Edgar Filing: KINDRED HEALTHCARE, INC

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

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

EXCHANGE ACT OF 1934

For the transition period from to .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)


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

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

(502) 596-7300

(Registrant’s telephone number, including area code)

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

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


Large accelerated filer þ		Accelerated filer ¨		Non-accelerated filer ¨		Smaller reporting company ¨

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

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


Class of Common Stock		Outstanding at July 31, 2008
Common stock, $0.25 par value		38,833,846 shares

1 of 39

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 June 30, 2008 and 2007 and for the six months ended June 30, 2008 and 2007	3
	Condensed Consolidated Balance Sheet — June 30, 2008 and December 31, 2007	4
	Condensed Consolidated Statement of Cash Flows — for the three months ended June 30, 2008 and 2007 and for the six months ended June 30, 2008 and 2007	5
	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36

Item 4.	Controls and Procedures	37

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	38

Item 4.	Submission of Matters to a Vote of Security Holders	38

Item 6.	Exhibits	38

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended June 30,						Six months ended June 30,
	2008			2007			2008			2007
Revenues	$	1,050,342		$	1,096,245		$	2,110,103		$	2,205,234

Salaries, wages and benefits		602,752			603,047			1,211,653			1,206,599
Supplies		82,586			181,121			162,548			362,756
Rent		88,461			88,273			174,587			172,945
Other operating expenses		225,113			177,587			455,813			360,021
Other income		(5,167	)		–			(9,884	)		–
Depreciation and amortization		31,269			30,388			62,674			58,590
Interest expense		2,907			2,692			7,828			6,287
Investment income		(2,340	)		(3,617	)		(5,608	)		(7,450	)

		1,025,581			1,079,491			2,059,611			2,159,748

Income from continuing operations before income taxes		24,761			16,754			50,492			45,486
Provision for income taxes		10,044			7,111			20,754			19,318

Income from continuing operations		14,717			9,643			29,738			26,168
Discontinued operations, net of income taxes:
Income (loss) from operations		1,104			(1,874	)		773			(3,300	)
Gain (loss) on divestiture of operations		5,840			(69,702	)		5,840			(76,968	)

Net income (loss)	$	21,661		$	(61,933	)	$	36,351		$	(54,100	)

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.39		$	0.24		$	0.79		$	0.66
Discontinued operations:
Income (loss) from operations		0.03			(0.05	)		0.02			(0.08	)
Gain (loss) on divestiture of operations		0.15			(1.76	)		0.16			(1.95	)

Net income (loss)	$	0.57		$	(1.57	)	$	0.97		$	(1.37	)

Diluted:
Income from continuing operations	$	0.38		$	0.24		$	0.77		$	0.65
Discontinued operations:
Income (loss) from operations		0.03			(0.05	)		0.02			(0.08	)
Gain (loss) on divestiture of operations		0.15			(1.71	)		0.15			(1.91	)

Net income (loss)	$	0.56		$	(1.52	)	$	0.94		$	(1.34	)

Shares used in computing earnings (loss) per common share:
Basic		37,714			39,591			37,579			39,403
Diluted		38,943			40,645			38,783			40,426

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	June 30, 2008			December 31, 2007
ASSETS
Current assets:
Cash and cash equivalents	$	18,816		$	32,877
Cash – restricted		4,913			5,360
Insurance subsidiary investments		191,209			231,693
Accounts receivable less allowance for loss of $30,463 – June 30, 2008 and $33,305 – December 31, 2007		666,108			598,108
Inventories		22,462			22,035
Deferred tax assets		53,429			59,936
Income taxes		11,498			43,128
Other		25,163			20,510

		993,598			1,013,647

Property and equipment		1,309,328			1,226,111
Accumulated depreciation		(601,696	)		(542,773	)

		707,632			683,338

Goodwill		71,257			69,100
Intangible assets less accumulated amortization of $1,523 – June 30, 2008 and $1,095 – December 31, 2007		80,078			79,956
Assets held for sale		511			15,837
Insurance subsidiary investments		51,364			49,166
Deferred tax assets		126,276			113,854
Other		45,936			54,654

	$	2,076,652		$	2,079,552

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	164,676		$	180,367
Salaries, wages and other compensation		261,341			261,608
Due to third party payors		27,173			41,980
Professional liability risks		56,550			64,740
Other accrued liabilities		79,125			80,663
Long-term debt and capital lease obligation due within one year		78			584

		588,943			629,942

Long-term debt		266,174			275,814
Capital lease obligation		–			15,760
Professional liability risks		201,790			186,652
Deferred credits and other liabilities		110,261			109,260

Commitments and contingencies

Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 38,770 shares – June 30, 2008 and 38,339 shares – December 31, 2007		9,692			9,585
Capital in excess of par value		803,324			790,367
Accumulated other comprehensive income (loss)		(518	)		1,250
Retained earnings		96,986			60,922

		909,484			862,124

	$	2,076,652		$	2,079,552

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended June 30,						Six months ended June 30,
	2008			2007			2008			2007
Cash flows from operating activities:
Net income (loss)	$	21,661		$	(61,933	)	$	36,351		$	(54,100	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		31,269			31,682			62,674			61,103
Amortization of stock-based compensation costs		3,626			4,572			7,395			8,152
Provision for doubtful accounts		6,788			9,687			15,160			16,882
Deferred income taxes		(8,429	)		(9,484	)		(13,147	)		(14,915	)
(Gain) loss on divestiture of discontinued operations		(5,840	)		69,702			(5,840	)		76,968
Other		4,569			(863	)		3,993			(1,515	)
Change in operating assets and liabilities:
Accounts receivable		17,997			1,764			(84,146	)		(45,428	)
Inventories and other assets		2,714			2,808			(4,458	)		(2,910	)
Accounts payable		(11,382	)		(5,523	)		(11,030	)		(16,614	)
Income taxes		(4,570	)		10,894			37,026			27,081
Due to third party payors		(11,316	)		6,570			(14,807	)		4,388
Other accrued liabilities		(3,133	)		13,458			4,989			21,500

Net cash provided by operating activities		43,954			73,334			34,160			80,592

Cash flows from investing activities:
Purchase of property and equipment		(39,920	)		(44,734	)		(64,860	)		(78,756	)
Acquisitions		(24,325	)		(175,612	)		(26,405	)		(215,254	)
Sale of assets		20,760			2,740			27,239			79,906
Purchase of insurance subsidiary investments		(33,835	)		(41,201	)		(69,068	)		(91,879	)
Sale of insurance subsidiary investments		28,034			46,797			66,933			98,284
Net change in insurance subsidiary cash and cash equivalents		(1,525	)		(20,312	)		38,428			4,681
Net change in other investments		7,000			14			7,000			14
Other		194			3,691			1,288			(3,423	)

Net cash used in investing activities		(43,617	)		(228,617	)		(19,445	)		(206,427	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		353,100			439,000			728,100			875,800
Repayment of borrowings under revolving credit		(343,500	)		(300,400	)		(737,700	)		(753,800	)
Repayment of long-term debt		(19	)		(18	)		(38	)		(35	)
Repayment of capital lease obligation		(15,993	)		–			(16,268	)		–
Payment of deferred financing costs		(48	)		(235	)		(179	)		(306	)
Issuance of common stock		5,056			8,878			5,778			9,748
Other		2,991			5,854			(8,469	)		(8,870	)

Net cash provided by (used in) financing activities		1,587			153,079			(28,776	)		122,537

Change in cash and cash equivalents		1,924			(2,204	)		(14,061	)		(3,298	)
Cash and cash equivalents at beginning of period		16,892			19,763			32,877			20,857

Cash and cash equivalents at end of period	$	18,816		$	17,559		$	18,816		$	17,559

Supplemental information:
Interest payments	$	2,546		$	2,289		$	7,633		$	6,229
Income tax payments (refunds)		23,641			3,141			(2,690	)		3,399

See accompanying notes.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. is a healthcare services company that through its subsidiaries operates hospitals, nursing centers and a contract rehabilitation services business across the United States (collectively, the “Company”). At June 30, 2008, the Company’s hospital division operated 83 long-term acute care (“LTAC”) hospitals in 24 states. The Company’s health services division operated 228 nursing centers in 27 states. The Company also operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings.

On July 31, 2007, the Company completed the spin-off of its former institutional pharmacy business. See Note 2.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals, nursing centers and other healthcare businesses to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains, losses or impairments associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2008 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.

