UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

CHECK ONE:

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

For the Quarterly Period Ended: September 30, 2006

OR

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

For the transition period from                      to                      .

Commission file No.: 1-12996

Advocat Inc.

(615) 771-7575

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

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

Large accelerated filer o       Accelerated filer o       Non-accelerated filer þ

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

(Outstanding shares of the issuer’s common stock as of November 1, 2006)

 

 

TABLE OF CONTENTS

NON-CASH TRANSACTIONS:

During the nine month periods ended September 30, 2006 and 2005, the Company accrued, but did not pay, preferred stock dividends of $254 and $237, respectively. Preferred stock dividends of $86 for the three months ended September 30, 2006 were declared and paid subsequent to September 30, 2006.

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

ADVOCAT INC.

3. INSURANCE MATTERS

Professional Liability and Other Liability Insurance-

Due to the Company’s past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by the Company for professional liability and other liability insurance to cover future periods exceed the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, the Company has purchased professional liability insurance coverage for its facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, the Company is effectively self-insured and expects to remain so for the foreseeable future.

The Company has essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2006. For claims made during the period from March 10, 2006 through March 9, 2007, the Company maintains insurance with coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.

Reserve for Estimated Self-Insured Professional Liability Claims-

Because the Company anticipates that its actual liability for existing and anticipated claims will exceed the Company’s limited professional liability insurance coverage, the Company has recorded total liabilities for professional liability and other claims of approximately $26.8 million as of September 30, 2006. 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.

The Company records its estimated liability for these professional liability claims based on the results of a third-party actuarial analysis. Each quarter, amounts are added to the accrual for estimates of anticipated liability for claims incurred during that period. These estimates are assessed and adjusted quarterly as claims are actually reported, as lawsuits are filed, and as those actions are actually resolved. As indicated by the chart of reserves by policy year set forth below, final determination of the Company’s actual liability for claims incurred in any given period is a process that takes years. At each quarter end, the Company records any revisions in estimates and differences between actual settlements and reserves, with changes in estimated losses being recorded in the consolidated income statements in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period.

Although the Company retains a third-party actuarial firm to assist management in estimating the appropriate accrual for these claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. 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 quarter. 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.

While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect the Company’s cash position because the accrual for these liabilities is not funded. A significant judgment entered against the Company in one or more legal actions could have a material adverse impact on the Company’s financial position and cash flows.

The following summarizes the Company’s accrual for professional liability and other claims for each policy year as of the end of the period:

Other Insurance-

With respect to workers compensation insurance, substantially all of the Company’s employees became covered under either indemnity insurance plans or state-sponsored programs in May 1997. Prior to that time, the Company was self-insured for the first $250,000, on a per claim basis, for workers compensation claims in a majority of its facilities. However, the insurance carrier providing coverage above the Company’s self insured retention has been declared insolvent by the applicable state insurance agency. As a result, 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 workers compensation claims with respect to its Texas operations. The Company has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability recorded by the Company for the self-insured obligations under these plans is $0.6 million as of September 30, 2006.

Effective June 30, 2003, the Company entered into workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. The Company accounts for premium expense under these policies based on its estimate of the level of claims expected to be incurred. As of September 30, 2006, the Company has recorded estimated premium refunds due under these programs totaling approximately $5.0 million, with $3.1 million included in “insurance refunds receivable” in current assets and the balance included in “other noncurrent assets” in the accompanying balance sheet, based upon expected settlement dates. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized.

The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 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 $0.9 million at September 30, 2006. The differences between actual settlements and reserves are included in expense in the period finalized.

4. STOCK-BASED COMPENSATION

Beginning January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” using the modified prospective method, in which compensation cost is recognized (a) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. The Company had no unvested awards granted to employees on the effective date. In March 2005, the United States Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”), which provides supplemental implementation guidance for SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and the related Interpretations (“APB No. 25”). Under APB No. 25, no compensation cost related to stock options was recognized because all options were issued with exercise prices equal to the fair market value at the date of grant. Because the Company elected to use the modified prospective method in adopting the provisions of SFAS No. 123R, results for prior periods have not been restated. Had compensation cost for the Company’s stock-based compensation plans in prior periods been determined consistent with SFAS No. 123R, the Company’s net income for common stock and net income per common share would not have differed from the amounts reported.

