additional capital obligations for the Expiring Facilities under the master lease agreements with Ventas. The Company transferred the operations of 19 of the 54 nursing centers to new operators during the three months ended March 31, 2013. The Company reclassified the results of operations and losses associated with the 19 divestitures to discontinued operations, net of income taxes, for all periods presented. The Company will continue to operate the remaining 35 Expiring Facilities and include the Expiring Facilities in its results from continuing operations through the expiration of the lease term, and for such additional time period as required to transfer operations to new operators. When the Company terminates its operations of the remaining Expiring Facilities, these facilities will be reclassified to discontinued operations.

A summary of discontinued operations follows (in thousands):


	Three months ended March 31,
	2013			2012
Revenues	$	28,505		$	46,733

Salaries, wages and benefits		15,612			23,845
Supplies		1,713			2,762
Rent		3,670			5,384
Other operating expenses		13,530			15,966
Other expense		108			—
Impairment charges		—			19
Depreciation		1,758			1,704
Interest expense		2			—
Investment income		(8	)		(4	)

		36,385			49,676

Loss from operations before income taxes		(7,880	)		(2,943	)
Income tax benefit		(3,093	)		(1,140	)

Loss from operations		(4,787	)		(1,803	)
Loss on divestiture operations		(1,244	)		(1,170	)

Loss from discontinued operations	$	(6,031	)	$	(2,973	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

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


	Three months ended March 31,
	2013			2012
Revenues:
Hospital division	$	(56	)	$	3,785
Nursing center division		28,561			42,948

	$	28,505		$	46,733

Operating income (loss):
Hospital division	$	(673	)	$	(1,746	)
Nursing center division		(1,785	)		5,887

	$	(2,458	)	$	4,141

Rent:
Hospital division	$	16		$	375
Nursing center division		3,654			5,009

	$	3,670		$	5,384

Depreciation:
Hospital division	$	4		$	257
Nursing center division		1,754			1,447

	$	1,758		$	1,704

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


	March 31, 2013			December 31, 2012
Long-term assets:
Property and equipment, net	$	2,793		$	4,126
Other		—			5

		2,793			4,131
Current liabilities (included in other accrued liabilities)		(29	)		—

	$	2,764		$	4,131

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – REVENUES

Revenues are recorded based upon estimated amounts due from patients and third party payors for healthcare services provided, including anticipated settlements under reimbursement agreements with Medicare, Medicaid, Medicare Advantage and other third party payors.

A summary of revenues by payor type follows (in thousands):


	Three months ended March 31,
	2013			2012
Medicare	$	675,050		$	665,509
Medicaid		243,281			246,216
Medicare Advantage		116,880			111,508
Other		602,639			598,113

		1,637,850			1,621,346
Eliminations		(82,942	)		(83,415	)

	$	1,554,908		$	1,537,931

NOTE 5 – EARNINGS PER SHARE

Earnings per common share are based upon the weighted average number of common shares outstanding during the respective periods. The diluted calculation of earnings per common share includes the dilutive effect of stock options. The Company follows the provisions of the authoritative guidance for determining whether instruments granted in share-based payment transactions are participating securities, which requires that unvested restricted stock that entitles the holder to receive nonforfeitable dividends before vesting be included as a participating security in the basic and diluted earnings per common share calculation pursuant to the two-class method.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – EARNINGS PER SHARE (Continued)

A computation of earnings per common share follows (in thousands, except per share amounts):


	Three months ended March 31,
	2013						2012
	Basic			Diluted			Basic			Diluted
Earnings:
Amounts attributable to Kindred stockholders:
Income from continuing operations:
As reported in Statement of Operations	$	9,088		$	9,088		$	21,164		$	21,164
Allocation to participating unvested restricted stockholders		(256	)		(256	)		(289	)		(289	)

Available to common stockholders	$	8,832		$	8,832		$	20,875		$	20,875

Discontinued operations, net of income taxes:
Loss from operations:
As reported in Statement of Operations	$	(4,787	)	$	(4,787	)	$	(1,803	)	$	(1,803	)
Allocation to participating unvested restricted stockholders		135			135			25			25

Available to common stockholders	$	(4,652	)	$	(4,652	)	$	(1,778	)	$	(1,778	)

Loss on divestiture of operations:
As reported in Statement of Operations	$	(1,244	)	$	(1,244	)	$	(1,170	)	$	(1,170	)
Allocation to participating unvested restricted stockholders		35			35			16			16

Available to common stockholders	$	(1,209	)	$	(1,209	)	$	(1,154	)	$	(1,154	)

Loss from discontinued operations:
As reported in Statement of Operations	$	(6,031	)	$	(6,031	)	$	(2,973	)	$	(2,973	)
Allocation to participating unvested restricted stockholders		170			170			41			41

Available to common stockholders	$	(5,861	)	$	(5,861	)	$	(2,932	)	$	(2,932	)

Net income:
As reported in Statement of Operations	$	3,057		$	3,057		$	18,191		$	18,191
Allocation to participating unvested restricted stockholders		(86	)		(86	)		(248	)		(248	)

Available to common stockholders	$	2,971		$	2,971		$	17,943		$	17,943

Shares used in the computation:
Weighted average shares outstanding–basic computation		52,062			52,062			51,603			51,603

Dilutive effect of employee stock options					21						35

Adjusted weighted average shares outstanding–diluted computation					52,083						51,638

Earnings per common share:
Income from continuing operations	$	0.17		$	0.17		$	0.40		$	0.40
Discontinued operations:
Loss from operations		(0.09	)		(0.09	)		(0.03	)		(0.03	)
Loss on divestiture of operations		(0.02	)		(0.02	)		(0.02	)		(0.02	)

Loss from discontinued operations		(0.11	)		(0.11	)		(0.05	)		(0.05	)

Net income	$	0.06		$	0.06		$	0.35		$	0.35

Number of antidilutive stock options excluded from shares used in the diluted earnings per common share computation					1,274						2,562

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA

The Company is organized into four operating divisions: the hospital division, the nursing center division, the rehabilitation division and the home health and hospice division. Based upon the authoritative guidance for business segments, the operating divisions represent five reportable operating segments, including (1) hospitals, (2) nursing centers, (3) skilled nursing rehabilitation services, (4) hospital rehabilitation services and (5) home health and hospice services. These reportable operating segments are consistent with information used by the Company’s President and Chief Operating Officer to assess performance and allocate resources. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies. Prior period segment information has been reclassified to conform with the current period presentation.

For segment purposes, the Company defines operating income as earnings before interest, income taxes, depreciation, amortization and rent. Segment operating income reported for each of the Company’s operating segments excludes impairment charges, transaction costs and the allocation of corporate overhead.

On January 1, 2013, the Company transferred the operations of its hospital-based sub-acute unit business from the hospital division to the nursing center division. Historical amounts have been reclassified to conform with the current period presentation.

Segment operating income for the three months ended March 31, 2013 included one-time bonus costs paid to approximately 50,000 employees who do not participate in the Company’s incentive compensation program of $25.9 million (hospital division – $8.8 million, nursing center division – $9.7 million, rehabilitation division – $6.3 million (skilled nursing rehabilitation services – $5.0 million and hospital rehabilitation services – $1.3 million), home health and hospice division – $0.8 million and corporate – $0.3 million).

Segment operating income for the hospital division for the three months ended March 31, 2013 also included employee retention costs of $0.3 million incurred in connection with the planned divestiture of 17 non-strategic facilities.

Segment operating income for the nursing center division for the three months ended March 31, 2013 also included employee retention costs of $0.4 million incurred in connection with the nonrenewal of 54 nursing centers leased from Ventas.

Segment operating income for the hospital division for the three months ended March 31, 2012 included severance costs of $2.0 million and other costs of $0.1 million incurred in connection with the closing of a regional office.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA (Continued)

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


	Three months ended March 31,
	2013			2012
Revenues:
Hospital division	$	748,214		$	749,383
Nursing center division		502,703			512,148
Rehabilitation division:
Skilled nursing rehabilitation services		260,789			257,014
Hospital rehabilitation services		74,523			74,369

		335,312			331,383
Home health and hospice division		51,621			28,432

		1,637,850			1,621,346
Eliminations:
Skilled nursing rehabilitation services		(52,889	)		(53,612	)
Hospital rehabilitation services		(27,994	)		(28,161	)
Nursing centers		(2,059	)		(1,642	)

		(82,942	)		(83,415	)

	$	1,554,908		$	1,537,931

Income from continuing operations:
Operating income (loss):
Hospital division	$	161,819		$	161,826
Nursing center division		51,178			63,906
Rehabilitation division:
Skilled nursing rehabilitation services		15,278			14,323
Hospital rehabilitation services		18,132			16,116

		33,410			30,439
Home health and hospice division		2,786			2,341
Corporate:
Overhead		(45,582	)		(42,728	)
Insurance subsidiary		(509	)		(482	)

		(46,091	)		(43,210	)
Impairment charges		(436	)		(848	)
Transaction costs		(2,285	)		(485	)

Operating income		200,381			213,969
Rent		(105,978	)		(104,313	)
Depreciation and amortization		(51,196	)		(46,986	)
Interest, net		(28,083	)		(26,290	)

Income from continuing operations before income taxes		15,124			36,380
Provision for income taxes		5,620			14,765

	$	9,504		$	21,615

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA (Continued)


	Three months ended March 31,
	2013		2012
Rent:
Hospital division	$	53,148	$	53,151
Nursing center division		49,766		48,451
Rehabilitation division:
Skilled nursing rehabilitation services		1,235		1,440
Hospital rehabilitation services		17		78

		1,252		1,518
Home health and hospice division		1,186		615
Corporate		626		578

	$	105,978	$	104,313

Depreciation and amortization:
Hospital division	$	23,941	$	22,346
Nursing center division		12,720		11,262
Rehabilitation division:
Skilled nursing rehabilitation services		3,112		2,660
Hospital rehabilitation services		2,331		2,324

		5,443		4,984
Home health and hospice division		1,526		898
Corporate		7,566		7,496

	$	51,196	$	46,986

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division:
Routine	$	10,271	$	10,345
Development		2,388		9,949

		12,659		20,294

Nursing center division:
Routine		5,819		4,229
Development		—		673

		5,819		4,902

Rehabilitation division:
Skilled nursing rehabilitation services:
Routine		605		326
Development		—		—

		605		326

Hospital rehabilitation services:
Routine		32		46
Development		—		—

		32		46

Home health and hospice division:
Routine		195		124
Development		—		—

		195		124

Corporate:
Routine:
Information systems		5,289		6,864
Other		159		172

	$	24,758	$	32,728

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA (Continued)


	March 31, 2013		December 31, 2012
Assets at end of period:
Hospital division	$	2,148,491	$	2,129,303
Nursing center division		619,505		626,016
Rehabilitation division:
Skilled nursing rehabilitation services		354,590		336,445
Hospital rehabilitation services		338,874		340,668

		693,464		677,113
Home health and hospice division		204,457		202,156
Corporate		611,742		603,358

	$	4,277,659	$	4,237,946

Goodwill:
Hospital division	$	747,065	$	747,065
Rehabilitation division:
Skilled nursing rehabilitation services		—		—
Hospital rehabilitation services		168,019		168,019

		168,019		168,019
Home health and hospice division		126,182		126,182

	$	1,041,266	$	1,041,266

NOTE 7 – INSURANCE RISKS

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

The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of, or less than, the amounts recorded. To the extent that expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited.

The provision for loss for insurance risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, follows (in thousands):


	Three months ended March 31,
	2013		2012
Professional liability:
Continuing operations	$	21,605	$	17,951
Discontinued operations		3,860		798
Workers compensation:
Continuing operations	$	14,894	$	14,319
Discontinued operations		578		652

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – INSURANCE RISKS (Continued)

A summary of the assets and liabilities related to insurance risks included in the accompanying unaudited condensed consolidated balance sheet follows (in thousands):


	March 31, 2013						December 31, 2012
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	55,196	$	35,861	$	91,057	$	53,133	$	33,035	$	86,168
Reinsurance recoverables		4,116		—		4,116		5,382		—		5,382
Other		—		150		150		—		150		150

		59,312		36,011		95,323		58,515		33,185		91,700
Non-current:
Insurance subsidiary investments		71,685		75,300		146,985		46,546		69,878		116,424
Reinsurance and other recoverables		63,741		73,965		137,706		58,025		76,794		134,819
Deposits		4,238		1,574		5,812		3,977		1,574		5,551
Other		—		40		40		—		40		40

		139,664		150,879		290,543		108,548		148,286		256,834

	$	198,976	$	186,890	$	385,866	$	167,063	$	181,471	$	348,534

Liabilities:
Allowance for insurance risks:
Current	$	67,859	$	39,978	$	107,837	$	54,088	$	37,096	$	91,184
Non-current		240,070		154,742		394,812		236,630		156,265		392,895

	$	307,929	$	194,720	$	502,649	$	290,718	$	193,361	$	484,079

Provisions for loss for professional liability risks retained by the Company’s limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 1% to 5% depending upon the policy year. The discount rate was 1% for the 2013 and 2012 policy years. The discount rates are based upon the risk free interest rate for the respective year. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $310.6 million at March 31, 2013 and $293.3 million at December 31, 2012.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually.

NOTE 8 – INSURANCE SUBSIDIARY INVESTMENTS

The Company maintains investments, consisting principally of cash and cash equivalents, debt securities, equities and certificates of deposit for the payment of claims and expenses related to professional liability and workers compensation risks. These investments have been categorized as available-for-sale and are reported at fair value.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE SUBSIDIARY INVESTMENTS (Continued)

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


	March 31, 2013									December 31, 2012
	Cost		Unrealized gains		Unrealized losses			Fair value		Cost		Unrealized gains		Unrealized losses			Fair value
Cash and cash equivalents (a)	$	173,258	$	—	$	—		$	173,258	$	140,162	$	—	$	—		$	140,162
Debt securities:
Debt securities issued by U.S. government agencies		19,919		74		(1	)		19,992		16,624		89		—			16,713
Corporate bonds		19,538		85		(20	)		19,603		21,352		118		(16	)		21,454
U.S. Treasury notes		5,666		3		—			5,669		6,131		3		—			6,134

		45,123		162		(21	)		45,264		44,107		210		(16	)		44,301
Equities by industry:
Consumer		2,171		986		—			3,157		2,171		599		(15	)		2,755
Industrials		2,039		532		(27	)		2,544		2,039		331		(53	)		2,317
Healthcare		1,474		429		—			1,903		1,474		179		(14	)		1,639
Technology		1,482		374		—			1,856		1,482		268		(70	)		1,680
Financial services		1,419		466		(61	)		1,824		1,419		284		(86	)		1,617
Other		2,411		1,041		(70	)		3,382		2,554		706		(243	)		3,017

		10,996		3,828		(158	)		14,666		11,139		2,367		(481	)		13,025
Certificates of deposit		4,850		4		—			4,854		5,101		3		—			5,104

	$	234,227	$	3,994	$	(179	)	$	238,042	$	200,509	$	2,580	$	(497	)	$	202,592

(a)	Includes $3.1 million and $3.7 million of money market funds at March 31, 2013 and December 31, 2012, respectively.