Impact of recent accounting pronouncements

In June 2008, the Financial Accounting Standards Board (the “FASB”) issued FASB Staff Position EITF 03-6-1 (“EITF 03-6-1”), “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities,” which clarifies that share-based payment awards that entitle the holder to receive nonforfeitable dividends before vesting would be considered participating securities. As participating securities, these instruments should be included in the calculation of basic earnings per common share. The provisions of EITF 03-6-1 will be effective for fiscal years beginning after December 15, 2008. The adoption of EITF 03-6-1 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

In December 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007) (“SFAS 141R”), “Business Combinations,” which significantly changes the accounting for business combinations, including, among other changes, new accounting concepts in determining the fair value of assets and liabilities acquired, recording the fair value of contingent considerations and contingencies at acquisition date and expensing acquisition and restructuring costs. SFAS 141R will be applied prospectively and is effective for business combinations which occur during fiscal years beginning after December 15, 2008. At this time, the Company cannot determine the impact that SFAS 141R will have on its financial position, results of operations or liquidity.

In December 2007, the FASB issued SFAS No. 160 (“SFAS 160”), “Noncontrolling Interests in Consolidated Financial Statements,” which will change the accounting and reporting for minority interests. SFAS 160 will recharacterize minority interests as noncontrolling interests and will be classified as a component of stockholders’ equity. The new consolidation method will significantly change the accounting for transactions with minority-interest holders. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The adoption of SFAS 160 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

In September 2006, the FASB issued SFAS No. 157 (“SFAS 157”), “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. SFAS 157 is effective for

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Impact of recent accounting pronouncements (Continued)

fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FASB Staff Position SFAS No. 157-2 (“SFAS 157-2”), “Effective Date of FASB Statement No. 157,” which deferred the effective date of SFAS 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. Accordingly, the Company will defer the adoption of SFAS 157-2 until January 2009. The provisions of SFAS 157 apply to assets and liabilities, including investments, loans and transfers (including sales and securitizations) of financial assets, derivatives, financial liabilities, and other various financial assets and liabilities. The adoption of SFAS 157 did not have a material impact on the Company’s financial position, results of operations or liquidity. The adoption of SFAS 157-2 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

SFAS 157 defines fair value 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. SFAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard 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.

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


	June 30, 2008
	Fair value measurements						Assets/liabilities at fair value
	Level 1		Level 2		Level 3		Assets/liabilities at fair value
Assets:
Available-for-sale securities	$	32,821	$	108,983	$	–	$	141,804
Deposits held in money market funds		2,055		–		–		2,055

	$	34,876	$	108,983	$	–	$	143,859

Liabilities	$	–	$	–	$	–	$	–

The Company’s available-for-sale securities are held by its wholly owned limited purpose insurance subsidiary and are comprised of money market funds, asset backed securities, corporate bonds, commercial paper, equities and U.S. Treasury notes. These available-for-sale securities and the insurance subsidiary’s cash

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Impact of recent accounting pronouncements (Continued)

and cash equivalents of $100.8 million, classified as insurance subsidiary investments, are maintained for the payment of claims and expenses related to professional liability and workers compensation risks.

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 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.

Comprehensive income (loss)

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


	Three months ended June 30,						Six months ended June 30,
	2008			2007			2008			2007
Net income (loss)	$	21,661		$	(61,933	)	$	36,351		$	(54,100	)
Net unrealized investment gains (losses), net of income taxes		(1,051	)		372			(1,768	)		461

Comprehensive income (loss)	$	20,610		$	(61,561	)	$	34,583		$	(53,639	)

Other information

The accompanying unaudited condensed consolidated financial statements are 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, 2007 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K. The accompanying condensed consolidated balance sheet at December 31, 2007 was derived from audited 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. These changes did not have any impact on the Company’s financial position, results of operations or liquidity.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – SPIN-OFF TRANSACTION

On July 31, 2007, the Company completed the spin-off of its former institutional pharmacy business, Kindred Pharmacy Services, Inc. (“KPS”), and the immediate subsequent combination of KPS with the former institutional pharmacy business of AmerisourceBergen Corporation to form a new, independent, publicly traded company named PharMerica Corporation (“PharMerica”) (the “Spin-off Transaction”).

For accounting purposes, the assets and liabilities of KPS were eliminated from the balance sheet of the Company effective at the close of business on July 31, 2007, and beginning August 1, 2007, the operating results of KPS are no longer included in the operating results of the Company. In accordance with SFAS No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets,” the historical operating results of KPS were not reported as a discontinued operation of the Company because of the significance of the expected continuing cash flows between PharMerica and the Company under pharmacy services contracts for services to be provided by PharMerica to the Company’s hospitals and nursing centers. Accordingly, for periods prior to August 1, 2007, the historical operating results of KPS are included in the historical continuing operations of the Company.

In addition to the pharmacy services contracts noted above, the Company also entered into new agreements with PharMerica for information systems services, transition services and certain tax matters. The Company recorded $5.2 million and $9.9 million in other income in the second quarter of 2008 and for the six months ended June 30, 2008, respectively, related to the information systems and transition services agreements.

NOTE 3 – DISCONTINUED OPERATIONS

In accordance with SFAS 144, the divestiture of unprofitable businesses discussed in Note 1 have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the gains, losses or impairments related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. At June 30, 2008, the Company held for sale two nursing centers.

In June 2007, the Company purchased for resale 21 nursing centers and one LTAC hospital (collectively, the “Facilities”) previously leased from Ventas, Inc. (“Ventas”) for $171.5 million (the “Facility Acquisitions”). In addition, the Company paid Ventas a lease termination fee of $3.5 million.

The Facilities, which contained 2,634 licensed nursing center beds and 220 licensed hospital beds, generated pretax losses of approximately $4 million for the year ended December 31, 2007. As of June 30, 2008, the Company had sold 20 of the Facilities for approximately $94 million.

The Company recorded a pretax gain of $9.5 million ($5.9 million net of income taxes) in the second quarter 2008 and a pretax loss of $112.7 million ($69.3 million net of income taxes) in the second quarter of 2007 related to these divestitures.

In January 2007, the Company acquired from Health Care Property Investors, Inc. (“HCP”) the real estate related to 11 unprofitable leased nursing centers operated by the Company for resale in exchange for the real estate related to three hospitals previously owned by the Company (the “HCP Transaction”). As part of the HCP Transaction, the Company continues to operate the hospitals under a long-term lease arrangement with HCP. In addition, the Company paid HCP a one-time cash payment of approximately $36 million. The Company also amended its existing master lease with HCP to (1) terminate the current annual rent of approximately $9.9 million on the 11 nursing centers, (2) add the three hospitals to the master lease with current annual rent payments of approximately $6.3 million and (3) extend the initial expiration date of the master lease until January 31, 2017 except for one hospital which has an expiration date of January 31, 2022. During the six months ended June 30, 2007, the Company sold all of the nursing centers acquired in the HCP Transaction and received proceeds of $77.9 million. In addition, the Company terminated a nursing center lease with another

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

landlord in the second quarter of 2007. The Company recorded a pretax loss related to these divestitures of $13.4 million ($8.2 million net of income taxes) during the six months ended June 30, 2007.

A summary of discontinued operations follows (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2008			2007			2008			2007
Revenues	$	3,189		$	40,812		$	13,892		$	89,645

Salaries, wages and benefits		2,279			22,375			8,360			49,360
Supplies		230			2,537			1,013			5,497
Rent		15			2,620			46			6,086
Other operating expenses (income)		(1,130	)		15,029			3,218			31,551
Depreciation		–			1,294			–			2,513
Interest expense		–			3			2			4
Investment income		–			–			(4	)		(1	)

		1,394			43,858			12,635			95,010

Income (loss) from operations before income taxes		1,795			(3,046	)		1,257			(5,365	)
Income tax provision (benefit)		691			(1,172	)		484			(2,065	)

Income (loss) from operations		1,104			(1,874	)		773			(3,300	)
Gain (loss) on divestiture of operations, net of income taxes		5,840			(69,702	)		5,840			(76,968	)

	$	6,944		$	(71,576	)	$	6,613		$	(80,268	)

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


	Three months ended June 30,					Six months ended June 30,
	2008			2007		2008			2007
Revenues:
Hospital division	$	1,396		$	3,762	$	4,899		$	7,793
Health services division		1,793			37,050		8,993			81,852

	$	3,189		$	40,812	$	13,892		$	89,645

Operating income (loss):
Hospital division	$	(195	)	$	550	$	(145	)	$	1,532
Health services division		2,005			321		1,446			1,705

	$	1,810		$	871	$	1,301		$	3,237

Rent:
Hospital division	$	13		$	255	$	26		$	516
Health services division		2			2,365		20			5,570

	$	15		$	2,620	$	46		$	6,086

Depreciation:
Hospital division	$	–		$	99	$	–		$	198
Health services division		–			1,195		–			2,315

	$	–		$	1,294	$	–		$	2,513

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

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


	June 30, 2008		December 31, 2007
Long-term assets:
Property and equipment, net	$	486	$	15,595
Other		25		242

		511		15,837
Current liabilities (included in other accrued liabilities)		–		(717	)

	$	511	$	15,120

NOTE 4 – SIGNIFICANT QUARTERLY ADJUSTMENTS

Operating results for the second quarter of 2008 included pretax income of $10.3 million related to the favorable settlement of a prior year nursing center Medicaid cost report dispute and a pretax charge of $5.1 million related to a hospital asset impairment. Operating results for the second quarter of 2008 also included a pretax charge of $1.9 million related to a prior period rent escalator adjustment for ten leased facilities which the Company does not believe is material to the financial statements for the current or prior periods.