In December 2005, the Compensation Committee of the Board of Directors adopted the 2005 Long-Term Incentive Plan (“the 2005 Plan”). The 2005 Plan allows the Company to issue stock options and other share and cash based awards. Under the 2005 Plan, 700,000 shares of the Company’s common stock have been reserved for issuance upon exercise of options granted thereunder.

At the time of adoption, the Board approved the issuance of options to purchase approximately 332,000 shares of the Company’s common stock at a purchase price of $5.44 per share, the market price of the Company’s common stock on the date the options were authorized. This issuance was subject to shareholder approval of the 2005 Plan which occurred in June 2006 at the Company’s 2006 Annual Shareholders’ Meeting. At the time of shareholder approval, the Company’s stock price had increased to $16.80. Upon shareholder approval, the options for the purchase of approximately 314,000 shares were vested with the remainder vesting one-half each on the next two anniversaries of the date the shares were authorized by the Board of Directors. All options under this plan expire 10 years from the date the shares were authorized by the Board of Directors.

Upon shareholder approval, the Company recorded stock-based compensation expense for stock options issued under the 2005 Plan of approximately $5.1 million for the nine months ended September 30, 2006. This stock-based compensation expense resulted in an increase to paid-in capital of $5.1 million. As of September 30, 2006, there was $0.2 million of total remaining compensation costs related to stock-based compensation to be recognized over the applicable remaining vesting periods. The Company estimated the total recognized and unrecognized compensation using the Black-Scholes-Merton option valuation model.

The table below shows the weighted average assumptions the Company used to develop the fair value estimates under its option valuation model. The Company did not grant any stock options during the nine months ended September 30, 2005.

In computing the fair value estimates using the Black-Scholes-Merton valuation model, the Company took into consideration the exercise price of the options, $5.44, and the market price of the Company’s stock on the date of shareholder approval, $16.80. The Company used an expected volatility that equals the historical volatility over the most recent period equal to the expected life of the options. The risk free interest rate is based on the U.S. treasury yield curve in effect at the time of grant. The Company used an expected dividend yield of zero since it has not paid cash dividends on its common stock and estimated the options expected term based on the average of the vesting term and the original contractual terms of the grants, consistent with the interpretive guidance in SAB 107.

During the nine months ending September 30, 2006 approximately 110,000 shares were exercised generating proceeds of approximately $0.4 million.

5. RECLASSIFICATIONS

Certain amounts in the 2005 financial statements have been reclassified to conform with the 2006 presentation, including, as discussed in Note 6, reclassifications made to reflect certain divestitures as discontinued operations.

In 2006, the Company has separately disclosed the operating, investing and financing portions of the cash flows attributable to its discontinued operations, which in prior periods were reported on a combined basis as a single amount, and has revised the prior period presentation to be consistent with that of the nine months ended September 30, 2006.

6. DISCONTINUED OPERATIONS

In November 2005, the Company entered into an agreement to sell certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. The sale was completed on May 15, 2006. Proceeds from this transaction were used to pay transaction costs and repay debt.

In late June 2006, the buyer terminated the Company’s agreement to sell its only remaining assisted living facility in North Carolina. The Company closed this facility in April 2006. The Company is continuing its efforts to sell this facility.

In February 2005, the Company sold two nursing homes in Texas that were operating with low occupancy and experiencing operating losses. The net proceeds from the transactions were approximately $375,000, and were used to pay transaction costs and repay debt. In periods prior to the sale, the Company had recorded impairment provisions and reduced the property to its estimated realizable value, and no significant gain or loss was realized on the transactions.

Each of these facilities and businesses constitute components under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and, accordingly, the Company has reclassified the operations and disposed property of each of these components as discontinued operations for all periods presented in the Company’s consolidated financial statements.