The Company’s investment policy governing insurance subsidiary investments precludes the investment portfolio managers from selling any security at a loss without prior authorization from the Company. The investment managers also limit the exposure to any one issue, issuer or type of investment. The Company intends, and has the ability, to hold insurance subsidiary investments for a long duration without the necessity of selling securities to fund the underwriting needs of its insurance subsidiary. This ability to hold securities allows sufficient time for recovery of temporary declines in the market value of equity securities and the par value of debt securities as of their stated maturity date.

The Company considered the severity and duration of its unrealized losses at March 31, 2013 and recognized a $0.1 million pretax-other-than-temporary impairment in the first quarter of 2013 for various investments held in its insurance subsidiary investment portfolio. The Company considered the severity and duration of its unrealized losses at March 31, 2012 for various investments held in its insurance subsidiary investment portfolio and determined that these unrealized losses were temporary and did not record any impairment losses related to these investments.

As a result of deterioration in professional liability and workers compensation underwriting results of the Company’s limited purpose insurance subsidiary in 2012 and 2011, the Company made capital contributions of $14.2 million and $8.6 million during the three months ended March 31, 2013 and 2012, respectively, to its limited purpose insurance subsidiary. These transactions were completed in accordance with applicable regulations. Neither capital contribution had any impact on earnings.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9 – CONTINGENCIES

Management continually evaluates contingencies based upon the best available information. In addition, allowances for losses are provided currently for disputed items that have continuing significance, such as certain third party reimbursements and deductions that continue to be claimed in current cost reports and tax returns.

Management believes that allowances for losses have been provided to the extent necessary and that its assessment of contingencies is reasonable.

Principal contingencies are described below:

Revenues—Certain third party payments are subject to examination by agencies administering the various reimbursement programs. The Company is contesting certain issues raised in audits of prior year cost reports.

Professional liability risks—The Company has provided for losses for professional liability risks based upon management’s best available information including actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Note 7.

Income taxes—The Company is subject to various federal and state income tax audits in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties.

Litigation—The Company is a party to various legal actions (some of which are not insured), and regulatory and other governmental audits and investigations in the ordinary course of business. The Company cannot predict the ultimate outcome of pending litigation and regulatory and other governmental audits and investigations. These matters could potentially subject the Company to sanctions, damages, recoupments, fines and other penalties. The U.S. Department of Justice (the “DOJ”), the Centers for Medicare and Medicaid Services (“CMS”) or other federal and state enforcement and regulatory agencies may conduct additional investigations related to the Company’s businesses in the future which may, either individually or in the aggregate, have a material adverse effect on the Company’s business, financial position, results of operations and liquidity. See Note 12.

Other indemnifications—In the ordinary course of business, the Company enters into contracts containing standard indemnification provisions and indemnifications specific to a transaction, such as a disposal of an operating facility. These indemnifications may cover claims related to employment-related matters, governmental regulations, environmental issues and tax matters, as well as patient, third party payor, supplier and contractual relationships. Obligations under these indemnities generally are initiated by a breach of the terms of a contract or by a third party claim or event.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The Company follows the provisions of the authoritative guidance for fair value measurements, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles.

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The guidance related to fair value measures establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:


Level 1		Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as certain U.S. Treasury, other U.S. Government and agency asset backed debt securities that are highly liquid and are actively traded in over-the-counter markets.

Level 2		Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3		Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

The Company’s assets and liabilities measured at fair value on a recurring and non-recurring basis and any associated losses are summarized below (in thousands):


	Fair value measurements							Assets/liabilities at fair value			Total losses
	Level 1		Level 2			Level 3		Assets/liabilities at fair value			Total losses
March 31, 2013:
Recurring:
Assets:
Available-for-sale debt securities:
Debt securities issued by U.S. government agencies	$	—	$	19,992		$	—	$	19,992		$	—
Corporate bonds		—		19,603			—		19,603			—
U.S. Treasury notes		5,669		—			—		5,669			—

		5,669		39,595			—		45,264			—
Available-for-sale equity securities		14,666		—			—		14,666			—
Money market funds		6,527		—			—		6,527			—
Certificates of deposit		—		4,854			—		4,854			—

Total available-for-sale investments		26,862		44,449			—		71,311			—
Deposits held in money market funds		347		4,238			—		4,585			—

	$	27,209	$	48,687		$	—	$	75,896		$	—

Liabilities:
Interest rate swaps	$	—	$	(1,804	)	$	—	$	(1,804	)	$	—

Non-recurring:
Assets:
Hospital available for sale	$	—	$	—		$	3,250	$	3,250		$	(1,250	)
Property and equipment		—		—			29		29			(436	)

	$	—	$	—		$	3,279	$	3,279		$	(1,686	)

Liabilities	$	—	$	—		$	—	$	—		$	—

December 31, 2012:
Recurring:
Assets:
Available-for-sale debt securities:
Debt securities issued by U.S. government agencies	$	—	$	16,713		$	—	$	16,713		$	—
Corporate bonds		—		21,454			—		21,454			—
U.S. Treasury notes		6,134		—			—		6,134			—

		6,134		38,167			—		44,301			—
Available-for-sale equity securities		13,025		—			—		13,025			—
Money market funds		7,438		—			—		7,438			—
Certificates of deposit		—		5,104			—		5,104			—

Total available-for-sale investments		26,597		43,271			—		69,868			—
Deposits held in money market funds		347		3,978			—		4,325			—

	$	26,944	$	47,249		$	—	$	74,193		$	—

Liabilities:
Interest rate swaps	$	—	$	(2,649	)	$	—	$	(2,649	)	$	—

Non-recurring:
Assets:
Hospital available for sale	$	—	$	—		$	105	$	105		$	(569	)
Property and equipment		—		—			286		286			(3,630	)
Goodwill—skilled nursing rehabilitation services		—		—			—		—			(107,899	)
Intangible assets—Medicare license		—		—			—		—			(2,530	)

	$	—	$	—		$	391	$	391		$	(114,628	)

Liabilities	$	—	$	—		$	—	$	—		$	—

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Recurring measurements

The Company’s available-for-sale investments held by its limited purpose insurance subsidiary consist of debt securities, equities, money market funds and certificates of deposit. These available-for-sale investments and the insurance subsidiary’s cash and cash equivalents of $170.2 million as of March 31, 2013 and $136.5 million as of December 31, 2012, classified as insurance subsidiary investments, are maintained for the payment of claims and expenses related to professional liability and workers compensation risks.

The Company also has available-for-sale investments totaling $3.4 million as of March 31, 2013 and $3.7 million as of December 31, 2012 related to a deferred compensation plan that is maintained for certain of the Company’s current and former employees.

The fair value of actively traded debt and equity securities and money market funds are based upon quoted market prices and are generally classified as Level 1. The fair value of inactively traded debt securities and certificates of deposit are based upon either quoted market prices of similar securities or observable inputs such as interest rates using either a market or income valuation approach and are generally classified as Level 2. The Company’s investment advisors obtain and review pricing for each security. The Company is responsible for the determination of fair value and as such the Company reviews the pricing information from its advisors in determining reasonable estimates of fair value. Based upon the Company’s internal review procedures, there were no adjustments to the prices during the three months ended March 31, 2013 or March 31, 2012.

The Company’s deposits held in money market funds consist primarily of cash and cash equivalents held for general corporate purposes.

The fair value of the derivative liability associated with the interest rate swaps is estimated using industry-standard valuation models, which are Level 2 measurements. Such models project future cash flows and discount the future amounts to a present value using market-based observable inputs, including interest rate curves.

The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments. The carrying value is equal to fair value for financial instruments that are based upon quoted market prices or current market rates. The Company’s long-term debt is based upon Level 2 inputs.


	March 31, 2013				December 31, 2012
(In thousands)	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	42,664	$	42,664	$	50,007	$	50,007
Cash–restricted		5,263		5,263		5,197		5,197
Insurance subsidiary investments		238,042		238,042		202,592		202,592
Tax refund escrow investments		207		207		207		207
Long-term debt, including amounts due within one year (excluding capital lease obligations totaling $26,000 and $0.6 million at March 31, 2013 and December 31, 2012, respectively)		1,679,616		1,687,614		1,657,039		1,630,649

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Non-recurring measurements

In the first quarter of 2013, the Company reduced the fair value of a hospital held for sale based upon a pending offer, which resulted in a pretax loss of $1.3 million recorded in discontinued operations. The primary reason for the reduction was to compensate for certain real estate restrictions associated with the property. The fair value of the asset was measured using a Level 3 input of the pending offer.

CMS issued final rules which, among other things, significantly reduced Medicare payments to nursing centers and changed the reimbursement for the provision for group rehabilitation therapy services to Medicare beneficiaries beginning October 1, 2011 (the “2011 CMS Rules”). The Company recorded pretax impairment charges aggregating $0.4 million in the first quarter of 2013 for property and equipment expenditures in the nursing center asset groups that were determined to be impaired by the 2011 CMS Rules. These charges reflected the amount by which the carrying value of certain assets exceeded their estimated fair value. The fair value of property and equipment was measured using Level 3 inputs such as replacement costs factoring in depreciation, economic obsolesce and inflation trends.

NOTE 11 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION

The accompanying unaudited condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X, Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The Company’s private placement of $550 million of senior notes due 2019 (the “Notes”) issued on June 1, 2011 are fully and unconditionally guaranteed, subject to certain customary release provisions, by substantially all of the Company’s domestic 100% owned subsidiaries. The equity method has been used with respect to the parent company’s investment in subsidiaries.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

The following unaudited condensed consolidating financial data present the financial position of the parent company/issuer, the guarantor subsidiaries and the non-guarantor subsidiaries as of March 31, 2013 and December 31, 2012, and the respective results of operations and cash flows for the three months ended March 31, 2013 and March 31, 2012.

Condensed Consolidating Statement of Operations and Comprehensive Income (Loss)


	Three months ended March 31, 2013
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,455,428		$	128,501		$	(29,021	)	$	1,554,908

Salaries, wages and benefits		3			898,450			45,320			—			943,773
Supplies		—			96,965			8,843			—			105,808
Rent		—			97,950			8,028			—			105,978
Other operating expenses		—			282,144			52,380			(29,021	)		305,503
Other income		—			(993	)		—			—			(993	)
Impairment charges		—			436			—			—			436
Depreciation and amortization		—			48,082			3,114			—			51,196
Management fees		—			(3,059	)		3,059			—			—
Intercompany interest (income) expense from affiliates		(26,874	)		23,218			3,656			—			—
Interest expense (income)		27,033			(3,955	)		5,096			—			28,174
Investment income		—			(42	)		(49	)		—			(91	)
Equity in net income of consolidating affiliates		(3,126	)		—			—			3,126			—

		(2,964	)		1,439,196			129,447			(25,895	)		1,539,784

Income (loss) from continuing operations before income taxes		2,964			16,232			(946	)		(3,126	)		15,124
Provision (benefit) for income taxes		(93	)		5,587			126			—			5,620

Income (loss) from continuing operations		3,057			10,645			(1,072	)		(3,126	)		9,504
Discontinued operations, net of income taxes:
Loss from operations		—			(4,787	)		—			—			(4,787	)
Loss on divestiture of operations		—			(1,244	)		—			—			(1,244	)

Loss from discontinued operations		—			(6,031	)		—			—			(6,031	)

Net income (loss)		3,057			4,614			(1,072	)		(3,126	)		3,473
Earnings attributable to noncontrolling interests		—			—			(416	)		—			(416	)

Income (loss) attributable to Kindred	$	3,057		$	4,614		$	(1,488	)	$	(3,126	)	$	3,057

Comprehensive income	$	4,691		$	4,614		$	54		$	(4,252	)	$	5,107

Comprehensive income (loss) attributable to Kindred	$	4,691		$	4,614		$	(362	)	$	(4,252	)	$	4,691

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

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


	Three months ended March 31, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,436,195		$	126,848		$	(25,112	)	$	1,537,931

Salaries, wages and benefits		69			877,470			43,820			—			921,359
Supplies		—			98,536			9,997			—			108,533
Rent		—			96,400			7,913			—			104,313
Other operating expenses		3			271,560			49,914			(25,112	)		296,365
Other income		—			(3,143	)		—			—			(3,143	)
Impairment charges		—			848			—			—			848
Depreciation and amortization		—			43,605			3,381			—			46,986
Management fees		—			(3,348	)		3,348			—			—
Intercompany interest (income) expense from affiliates		(27,907	)		24,277			3,630			—			—
Interest expense (income)		26,293			(4,762	)		5,047			—			26,578
Investment income		—			(23	)		(265	)		—			(288	)
Equity in net income of consolidating affiliates		(17,218	)		—			—			17,218			—

		(18,760	)		1,401,420			126,785			(7,894	)		1,501,551

Income from continuing operations before income taxes		18,760			34,775			63			(17,218	)		36,380
Provision for income taxes		569			14,089			107			—			14,765

Income (loss) from continuing operations		18,191			20,686			(44	)		(17,218	)		21,615
Discontinued operations, net of income taxes:
Loss from operations		—			(1,803	)		—			—			(1,803	)
Loss on divestiture of operations		—			(1,170	)		—			—			(1,170	)

Loss from discontinued operations		—			(2,973	)		—			—			(2,973	)

Net income (loss)		18,191			17,713			(44	)		(17,218	)		18,642
Earnings attributable to noncontrolling interests		—			—			(451	)		—			(451	)

Income (loss) attributable to Kindred	$	18,191		$	17,713		$	(495	)	$	(17,218	)	$	18,191

Comprehensive income	$	18,966		$	17,713		$	688		$	(17,950	)	$	19,417

Comprehensive income attributable to Kindred	$	18,966		$	17,713		$	237		$	(17,950	)	$	18,966

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Balance Sheet


	As of March 31, 2013
(In thousands)	Parent company/ issuer		Guarantor subsidiaries		Non-guarantor subsidiaries		Consolidating and eliminating adjustments			Consolidated
ASSETS
Current assets:
Cash and cash equivalents	$	—	$	31,989	$	10,675	$	—		$	42,664
Cash—restricted		—		5,263		—		—			5,263
Insurance subsidiary investments		—		—		91,057		—			91,057
Accounts receivable, net		—		991,184		103,566		—			1,094,750
Inventories		—		29,035		3,022		—			32,057
Deferred tax assets		—		11,366		—		—			11,366
Income taxes		—		1,425		410		—			1,835
Other		—		36,484		3,297		—			39,781

		—		1,106,746		212,027		—			1,318,773

Property and equipment, net		—		1,062,014		51,478		—			1,113,492
Goodwill		—		771,533		269,733		—			1,041,266
Intangible assets, net		—		411,345		22,675		—			434,020
Assets held for sale		—		2,793		—		—			2,793
Insurance subsidiary investments		—		—		146,985		—			146,985
Investment in subsidiaries		225,800		—		—		(225,800	)		—
Intercompany		2,691,072		—		—		(2,691,072	)		—
Deferred tax assets		—		—		13,326		(13,326	)		—
Other		44,958		103,310		72,062		—			220,330