The hospital asset impairment charge noted above related to the Company’s voluntary termination of its participation in the Medicare program in the second quarter of 2008 at one of the Company’s LTAC hospitals. The Company continues to operate a skilled nursing and transitional care program in the facility. The estimated fair value of the hospital’s long-lived assets at June 30, 2008 was based upon a weighted average valuation methodology that relied upon current market prices and market conditions for similar assets depending on asset use. This impairment charge is recorded in other operating expenses in the accompanying unaudited condensed consolidated statement of operations.

Operating results for the second quarter of 2007 included a pretax charge of $2.8 million for professional fees and other costs incurred in connection with the Spin-off Transaction and a pretax charge of $3.4 million for employee severance costs. The Company also recorded a pretax charge of $4.6 million related to an unfavorable judgment rendered in connection with a civil dispute with a hospital vendor. In addition, operating results for the second quarter of 2007 included pretax income of $5.5 million related to a favorable settlement of a rehabilitation therapy contract dispute from prior years. For the six months ended June 30, 2007, the Company recorded a pretax charge of $6.9 million for professional fees and other costs incurred in connection with the Spin-off Transaction.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – 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 and other third party payors.

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


	Three months ended June 30,						Six months ended June 30,
	2008			2007			2008			2007
Medicare	$	451,339		$	498,604		$	917,640		$	1,022,366
Medicaid		277,255			275,873			545,331			549,071
Other third parties		390,091			418,090			783,250			825,031

		1,118,685			1,192,567			2,246,221			2,396,468
Eliminations:
Rehabilitation		(68,343	)		(59,251	)		(136,118	)		(118,168	)
Pharmacy		–			(37,071	)		–			(73,066	)

		(68,343	)		(96,322	)		(136,118	)		(191,234	)

	$	1,050,342		$	1,096,245		$	2,110,103		$	2,205,234

NOTE 6 – EARNINGS (LOSS) PER SHARE

Earnings (loss) per common share are based upon the weighted average number of common shares outstanding during the respective periods. The diluted calculation of earnings (loss) per common share includes the dilutive effect of stock options and non-vested restricted stock.

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


	Three months ended June 30,					Six months ended June 30,
	2008		2007			2008		2007
Earnings (loss):
Income from continuing operations	$	14,717	$	9,643		$	29,738	$	26,168
Discontinued operations, net of income taxes:
Income (loss) from operations		1,104		(1,874	)		773		(3,300	)
Gain (loss) on divestiture of operations		5,840		(69,702	)		5,840		(76,968	)

Net income (loss)	$	21,661	$	(61,933	)	$	36,351	$	(54,100	)

Shares used in the computation:
Weighted average shares outstanding – basic computation		37,714		39,591			37,579		39,403
Dilutive effect of certain securities:
Employee stock options		760		633			694		604
Non-vested restricted stock		469		421			510		419

Adjusted weighted average shares outstanding – diluted computation		38,943		40,645			38,783		40,426

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – EARNINGS (LOSS) PER SHARE (Continued)


	Three months ended June 30,					Six months ended June 30,
	2008		2007			2008		2007
Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.39	$	0.24		$	0.79	$	0.66
Discontinued operations:
Income (loss) from operations		0.03		(0.05	)		0.02		(0.08	)
Gain (loss) on divestiture of operations		0.15		(1.76	)		0.16		(1.95	)

Net income (loss)	$	0.57	$	(1.57	)	$	0.97	$	(1.37	)

Diluted:
Income from continuing operations	$	0.38	$	0.24		$	0.77	$	0.65
Discontinued operations:
Income (loss) from operations		0.03		(0.05	)		0.02		(0.08	)
Gain (loss) on divestiture of operations		0.15		(1.71	)		0.15		(1.91	)

Net income (loss)	$	0.56	$	(1.52	)	$	0.94	$	(1.34	)

Number of antidilutive stock options and non-vested restricted stock excluded from shares used in the diluted earnings (loss) per share computation		408		615			544		626

NOTE 7 – BUSINESS SEGMENT DATA

At June 30, 2008, the Company operated three business segments: the hospital division, the health services division and the rehabilitation division. The hospital division operates LTAC hospitals. The health services division operates nursing centers. The rehabilitation division provides rehabilitation services primarily in long- term care settings. The Company defines operating income as earnings before interest, income taxes, depreciation, amortization and rent. Operating income reported for each of the Company’s business segments excludes the allocation of corporate overhead.

Beginning January 1, 2008, certain incentive compensation costs were charged to the operating divisions that had previously been classified as corporate overhead. These charges approximated $1.7 million for the hospital division, $1.5 million for the health services division and $0.3 million for the rehabilitation division in the second quarter of 2008 and approximated $3.3 million for the hospital division, $2.7 million for the health services division and $0.7 million for the rehabilitation division for the six months ended June 30, 2008. Segment operating results for prior periods were not restated to reflect this reclassification.

The Spin-off Transaction was completed on July 31, 2007. As a result, the Company’s consolidated operating results for the second quarter of 2007 and for the six months ended June 30, 2007 included the results of the Company’s former pharmacy division. For accounting purposes, the pharmacy division was not treated as a discontinued operation in the Company’s historical consolidated financial statements. See Note 2.

The Company identifies its segments in accordance with the aggregation provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This information is consistent with information used by the Company in managing its businesses and aggregates businesses with similar economic characteristics.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)

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


	Three months ended June 30,						Six months ended June 30,
	2008			2007			2008			2007
Revenues:
Hospital division	$	470,160		$	437,473		$	958,404		$	897,279
Health services division		542,207			496,399			1,077,000			982,034
Rehabilitation division		106,318			85,288			210,817			169,044
Pharmacy division		–			173,407			–			348,111

		1,118,685			1,192,567			2,246,221			2,396,468
Eliminations:
Rehabilitation		(68,343	)		(59,251	)		(136,118	)		(118,168	)
Pharmacy		–			(37,071	)		–			(73,066	)

		(68,343	)		(96,322	)		(136,118	)		(191,234	)

	$	1,050,342		$	1,096,245		$	2,110,103		$	2,205,234

Income from continuing operations:
Operating income (loss):
Hospital division	$	78,981		$	85,696		$	174,644		$	185,444
Health services division		90,446			71,953			164,646			133,622
Rehabilitation division		10,178			9,097			21,664			19,141
Pharmacy division		–			7,883			–			17,126
Corporate:
Overhead		(33,200	)		(38,506	)		(68,131	)		(76,300	)
Insurance subsidiary		(1,347	)		(1,633	)		(2,850	)		(3,175	)

		(34,547	)		(40,139	)		(70,981	)		(79,475	)

Operating income		145,058			134,490			289,973			275,858
Rent		(88,461	)		(88,273	)		(174,587	)		(172,945	)
Depreciation and amortization		(31,269	)		(30,388	)		(62,674	)		(58,590	)
Interest, net		(567	)		925			(2,220	)		1,163

Income from continuing operations before income taxes		24,761			16,754			50,492			45,486
Provision for income taxes		10,044			7,111			20,754			19,318

	$	14,717		$	9,643		$	29,738		$	26,168

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)


	Three months ended June 30,				Six months ended June 30,
	2008		2007		2008		2007
Rent:
Hospital division	$	38,787	$	36,129	$	75,640	$	70,777
Health services division		48,175		48,985		96,058		96,224
Rehabilitation division		1,393		1,133		2,751		2,202
Pharmacy division		–		1,943		–		3,585
Corporate		106		83		138		157

	$	88,461	$	88,273	$	174,587	$	172,945

Depreciation and amortization:
Hospital division	$	11,794	$	10,027	$	23,447	$	19,110
Health services division		13,677		11,825		28,066		22,806
Rehabilitation division		485		273		872		509
Pharmacy division		–		2,760		–		5,576
Corporate		5,313		5,503		10,289		10,589