7. EARNINGS PER SHARE

Information with respect to basic and diluted net income per share is presented below:

8. FINANCING TRANSACTIONS

On August 7, 2006, the Company entered into an agreement with its commercial mortgage lender, Capmark Finance Inc. (“Capmark”), for a comprehensive refinancing of the Company’s long term debt. Under the terms of the new agreement, Capmark provided mortgage debt (“Mortgage Loan”) of approximately $22.5 million with a five year maturity and a term note of approximately $8.1 million with a four year maturity (“Term Note”) to refinance the Company’s remaining mortgage and bank term debt. The proceeds of these new loans were used to retire the existing debt and will fund a $1.1 million renovation of a nursing center that is part of the collateral for the mortgage loans. As of September 30, 2006, the loan proceeds to be used for the nursing center renovation, $1.1 million, are held in an account controlled by the lender and are classified as “cash restricted for capital expenditures,” a non-current asset, in the accompanying balance sheet. In connection with this loan, the Company made a payment of approximately $2.6 million to reduce outstanding debt and expensed existing deferred financing costs of $194,000 during the quarter ending September 30, 2006. The deferred financing costs written off relate to the debt that was retired and are reflected as debt retirement costs on the income statement.

The Mortgage Loan has a term of five years, with principal and interest payable monthly based on a 25 year amortization. Interest is based on 30 day LIBOR plus a margin of 3.75%. The mortgage loan is secured by seven owned nursing centers, related equipment, and a second lien on the accounts receivable of these facilities. The Term Note is due in four years, and is payable monthly based on a 25 year amortization. The note provides for additional semi-annual payments of $1.0 million each such that the loan will amortize in full in four years. Any proceeds received upon disposition of any assets securing the Term Note must be paid to Capmark to reduce the balance of the Term Note. Interest is based on 30 day LIBOR plus a margin of 6.25%. The Term Note is secured by an assignment of a Note Receivable taken in the sale of the Company’s Canadian subsidiary, an assignment of the proceeds from certain workers compensation insurance premium refunds, by certain real estate held for sale, by two owned nursing centers, and a second mortgage on the seven nursing centers securing the Mortgage Loan. The Mortgage Loan and the Term Note are cross-collateralized. The Mortgage and Term Loans include certain financial covenants, with which the Company is currently in compliance. In connection with these new loans, the Company recorded total deferred loan costs of $0.8 million.

9. SALE OF BED LICENSE

In January 2006, the Company sold 10 licensed beds which it owned in Kentucky but had not placed in service. The sales price was $260,000, and the Company recognized a gain of $207,000 on the sale, which is included in “other income” in the consolidated statements of operations.

10. INCOME TAXES

The Company has maintained a valuation allowance for its deferred tax assets, as the absence of pre-tax income in the past as well as the significant uncertainty of the Company’s ability to continue as a going concern created uncertainty surrounding the realization of the benefits of the Company’s deferred tax assets in future periods. At December 31, 2005, the Company had total valuation allowances of $15.9 million on its deferred tax assets. During 2006 the Company assessed the valuation allowance on deferred tax assets based on Management’s belief that it is more likely than not that a larger portion of the Company’s net deferred tax assets will be realized due to the Company’s achieved earnings trend and outlook. The Company considered many factors when assessing the likelihood of future realization of its deferred tax assets including its recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carryforward periods available to the Company, and the recent refinancing of debt and its impact on the Company’s ability to continue as a going concern as well as other relevant factors.

The Company had a deferred tax benefit in the nine months ending September 30, 2006 of $9.1 million primarily resulting from the effect of changes in our valuation assessment of deferred tax assets during 2006. The Company continues to maintain a valuation allowance of approximately $1.0 million to reduce the deferred tax assets by the amount management believes is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof. In future periods, the Company will continue to assess the need for and adequacy of the remaining valuation allowance of $1.0 million.

11. EVENT SUBSEQUENT TO BALANCE SHEET DATE

On October 20, 2006 the Company entered into a Restructuring Stock Issuance and Subscription Agreement (“Restructuring Agreement”) to restructure its Series B Redeemable Convertible Preferred Stock held by Omega Healthcare Investors (together with its subsidiaries, “Omega”), a publicly owned REIT, eliminating the option of Omega to convert the Preferred Stock into shares of Advocat common stock. Advocat and Omega also entered into a Third Amendment to Consolidated Amended and Restated Master Lease (“Lease Amendment”) to extend the term of its lease covering 29 nursing centers it currently leases from Sterling Acquisition Corp., a wholly-owned subsidiary of Omega. In addition, Omega agreed to provide up to $5 million to fund capital improvements made to certain nursing centers by June 30, 2008.