	$	2,961,830	$	3,457,741	$	788,286	$	(2,930,198	)	$	4,277,659

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	49	$	179,025	$	14,189	$	—		$	193,263
Salaries, wages and other compensation		—		344,850		45,851		—			390,701
Due to third party payors		—		34,392		—		—			34,392
Professional liability risks		—		15,289		52,570		—			67,859
Other accrued liabilities		28,004		116,081		8,156		—			152,241
Long-term debt due within one year		8,000		105		258		—			8,363

		36,053		689,742		121,024		—			846,819
Long-term debt		1,667,054		330		3,895		—			1,671,279
Intercompany		—		2,348,784		342,288		(2,691,072	)		—
Professional liability risks		—		62,376		177,694		—			240,070
Deferred tax liabilities		—		23,914		—		(13,326	)		10,588
Deferred credits and other liabilities		—		140,014		73,556		—			213,570
Commitments and contingencies
Equity:
Stockholders’ equity		1,258,723		192,581		33,219		(225,800	)		1,258,723
Noncontrolling interests		—		—		36,610		—			36,610

		1,258,723		192,581		69,829		(225,800	)		1,295,333

	$	2,961,830	$	3,457,741	$	788,286	$	(2,930,198	)	$	4,277,659

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Balance Sheet (Continued)


	As of December 31, 2012
(In thousands)	Parent company/ issuer		Guarantor subsidiaries		Non-guarantor subsidiaries		Consolidating and eliminating adjustments			Consolidated
ASSETS
Current assets:
Cash and cash equivalents	$	—	$	37,370	$	12,637	$	—		$	50,007
Cash—restricted		—		5,197		—		—			5,197
Insurance subsidiary investments		—		—		86,168		—			86,168
Accounts receivable, net		—		940,524		98,081		—			1,038,605
Inventories		—		29,023		2,998		—			32,021
Deferred tax assets		—		12,663		—		—			12,663
Income taxes		—		13,187		386		—			13,573
Other		—		15,118		20,414		—			35,532

		—		1,053,082		220,684		—			1,273,766

Property and equipment, net		—		1,090,523		52,603		—			1,143,126
Goodwill		—		771,533		269,733		—			1,041,266
Intangible assets, net		—		417,092		22,675		—			439,767
Assets held for sale		—		4,131		—		—			4,131
Insurance subsidiary investments		—		—		116,424		—			116,424
Investment in subsidiaries		221,799		—		—		(221,799	)		—
Intercompany		2,655,242		—		—		(2,655,242	)		—
Deferred tax assets		1,040		—		13,932		(14,972	)		—
Other		47,364		108,143		63,959		—			219,466

	$	2,925,445	$	3,444,504	$	760,010	$	(2,892,013	)	$	4,237,946

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	168	$	195,268	$	15,232	$	—		$	210,668
Salaries, wages and other compensation		—		345,223		43,786		—			389,009
Due to third party payors		—		35,420		—		—			35,420
Professional liability risks		—		3,623		50,465		—			54,088
Other accrued liabilities		16,724		111,113		9,367		—			137,204
Long-term debt due within one year		8,000		102		840		—			8,942

		24,892		690,749		119,690		—			835,331
Long-term debt		1,644,394		358		3,954		—			1,648,706
Intercompany		—		2,328,711		326,531		(2,655,242	)		—
Professional liability risks		—		68,116		168,514		—			236,630
Deferred tax liabilities		—		24,736		—		(14,972	)		9,764
Deferred credits and other liabilities		—		143,722		70,949		—			214,671
Commitments and contingencies
Equity:
Stockholders’ equity		1,256,159		188,112		33,687		(221,799	)		1,256,159
Noncontrolling interests		—		—		36,685		—			36,685

		1,256,159		188,112		70,372		(221,799	)		1,292,844

	$	2,925,445	$	3,444,504	$	760,010	$	(2,892,013	)	$	4,237,946

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Cash Flows


	Three months ended March 31, 2013
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Net cash provided by operating activities	$	11,229		$	7,981		$	5,623		$	—		$	24,833

Cash flows from investing activities:
Routine capital expenditures		—			(20,142	)		(2,228	)		—			(22,370	)
Development capital expenditures		—			(2,222	)		(166	)		—			(2,388	)
Sale of assets		—			5,060			—			—			5,060
Purchase of insurance subsidiary investments		—			—			(10,836	)		—			(10,836	)
Sale of insurance subsidiary investments		—			—			10,002			—			10,002
Net change in insurance subsidiary cash and cash equivalents		—			—			(33,096	)		—			(33,096	)
Change in other investments		—			319			—			—			319
Capital contribution to insurance subsidiary		—			(14,220	)		—			14,220			—
Other		—			(144	)		—			—			(144	)

Net cash used in investing activities		—			(31,349	)		(36,324	)		14,220			(53,453	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		483,500			—			—			—			483,500
Repayment of borrowings under revolving credit		(459,200	)		—			—			—			(459,200	)
Repayment of other long-term debt		(2,000	)		(25	)		(641	)		—			(2,666	)
Payment of deferred financing costs		(202	)		—			—			—			(202	)
Distribution made to noncontrolling interests		—			—			(491	)		—			(491	)
Issuance of common stock		4			—			—			—			4
Capital contribution to insurance subsidiary		—			—			14,220			(14,220	)
Other		—			332			—			—			332
Change in intercompany accounts		(33,331	)		17,680			15,651			—			—

Net cash provided by (used in) financing activities		(11,229	)		17,987			28,739			(14,220	)		21,277

Change in cash and cash equivalents		—			(5,381	)		(1,962	)		—			(7,343	)
Cash and cash equivalents at beginning of period		—			37,370			12,637			—			50,007

Cash and cash equivalents at end of period	$	—		$	31,989		$	10,675		$	—		$	42,664

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Cash Flows (Continued)


	Three months ended March 31, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Net cash provided by (used in) operating activities	$	2,431		$	(12,603	)	$	6,747		$	—		$	(3,425	)

Cash flows from investing activities:
Routine capital expenditures		—			(20,940	)		(1,166	)		—			(22,106	)
Development capital expenditures		—			(9,703	)		(919	)		—			(10,622	)
Acquisitions, net of cash acquired		—			(50,448	)		—			—			(50,448	)
Acquisition deposit		—			(16,866	)		—			—			(16,866	)
Sale of assets		—			1,110			—			—			1,110
Purchase of insurance subsidiary investments		—			—			(13,773	)		—			(13,773	)
Sale of insurance subsidiary investments		—			—			14,006			—			14,006
Net change in insurance subsidiary cash and cash equivalents		—			—			(13,123	)		—			(13,123	)
Change in other investments		—			269			—			—			269
Capital contribution to insurance subsidiary		—			(8,600	)		—			8,600			—
Other		—			(749	)		—			—			(749	)

Net cash used in investing activities		—			(105,927	)		(14,975	)		8,600			(112,302	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		515,400			—			—			—			515,400
Repayment of borrowings under revolving credit		(397,000	)		—			—			—			(397,000	)
Repayment of other long-term debt		(1,750	)		(23	)		(893	)		—			(2,666	)
Payment of deferred financing costs		(43	)		—			—			—			(43	)
Distribution made to noncontrolling interests		—			—			(1,388	)		—			(1,388	)
Change in intercompany accounts		(119,038	)		120,315			(1,277	)		—			—
Capital contribution to insurance subsidiary		—			—			8,600			(8,600	)		—

Net cash provided by (used in) financing activities		(2,431	)		120,292			5,042			(8,600	)		114,303

Change in cash and cash equivalents		—			1,762			(3,186	)		—			(1,424	)
Cash and cash equivalents at beginning of period		—			21,825			19,736			—			41,561

Cash and cash equivalents at end of period	$	—		$	23,587		$	16,550		$	—		$	40,137

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – LEGAL AND REGULATORY PROCEEDINGS

The Company provides services in a highly regulated industry and is subject to various legal actions (some of which are not insured) and regulatory and other governmental and internal audits and investigations from time to time. These matters could (1) require the Company to pay substantial damages, fines, penalties or amounts in judgments or settlements, which individually or in the aggregate could exceed amounts, if any, that may be recovered under the Company’s insurance policies where coverage applies and is available; (2) cause the Company to incur substantial expenses; (3) require significant time and attention from the Company’s management; (4) subject the Company to sanctions including possible exclusions from the Medicare and Medicaid programs; and (5) cause the Company to close or sell one or more facilities or otherwise modify the way the Company conducts business. The ultimate resolution of these matters, whether as a result of litigation or settlement, could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

In accordance with authoritative accounting guidance related to loss contingencies, the Company records an accrued liability for litigation and regulatory matters that are both probable and can be reasonably estimated. Additional losses in excess of amounts accrued may be reasonably possible. The Company reviews loss contingencies that are reasonably possible and determines whether an estimate of the possible loss or range of loss, individually or in aggregate, can be disclosed in the Company’s consolidated financial statements. These estimates are based upon currently available information for those legal and regulatory proceedings in which the Company is involved, taking into account the Company’s best estimate of losses for those matters for which such estimate can be made. The Company’s estimates involve significant judgment, given that (1) these legal and regulatory proceedings are in early stages; (2) discovery is not completed; (3) damages sought in these legal and regulatory proceedings can be unsubstantiated or indeterminate; (4) the matters present legal uncertainties or evolving areas of law; (5) there are often significant facts in dispute; and (6) there is a wide range of possible outcomes. Accordingly, the Company’s estimated loss or range of loss may change from time to time, and actual losses may be more or less than the current estimate. At this time, no estimate of the possible loss or range of loss, individually or in the aggregate, in excess of the amounts accrued, if any, can be made regarding the matters described below.

Set forth below are descriptions of the Company’s significant legal proceedings.

Medicare and Medicaid payment reviews, audits and investigations—as a result of the Company’s participation in the Medicare and Medicaid programs, the Company faces and is currently subject to various governmental and internal reviews, audits and investigations to verify the Company’s compliance with these programs and applicable laws and regulations. The Company is routinely subject to audits under various government programs, such as the CMS Recovery Audit Contractor program, in which third party firms engaged by CMS conduct extensive reviews of claims data and medical and other records to identify potential improper payments to healthcare providers under the Medicare program. In addition, the Company, like other hospitals, nursing center operators and rehabilitation therapy service contractors, is subject to ongoing investigations by the U.S. Department of Health and Human Services Office of Inspector General into the billing of rehabilitation services provided to Medicare patients and general compliance with conditions of participation in the Medicare and Medicaid programs. Private pay sources such as third party insurance and managed care entities also often reserve the right to conduct audits. The Company’s costs to respond to and defend any such reviews, audits and investigations can be significant and are likely to increase in the current enforcement environment. These audits and investigations may require the Company to refund or retroactively adjust amounts that have been paid under the relevant government program or by other payors. Further, an adverse review, audit or investigation also could result in other adverse consequences, particularly if the underlying conduct is found to be pervasive or systemic. These consequences include (1) state or federal agencies imposing fines, penalties and other sanctions on the Company; (2) loss of the Company’s right to participate in the Medicare or Medicaid programs or one or more third party payor networks; and/or (3) damage to the Company’s reputation in various markets, which could adversely affect the Company’s ability to attract patients, residents and employees.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – LEGAL AND REGULATORY PROCEEDINGS (Continued)

Whistleblower lawsuits—the Company is also subject to qui tam or “whistleblower” lawsuits under the False Claims Act and comparable state laws for allegedly submitting fraudulent bills for services to the Medicare and Medicaid programs. These lawsuits involve monetary damages, fines, attorneys’ fees and the award of bounties to private qui tam plaintiffs who successfully bring these lawsuits and to the respective government programs. The Company also could be subject to civil penalties (including the loss of the Company’s licenses to operate one or more facilities or healthcare activities), criminal penalties (for violations of certain laws and regulations), and exclusion of one or more facilities or healthcare activities from participation in the Medicare, Medicaid and other federal and state healthcare programs.

Employment-related lawsuits—the Company’s operations are subject to a variety of federal and state employment-related laws and regulations, including but not limited to the U.S. Fair Labor Standards Act, regulations of the Equal Employment Opportunity Commission, the Office of Civil Rights and state attorneys general, federal and state wage and hour laws and a variety of laws enacted by the federal and state governments that govern these and other employment-related matters. Accordingly, the Company is currently subject to employee-related claims, class action and other lawsuits and proceedings in connection with the Company’s operations, including but not limited to those related to alleged wrongful discharge, illegal discrimination and violations of equal employment and federal and state wage and hour laws. Because labor represents such a large portion of the Company’s operating costs, non-compliance with these evolving federal and state laws and regulations could subject the Company to significant back pay awards, fines and additional lawsuits and proceedings. These claims, lawsuits and proceedings are in various stages of adjudication or investigation and involve a wide variety of claims and potential outcomes. Based upon available information, the Company recorded a $5 million loss provision in the second quarter of 2012 related to these claims, lawsuits and proceedings, but the actual losses may be more than the provision for loss.

Minimum staffing lawsuits—various states in which the Company operates hospitals and nursing centers have established minimum staffing requirements or may establish minimum staffing requirements in the future. While the Company seeks to comply with all applicable staffing requirements, the regulations in this area are complex and the Company may experience compliance issues from time to time. Failure to comply with such minimum staffing requirements may result in one or more facilities failing to meet the conditions of participation under relevant federal and state healthcare programs and the imposition of significant fines, damages or other sanctions. Private litigation involving these matters also has become more common, and certain of the Company’s facilities are the subject of a class action lawsuit involving claims that these facilities did not meet relevant staffing requirements from time to time since 2006.

Ordinary course matters—in addition to the matters described above, the Company is subject to investigations, claims and lawsuits in the ordinary course of business, including professional liability claims, particularly in the Company’s hospital and nursing center operations. In many of these claims, plaintiffs’ attorneys are seeking significant fines and compensatory and punitive damages, along with attorneys’ fees. The Company maintains professional and general liability insurance in amounts and coverage that management believes are sufficient for the Company’s operations. However, the Company’s insurance may not cover all claims against the Company or the full extent of the Company’s liability.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13 – SUBSEQUENT EVENT

On April 25, 2013, the Company announced that it signed a definitive agreement to sell 17 non-strategic facilities (the “Facilities”) for $187 million to an affiliate of Vibra Healthcare, LLC (“Vibra”).

The Facilities consist of 15 TC hospitals containing 1,052 licensed beds, one IRF containing 44 licensed beds and one nursing center containing 135 licensed beds. Six of the TC hospitals and the one nursing center are owned facilities. The remaining Facilities are leased. The Facilities generated revenues of approximately $289 million and segment operating income of approximately $43 million (excluding the allocation of approximately $9 million of overhead costs) for the year ended December 31, 2012. The Facilities had aggregate rent expense of approximately $14 million for the year ended December 31, 2012.

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

RESULTS OF OPERATIONS

Cautionary Statement

This Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements regarding the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities, plans and objectives of management and statements containing the words such as “anticipate,” “approximate,” “believe,” “plan,” “estimate,” “expect,” “project,” “could,” “should,” “will,” “intend,” “may” and other similar expressions, are forward-looking statements. Statements in the Form 10-Q concerning the Company’s business outlook or future economic performance, anticipated profitability, revenues, expenses or other financial items, and product or services line growth, together with other statements that are not historical facts, are forward-looking statements that are estimates reflecting the best judgment of the Company based upon currently available information.

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

•

the impact of healthcare reform, which will initiate significant changes to the United States healthcare system, including potential material changes to the delivery of healthcare services and the reimbursement paid for such services by the government or other third party payors, including reforms resulting from the Patient Protection and Affordable Care Act and the Healthcare Education and Reconciliation Act (collectively, the “ACA”) or future deficit reduction measures adopted at the federal or state level. Healthcare reform is affecting each of the Company’s businesses in some manner. Potential future efforts in the U.S. Congress to repeal, amend, modify or retract funding for various aspects of the ACA create additional uncertainty about the ultimate impact of the ACA on the Company and the healthcare industry. Due to the substantial regulatory changes that will need to be implemented by CMS and others, and the numerous processes required to implement these reforms, the Company cannot predict which healthcare initiatives will be implemented at the federal or state level, the timing of any such reforms, or the effect such reforms or any other future legislation or regulation will have on the Company’s business, financial position, results of operations and liquidity,

•

the impact of final rules issued by CMS on August 1, 2012 (the “2012 CMS Rule”) which, among other things, will reduce Medicare reimbursement to the Company’s TC hospitals in 2013 and beyond by imposing a budget neutrality adjustment and modifying the short-stay outlier rules,

•

the impact of the 2011 CMS Rules which significantly reduced Medicare reimbursement to the Company’s nursing centers and changed payments for the provision of group therapy services effective October 1, 2011,

•

the impact of the Budget Control Act of 2011 (as amended by the American Taxpayer Relief Act of 2012 (the “Taxpayer Relief Act”)) which will automatically reduce federal spending by approximately $1.2 trillion split evenly between domestic and defense spending. An automatic 2% reduction on each claim submitted to Medicare began on April 1, 2013,

•

the impact of the Taxpayer Relief Act which, among other things, reduces Medicare payments by 50% for subsequent procedures when multiple therapy services are provided on the same day. At this time, the Company believes that the new rules related to multiple therapy services will reduce its Medicare revenues by $25 million to $30 million on an annual basis,

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

RESULTS OF OPERATIONS (Continued)

Cautionary Statement (Continued)

•

changes in the reimbursement rates or the methods or timing of payment from third party payors, including commercial payors and the Medicare and Medicaid programs, changes arising from and related to the Medicare prospective payment system for LTAC hospitals, including potential changes in the Medicare payment rules, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, and changes in Medicare and Medicaid reimbursement for the Company’s TC hospitals, nursing centers, IRFs and home health and hospice operations, and the expiration of the Medicare Part B therapy cap exception process,

•

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

•

the ability of the Company’s hospitals to adjust to potential LTAC certification and medical necessity reviews,

•

the impact of the Company’s significantly increased levels of indebtedness as a result of the acquisition of RehabCare Group, Inc. (“RehabCare”) (the “RehabCare Merger”) on its funding costs, operating flexibility and ability to fund ongoing operations, development capital expenditures or other strategic acquisitions with additional borrowings,

•

the Company’s ability to successfully pursue its development activities, including through acquisitions, and successfully integrate new operations, including the realization of anticipated revenues, economies of scale, cost savings and productivity gains associated with such operations, as and when planned, including the potential impact of unanticipated issues, expenses and liabilities associated with those activities,

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

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

RESULTS OF OPERATIONS (Continued)

Cautionary Statement (Continued)

•

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

•

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

•

events or circumstances which could result in the impairment of an asset or other charges, such as the impact of the Medicare reimbursement regulations that resulted in the Company recording significant impairment charges in 2012 and 2011,

•

changes in generally accepted accounting principles or practices, and changes in tax accounting or tax laws (or authoritative interpretations relating to any of these matters), and

•

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

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

General

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

The Company is a healthcare services company that through its subsidiaries operates TC hospitals, IRFs, nursing centers, assisted living facilities, a contract rehabilitation services business and a home health and hospice business across the United States. At March 31, 2013, the Company’s hospital division operated 116 TC hospitals (8,382 licensed beds) and six IRFs (259 licensed beds) in 26 states. The Company’s nursing center division operated 204 nursing centers (24,910 licensed beds) and six assisted living facilities (341 licensed beds) in 26 states. The Company’s rehabilitation division provided rehabilitation services primarily in hospitals and long-term care settings. The Company’s home health and hospice division provided home health, hospice and private duty services from 101 locations in ten states.

RehabCare Merger

On June 1, 2011, the Company completed the RehabCare Merger. Upon consummation of the RehabCare Merger, each issued and outstanding share of RehabCare common stock was converted into the right to receive 0.471 of a share of the Company’s common stock and $26 per share in cash, without interest (the “Merger Consideration”). Kindred issued approximately 12 million shares of its common stock in connection with the RehabCare Merger. The purchase price totaled $963 million and was comprised of $662 million in cash and $301 million of Kindred common stock at fair value. The Company also assumed $356 million of long-term debt in the RehabCare Merger, of which $345 million was refinanced on June 1, 2011. The operating results of RehabCare have been included in the accompanying unaudited condensed consolidated financial statements of the Company since June 1, 2011.

Discontinued operations

In recent years, the Company has completed several strategic divestitures to improve its future operating results. For accounting purposes, the operating results of these businesses and the losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets held for sale at March 31, 2013 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet.

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

RESULTS OF OPERATIONS (Continued)

General (Continued)

Discontinued operations (Continued)

On April 27, 2012, the Company announced that it would not renew the Expiring Facilities under operating leases with Ventas that expire on April 30, 2013. The Expiring Facilities contain 6,140 licensed nursing center beds and generated revenues of approximately $475 million for the year ended December 31, 2012. The current annual rent for these facilities approximates $57 million. The Company has also entered into an agreement with Ventas to provide Ventas with more flexibility to accelerate the transfer of the Expiring Facilities, as well as to extend the term of the leases as necessary to facilitate these transfers. The Company may be required to pay for additional capital obligations for the Expiring Facilities under the master lease agreements with Ventas. The Company transferred the operations of 19 of the 54 nursing centers to new operators during the three months ended March 31, 2013. The Company reclassified the results of operations and losses associated with the 19 divestitures to discontinued operations, net of income taxes, for all periods presented. The Company will continue to operate the remaining 35 Expiring Facilities and include the Expiring Facilities in its results from continuing operations through the expiration of the lease term, and for such additional time period as required to transfer operations to new operators. When the Company terminates its operations of the remaining Expiring Facilities, these facilities will be reclassified to discontinued operations.

Critical Accounting Policies

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

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

Revenue recognition

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

Collectibility of accounts receivable

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

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

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Collectibility of accounts receivable (Continued)

The provision for doubtful accounts totaled $11 million and $7 million for the first quarter of 2013 and 2012, respectively.

Allowances for insurance risks

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

Provisions for loss for professional liability risks retained by the Company’s limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 1% to 5% depending upon the policy year. The discount rate was 1% for the 2013 and 2012 policy years. The discount rates are based upon the risk free interest rate for the respective year. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks aggregated $308 million at March 31, 2013 and $291 million at December 31, 2012. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $311 million at March 31, 2013 and $293 million at December 31, 2012.

As a result of deterioration in professional liability and workers compensation underwriting results of the Company’s limited purpose insurance subsidiary in 2012 and 2011, the Company made capital contributions of $14 million and $9 million during the three months ended March 31, 2013 and 2012, respectively, to its limited purpose insurance subsidiary. These transactions were completed in accordance with applicable regulations. Neither capital contribution had any impact on earnings.

Changes in the number of professional liability claims and the cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at March 31, 2013 would impact the Company’s operating income by approximately $3 million.

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $22 million and $18 million for the first quarter of 2013 and 2012, respectively.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $195 million at March 31, 2013 and $193 million at December 31, 2012. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $15 million and $14 million for the first quarter of 2013 and 2012, respectively.

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Accounting for income taxes

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

The Company’s effective income tax rate was 37.2% and 40.6% for the first quarter of 2013 and 2012, respectively. The decrease in the effective tax rate for the first quarter of 2013 was primarily related to favorable jobs tax credit legislation approved by Congress in the first quarter of 2013 that was retroactive to 2012. The full impact of the retroactive legislation reduced the provision for incomes taxes by approximately $1 million in the first quarter of 2013.

There are significant uncertainties with respect to capital loss carryforwards that could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized and a valuation allowance is provided for deferred tax assets to the extent that it is uncertain that the deferred tax asset will be realized. The Company recognized net deferred tax assets totaling $1 million and $3 million at March 31, 2013 and December 31, 2012, respectively.

The Company is subject to various federal and state income tax audits in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties. While the Company believes its tax positions are appropriate, there can be no assurance that the various authorities engaged in the examination of its income tax returns will not challenge the Company’s positions.

Valuation of long-lived assets, goodwill and intangible assets

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

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

The Company’s intangible assets with finite lives are amortized in accordance with the authoritative guidance for goodwill and other intangible assets using the straight-line method over their estimated useful lives ranging from two to 20 years.

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Valuation of long-lived assets, goodwill and intangible assets (Continued)

In connection with the 2011 CMS Rules, the Company determined that the impact of the 2011 CMS Rules was a triggering event in the third quarter of 2011 and accordingly tested the recoverability of its nursing centers reporting unit goodwill, intangible assets and property and equipment asset groups impacted by the reduced Medicare payments. The Company recorded pretax impairment charges aggregating $0.4 million ($0.3 million net of income taxes) in the first quarter of 2013 and $0.8 million ($0.5 million net of income taxes) in the first quarter of 2012 for property and equipment expenditures in the nursing center asset groups that were determined to be impaired by the 2011 CMS Rules. These charges reflected the amount by which the carrying value of certain assets exceeded their estimated fair value. The impairment charges did not impact the Company’s cash flows or liquidity.

In accordance with the authoritative guidance for goodwill and other intangible assets, the Company is required to perform an impairment test for goodwill and indefinite-lived intangible assets at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company performs its annual goodwill impairment test at the end of each fiscal year for each of its reporting units. A reporting unit is either an operating segment or one level below the operating segment, referred to as a component. When the components within the Company’s operating segments have similar economic characteristics, the Company aggregates the components of its operating segments into one reporting unit. Accordingly, the Company has determined that its reporting units are hospitals, nursing centers, skilled nursing rehabilitation services, hospital rehabilitation services, home health and hospice. The carrying value of goodwill for each of the Company’s reporting units at March 31, 2013 and December 31, 2012 follows (in thousands):


	March 31, 2013		December 31, 2012
Hospitals	$	747,065	$	747,065
Nursing centers		—		—
Rehabilitation division:
Skilled nursing rehabilitation services		—		—
Hospital rehabilitation services		168,019		168,019

		168,019		168,019
Home health and hospice division:
Home health		99,317		99,317
Hospice		26,865		26,865

		126,182		126,182

	$	1,041,266	$	1,041,266

The goodwill impairment test involves a two-step process. The first step is a comparison of each reporting unit’s fair value to its carrying value. If the carrying value of the reporting unit is greater than its fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss, if any. Based upon the results of the step one impairment test for goodwill for hospitals, hospital rehabilitation services, home health and hospice reporting units for the year ended December 31, 2012, no goodwill impairment charges were recorded in connection with the Company’s annual impairment test.

Since quoted market prices for the Company’s reporting units are not available, the Company applies judgment in determining the fair value of these reporting units for purposes of performing the goodwill impairment test. The Company relies on widely accepted valuation techniques, including discounted cash flow and market multiple analyses approaches, which capture both the future income potential of the reporting unit and the market

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Valuation of long-lived assets, goodwill and intangible assets (Continued)

behaviors and actions of market participants in the industry that includes the reporting unit. These types of analyses require the Company to make assumptions and estimates regarding future cash flows, industry-specific economic factors and the profitability of future business strategies. The discounted cash flow approach uses a projection of estimated operating results and cash flows that are discounted using a weighted average cost of capital. Under the discounted cash flow approach, the projection uses management’s best estimates of economic and market conditions over the projected period for each reporting unit including growth rates in the number of admissions, patient days, reimbursement rates, operating costs, rent expense and capital expenditures. Other significant estimates and assumptions include terminal value growth rates, changes in working capital requirements and weighted average cost of capital. The market multiple analysis estimates fair value by applying cash flow multiples to the reporting unit’s operating results. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics to the reporting units.

The Company has determined that during the first quarter ended March 31, 2013 there were no events or changes in circumstances since December 31, 2012 requiring an interim impairment test. Although the Company has determined that there was no other goodwill or other indefinite-lived intangible asset impairments as of March 31, 2013, adverse changes in the operating environment and related key assumptions used to determine the fair value of the Company’s reporting units and indefinite-lived intangible assets or declines in the value of the Company’s common stock may result in future impairment charges for a portion or all of these assets. Specifically, if the rate of growth of government and commercial revenues earned by the Company’s reporting units were to be less than projected or if healthcare reforms were to negatively impact the Company’s business, an impairment charge of a portion or all of these assets may be required. An impairment charge could have a material adverse effect on the Company’s business, financial position and results of operations, but would not be expected to have an impact on the Company’s cash flows or liquidity.

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

Recently Issued Accounting Requirements

In February 2013, the FASB amended its authoritative guidance issued in December 2011 related to the deferral of the requirement to present reclassification adjustments out of accumulated other comprehensive income in both the statement in which net income is presented and the statement in which other comprehensive income is presented. The amended provisions require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under United States generally accepted accounting principles to be reclassified to net income in its entirety in the same reporting period. For all other amounts, an entity is required to cross-reference to other disclosures that provide additional details about these amounts. All other requirements of the original June 2011 update were not impacted by the amendment which became effective for all interim and annual reporting periods beginning after December 15, 2012. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations

Hospital division

Revenues were flat at $748 million in the first quarter of 2013 compared to the first quarter of 2012. Aggregate same-facility admissions declined 4% in the first quarter of 2013 compared to the first quarter of 2012. The decline in admissions was partially attributable to the extra leap year day in 2012. Same-facility average daily census was flat in the first quarter of 2013 compared to the first quarter of 2012.

Operating income in the first quarter of 2013 included $9 million related to one-time bonus costs. Operating income in the first quarter of 2012 included $2 million related to severance and other costs incurred in connection with the closing of a regional office. Excluding these charges, hospital operating margins increased in the first quarter of 2013 compared to the first quarter of 2012, primarily as a result of higher reimbursement rates and cost efficiencies.

Average hourly wage rates were relatively unchanged in the first quarter of 2013 compared to the first quarter of 2012. Employee benefit costs decreased 4% in the first quarter of 2013 compared to the first quarter of 2012, primarily as a result of a reduction in retirement plan expense.

Professional liability costs were $9 million and $10 million in the first quarter of 2013 and 2012, respectively.

Nursing center division

Revenues declined 2% to $503 million in the first quarter of 2013 compared to $512 million in the first quarter of 2012, primarily as a result of a decline in volumes. Same-facility admissions were relatively unchanged in the first quarter of 2013 compared to the first quarter of 2012. Same-facility average daily census declined 2% in the first quarter of 2013 compared to the first quarter of 2012, primarily as a result of the decline in Medicare average length of stay.

Operating income in the first quarter of 2013 included $10 million related to one-time bonus costs. Excluding these charges, nursing center operating margins declined in the first quarter of 2013 compared to the first quarter of 2012, primarily as a result a decline in volumes and related cost inefficiencies.

Average hourly wage rates were relatively unchanged in the first quarter of 2013 compared to the first quarter of 2012. Employee benefit costs decreased 3% in the first quarter of 2013 compared to the first quarter of 2012, primarily as a result of a reduction in compensated absences and retirement plan expenses.

Professional liability costs were $12 million and $7 million in the first quarter of 2013 and 2012, respectively. The increase in professional liability costs was attributable to continued deterioration in the frequency and severity of claims.

Rehabilitation division

Skilled nursing rehabilitation services

Revenues increased 1% to $261 million in the first quarter of 2013 compared to $257 million in the first quarter of 2012, primarily attributable to growth in the volume of services provided to existing customers. Revenues derived from non-affiliated customers aggregated $208 million and $203 million in the first quarter of 2013 and 2012, respectively.

Operating margins increased in the first quarter of 2013 compared to the first quarter of 2012, primarily as a result of increased operating efficiencies and lower employee turnover. Operating income in the first quarter of 2013 included $5 million related to one-time bonus costs.

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Rehabilitation division (Continued)

Hospital rehabilitation services

Revenues were relatively unchanged at $74 million in the first quarter of 2013 compared to the first quarter of 2012. Revenues derived from non-affiliated customers aggregated $46 million in the first quarter of both 2013 and 2012.

Home health and hospice division

Revenues increased to $52 million in the first quarter of 2013 compared to $28 million in the first quarter of 2012, primarily attributable to acquisitions completed during 2012.

Operating margins declined in the first quarter of 2013 compared to the first quarter of 2012, primarily due to start-up costs in connection with the development of this business segment. Operating income in the first quarter of 2013 included $1 million related to one-time bonus costs.

Corporate overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $46 million and $43 million in the first quarter of 2013 and 2012, respectively. As a percentage of consolidated revenues, corporate overhead totaled 2.9% and 2.8% in the first quarter of 2013 and 2012, respectively.

Transaction costs

Operating results included transaction costs totaling $2 million and $0.5 million in the first quarter of 2013 and 2012, respectively. Transaction costs in both periods were included in other operating expenses.

Capital costs

Rent expense increased 2% to $106 million in the first quarter of 2013 compared to $104 million in the first quarter of 2012. The increase in the first quarter of 2013 resulted primarily from contractual inflation and contingent rent increases.

Depreciation and amortization expense increased 9% to $51 million in the first quarter of 2013 compared to $47 million in the first quarter of 2012. The increase in the first quarter of 2013 resulted from the Company’s ongoing capital expenditure program and hospital development projects.

Interest expense increased to $28 million in the first quarter of 2013 from $26 million in the first quarter of 2012. The increase in the first quarter of 2013 was primarily attributable to increased borrowings under the Term Loan Facility.

Consolidated results

Income from continuing operations before income taxes aggregated $15 million in the first quarter of 2013 compared to $36 million in the first quarter of 2012. Income from continuing operations aggregated $9 million in the first quarter of 2013 compared to $21 million in the first quarter of 2012. One-time bonus costs, employee retention costs and transaction costs negatively impacted the consolidated pretax operating results by $29 million ($17 million

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Consolidated results (Continued)

net of income taxes) in the first quarter of 2013. Severance and other costs incurred in connection with the closing of a regional office and transaction costs negatively impacted the consolidated pretax operating results by $3 million ($2 million net of income taxes) in the first quarter of 2012.

Results of Operations – Discontinued Operations

Loss from discontinued operations aggregated $5 million in the first quarter of 2013 compared to $2 million in the first quarter of 2012. The Company recorded a net loss of $1 million in the first quarter of both 2013 and 2012 related to the divestiture of discontinued operations.

Liquidity

Operating cash flows

Cash flows provided by operations (including discontinued operations) aggregated $25 million in the first quarter of 2013 compared to cash flows used in operations of $3 million in the first quarter of 2012. Operating cash flows were favorably impacted by federal income tax refunds of $10 million and $15 million in the first quarter of 2013 and 2012, respectively.

The Company utilizes its $750 million senior secured asset-based revolving credit facility (the “ABL Facility”) to meet working capital needs and finance its acquisition and development activities. As a result, the Company typically carries minimal amounts of cash on its consolidated balance sheet. Based upon the Company’s expected operating cash flows and the availability of borrowings under the Company’s ABL Facility ($396 million at March 31, 2013), management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.

Credit facilities and notes

In connection with the RehabCare Merger, the Company entered into the ABL Facility and the Term Loan Facility (collectively, the “Credit Facilities”). The Company also completed a private placement of the Notes. In 2011, the Company used proceeds from the Credit Facilities and the Notes to pay the Merger Consideration, repay all amounts outstanding under the Company’s and RehabCare’s previous credit facilities and to pay transaction costs. The amounts outstanding under the Company’s and RehabCare’s former credit facilities that were repaid at the RehabCare Merger closing were $390 million and $345 million, respectively.

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

RESULTS OF OPERATIONS (Continued)

Liquidity (Continued)

Credit facilities and notes (Continued)

The Credit Facilities had an incremental facility capacity in an aggregate amount between the two facilities of $200 million. In October 2012, the Company executed the incremental capacity by completing modifications to increase by $100 million its Term Loan Facility and expand by $100 million the borrowing capacity under its ABL Facility. The additional Term Loan Facility borrowings were issued at 97.5% and the net proceeds were used to pay down a portion of the outstanding balance under the ABL Facility. The aggregate amount outstanding under the Term Loan Facility at March 31, 2013 approximated $788 million. In connection with the $100 million expansion of the borrowing capacity under its ABL Facility, the Company also modified the accounts receivable borrowing base which will allow the Company to more easily access the full amount of the available credit. The other terms of the Term Loan Facility and the ABL Facility were unchanged.

All obligations under the Credit Facilities are fully and unconditionally guaranteed, subject to certain customary release provisions, by substantially all of the Company’s existing and future direct and indirect domestic 100% owned subsidiaries, as well as certain non-100% owned domestic subsidiaries as the Company may determine from time to time in its sole discretion. The Notes are fully and unconditionally guaranteed, subject to certain customary release provisions, by substantially all of the Company’s domestic 100% owned subsidiaries.

The agreements governing the Credit Facilities and the indenture governing the Notes include a number of restrictive covenants that, among other things and subject to certain exceptions and baskets, impose operating and financial restrictions on the Company and certain of its subsidiaries. The Company’s ability to pay dividends is limited to certain restricted payment baskets, which may expand based upon accumulated earnings. In addition, the Company is required to comply with a minimum fixed charge coverage ratio and a maximum total leverage ratio under the Credit Facilities. These financing agreements governing the Credit Facilities and the indenture governing the Notes also contain customary affirmative covenants and events of default. The Company was in compliance with the terms of the Credit Facilities and the indenture governing the Notes at March 31, 2013.

Other financing activities

As a result of deterioration in professional liability and workers compensation underwriting results of the Company’s limited purpose insurance subsidiary in 2012 and 2011, the Company made capital contributions of $14 million and $9 million during the three months ended March 31, 2013 and 2012, respectively, to its limited purpose insurance subsidiary. These transactions were completed in accordance with applicable regulations. Neither capital contribution had any impact on earnings.

Divestiture of the Facilities

On April 25, 2013, the Company announced that it signed a definitive agreement to sell the Facilities for $187 million to Vibra.

The Company expects that the after-tax net proceeds from the transaction, including transaction costs, will approximate $180 million. In the near term, the Company intends to use the net proceeds to pay down the outstanding balance under its ABL Facility. Over time, the Company expects that these proceeds will be reinvested in the Company’s integrated care markets and used to finance home health and hospice acquisitions.

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

RESULTS OF OPERATIONS (Continued)

Liquidity (Continued)

Divestiture of the Facilities (Continued)

The transaction is subject to Vibra finalizing its financing for the transaction and to regulatory approvals and other conditions to closing, including but not limited to the expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvement Act of 1976, as amended. The Company expects to complete the transaction through multiple closings occurring during the third and fourth quarters of 2013 as these conditions are satisfied. In connection with the transaction, the Company expects to record a pretax loss that could approximate $100 million, including a significant write-off of both goodwill and other intangible assets allocable to the disposed operations.

Capital Resources

Capital expenditures and acquisitions

Excluding acquisitions, routine capital expenditures (expenditures necessary to maintain existing facilities that generally do not increase capacity or add services) totaled $22 million in the first quarter of both 2013 and 2012. Hospital development capital expenditures (primarily replacement facility construction) totaled $3 million in the first quarter of 2013 compared to $10 million in the first quarter of 2012. Nursing center development capital expenditures (primarily the addition of transitional care services for higher acuity patients) were immaterial in the first quarter of 2013 and totaled $1 million in the first quarter of 2012. Excluding acquisitions, the Company anticipates that routine capital spending for 2013 should approximate $120 million to $130 million and development capital spending should approximate $20 million to $30 million. Management expects that substantially all of these expenditures will be financed through internal sources. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. At March 31, 2013, the estimated cost to complete and equip construction in progress approximated $17 million.

Acquisition expenditures totaled $50 million in the first quarter of 2012 and a deposit for the purchase of a leased hospital totaled $17 million in the first quarter of 2012. The Company financed these acquisitions with its operating cash flows and its ABL Facility.

Other Information

Effects of inflation and changing prices

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

Medicaid reimbursement rates in many states in which the Company operates nursing centers also are based upon fixed payment systems. Generally, these rates are adjusted annually for inflation. However, these adjustments may not reflect the actual increase in the costs of providing healthcare services.

Various healthcare reform provisions became law upon the enactment of the ACA. The reforms contained in the ACA have affected each of the Company’s businesses in some manner and are directed in large part at increased quality and cost reductions. Several of the reforms are very significant and could ultimately change the nature of the Company’s services, the methods of payment for the Company’s services and the underlying regulatory environment. These reforms include possible modifications to the conditions of qualification for payment, bundling of payments to cover both acute and post-acute care and the imposition of enrollment limitations on new providers.

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

The ACA also provides for: (1) reductions to the annual market basket payment updates for LTAC hospitals, IRFs, home health agencies and hospice providers which could result in lower reimbursement than in the preceding year; (2) additional annual “productivity adjustment” reductions to the annual market basket payment update as determined by CMS for LTAC hospitals, IRFs, and nursing centers (beginning in federal fiscal year 2012), home health agencies (beginning in federal fiscal year 2015) and hospice providers (beginning in federal fiscal year 2013); (3) new transparency, reporting and certification requirements for skilled nursing facilities, including disclosures regarding organizational structure, officers, directors, trustees, managing employees and financial, clinical and other related data; (4) a quality reporting system for hospitals (including LTAC hospitals and IRFs) beginning in federal fiscal year 2014; and (5) reductions in Medicare payments to hospitals (including LTAC hospitals and IRFs) beginning in federal fiscal year 2014 for failure to meet certain quality reporting standards or to comply with standards in new value based purchasing demonstration project programs.

The healthcare reforms and changes resulting from the ACA, as well as other similar healthcare reforms, could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

Under the Budget Control Act of 2011, $1.2 trillion in domestic and defense spending reductions automatically began February 1, 2013, split evenly between domestic and defense spending. Payments to Medicare providers are subject to these automatic spending reductions, subject to a 2% cap. As discussed below, the Taxpayer Relief Act subsequently delayed by two months the automatic budget sequestration cuts established by the Budget Control Act of 2011. The automatic 2% reduction on each claim submitted to Medicare began on April 1, 2013. Reductions to Medicare and Medicaid reimbursement resulting from the Budget Control Act of 2011 could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

The Taxpayer Relief Act was enacted on January 2, 2013. As noted above, this Act delayed by two months the automatic budget sequestration cuts established by the Budget Control Act of 2011. The Taxpayer Relief Act also: (1) reduces Medicare payments by 50% for subsequent procedures when multiple therapy services are provided on the same day; (2) extends the Medicare Part B outpatient therapy cap exception process to December 31, 2013; (3) suspends until December 31, 2013 the sustainable growth rate adjustment (“SGR”) reduction applicable to the Medicare Physician Fee Schedule (“MPFS”) for certain services provided under Medicare Part B; (4) increases the statute of limitations to recover Medicare overpayments from three years to five years; and (5) creates a new federal Commission on Long-Term Care that has six months in which to provide recommendations on the establishment, implementation and financing of a comprehensive, coordinated and high-quality system that ensures the availability of long-term care services. The Company believes that the new rules related to multiple therapy services will reduce its Medicare revenues by $25 million to $30 million on an annual basis.

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

For additional information regarding Medicare and Medicaid reimbursement and other government regulations impacting the Company, see the Company’s Annual Report on Form 10-K for 2012 as filed with the SEC.

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

Hospital division

The Long-Term Acute Care Prospective Payment System (“LTAC PPS”) maintains LTAC hospitals as a distinct provider type, separate from short-term acute care hospitals. Only providers certified as LTAC hospitals may be paid under this system. All of the Company’s TC hospitals are certified as LTAC hospitals. To maintain certification under LTAC PPS, the average length of stay of fee-for-service Medicare patients must be greater than 25 days. Medicare Advantage patients are included with Medicare fee-for-service patients in order to determine compliance with the 25 day average length of stay requirement.

CMS has, for a number of years, considered the development of facility and patient certification criteria for LTAC hospitals, potentially as an alternative to the current 25 day length of stay certification system. In 2004, the Medicare Payment Advisory Commission, a commission chartered by Congress to advise it on Medicare payment issues (“MedPAC”) recommended the adoption by CMS of new facility staffing and services criteria and patient clinical characteristics and treatment requirements for LTAC hospitals in order to ensure that only appropriate patients are admitted to these facilities. Since the MedPAC recommendation, CMS has initiated studies to examine such recommendations and those studies are ongoing. Implementation of additional criteria that may limit the population of patients eligible for the Company’s hospital services or change the basis on which the Company is paid could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

On April 26, 2013, CMS issued proposed regulations regarding Medicare reimbursement for LTAC hospitals for the federal fiscal year beginning October 1, 2013. Included in the proposed regulations is: (1) a market basket increase to the standard federal payment rate of 2.5%; (2) offsets to the standard federal payment rate mandated by the ACA of: (a) 0.4% to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute; (3) a wage level budget neutrality factor of 1.000433 applied to the adjusted standard federal payment rate; (4) adjustments to area wage indexes; and (5) a decrease in the high cost outlier threshold per discharge to $14,139. In addition, the proposed regulations also would implement the second year of a three-year phase-in of a 3.75% budget neutrality adjustment which would reduce LTAC hospital rates by 1.3% in 2014. CMS has projected the impact of these changes will result in a 1.1% increase to average Medicare payments to LTAC hospitals. These proposed regulations also allow for the expiration of the existing moratorium on the “25 Percent Rule,” which dictates that LTAC hospitals are to be paid under LTAC PPS for admissions from a single referral source up to 25% of aggregate Medicare admissions. Admissions beyond the 25% threshold are to be paid at a lower amount based upon the Medicare prospective payment system applicable to general short-term acute care hospitals (“IPPS”). CMS has indicated that the impact of the expiration of the “25 Percent Rule” will result in approximately a 3.4% reduction in payments to LTAC hospitals. In addition, CMS published preliminary findings regarding patient and facility-level criteria for LTAC hospitals, with proposed specific recommendations expected in the spring of 2014 which could potentially be implemented in the federal fiscal year beginning October 1, 2014. CMS is considering payment options that would limit the full payment under LTAC PPS to patients that are defined as chronically critically ill (“CCI”). CMS’s research suggests that CCI patients be defined as having at least one of five medically complex conditions combined with a stay of at least eight days in an intensive care or cardiac care unit in a general short-term acute care hospital. For those patients not meeting the CCI criteria, CMS suggests that payments could be made to the LTAC hospital at an amount comparable to what a general short-term hospital would receive under IPPS.

On August 1, 2012, CMS issued the 2012 CMS Rule, which, among other things, will reduce Medicare reimbursement to the Company’s TC hospitals in 2013 and beyond by imposing a budget neutrality adjustment and modifying the short-stay outlier rules. Included in the 2012 CMS Rule is: (1) a market basket increase to the standard federal payment rate of 2.6%; (2) offsets to the standard federal payment rate mandated by the ACA of: (a) 0.7% to account for the effect of a productivity adjustment, and (b) 0.1% as required by statute; (3) a wage level budget neutrality factor of 0.999265 applied to the adjusted standard federal payment rate; (4) adjustments to area

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

Hospital division (Continued)

wage indexes; and (5) a decrease in the high cost outlier threshold per discharge to $15,408. Effective December 29, 2012, the 2012 CMS Rule (1) began a three-year phase-in of a 3.75% budget neutrality adjustment which will reduce LTAC hospital rates by 1.3% in 2013; and (2) restored a payment reduction that will limit payments for very short-stay outliers that will reduce the Company’s TC hospital payments by approximately 0.5%. The 2012 CMS Rule also (1) provides for a one-year extension of the existing moratorium on the “25 Percent Rule” pending the results of an ongoing research initiative to re-define the role of LTAC hospitals in the Medicare program, and (2) allows for the expiration of the moratorium on the development or expansion of LTAC hospitals on December 29, 2012.

In aggregate, based upon its review of the 2012 CMS Rule, the Company expects that LTAC Medicare payment rates will decline slightly in 2013. The 2012 CMS Rule does not include the impact of a 2% sequestration payment reduction mandated by Congress that applies to each claim submitted to Medicare that began on April 1, 2013.

On August 1, 2011, CMS issued final regulations regarding Medicare reimbursement for LTAC hospitals for the fiscal year beginning October 1, 2011. Included in the final regulations is: (1) a market basket increase to the standard federal payment rate of 2.9%; (2) offsets to the standard federal payment rate mandated by the ACA of: (a) 1.0% to account for the effect of a productivity adjustment, and (b) 0.1% as required by statute; (3) a wage level budget neutrality factor of 0.99775 applied to the adjusted standard federal payment rate; (4) adjustments to area wage indexes; and (5) a decrease in the high cost outlier threshold per discharge to $17,931. CMS has projected the impact of these changes will result in a 2.5% increase to average Medicare payments to LTAC hospitals. Management believes that the impact of these changes to LTAC PPS resulted in an approximate 0.7% increase in payments to the Company’s TC hospitals.

On December 29, 2007, the SCHIP Extension Act of 2007 (the “SCHIP Extension Act”) became law. This legislation provided for, among other things: (1) a mandated study by the Secretary of Health and Human Services on the establishment of LTAC hospital certification criteria; (2) enhanced medical necessity review of LTAC hospital cases; (3) a three-year moratorium on the establishment of new LTAC hospital or satellite facilities and increases in the number of licensed beds at a LTAC hospital or satellite facility; (4) a three-year moratorium on the application of a one-time budget neutrality adjustment to payment rates to LTAC hospitals under LTAC PPS; (5) a three-year moratorium on very short-stay outlier payment reductions to LTAC hospitals initially implemented on May 1, 2007; and (6) a three-year moratorium on the application of the “25 Percent Rule” to freestanding LTAC hospitals.

The ACA extended the moratoriums on the establishment of new LTAC hospitals or satellites and bed increases at LTAC hospitals or satellites, the application of a one-time budget neutrality adjustment to rates, and the payment reductions due to the very short-stay outlier provisions from three years to five years. These moratoriums expired on December 29, 2012. As discussed above, the 2012 CMS Rule began a three-year phase-in of a 3.75% budget neutrality adjustment which will reduce LTAC hospital rates by 1.3% in 2013.

The ACA also extended the moratorium on the expansion of the “25 Percent Rule” to freestanding LTAC hospitals from three years to five years. Following the ACA, the moratorium on the expansion of the “25 Percent Rule” to freestanding LTAC hospitals was set to expire for cost reporting periods beginning on or after July 1, 2012. However, the 2012 CMS Rule further extended the moratorium to all freestanding LTAC hospitals with cost reporting periods beginning on or after October 1, 2012 and before October 1, 2013. This created a potential gap period that will not affect any of the Company’s freestanding TC hospitals.

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

Hospital division (Continued)

CMS has regulations governing payments to LTAC hospitals that are co-located with another hospital (a “HIH”). The rules generally limit Medicare payments to the HIH if the Medicare admissions to the HIH from its co-located hospital exceed 25% of the total Medicare discharges for the HIH’s cost reporting period, the “25 Percent Rule.” There are limited exceptions for admissions from rural, urban single or a hospital that generates more than 25% of the Medicare discharges in a metropolitan statistical area (“MSA Dominant hospital”). Admissions that exceed this “25 Percent Rule” are paid a lower amount under IPPS. Patients transferred after they have reached the short-term acute care outlier payment status are not counted toward the admission threshold. Patients admitted prior to meeting the admission threshold, as well as Medicare patients admitted from a non co-located hospital, are eligible for the full payment under LTAC PPS. If the HIH’s admissions from the co-located hospital exceed the limit in a cost reporting period, Medicare will pay the lesser of: (1) the amount payable under LTAC PPS; or (2) the amount payable under IPPS. At March 31, 2013, the Company operated 24 HIHs with 876 licensed beds.

On May 1, 2007, CMS issued regulatory changes regarding Medicare reimbursement for LTAC hospitals (the “2007 Final Rule”). In the 2007 Final Rule, the “25 Percent Rule” was expanded to all LTAC hospitals, regardless of whether they are co-located with another hospital. Under the 2007 Final Rule, all LTAC hospitals were to be paid LTAC PPS rates for admissions from a single referral source up to 25% of aggregate Medicare admissions. Patients reaching high cost outlier status in the short-term hospital were not to be counted when computing the 25% limit. Admissions beyond the 25% threshold were to be paid at a lower amount based upon IPPS rates. However, as set forth above, the SCHIP Extension Act initially placed a three-year moratorium on the expansion of the “25 Percent Rule” to freestanding hospitals. That moratorium was extended to five years by the ACA. This moratorium was further extended for one additional year under the 2012 CMS Rule. In addition, the SCHIP Extension Act initially provided for a three-year period during which: (1) LTAC hospitals may admit up to 50% of their patients from their co-located hospitals and still be paid according to LTAC PPS; and (2) LTAC hospitals that are co-located with an urban single hospital or a MSA Dominant hospital may admit up to 75% of their patients from such urban single hospital or MSA Dominant hospital and still be paid according to LTAC PPS. Those periods also were extended to five years under the ACA and for one additional year under the 2012 CMS Rule. The proposed LTAC hospital rule issued April 26, 2013 would allow the moratorium to expire for providers with cost reporting periods beginning on or after October 1, 2013.

The ACA requires a quality reporting system for LTAC hospitals beginning in federal fiscal year 2014 under which any market basket update would be reduced by 2% for any LTAC hospital that does not meet the quality reporting standards. The final regulations issued on August 1, 2011 include three quality reporting measures: (1) catheter-associated urinary tract infections; (2) central line associated blood stream infections; and (3) new or worsening pressure ulcers. CMS also listed 27 additional quality measures that it was considering for future adoption. CMS has indicated that data collection associated with these events began in October 2012.

The Job Creation Act of 2012 (the “Job Creation Act”) provides for reductions in reimbursement of Medicare bad debts at the Company’s hospitals and nursing centers. For the hospitals, the current bad debt reimbursement rate of 70% for all bad debts will be lowered to 65% effective for cost reporting periods beginning on or after October 1, 2012.

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

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

Hospital division (Continued)

On May 2, 2013, CMS issued proposed regulations regarding Medicare reimbursement for IRFs for the fiscal year beginning October 1, 2013. Included in these proposed regulations are: (1) a market basket increase to the standard payment conversion factor of 2.5%; (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) 0.4% to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute; (3) adjustments to area wage indexes; and (4) a decrease in the high cost outlier threshold per discharge to $10,111. CMS has projected the impact of these changes will result in a 2.0% increase to average Medicare payments to IRFs.

On July 25, 2012, CMS issued final regulations regarding Medicare reimbursement for IRFs for the fiscal year beginning October 1, 2012. Included in these final regulations are: (1) a market basket increase to the standard payment conversion factor of 2.7%; (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) 0.7% to account for the effect of a productivity adjustment, and (b) 0.1% as required by statute; (3) adjustments to area wage indexes; and (4) a decrease in the high cost outlier threshold per discharge to $10,466. CMS has projected the impact of these changes will result in a 2.1% increase to average Medicare payments to IRFs.

On July 29, 2011, CMS issued final regulations regarding Medicare reimbursement for IRFs for the fiscal year beginning October 1, 2011. Included in these final regulations are: (1) a market basket increase to the standard payment conversion factor of 2.9%; (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) 1.0% to account for the effect of a productivity adjustment, and (b) 0.1% as required by statute; (3) a wage level budget neutrality factor of 0.9988 applied to the standard payment conversion factor; (4) a case mix group budget neutrality factor of 0.9988 applied to the standard payment conversion factor; (5) adjustments to area wage indexes; and (6) a decrease in the high cost outlier threshold per discharge to $10,660. CMS has projected the impact of these changes will result in a 2.2% increase to average Medicare payments to IRFs.

Similar to LTAC hospitals, the ACA requires a quality reporting system for IRFs beginning in fiscal year 2014 in which any market basket update would be reduced by 2% for any IRF that does not meet quality reporting standards. The final regulations issued on July 29, 2011 include two quality reporting measures, catheter-associated urinary tract infections and pressure ulcers, and CMS indicated that it is still developing a 30-day comprehensive all risk standardized readmission measure that is expected to be standardized in the near future. CMS also listed 26 additional quality measures that it was considering for future adoption. CMS has indicated that data collection associated with these events began in October 2012.

Nursing center division

On July 16, 2010, CMS issued a notice that updated the payment rates for nursing centers for the fiscal year beginning October 1, 2010. Under this rule, for the fiscal year beginning October 1, 2010, CMS increased the number of resource utilization group (“RUG”) categories for nursing centers from 53 to 66 (i.e., RUGs IV) and amended the criteria, including the provision of therapy services, used to classify patients into these categories. CMS indicated that these changes would be enacted in a budget neutral manner. CMS began paying claims using the RUGs IV system effective October 1, 2010. Under RUGs IV, among other requirements, providers must allocate therapy minutes among the patients being served during concurrent therapy sessions, and a therapist/assistant may treat concurrently only two patients. These changes have required us to employ more therapists to provide additional individual therapy minutes.

The therapy time requirements to qualify for rehabilitation RUG categories are unchanged under RUGs IV, however the regulatory changes altered how minutes were allocated to calculate the RUGs scores using the most recent clinical assessment tool of the minimum data set, MDS 3.0. Rather than count all therapy time that a nursing center patient receives, rehabilitation providers must instead allocate therapy minutes between the patients being served during concurrent therapy sessions. In addition, the number of patients that a therapist/assistant may treat

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

Nursing center division (Continued)

concurrently is limited to two patients. Under final rules issued by CMS in 2011, group therapy is defined as therapy sessions with four patients who are performing similar therapy activities. Irrespective of the number of patients ultimately treated in a group therapy session, rehabilitation providers must allocate therapy minutes during such sessions as if four patients are being served. The Company’s rehabilitation division hired additional therapists to facilitate the provision of additional individual minutes to address patient needs.

On May 1, 2013, CMS issued proposed regulations updating Medicare payment rates for skilled nursing centers effective October 1, 2013. These proposed regulations implement a net market basket increase of 1.4% consisting of: (1) a 2.3% market basket inflation increase, less (2) a 0.4% adjustment to account for the effect of a productivity adjustment, and less (3) a 0.5% market basket forecast error adjustment.

On July 27, 2012, CMS issued final regulations updating Medicare payment rates for skilled nursing centers effective October 1, 2012. These final regulations implement a net market basket increase of 1.8% consisting of: (1) a 2.5% market basket inflation increase, less (2) a 0.7% adjustment to account for the effect of a productivity adjustment.

On July 29, 2011, CMS issued the 2011 CMS Rules which, among other things, impose: (1) a negative adjustment to RUGs IV therapy rates, and (2) a net market basket increase of 1.7% consisting of (a) a 2.7% market basket inflation increase, less (b) a 1.0% adjustment to account for the effect of a productivity adjustment, beginning on October 1, 2011. CMS projected the impact of these changes will result in an 11.1% decrease in payments to skilled nursing centers. In addition to these rate changes, the 2011 CMS Rules introduced additional changes to RUG calculations along with adding additional patient assessments. Under the 2011 CMS Rules, group therapy is defined as therapy sessions with four patients who are performing similar therapy activities. In addition, for purposes of assigning patients to RUGs IV payment categories, the minutes of group therapy are divided by four with 25% of the minutes being allocated to each patient. The 2011 CMS Rules also clarify the circumstances for reporting breaks in care of three or more days of therapy and also implement a new change of therapy assessment that is designed to allocate the patient to the RUG level that represents the treatment provided in the last seven days. Both changes are likely to produce alterations in the RUG scores billed for the patient along with generating additional patient assessments. The Company believes that the 2011 CMS Rules on an annual basis have reduced its revenues by approximately $100 million to $110 million in the Company’s nursing center business and have negatively impacted the Company’s rehabilitation therapy business by approximately $40 million to $50 million.

In February 2012, Congress passed the Job Creation Act which provides for reductions in reimbursement of Medicare bad debts at the Company’s nursing centers. The Job Creation Act provides for a phase-in of the reduction in the rate of reimbursement for bad debts of patients that are dually eligible for Medicare and Medicaid. The rate of reimbursement for bad debts for these dually eligible patients will be reduced from 100% to 88%, then 76% and then 65% for cost reporting periods beginning on or after October 1, 2012, October 1, 2013, and October 1, 2014, respectively. The rate of reimbursement for bad debts for patients not dually eligible for both Medicare and Medicaid was reduced from 70% to 65%, for cost reporting periods beginning on or after October 1, 2012. Approximately 90% of the Company’s Medicare bad debt reimbursements are associated with patients that are dually eligible.

Rehabilitation division

Effective January 1, 2011, reimbursement rates for Medicare Part B therapy services included in the MPFS were reduced by 25% for subsequent procedures when multiple therapy services are provided on the same day. The Taxpayer Relief Act will further reduce Medicare payments for subsequent procedures when multiple therapy services are provided on the same day. The Company believes that the new rules related to multiple therapy services will reduce its revenues by $25 million to $30 million on an annual basis.

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of inflation and changing prices (Continued)

Rehabilitation division (Continued)

Medicare Part B provides reimbursement for certain physician services, limited drug coverage and other outpatient services, such as therapy and other services, outside of a Medicare Part A covered patient stay. Payment for these services is determined according to the MPFS. Annually since 1997, the MPFS has been subject to the SGR, which is intended to keep spending growth in line with allowable spending. Each year since the SGR was enacted, this adjustment produced a scheduled negative update to payment for physicians, therapists and other healthcare providers paid under the MPFS. Annually, since 2002, Congress has stepped in with so-called “doc fix” legislation to suspend payment cuts to physicians. Various legislation has annually suspended the payment cut. The Taxpayer Relief Act further suspended the payment cut until December 31, 2013.

Since 2006, federal legislation has provided for an annual Medicare Part B outpatient therapy cap. In succeeding years, CMS increased the amount of the therapy cap. Legislation also was passed that required CMS to implement a broad process for reviewing medically necessary therapy claims, creating an exception to the cap. Legislation has annually extended the Medicare Part B outpatient therapy cap exception process. The Job Creation Act extended the therapy cap exception process through December 31, 2012. The Taxpayer Relief Act further extended the therapy cap exception process through December 31, 2013. Patients in the Company facilities whose stay is not reimbursed by Medicare Part A must seek reimbursement for their therapy under Medicare Part B and are subject to the therapy cap.

In February 2012, the Middle Class Tax Relief Act of 2012 was enacted, which provides that certain Medicare Part B therapy services exceeding a threshold of $3,700 would be subject to a pre-payment manual medical review process effective October 1, 2012. The review process for these services was scheduled to expire on December 31, 2012 but was extended through December 31, 2013 under the Taxpayer Relief Act. This review process has had an adverse effect on the provision and billing of services for patients and could negatively impact therapist efficiencies.

Home health and hospice division

On April 29, 2013, CMS issued proposed regulations regarding Medicare payment rates for hospice providers effective October 1, 2013. These proposed regulations implement a net market basket increase of 1.8% consisting of: (1) a 2.5% market basket inflation increase, less (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) a 0.4% adjustment to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute. In addition, CMS continued the phase-out of the wage index budget neutrality adjustment. CMS has projected the impact of these changes will result in a 1.1% increase in payments to hospice providers.

On November 2, 2012, CMS issued final regulations regarding Medicare payment rates for home health agencies effective January 1, 2013. These final regulations implement a net market basket increase of 1.3% consisting of: (1) a 2.3% market basket inflation increase, less (2) a 1.0% adjustment mandated by the ACA. In addition, CMS implemented a 1.32% reduction in case mix. CMS has projected the impact of these changes will result in a 0.01% decrease in payments to home health agencies.

On July 24, 2012, CMS issued final regulations regarding Medicare payment rates for hospice providers effective October 1, 2012. These final regulations implement a net market basket increase of 1.6% consisting of: (1) a 2.6% market basket inflation increase, less (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) a 0.7% adjustment to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute. In addition, CMS continued the phase-out of the wage index budget neutrality adjustment. CMS has projected the impact of these changes will result in a 0.9% increase in payments to hospice providers.

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

RESULTS OF OPERATIONS (Continued)

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)


	2012 Quarters												Year			First Quarter 2013
	First			Second			Third			Fourth			Year			First Quarter 2013
Revenues	$	1,537,931		$	1,495,146		$	1,487,458		$	1,512,115		$	6,032,650		$	1,554,908

Salaries, wages and benefits		921,359			884,990			891,813			894,945			3,593,107			943,773
Supplies		108,533			105,646			104,237			104,946			423,362			105,808
Rent		104,313			105,629			106,796			106,492			423,230			105,978
Other operating expenses		296,365			298,971			292,682			292,325			1,180,343			305,503
Other income		(3,143	)		(3,149	)		(3,154	)		(3,027	)		(12,473	)		(993	)
Impairment charges		848			317			693			108,909			110,767			436
Depreciation and amortization		46,986			48,279			49,059			50,885			195,209			51,196
Interest expense		26,578			26,715			26,667			27,933			107,893			28,174
Investment income		(288	)		(267	)		(231	)		(253	)		(1,039	)		(91	)

		1,501,551			1,467,131			1,468,562			1,583,155			6,020,399			1,539,784

Income (loss) from continuing operations before income taxes		36,380			28,015			18,896			(71,040	)		12,251			15,124
Provision for income taxes		14,765			11,549			7,781			7,180			41,275			5,620

Income (loss) from continuing operations		21,615			16,466			11,115			(78,220	)		(29,024	)		9,504
Discontinued operations, net of income taxes:
Loss from operations		(1,803	)		(847	)		(1,228	)		(1,677	)		(5,555	)		(4,787	)
Loss on divestiture of operations		(1,170	)		(356	)		(2,280	)		(939	)		(4,745	)		(1,244	)

Loss from discontinued operations		(2,973	)		(1,203	)		(3,508	)		(2,616	)		(10,300	)		(6,031	)

Net income (loss)		18,642			15,263			7,607			(80,836	)		(39,324	)		3,473
(Earnings) loss attributable to noncontrolling interests		(451	)		239			(41	)		(790	)		(1,043	)		(416	)

Income (loss) attributable to Kindred	$	18,191		$	15,502		$	7,566		$	(81,626	)	$	(40,367	)	$	3,057

Amounts attributable to Kindred stockholders:
Income (loss) from continuing operations	$	21,164		$	16,705		$	11,074		$	(79,010	)	$	(30,067	)	$	9,088
Loss from discontinued operations		(2,973	)		(1,203	)		(3,508	)		(2,616	)		(10,300	)		(6,031	)

Net income (loss)	$	18,191		$	15,502		$	7,566		$	(81,626	)	$	(40,367	)	$	3,057

Earnings (loss) per common share:
Basic:
Income (loss) from continuing operations	$	0.40		$	0.32		$	0.21		$	(1.53	)	$	(0.58	)	$	0.17
Discontinued operations:
Loss from operations		(0.03	)		(0.02	)		(0.03	)		(0.03	)		(0.11	)		(0.09	)
Loss on divestiture of operations		(0.02	)		(0.01	)		(0.04	)		(0.02	)		(0.09	)		(0.02	)

Loss from discontinued operations		(0.05	)		(0.03	)		(0.07	)		(0.05	)		(0.20	)		(0.11	)

Net income (loss)	$	0.35		$	0.29		$	0.14		$	(1.58	)	$	(0.78	)	$	0.06

Diluted:
Income (loss) from continuing operations	$	0.40		$	0.32		$	0.21		$	(1.53	)	$	(0.58	)	$	0.17
Discontinued operations:
Loss from operations		(0.03	)		(0.02	)		(0.03	)		(0.03	)		(0.11	)		(0.09	)
Loss on divestiture of operations		(0.02	)		(0.01	)		(0.04	)		(0.02	)		(0.09	)		(0.02	)

Loss from discontinued operations		(0.05	)		(0.03	)		(0.07	)		(0.05	)		(0.20	)		(0.11	)

Net income (loss)	$	0.35		$	0.29		$	0.14		$	(1.58	)	$	(0.78	)	$	0.06

Shares used in computing earnings (loss) per common share:
Basic		51,603			51,664			51,676			51,692			51,659			52,062
Diluted		51,638			51,675			51,709			51,692			51,659			52,083

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

RESULTS OF OPERATIONS (Continued)

Operating Data

(Unaudited)

(In thousands)


	2012 Quarters												Year			First Quarter 2013
	First			Second			Third			Fourth			Year			First Quarter 2013
Revenues:
Hospital division	$	749,383		$	714,517		$	699,175		$	712,005		$	2,875,080		$	748,214
Nursing center division		512,148			503,325			505,192			506,891			2,027,556			502,703
Rehabilitation division:
Skilled nursing rehabilitation services		257,014			256,941			255,217			247,572			1,016,744			260,789
Hospital rehabilitation services		74,369			73,402			71,899			73,910			293,580			74,523

		331,383			330,343			327,116			321,482			1,310,324			335,312

Home health and hospice division		28,432			28,872			35,943			50,093			143,340			51,621

		1,621,346			1,577,057			1,567,426			1,590,471			6,356,300			1,637,850
Eliminations:
Skilled nursing rehabilitation services		(53,612	)		(52,440	)		(51,154	)		(48,714	)		(205,920	)		(52,889	)
Hospital rehabilitation services		(28,161	)		(27,646	)		(26,909	)		(27,620	)		(110,336	)		(27,994	)
Nursing centers		(1,642	)		(1,825	)		(1,905	)		(2,022	)		(7,394	)		(2,059	)

		(83,415	)		(81,911	)		(79,968	)		(78,356	)		(323,650	)		(82,942	)

	$	1,537,931		$	1,495,146		$	1,487,458		$	1,512,115		$	6,032,650		$	1,554,908

Income (loss) from continuing operations:
Operating income (loss):
Hospital division	$	161,826		$	142,668		$	138,250		$	156,924		$	599,668		$	161,819	(a,b)
Nursing center division		63,906			68,012			69,906			65,085			266,909			51,178	(a,c)
Rehabilitation division:
Skilled nursing rehabilitation services		14,323			23,279			20,012			24,088			81,702			15,278	(a)
Hospital rehabilitation services		16,116			17,860			16,977			18,792			69,745			18,132	(a)

		30,439			41,139			36,989			42,880			151,447			33,410

Home health and hospice division		2,341			2,789			3,645			4,933			13,708			2,786	(a)
Corporate:
Overhead		(42,728	)		(44,723	)		(45,883	)		(45,729	)		(179,063	)		(45,582	)(a)
Insurance subsidiary		(482	)		(600	)		(545	)		(500	)		(2,127	)		(509	)

		(43,210	)		(45,323	)		(46,428	)		(46,229	)		(181,190	)		(46,091	)
Impairment charges		(848	)		(317	)		(693	)		(108,909	)		(110,767	)		(436	)
Transaction costs		(485	)		(597	)		(482	)		(667	)		(2,231	)		(2,285	)

Operating income		213,969			208,371			201,187			114,017			737,544			200,381
Rent		(104,313	)		(105,629	)		(106,796	)		(106,492	)		(423,230	)		(105,978	)
Depreciation and amortization		(46,986	)		(48,279	)		(49,059	)		(50,885	)		(195,209	)		(51,196	)
Interest, net		(26,290	)		(26,448	)		(26,436	)		(27,680	)		(106,854	)		(28,083	)

Income (loss) from continuing operations before income taxes		36,380			28,015			18,896			(71,040	)		12,251			15,124
Provision for income taxes		14,765			11,549			7,781			7,180			41,275			5,620

	$	21,615		$	16,466		$	11,115		$	(78,220	)	$	(29,024	)	$	9,504

(a)

Includes one-time bonus costs of $25.9 million (hospital division – $8.8 million, nursing center division – $9.7 million, rehabilitation division – $6.3 million (skilled nursing rehabilitation services – $5.0 million and hospital rehabilitation services – $1.3 million), home health and hospice division – $0.8 million and corporate – $0.3 million).

(b)	Includes employee retention costs of $0.3 million incurred in connection with the planned divestiture of 17 non-strategic facilities.

(c)	Includes employee retention costs of $0.4 million incurred in connection with the nonrenewal of 54 nursing centers leased from Ventas.

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)

(In thousands)


	2012 Quarters								Year		First Quarter 2013
	First		Second		Third		Fourth		Year		First Quarter 2013
Rent:
Hospital division	$	53,151	$	54,079	$	55,127	$	54,427	$	216,784	$	53,148
Nursing center division		48,451		48,908		48,854		49,082		195,295		49,766
Rehabilitation division:
Skilled nursing rehabilitation services		1,440		1,408		1,356		1,238		5,442		1,235
Hospital rehabilitation services		78		39		2		21		140		17

		1,518		1,447		1,358		1,259		5,582		1,252
Home health and hospice division		615		609		805		1,111		3,140		1,186
Corporate		578		586		652		613		2,429		626

	$	104,313	$	105,629	$	106,796	$	106,492	$	423,230	$	105,978

Depreciation and amortization:
Hospital division	$	22,346	$	22,807	$	23,048	$	23,575	$	91,776	$	23,941
Nursing center division		11,262		11,737		12,065		12,518		47,582		12,720
Rehabilitation division:
Skilled nursing rehabilitation services		2,660		2,752		2,811		2,945		11,168		3,112
Hospital rehabilitation services		2,324		2,323		2,328		2,334		9,309		2,331

		4,984		5,075		5,139		5,279		20,477		5,443
Home health and hospice division		898		925		1,137		1,482		4,442		1,526
Corporate		7,496		7,735		7,670		8,031		30,932		7,566

	$	46,986	$	48,279	$	49,059	$	50,885	$	195,209	$	51,196

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division:
Routine	$	10,345	$	9,095	$	9,015	$	9,817	$	38,272	$	10,271
Development		9,949		11,289		14,334		6,693		42,265		2,388

		20,294		20,384		23,349		16,510		80,537		12,659
Nursing center division:
Routine		4,229		3,417		4,965		8,153		20,764		5,819
Development		673		1,087		843		5,454		8,057		—

		4,902		4,504		5,808		13,607		28,821		5,819
Rehabilitation division:
Skilled nursing rehabilitation services:
Routine		326		569		707		672		2,274		605
Development		—		—		—		—		—		—

		326		569		707		672		2,274		605
Hospital rehabilitation services:
Routine		46		60		125		117		348		32
Development		—		—		—		—		—		—

		46		60		125		117		348		32
Home health and hospice division:
Routine		124		145		160		1,187		1,616		195
Development		—		—		—		—		—		—

		124		145		160		1,187		1,616		195
Corporate:
Routine:
Information systems		6,864		15,195		10,842		17,440		50,341		5,289
Other		172		278		125		985		1,560		159

	$	32,728	$	41,135	$	41,116	$	50,518	$	165,497	$	24,758

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

RESULTS OF OPERATIONS (Continued)

Condensed Consolidating Statement of Operations

(Unaudited)

(In thousands)


	First Quarter 2013
							Rehabilitation division
	Hospital division (a,b)			Nursing center division (a,c)			Skilled nursing services (a)			Hospital services (a)		Total			Home health and hospice division (a)		Corporate (a)			Transaction- related costs			Eliminations			Consolidated
Revenues	$	748,214		$	502,703		$	260,789		$	74,523	$	335,312		$	51,621	$	—		$	—		$	(82,942	)	$	1,554,908

Salaries, wages and benefits		332,256			254,450			234,844			52,420		287,264			40,314		29,730			—			(241	)		943,773
Supplies		77,637			24,874			811			32		843			2,238		216			—			—			105,808
Rent		53,148			49,766			1,235			17		1,252			1,186		626			—			—			105,978
Other operating expenses		176,603			172,590			9,856			3,919		13,775			6,283		16,668			2,285			(82,701	)		305,503
Other (income) expense		(101	)		(389	)		—			20		20			—		(523	)		—			—			(993	)
Impairment charges		176			260			—			—		—			—		—			—			—			436
Depreciation and amortization		23,941			12,720			3,112			2,331		5,443			1,526		7,566			—			—			51,196
Interest expense		182			20			96			—		96			—		27,876			—			—			28,174
Investment income		(5	)		(13	)		(28	)		—		(28	)		—		(45	)		—			—			(91	)

		663,837			514,278			249,926			58,739		308,665			51,547		82,114			2,285			(82,942	)		1,539,784

Income (loss) from continuing operations before income taxes	$	84,377		$	(11,575	)	$	10,863		$	15,784	$	26,647		$	74	$	(82,114	)	$	(2,285	)	$	—			15,124

Provision for income taxes																											5,620

Income from continuing operations																										$	9,504


	First Quarter 2012
							Rehabilitation division
	Hospital division (d)			Nursing center division			Skilled nursing services			Hospital services		Total			Home health and hospice division		Corporate			Transaction- related costs			Eliminations			Consolidated
Revenues	$	749,383		$	512,148		$	257,014		$	74,369	$	331,383		$	28,432	$	—		$	—		$	(83,415	)	$	1,537,931

Salaries, wages and benefits		330,309			252,877			233,204			53,731		286,935			21,291		29,979			—			(32	)		921,359
Supplies		80,047			26,382			808			54		862			1,033		209			—			—			108,533
Rent		53,151			48,451			1,440			78		1,518			615		578			—			—			104,313
Other operating expenses		177,292			169,287			8,679			4,468		13,147			3,767		15,770			485			(83,383	)		296,365
Other income		(91	)		(304	)		—			—		—			—		(2,748	)		—			—			(3,143	)
Impairment charges		304			544			—			—		—			—		—			—			—			848
Depreciation and amortization		22,346			11,262			2,660			2,324		4,984			898		7,496			—			—			46,986
Interest expense		306			28			—			—		—			—		26,244			—			—			26,578
Investment income		(8	)		(14	)		(1	)		—		(1	)		—		(265	)		—			—			(288	)

		663,656			508,513			246,790			60,655		307,445			27,604		77,263			485			(83,415	)		1,501,551

Income from continuing operations before income taxes	$	85,727		$	3,635		$	10,224		$	13,714	$	23,938		$	828	$	(77,263	)	$	(485	)	$	—			36,380

Provision for income taxes																											14,765

Income from continuing operations																										$	21,615

(a)

(b)	Includes employee retention costs of $0.3 million incurred in connection with the planned divestiture of 17 non-strategic facilities.

(c)	Includes employee retention costs of $0.4 million incurred in connection with the nonrenewal of 54 nursing centers leased from Ventas.

(d)	Includes severance costs of $2.0 million and other costs of $0.1 million incurred in connection with the closing of a regional office.

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

RESULTS OF OPERATIONS (Continued)

Operating Data

(Unaudited)


	2012 Quarters								Year		First Quarter 2013
	First		Second		Third		Fourth		Year		First Quarter 2013
Hospital division data:
End of period data:
Number of hospitals:
Transitional care		118		117		116		116				116
Inpatient rehabilitation		6		6		6		6				6

		124		123		122		122				122

Number of licensed beds:
Transitional care		8,454		8,404		8,347		8,382				8,382
Inpatient rehabilitation		229		259		259		259				259

		8,683		8,663		8,606		8,641				8,641

Revenue mix %:
Medicare		63		62		61		63		62		63
Medicaid		6		6		6		6		6		5
Medicare Advantage		10		10		11		10		10		10
Commercial insurance and other		21		22		22		21		22		22
Admissions:
Medicare		11,989		11,152		10,891		11,023		45,055		11,867
Medicaid		984		1,009		1,006		941		3,940		778
Medicare Advantage		1,658		1,757		1,616		1,579		6,610		1,734
Commercial insurance and other		2,868		2,630		2,661		2,509		10,668		2,512

		17,499		16,548		16,174		16,052		66,273		16,891

Admissions mix %:
Medicare		69		67		67		69		68		70
Medicaid		6		6		6		6		6		5
Medicare Advantage		9		11		10		10		10		10
Commercial insurance and other		16		16		17		15		16		15
Patient days:
Medicare		293,746		278,614		270,555		275,008		1,117,923		290,942
Medicaid		38,487		36,654		40,169		38,045		153,355		35,447
Medicare Advantage		46,824		49,672		47,659		46,193		190,348		48,784
Commercial insurance and other		84,372		81,957		81,445		77,562		325,336		82,466

		463,429		446,897		439,828		436,808		1,786,962		457,639

Average length of stay:
Medicare		24.5		25.0		24.8		24.9		24.8		24.5
Medicaid		39.1		36.3		39.9		40.4		38.9		45.6
Medicare Advantage		28.2		28.3		29.5		29.3		28.8		28.1
Commercial insurance and other		29.4		31.2		30.6		30.9		30.5		32.8
Weighted average		26.5		27.0		27.2		27.2		27.0		27.1
Revenues per admission:
Medicare	$	39,256	$	39,467	$	39,188	$	40,479	$	39,591	$	39,697
Medicaid		44,447		42,787		43,272		43,492		43,494		51,806
Medicare Advantage		43,923		42,639		45,885		45,646		44,473		43,949
Commercial insurance and other		56,549		59,427		58,134		60,903		58,678		63,940
Weighted average		42,824		43,178		43,228		44,356		43,382		44,297
Revenues per patient day:
Medicare	$	1,602	$	1,580	$	1,577	$	1,622	$	1,596	$	1,619
Medicaid		1,136		1,178		1,084		1,076		1,117		1,137
Medicare Advantage		1,555		1,508		1,556		1,560		1,544		1,562
Commercial insurance and other		1,922		1,907		1,899		1,970		1,924		1,948
Weighted average		1,617		1,599		1,590		1,630		1,609		1,635
Medicare case mix index (discharged patients only)		1.18		1.17		1.15		1.14		1.16		1.18
Average daily census		5,093		4,911		4,781		4,748		4,882		5,085
Occupancy %		67.4		64.6		63.5		63.1		64.6		67.4
Annualized employee turnover %		21.8		22.2		21.1		20.1				21.1

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)


	2012 Quarters								Year		First Quarter 2013
	First		Second		Third		Fourth		Year		First Quarter 2013
Nursing center division data:
End of period data:
Number of facilities:
Nursing centers:
Owned or leased		201		201		201		200				200
Managed		4		4		4		4				4
Assisted living facilities		6		6		6		6				6

		211		211		211		210				210

Number of licensed beds:
Nursing centers:
Owned or leased		24,431		24,479		24,479		24,425				24,425
Managed		485		485		485		485				485
Assisted living facilities		413		341		341		341				341

		25,329		25,305		25,305		25,251				25,251

Revenue mix %:
Medicare		35		34		33		33		34		33
Medicaid		39		40		40		40		40		39
Medicare Advantage		7		7		7		7		7		8
Private and other		19		19		20		20		19		20
Patient days (a):
Medicare		331,857		319,333		308,218		305,987		1,265,395		310,180
Medicaid		1,129,717		1,129,200		1,139,559		1,130,949		4,529,425		1,094,229
Medicare Advantage		91,477		86,441		84,245		82,879		345,042		93,117
Private and other		398,634		388,137		400,106		398,918		1,585,795		382,837

		1,951,685		1,923,111		1,932,128		1,918,733		7,725,657		1,880,363

Patient day mix % (a):
Medicare		17		17		16		16		16		17
Medicaid		58		59		59		59		59		58
Medicare Advantage		5		4		4		4		4		5
Private and other		20		20		21		21		21		20
Revenues per patient day (a):
Medicare Part A	$	483	$	483	$	490	$	505	$	490	$	497
Total Medicare (including Part B)		533		535		543		548		539		540
Medicaid		177		179		179		182		179		181
Medicaid (net of provider taxes) (b)		157		158		159		161		159		160
Medicare Advantage		410		406		410		414		410		409
Private and other		245		246		248		249		247		257
Weighted average		263		262		261		264		262		267
Average daily census (a)		21,447		21,133		21,001		20,856		21,108		20,893
Admissions (a)		19,386		18,188		17,878		18,292		73,744		19,439
Occupancy % (a)		85.1		84.0		83.4		82.9		83.9		83.0
Medicare average length of stay (a)		31.9		32.3		32.7		31.4		32.1		30.6
Annualized employee turnover %		37.9		40.0		39.8		39.5				38.9

(a)	Excludes managed facilities.

(b)	Provider taxes are recorded in other operating expenses for all periods presented.

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)


	2012 Quarters								Year		First Quarter 2013
	First		Second		Third		Fourth		Year		First Quarter 2013
Rehabilitation division data:
Skilled nursing rehabilitation services:
Revenue mix %:
Company-operated		21		20		20		20		20		20
Non-affiliated		79		80		80		80		80		80
Sites of service (at end of period)		1,722		1,730		1,735		1,726				1,729
Revenue per site	$	149,253	$	148,521	$	147,098	$	143,437	$	588,309	$	150,832
Therapist productivity %		80.3		80.4		80.5		80.5		80.4		81.1
Hospital rehabilitation services:
Revenue mix %:
Company-operated		38		38		37		37		38		38
Non-affiliated		62		62		63		63		62		62
Sites of services (at end of period):
Inpatient rehabilitation units		100		102		104		105				103
LTAC hospitals		125		125		123		123				123
Sub-acute units		19		20		20		21				8
Outpatient units		111		115		117		119				98
Other		5		5		5		5				–

		360		367		369		373				332

Revenue per site	$	206,580	$	200,006	$	194,849	$	198,150	$	799,585	$	224,466

Annualized employee turnover %		19.6		16.9		17.3		16.9				10.4

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

Interest Rate Sensitivity

Principal (Notional) Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)


	Expected maturities																				Fair value 3/31/13
	2013			2014			2015			2016			2017			Thereafter			Total		Fair value 3/31/13
Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate:
Notes	$	—		$	—		$	—		$	—		$	—		$	550,000		$	550,000	$	546,150
Other		77			109			116			123			10			—			435		427	(a)

	$	77		$	109		$	116		$	123		$	10		$	550,000		$	550,435	$	546,577

Average interest rate		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%		8.3	%

Variable rate:
ABL Facility (b)	$	—		$	—		$	—		$	345,000		$	—		$	—		$	345,000	$	345,000
Term Loan Facility (c,d)		6,000			8,000			8,000			8,000			8,000			749,500			787,500		791,910
Other (e)		175			232			3,720			—			—			—			4,127		4,127

	$	6,175		$	8,232		$	11,720		$	353,000		$	8,000		$	749,500		$	1,136,627	$	1,141,037

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

(b)

Interest on borrowings under the Company’s ABL Facility is payable at a rate per annum equal to the applicable margin plus, at the Company’s option, either: (1) LIBOR determined by reference to the costs of funds for Eurodollar deposits for the interest period relevant to such borrowing adjusted for certain additional costs, or (2) a base rate determined by reference to the highest of: (a) the prime rate of JPMorgan Chase Bank, N.A., (b) the federal funds effective rate plus one-half of 1.00% and (c) LIBOR as described in subclause (1) plus 1.00%. At March 31, 2013, the applicable margin for borrowings under the ABL Facility was 2.75% with respect to LIBOR borrowings and 1.75% with respect to base rate borrowings. The applicable margin is subject to adjustment each fiscal quarter, based upon average historical excess availability during the preceding quarter.

(c)

Interest on borrowings under the Term Loan Facility is payable at a rate per annum equal to an applicable margin plus, at the Company’s option, either: (1) LIBOR determined by reference to the costs of funds for Eurodollar deposits for the interest period relevant to such borrowing adjusted for certain additional costs, or (2) a base rate determined by reference to the highest of: (a) the prime rate of JPMorgan Chase Bank, N.A., (b) the federal funds effective rate plus one-half of 1.00% and (c) LIBOR described in subclause (1) plus 1.00%. LIBOR is subject to an interest rate floor of 1.50%. The applicable margin for borrowings under the Term Loan Facility is 3.75% with respect to LIBOR borrowings and 2.75% with respect to base rate borrowings. The expected maturities for the Term Loan Facility exclude the original issue discount of approximately $7 million.

(d)

In December 2011, the Company entered into two interest rate swap agreements to hedge its floating interest rate on an aggregate of $225 million of outstanding Term Loan Facility debt. The interest rate swaps have an effective date of January 9, 2012, and expire on January 11, 2016. The Company is required to make payments based upon a fixed interest rate of 1.8925% calculated on the notional amount of $225 million. In exchange, the Company will receive interest on $225 million at a variable interest rate that is based upon the three-month LIBOR, subject to a minimum rate of 1.5%.

(e)	Interest based upon LIBOR plus 4%.

ITEM 4. CONTROLS AND PROCEDURES

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

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of March 31, 2013, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended March 31, 2013, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings

The Company is a party to various legal actions (some of which are not insured), and regulatory and other governmental audits and investigations in the ordinary course of business. The Company cannot predict the ultimate outcome of pending litigation and regulatory and other governmental audits and investigations. These matters could potentially subject the Company to sanctions, damages, recoupments, fines and other penalties. The DOJ, CMS or other federal and state enforcement and regulatory agencies may conduct additional investigations related to the Company’s businesses in the future which may, either individually or in the aggregate, have a material adverse effect on the Company’s business, financial position, results of operations and liquidity. See Note 12 of the notes to condensed consolidated financial statements for a description of the Company’s other pending legal proceedings.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES


Period	Total number of shares (or units) purchased (a)		Average price paid per share (or unit) (b)		Total number of shares (or units) purchased as part of publicly announced plans or programs		Maximum number (or approximate dollar value) of shares (or units) that may yet be purchased under the plans or programs
Month #1 (January 1 – January 31)		—	$	—		—	$	—
Month #2 (February 1 – February 28)		176,522		11.48		—		—
Month #3 (March 1 – March 31)		74,400		10.88		—		—

Total		250,922	$	11.30		—	$	—

(a)

These amounts represent shares of the Company’s common stock, par value $0.25 per share, withheld to offset tax withholding obligations that occurred upon the vesting and release of service-based and performance-based restricted share awards previously granted under the Company’s stock-based compensation plans for its employees (the “Withheld Shares”). For each employee, the total tax withholding obligation is divided by the closing price of the Company’s common stock on the New York Stock Exchange on the applicable vesting date to determine the total number of Withheld Shares required to satisfy such withholding obligation.

(b)	The average price per share for each period was calculated by dividing the sum of the aggregate value of the Withheld Shares by the total number of Withheld Shares.

Item 6.

Exhibits


10.1		Side Letter dated as of March 1, 2013 to the Second Amended and Restated Master Lease Agreement No. 1.

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

32		Section 1350 Certifications.

101.INS		XBRL Instance Document.

101.SCH		XBRL Taxonomy Extension Schema Document.

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document.

101.DEF		XBRL Taxonomy Extension Definition Linkbase Document.

101.LAB		XBRL Taxonomy Extension Label Linkbase Document.

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document.

SIGNATURES

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


						KINDRED HEALTHCARE, INC.

Date: May 9, 2013						/s/ PAUL J. DIAZ
						Paul J. Diaz Chief Executive Officer

Date: May 9, 2013						/s/ RICHARD A. LECHLEITER
						Richard A. Lechleiter Executive Vice President and Chief Financial Officer