	$	31,269	$	30,388	$	62,674	$	58,590

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	20,022	$	25,909	$	33,578	$	46,674
Health services division		10,744		10,460		17,879		17,156
Rehabilitation division		280		253		562		371
Pharmacy division		–		1,613		–		3,325
Corporate:
Information systems		8,616		5,765		12,448		10,222
Other		258		734		393		1,008

	$	39,920	$	44,734	$	64,860	$	78,756


					June 30, 2008		December 31, 2007
Assets at end of period:
Hospital division					$	889,597	$	846,429
Health services division						569,286		550,525
Rehabilitation division						40,315		30,751
Corporate						577,454		651,847

					$	2,076,652	$	2,079,552

Goodwill:
Hospital division					$	68,577	$	67,598
Health services division						639		639
Rehabilitation division						2,041		863

					$	71,257	$	69,100

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE RISKS

The Company insures a substantial portion of its professional liability risks and workers compensation risks through a 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 subsequent 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 June 30,					Six months ended June 30,
	2008			2007		2008			2007
Professional liability:
Continuing operations	$	10,934		$	12,870	$	26,924		$	30,815
Discontinued operations		(2,605	)		3,693		(2,391	)		6,470

Workers compensation:
Continuing operations	$	6,628		$	10,064	$	17,103		$	21,448
Discontinued operations		15			562		146			1,195

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


	June 30, 2008						December 31, 2007
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	109,062	$	82,147	$	191,209	$	127,017	$	104,676	$	231,693
Reinsurance recoverables		3,177		–		3,177		4,334		–		4,334

		112,239		82,147		194,386		131,351		104,676		236,027
Non-current:
Insurance subsidiary investments		51,364		–		51,364		49,166		–		49,166
Reinsurance recoverables		8,883		393		9,276		4,530		–		4,530
Deposits		2,000		1,460		3,460		6,250		1,455		7,705
Other		–		160		160		–		261		261

		62,247		2,013		64,260		59,946		1,716		61,662

	$	174,486	$	84,160	$	258,646	$	191,297	$	106,392	$	297,689

Liabilities:
Allowance for insurance risks:
Current	$	56,550	$	24,927	$	81,477	$	64,740	$	26,144	$	90,884
Non-current		201,790		63,555		265,345		186,652		63,132		249,784

	$	258,340	$	88,482	$	346,822	$	251,392	$	89,276	$	340,668

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE RISKS (Continued)

Provisions for loss for professional liability risks retained by the Company’s limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 5% in each period presented. 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 $271.4 million at June 30, 2008 and $263.8 million at December 31, 2007.

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 9 – CONTINGENCIES

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

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

Principal contingencies are described below:

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

Professional liability risks – The Company has provided for loss for professional liability risks based upon management’s best available information including actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Note 8.

Income taxes – The Company is subject to various federal and state income tax audits in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties. In addition, the Company is a party to a tax matters agreement with PharMerica which sets forth the Company’s rights and obligations related to taxes for periods before and after the Spin-off Transaction.

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

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

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.

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

the increase in the costs of defending and insuring against alleged professional liability claims and the Company’s ability to predict the estimated costs related to such claims,

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 claims,

•

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

•

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

•

changes in generally accepted accounting principles or practices, and

•

the Company’s ability to maintain an effective system of internal controls 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 condensed consolidated financial statements, including the notes thereto, should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that through its subsidiaries operates hospitals, nursing centers and a contract rehabilitation services business across the United States. At June 30, 2008, the Company’s hospital division operated 83 LTAC hospitals (6,501 licensed beds) in 24 states. The Company’s health services division operated 228 nursing centers (28,736 licensed beds) in 27 states. The Company also operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings.

On July 31, 2007, the Company completed the Spin-off Transaction. See Note 2 of the accompanying Notes to Condensed Consolidated Financial Statements.

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 gains, losses or impairments associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2008 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.

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.

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

Critical Accounting Policies (Continued)

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, 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.

Operating results for the second quarter of 2008 included pretax income of approximately $10 million related to the favorable settlement of a prior year nursing center Medicaid cost report dispute.

Collectibility of accounts receivable

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

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

The provision for doubtful accounts totaled $7 million and $9 million for the second quarter of 2008 and 2007, respectively, and $14 million and $15 million for the six months ended June 30, 2008 and 2007, respectively.

Allowances for insurance risks

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 5% in each period presented. 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 $258 million at June 30, 2008 and $251 million at December 31, 2007. If the Company

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

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

did not discount any of the allowances for professional liability risks, these balances would have approximated $271 million at June 30, 2008 and $264 million at December 31, 2007.

As a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary, the Company received distributions of approximately $39 million and $37 million during the six months ended June 30, 2008 and 2007, respectively, from its limited purpose insurance subsidiary. These proceeds were used to repay borrowings under the Company’s revolving credit facility.

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 June 30, 2008 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 $11 million and $13 million for the second quarter of 2008 and 2007, respectively, and $27 million and $31 million for the six months ended June 30, 2008 and 2007, 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 $88 million at June 30, 2008 and $89 million at December 31, 2007. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $6 million and $11 million for the second quarter of 2008 and 2007, respectively, and $17 million and $22 million for the six months ended June 30, 2008 and 2007, respectively.

Accounting for income taxes

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

The Company’s effective income tax rate was 40.6% and 42.4% for the second quarter of 2008 and 2007, respectively, and 41.1% and 42.5% for the six months ended June 30, 2008 and 2007, respectively.

There are significant uncertainties with respect to capital loss and net operating 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

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

Critical Accounting Policies (Continued)

Accounting for income taxes (Continued)

Company recognized deferred tax assets totaling $180 million at June 30, 2008 and $174 million at December 31, 2007.

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

Valuation of long-lived assets and goodwill

The Company regularly reviews the carrying value of certain long-lived assets and identifiable 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 the recorded amounts cannot be recovered based upon estimated future 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 as the lowest level for which there are independent, identifiable cash flows. Accordingly, the estimated cash flows of all facilities within a master lease are aggregated for purposes of evaluating the carrying values of long-lived assets.

Operating results for the second quarter of 2008 included a pretax charge of approximately $5 million related to a hospital asset impairment. The hospital asset impairment charge related to the Company’s voluntary termination of its participation in the Medicare program in the second quarter of 2008 at one of the Company’s LTAC hospitals. The Company continues to operate a skilled nursing and transitional care program in the facility. The estimated fair value of the hospital’s long-lived assets at June 30, 2008 was based upon a weighted average valuation methodology that relied upon current market prices and market conditions for similar assets depending on asset use. This impairment charge is recorded in other operating expenses in the accompanying unaudited condensed consolidated statement of operations.

In accordance with SFAS No. 142 (“SFAS 142”), “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 impairment test at the end of each year. No impairment charge was recorded at December 31, 2007 in connection with the Company’s annual impairment test.

The Company’s other intangible assets with finite lives are amortized under SFAS 142 using the straight-line method over their estimated useful lives ranging from one to five years.

Recently Issued Accounting Pronouncements

In June 2008, the FASB issued EITF 03-6-1, which clarifies that share-based payment awards that entitle the holder to receive nonforfeitable dividends before vesting would be considered participating securities. As

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

Recently Issued Accounting Pronouncements (Continued)

participating securities, these instruments should be included in the calculation of basic earnings per common share. The provisions of EITF 03-6-1 will be effective for fiscal years beginning after December 15, 2008. The adoption of EITF 03-6-1 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

In December 2007, the FASB issued SFAS 141R, which significantly changes the accounting for business combinations, including, among other changes, new accounting concepts in determining the fair value of assets and liabilities acquired, recording the fair value of contingent considerations and contingencies at acquisition date and expensing acquisition and restructuring costs. SFAS 141R will be applied prospectively and is effective for business combinations which occur during fiscal years beginning after December 15, 2008. At this time, the Company cannot determine the impact that SFAS 141R will have on its financial position, results of operations or liquidity.

In December 2007, the FASB issued SFAS 160, which will change the accounting and reporting for minority interests. SFAS 160 will recharacterize minority interests as noncontrolling interests and will be classified as a component of stockholders’ equity. The new consolidation method will significantly change the accounting for transactions with minority-interest holders. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The adoption of SFAS 160 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

In September 2006, the FASB issued SFAS 157, 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. SFAS 157 is effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued SFAS 157-2, which deferred the effective date of SFAS 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. Accordingly, the Company will defer the adoption of SFAS 157-2 until January 2009. The provisions of SFAS 157 apply to assets and liabilities, including investments, loans and transfers (including sales and securitizations) of financial assets, derivatives, financial liabilities, and other various financial assets and liabilities. The adoption of SFAS 157 did not have a material impact on the Company’s financial position, results of operations or liquidity. The adoption of SFAS 157-2 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

Results of Operations – Continuing Operations

Hospital Division

Revenues increased 7% in the second quarter of 2008 to $470 million compared to $437 million in the second quarter of 2007 and increased 7% to $958 million for the six months ended June 30, 2008 from $897 million in the same period in 2007. Revenue growth in both periods was primarily a result of increases in same-store admissions, expansion of services and new hospitals recently opened. On a same-store basis, aggregate admissions rose 6% in both the second quarter of 2008 and for the six months ended June 30, 2008 compared to the same periods in 2007, while non-government same-store admissions increased 19% in the second quarter of 2008 and 18% for the six months ended June 30, 2008 compared to the same periods in 2007.

Despite growth in volumes and revenues, hospital operating margins declined in the second quarter of 2008 primarily because the growth in wage and benefit costs exceeded overall revenue growth. Hospital wage and benefit costs increased 9% to $218 million in the second quarter of 2008 from $199 million in the same period in 2007 and increased 9% to $439 million for the six months ended June 30, 2008 from $403 million in the same period in 2007. Average hourly wage rates grew 2% in the second quarter of 2008 and 3% for the six months

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

Results of Operations – Continuing Operations (Continued)

Hospital Division (Continued)

ended June 30, 2008 compared to the respective prior year periods, while employee benefit costs increased 7% in the second quarter of 2008 and 8% for the six months ended June 30, 2008 compared to the respective prior year periods. The increase in employee benefit costs was primarily attributable to certain incentive compensation costs that were charged to the division beginning in 2008 that had previously been charged to corporate overhead.

Operating results for the second quarter of 2008 also included a pretax charge of approximately $5 million related to a hospital asset impairment.

Professional liability costs were $3 million and $4 million in the second quarter of 2008 and 2007, respectively, and $9 million and $10 million for the six months ended June 30, 2008 and 2007, respectively.

Health Services Division

Revenues increased 9% in the second quarter of 2008 to $542 million compared to $497 million in the second quarter of 2007 and increased 10% to $1.1 billion for the six months ended June 30, 2008 from $982 million in the same period in 2007. Revenue growth in both periods was primarily attributable to reimbursement rate increases, growth in Medicare and managed care volumes, and acquired nursing centers. On a same-store basis, aggregate patient days were relatively unchanged in both the second quarter of 2008 and for the six months ended June 30, 2008 compared to the same periods in 2007. For the first six months of 2008, revenues have been favorably impacted by growth in Medicare, Medicare Advantage and private and other patient volumes.

Operating results for the second quarter of 2008 also included pretax income of approximately $10 million related to the favorable settlement of a prior year nursing center Medicaid cost report dispute.

Nursing center operating margins improved in the second quarter of 2008 and for the six months ended June 30, 2008 primarily due to same-store growth in Medicare, Medicare Advantage and private and other patient volumes, the favorable impact of acquired nursing centers and reductions in professional liability and workers compensation costs. Nursing center wage and benefit costs increased 4% to $270 million in the second quarter of 2008 compared to $258 million in the same period of 2007 and increased 6% to $545 million for the six months ended June 30, 2008 from $514 million in the same period in 2007. Average hourly wage rates grew 4% in both the second quarter of 2008 and for the six months ended June 30, 2008 compared to the respective prior year periods, while employee benefit costs increased 2% in the second quarter of 2008 and 5% for the six months ended June 30, 2008 compared to the respective prior year periods. The increase in employee benefit costs was primarily attributable to certain incentive compensation costs that were charged to the division beginning in 2008 that had previously been charged to corporate overhead.

Professional liability costs were $7 million and $8 million in the second quarter of 2008 and 2007, respectively, and $17 million and $20 million for the six months ended June 30, 2008 and 2007, respectively.

Rehabilitation Division

Revenues increased 25% in the second quarter of 2008 to $106 million compared to $85 million in the second quarter of 2007 and increased 25% to $211 million for the six months ended June 30, 2008 from $169 million in the same period in 2007. The increase in revenues in both periods was primarily attributable to

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

Results of Operations – Continuing Operations (Continued)

Rehabilitation Division (Continued)

growth in new contracts and the volume of services provided to existing customers. Revenues derived from unaffiliated customers aggregated $38 million and $26 million in the second quarter of 2008 and 2007, respectively, and $75 million and $51 million for the six months ended June 30, 2008 and 2007, respectively.

Despite growth in volumes and revenues, operating margins in both the second quarter of 2008 and for the six months ended June 30, 2008 declined primarily due to wage rate pressures resulting from an increasingly competitive marketplace for therapists and start-up costs associated with unaffiliated customer contract growth.

Pharmacy Division

The Spin-off Transaction was completed on July 31, 2007. As a result, the Company’s consolidated operating results for the second quarter of 2008 and for the six months ended June 30, 2008 did not include any results of the pharmacy division.

For accounting purposes, the pharmacy division was not treated as a discontinued operation in the Company’s historical condensed consolidated financial statements.

Corporate Overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $33 million and $38 million in the second quarter of 2008 and 2007, respectively, and $68 million and $76 million for the six months ended June 30, 2008 and 2007, respectively. As a percentage of consolidated revenues, corporate overhead totaled 3.2% in both the second quarter of 2008 and for the six months ended June 30, 2008, compared to 3.5% for both same prior year periods.

Beginning January 1, 2008, certain incentive compensation costs were charged to the operating divisions that had previously been classified as corporate overhead. These charges approximated $1 million for the hospital division, $2 million for the health services division and $0.3 million for the rehabilitation division in the second quarter of 2008 and approximated $3 million for the hospital division, $3 million for the health services division and $1 million for the rehabilitation division for the six months ended June 30, 2008.

The Company recorded approximately $5 million and $10 million in other income in the second quarter of 2008 and for the six months ended June 30, 2008, respectively, related to the information systems and transition services agreements in connection with the Spin-off Transaction.

Corporate expenses included the operating losses from the Company’s limited purpose insurance subsidiary of $2 million in the second quarter of both 2008 and 2007, and $3 million for both the six months ended June 30, 2008 and 2007.

Capital Costs

Rent expense of $89 million in the second quarter of 2008 was relatively flat compared to the second quarter of 2007 and increased 1% to $175 million for the six months ended June 30, 2008 from $173 million in the same period in 2007. Rent expense in the second quarter of 2008 included a charge of approximately $2 million related to a prior period rent escalator adjustment for ten leased facilities which the Company does not believe is material to the financial statements for the current or prior periods.

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

Results of Operations – Continuing Operations (Continued)

Capital Costs (Continued)

Depreciation and amortization expense increased 3% in the second quarter of 2008 to $31 million compared to the second quarter of 2007 and increased 7% to $62 million for the six months ended June 30, 2008 from $59 million in the same period in 2007. The increase was primarily a result of the Company’s ongoing capital expenditure program and its acquisition and development activities.

Interest expense aggregated $3 million and $2 million in the second quarter of 2008 and 2007, respectively, and aggregated $8 million and $6 million for the six months ended June 30, 2008 and 2007, respectively. Despite declines in interest rates, the increase in both periods was primarily attributable to increased borrowings under the Company’s revolving credit facility related to its acquisition and development activities.

Investment income related primarily to the Company’s insurance subsidiary investments totaled $3 million in the second quarter of both 2008 and 2007, and aggregated $6 million and $7 million for the six months ended June 30, 2008 and 2007, respectively.

Consolidated Results

Income from continuing operations before income taxes increased 48% to $25 million in the second quarter of 2008 compared to $16 million in the second quarter of 2007 and increased 11% to $51 million for the six months ended June 30, 2008 from $45 million in the same period in 2007. Net income from continuing operations increased 53% to $15 million in the second quarter of 2008 compared to $9 million in the second quarter of 2007 and increased 14% to $30 million for the six months ended June 30, 2008 from $26 million in the same period in 2007.

Results of Operations – Discontinued Operations

Net income from discontinued operations aggregated $1 million in the second quarter of 2008 compared to a net loss of $1 million in the second quarter of 2007, while net income from discontinued operations aggregated $1 million for the six months ended June 30, 2008 compared to a net loss of $3 million in the same period in 2007.

The Company recorded a pretax gain on divestiture of operations of $10 million ($6 million net of income taxes) in the second quarter of 2008 related primarily to divestitures associated with the Facility Acquisitions. The Company recorded a pretax loss on divestiture of operations of $113 million ($69 million net of income taxes) in the second quarter of 2007 related to the Facility Acquisitions and related planned divestitures. The Company also recorded a pretax loss on divestiture of operations related to the HCP Transaction of $13 million ($8 million net of income taxes) during the six months ended June 30, 2007.

Liquidity

Operating cash flows and capital spending

Cash flows provided by operations (including discontinued operations) aggregated $34 million for the six months ended June 30, 2008 compared to $80 million for the same period in 2007. Operating cash flows for the six months ended June 30, 2008 were negatively impacted by the growth in accounts receivable. During both periods, the Company maintained sufficient liquidity to fund its ongoing capital expenditure program and finance ongoing hospital development expenditures, as well as its acquisition and strategic divestiture activities.

Cash and cash equivalents totaled $19 million at June 30, 2008 compared to $33 million at December 31, 2007. The Company’s long-term debt at June 30, 2008 aggregated $266 million (substantially all of which

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

Liquidity (Continued)

Operating cash flows and capital spending (Continued)

related to borrowings under the Company’s revolving credit facility). Based upon the Company’s existing cash levels, expected operating cash flows and capital spending (including planned acquisition and development activities), and the availability of borrowings under the Company’s revolving credit facility, management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.

The Company was in compliance with the terms of its revolving credit facility at June 30, 2008.

In May 2008, the Company received a cash distribution of $7 million related to a partnership land sale. The Company has a noncontrolling ownership interest in the partnership which is accounted for under the equity method of accounting. No gain or loss was recognized on the land sale.

In April 2008, the Company repaid a capital lease obligation of approximately $16 million in connection with a purchase option under a hospital lease agreement.

Strategic divestitures

In June 2007, the Company paid approximately $176 million to complete the Facility Acquisitions with borrowings under the Company’s revolving credit facility. As of June 30, 2008, the Company had sold 20 of the Facilities for approximately $94 million.

In January 2007, the Company paid $37 million to complete the HCP Transaction. The Company also divested the 11 nursing centers acquired in the HCP Transaction during the first six months of 2007 for approximately $78 million.

Capital Resources

Excluding acquisitions, capital expenditures totaled $65 million for the six months ended June 30, 2008 compared to $79 million for the same period in 2007. Excluding acquisitions, capital expenditures (including hospital development) could approximate $175 million to $200 million in 2008. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. The Company’s capital expenditure program is financed generally through the use of internally generated funds and borrowings under the revolving credit facility. At June 30, 2008, the estimated cost to complete and equip construction in progress approximated $59 million.

The terms of the Company’s revolving credit facility include certain covenants that limit the Company’s acquisitions and annual capital expenditures. At June 30, 2008, the Company’s remaining amount for permitted acquisitions under its revolving credit facility aggregated $322 million.

During the second quarter of 2008, the Company acquired four nursing centers that were previously leased for approximately $24 million. Annual rents associated with the four nursing centers approximated $3 million. These transactions were financed through borrowings under the Company’s revolving credit facility.

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

Other Information

Effects of Inflation and Changing Prices

The Company derives a substantial portion of its revenues from the Medicare and Medicaid programs. Congress and certain state legislatures have enacted or may enact additional significant cost containment measures limiting the Company’s ability to recover its cost increases through increased pricing of its healthcare services. Medicare revenues in LTAC hospitals and nursing centers are subject to fixed payments under the Medicare prospective payment systems. Medicaid reimbursement rates in many states in which the Company operates nursing centers also are based upon fixed payment systems. Generally, these rates are adjusted annually for inflation. However, these adjustments may not reflect the actual increase in the costs of providing healthcare services.

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

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

The SCHIP Extension Act became effective for cost reporting periods after December 29, 2007. This legislation provides for, among other things:

(1)

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

(2)

enhanced medical necessity review of LTAC hospital cases;

(3)

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

(4)

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

(5)

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

(6)

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

(7)

a three-year moratorium on the application of the so-called “25 Percent Rule” to freestanding LTAC hospitals;

(8)

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

(9)

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

(10)

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

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

Other Information (Continued)

Effects of Inflation and Changing Prices (Continued)

On May 1, 2007, CMS issued regulatory changes regarding Medicare reimbursement for LTAC hospitals (the “2007 Final Rule”) that became effective for discharges occurring on or after July 1, 2007. The 2007 Final Rule was amended on June 29, 2007 by revising the high cost outlier threshold. The 2007 Final Rule projected an overall decrease in payments to all Medicare certified LTAC hospitals of approximately 1.2%. Included in the 2007 Final Rule were (1) an increase to the standard federal payment rate of 0.71% (eliminated for discharges occurring on or after April 1, 2008 by the SCHIP Extension Act); (2) revisions to payment methodologies impacting short-stay outliers, which reduce payments by 0.9% (currently subject to a three-year moratorium pursuant to the SCHIP Extension Act); (3) adjustments to the wage index component of the federal payment resulting in projected reductions in payments of 0.5%; (4) an increase in the high cost outlier threshold per discharge to $20,707, resulting in projected reductions of 0.4%; and (5) an extension of the policy known as the “25 Percent Rule” to all LTAC hospitals, with a three-year phase-in, which CMS projects will not result in payment reductions for the first year of implementation (also currently subject to a three-year moratorium pursuant to the SCHIP Extension Act).

The 2007 Final Rule expanded the so-called “25 Percent Rule” to all LTAC hospitals, regardless of whether they are co-located within another hospital. Under the 2007 Final Rule, all LTAC hospitals were to be paid the LTAC PPS rates for admissions from a single referral source up to 25% of aggregate Medicare admissions. Patients reaching high cost outlier status in the short-term hospital were not to be counted when computing the 25% limit. Admissions beyond the 25% threshold were to be paid at a lower amount based upon short-term acute care hospital rates. However, as set forth above, the SCHIP Extension Act has placed a three-year moratorium on the expansion of the “25 Percent Rule” to freestanding hospitals. In addition, the SCHIP Extension Act provides for a three-year period during which (1) LTAC hospitals that are co-located within another hospital may admit up to 50% of their patients from their host hospitals and still be paid according to LTAC PPS, and (2) LTAC hospitals that are co-located with an urban single hospital or a MSA Dominant hospital may admit up to 75% of their patients from such urban single or MSA Dominant hospital and still be paid according to LTAC PPS.

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

CMS has regulations governing payments to LTAC hospitals that are co-located within another hospital, such as a hospital-in-hospital (“HIH”). The rules generally limit Medicare payments to the HIH if the Medicare admissions to the HIH from the host hospital exceed 25% of the total Medicare discharges for the HIH’s cost reporting period. There are limited exceptions for admissions from rural, urban single and MSA Dominant hospitals. Admissions that exceed this “25 Percent Rule” are paid using the short-term acute care inpatient payment system (“IPPS”). Patients transferred after they have reached the short-term acute care outlier payment status are not counted toward the admission threshold. Patients admitted prior to meeting the admission threshold, as well as Medicare patients admitted from a non-host hospital, are eligible for the full payment under LTAC PPS. If the HIH’s admissions from the host 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 June 30, 2008, the Company operated 16 HIHs with 692 licensed beds.

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

Other Information (Continued)

Effects of Inflation and Changing Prices (Continued)

On August 1, 2007, CMS issued final regulations regarding Medicare hospital inpatient payments to short-term acute care hospitals as well as certain provisions affecting LTAC hospitals. These regulations adopt a new system for classifying patients into diagnostic categories called Medicare Severity Diagnosis Related Groups or more specifically, for LTAC hospitals, “MS-LTC-DRGs.” This new MS-LTC-DRG system replaces the previous diagnostic related group system for LTAC hospitals and became effective for discharges occurring on or after October 1, 2007. The MS-LTC-DRG system creates additional severity-adjusted categories for most diagnoses, resulting in an expansion of the aggregate number of diagnostic groups from 538 to 745. CMS states that MS-LTC-DRG weights were developed in a budget neutral manner and as such, the estimated aggregate payments under LTAC PPS would be unaffected by the annual recalibration of MS-LTC-DRG payment weights.

On July 31, 2008, CMS issued final regulations regarding the re-weighting of MS-LTC-DRGs for discharges occurring on or after October 1, 2008. CMS announced that this update was made in a budget neutral manner, and that estimated aggregate LTAC Medicare payments would be unaffected by these regulations.

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 could significantly change Medicare revenues generated under LTAC PPS. In addition, the Company’s hospitals may not be able to appropriately adjust their operating costs as patient acuity levels change 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 non-government third party payors. Various factors, including a reduction in average length of stay, have negatively impacted revenues from non-government third party payors.

On July 31, 2008, CMS issued final regulations regarding Medicare reimbursement for nursing centers for the fiscal year beginning October 1, 2008. These regulations included, among other things, a market basket increase to the federal payment rates of 3.4% and updates to the wage indexes which adjust the federal payment. CMS estimates that the overall impact of these proposed changes will be a net increase in payments of 3.4%.

On February 1, 2006, Congress passed the Deficit Reduction Act of 2005. This legislation allowed, among other things, an annual $1,740 Medicare Part B outpatient therapy cap that was effective on January 1, 2006. CMS subsequently increased the therapy cap to $1,780 on January 1, 2007 and to $1,810 on January 1, 2008. The legislation also required CMS to implement a broad process for reviewing medically necessary therapy claims, creating an exception to the cap. The exception process, which was set to expire on January 1, 2007, was included in the Tax Relief and Health Care Act of 2006 and continued to function as an exception to the Medicare Part B outpatient therapy cap until January 1, 2008. The SCHIP Extension Act further extended the Medicare Part B outpatient therapy cap exception process until June 30, 2008. The Medicare Improvements for Patients and Providers Act of 2008, enacted on July 15, 2008, extended the therapy cap exception process from July 1, 2008 to December 31, 2009.

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

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

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)


	2007 Quarters												2008 Quarters
	First			Second			Third			Fourth			First			Second
Revenues	$	1,108,989		$	1,096,245		$	1,009,459		$	1,005,573		$	1,059,761		$	1,050,342


Salaries, wages and benefits		603,552			603,047			599,049			581,054			608,901			602,752
Supplies		181,635			181,121			109,900			78,331			79,962			82,586
Rent		84,672			88,273			88,085			86,530			86,126			88,461
Other operating expenses		182,434			177,587			194,049			199,971			230,700			225,113
Other income		–			–			(3,201	)		(4,500	)		(4,717	)		(5,167	)
Depreciation and amortization		28,202			30,388			30,916			32,261			31,405			31,269
Interest expense		3,595			2,692			5,014			5,743			4,921			2,907
Investment income		(3,833	)		(3,617	)		(3,785	)		(4,920	)		(3,268	)		(2,340	)

		1,080,257			1,079,491			1,020,027			974,470			1,034,030			1,025,581

Income (loss) from continuing operations before income taxes		28,732			16,754			(10,568	)		31,103			25,731			24,761
Provision (benefit) for income taxes		12,207			7,111			(1,510	)		13,493			10,710			10,044

Income (loss) from continuing operations		16,525			9,643			(9,058	)		17,610			15,021			14,717
Discontinued operations, net of income taxes:
Income (loss) from operations		(1,426	)		(1,874	)		(4	)		(1,265	)		(331	)		1,104
Gain (loss) on divestiture of operations		(7,266	)		(69,702	)		–			(53	)		–			5,840

Net income (loss)	$	7,833		$	(61,933	)	$	(9,062	)	$	16,292		$	14,690		$	21,661

Earnings (loss) per common share:
Basic:
Income (loss) from continuing operations	$	0.42		$	0.24		$	(0.23	)	$	0.47		$	0.40		$	0.39
Discontinued operations:
Income (loss) from operations		(0.03	)		(0.05	)		–			(0.03	)		(0.01	)		0.03
Gain (loss) on divestiture of operations		(0.19	)		(1.76	)		–			–			–			0.15

Net income (loss)	$	0.20		$	(1.57	)	$	(0.23	)	$	0.44		$	0.39		$	0.57

Diluted:
Income (loss) from continuing operations	$	0.41		$	0.24		$	(0.23	)	$	0.46		$	0.39		$	0.38
Discontinued operations:
Income (loss) from operations		(0.03	)		(0.05	)		–			(0.03	)		(0.01	)		0.03
Gain (loss) on divestiture of operations		(0.18	)		(1.71	)		–			–			–			0.15

Net income (loss)	$	0.20		$	(1.52	)	$	(0.23	)	$	0.43		$	0.38		$	0.56

Shares used in computing earnings (loss) per common share:
Basic		39,212			39,591			39,013			37,365			37,444			37,714
Diluted		39,997			40,645			39,013			38,366			38,618			38,943

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

Operating Data

(Unaudited)

(In thousands)


	2007 Quarters												2008 Quarters
	First			Second			Third			Fourth			First			Second
Revenues:
Hospital division	$	459,806		$	437,473		$	427,199		$	447,794		$	488,244		$	470,160
Health services division		485,635			496,399			508,191			524,561			534,793			542,207	(a)
Rehabilitation division		83,756			85,288			88,284			95,069			104,499			106,318
Pharmacy division		174,704			173,407			58,000			–			–			–

		1,203,901			1,192,567			1,081,674			1,067,424			1,127,536			1,118,685
Eliminations:
Rehabilitation		(58,917	)		(59,251	)		(59,721	)		(61,851	)		(67,775	)		(68,343	)
Pharmacy		(35,995	)		(37,071	)		(12,494	)		–			–			–

		(94,912	)		(96,322	)		(72,215	)		(61,851	)		(67,775	)		(68,343	)

	$	1,108,989		$	1,096,245		$	1,009,459		$	1,005,573		$	1,059,761		$	1,050,342

Income (loss) from continuing operations:
Operating income (loss):
Hospital division	$	99,748		$	85,696		$	82,566		$	94,189		$	95,663		$	78,981	(b,c)
Health services division		61,669			71,953			75,166			87,961			74,200			90,446	(a,b)
Rehabilitation division		10,044			9,097			8,309			7,076			11,486			10,178	(b)
Pharmacy division		9,243			7,883			431			–			–			–
Corporate:
Overhead		(37,794	)		(38,506	)		(54,954	)		(36,463	)		(34,931	)		(33,200	)(b)
Insurance subsidiary		(1,542	)		(1,633	)		(1,856	)		(2,046	)		(1,503	)		(1,347	)

		(39,336	)		(40,139	)		(56,810	)		(38,509	)		(36,434	)		(34,547	)

Operating income		141,368			134,490			109,662			150,717			144,915			145,058
Rent		(84,672	)		(88,273	)		(88,085	)		(86,530	)		(86,126	)		(88,461	)(d)
Depreciation and amortization		(28,202	)		(30,388	)		(30,916	)		(32,261	)		(31,405	)		(31,269	)
Interest, net		238			925			(1,229	)		(823	)		(1,653	)		(567	)

Income (loss) from continuing operations before income taxes		28,732			16,754			(10,568	)		31,103			25,731			24,761
Provision (benefit) for income taxes		12,207			7,111			(1,510	)		13,493			10,710			10,044

	$	16,525		$	9,643		$	(9,058	)	$	17,610		$	15,021		$	14,717

(a)	Includes $10.3 million of income related to the favorable settlement of a prior year nursing center Medicaid cost report dispute.

(b)

Beginning January 1, 2008, certain incentive compensation costs were charged to the operating divisions that had previously been classified as corporate overhead. These charges approximated $1.7 million for the hospital division, $1.5 million for the health services division and $0.3 million for the rehabilitation division in the second quarter of 2008. Segment operating results for prior periods were not restated to reflect this reclassification.

(c)	Includes a $5.1 million asset impairment charge.

(d)	Includes a $1.9 million charge related to a prior period facility rent escalator adjustment.

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

Operating Data (Continued)

(Unaudited)

(In thousands)


	2007 Quarters								2008 Quarters
	First		Second		Third		Fourth		First		Second
Rent:
Hospital division	$	34,648	$	36,129	$	36,001	$	36,940	$	36,853	$	38,787	(a)
Health services division		47,239		48,985		50,078		48,245		47,883		48,175	(a)
Rehabilitation division		1,069		1,133		1,180		1,259		1,358		1,393
Pharmacy division		1,642		1,943		740		–		–		–
Corporate		74		83		86		86		32		106

	$	84,672	$	88,273	$	88,085	$	86,530	$	86,126	$	88,461

Depreciation and amortization:
Hospital division	$	9,083	$	10,027	$	11,156	$	12,038	$	11,653	$	11,794
Health services division		10,981		11,825		13,284		14,572		14,389		13,677
Rehabilitation division		236		273		284		383		387		485
Pharmacy division		2,816		2,760		934		–		–		–
Corporate		5,086		5,503		5,258		5,268		4,976		5,313

	$	28,202	$	30,388	$	30,916	$	32,261	$	31,405	$	31,269

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	20,765	$	25,909	$	23,505	$	24,905	$	13,556	$	20,022
Health services division		6,696		10,460		13,908		15,876		7,135		10,744
Rehabilitation division		118		253		385		1,281		282		280
Pharmacy division		1,712		1,613		790		–		–		–
Corporate:
Information systems		4,457		5,765		4,668		9,541		3,832		8,616
Other		274		734		11,000		1,873		135		258

	$	34,022	$	44,734	$	54,256	$	53,476	$	24,940	$	39,920

(a)	Includes adjustments to prior period facility rent escalators of $1.5 million for the hospital division and $0.4 million for the health services division.

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

Operating Data (Continued)

(Unaudited)


	2007 Quarters								2008 Quarters
	First		Second		Third		Fourth		First		Second
Hospital data:
End of period data:
Number of hospitals		81		81		83		84		84		83
Number of licensed beds		6,319		6,378		6,495		6,567		6,567		6,501
Revenue mix %:
Medicare		60		58		56		57		57		56
Medicaid		10		10		11		11		9		9
Medicare Advantage		n/a		4		6		7		8		9
Commercial insurance and other		30		28		27		25		26		26
Admissions:
Medicare		7,745		7,160		6,884		7,473		8,227		7,458
Medicaid		1,067		1,021		1,115		1,072		1,053		1,019
Medicare Advantage		n/a		391		600		696		912		855
Commercial insurance and other		2,278		1,858		1,730		1,786		1,911		1,865

		11,090		10,430		10,329		11,027		12,103		11,197

Admissions mix %:
Medicare		70		69		67		68		68		66
Medicaid		10		10		11		10		9		9
Medicare Advantage		n/a		3		6		6		7		8
Commercial insurance and other		20		18		16		16		16		17
Patient days:
Medicare		213,622		205,545		196,927		207,733		224,332		215,328
Medicaid		53,346		52,286		52,548		54,995		53,148		53,362
Medicare Advantage		n/a		14,013		18,612		22,583		28,712		29,527
Commercial insurance and other		83,292		71,928		66,602		68,169		69,702		70,323

		350,260		343,772		334,689		353,480		375,894		368,540

Average length of stay:
Medicare		27.6		28.7		28.6		27.8		27.3		28.9
Medicaid		50.0		51.2		47.1		51.3		50.5		52.4
Medicare Advantage		n/a		35.8		31.0		32.4		31.5		34.5
Commercial insurance and other		36.6		38.7		38.5		38.2		36.5		37.7
Weighted average		31.6		33.0		32.4		32.1		31.1		32.9
Revenues per admission:
Medicare	$	35,532	$	35,373	$	34,837	$	34,468	$	33,705	$	35,401
Medicaid		42,911		44,265		40,719		44,689		42,757		43,431
Medicare Advantage		n/a		49,038		41,075		41,527		41,966		46,399
Commercial insurance and other		60,940		64,495		67,824		63,497		66,802		65,528
Weighted average		41,461		41,944		41,359		40,609		40,341		41,990
Revenues per patient day:
Medicare	$	1,288	$	1,232	$	1,218	$	1,240	$	1,236	$	1,226
Medicaid		858		864		864		871		847		829
Medicare Advantage		n/a		1,368		1,324		1,280		1,333		1,344
Commercial insurance and other		1,667		1,666		1,762		1,664		1,832		1,738
Weighted average		1,313		1,272		1,277		1,267		1,299		1,276
Medicare case mix index (discharged patients only)		1.11		1.10		1.09		1.10		1.11		1.15
Average daily census		3,892		3,778		3,638		3,842		4,131		4,050
Occupancy %		68.4		65.6		61.6		64.1		68.1		67.2

n/a – not available

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

Operating Data (Continued)

(Unaudited)


	2007 Quarters								2008 Quarters
	First		Second		Third		Fourth		First		Second
Nursing center data:
End of period data:
Number of nursing centers:
Owned or leased		223		223		224		224		224		224
Managed		4		4		4		4		4		4

		227		227		228		228		228		228

Number of licensed beds:
Owned or leased		28,481		28,477		28,719		28,621		28,371		28,251
Managed		485		485		485		485		485		485

		28,966		28,962		29,204		29,106		28,856		28,736

Revenue mix %:
Medicare		35		35		34		34		35		35
Medicaid		44		44		44		44		42		43
Medicare Advantage		n/a		n/a		n/a		n/a		5		5
Private and other		21		21		22		22		18		17

Patient days (excludes managed facilities):
Medicare		389,354		390,142		382,527		390,907		409,902		402,269
Medicaid		1,405,392		1,417,578		1,441,273		1,429,155		1,394,925		1,387,374
Medicare Advantage		n/a		n/a		n/a		n/a		79,221		82,886
Private and other		432,145		448,605		478,831		489,190		415,290		407,141

		2,226,891		2,256,325		2,302,631		2,309,252		2,299,338		2,279,670

Patient day mix %:
Medicare		18		17		17		17		18		18
Medicaid		63		63		62		62		61		61
Medicare Advantage		n/a		n/a		n/a		n/a		3		3
Private and other		19		20		21		21		18		18

Revenues per patient day:
Medicare Part A	$	406	$	408	$	408	$	422	$	429	$	431
Total Medicare (including Part B)		442		444		445		458		461		466
Medicaid		152		153		156		160		160		168
Medicare Advantage		n/a		n/a		n/a		n/a		348		351
Private and other		231		237		237		238		229		228
Weighted average		218		220		221		227		232		238

Average daily census		24,743		24,795		25,029		25,101		25,267		25,051
Occupancy %		88.2		87.4		87.8		87.8		89.2		89.0

Rehabilitation data:
Revenue mix %:
Company-operated		74		69		68		65		65		64
Non-affiliated		26		31		32		35		35		36

Therapist productivity %		79.6		80.2		79.0		78.9		81.9		81.3

n/a – not available

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. The information presented has been prepared utilizing certain assumptions considered reasonable in light of information currently available to the Company. 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 the London Interbank Offered Rate, 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 6/30/08
	2008			2009			2010			2011			2012			Thereafter			Total		Fair value 6/30/08
Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate	$	38		$	81		$	86		$	91		$	96		$	460		$	852	$	818
Average interest rate		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%
Variable rate (a)	$	–		$	–		$	–		$	–		$	265,400		$	–		$	265,400	$	265,400

(a)

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

ITEM 4. CONTROLS AND PROCEDURES

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

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2008, 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 June 30, 2008, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings

The Company is a party to various legal actions (some of which are not insured), and regulatory and other government investigations and sanctions in the ordinary course of business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory and other government investigations. 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 financial position, results of operations and liquidity.

Item 4.

Submission of Matters to a Vote of Security Holders

The Company’s Annual Meeting of Shareholders was held on May 22, 2008 in Louisville, Kentucky. At the meeting, shareholders elected a board of eight directors pursuant to the following votes:


Director	Votes in Favor	Votes Withheld	Abstentions

Edward L. Kuntz	35,761,887	448,473	2,736

Ann C. Berzin	36,023,244	184,631	5,221

Thomas P. Cooper, M.D.	35,953,956	253,729	5,411

Paul J. Diaz	36,060,680	149,742	2,675

Garry N. Garrison	35,960,172	247,397	5,527

Isaac Kaufman	35,952,447	255,123	5,527

John H. Klein	35,330,073	877,495	5,529

Eddy J. Rogers, Jr.	35,959,763	247,804	5,529

In addition to electing directors, shareholders of the Company approved a proposal to amend and restate the Company’s 2001 Stock Incentive Plan, Amended and Restated, by the vote of 18,352,051 in favor, 16,512,626 against, 142,036 abstentions and 1,206,384 broker non-votes.

Also at the Annual Meeting, the Company’s shareholders ratified the appointment of PricewaterhouseCoopers LLP as the Company’s independent auditor for fiscal 2008 by the vote of 35,865,704 in favor, 331,247 against, 16,145 abstentions and no broker non-votes.

Item 6.

Exhibits



10.1		Kindred Healthcare, Inc. 2001 Stock Incentive Plan, Amended and Restated. Exhibit 10.1 to the Company’s Current Report on Form 8-K dated May 22, 2008 (Comm. File No. 001-14057) is hereby incorporated by reference.

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

32		Section 1350 Certifications.

SIGNATURES

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


				KINDRED HEALTHCARE, INC.

Date: August 11, 2008				/s/ PAUL J. DIAZ
				Paul J. Diaz
				President and Chief Executive Officer

Date: August 11, 2008				/s/ RICHARD A. LECHLEITER
				Richard A. Lechleiter
				Executive Vice President and Chief Financial Officer

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents