UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________________________  
FORM 10-Q
________________________________ 
CHECK ONE:
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: September 30, 2013
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             .

Commission file No.: 1-12996
________________________________ 
Diversicare Healthcare Services, Inc.
(exact name of registrant as specified in its charter)
 ________________________________
Delaware
 
62-1559667
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)
1621 Galleria Boulevard, Brentwood, TN 37027
(Address of principal executive offices) (Zip Code)
(615) 771-7575
(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   ý     No   ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   ý     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 a “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
Accelerated filer
 
¨
 
 
 
 
Non-accelerated filer
 
¨
Smaller reporting Company
 
ý
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨     No   ý
6,081,969
(Outstanding shares of the issuer’s common stock as of October 31, 2013 )
 



Part I. FINANCIAL INFORMATION
ITEM 1 – FINANCIAL STATEMENTS
DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
September 30,
2013
 
December 31,
2012
 
(Unaudited)
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
3,419

 
$
5,930

Receivables, less allowance for doubtful accounts of $3,741 and $3,143, respectively
27,838

 
24,631

Other receivables
772

 
1,397

Prepaid expenses and other current assets
2,838

 
3,729

Income tax refundable
843

 
1,215

Current assets of discontinued operations
1,970

 
4,649

Deferred income taxes
7,667

 
5,305

Total current assets
45,347

 
46,856

PROPERTY AND EQUIPMENT, at cost
102,395

 
82,939

Less accumulated depreciation and amortization
(48,836
)
 
(43,938
)
Discontinued operations, net
1,053

 
2,921

Property and equipment, net (variable interest entity restricted – 2013: $6,909; 2012: $7,144)
54,612

 
41,922

OTHER ASSETS:
 
 
 
Deferred income taxes
15,334

 
12,352

Deferred financing and other costs, net
2,179

 
1,438

Investment in unconsolidated affiliate
519

 
420

Other noncurrent assets
8,146

 
3,317

Acquired leasehold interest, net
8,324

 
8,612

Noncurrent assets of discontinued operations
37

 
46

Total other assets
34,539

 
26,185

 
$
134,498

 
$
114,963

The accompanying notes are an integral part of these interim consolidated financial statements.

2


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
(continued)
 
 
September 30,
2013
 
December 31,
2012
 
(Unaudited)
 
 
CURRENT LIABILITIES:
 
 
 
Current portion of long-term debt and capitalized lease obligations (variable interest entity nonrecourse – 2013: $215; 2012: $206)
$
1,913

 
$
1,436

Trade accounts payable
6,777

 
3,603

Current liabilities of discontinued operations
587

 
2,209

Accrued expenses:
 
 
 
Payroll and employee benefits
10,336

 
11,048

Self-insurance reserves, current portion
12,091

 
9,175

Other current liabilities
4,719

 
3,722

Total current liabilities
36,423

 
31,193

NONCURRENT LIABILITIES:
 
 
 
Long-term debt and capitalized lease obligations, less current portion (variable interest entity nonrecourse – 2013: $5,313; 2012: $5,472)
49,142

 
28,026

Self-insurance reserves, noncurrent portion
17,131

 
14,531

Other noncurrent liabilities
16,464

 
17,544

Total noncurrent liabilities
82,737

 
60,101

COMMITMENTS AND CONTINGENCIES

 

SERIES C REDEEMABLE PREFERRED STOCK
 
 
 
$.10 par value, 5,000 shares authorized, issued and outstanding
4,918

 
4,918

SHAREHOLDERS’ EQUITY:
 
 
 
Series A preferred stock, authorized 200,000 shares, $.10 par value, none issued and outstanding
—

 
—

Common stock, authorized 20,000,000 shares, $.01 par value, 6,307,000 and 6,161,000 shares issued, and 6,075,000 and 5,929,000 shares outstanding, respectively
63

 
62

Treasury stock at cost, 232,000 shares of common stock
(2,500
)
 
(2,500
)
Paid-in capital
19,486

 
18,757

Retained earnings (accumulated deficit)
(7,423
)
 
1,779

Accumulated other comprehensive loss
(677
)
 
(920
)
Total shareholders’ equity of Diversicare Healthcare Services, Inc.
8,949

 
17,178

Noncontrolling interest
1,471

 
1,573

Total shareholders’ equity
10,420

 
18,751

 
$
134,498

 
$
114,963

The accompanying notes are an integral part of these interim consolidated financial statements.

3


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)
 
Three Months Ended
September 30,
 
2013
 
2012
PATIENT REVENUES, net
$
70,353

 
$
61,824

EXPENSES:
 
 
 
Operating
57,694

 
48,768

Lease and rent expense
5,250

 
4,711

Professional liability
1,382

 
1,348

General and administrative
6,092

 
5,651

Depreciation and amortization
1,784

 
1,578

Restructuring
944

 
—

Total expenses
73,146

 
62,056

OPERATING LOSS
(2,793
)
 
(232
)
OTHER INCOME (EXPENSE):
 
 
 
Equity in net income (loss) of unconsolidated affiliate
63

 
(95
)
Interest expense, net
(1,002
)
 
(696
)
Total other income (expense)
(939
)
 
(791
)
LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(3,732
)
 
(1,023
)
BENEFIT FOR INCOME TAXES
1,388

 
525

LOSS FROM CONTINUING OPERATIONS
(2,344
)
 
(498
)
INCOME (LOSS) FROM DISCONTINUED OPERATIONS:
 
 
 
Operating income (loss), net of tax benefit (provision) of $1,422 and $(312), respectively
(2,421
)
 
348

Gain on disposal, net of taxes of $0 and $107, respectively
—

 
170

Income (Loss) from discontinued operations
(2,421
)
 
518

NET INCOME (LOSS)
(4,765
)
 
20

Less: income attributable to noncontrolling interests
(17
)
 
(16
)
NET INCOME (LOSS) ATTRIBUTABLE TO DIVERSICARE HEALTHCARE SERVICES, INC.
(4,782
)
 
4

PREFERRED STOCK DIVIDENDS
(86
)
 
(86
)
NET LOSS FOR DIVERSICARE HEALTHCARE SERVICES, INC. COMMON SHAREHOLDERS
$
(4,868
)
 
$
(82
)
NET INCOME (LOSS) PER COMMON SHARE FOR DIVERSICARE HEALTHCARE SERVICES, INC. SHAREHOLDERS:
 
 
 
Per common share – basic and diluted
 
 
 
Continuing operations
$
(0.42
)
 
$
(0.10
)
Discontinued operations
(0.41
)
 
0.09

 
$
(0.83
)
 
$
(0.01
)
COMMON STOCK DIVIDENDS DECLARED PER SHARE OF COMMON STOCK
$
0.055

 
$
0.055

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
 
 
 
Basic and diluted
5,892

 
5,828

                              
The accompanying notes are an integral part of these interim consolidated financial statements.

4


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands and unaudited)
 
 
Three Months Ended
September 30,
 
2013
 
2012
NET INCOME (LOSS)
$
(4,765
)
 
$
20

OTHER COMPREHENSIVE INCOME (LOSS):
 
 
 
Change in fair value of cash flow hedge
(57
)
 
(12
)
Income tax effect
22

 
5

COMPREHENSIVE INCOME (LOSS)
(4,800
)
 
13

Less: comprehensive income attributable to noncontrolling interest
(17
)
 
(16
)
COMPREHENSIVE LOSS ATTRIBUTABLE TO DIVERSICARE HEALTHCARE SERVICES, INC.
$
(4,817
)
 
$
(3
)

The accompanying notes are an integral part of these interim consolidated financial statements.

5


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)
 
 
Nine Months Ended
September 30,
 
2013
 
2012
PATIENT REVENUES, net
$
200,502

 
$
182,798

EXPENSES:
 
 
 
Operating
160,770

 
145,100

Lease and rent expense
15,343

 
14,035

Professional liability
5,682

 
3,603

General and administrative
18,579

 
17,698

Depreciation and amortization
5,014

 
4,716

Restructuring
944

 
—

Total expenses
206,332

 
185,152

OPERATING LOSS
(5,830
)
 
(2,354
)
OTHER INCOME (EXPENSE):
 
 
 
Equity in net loss of unconsolidated affiliate
(152
)
 
(127
)
Interest expense, net
(2,582
)
 
(2,099
)
Debt retirement costs
(320
)
 
—

Total other income (expense)
(3,054
)
 
(2,226
)
LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(8,884
)
 
(4,580
)
BENEFIT FOR INCOME TAXES
3,548

 
1,778

LOSS FROM CONTINUING OPERATIONS
(5,336
)
 
(2,802
)
INCOME (LOSS) FROM DISCONTINUED OPERATIONS:
 
 
 
Operating income (loss), net of tax benefit (provision) of $1,501 and $(727), respectively
(2,555
)
 
843

Gain on disposal, net of taxes of $0 and $107, respectively
—

 
170

Income (Loss) from discontinued operations
(2,555
)
 
1,013

NET LOSS
(7,891
)
 
(1,789
)
Less: income attributable to noncontrolling interests
(51
)
 
(109
)
NET INCOME (LOSS) ATTRIBUTABLE TO DIVERSICARE HEALTHCARE SERVICES, INC.
(7,942
)
 
(1,898
)
PREFERRED STOCK DIVIDENDS
(258
)
 
(258
)
NET LOSS FOR DIVERSICARE HEALTHCARE SERVICES, INC. COMMON SHAREHOLDERS
$
(8,200
)
 
$
(2,156
)
NET INCOME (LOSS) PER COMMON SHARE FOR DIVERSICARE HEALTHCARE SERVICES, INC. SHAREHOLDERS:
 
 
 
Per common share – basic and diluted
 
 
 
Continuing operations
$
(0.96
)
 
$
(0.54
)
Discontinued operations
(0.43
)
 
0.17

 
$
(1.39
)
 
$
(0.37
)
COMMON STOCK DIVIDENDS DECLARED PER SHARE OF COMMON STOCK
$
0.165

 
$
0.165

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
 
 
 
Basic and diluted
5,878

 
5,816


The accompanying notes are an integral part of these interim consolidated financial statements.



6



DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands and unaudited)
 
 
Nine Months Ended
September 30,
 
2013
 
2012
NET LOSS
$
(7,891
)
 
$
(1,789
)
OTHER COMPREHENSIVE INCOME (LOSS):
 
 
 
Change in fair value of cash flow hedge
392

 
(83
)
Income tax effect
(149
)
 
32

COMPREHENSIVE LOSS
(7,648
)
 
(1,840
)
Less: comprehensive income attributable to noncontrolling interest
(51
)
 
(109
)
COMPREHENSIVE LOSS ATTRIBUTABLE TO DIVERSICARE HEALTHCARE SERVICES, INC.
$
(7,699
)
 
$
(1,949
)

The accompanying notes are an integral part of these interim consolidated financial statements.



7


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands and unaudited)
 
 
Nine Months Ended
September 30,
 
2013
 
2012
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net loss
$
(7,891
)
 
$
(1,789
)
Discontinued operations
(2,555
)
 
1,013

Loss from continuing operations
(5,336
)
 
(2,802
)
Adjustments to reconcile loss from continuing operations to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
5,014

 
4,716

Provision for doubtful accounts
2,860

 
2,122

Deferred income tax benefit
(4,214
)
 
(435
)
Provision for self-insured professional liability, net of cash payments
1,273

 
1,922

Stock-based compensation
809

 
435

Equity in net losses of unconsolidated affiliate, net of investment
(99
)
 
(223
)
Debt retirement costs
320

 
—

Other
38

 
288

Changes in assets and liabilities affecting operating activities:
 
 
 
Receivables, net
(5,662
)
 
(2,874
)
Prepaid expenses and other assets
(1,107
)
 
(2,744
)
Trade accounts payable and accrued expenses
2,117

 
(1,524
)
Net cash provided by (used in) continuing operations
(3,987
)
 
(1,119
)
Discontinued operations
3,630

 
3,613

Net cash provided by (used in) operating activities
(357
)
 
2,494

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(4,000
)
 
(3,531
)
Acquisition of property and equipment through business combination
(14,742
)
 
—

Change in restricted cash
(4,072
)
 
665

Proceeds from sale of discontinued operations
—

 
3,632

Deposits and other deferred balances
—

 
(224
)
Net cash used in continuing operations
(22,814
)
 
542

Discontinued operations
1,877,000

 
(432
)
Net cash used in investing activities
(20,937
)
 
110

CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Repayment of debt obligations
(28,907
)
 
(1,011
)
Proceeds from issuance of debt and capital leases
50,500

 
927

Financing costs
(1,341
)
 
(118
)
Issuance and redemption of employee equity awards
26

 
56

Payment of common stock dividends
(647
)
 
(961
)
Payment of preferred stock dividends
(258
)
 
(258
)
Distributions to noncontrolling interest
(156
)
 
(154
)
Payment for preferred stock restructuring
(434
)
 
(420
)
Net cash provided by (used in) financing activities
$
18,783

 
$
(1,939
)

8


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands and unaudited)
(continued)
 
 
Nine Months Ended
September 30,
 
2013
 
2012
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
$
(2,511
)
 
$
665

CASH AND CASH EQUIVALENTS, beginning of period
5,930

 
6,692

CASH AND CASH EQUIVALENTS, end of period
$
3,419

 
$
7,357

SUPPLEMENTAL INFORMATION:
 
 
 
Cash payments of interest, net of amounts capitalized
$
2,080

 
$
1,776

Cash payments of income taxes
$
74

 
$
176

The accompanying notes are an integral part of these interim consolidated financial statements.

9


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2013 AND 2012

1.
BUSINESS
Diversicare Healthcare Services, Inc. (together with its subsidiaries, “Diversicare Healthcare Services” or the “Company”) provides long-term care services to nursing center patients in eight states, primarily in the Southeast and Southwest. The Company’s centers provide a range of health care services to their patients and residents that include nursing, personal care, and social services. In addition to the nursing, personal care and social services usually provided in long-term care centers, the Company’s nursing centers also offer a variety of comprehensive rehabilitation services, as well as nutritional support services. The Company's continuing operations include centers in Alabama, Florida, Kansas, Kentucky, Ohio, Tennessee, Texas, and West Virginia.
As of September 30, 2013 , the Company’s continuing operations consist of 43 nursing centers with 4,882 licensed nursing beds. The Company owns 13 and leases 30 of its nursing centers. The nursing center and licensed bed count includes the 107 -bed facility in Louisville, Kentucky, for which the Company entered into a lease agreement in August 2013. The Medicaid and Medicare certification processes for this facility are currently underway, and are expected to be completed in the fourth quarter of 2013. The nursing center and licensed nursing bed count also includes the Kansas centers acquired in May 2013, which comprise five skilled nursing centers and 418 licensed beds. The Medicaid certification process was completed for these facilities during the second quarter of 2013, and the Medicare certification process was completed for these facilities during the third quarter of 2013. The count also includes the 88 -bed skilled nursing center in Clinton, Kentucky for which the Company entered into a lease agreement in April 2012. The Company had a limited number of patients at this facility while it completed the Medicare certification process which was obtained in the fourth quarter of 2012. The Medicaid certification for the Clinton, Kentucky center was obtained in the first quarter of 2013. The nursing center and licensed nursing bed count also includes the 154 -bed skilled nursing center leased in Louisville, Kentucky, that the Company has operated since September 2012. The Medicaid certification for the Louisville, Kentucky center was also obtained in the first quarter of 2013.

2.
CONSOLIDATION AND BASIS OF PRESENTATION OF FINANCIAL STATEMENTS
The interim consolidated financial statements include the operations and accounts of Diversicare Healthcare Services and its subsidiaries, all wholly-owned. All significant intercompany accounts and transactions have been eliminated in consolidation. Any variable interest entities (“VIEs”) in which the Company has an interest are consolidated when the Company identifies that it is the primary beneficiary. The Company has one variable interest entity related to a nursing center in West Virginia described in Note 8. The investment in an unconsolidated affiliate (a 50 percent -owned joint venture partnership) is accounted for using the equity method and is described in Note 9.
The interim consolidated financial statements for the three and nine month periods ended September 30, 2013 and 2012 , included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management of the Company, the accompanying interim consolidated financial statements reflect all normal, recurring adjustments necessary to present fairly the Company’s financial position at September 30, 2013 , and the results of operations for the three and nine month periods ended September 30, 2013 and 2012 , and cash flows for the nine month periods ended September 30, 2013 and 2012 . The Company’s balance sheet information at December 31, 2012 , was derived from its audited consolidated financial statements as of December 31, 2012 .
The results of operations for the nine month periods ended September 30, 2013 and 2012 are not necessarily indicative of the operating results that may be expected for a full year. These interim consolidated financial statements should be read in connection with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012 .

3.
RECENT ACCOUNTING GUIDANCE
In July 2012, the Financial Accounting Standards Board ("FASB") issued updated guidance in the form of ASU 2012-02 which amends ASC 350, “Intangibles-Goodwill and Other, Testing Indefinite-Lived Intangible Assets for Impairment.” This guidance is intended to reduce the cost and complexity of testing indefinite-lived intangible assets other than goodwill for impairment. This new guidance is an extension of guidance from September 2011 related to the testing of goodwill for impairment issued in the form of ASU 2011-08. Feedback from stakeholders during the exposure period related to the goodwill impairment testing guidance was that the qualitative assessment would also be helpful in impairment testing for intangible assets other than goodwill.

10



The updated guidance allows an entity the option to first qualitatively assess whether it is more likely than not (that is, a likelihood of more than 50 percent) that an indefinite-lived intangible asset is impaired. If an entity believes, as a result of its qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test for other non-amortized intangible assets is required. An entity is not required to perform the quantitative impairment test unless the entity determines that it is more likely than not that the asset is impaired. It is an entity's option to bypass the qualitative assessment and proceed directly to performing the quantitative impairment test for other non-amortized intangible assets. The guidance is effective for annual and interim impairment tests performed by the Company after January 1, 2013. The adoption of this guidance did not have a material impact on the Company's interim consolidated financial statements.

4.
LONG-TERM DEBT AND INTEREST RATE SWAP
The Company has agreements with a syndicate of banks for a mortgage term loan ("Original Mortgage Loan") and the Company’s revolving credit agreement ("Original Revolver"). On May 1, 2013, the Company executed an Amended and Restated Credit Agreement (the "Credit Agreement") which modified the terms of the Original Mortgage Loan and the Original Revolver Agreements dated February 28, 2011. The Credit Agreement increases the Company's borrowing capacity to $65,000,000 allocated between a $45,000,000 Mortgage Loan ("Amended Mortgage Loan") and a $20,000,000 Revolver ("Amended Revolver"). Loan acquisition costs associated with the Amended Mortgage Loan and the Amended Revolver were capitalized in the amount of $1,341,000 and are being amortized over the five -year term of the agreements. Loan acquisition costs of $320,000 associated with the Original Mortgage Loan were written off as a result of this transaction, and are recorded in Debt Retirement Costs in the Interim Consolidated Statement of Operations.
Under the terms of the amended agreements, the syndicate of banks provided the Amended Mortgage Loan with an original balance of $45,000,000 with a five -year maturity through April 30, 2018, and a $20,000,000 Amended Revolver through April 30, 2018. The Amended Mortgage Loan has a term of five years, with principal and interest payable monthly based on a 25 -year amortization. Interest is based on LIBOR plus 4.5% . A portion of the Amended Mortgage Loan is effectively fixed at 6.87% pursuant to an interest rate swap with a notional amount of $22,338,000 . As of September 30, 2013 , the interest rate related to the Amended Mortgage Loan was 4.68% . The Amended Mortgage Loan is secured by thirteen owned nursing centers, related equipment and a lien on the accounts receivable of these centers. The Amended Mortgage Loan and the Amended Revolver are cross-collateralized. The Company’s Amended Revolver has an interest rate of LIBOR plus 4.5% .
The Amended Revolver is secured by accounts receivable and is subject to limits on the maximum amount of loans that can be outstanding under the revolver based on borrowing base restrictions. As of September 30, 2013 , the Company had no borrowings outstanding under the revolving credit center. Annual fees for letters of credit issued under this Revolver are 3.00% of the amount outstanding. The Company has two letters of credit with a total value of $5,551,000 outstanding as of September 30, 2013 . Considering the balance of eligible accounts receivable, the letter of credit, the amounts outstanding under the revolving credit facility and the maximum loan amount of $20,000,000 , the balance available for borrowing under the revolving credit center is $14,449,000 at September 30, 2013 .
The Company’s debt agreements contain various financial covenants, the most restrictive of which relate to minimum cash deposits, cash flow and debt service coverage ratios. The Company is in compliance with all such covenants at September 30, 2013 .
The Company's consolidated financial statements also includes debt of $5,528,000 that is owed by the variable interest entity that owns the West Virginia nursing center described in Note 8. The borrower is subject to covenants concerning total liabilities to tangible net worth as well as current assets compared to current liabilities. The borrower was in compliance with all such covenants at December 31, 2012 . The borrower’s liabilities do not provide creditors with recourse to the general assets of the Company.
Interest Rate Swap Transaction
As part of the debt agreements entered into in March 2011, the Company entered into an interest rate swap agreement with a member of the bank syndicate as the counterparty. The Company designated its interest rate swap as a cash flow hedge and the earnings component of the hedge, net of taxes, is reflected as a component of other comprehensive income (loss). In conjunction with the amendment to the credit facility, the Company retained the previously agreed upon interest rate swap terms, and redesignated the interest rate swap as a cash flow hedge. The interest rate swap agreement requires the Company to make fixed rate payments to the bank calculated on the applicable notional amount of $22,338,000 at an annual fixed rate of 6.87% while the bank is obligated to make payments to the Company based on LIBOR on the same notional amounts.
The Company assesses the effectiveness of its interest rate swap on a quarterly basis and at September 30, 2013 , the Company determined that the interest rate swap was effective. The interest rate swap valuation model indicated a net liability of $1,091,000 at September 30, 2013 . The fair value of the interest rate swap is included in “other noncurrent liabilities” on the

11


Company’s interim consolidated balance sheet. The balance of accumulated other comprehensive loss at September 30, 2013 is $677,000 and reflects the liability related to the interest rate swap, net of the income tax benefit of $414,000 . As the Company’s interest rate swap is not traded on a market exchange, the fair value is determined using a valuation based on a discounted cash flow analysis. This analysis reflects the contractual terms of the interest rate swap agreement and uses observable market-based inputs, including estimated future LIBOR interest rates. The interest rate swap valuation is classified in Level 2 of the fair value hierarchy, in accordance with the FASB guidance set forth in ASC 820, Fair Value Measurement .

5.
INSURANCE MATTERS
Professional Liability and Other Liability Insurance
The Company has professional liability insurance coverage for its nursing centers that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. Effective July 1, 2013, the Company established a wholly-owned, consolidated offshore limited purpose insurance subsidiary, SHC Risk Carriers, Inc. (“SHC”) which has issued a policy insuring claims made against all of the Company's nursing centers in Florida, Ohio, Tennessee, and West Virginia as well as the Company’s formerly operated Arkansas facilities. Several of the Company’s nursing centers in Alabama, Kentucky, and Texas are also covered under this policy. The SHC policy provides coverage limits of either $500,000 or $1,000,000 per medical incident with a sublimit per center of $1,000,000 and total annual aggregate policy limits of $5,000,000 . The remaining nursing centers are covered by one of three claims made professional liability insurance policies purchased from entities unaffiliated with the Company. These policies provide coverage limits of $1,000,000 per claim and have sublimits of $3,000,000 per center, with varying aggregate policy limits. 
Reserve for Estimated Self-Insured Professional Liability Claims
Because the Company’s actual liability for existing and anticipated professional liability and general liability claims will likely exceed the Company’s limited insurance coverage, the Company has recorded total liabilities for reported and estimated future claims of $28,134,000 as of September 30, 2013 . This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of legal costs related to these claims. All losses are projected on an undiscounted basis and are presented without regard to any potential insurance recoveries. Amounts are added to the accrual for estimates of anticipated liability for claims incurred during each period, and amounts are deducted from the accrual for settlements paid on existing claims during each period.
The Company evaluates the adequacy of this liability on a quarterly basis. Semi-annually, the Company retains a third-party actuarial firm to assist in the evaluation of this reserve. Merlinos & Associates, Inc. (“Merlinos”) assisted management in the preparation of an estimate of the appropriate accrual for the claims period ending June 30, 2013 and for incurred, but not reported general and professional liability claims as of that date based on data furnished as of May 31, 2013. Merlinos primarily utilizes historical data regarding the frequency and cost of the Company’s past claims over a multi-year period, industry data and information regarding the number of occupied beds to develop its estimates of the Company’s ultimate professional liability cost for current periods. The Actuarial Division of Willis of Tennessee, Inc. assisted the Company with all estimates prior to May 2012.
On a quarterly basis, the Company obtains reports of asserted claims and lawsuits incurred. These reports, which are provided by the Company’s insurers and a third-party claims administrator, contain information relevant to the actual expense already incurred with each claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim. This information is reviewed by the Company quarterly and provided to the actuary semi-annually. Based on the Company’s evaluation of the actual claim information obtained, the semi-annual estimates received from the third-party actuary, the amounts paid and committed for settlements of claims and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular period may be revised upward or downward on a quarterly basis. Any increase in the accrual decreases results of operations in the period and any reduction in the accrual increases results of operations during the period.
As of September 30, 2013 , the Company is engaged in 53 professional liability lawsuits. Three lawsuits are currently scheduled for trial or arbitration during the next twelve months, and it is expected that additional cases will be set for trial or hearing. The Company’s cash expenditures for self-insured professional liability costs from continuing operations were $3,502,000 and $1,616,000 for the nine months ended September 30, 2013 and 2012 , respectively.
The Company follows current accounting guidance set forth in FASB ASU 2010-24, “Presentation of Insurance Claims and Related Insurance Recoveries,” that clarifies that a health care entity should not net insurance recoveries against a related professional liability claim, and that the amount of the claim liability should be determined without consideration of insurance recoveries. Accordingly, the Company has recorded assets and equal liabilities of $650,000 at September 30, 2013 and $1,238,000 at December 31, 2012 , respectively.

12


Although the Company adjusts its accrual for professional and general liability claims on a quarterly basis and retains a third-party actuarial firm semi-annually to assist management in estimating the appropriate accrual, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. Professional liability cases have a long cycle from the date of an incident to the date a case is resolved, and final determination of the Company’s actual liability for claims incurred in any given period is a process that takes years. As a result, the Company’s actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given period. Each change in the amount of this accrual will directly affect the Company’s reported earnings and financial position for the period in which the change in accrual is made.
Other Insurance
With respect to workers’ compensation insurance, substantially all of the Company’s employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. The Company is completely self-insured for workers’ compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers’ compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. From June 30, 2003 until June 30, 2007, the Company’s workers’ compensation insurance programs provided coverage for claims incurred with premium adjustments depending on incurred losses. For the period from July 1, 2008 through June 30, 2013, the Company is covered by a prefunded deductible policy. Under this policy, the Company is self-insured for the first $500,000 per claim, subject to an aggregate maximum of $3,000,000 . The Company funds a loss fund account with the insurer to pay for claims below the deductible. The Company accounts for premium expense under this policy based on its estimate of the level of claims subject to the policy deductibles expected to be incurred. The liability for workers’ compensation claims is $253,000 at September 30, 2013 . The Company has a non-current receivable for workers’ compensation policies covering previous years of $1,140,000 as of September 30, 2013 . The non-current receivable is a function of payments paid to the Company’s insurance carrier in excess of the estimated level of claims expected to be incurred.
As of September 30, 2013 , the Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $175,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $834,000 at September 30, 2013 . The differences between actual settlements and reserves are included in expense in the period finalized.

6.
STOCK-BASED COMPENSATION
During 2013 and 2012 , the Compensation Committee of the Board of Directors approved grants totaling approximately 69,000 and 86,000 shares of restricted common stock to certain employees and members of the Board of Directors, respectively. The fair value of restricted shares are determined as the quoted market price of the underlying common shares at the date of the grant. The restricted shares typically vest 33% on the first, second and third anniversaries of the grant date. Unvested shares may not be sold or transferred. During the vesting period, dividends accrue on the restricted shares, but are paid in additional shares of common stock upon vesting, subject to the vesting provisions of the underlying restricted shares. The restricted shares are entitled to the same voting rights as other common shares. Upon vesting, all restrictions are removed. In addition to the shares of restricted common stock granted in the current year, the Compensation Committee of the Board of Directors also approved grants of approximately 55,000 unrestricted shares of common stock to certain employees. These shares were granted without restrictions and considered fully vested upon the date of the grant.

During 2012, the Compensation Committee of the Board of Directors also approved grants of Stock Only Stock Appreciation Rights (“SOSARs”) at the market price of the Company's common stock on the grant date. The SOSARs vest 33% on the first, second and third anniversaries of the grant date. The SOSARs were valued and recorded in the same manner as stock options, and will be settled with issuance of new stock for the difference between the market price on the date of exercise and the exercise price. The Company estimated the total recognized and unrecognized compensation using the Black-Scholes-Merton equity grant valuation model.

 
2012
Expected volatility (range)
58% - 59%
Risk free interest rate (range)
0.795% - 1.025%
Expected dividends
3.75%
Weighted average expected term (years)
6


13



In computing the fair value estimates using the Black-Scholes-Merton valuation model, the Company took into consideration the exercise price of the equity grants and the market price of the Company's stock on the date of grant. The Company used an expected volatility that equals the historical volatility over the most recent period equal to the expected life of the equity grants. The risk free interest rate is based on the U.S. treasury yield curve in effect at the time of grant. The Company used the expected dividend yield at the date of grant, reflecting the level of annual cash dividends currently being paid on its common stock.
Stock-based compensation expense is non-cash and is included as a component of general and administrative expense or operating expense based upon the classification of cash compensation paid to the related employees. The Company recorded total stock-based compensation expense of $809,000 and $435,000 in the nine month periods ended September 30, 2013 and 2012 , respectively.

7.
EARNINGS (LOSS) PER COMMON SHARE
Information with respect to basic and diluted net loss per common share is presented below in thousands, except per share:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
2013
 
2012
 
2013
 
2012
Numerator: Loss amounts attributable to Diversicare Healthcare Services, Inc. common shareholders:
 
 
 
 
 
 
 
Loss from continuing operations
$
(2,344
)
 
$
(498
)
 
$
(5,336
)
 
$
(2,802
)
Less: income attributable to noncontrolling interests
(17
)
 
(16
)
 
(51
)
 
(109
)
Loss from continuing operations attributable to Diversicare Healthcare Services, Inc.
(2,361
)
 
(514
)
 
(5,387
)
 
(2,911
)
Preferred stock dividends
(86
)
 
(86
)
 
(258
)
 
(258
)
Loss from continuing operations attributable to Diversicare Healthcare Services, Inc. shareholders
(2,447
)
 
(600
)
 
(5,645
)
 
(3,169
)
Income (loss) from discontinued operations, net of income taxes
(2,421
)
 
518

 
(2,555
)
 
1,013

Net loss attributable to Diversicare Healthcare Services, Inc. common shareholders
$
(4,868
)
 
$
(82
)
 
$
(8,200
)
 
$
(2,156
)
 

14


 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Net loss per common share:
 
 
 
 
 
 
 
Per common share – basic
 
 
 
 
 
 
 
Loss from continuing operations
$
(0.42
)
 
$
(0.10
)
 
$
(0.96
)
 
$
(0.54
)
Income from discontinued operations
 
 
 
 
 
 
 
Operating income (loss), net of taxes
(0.41
)
 
0.06

 
(0.43
)
 
0.14

Gain on disposal, net of taxes
—

 
0.03

 
—

 
0.03

Discontinued operations, net of taxes
(0.41
)
 
0.09

 
(0.43
)
 
0.17

Net loss per common share – basic
$
(0.83
)
 
$
(0.01
)
 
$
(1.39
)
 
$
(0.37
)
Per common share – diluted
 
 
 
 
 
 
 
Loss from continuing operations
$
(0.42
)
 
$
(0.10
)
 
$
(0.96
)
 
$
(0.54
)
Income from discontinued operations
 
 
 
 
 
 
 
Operating income, net of taxes
(0.41
)
 
0.06

 
(0.43
)
 
0.14

Gain on disposal, net of taxes
—

 
0.03

 
—

 
0.03

Discontinued operations, net of taxes
(0.41
)
 
—

 
(0.04
)
 
0.17

Net loss per common share - diluted
$
(0.83
)
 
$
(0.01
)
 
$
(1.39
)
 
$
(0.37
)
Denominator: Weighted Average Common Shares Outstanding:
 
 
 
 
 
 
 
Basic
5,892

 
5,828

 
5,878

 
5,816

Diluted
5,892

 
5,828

 
5,878

 
5,816

The effects of 326,000 and 239,000 SOSARs and options outstanding were excluded from the computation of diluted earnings per common share in 2013 and 2012 , respectively, because these securities would have been anti-dilutive due to the net loss. The weighted average common shares for basic and diluted earnings for common shares were the same due to the quarterly and year-to-date loss in 2013 and 2012 .

8.
VARIABLE INTEREST ENTITY
Accounting guidance requires that a variable interest entity (“VIE”) must be consolidated by the primary beneficiary in accordance with the provisions set forth in FASB ASC 810, Consolidation , as mentioned in Note 2 above. The primary beneficiary is the party that has both the power to direct activities of a VIE that most significantly impact the entity's economic performance and the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. We perform an ongoing qualitative analysis to determine if we are the primary beneficiary of a VIE. At September 30, 2013 , we are the primary beneficiary of one VIE, and therefore, consolidate that entity.
Rose Terrace Health and Rehabilitation Center
On December 28, 2011, the Company completed construction of Rose Terrace Health and Rehabilitation Center (“Rose Terrace”), its third health care center in West Virginia. The 90 -bed skilled nursing center is located in Culloden, West Virginia, along the Huntington-Charleston corridor, and offers 24-hour skilled nursing care designed to meet the care needs of both short and long-term nursing patients. The Rose Terrace nursing center utilizes a Certificate of Need the Company obtained in June 2009, when the Company completed the acquisition of certain assets of a skilled nursing center in West Virginia. The nursing center is licensed to operate by the state of West Virginia.
The Company has a lease agreement with the real estate developer that constructed, furnished, and equipped Rose Terrace that provides an initial lease term of 20 years and the option to renew the lease for two additional five -year periods. The agreement provides the Company the right to purchase the center beginning at the end of the first year of the initial term of the lease and continuing through the fifth year for a purchase price ranging from 110% to 120% of the total project cost.
The Company has no equity interest in the entity that constructed the new center and does not guarantee any debt obligations of the entity. The owners of the center have provided guarantees of the debt of the entity and, based on those guarantees, the entity is considered to be a VIE. The Company owns the underlying Certificate of Need that is required for operation as a skilled

15


nursing center. During 2011, the Company determined it is the primary beneficiary of the VIE based primarily on the ownership of the Certificate of Need, the fixed price purchase option described above, the Company’s ability to direct the activities that most significantly impact the economic performance of the VIE, and the right to receive potentially significant benefits from the VIE. Accordingly, as the primary beneficiary, the Company consolidates the balance sheet and results of operations of the VIE.

9. EQUITY METHOD INVESTMENT
The investment in unconsolidated affiliate reflected on the interim consolidated balance sheet relates to a pharmacy joint venture partnership in which the Company owns 50% . The joint venture was initially funded by the Company and its partner and began operations during 2012. This investment in unconsolidated affiliate is accounted for using the equity method as the Company exerts significant influence, but does not control or otherwise consolidate the entity. The investment in unconsolidated affiliate balance at September 30, 2013 , was $519,000 as compared to $420,000 at December 31, 2012 . Additionally, the Company's share of the net profits and losses of the unconsolidated affiliate are reported in equity in net earnings or losses of unconsolidated affiliate in our statement of operations. The Company's equity in the net losses of unconsolidated affiliate for the nine month period ended September 30, 2013 , was $152,000 as compared to $127,000 for the nine month period ended September 30, 2012 .

10.
BUSINESS DEVELOPMENT
Acquisitions
On March 6, 2013, the Company entered into an asset purchase agreement ("the Agreement") with Cumberland & Ohio Co. of Texas, as receiver of the assets of SeniorTrust of Florida, Inc. to acquire certain land, improvements, furniture, fixtures and equipment, and personal property of five facilities, all located in Kansas, for an aggregate purchase price of $15,500,000 . The purchase of the Kansas facilities commenced on May 1, 2013. The Company also incurred $338,000 in acquisition-related expenses associated with this transaction. The five facilities acquired under the Agreement include the following:

•
77 -bed skilled nursing facility known as Chanute HealthCare Center
• 80
-bed skilled nursing facility known as Council Grove HealthCare Center
•
119 -bed skilled nursing facility known as Haysville HealthCare Center
•
80 -bed skilled nursing facility known as Larned HealthCare Center
•
62 -bed skilled nursing facility known as Sedgwick HealthCare Center

As a result of the consummation of the Agreement, the Company allocated the purchase price of $15,500,000 between the assets associated with the transaction based on the fair value of the acquired net assets. In addition to the assets acquired in the transaction, the Company also assumed liabilities of $758,000 which resulted in total cash outlay of $14,742,000 . The allocation of the purchase price was determined with the assistance of HealthTrust LLC, a third-party real estate valuation firm. The allocation for the net assets acquired is as follows:

 
As of May 1, 2013
Purchase Price
$
15,500,000

 
 
Land
$
2,130,000

Buildings
12,127,000

Furniture, fixtures, and equipment
1,200,000

Inventory
43,000

 
 
Less: Liabilities assumed
$
758,000

 
 
Total cash paid
$
14,742,000


Since finalizing the purchase, the aforementioned facilities have contributed $9,706,000 in revenue to the Consolidated Interim Statement of Operations during the nine month period ended September 30, 2013 .


16


Lease Agreements
In April 2012, the Company entered into a lease agreement to operate a 88 -bed skilled nursing center in Clinton, Kentucky. The center is subject to a mortgage insured through the United States Department of Housing and Urban Development. The current annual lease payments are approximately $373,000 . The lease has an initial ten -year term with two five -year renewal options and contains an option to purchase the property for $3,300,000 during the first five years. The center was without residents since April 2011 after being decertified by Medicare and Medicaid. The lease agreement called for a $125,000 lease commencement fee and the transaction is considered a lease agreement. The Medicare certification for this facility was obtained during the fourth quarter of 2012, while the Medicaid certification was completed during the first quarter of 2013.
Separate from the above lease transaction, in September 2012, the Company entered into a lease agreement to operate a 154 -bed skilled nursing center in Louisville, Kentucky. The nursing center is owned by a real estate investment trust ("REIT") and the lease provides for an initial fifteen -year lease term with a five -year renewal option. The Company began operating the skilled nursing center in September 2012. This skilled nursing center was already operating and treating patients on the transition date. There was no purchase price paid to enter into the lease agreement for this skilled nursing center.
On August 1, 2013, the Company assumed operations at Seneca Place, an existing 107 -bed facility in Louisville, KY.  The nursing center is owned by a REIT and the lease provides for an initial 15 -year lease term with a 5 -year renewal option. This additional skilled nursing center increases the Company's footprint in Kentucky to nine nursing centers. The center was already operating and treating patients on the transition date. There was no purchase price paid to enter into the lease agreement for this skilled nursing center.

11.
DISCONTINUED OPERATIONS
Arkansas Lease Termination
Effective September 1, 2013, the Company entered into an agreement with Omega Healthcare Investors, Inc. ("Omega") to terminate its lease with respect to eleven nursing centers and 1,181 licensed beds located in Arkansas and concurrently entered into operation transfer agreements to transfer the operations of each of those eleven centers to an operator selected by Omega. Upon the completion of the transaction, the Company no longer operates any skilled nursing centers in the State of Arkansas. In connection with the closing of this transaction, the Company and Omega entered into the Thirteenth Amendment to Consolidated Amended and Restated Master Lease ("Master Lease") most recently amended on January 22, 2013. This amendment effectively modifies the terms of the Master Lease to terminate the terms surrounding the eleven nursing centers in Arkansas, and only as to those eleven centers, and effectively reduces the annual rent payable under the Master Lease by $5,000,000 .
As a result of this transaction, the Company has reclassified the operations of these centers as discontinued operations for all periods presented in the accompanying interim consolidated financial statements. These centers contributed revenues of $40,161,000 and $46,140,000 and net loss of $2,432,000 and net income of $836,000 during the nine months ended September 30, 2013 and 2012 , respectively.  The net income or loss for the nursing centers included in discontinued operations does not reflect any allocation of corporate general and administrative expense or any allocation of corporate interest expense. The Company considered these additional costs along with the centers' future prospects based upon operating history when determining the contribution of the skilled nursing centers to its operations. In addition to the expenses associated with the discontinued operations, the Company also incurred $944,000 in restructuring expenses that represent corporate expenses and exit costs associated with the Arkansas disposition, but not classified as discontinued operations.
The discontinued assets and liabilities of the disposed skilled nursing centers have been reclassified and are segregated in the interim consolidated balance sheets as assets and liabilities of discontinued operations. The current asset amounts, which are primarily composed of net accounts receivable, of $1,963,000 and $4,485,000 , and the current liabilities are primarily composed of trade payable and various accrued expenses such as payroll and real estate taxes of $546,000 and $2,199,000 at September 30, 2013 and December 31, 2012 , respectively. The Company expects to collect the balance of the accounts receivable and pay the remaining trade payables and accrued expenses in the ordinary course of business. The Company did not transfer the accounts receivable or liabilities to the new owner. Further, in accordance with Company accounting policy, the reserve for professional liability and workers' compensation will remain in the consolidated liability accounts as future payment of these liabilities will be paid through the Company's future operating cash flows.

Newport Disposition
In addition to the transaction above, the Company sold an owned skilled nursing center in Arkansas to an unrelated party and has reclassified the operations of this center as discontinued operations for all periods presented in the accompanying interim consolidated financial statements effective September 1, 2012. The financial impact of this skilled nursing center continues to be reflected in the current and historical interim consolidated financial statements during this period. This center contributed

17


revenues of $0 and $3,463,000 and net loss of $130,000 and net income of $7,000 during the nine months ended September 30, 2013 and 2012 , respectively.  Similar to the transaction above, the net income or loss for the nursing center included in discontinued operations does not reflect any allocation of corporate general and administrative expense or any allocation of corporate interest expense. The Company considered these additional costs along with the center's future prospects when determining the contribution of the skilled nursing center to its operations.


12.
SUBSEQUENT EVENTS

On October 1, 2013, the Company finalized its previously announced transaction to assume operations of three centers in Ohio and one center in Indiana from Catholic Health Partners.  The centers were purchased by a REIT and the Company assumed responsibility for their operations upon the closing of the transaction.  The transaction included the following centers with 712 licensed beds, as branded by Diversicare:

•
173 -bed skilled nursing center known as Diversicare of Bradford Place
•
167 -bed skilled nursing center known as Diversicare of Siena Woods
•
200 -bed skilled nursing center known as Diversicare of St. Theresa
•
172 -bed skilled nursing center known as Diversicare of Providence

Upon the completion of this transaction, the Company’s continuing operations consist of 47 nursing centers with 5,594 licensed nursing beds. The Company owns 13 and leases 34 of its nursing centers.

Additionally, subsequent to September 30, 2013 , the Company amended the prescribed calculation of various financial covenants with the Credit Agreement to allow for certain costs incurred from the disposition of the Arkansas operations. The amendment of the covenant calculations is reflected in the covenant compliance levels as of September 30, 2013 , included herein.


18



ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Diversicare Healthcare Services, Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast and Southwest. Our centers provide a range of health care services to their patients and residents that include nursing, personal care, and social services. In addition to the services usually provided in long-term care centers, we also offer a variety of comprehensive rehabilitation services as well as nutritional support services.As of September 30, 2013 , the Company’s continuing operations consist of 43 nursing centers with 4,882 licensed nursing beds. The Company owns 13 and leases 30 of its nursing centers. The nursing center and licensed bed count includes the 107 -bed facility in Louisville, Kentucky, for which the Company entered into a lease agreement in August 2013. The Medicaid and Medicare certification processes for this facility are currently underway, and are expected to be completed in the fourth quarter of 2013. The nursing center and licensed nursing bed count also includes the Kansas centers acquired in May 2013, which comprise five skilled nursing centers and 418 licensed beds. The Medicaid certification process was completed for these facilities during the second quarter of 2013, the Medicare certification process was completed for these facilities during the third quarter of 2013. The count also includes the 88 -bed skilled nursing center in Clinton, Kentucky for which the Company entered into a lease agreement in April 2012. The Company had a limited number of patients at this facility while it completed the Medicare certification process which was obtained in the fourth quarter of 2012. The Medicaid certification for the Clinton, Kentucky center was obtained in the first quarter of 2013. The nursing center and licensed nursing bed count also includes the 154 -bed skilled nursing center leased in Louisville, Kentucky, that the Company has operated since September 2012. The Medicaid certification for the Louisville, Kentucky center was also obtained in the first quarter of 2013. Our continuing operations include centers in Alabama, Florida, Kansas, Kentucky, Ohio, Tennessee, Texas and West Virginia.
Discontinued Operations
Effective September 1, 2012, we sold an owned skilled nursing center in Arkansas to an unrelated party, and have reclassified the operations of this center as discontinued operations for all periods presented in the accompanying interim consolidated financial statements. Additionally, effective September 1, 2013, the Company finalized an agreement with Omega Healthcare Investors, Inc. ("Omega") to terminate its lease with respect only to eleven nursing centers with 1,181 licensed beds located in Arkansas and to concurrently transfer operations to an operator selected by Omega. The completion of this transaction represents disposal of all of the Company's operations in the state of Arkansas.
The net income for the nursing centers included in discontinued operations does not reflect any allocation of regional or corporate general and administrative expense or any allocation of corporate interest expense. We considered these additional costs along with the future prospects of these nursing centers when determining the contribution of the skilled nursing centers to our operations.
The assets and liabilities of the disposed skilled nursing centers have been reclassified and are segregated in the interim consolidated balance sheets as assets and liabilities of discontinued operations. The current asset amounts are primarily composed of net accounts receivable of $2.0 million and $4.6 million , and the current liabilities are primarily composed of trade payable and various accrued expenses such as payroll and real estate taxes of $0.6 million and $2.2 million at September 30, 2013 and December 31, 2012 , respectively. The Company expects to collect the balance of the accounts receivable and pay the remaining trade payables and taxes in the ordinary course of business. The Company did not transfer the accounts receivable or liabilities to the new operators of these centers. Further, in accordance with Company accounting policy, the reserve for professional liability and workers' compensation will remain in the consolidated liability accounts as future payment of these liabilities will be paid through the Company's future operating cash flows.
Strategic Operating Initiatives
During the third quarter of 2010, we identified several key strategic objectives to increase shareholder value through improved operations and business development. These strategic operating initiatives included: improving skilled mix in our nursing centers, improving our average Medicare rate, implementing Electronic Medical Records (“EMR”) to improve Medicaid capture, accelerating center renovations and completing strategic acquisitions. We have experienced success in these initiatives and expect to continue to build on these improvements. We describe each of these below as well as provide metrics for our most recent quarter versus the third quarter of 2010, the quarter before we embarked on our strategic operating initiatives.
Improving skilled mix and average Medicare rate:
Our strategic operating initiatives of improving our skilled mix and our average Medicare rate required investing in nursing and clinical care to treat more acute patients along with nursing center based marketing representatives to attract these patients.

19


These initiatives developed referral and Managed Care relationships that have attracted and are expected to continue to attract quality payor sources for patients covered by Medicare and Managed Care. A comparison of our most recent quarter versus the third quarter of 2010, the quarter before we embarked on our strategic operating initiatives, reflects our success with these strategic operating initiatives:  
 
Three Months Ended
 
September 30, 2013
 
September 30,
2010
As a percent of total census:
 
 
 
Medicare census
11.0
%
 
12.3
%
Managed Care census
2.9
%
 
1.3
%
Total skilled mix census
13.9
%
 
13.6
%
As a percent of total revenues:
 
 
 
Medicare revenues
26.3
%
 
29.3
%
Managed Care revenues
5.6
%
 
2.8
%
Total skilled mix revenues
31.9
%
 
32.1
%
Medicare average rate per day:
$
430.73

 
$
394.23

The initiatives have developed positive skilled results, increasing the Managed Care census to 2.9% of total census in the third quarter of 2013 , as compared to 1.3% in the third quarter of 2010, and total skilled mix census from 13.6% to 13.9% over the same period.
Implementing Electronic Medical Records to improve Medicaid capture:
As another part of our strategic operating initiative, we implemented EMR to improve activity documentation, primarily in our states where Medicaid payments are acuity-based. We completed the implementation of EMR in all our nursing centers in December 2011, on time and under budget. A comparison of our most recent quarter versus the third quarter of 2010 reflects the increase in our average Medicaid rate per day:
 
Three Months Ended
 
September 30, 2013
 
September 30,
2010
Medicaid average rate per day:
$
162.08

 
$
147.93

Accelerating center renovations:
As part of our strategic operating initiatives, we have accelerated our program for improving our physical plants. Since 2005, we have been completing strategic renovations of certain centers that improve quality of care and profitability. We plan to continue these nursing center renovation projects and accelerate this strategy using the knowledge obtained in the first few years of this program. A comparison of our most recent quarter versus the third quarter of 2010 reflects our success with accelerating center renovations:  
 
September 30, 2013
 
September 30,
2010
Renovated nursing centers*
17

 
14

Amounts expended on renovations (in millions)*
$
28.1

 
$
20.9


*The amounts above include renovations which were performed on six homes within the state of Arkansas that have since been disposed of and recorded within discontinued operations. Renovation spending on these facilities totaled $7.3 million .
Completing strategic acquisitions:
Our strategic operating initiatives include a renewed focus on completing strategic acquisitions. We continue to pursue and investigate opportunities to acquire, lease or develop new centers, focusing primarily on opportunities within our existing areas of operation. We expect to announce additional development projects in the near future. We have added three skilled nursing centers in Kentucky, one in West Virginia, and five in Kansas. As detailed further in our results of operations, we experienced a significant amount of expenses related to start-up activities during 2012 at our two newly opened centers, while the center in Louisville, Kentucky, was accretive to earnings during 2012. We expect our West Virginia nursing center, our two newly leased Kentucky nursing centers, and the five Kansas centers to be accretive to earnings in 2013.

20


These investments in business initiatives have increased our operating expenses during 2013 and 2012 . While we expect to see additional start-up losses at some of these centers, we also expect our investments to create additional revenue and improved profitability over the next several quarters.
As part of our strategic efforts, we have also performed thorough analysis on our existing centers in order to determine whether continuing operations within certain markets or regions was in line with the short-term and long-term strategy of the business. As a result, we disposed of an owned building in Arkansas in 2012, and reached an agreement to terminate our lease for eleven other facilities in Arkansas in 2013. As a result of these transactions, we no longer operate within the state of Arkansas.
Basis of Financial Statements
Our patient revenues consist of the fees charged for the care of patients in the nursing centers we own and lease. Our operating expenses include the costs, other than lease, professional liability, depreciation and amortization expenses, incurred in the operation of the nursing centers we own and lease. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our interest, depreciation and amortization expenses include all such expenses across the range of our operations.

Critical Accounting Policies and Judgments
A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often involving estimates of the effect of matters that are inherently uncertain. Actual results could differ from those estimates and cause our reported net income or loss to vary significantly from period to period. Our critical accounting policies are more fully described in our 2012 Annual Report on Form 10-K.
Revenue Sources
We classify our revenues from patients and residents into four major categories: Medicaid, Medicare, Managed Care, and Private Pay and other. Medicaid revenues are composed of the traditional Medicaid program established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. Managed Care revenues include payments for patients who are insured by a third-party entity, typically called a Health Maintenance Organization, often referred to as an HMO plan, or are Medicare beneficiaries who assign their Medicare benefits to a Managed Care replacement plan often referred to as Medicare replacement products. The Private Pay and other revenues are composed primarily of individuals or parties who directly pay for their services. Included in the Private Pay and other are patients who are hospice beneficiaries as well as the recipients of Veterans Administration benefits. Veterans Administration payments are made pursuant to renewable contracts negotiated with these payors.
The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the periods presented (dollar amounts in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Medicaid
$
38,897

 
55.3
%
 
$
33,023

 
53.4
%
 
$108,536
 
54.1%
 
$96,075
 
52.6%
Medicare
18,532

 
26.3

 
18,381

 
29.7

 
55,114
 
27.5
 
56,108
 
30.7
Managed Care
3,966

 
5.6

 
3,092

 
5.0

 
12,036
 
6.0
 
9,049
 
5.0
Private Pay and other
8,958

 
12.8

 
7,328

 
11.9

 
24,816
 
12.4
 
21,566
 
11.7
Total
$
70,353

 
100.0
%
 
$
61,824

 
100.0
%
 
$200,502
 
100.0%
 
$182,798
 
100.0%
The following table sets forth average daily skilled nursing census by payor source for our continuing operations for the periods presented:  

21


 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
2012
 
2013
 
2012
Medicaid
2,610

 
70.8
%
 
2,282

 
70.1
%
 
2,461

 
70.3
%
 
2,252

 
69.7
%
Medicare
404

 
11.0

 
417

 
12.8

 
409

 
11.7

 
420

 
13.0

Managed Care
105

 
2.9

 
79

 
2.4

 
106

 
3.0

 
79

 
2.4

Private Pay and other
565

 
15.3

 
478

 
14.7

 
527

 
15.0

 
479

 
14.9

Total
3,684

 
100.0
%
 
3,256

 
100.0
%
 
3,503

 
100.0
%
 
3,230

 
100.0
%
Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, Managed Care, and Private Pay and other can significantly affect the profitability of the facility’s operations.

Health Care Industry
The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse laws and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions in which government agencies seek to impose fines and penalties. The Company is involved in regulatory actions of this type from time to time.
In March 2010, significant legislation concerning health care and health insurance was passed, including the “Patient Protection and Affordable Care Act,” (“Affordable Care Act”) along with the “Health Care and Education Reconciliation Act of 2010” (“Reconciliation Act”) collectively defined as the “Legislation.” As previously noted, we expect this Legislation to impact our Company, our employees and our patients and residents in a variety of ways. This Legislation significantly changes the future responsibility of employers with respect to providing health care coverage to employees in the United States. Two of the main provisions of the Legislation become effective in 2014 whereby most individuals will be required to either have health insurance or pay a fine and employers with 50 or more employees will either have to provide minimum essential coverage or will be subject to additional taxes. On July 2, 2013, the United States Treasury Department announced that it will delay the employer reporting mandate, which was to be effective for 2014, until 2015 to allow additional time for process improvement and system integration. We have not estimated the financial impact of the Legislation and the costs associated with complying with the increased levels of health insurance we will be required to provide our employees and their dependents in future years. We expect the Legislation will result in increased operating expenses.
We also expect for this Legislation to continue to impact our Medicaid and Medicare reimbursement as well, though the exact timing and level of that impact is currently unknown. The Legislation expands the role of home-based and community services, which may place downward pressure on our ability to maintain our population of Medicaid residents.
On June 28, 2012, the United States Supreme Court ruled that the enactment of the Affordable Care Act did not violate the Constitution of the United States. This ruling permits the implementation of most of the provisions of the Affordable Care Act to proceed. The provisions of the Affordable Care Act discussed above are only examples of federal health reform provisions that we believe may have a material impact on the long-term care industry and on our business. We anticipate that many of the provisions of the Legislation may be subject to further clarification and modification through the rule making process and could have a material adverse impact on our results of operations.
Medicare and Medicaid Reimbursement
A significant portion of our revenues are derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare, Managed Care, Private Pay and other third party sources. We employ third-party specialists in reimbursement and also use these services to monitor regulatory developments to comply with reporting requirements and to ensure that proper payments are made to our operated nursing centers. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect our future reimbursement is unknown.
Medicare

22


Effective October 1, 2011, Medicare rates were reduced by a nationwide average of 11.1%, the net effect of a reduction to restore overall payments to their intended levels on a prospective basis and the application of a 2.7% market basket increase and a negative 1.0% productivity adjustment required by the Affordable Care Act. The final Centers for Medicare and Medicaid Services (“CMS”) rule also adjusts the method by which group therapy is counted for reimbursement purposes and, for patients receiving therapy, changes the timing of reassessment for purposes of determining patient RUG categories. These October 2011 Medicare reimbursement changes decreased our Medicare revenue and our Medicare rate per patient day. The new regulations also resulted in an increase in costs to provide therapy services to our patients.
The Budget Control Act of 2011 (“BCA”), enacted on August 2, 2011, increased the United States debt ceiling and linked the debt ceiling increase to corresponding deficit reductions through 2021. The BCA also established a 12 member joint committee of Congress known as the Joint Select Committee on Deficit Reduction (“Super Committee”). The Super Committee’s objective was to create proposed legislation to reduce the United States federal budget deficit by $1.5 trillion for fiscal years 2012 through 2021. Part of the BCA required this legislation to be enacted by December 23, 2011, or approximately $1.2 trillion in spending reductions would automatically begin through sequestration on January 1, 2013, split between domestic and defense spending. As no legislation was passed that would achieve the targeted savings outlined in the BCA, payments to Medicare providers have been reduced by 2% from planned levels effective April 1, 2013. As a result of sequestration, we experienced an approximate decrease in revenue of $901,000 for the quarter ended September 30, 2013 .
In July 2013, CMS issued Medicare payment rates, effective October 1, 2013, that increased reimbursement to skilled nursing centers by approximately 0.6% compared to the fiscal year ending September 30, 2013. The increase is the net effect of a 2.5% inflation increase as measured by the SNF market basket, offset by a 0.7% negative productivity adjustment required by the Affordable Care Act, and a 1.2% budget neutrality adjustment. This adjustment if further offset by the ongoing sequestration from the BCA as mentioned above. The 2% sequestration is not applied to the payment rate, but rather it is applied to Medicare claims after determining coinsurance, any applicable deductibles, and any applicable Medicare secondary payment adjustments.
Therapy Services . There are annual Medicare Part B reimbursement limits on therapy services that can be provided to an individual. The limits impose a $1,900 per patient annual ceiling on physical and speech therapy services, and a separate $1,900 per patient annual ceiling on occupational therapy services. CMS established an exception process to permit therapy services in certain situations and we provide services that are reimbursed under the exceptions process. The exceptions process has been extended several times, most recently by the American Taxpayer Relief Act of 2012, which extended this exception process through December 31, 2013.
Related to the exceptions process discussed above, for services provided with dates of service between January 1, 2013, through March 31, 2013, providers were required to submit a request for an exception for therapy services above the threshold of $3,700 which will then be manually medically reviewed. Similar to the therapy cap exceptions process, the threshold process will have a $3,700 per patient threshold on physical and speech therapy services, and a separate $3,700 per patient threshold on occupational therapy services. The exception reviews were conducted by Medicare Administrative Contractors during this period. Effective April 1, 2013, Recovery Auditors began conducting prepayment and postpayment reviews of claims dated April 1, 2013 and later.
It is unknown if any further extension of the therapy cap exceptions or the new threshold process will be included in future legislation or CMS policy decisions. If the exception process is discontinued or if the manual review process for therapy in excess of $3,700 negatively impacts our Medicare Part B reimbursement, we would likely see a reduction in our therapy revenues which would negatively impact our operating results and cash flows.
On November 2, 2010, CMS released a final proposed rule as part of the Medicare Physician Fee Schedule (“MPFS”) that was effective January 1, 2011. The policy impacts the reimbursement we receive for Medicare Part B therapy services in our facilities. The policy provides that Medicare Part B pay the full rate for the therapy unit of service that has the highest Practice Expense ("PE") component for each patient on each day they receive multiple therapy treatments. Reimbursement for the second and subsequent therapy units for each patient each day they receive multiple therapy treatments is reimbursed at a rate equal to 75% of the applicable PE component through March 31, 2013. Effective April 1, 2013, the rate at which these services are reimbursed was reduced to 50% of the applicable PE component.
Medicare Part B therapy services in our centers are determined according to MPFS. Annually since 1997, the MPFS has been subject to a Sustainable Growth Rate Adjustment (“SGR”) intended to keep spending growth in line with allowable spending. Each year since the SGR was enacted, this adjustment produced a scheduled negative update to payment for physicians, therapists and other healthcare providers paid under the MPFS. Congress has stepped in with so-called “doc fix” legislation numerous times to stop payment cuts to physicians, most recently by the Middle Class Tax Relief and Job Creation Act of 2012, which stopped these payment cuts through December 31, 2012. Effective April 1, 2013, MPFS included a reduction of

23


Medicare Part B therapy services reimbursements of 7%. This reduction in reimbursements has resulted in a reduction in revenue of $478,000 for the three-month period ended September 30, 2013 .
The Middle Class Tax Relief and Job Creation Act of 2012 also resulted in a reduction of bad debt treated as an allowable cost. Prior to this act, Medicare reimbursed providers for beneficiaries’ unpaid coinsurance and deductible amounts after reasonable collection efforts at a rate between 70 and 100 percent of beneficiary bad debt. This provision reduced bad debt reimbursement exposure for all providers to 65 percent.
Medicaid
Several states in which we operate face budget shortfalls, which could result in reductions in Medicaid funding for nursing centers. The federal government made an effort to address the financial challenges state Medicaid programs are facing by increasing the amount of Medicaid funding available to states. Pressures on state budgets are expected to continue in the future and are expected to result in Medicaid rate reductions.
We receive the majority of our annual Medicaid rate increases during the third quarter of each year. The rate changes received in the third quarter of 2012 and the third quarter of 2011, along with increased Medicaid acuity in our acuity based states, was the primary contributor to our 3.0% increase in average rate per day for Medicaid patients in 2013 compared to 2012 . Based on the rate changes received during the third quarter of 2013, we expect downward pressure on our rate per day for Medicaid patients as we move into 2014 due to modest rate decreases in many of the states within which we operate.
We are unable to predict what, if any, reform proposals or reimbursement limitations will be implemented in the future, or the effect such changes would have on our operations. For the nine months ended September 30, 2013 , we derived 27.5% and 54.1% of our total patient revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on our profitability.
We will attempt to increase revenues from non-governmental sources to the extent capital is available to do so. However, private payors, including Managed Care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.
Licensure and Other Health Care Laws
All of our nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing centers are subject to CON laws, which require us to obtain government approval for the construction of new nursing centers or the addition of new licensed beds to existing centers. Our nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, patient rights, and the physical condition of the center and the adequacy of the equipment used therein. Each center is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the center is subject to various sanctions, including, but not limited to, monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a center receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, we will be able to maintain such licenses and certifications for our facilities or that we will not be required to expend significant sums in order to comply with regulatory requirements.

Contractual Obligations and Commercial Commitments
We have certain contractual obligations of continuing operations as of September 30, 2013 , summarized by the period in which payment is due, as follows (dollar amounts in thousands):

24


Contractual Obligations
Total
 
Less than
1  year
 
1 to 3
Years
 
3 to 5
Years
 
After
5 Years
Long-term debt obligations (1)
$
65,314

 
$
5,269

 
$
13,757

 
$
46,288

 
$
—

Settlement obligations (2)
5,583

 
5,583

 
—

 
—

 
—

Series C Preferred Stock (3)
4,918

 
4,918

 
—

 
—

 
—

Elimination of Preferred Stock Conversion feature (4)
3,435

 
687

 
1,374

 
1,374

 
—

Operating leases (5)
517,424

 
22,523

 
46,796

 
49,394

 
398,711

Required capital expenditures under operating leases (6)
7,519

 
249

 
498

 
498

 
6,274

Total
$
604,193

 
$
39,229

 
$
62,425

 
$
97,554

 
$
404,985

 
(1)
Long-term debt obligations include scheduled future payments of principal and interest of long-term debt and amounts outstanding on our capital lease obligations.
(2)
Settlement obligations relate to professional liability cases that are expected to be paid within the next twelve months. The professional liabilities are included in our current portion of self-insurance reserves.
(3)
Series C Preferred Stock equals the redemption value at the preferred shareholder’s earliest redemption date.
(4)
Payments to Omega Health Investors ("Omega"), from which we lease 25 nursing centers, for the elimination of the preferred stock conversion feature in connection with restructuring the preferred stock and master lease agreements. Monthly payments of approximately $57,000 will be made through the end of the initial lease period that ends in September 2018.
(5)
Represents lease payments under our operating lease agreements. Assumes all renewal periods are enacted.
(6)
Includes annual expenditure requirements under operating leases.
We have employment agreements with certain members of management that provide for the payment to these members of amounts up to two times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1,260,000 as of September 30, 2013 . The terms of such agreements are for one year and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, those certain members of management may elect to require that we purchase equity awards granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated equity award exercise price. Based on the closing price of our common stock on September 30, 2013 , there is no contingent liability for the repurchase of the equity grants. No amounts have been accrued for these contingent liabilities.

Results of Operations
The results of operations presented have been reclassified to present the effects of certain divestitures discussed in the overview to "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The following tables present the unaudited interim statements of operations and related data for the three and nine month periods ended September 30, 2013 and 2012 :
 

25


(in thousands)
Three Months Ended
September 30,
 
2013
 
2012
 
Change
 
%
PATIENT REVENUES, net
$
70,353

 
$
61,824

 
$
8,529

 
13.8
 %
EXPENSES:
 
 
 
 
 
 
 
Operating
57,694

 
48,768

 
8,926

 
18.3
 %
Lease and rent expense
5,250

 
4,711

 
539

 
11.4
 %
Professional liability
1,382

 
1,348

 
34

 
2.5
 %
General and administrative
6,092

 
5,651

 
441

 
7.8
 %
Depreciation and amortization
1,784

 
1,578

 
206

 
13.1
 %
Restructuring
944

 
—

 
944

 
100.0
 %
Total expenses
73,146

 
62,056

 
11,090

 
17.9
 %
OPERATING INCOME (LOSS)
(2,793
)
 
(232
)
 
(2,561
)
 
1,103.9
 %
OTHER INCOME (EXPENSE):
 
 
 
 
 
 
 
Equity in net income (loss) of unconsolidated affiliate
63

 
(95
)
 
158

 
(166.3
)%
Interest expense, net
(1,002
)
 
(696
)
 
(306
)
 
44.0
 %
Debt retirement costs
—

 
—

 
—

 
—
 %
 
(939
)
 
(791
)
 
(148
)
 
18.7
 %
LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(3,732
)
 
(1,023
)
 
(2,709
)
 
264.8
 %
BENEFIT FOR INCOME TAXES
1,388

 
525

 
863

 
164.4
 %
LOSS FROM CONTINUING OPERATIONS
$
(2,344
)
 
$
(498
)
 
$
(1,846
)
 
370.7
 %
 
(in thousands)
Nine Months Ended
September 30,
 
2013
 
2012
 
Change
 
%
PATIENT REVENUES, net
$
200,502

 
$
182,798

 
$
17,704

 
9.7
%
EXPENSES:
 
 
 
 
 
 
 
Operating
160,770

 
145,100

 
15,670

 
10.8
%
Lease and rent expense
15,343

 
14,035

 
1,308

 
9.3
%
Professional liability
5,682

 
3,603

 
2,079

 
57.7
%
General and administrative
18,579

 
17,698

 
881

 
5.0
%
Depreciation and amortization
5,014

 
4,716

 
298

 
6.3
%
Restructuring
944

 
—

 
944

 
100.0
%
Total expenses
206,332

 
185,152

 
21,180

 
11.4
%
OPERATING LOSS
(5,830
)
 
(2,354
)
 
(3,476
)
 
147.7
%
OTHER INCOME (EXPENSE):
 
 
 
 
 
 
 
Equity in net losses of unconsolidated affiliate
(152
)
 
(127
)
 
(25
)
 
19.7
%
Interest expense, net
(2,582
)
 
(2,099
)
 
(483
)
 
23.0
%
Debt retirement costs
(320
)
 
—

 
(320
)
 
100.0
%
 
(3,054
)
 
(2,226
)
 
(828
)
 
37.2
%
LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(8,884
)
 
(4,580
)
 
(4,304
)
 
94.0
%
BENEFIT FOR INCOME TAXES
3,548

 
1,778

 
1,770

 
99.6
%
LOSS FROM CONTINUING OPERATIONS
$
(5,336
)
 
$
(2,802
)
 
$
(2,534
)
 
90.4
%


26


Percentage of Net Revenues
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
PATIENT REVENUES, net
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
EXPENSES:
 
 
 
 
 
 
 
Operating
82.0

 
78.9

 
80.2

 
79.4

Lease and rent expense
7.5

 
7.6

 
7.7

 
7.7

Professional liability
2.0

 
2.2

 
2.8

 
2.0

General and administrative
8.7

 
9.1

 
9.3

 
9.7

Depreciation and amortization
2.5

 
2.6

 
2.5

 
2.6

Restructuring
1.3

 
—

 
0.5

 
—

Total expenses
104.0

 
100.4

 
103.0

 
101.4

OPERATING INCOME (LOSS)
(4.0
)
 
(0.4
)
 
(3.0
)
 
(1.4
)
OTHER INCOME (EXPENSE):
 
 
 
 
 
 
 
Equity in net losses of unconsolidated affiliate
0.1

 
(0.2
)
 
(0.1
)
 
(0.1
)
Interest expense, net
(1.4
)
 
(1.1
)
 
(1.3
)
 
(1.1
)
Debt retirement costs
—

 
—

 
(0.2
)
 
—

 
(1.3
)
 
(1.3
)
 
(1.6
)
 
(1.2
)
LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(5.3
)
 
(1.7
)
 
(4.6
)
 
(2.6
)
BENEFIT FOR INCOME TAXES
2.0

 
0.8

 
1.8

 
1.0

LOSS FROM CONTINUING OPERATIONS
(3.3
)%
 
(0.9
)%
 
(2.8
)%
 
(1.6
)%

27


Three Months Ended September 30, 2013 Compared With Three Months Ended September 30, 2012
Patient Revenues
Patient revenues were $70.4 million  in 2013 and $61.8 million in 2012 . The increase is primarily attributable to the contribution of newly leased and newly acquired centers. The recently acquired Kansas centers contributed $5.8 million in revenues during the quarter. The newly leased 107 -bed skilled nursing center in Louisville, Kentucky contributed $1.3 million in additional revenues during the third quarter of 2013 , subsequent to assuming operations of this center effective August 1, 2013.
In addition to our nursing center operations acquired in the current year, certain centers that were acquired in 2012 , also contributed increased revenues in third quarter of 2013 as compared to the same quarter in 2012 . Our 90 -bed West Virginia nursing center has contributed $1.3 million in additional revenue as it continues to develop its total census and Medicare and Managed Care census. Additionally, the leased 88 -bed nursing center in Clinton, Kentucky, generated additional revenues of $0.8 million , and the leased 154 -bed skilled nursing center in Louisville, Kentucky, contributed $2.4 million in additional revenues for the three months ended September 30, 2013 as compared to the same period in 2012 .
The following table summarizes key revenue and census statistics for continuing operations for each period:
 
 
Three Months Ended
September 30,
 
 
 
2013
 
 
 
2012
 
 
Skilled nursing occupancy
76.6
%
 
(1)  
 
78.1
%
 
(1)  
As a percent of total census:
 
 
 
 
 
 
 
Medicare census
11.0
%
 
 
 
12.8
%
 
 
Managed Care census
2.9
%
 
 
 
2.4
%
 
 
As a percent of total revenues:
 
 
 
 
 
 
 
Medicare revenues
26.3
%
 
 
 
29.7
%
 
 
Medicaid revenues
55.3
%
 
 
 
53.4
%
 
 
Managed Care revenues
5.6
%
 
 
 
5.0
%
 
 
Average rate per day:
 
 
 
 
 
 
 
Medicare
$
430.73

 
  
 
$
425.09

 
 
Medicaid
$
162.08

 
  
 
$
157.44

 
 
Managed Care
$
379.92

 
  
 
$
379.85

 
 
 
(1)
Skilled nursing occupancy excludes our recently leased Clinton, Kentucky nursing center, recently leased Louisville, Kentucky nursing center, and recently acquired Kansas nursing centers.

The increase in revenues from the newly leased or acquired facilities was partially offset by an overall decrease in census at our same-store nursing centers of $0.9 million . The overall decrease in same-store census is primarily driven by a decrease in Medicare census which resulted in decreased revenue of $2.5 million in same-store nursing centers. The decrease in Medicare census was partially offset by an increase in both Medicaid and Managed Care census during the period. Medicaid census increased in 2013 resulting in increased revenue of $0.9 million compared to 2012 . Managed Care average daily census at our same-store nursing centers increased 26.5% during 2013 resulting in an additional $0.7 million in revenue.

The average Medicaid rate per patient day at same-store nursing centers for 2013 increased 3.1% compared to 2012 , resulting in an increase in revenue of $1.0 million . This average rate per day for Medicaid patients is the result of rate increases in certain states and increasing patient acuity levels. The average Medicare rate per patient day for 2013 increased 0.5% compared to 2012 , resulting in an increase in revenue of $0.3 million .
Operating Expense
Operating expense increased in the third quarter of 2013 to $57.7 million as compared to $48.8 million in the third quarter of 2012 , driven primarily by the $9.3 million increase in operating costs attributable to the recently added nursing centers. Operating expense increased as a percentage of revenue at 82.0% for the third quarter of 2013 as compared to 78.9% for the third quarter of 2012 .
The largest component of operating expenses is wages. Considering the aforementioned addition of the new centers, we experienced an increase to $33.2 million in the third quarter of 2013 as compared to $30.1 million in the third quarter of 2012 ,

28


an increase of $3.1 million , or 10.1% . While wages increased overall, wages as a percentage of revenue decreased in the third quarter of 2013 to 47.2% as compared to 48.8% in the third quarter of 2012 , a decrease of 1.6% .
In addition to the factors above, operating expense was also impacted by an increase in provider taxes of $0.4 million in the third quarter of 2013 as compared to the corresponding period in the prior year, primarily as a result of taxes for new centers.
Lease Expense
Lease expense increased in the third quarter of 2013 to $5.3 million as compared to $4.7 million in the third quarter of 2012 . The increase in lease expense was primarily attributable to $0.4 million in combined lease expense for the two newly leased nursing centers in Louisville, Kentucky, and the leased nursing center in Clinton, Kentucky. The remaining increase is attributable to annual rent increases on existing lease agreements.
Professional Liability
Professional liability expense was $1.4 million in the third quarter of 2013 compared to $1.3 million in the third quarter of 2012 , an increase of $0.1 million. We were engaged in 53 professional liability lawsuits as of September 30, 2013 , compared to 49 as of December 31, 2012 . Our quarterly cash expenditures for professional liability costs of continuing operations were $1.3 million and $0.2 million for 2013 and 2012 , respectively. Professional liability expense and cash expenditures fluctuate from year to year based respectively on the results of our third-party professional liability actuarial studies and on the costs incurred in defending and settling existing claims. See “Liquidity and Capital Resources” for further discussion of the accrual for professional liability.

General and Administrative Expense
General and administrative expense was $6.1 million in the third quarter of 2013 as compared to $5.7 million in the third quarter of 2012 , an increase of $ 0.4 million . The increase in general and administrative expense is primarily attributable to an increase in salaries and related taxes, primarily as a result of wage increases, of $0.5 million in the third quarter of 2013 .
Depreciation and Amortization
Depreciation and amortization expense was approximately $1.8 million in the third quarter of 2013 as compared to $1.6 million in 2012 . The increase in depreciation expense relates to fixed assets at the newly leased and acquired centers.
Restructuring
We incurred certain charges in connection with the termination of our existing lease for 11 Arkansas nursing centers, including severance of $0.2 million, transition bonuses, and legal expenses. These expenses were classified as restructuring expenses on the interim consolidated statement of operations for the three-month period ended September 30, 2013 . As these expenses related to the transaction which occurred in 2013 , the $0.9 million in restructuring expense represents an increase from the same period in 2012 .
Interest Expense, Net
Interest expense was $1.0 million in the third quarter of 2013 and $0.7 million in the third quarter of 2012 , an increase of $0.3 million . The increase was primarily attributable to slightly higher debt balances in 2013 as a result of the amended Mortgage Loan, which increased the balance of outstanding debt as a result of the acquisition of the Kansas centers.
Loss from Continuing Operations before Income Taxes; Loss from Continuing Operations per Common Share
As a result of the above, continuing operations reported a loss before income taxes of $3.7 million for the third quarter of 2013 as compared to a loss of $1.0 million for the third quarter of 2012 . The benefit for income taxes was $1.4 million in the third quarter of 2013 as compared to $0.5 million in the third quarter of 2012 . The basic and diluted loss per common share from continuing operations were both $0.42 for the third quarter of 2013 as compared to $0.10 in the third quarter of 2012 .
Nine Months Ended September 30, 2013 Compared With Nine Months Ended September 30, 2012
Patient Revenues
Patient revenues were $200.5 million and $182.8 million in the nine-month periods ended September 30, 2013 and 2012 , respectively. The increase is primarily attributable to the contribution of newly leased and newly acquired centers. The recently acquired Kansas centers contributed $9.7 million in revenues during the period. The newly-leased 107 -bed skilled

29


nursing center in Louisville, Kentucky contributed $1.3 million in additional revenues during 2013 , subsequent to assuming operations of this center effective August 1, 2013.
In addition to our nursing center operations acquired in the current year, certain centers that were acquired in 2012 also contributed increased revenues in the nine-month period ended September 30, 2013 as compared to the same period in 2012 . Our 90 -bed West Virginia nursing center has contributed $4.8 million in additional revenue as it continues to develop its total census and Medicare and Managed Care census. Additionally, the leased 88 -bed nursing center in Clinton, Kentucky, generated additional revenues of $1.9 million , and the leased 154 -bed skilled nursing center in Louisville, Kentucky, contributed $7.2 million in additional revenues for 2013 as compared to 2012 .
The following table summarizes key revenue and census statistics for continuing operations for each period:
 
 
Nine Months Ended
September 30,
 
 
 
2013
 
 
 
2012
 
 
Skilled nursing occupancy
76.7
%
 
(1)  
 
77.9
%
 
(1)  
As a percent of total census:
 
 
 
 
 
 
 
Medicare census
11.7
%
 
 
 
13.0
%
 
 
Managed Care census
3.0
%
 
 
 
2.4
%
 
 
As a percent of total revenues:
 
 
 
 
 
 
 
Medicare revenues
27.5
%
 
 
 
30.7
%
 
 
Medicaid revenues
54.1
%
 
 
 
52.6
%
 
 
Managed Care revenues
6.0
%
 
 
 
5.0
%
 
 
Average rate per day:
 
 
 
 
 
 
 
Medicare
$
430.28

 
  
 
$
426.63

 
 
Medicaid
$
161.25

 
  
 
$
156.62

 
 
Managed Care
$
382.90

 
  
 
$
383.88

 
 
 
(1)
Skilled nursing occupancy excludes our recently leased Clinton, Kentucky nursing center, recently leased Louisville, Kentucky nursing center, and recently acquired Kansas nursing centers.

In addition to the increase in revenues from the newly leased or acquired facilities, there was also an increase in same-store revenues as a result of favorable rate increases in 2013 . The average Medicaid rate per patient day at same-store nursing centers for 2013 increased 3.0% compared to 2012 , resulting in an increase in same-store revenue of $3.0 million . This average rate per day for Medicaid patients is the result of rate increases in certain states and increasing patient acuity levels. The average Medicare rate per patient day for 2013 increased 1.4% compared to 2012 , resulting in an increase in revenue of $0.6 million .

The increase in same-store revenues as a result of rates was offset by a decrease of $0.2 million in revenues at our same-store nursing centers as a result of census. The decrease in same-store census was primarily driven by a decrease in Medicare census for 2013 , which resulted in a reduction of $5.1 million in same-center revenues. The decrease in Medicare census was partially offset by an increase in both Medicaid and Managed Care census during the period. The Medicaid census for 2013 increased $2.4 million compared to 2012 . Managed Care average daily census at our same-store nursing centers increased 30.1% during 2013 for a $2.5 million increase in revenue.
Operating Expense
Operating expense increased in 2013 to $160.8 million as compared to $145.1 million in 2012 , driven primarily by the $19.1 million increase in operating costs attributable to the recently added nursing centers. Operating expense increased slightly to 80.2% of revenue in 2013 , compared to 79.4% of revenue in 2012 .
The largest component of operating expenses is wages. Considering the aforementioned addition of the new centers, we experienced an increase to $94.4 million in 2013 as compared to $90.1 million in 2012 , an increase of $4.4 million , or 4.8% . While wages increased overall, wages as a percentage of revenue decreased in 2013 to 47.1% as compared to 49.3% in 2012 , a decrease of 2.2% .
Lease Expense
Lease expense increased in 2013 to $15.3 million as compared to $14.0 million in 2012 . The increase in lease expense was primarily attributable to $1.0 million in combined lease expense for the two newly leased nursing centers in Louisville,

30


Kentucky, and the leased nursing center in Clinton, Kentucky. The remaining increase is attributable to annual rent increases on existing lease agreements.
Professional Liability
Professional liability expense was $5.7 million in 2013 compared to $3.6 million in 2012 , an increase of $2.1 million. We were engaged in 53 professional liability lawsuits as of September 30, 2013 , compared to 49 as of December 31, 2012 . Our cash expenditures for professional liability costs of continuing operations were $3.5 million and $1.6 million for the nine-month periods ended September 30, 2013 and 2012 , respectively. Professional liability expense and cash expenditures fluctuate from year-to-year based respectively on the results of our third-party professional liability actuarial studies and on the costs incurred in defending and settling existing claims. See “Liquidity and Capital Resources” for further discussion of the accrual for professional liability.

General and Administrative Expense
General and administrative expense was approximately $18.6 million in 2013 as compared to $17.7 million in 2012 , an increase of $ 0.9 million . The overall increase is primarily attributable to an increase in share-based compensation expense of $0.4 million and acquisition-related costs of $0.2 million in 2013 as compared to the same period in 2012 .
Depreciation and Amortization
Depreciation and amortization expense was approximately $5.0 million in 2013 and $4.7 million in 2012 , an increase of $0.3 million. The depreciation expense associated with the fixed assets at the newly leased and acquired centers were offset by assets at a leased center in Tennessee which became fully depreciated during 2012 .
Restructuring
We incurred certain charges in connection with the termination of our existing lease for 11 Arkansas nursing centers, including severance of $0.2 million, transition bonuses, and legal expenses. These expenses were classified as restructuring expenses on the interim consolidated statement of operations for the nine-month period ended September 30, 2013 . As these expenses related to the transaction which occurred in 2013 , the $0.9 million in restructuring expense represents an increase from the same period in 2012 .
Interest Expense, Net
Interest expense was $2.6 million in 2013 and $2.1 million in 2012 , an increase of $0.5 million . The increase was primarily attributable to slightly higher debt balances in 2013 as a result of the amended Mortgage Loan which increased the balance of outstanding debt as a result of the acquisition of the Kansas centers.
Loss from Continuing Operations before Income Taxes; Loss from Continuing Operations per Common Share
As a result of the above, continuing operations reported loss before income taxes of $8.9 million in 2013 and $4.6 million in 2012 . The benefit for income taxes was $3.5 million in 2013 as compared to $1.8 million in 2012 . The increase in the benefit for income taxes is primarily attributable to the increased loss from continuing operations, but also the recognition of the Work Opportunity Tax Credit ("WOTC") of $0.5 million in 2013 . The basic and diluted loss per common share from continuing operations were both $1.39 in 2013 as compared to $0.37 in 2012 .

Liquidity and Capital Resources
Liquidity
Our primary source of liquidity is the net cash flow provided by the operating activities of our centers. We believe that these internally generated cash flows will be adequate to service existing debt obligations, fund required capital expenditures as well as provide cash flows for investing opportunities. In determining priorities for our cash flow, we evaluate alternatives available to us and select the ones that we believe will most benefit us over the long-term. Options for our cash include, but are not limited to, capital improvements, dividends, purchase of additional shares of our common stock, acquisitions, payment of existing debt obligations, preferred stock redemptions as well as initiatives to improve nursing center performance. We review these potential uses and align them to our cash flows with a goal of achieving long-term success.
Net cash used by operating activities of continuing operations totaled $4.0 million in the nine months ended September 30, 2013 , as compared to $1.1 million in the same period of 2012 .

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Our cash expenditures related to professional liability claims of continuing operations were $3.5 million and $1.6 million for each year of 2013 and 2012 , respectively. Although we work diligently to limit the cash required to settle and defend professional liability claims, a significant judgment entered against us in one or more legal actions could have a material adverse impact on our cash flows and could result in our being unable to meet all of our cash needs as they become due.
Investing activities of continuing operations used cash of $22.8 million and $0.1 million in 2013 and 2012 , respectively. The increase is primarily attributable to the $14.7 million purchase price paid for the acquisition of the five Kansas centers. The increase is also attributable to the $4.1 million change in restricted cash used to fund capital improvements at the owned nursing centers that secure the mortgage loan. We also used $4.0 million in cash for capital expenditures at existing centers.
Financing activities of continuing operations provided cash of $18.8 million in 2013 as compared to cash used of $1.9 million in 2012 primarily due to the restructuring of our credit facility during the second quarter of 2013. As part of the amendment to the mortgage loan portion of the credit facility, we received cash of $50.5 million and made a repayment of the existing debt obligation of $28.9 million for a net increase of $22.1 million. The net cash provided from this transaction was further reduced by $1.3 million for financing costs in relation to the acquisition of the Kansas centers. The net cash received from the restructuring of the credit facility was further offset by payment of common stock dividends of $0.6 million and preferred stock dividends of $0.3 million .

Dividends
On November 6, 2013 , the Board of Directors declared a quarterly dividend of $0.055 per common share payable to shareholders of record as of December 31, 2013 , to be paid on January 13, 2014. While the Board of Directors intends to pay quarterly dividends, the Board will make the determination of the amount of future cash dividends, if any, to be declared and paid based on, among other things, the Company’s financial condition, funds from operations, the level of its capital expenditures and its future business prospects and opportunities.
Redeemable Preferred Stock
At September 30, 2013 , we have outstanding 5,000 shares of Series C Redeemable Preferred Stock (“Preferred Stock”) that has a stated value of approximately $4.9 million which pays an annual dividend rate of 7% of its stated value. Dividends on the Preferred Stock are paid quarterly in cash. The Preferred Stock was issued to Omega in 2006 and is not convertible, but has been redeemable at its stated value at Omega’s option since September 30, 2010, and since September 30, 2007, has been redeemable at its stated value at our option. Redemption under our option or Omega’s is subject to certain limitations. We believe we have adequate resources to redeem the Preferred Stock if Omega were to elect to redeem it.
Professional Liability
The Company has professional liability insurance coverage for its nursing centers that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. Effective July 1, 2013, the Company established a wholly-owned, offshore limited purpose insurance subsidiary, SHC Risk Carriers, Inc. (“SHC”), to replace some of the expiring commercial policies. SHC covers losses up to specified limits per occurrence. On a per claim basis, coverage for losses in excess of those covered by SHC are maintained through unaffiliated commercial reinsurance carriers. All of the Company's nursing centers in Florida, Ohio, Tennessee, and West Virginia are now covered under the captive insurance policies along with most of the nursing centers in Alabama, Kentucky, and Texas. The insurance coverage provided for these centers under the SHC policy include coverage limits of $500,000 per medical incident with a sublimit per center of $1,000,000 and total annual aggregate policy limits of $5,000,000 . All other centers within the Company’s portfolio are covered through various commercial insurance policies which provide similar coverage limits per medical incident, per location, and on an aggregate basis for covered centers. 
As of September 30, 2013 , we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred, but unreported claims of $28.1 million . Our calculation of this estimated liability is based on an assumption that the Company will not incur a severely adverse judgment with respect to any asserted claim; however, a significant judgment could be entered against us in one or more of these legal actions, and such a judgment could have a material adverse impact on our financial position and cash flows.

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Capital Resources
As of September 30, 2013 , we had $51.1 million of outstanding long-term debt and capital lease obligations. The $51.1 million total includes $0.9 million in capital lease obligations and $5.5 million in a note payable for the nursing center that was recently constructed in West Virginia. The balance of the long-term debt is comprised of $44.7 million owed on our mortgage loan.
On May 1, 2013, the Company executed an Amended and Restated Credit Agreement (the "Credit Agreement") which modified the terms of the Original Mortgage Loan and the Original Revolver Agreements dated February 28, 2011. The Credit Agreement increases the Company's borrowing capacity to $65,000,000 allocated between a $45,000,000 Mortgage Loan ("Amended Mortgage Loan") and a $20,000,000 Revolver ("Amended Revolver"). Loan acquisition costs associated with the Amended Mortgage Loan and the Amended Revolver were capitalized in the amount of $1,341,000 and are being amortized over the five-year term of the agreements. Loan acquisition costs of $320,000 associated with the Original Mortgage Loan were written off in conjunction with this restructuring and are recorded in Debt Retirement Costs in the Interim Consolidated Statement of Operations for the nine-month period ended September 30, 2013 .
Under the terms of the amended agreements, the syndicate of banks provided the Amended Mortgage Loan with an original balance of $45,000,000 with a five -year maturity through April 30, 2018, and a $20,000,000 Amended Revolver through April 30, 2018. The Amended Mortgage Loan has a term of five years, with principal and interest payable monthly based on a 25 -year amortization. Interest is based on LIBOR plus 4.5% , which was 4.68% at September 30, 2013 , but a portion of the outstanding principal balance under the Amended Mortgage Loan is effectively fixed at 6.87% as a result of the interest rate swap described below. The Amended Mortgage Loan is secured by thirteen owned nursing centers, related equipment and a lien on the accounts receivable of these centers. The Amended Mortgage Loan and the Amended Revolver are cross-collateralized. The Company’s Amended Revolver has an interest rate of LIBOR plus 4.5% .
The Amended Revolver is secured by accounts receivable and is subject to limits on the maximum amount of loans that can be outstanding under the Amended Revolver based on borrowing base restrictions. As of September 30, 2013 , we had no borrowings outstanding under the Amended Revolver. Annual fees for letters of credit issued under the Amended Revolver are 3.0% of the amount outstanding. We have two letters of credit that reduce our borrowing capacity under the Amended Revolver. The first letter of credit in the amount of $4.6 million serves as a security deposit for our Omega lease. The second letter of credit serves our initial funding of insurance policies with a captive insurance company for which coverage begins in July 2013 in the amount of $1.0 million . Considering the balance of eligible accounts receivable at September 30, 2013 , the letters of credit, the amounts outstanding under the Amended Revolver and the maximum loan amount of $20.0 million , the balance available for borrowing under the Amended Revolver is $14.4 million . Eligible accounts receivable are calculated as defined and consider 80% of certain net receivables while excluding receivables from private pay patients, those pending approval by Medicaid and receivables greater than 90 days.
Our lending agreements contain various financial covenants, the most restrictive of which relate to minimum cash deposits, cash flow and debt service coverage ratios. We are in compliance with all such covenants at September 30, 2013 .
Our calculated compliance with financial covenants is presented below:
 
 
Requirement
  
Level at
September 30, 2013
Minimum fixed charge coverage ratio
1.10:1.00
 
1.11:1.00
Minimum adjusted EBITDA
$5.00 million
 
$5.84 million
EBITDAR (mortgaged centers)
$2.55 million
 
$2.82 million
The consolidated balance sheet as of September 30, 2013 includes $5.5 million in debt that is owed by the variable interest entity that owns one of our West Virginia nursing centers. The borrower is subject to covenants concerning total liabilities to tangible net worth as well as current assets compared to current liabilities. The borrower is in compliance with all such covenants at December 31, 2012 . The borrower’s liabilities do not provide creditors with recourse to our general assets.
As part of the debt agreements entered into in March 2011, we entered into an interest rate swap agreement with a member of the bank syndicate as the counterparty. The interest rate swap agreement has the same effective date and maturity date as the Amended Mortgage Loan, and carries a notional equivalent to half of the outstanding principal on the Amended Mortgage Loan. The interest rate swap agreement requires us to make fixed rate payments to the bank calculated on the applicable notional amount at an annual fixed rate of 6.87% while the bank is obligated to make payments to us based on LIBOR on the same notional amounts. We entered into the interest rate swap agreement to mitigate the variable interest rate risk on our outstanding mortgage borrowings.

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Nursing Center Renovations
During 2005, we began an initiative to complete strategic renovations of certain centers to improve occupancy, quality of care and profitability. We developed a plan to begin with those centers with the greatest potential for benefit, and began the renovation program during the third quarter of 2005. As of September 30, 2013 , we have completed renovations at 17 centers, 11 of which are within our continuing operations as a result of our Arkansas divestiture. We are currently implementing plans for renovation projects at two of our Texas centers.
A total of $28.1 million has been spent on these renovation programs to date, with $21.4 million financed through Omega, $6.0 million financed with internally generated cash, and $0.7 million financed with long-term debt.
Receivables
Our operations could be adversely affected if we experience significant delays in reimbursement from Medicare, Medicaid or other third-party revenue sources. Our future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on our liquidity. Continued efforts by governmental and third-party payors to contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by us in the processing of our invoices, could adversely affect our liquidity and results of operations.
Accounts receivable attributable to patient services of continuing operations totaled $31.4 million at September 30, 2013 compared to $27.8 million at December 31, 2012 , representing approximately 38 days and 39 days revenue in accounts receivable, respectively. The increase in accounts receivable is due to increases in payor sources with longer payment cycles, including Managed Care payors, as well as an increase in Medicaid patients undergoing the initial qualification process.
Our accounts receivable included approximately $4.7 million and $2.4 million at September 30, 2013 and December 31, 2012 , respectively of unbilled accounts, primarily attributable to newly acquired facilities.  During the change of ownership process, we were required to hold these accounts while waiting for final Medicare and Medicaid approvals.
The allowance for bad debt was $3.7 million at September 30, 2013 as compared to $3.1 million at December 31, 2012 . We continually evaluate the adequacy of our bad debt reserves based on patient mix trends, aging of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. We continue to evaluate and implement additional procedures to strengthen our collection efforts and reduce the incidence of uncollectible accounts.
Off-Balance Sheet Arrangements
We have two letters of credit outstanding with an aggregate value of approximately $5.6 million as of September 30, 2013 , the first of which serves as a security deposit for our facility lease with Omega in the amount of $4.6 million . The second letter of credit serves our initial funding of insurance policies with a captive insurance company in the amount of $1.0 million . These letters of credit were issued under our revolving credit facility. Our accounts receivable serve as the collateral for this revolving credit facility.

Forward-Looking Statements
The foregoing discussion and analysis provides information deemed by management to be relevant to an assessment and understanding of our consolidated results of operations and financial condition. This discussion and analysis should be read in conjunction with our consolidated financial statements included herein. Certain statements made by or on behalf of us, including those contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those contemplated by the forward-looking statements made herein. In addition to any assumptions and other factors referred to specifically in connection with such statements, other factors, many of which are beyond our ability to control or predict, could cause our actual results to differ materially from the results expressed or implied in any forward-looking statements including, but not limited to, our ability to successfully operate the new nursing centers in Kansas, West Virginia, Kentucky, Ohio, and Indiana, our ability to increase census at our renovated centers, changes in governmental reimbursement, including the impact of the CMS final rule that has resulted in a reduction in Medicare reimbursement as of October 2012 and our ability to mitigate the impact of the revenue reduction, government regulation, the impact of the recently adopted federal health care reform or any future health care reform, any increases in the cost of borrowing under our credit agreements, our ability to comply with covenants contained in those credit agreements, the outcome of professional liability lawsuits and claims, our ability to control ultimate professional liability costs, the accuracy of our estimate of our anticipated professional liability expense, the impact of future licensing surveys, the outcome of proceedings alleging violations of laws and regulations governing quality of care or violations of other laws and regulations applicable to

34


our business, impacts associated with the implementation of our electronic medical records plan, the costs of investing in our business initiatives and development, our ability to control costs, changes to our valuation of deferred tax assets, changes in occupancy rates in our centers, changing economic and competitive conditions, changes in anticipated revenue and cost growth, changes in the anticipated results of operations, the effect of changes in accounting policies as well as others. Investors also should refer to the risks identified in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as risks identified in “Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2012 , for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, we can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, caution investors not to place undue reliance on them. These assumptions may not materialize to the extent assumed, and risks and uncertainties may cause actual results to be different from anticipated results. These risks and uncertainties also may result in changes to the Company’s business plans and prospects. Such cautionary statements identify important factors that could cause our actual results to materially differ from those projected in forward-looking statements. In addition, we disclaim any intent or obligation to update these forward-looking statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The chief market risk factor affecting our financial condition and operating results is interest rate risk. As of September 30, 2013 , we had outstanding borrowings of approximately $44.7 million , $22.3 million of which was subject to variable interest rates. In connection with our May 2013 financing agreement, we entered into an interest rate swap with respect to one half of the Amended Mortgage Loan to mitigate the floating interest rate risk of such borrowing. In the event that interest rates were to change 1%, the impact on future pre-tax cash flows would be approximately $223,000 annually, representing the impact of increased or decreased interest expense on variable rate debt.

ITEM 4. CONTROLS AND PROCEDURES
Diversicare Healthcare Services, with the participation of our principal executive and financial officers has evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of September 30, 2013 . Based on this evaluation, the principal executive and financial officer have determined that such disclosure controls and procedures are effective to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
There has been no change (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal control over financial reporting that has occurred during our fiscal quarter ended September 30, 2013 , that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. Like many other companies engaged in the long-term care profession in the United States, we have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. It is expected that we will continue to be subject to such suits as a result of the nature of our business. Further, as with all health care providers, we are periodically subject to regulatory actions seeking fines and penalties for alleged violations of health care laws and are potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws and with respect to the quality of care provided to residents of our facility. Like other health care providers, in the ordinary course of our business, we are also subject to claims made by employees and other disputes and litigation arising from the conduct of our business.
As of September 30, 2013 , we are engaged in 53 professional liability lawsuits. Three lawsuits are currently scheduled for trial or arbitration during the next twelve months, and it is expected that additional cases will be set for trial or hearing. The ultimate results of any of our professional liability claims and disputes cannot be predicted with certainty. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows.
On May 16, 2012, a purported stockholder class action complaint was filed in the U.S. District Court for the Middle District of Tennessee, against the Company's Board of Directors. This action alleges that the Board of Directors breached its fiduciary duties to stockholders related to its response to certain expressions of interest in a potential strategic transaction from Covington Investments, LLC (“Covington”). The complaint asserts that the Board failed to negotiate or otherwise appropriately consider Covington's proposals. In November, 2012, the lawsuit was dismissed without prejudice for lack of subject matter jurisdiction.

35


The action was refiled in the Chancery Court for Williamson County, Tennessee (21 st Judicial District) on November 30, 2012. The lawsuit remains in its early stages and has not yet been certified by the court as a class action. We intend to defend the matter vigorously.
In June 2012, a collective action complaint was filed in the U.S. District Court for the U.S. District Court for the Western District of Arkansas against us and certain of our subsidiaries.  The complaint alleges that the defendants violated the Fair Labor Standards Act (FLSA) and seeks unpaid overtime wages as well as liquidated damages.  The Court conditionally certified a nationwide class of all of the Company's hourly employees.  The Company will defend the lawsuit vigorously.


In January 2009, a purported class action complaint was filed in the Circuit Court of Garland County, Arkansas against the Company and certain of its subsidiaries and Garland Nursing & Rehabilitation Center (the “Facility”). The complaint alleges that the defendants breached their statutory and contractual obligations to the patients of the Facility over the past five years. The lawsuit remains in its early stages and has not yet been certified by the court as a class action. The Company intends to defend the lawsuit vigorously.
We cannot currently predict with certainty the ultimate impact of any of the above cases on our financial condition, cash flows or results of operations. Our reserve for professional liability expenses does not include any amounts for the collective actions, the purported class action against the Facility or the lawsuit filed against our directors. An unfavorable outcome in any of these lawsuits or any of our professional liability actions, any regulatory action, any investigation or lawsuit alleging violations of fraud and abuse laws or of elderly abuse laws or any state or Federal False Claims Act case could subject us to fines, penalties and damages, including exclusion from the Medicare or Medicaid programs, and could have a material adverse impact on our financial condition, cash flows or results of operations.

ITEM 6. EXHIBITS
The exhibits filed as part of this report on Form 10-Q are listed in the Exhibit Index immediately following the signature page.

36


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.
 
 
 
 
 
 
Diversicare Healthcare Services, Inc.
 
 
 
November 7, 2013
 
 
 
 
 
 
 
By:
 
/s/ Kelly J. Gill
 
 
 
Kelly J. Gill
 
 
 
President and Chief Executive Officer, Principal Executive Officer and
 
 
 
An Officer Duly Authorized to Sign on Behalf of the Registrant
 
 
 
 
By:
 
/s/ James Reed McKnight, Jr.
 
 
 
James Reed McKnight, Jr.
 
 
 
Executive Vice President and Chief Financial Officer and
 
 
 
An Officer Duly Authorized to Sign on Behalf of the Registrant

37


 
 
 
Exhibit
Number
  
Description of Exhibits
3.1

  
Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement No. 33-76150 on Form S-1).
 
 
3.2

  
Certificate of Designation of Registrant (incorporated by reference to Exhibit 3.5 to the Company’s quarterly report on Form 10-Q for the quarter ended September 30, 2006).
 
 
3.3

  
Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company’s Registration Statement No. 33-76150 on Form S-1).
 
 
3.4

  
Bylaw Amendment adopted November 5, 2007 (incorporated by reference to Exhibit 3.4 to the Company’s annual report on Form 10-K for the year ended December 31, 2007).
 
 
3.5

  
Amendment to Certificate of Incorporation dated March 23, 1995 (incorporated by reference to Exhibit A of Exhibit 1 to the Company’s Form 8-A filed March 30, 1995).
 
 
3.6

  
Certificate of Designation of Registrant (incorporated by reference to Exhibit 3.4 to the Company’s quarterly report on Form 10-Q for the quarter ended March 31, 2001).
 
 
4.1

  
Form of Common Stock Certificate (incorporated by reference to Exhibit 4 to the Company’s Registration Statement No. 33-76150 on Form S-1).
 
 
4.2

  
Amended and Restated Rights Agreement dated as of December 7, 1998 (incorporated by reference to Exhibit 1 to Form 8-A/A filed December 7, 1998).
 
 
4.3

  
Amendment No. 1 to the Amended and Restated Rights Agreement, dated March 19, 2005, by and between the Company and SunTrust Bank, as Rights Agent (incorporated by reference to Exhibit 2 to Form 8-A/A filed on March 24, 2005).
 
 
4.4

  
Second Amendment to the Amended and Restated Rights Agreement, dated August 15, 2008, by and between the Company and ComputerShare Trust Company, N.A., as successor to SunTrust Bank (incorporated by reference to Exhibit 3 to Form 8-A/A filed on August 18, 2008).
 
 
4.5

  
Third Amendment to Amended and Restated Rights Agreement, dated August 14, 2009, between the Company and Computershare Trust Company, N.A, as successor to SunTrust Bank, (incorporated by reference to Exhibit 4 to the Company’s Registration Statement on Form 8-A/A filed on August 14, 2009).
 
 
10.1

 
Thirteenth Amendment to Consolidated Amended and Restated Master Lease effective September 1, 2013 by and between Sterling Acquisition Corp and Diversicare Leasing Corp.
 
 
 
31.1

  
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a).
 
 
31.2

  
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a).
 
 
32

  
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b).
 
 
101.INS

  
XBRL Instance Document
 
 
101.SCH

  
XBRL Taxonomy Extension Schema Document
 
 
101.CAL

  
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.LAB

  
XBRL Taxonomy Extension Labels Linkbase Document
 
 
101.PRE

  
XBRL Taxonomy Extension Presentation Linkbase Document
 
 


38

THIRTEENTH AMENDMENT TO CONSOLIDATED
AMENDED AND RESTATED MASTER LEASE

This Thirteenth Amendment to Consolidated Amended and Restated Master Lease (this “ Amendment ”) is executed and delivered as of August 1, 2013 by and between STERLING ACQUISITION CORP., a Kentucky corporation (“ Lessor ”), the address of which is 200 International Circle, Suite 3500, Hunt Valley, MD 21030, and DIVERSICARE LEASING CORP., a Tennessee corporation, the address of which is 1621 Galleria Boulevard, Brentwood, TN 37027.
RECITALS:

A.    Lessee has executed and delivered to Lessor a Consolidated Amended and Restated Master Lease dated as of November 8, 2000, but effective as of October 1, 2000, as amended by a First Amendment to Consolidated Amended and Restated Master Lease dated as of September 30, 2001, a Second Amendment to Consolidated Amended and Restated Master Lease dated as of June 15, 2005, a Third Amendment to Consolidated Amended and Restated Master Lease dated as of October 20, 2006, a Fourth Amendment to Consolidated Amended and Restated Master Lease dated as of April 1, 2007, a Fifth Amendment to Consolidated Amended and Restated Master Lease dated as of August 10, 2007, a Sixth Amendment to Consolidated Amended and Restated Master Lease dated as of March 14, 2008, a Seventh Amendment to Consolidated Amended and Restated Master Lease dated as of October 24, 2008, an Eighth Amendment to Consolidated Amended and Restated Master Lease dated as of March 31, 2009, a Ninth Amendment to Consolidated Amended and Restated Master Lease dated as of May 5, 2009, a Tenth Amendment to Consolidated Amended and Restated Master Lease dated as of September 8, 2009, and a Eleventh Amendment to Consolidated Amended and Restated Master Lease dated as of April 18, 2011, and a Twelfth Amendment to Consolidated Amended and Restated Master Lease dated as of January 22, 2013 (collectively, the “ Existing Master Lease ”) pursuant to which Lessee leases from Lessor certain healthcare facilities.
B.    Lessor, certain Affiliates of Lessor listed on Exhibit A (the “ New Lessor Entities ”), and parties listed on Exhibit B (the “ New Tenant Entities ”) to this Amendment have entered into an Agreement to Enter into Master Lease dated as of the date of this Amendment, pursuant to which certain of the New Tenant Entities shall execute and deliver to the New Lessor Entities a Master Lease (the “ New Master Lease ”) covering the eleven (11) Facilities located in Arkansas and listed on Exhibit C to this Amendment (the “ Arkansas Facilities ”).
C.    Lessor and Lessee desire to terminate the Existing Master Lease as to the Arkansas Facilities, and, effective as of such termination, to reduce the Non-Texas Base Rent by Five Million Dollars ($5,000,000), all on the terms and conditions of this Amendment.
D.    Concurrently with the execution of this Amendment, Lessor, Lessee and the New Tenant Entities are entering into that certain Agreement to Fund Certain Improvements (the “ Agreement to Fund ”), pursuant to which Lessor and Lessee will fund the “Approved Improvements” (as defined in the Agreement to Fund).
NOW THEREFORE, the parties agree as follows:
1. Definitions . Any capitalized term used but not defined in this Amendment will have the meaning assigned to such term in the Master Lease. From and after the date of this Amendment, each reference in the Existing Master Lease or the other Transaction Documents to the “Lease” or “Master Lease” means, as applicable, the Existing Master Lease as modified by this Amendment.
2.      Termination as to Arkansas Facilities . Effective as of, and conditioned upon, the occurrence of the “Commencement Date” under the New Master Lease (the “ New Lease Commencement ”), (a) the Master Lease is terminated as to the Arkansas Facilities, and only as to the Arkansas Facilities; and (b) Exhibits A-5, A-6, A-8, A-9, A-10, A-11, A-12, A-13, A-14, A-15, and A-16 of the Master Lease are amended and restated in its entirety as follows:

Exhibit A-5, A-6, A-8, A-9, A-10, A-11, A-12, A-13, A-14, A-15, and A-16

Intentionally Omitted.

Effective as of, and conditioned upon, the occurrence of the New Lease Commencement, Lessee shall be and hereby is released from any further obligations first arising under the Master Lease from and after the New Lease Commencement Date as to the Arkansas Facilities. Notwithstanding the foregoing, the obligations of Lessee under the Master Lease with respect to matters first arising prior to the New Lease Commencement shall survive the termination of the Master Lease as to the Arkansas Facilities. Lessee acknowledges and agrees that the New Lessors, as successors in interest to Lessor, are also indemnified parties under Section 21.1 of the Master Lease; subject, however, to the exclusions for the gross negligence or willful misconduct, and the indemnity obligations, of the Lessor under Section 21.1 of the Master Lease. In addition, Lessor hereby releases Lessee of its obligations under Section 9.1.5 of the Master Lease with respect to any Approved Improvements to the extent funds are disbursed by Lessor (or the New Lessors) pursuant to the Agreement to Fund; provided, however, that such release is limited to the scope of work approved by Lessor (or the New Lessor) in connection with such Approved Improvement.

3.      Non-Texas Base Rent Reduction . Lessor and Lessee acknowledge and agree that, from and after the date of this Amendment, Lessor shall have no further obligation to fund the Improvement Allowance under the Existing Master Lease the with respect to the Non-Texas Facilities. Effective as of, and conditioned upon, the New Lease Commencement, the definition of Non-Texas Base Rent is hereby amended and restated in its entirety as follows:
Non-Texas Base Rent :

(A)     During the Initial Term, the Non-Texas Base Rent shall be:
(1)    For period prior to the New Lease Commencement, the Non-Texas Base Rent as set forth in the Existing Master Lease;
(2)    For the period from the New Lease Commencement thru September 30, 2013, the monthly sum of One Million One Hundred Eight Thousand Five Hundred Sixty Five and 19/100 Dollars ($1,108,565.19), which on an annual basis would be Thirteen Million Three Hundred Two Thousand Seven Hundred Eighty Two and 32/100 Dollars ($13,302,782.32) (the “ 2013 Annual NTBR ”);
(3)     For the Lease Year commencing on October 1, 2013, the product of the 2013 Annual NTBR and One Hundred Three Percent (103%);
(4)    For each of the each of the remaining Lease Years of the first Renewal Term, the product of the Non-Texas Base Rent during the previous Lease Year and and One Hundred Three Percent (103%).

Under no circumstances will the Non-Texas Base Rent in any Lease Year be less than the Non-Texas Base Rent during the preceding Lease Year.
(B)    During the second Renewal Term, the Non-Texas Base Rent shall be:
(1)    For the first Lease Year of the second Renewal Term, the greater of (a) the product of the Non-Texas Base Rent during the last Lease Year of the Initial Term and One hundred Three percent (103%), and (b) the Fair Market Rent for the Facilities other than the Texas Facilities on the first day of such Renewal Term as agreed upon by Lessor and Lessee, or, if prior to the commencement of the Renewal Term they are unable to agree, as determined by an appraisal pursuant to Article XXXII of this Lease; provided, however , that the Non-Texas Base Rent for the first Lease Year of the second Renewal Term shall not exceed one hundred ten percent (110%) of the Non-Texas Base Rent for the Lease Year immediately preceding the commencement of the second Renewal Term; and
(2)    For each of the second (2 nd ) through the twelfth (12 th ) Lease Years during the second Renewal Term, the lesser of (i) the Non-Texas Base Rent for the first (1st) Lease Year of the second Renewal Term, increased by a percentage equal to two (2) times the percentage increase in the CPI (if positive) from the commencement date of the second Renewal Term to the Adjustment Date in each of the second (2 nd ) through twelfth (12 th ) Lease Years, as applicable (the “ Adjustment Date ”), and (ii) the product of the Non-Texas Base Rent during the first (1 st ) Lease Year of the second Renewal Term and the following factor:
Lease Year During
Second Renewal Term

Applicable Factor
2
1.030
3
1.061
4
1.093
5
1.126
6
1.159
7
1.194
8
1.230
9
1.267
10
1.305
11
1.344
12
1.384

Under no circumstances will the Non-Texas Base Rent in any Lease Year during the Renewal Term be less than the Non-Texas Base Rent during the preceding Lease Year.
4.      Proceeds to Lessor; OTA; No Prorations with Lessor . All proceeds from the lease of the Arkansas Facilities shall be paid to Lessor. Lessee shall enter into an operations transfer agreement in form and substance reasonably acceptable to Lessee with the new operators of the Arkansas Facilities providing for the proration of revenues and expenses. The operations transfer agreement shall also include such indemnities from and in favor of Lessee as may be customarily included in transactions of this type in form and substance reasonably acceptable to Lessee. Lessee shall prorate all Impositions pursuant to the operations transfer agreement and such proration shall be in full satisfaction of the Lessee’s and Lessor’s obligation to prorate such Impositions pursuant to Section 4.3 of the Master Lease.
5.      Schedule 1 to Amended and Restated Security Agreement . Effective as of, and conditioned upon, the New Lease Commencement, Schedule 1 to the Amended and Restated Security Agreement between Lessee, as debtor, and Lessor, as secured party, is hereby amended and restated by Schedule 1 to this Amendment. After the occurrence of the New Lease Commencement, Lessor will file or record any UCC-3 termination statements necessary to terminate, release or amend, as applicable, any UCC-1 financing statements to extent such financing statements cover the Arkansas Facilities.
6.      Representations and Warranties of Lessee . Lessee hereby represents and warrants to Lessor that (i) it has the right and power and is duly authorized to enter into this Amendment; and (ii) the execution of this Amendment does not and will not constitute a breach of any provision contained in any agreement or instrument to which Lessee is or may become a party or by which Lessee is or may be bound or affected.
7.      Expenses of Lender . Lessee shall pay all reasonable expenses of Lessor incurred in connection with this Amendment, including reasonable attorneys fees and expenses.
8.      Execution and Counterparts . This Amendment may be executed in any number of counterparts, each of which, when so executed and delivered, shall be deemed to be an original, but when taken together shall constitute one and the same Amendment.
9.      Headings . Section headings used in this Amendment are for reference only and shall not affect the construction of the Amendment.
10.      Enforceability . Except as expressly and specifically set forth herein, the Existing Master Lease remains unmodified and in full force and effect. In the event of any discrepancy between the Existing Master Lease and this Amendment, the terms and conditions of this Amendment will control and the Existing Master Lease is deemed amended to conform hereto.
[SIGNATURE PAGES AND ACKNOWLEDGEMENTS FOLLOW]

LESSOR:

STERLING ACQUISITION CORP.,
a Kentucky corporation


By: /s/Daniel J. Booth                    
Name:    Daniel J. Booth
Title:    Chief Operating Officer


STATE OF MARYLAND    )
COUNTY OF BALTIMORE    )

This instrument was acknowledged before me on the 1 day of August, 2013, by Daniel J. Booth, the COO of STERLING ACQUISITION CORP., a Kentucky corporation, on behalf of said company.

                                                     
Notary Public, Baltimore County, MD
My commission expires:             


LESSEE:

DIVERSICARE LEASING CORP.,
a Tennessee corporation


By:     /s/James R. McKnight, Jr.    
Name:     James R. McKnight, Jr.    
Title:     EVP & CFO            
    

STATE OF TENNESSEE        )
                        
COUNTY OF WILLIAMSON    )

This instrument was acknowledged before me on the 1 st day of August, 2013, by James R. McKnight, Jr., the EVP & CFO of DIVERSICARE LEASING CORP., a Tennessee corporation, on behalf of said company


                                                     
Notary Public, Tenn. County, Williamson
My commission expires:             

 


The undersigned hereby consent to the transactions contemplated by this Amendment to ratify and affirm their respective Guaranties, Pledge Agreements, Security Agreements, Subordination Agreements and other Transaction Documents, and acknowledge and agree that the performance of the Master Lease and obligations described therein are secured by their Guaranties, Pledge Agreements, Security Agreement, Subordination Agreement and other Transaction Documents on the same terms and conditions in effect prior to this Amendment.
DIVERSICARE HEALTHCARE SERVICES, INC., a Delaware corporation f/k/a Advocat, Inc.



By:     /s/James R. McKnight, Jr.    
Name:     James R. McKnight, Jr.    
Title:     EVP & CFO            



STATE OF TENNESSEE         )

COUNTY OF WILLIAMSON    )

The foregoing instrument was acknowledged before me this 1 st day of August, 2013, by James R. McKnight, Jr., who is EVP & CFO of Diversicare Healthcare Services, INC., a Delaware corporation f/k/a Advocat, Inc, on behalf of the corporation, who acknowledged the same to be his or her free act and deed and the free act and deed of the corporation.


                            
Notary Public, Tenn. County, Williamson
My Commission Expires:                 

 

 

DIVERSICARE MANAGEMENT SERVICES CO.,
a Tennessee corporation



By:     /s/James R. McKnight, Jr.    
Name:     James R. McKnight, Jr.    
Title:     EVP & CFO            



STATE OF TENNESSEE         )

COUNTY OF WILLIAMSON    )

The foregoing instrument was acknowledged before me this 1 st day of August, 2013, by James R. McKnight, Jr., who is EVP & CFO of DIVERSICARE MANAGEMENT SERVICES CO., a Tennessee corporation, on behalf of the corporation, who acknowledged the same to be his or her free act and deed and the free act and deed of the corporation.


                            
Notary Public, Tenn. County, Williamson
My Commission Expires:                 


 
 
 

ADVOCAT FINANCE INC.,
a Delaware corporation



By:     /s/James R. McKnight, Jr.    
Name:     James R. McKnight, Jr.    
Title:     EVP & CFO            

STATE OF TENNESSEE         )

COUNTY OF WILLIAMSON    )

The foregoing instrument was acknowledged before me this 1 st day of August, 2013, by James R. McKnight, Jr., who is EVP & CFO of ADVOCAT FINANCE INC., a Delaware corporation, on behalf of the corporation, who acknowledged the same to be his or her free act and deed and the free act and deed of the corporation.


                            
Notary Public, Tenn. County, Williamson
My Commission Expires:                 

 

 
 

STERLING HEALTH CARE
MANAGEMENT, INC., a Kentucky corporation



By:     /s/James R. McKnight, Jr.    
Name:     James R. McKnight, Jr.    
Title:     EVP & CFO            



STATE OF TENNESSEE         )

COUNTY OF WILLIAMSON    )

The foregoing instrument was acknowledged before me this 1 st day of August, 2013, by James R. McKnight, Jr., who is EVP & CFO of STERLING HEALTH CARE MANAGEMENT, INC., a Kentucky corporation, on behalf of the corporation, who acknowledged the same to be his or her free act and deed and the free act and deed of the corporation.


                            
Notary Public, Tenn. County, Williamson
My Commission Expires:                 


 
 

DIVERSICARE TEXAS I, LLC


By:     /s/James R. McKnight, Jr.    
Name:     James R. McKnight, Jr.    
Title:     EVP & CFO            


DIVERSICARE BALLINGER, LLC
DIVERSICARE DOCTORS, LLC
DIVERSICARE ESTATES, LLC
DIVERSICARE HUMBLE, LLC
DIVERSICARE KATY, LLC
DIVERSICARE NORMANDY TERRACE, LLC
DIVERSICARE TREEMONT, LLC

BY:    DIVERSICARE TEXAS I, LLC,
its sole member


By:     /s/James R. McKnight, Jr.    
Name:     James R. McKnight, Jr.    
Title:     EVP & CFO            


STATE OF TENNESSEE         )

COUNTY OF WILLIAMSON     )

The foregoing instrument was acknowledged before me this 1 st day of August, 2013, by James R. McKnight, Jr., who is EVP & CFO of DIVERSICARE TEXAS I, LLC, on behalf of itself and as the sole member of each of DIVERSICARE BALLINGER, LLC, DIVERSICARE DOCTORS, LLC, DIVERSICARE ESTATES, LLC, DIVERSICARE HUMBLE, LLC, DIVERSICARE KATY, LLC, DIVERSICARE NORMANDY TERRACE, LLC, and DIVERSICARE TREEMONT, LLC, each a Delaware limited liability company, on behalf of the limited liability companies, who acknowledged the same to be his or her free act and deed and the free act and deed of the limited liability companies.


                            
Notary Public, Tenn. County, Williamson
My Commission Expires:                 
  

New Lessor Entities


To be formed subsidiaries of Omega Healthcare Investors, Inc. expected to be named as follows:

OHI Asset (AR) Malvern, LLC
OHI Asset (AR) Ash Flat, LLC
OHI Asset (AR) Conway, LLC
OHI Asset (AR) Des Arc, LLC
OHI Asset (AR) Hot Springs, LLC
OHI Asset (AR) Camden, LLC
OHI Asset (AR) Pocahontas, LLC
OHI Asset (AR) Mena, LLC
OHI Asset (AR) Sheridan, LLC
OHI Asset (AR) Walnut Ridge, LLC


New Tenant Entities

Southern Administrative Services, LLC
Polk Operations, LLC
Camden Operations, LLC
Faulkner Operations, LLC
Pines Operations, LLC
Garland Operations, LLC
Prairie Operations, LLC
Sharp Operations, LLC
Lawrence Operations, LLC
Randolph Operations, LLC
Grant Operations, LLC
Hot Spring Operations, LLC
Each an Arkansas limited liability company



Arkansas Facilities

1.     
Arbor Oaks Health & Rehab Center (Stillmeadow)
105 Russellville Road, Route 2, Highway 67 South
Malvern
Hot Spring
AR
72104
2.     
Ash Flat Nursing & Rehab Center
66 Ozbirn Lane
Ash Flat
Sharp
AR
72513
3.     
Conway Health & Rehab Center (Faulkner)
2603 Dave Ward Drive
Conway
Faulkner
AR
72032
4.     
Des Arc Nursing & Rehab Center
2216 West Main, P.O. box 143B
Des Arc
Prairie
AR
72040
5.     
Garland Nursing & Rehab Center and Apts.
610 Carpenter Dam Road
Hot Springs
Garland
AR
71901
6.     
Ouachita Nursing /Pine Manor Apts.
1411 Country Club Road
Camden
Ouachita
AR
71701
7.     
Pocahontas Nursing & Rehab Center
105 Country Club Road
Pocahontas
Randolph
AR
72455
8.     
Rich Mountain Nursing & Rehab Center
306 Hornbeck
Mena
Polk
AR
71953
9.     
Sheridan Nursing & Rehab Center
113 South Briarwood Drive
Sheridan
Grant
AR
72150
10.     
The Pines Nursing & Rehab Center
524 Carpenter Dam Road
Hot Springs
Garland
AR
71901
11.     
Walnut Ridge Nursing & Rehab Center
1500 West Main
Walnut Ridge
Lawrence
AR
72476

1.     
Best Care, Inc.
2159 Dogwood Ridge
Wheelersburg
Scioto
OH
45694
2.     
Boone Health Care Center, Inc.
Lick Creek Road, P.O. Box 605
Danville
Boone
WV
25053
3.     
Boyd Nursing and Rehab Center
12800 Princeland Drive
Ashland
Boyd
KY
41102
4.     
Canterbury Health Center
1720 Knowles Road
Phoenix City
Russell
AL
36867
5.     
Carter Nursing & Rehab Center
250 McDavid Boulevard, P.O. Box 904
Grayson
Carter
KY
41143
6.     
Elliott Nursing & Rehab Center
Howard Creek Road, P.O. Box 694, Route 32 East
Sandy Hook
Elliott
KY
41171
7.     
Hardee Manor Care Center
401 Orange Place
Wauchula
Hardee
FL
33873
8.     
Laurel Manor Health Center
902 Buchanan Road, P.O. Box 505
New Tazewell
Claiborne
TN
37825
9.     
Laurel Nursing & Rehab Center
HC 75, Box 153, Clinic Road
Ivydale
Clay
WV
25113
10.     
Lynwood Nursing Home
4164 Halls Mill Road
Mobile
Mobile
AL
36693
11.     
Manor House of Dover
537 Spring Street, P.O. Box 399
Dover
Stewart
TN
37058
12.     
Mayfield Rehab and Special Care Center
200 Mayfield Drive
Smyrna
Rutherford
TN
37167
13.     
Northside Health Care
700 Hutchins Ave
Gadsden
Etowah
AL
35901
14.     
South Shore Nursing & Rehab Center
James Hannah Drive, P.O. box 489
South Shore
Greenup
KY
41175
15.     
West Liberty Nursing & Rehab Center
774 Liberty Road, P.O. Box 219, Route 5 Wells Hill
West Liberty
Morgan
KY
41472
16.     
Westside Health Care Center
4320 Judith Lane
Huntsville
Madison
AL
35805
17.     
Wurtland Nursing & Rehab Center
100 Wurtland Avenue, P.O. Box 677
Wurtland
Greenup
KY
41144


Derwent – 8.1.13     1


Exhibit 31.1
CERTIFICATIONS PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
(i) CERTIFICATION
I, Kelly J. Gill, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Diversicare Healthcare Services, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
Date: November 7, 2013
 
 
/s/ Kelly J. Gill
Kelly J. Gill
Chief Executive Officer





Exhibit 31.2
CERTIFICATIONS PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
(ii) CERTIFICATION
I, James Reed McKnight, Jr., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Diversicare Healthcare Services, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
Date:   November 7, 2013
 
/s/ James Reed McKnight, Jr.
James Reed McKnight, Jr.
Executive Vice President and Chief Financial Officer





Exhibit 32
CERTIFICATION OF QUARTERLY REPORT ON FORM 10-Q
OF DIVERSICARE HEALTHCARE SERVICES, INC.
FOR THE QUARTER ENDED MARCH 31, 2013
The undersigned hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the undersigned’s best knowledge and belief, the Quarterly Report on Form 10-Q for Diversicare Healthcare Services, Inc. (the “Company”) for the period ending September 30, 2013 as filed with the Securities and Exchange Commission on the date hereof (the “Report”):
(a)
fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(b)
the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
This Certification is executed as of November 7, 2013 .

 
 
/s/ Kelly J. Gill
Kelly J. Gill
Chief Executive Officer
 
/s/ James Reed McKnight, Jr.
James Reed McKnight, Jr.
Executive Vice President and Chief Financial Officer
A signed original of this written statement required by Section 906 of the Sarbanes-Oxley Act of 2002 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.