Preferred Stock Restructuring-

Under the terms of the Restructuring Agreement, the Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”) held by Omega was exchanged for a new Series C Preferred Stock that is not convertible.

At the time of the Restructuring Agreement, the Series B Preferred Stock had a value (including accrued dividends) of approximately $4.9 million, accrued dividends at an annual rate of 7% of the stated value, compounded quarterly, and was convertible into approximately 792,000 shares of common stock.

The Restructuring Agreement required the Company to issue to Omega 5,000 shares of Series C Preferred Stock in exchange for the 393,658 shares of Series B Preferred Stock held by Omega. The new Series C Preferred Stock has a stated value of approximately $4.9 million and carries an annual dividend rate of 7% of its stated value. The Series C Preferred Stock will pay quarterly cash dividends. The Series C Preferred Stock is not convertible, but is redeemable at its stated value at Omega’s option after September 30, 2010, and is redeemable at its stated value at the Company’s option after September 30, 2007, subject to certain limitations. In connection with the termination of the conversion feature, the Company agreed to pay Omega an additional $687,000 annually under the Lease Amendment.

The Company will record the fair value of the elimination of the conversion feature as a reduction in Paid In Capital with an offsetting increase to record a premium on the Series C Preferred Stock. As a result, the Series C Preferred Stock will be initially recorded at a total value of $11.6 million, equal to the stated value of the Series B Preferred Stock ($4.9 million) plus the negotiated value of the conversion feature, $6.7 million. The agreed upon additional rental payments of $687,000 annually will be discounted over the twelve year term of the renewal so that the net present value of the payments is equal to the $6.7 million preferred stock premium. As payments are made, the preferred stock premium will be reduced, interest expense recorded and cash will be reduced.

On October 20, 2006, Advocat declared and paid the quarterly dividend of $86,000 on the Series B Preferred Stock for the quarter ended September 30, 2006.

Subordinated Promissory Note-

In connection with the Restructuring Agreement, the Company also replaced a Subordinated Promissory Note which was convertible at the Company’s option with a new Subordinated Note, which is not convertible. The new Subordinated Note is in the principal amount of approximately $2.5 million, bears interest at 7% and matures on September 30, 2007. Except for eliminating the conversion feature, the terms of the new Subordinated Note are the same as the original Subordinated Promissory Note.

Master Lease Amendment-

Under the terms of the Lease Amendment, Advocat and Omega also agreed to amend and renew the master lease covering 29 nursing centers. The initial term of the lease was set to expire in September 2010, with a ten year renewal option. The amended master lease commences on October 1, 2006, and extends to September 30, 2018. The Lease Amendment also provides for a renewal option of an additional twelve years. Other than the change in rent associated with the restructuring of the preferred stock described above, there is no change in the base rental amounts as a result of the Lease Amendment. Consistent with prior terms, the lease provides for annual increases in lease payments equal to the lesser of two times the increase in the consumer price index or 3.0%. Under generally accepted accounting principles, the Company is required to record these scheduled rent increases on a straight line basis over the 12 year term of the renewal period. As a result of recording these increases, the Company’s annual rent expense will increase by approximately $2.7 million effective October 1, 2006, although this increase has no effect on cash rent payments at the start of the lease term. They will only result in additional cash outlay as the 3 percent annual increases take effect each year.

The following table summarizes the Company’s annual cash rent payments under the lease renewal, including the 3% rent escalations but excluding the $687,000 annual payments related to the preferred stock restructuring:

Lease Year Ending September 30,
2007		$	13,338,000
2008			13,759,000
2009			14,193,000
2010			14,639,000
2011			15,099,000
2012			15,572,000
2013			16,060,000
2014			16,562,000
2015			17,080,000
2016			17,613,000
2017			18,162,000
2018			18,727,000
		$	190,804,000

The Company’s rent expense, recorded on a straight line basis, will be $15.5 million annually.

In addition, Omega agreed to provide up to $5 million to fund capital improvements made to certain nursing centers by June 30, 2008. The annual base rent related to these nursing centers will be increased to reflect the amount of capital improvements made to the facilities.

Unaudited Pro Forma Condensed Consolidated Financial Information-

The following unaudited pro forma condensed consolidated financial information has been prepared to give effect to the material transaction described herein and is based upon the assumptions and adjustments described in the notes to the unaudited pro forma condensed consolidated financial information included herein. The unaudited pro forma condensed consolidated financial information is presented for illustrative purposes only and is not necessarily indicative of the financial position or results of operations that would have actually been reported had the material transaction occurred on the dates indicated, nor is the information necessarily indicative of the future financial position or results of operations of Advocat. The unaudited pro forma amounts include adjustments, which are based upon preliminary estimates, to reflect the transactions described herein. Due to these varying assumptions, actual results may differ from the pro forma adjustments presented.

These unaudited pro forma condensed consolidated financial information is based upon, and should be read in conjunction with the historical consolidated financial statements of the Company and related notes contained in the reports and other information the Company has filed with the United States Securities and Exchange Commission.

	(2)		Income tax effects of the transaction are reflected at the statutory rate for Federal and state income taxes, 38%. The Company’s effective tax rate differs materially from the statutory rate mainly due to changes in the valuation allowance for net deferred tax assets.
	(3)		To record a reduction in the number of diluted shares outstanding for the effects of the cancellation of the conversion feature associated with the preferred stock. Omega, as a Real Estate Investment Trust, is limited in the amount of ownership in Advocat it can hold. The computation of diluted earnings per share has historically reflected the effects of these limitations on the number of common shares issued. The total number of shares that could be issued without these limitations is approximately 0.8 million.
	(4)		To record the effects of scheduled rent increases for the amended Master Lease on a straight-line basis.

Notes to Pro Forma Adjustments:

The following pro forma adjustments present the effects of the restructuring of preferred stock and the amendment to the master lease on the Consolidated Income Statement of Advocat for the year ended December 31, 2005 as if these transactions occurred on January 1, 2005.

	(1)		To record imputed interest expense associated with the required payments to be made for the cancellation of the conversion feature in the restructuring of preferred stock.
	(2)		Income tax effects of the transaction are reflected at the statutory rate for Federal and state income taxes, 38%. The Company’s effective tax rate differs materially from the statutory rate mainly due to changes in the valuation allowance for net deferred tax assets.
	(3)		To record a reduction in the number of diluted shares outstanding for the effects of the cancellation of the conversion feature associated with the preferred stock. Omega, as a Real Estate Investment Trust, is limited in the amount of ownership in Advocat it can hold. The computation of diluted earnings per share has historically reflected the effects of these limitations on the number of common shares issued. The total number of shares that could be issued without these limitations is approximately 0.8 million.
	(4)		To record the effects of scheduled rent increases for the amended Master Lease on a straight-line basis.

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

Overview

Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast. Our centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, we offer a variety of comprehensive rehabilitation services as well as nutritional support services.

As of September 30, 2006, our continuing operations consist of 43 nursing centers with 4,505 licensed nursing beds and 78 assisted living units. As of September 30, 2006, our continuing operations included nine owned nursing centers and 34 leased nursing centers.

Divestitures. We have undertaken several divestitures in recent periods. The divested operations have generally been poor performing properties. On May 15, 2006, we sold certain assets of eleven assisted living facilities located in North Carolina. Although our previous agreement to sell our only remaining assisted living facility in North Carolina was terminated by the buyer, we are continuing our efforts to sell this facility. In February 2005, we sold two nursing centers in Texas.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.

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 stock-based compensation expenses, incurred in the operation of the nursing centers we owned and leased. Our general and administrative expenses consist of the costs of the corporate office and regional support functions.

Transactions with Lessor. On October 20, 2006 we entered into a Restructuring Stock Issuance and Subscription Agreement (“Restructuring Agreement”) to restructure our Series B Redeemable Convertible Preferred Stock held by Omega Healthcare Investors (together with its subsidiaries, “Omega”), a publicly owned REIT, eliminating the option of Omega to convert the Preferred Stock into shares of our common stock. Advocat and Omega also entered into an amendment to the Master Lease to extend the term of our lease covering 29 nursing centers we currently lease from Sterling Acquisition Corp., a wholly-owned subsidiary of Omega. In addition, Omega agreed to provide up to $5 million to fund capital improvements made to certain nursing centers by June 30, 2008. Details of these transactions are described under Liquidity and Capital Resources.

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 of the need to make estimates about the effect of matters that are inherently uncertain. Our accounting policies that fit this definition include the following:

Revenues

Patient Revenues

The fees we charge patients in our nursing centers include fees with respect to individuals receiving benefits under federal and state-funded cost reimbursement programs. These revenues are generally based on approved rates for each facility that are either based on current costs with retroactive settlements or

prospective rates with no cost settlement. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the third-party payors. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Final cost settlements, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits.

Allowance for Doubtful Accounts

Our allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. We monitor these factors and determine the estimated provision for doubtful accounts. Historical bad debts have generally resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated income statements in the period identified.

Self-Insurance Reserves

Self-insurance reserves primarily represent the accrual for self insured risks associated with general and professional liability claims, employee health insurance and workers compensation. The self insurance reserves include 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 incurred and expected to be incurred. Our policy with respect to a significant portion of the general and professional liability claims is to use a third-party actuary to support the estimates recorded for the development of known claims and incurred but unreported claims. Our health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. Our workers compensation reserve relates primarily to periods of self insurance prior to May 1997, consists of known claims incurred and the reserve is based on an estimate of the future costs to be incurred for the known claims. Expected insurance coverages are reflected as a reduction of the reserves.

Because we anticipate that our actual liability for existing and anticipated claims will exceed our limited professional liability insurance coverage, we have recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $26.8 million as of September 30, 2006.

Our self insurance reserves are assessed on a quarterly basis based on currently available information. The amounts recorded for professional and general liability claims are adjusted for revisions in estimates and differences between actual settlements and reserves as determined each period with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period.

We retain a third-party actuarial firm to estimate the appropriate accrual for incurred professional liability claims. The actuarial estimate represents the ultimate cost for all professional liability claims incurred in a period and includes estimates for both claims reported and claims incurred but not reported. All losses are projected on an undiscounted basis.

We provide the actuary information with regard to historical losses we incurred for professional liability claims. The actuary considers losses covering a multi-year period as the basis for estimates. From this historical data, the actuary develops estimates of our ultimate professional liability cost for a given period in relation to our occupancy for that period. The estimate includes legal and other expenses expected to be incurred.

The actuary evaluates claims and potential claims incurred for periods beginning March 9, 2000. Prior to that time, we had adequate insurance in place to cover claims on a claims-incurred basis without significant

uninsured risk. Beginning with the March 9, 2000 policy period, insurance coverage was on a claims made basis. See Note 3, “Insurance Matters,” of the Notes to the Interim Consolidated Financial Statements for a description of our insurance coverage.

On a quarterly basis, as claims are reported and lawsuits filed, we obtain reports of claims we have incurred from insurers and a third party claims administrator. These reports contain information relevant to the liability actually incurred to date with that claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim (this estimate is initially developed based on the third-party administrator’s initial review of the facts giving rise to the claim). This information is reviewed by us and provided to the actuary. The actuary uses this information to determine the timing of claims reporting and the development of reserves, and compares the information obtained to its original estimates of liability. Based on the actual claim information obtained 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. Thus, the accrual for older periods is determined by using currently-known information to adjust the initial reserve that was created based on historical data. For information regarding the amount of accrual by period, see Note 3, “Insurance Matters,” of the Notes to the Interim Consolidated Financial Statements.

Any estimate of our exposure for professional liability claims is inherently uncertain. Some key factors that could lead to differences between amounts estimated and the ultimate amount of any loss are addressed below. One of the key assumptions in the actuarial analysis is that historical losses provide an accurate forecast of future losses. The actuary considers more than ten years of historical loss data, including losses incurred in periods with significant insurance coverage. Our ability to pay may limit losses in periods of lower insurance or self insurance. Our ability to pay in the future is not considered in the actuarial estimates. Changes in legislation such as tort reform may affect the severity and frequency of claims incurred in future periods. Changes in risk management practices may also affect the frequency of future claims.

Another key assumption is the limit of claims to a maximum of $4.5 million. The actuary has selected this limit based on our historical data. While most of our claims have been for amounts less than the $4.5 million, there have been claims at higher amounts, and there may be claims above this level in the future. The facts and circumstances of each claim vary significantly, and the amount of ultimate liability for an individual claim may vary due to many factors, including whether the case can be settled by agreement, the quality of legal representation, the individual jurisdiction in which the claim is pending, and the views of the particular judge or jury deciding the case. To date, we have not experienced an uninsured loss in excess of this limit. Our policy is to review the actuary report and assumptions each quarter. In the event that we believe we have incurred a loss in excess of this limit, an adjustment to the reserves determined by the actuary would be necessary.

We believe that the use of actuarial methods described above provides a valid and reasonable method to estimate our liability for professional and general liability claims. We also believe that expertise in actuarial methodologies is required to estimate liabilities using this methodology and thus employ a third-party actuary to provide this service. Because of the difficulties discussed above, any estimate of our professional liability claims is inherently uncertain; therefore, actual professional liability costs may differ materially from the accrual, regardless of the assumptions or methodology used. Professional liability costs are material to our financial position, and differences between estimates and the ultimate amount of loss may cause a material fluctuation in our reported results of operations. The liability recorded at September 30, 2006, was $26.8 million, compared to current assets of $34.4 million and total assets of $94.9 million. For the nine months ended September 30, 2006 and 2005, our professional liability expense was negative $5.1 million and negative $4.8 million, respectively, with negative amounts representing net benefits resulting from downward revisions in previous estimates. These amounts are material in relation to our reported net income from continuing operations for the related periods of $19.6 million and $12.7 million, respectively.

While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect our cash position because the accrual for these liabilities is not

funded. 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.

Asset Impairment

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we evaluate the recoverability of the carrying values of our properties on a property by property basis. On a quarterly basis, we review our properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment charge is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property.

Stock-Based Compensation

Beginning January 1, 2006, we adopted SFAS No. 123R, “Share-Based Payment,” using the modified prospective method, in which we recognize compensation cost for all share-based payments granted after the effective date. We recorded stock-based compensation expense and estimated our unrecognized stock-based compensation that we will recognize on a straight-line basis over the remaining vesting period. We calculated the recognized and unrecognized stock-based compensation using the Black-Scholes-Merton (BSM) option valuation model. The BSM requires us to use certain key assumptions to develop the fair value estimates. These key assumptions include expected volatility, risk-free interest rate, expected dividends and expected term.

Income Taxes

We follow SFAS No. 109, “Accounting for Income Taxes,” which requires an asset and liability approach for financial accounting and reporting of income taxes. Under this method, deferred tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. We assess the need for a valuation allowance to reduce the deferred tax assets by the amount we believe is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof, including certain net operating loss carryforwards we do not expect to realize due to change in ownership limitations.

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 statutes 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. We are involved in regulatory actions of this type from time to time. Additionally, changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the industry and our consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may further negatively impact us.

Medicare and Medicaid Reimbursement-

A significant portion of our revenues is derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare and private pay sources. We employ specialists in reimbursement at the corporate level to monitor regulatory developments, to comply with reporting requirements, and to maximize payments 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.

The Balanced Budget Act enacted during 1997 (the “BBA”) phased in the prospective payment system for nursing centers and contained numerous Medicare and Medicaid cost-saving measures. As initially implemented, the BBA negatively impacted the entire long-term care industry. During 1999 and 2000, certain amendments to the BBA were enacted, which helped restore some of the Medicare funding originally eliminated under the BBA. However, certain provisions in the amendments expired on September 30, 2002 and December 31, 2005.

In 2005, the Centers for Medicare and Medicaid (“CMS”) issued the final rule for the refinement of the Resource Utilization Group (“RUG”) system and provided for the elimination of the reimbursement add-ons for high acuity patients. In addition, Congress implemented a market basket adjustment of approximately 3.1% designed to increase reimbursement for the effects of inflation. The actual amount of the market basket adjustments is adjusted based on various factors. The market basket adjustment that becomes effective October 1, 2006, is expected to result in an average increase of approximately 2.1% for our facilities as a group, and is expected to increase our revenue by approximately $0.1 million per month.

Certain per person annual Medicare Part B reimbursement limits on therapy services became effective January 1, 2006. Subject to certain exceptions, the limits impose a $1,740 per patient annual ceiling on physical and speech therapy services, and a separate $1,740 per patient annual ceiling on occupational therapy services. CMS has established an exception process to permit therapy services in certain situations, and we believe the majority of services provided by us will be reimbursed under the exceptions. The exception process is currently only effective through December 31, 2006. If the exception process is discontinued for 2007, it is expected that the reimbursement limitations will reduce therapy revenues and negatively impact our operating results and cash flows.

The Federal Deficit Reduction Act of 2005 mandates the reduction by 30% the amount that Medicare reimburses nursing centers and other non-hospital providers for bad debts arising from uncollectible Medicare coinsurance and deductibles for those individuals that are not dually eligible for Medicare and Medicaid. The reduction is to be phased in over a three year period with 10% during fiscal 2006, 20% during fiscal 2007 and 30% thereafter. This provision is not expected to have a material impact on our operating results.

The budget proposed by President Bush for the government’s 2007 fiscal year includes a number of proposed reductions to Medicare reimbursement for nursing homes and also appears to challenge certain Federal matching programs that benefit many of the state Medicaid programs, including several of the states in which we operate nursing facilities. In the event the Federal government reduces the amount of state funding eligible for the Federal matching program, there will be pressure on the states to reduce our current reimbursement levels. If the states reduce the Medicaid reimbursement in response to any Federal action, it is expected that the reduction in revenues would have a material effect on our operating results. We are unable to quantify the impact that these possible reimbursement cuts would have on us.

Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the nine months ended September 30, 2006, we derived 30.5% and 56.2% 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 are unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes

would have on our operations. We will attempt to maximize the revenues available from governmental sources within the changes that have occurred and will continue to occur.

We will also attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. 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 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 homes are subject to certificate of need laws, which require us to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. 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, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility 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 facility 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 facility 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.

Insurance

Professional Liability and Other Liability Insurance-

Due to our past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by us for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we have purchased professional liability insurance coverage for our facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, we are effectively self-insured and expect to remain so for the foreseeable future.

We have essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2006. For claims made during the period from March 10, 2006 through March 9, 2007, we maintain insurance with coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000. See Note 3, “Insurance Matters,” of the Notes to the Interim Consolidated Financial Statements.

Other Insurance-

With respect to workers compensation insurance, substantially all of our employees became covered under either indemnity insurance plans or state-sponsored programs in May 1997. Prior to that time, we were self-insured for the first $250,000, on a per claim basis, for workers compensation claims in a majority of our facilities. However, the insurance carrier providing coverage above our self insured retention has been declared insolvent by the applicable state insurance agency. As a result, we are completely self-insured for workers compensation exposures prior to May 1997. We have been and remain a non-subscriber to the Texas workers

compensation system and are, therefore, completely self-insured for employee workers compensation claims with respect to our Texas operations. We have provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability we recorded for the self-insured obligations under these plans is $0.6 million as of September 30, 2006. Effective June 30, 2003, we entered into workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. As of September 30, 2006, we have recorded estimated premium refunds due under these programs totaling approximately $5.0 million, with $3.1 million included in “insurance refunds receivable” in current assets and the balance included in “other noncurrent assets” in the accompanying balance sheet, based upon expected settlement dates. See Note 3, “Insurance Matters,” of the Notes to the Interim Consolidated Financial Statements.

We are self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. We provide 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 $0.9 million at September 30, 2006. The differences between actual settlements and reserves are included in expense in the period finalized.

Contractual Obligations and Commercial Commitments

We have certain contractual obligations of continuing operations as of September 30, 2006. As noted above, we entered into transactions with Omega to restructure certain of our relationships in October 2006, as described in “Liquidity and Capital Resources.” The following table summarizes our contractual obligations by the period in which payment is due, after giving effect to the transactions with Omega (dollar amounts in thousands).

We have employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 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 for these payments under these agreements is approximately $1.7 million. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, certain executives may elect to require that we purchase options 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 option exercise price. Based on the closing price of

our stock on September 30, 2006, the maximum contingent liability for the repurchase of the currently vested options is approximately $3.9 million. No amounts have been accrued for this contingent liability.

Results of Operations

The following tables present the unaudited interim statements of operations and related data for the three and six month periods ended September 30, 2006 and 2005: