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, 2007

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.

(exact name of registrant as specified in its charter)

Delaware		62-1559667
(State or other jurisdiction of		(IRS Employer Identification No.)
incorporation or organization)

1621 Galleria Boulevard, Brentwood, TN 37027
(Address of principal executive offices)       (Zip Code)

(615) 771-7575
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report.)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 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 þ            Non-accelerated filer o

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

5,877,287
(Outstanding shares of the issuer’s common stock as of November 1, 2007)

TABLE OF CONTENTS

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

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

ADVOCAT INC.

renewal periods at the Company’s option through May 31, 2035. The lease provides for annual increases in lease payments equal to the increase in the consumer price index, capped at 2.5%.

The SMSA Acquisition is accounted for using the purchase method of accounting. The purchase price of this transaction was allocated to assets acquired based upon their respective fair values and the liabilities assumed are based on the expected or paid settlement amounts. The purchase price allocation is subject to change during the twelve month period subsequent to the acquisition date for items including actual settlement of the assumed liabilities. The operating results have been included in the Company’s interim consolidated financial statements since the date of the acquisition.

The initial purchase price allocation resulted in an acquired leasehold interest intangible asset of approximately $9,752,000. The intangible asset is subject to amortization over the remaining life of the lease, including renewal periods, a period of approximately 28 years. Amortization expense of approximately $49,000 related to this intangible asset was recorded in the three months ended September 30, 2007.

In connection with the SMSA Acquisition, the Company recognized a pre-tax charge for post acquisition integration costs of $326,000 in the three months ended September 30, 2007. The Company incurred $180,000 of travel and other out-of-pocket expenses immediately following the acquisition related to integration activities and $146,000 in severance and relocation costs resulting from the Texas regional office restructuring necessitated by the acquisition.

The SMSA Acquisition was financed with proceeds of a new loan, as discussed in Note 9.

4. 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 exceeds 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, 2007. For claims made during the period from March 10, 2007 through March 9, 2008, 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 $19,718,000 as of September 30, 2007. 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.

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 statements of income 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:

The Company’s cash expenditures for self-insured professional liability costs were $2,589,000 and $2,184,000 for the nine months ended September 30, 3007 and 2006, respectively.

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. 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 $411,000 as of September 30, 2007.

From June 30, 2003 until June 30, 2007, the Company entered into workers compensation insurance programs that provided 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, 2007, the Company has recorded estimated premium refunds due under these programs totaling approximately $2,712,000 included in “insurance refunds receivable” in the accompanying balance sheet. 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. Effective July 1, 2007, the Company obtained a guaranteed cost policy for workers compensation insurance, under which expense will be equal to the premiums paid. As a result, there will be no premium refunds associated with this new policy.

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 $1,003,000 at September 30, 2007. The differences between actual settlements and reserves are included in expense in the period finalized.

5. STOCK-BASED COMPENSATION

In August 2007 and in connection with the SMSA Acquisition, the Compensation Committee of the Board of Directors approved and the Company granted 4,950 Stock only Stock Appreciation Rights (“SOSARs”) at an exercise price of $10.67, the market price of the Company’s common stock on the date the SOSARs were granted. This grant is in addition to the 107,700 SOSARs granted in March 2007 at an exercise price of $11.59. All SOSARs granted during 2007 will vest one-third on the first, second, and third anniversaries of the grant date.

As a result of the SOSARs granted in August and March, the Company recorded $170,000 and $381,000 in stock-based compensation expense for the three month and nine month periods ending September 30, 2007. As of September 30, 2007, there was approximately $763,000 of remaining compensation costs related to the SOSARs granted to be recognized over the remaining vesting period. The Company estimated the total recognized and unrecognized compensation using the Black-Scholes-Merton (“BSM”) option valuation model.

6. RECLASSIFICATIONS

As discussed in Note 7, the consolidated financial statements of the Company have been reclassified to reflect as discontinued operations certain divestitures and lease terminations.

7. DISCONTINUED OPERATIONS

Effective March 31, 2007 the Company terminated operations at its leased facility in Eureka Springs, Arkansas. The owner of the property, a subsidiary of Omega , sold the property and the Company cooperated in an orderly transition to the new owner.

The facility had low occupancy and operated at a loss. The facility had been leased subject to a master lease covering 29 nursing centers. Under the terms of that lease, the master lease rental payment was not reduced. The discontinued facility contributed revenues of $575,000 and $1,508,000 during the nine month periods ended September 30, 2007 and 2006, respectively. In 2003, the Company recorded an impairment charge of $178,000 to reduce the net book value of this property to its estimated realizable value, and there was no material loss recorded in connection with the lease termination.

In May 2006, the Company completed the sale of certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. In 2005, the Company recorded an impairment charge of $4,397,000 to reduce the net book value of these properties to their estimated realizable value, and no material gain or loss was recognized upon the completion of the sale in 2006. The Company closed its only remaining North Carolina assisted living facility in April 2006 and is continuing its efforts to sell this facility and land. In September 2007 the Company sold the bed license for the remaining North Carolina assisted living facility for a sales price of $183,000 and recognized a pretax gain on sale of discontinued operations of $45,000.

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 interim consolidated financial statements.

8. EARNINGS PER SHARE

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

The impact of the weighted average SOSARs outstanding were not included in the computation of diluted earnings per common share because these securities would have been anti-dilutive due to the effects of stock based compensation charges that will be recognized in future periods. In addition, diluted earnings per common share in the three and nine months ended September 30, 2006 included the

impact of 642,000 and 635,000 dilutive shares, respectively, resulting from the assumed conversion of the Series B Convertible Preferred Stock. In 2006, the Series B Convertible Preferred Stock was exchanged for Series C Preferred Stock, which is not convertible into common shares and, therefore, no convertible preferred stock was outstanding during 2007.

9. LONG-TERM DEBT AND FINANCING TRANSACTION

In August 2007, the Company entered into an agreement with LaSalle Bank NA, for a $16,500,000 term loan to finance the SMSA Acquisition and repay certain existing indebtedness. The term loan has an interest rate of LIBOR plus 2.5%, a maturity of five years, and principal payments based on a ten year amortization, with additional payments based on cash flow from operations and amounts realized related to certain collateral. The term loan is secured by receivables and all other unencumbered assets of the Company, including land held for sale, insurance refunds receivable and notes receivable. In addition to financing the acquisition, the Company used proceeds from this term loan to retire a $4,027,000 term loan with an interest rate of LIBOR plus 6.25%, and a $2,534,000 subordinated note due in September 2007 with an interest rate of 7%, and expensed related deferred financing costs of $116,000 during the quarter ended September 30, 2007. The deferred financing costs written off relate to the debt that was retired and are reflected as debt retirement costs in the income statement.

In addition, the agreement with LaSalle also includes a $15,000,000 revolving credit facility that provides revolving credit loans as well as the issuance of letters of credit. The revolver is secured by accounts receivable and replaced the Company’s previous $2,300,000 line of credit. The revolver provides for a maximum draw of up to $21,000,000 during the first six months to finance start up working capital requirements of the SMSA Acquisition, after which period the maximum draw is reduced to $15,000,000. There are limits on the maximum amount of loans that may be outstanding under the revolver based on borrowing base restrictions. The revolver has a term of three years and bears interest at the Company’s option of LIBOR plus 2.25% or the bank’s prime lending rate. Annual fees for letters of credit issued under this revolver are 2.25% of the amount outstanding. Historically, the Company’s accounts receivable had been pledged as security primarily for the Company’s leases with Omega. Under this refinancing, the accounts receivable serve as the collateral for the new revolver as of September 30, 2007 and the Company has a letter of credit of approximately $8,117,000 to serve as a replacement security deposit for all of the Company’s leases with Omega. Considering this letter of credit and the borrowing base restrictions, the balance available for future revolving credit loans would be $7,073,000. Such amounts are available to fund the working capital needs of this transaction and future expansion opportunities. As of September 30, 2007, the Company had no borrowings outstanding under the revolving credit facility.

The Company’s debt agreements require that proceeds received upon certain asset dispositions be paid to reduce the balance. During the nine months ending September 30, 2007, additional principal payments of $2,441,000 were made from such proceeds.

The Company’s debt agreements contain various financial covenants the most restrictive of which relate to cash flow, debt service coverage ratios, liquidity and limits on the payment of dividends to shareholders. The Company is in compliance with such covenants at September 30, 2007.

10. 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 interim consolidated statements of income.

11. INCOME TAXES

Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48” or “the interpretation”). This interpretation provides guidance on financial statement recognition and measurement of tax positions taken, or expected to be taken, in tax returns. The initial adoption of the interpretation had no impact on the Company’s financial statements.

In connection with the Canadian Customs and Revenue Agency (“CCRA”) audit of the Canadian 2003 and 2002 federal tax returns of Diversicare Canada Management Services Co., Inc. (“DCMS”), the Company’s Canadian subsidiary sold in 2004, CCRA has proposed certain adjustments to the Company’s tax returns. Under the terms of the sale of DCMS, the Company is liable for any liability that arises from these adjustments.

As of September 30, 2007, the amount of unrecognized tax benefits was $823,000. The unrecognized tax benefits are accrued in “other current liabilities.” The $129,000 increase in the amount of unrecognized tax benefits in the three month period ended

September 30, 2007 was related to the adjustment of the estimated liability and to the fluctuation of the exchange rate between US and Canadian currencies.

The Company has chosen to classify interest and penalties as a component separate from income tax expense in its consolidated statements of income.

12. EVENT SUBSEQUENT TO THE BALANCE SHEET DATE

In November 2007, the Company’s Board of Directors authorized the repurchase of up to $2,500,000 of the Company’s common stock pursuant to a plan under Rule 10b5-1 and in compliance with Rule 10b-18 of the Securities Exchange Act of 1934, as amended. As of November 1, 2007, there were approximately 5,877,000 shares of common stock outstanding.

Share repurchases under this program are authorized through the earlier of one year from November 6, 2007 or the repurchase of the full amount authorized to be repurchased under the plan, subject to conditions specified in the plan. Repurchases may be made through open market or privately negotiated transactions in accordance with all applicable securities laws, rules, and regulations and will be funded from available working capital. The share repurchase program may be terminated at any time without prior notice.

retroactive adjustments. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Retroactive adjustments, 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 statements of income in the period identified.

Professional Liability and Other 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. 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 and consists of an estimate of the future costs to be incurred for the known claims. Expected insurance coverages are reflected as a reduction of the reserves. All of our self-insurance reserves are assessed and adjusted on a quarterly basis.

Accrual for Professional and General Liability Claims-

Because our actual liability for existing and anticipated professional liability and general liability claims will exceed our limited insurance coverage, we have recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $19.7 million as of September 30, 2007. 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 related legal costs incurred and expected to be incurred. All losses are projected on an undiscounted basis.

We retain a third-party actuarial firm to estimate the appropriate accrual for incurred general and professional liability claims. For current periods, the actuary primarily uses historical data regarding the frequency and cost of our past claims over a multi-year period and information regarding our number of occupied beds to develop its estimates of our ultimate professional liability cost for current periods. The actuary estimates our professional liability accrual for past periods by using currently-known information to adjust the initial reserve that was created for that period.

On a quarterly basis, we obtain reports of claims and lawsuits that 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 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 prior period may be revised upward or downward on a quarterly basis. Final determination of our actual liability for claims incurred in any given period is a process that takes years. For information regarding the amount of accrual by period, see Note 4, “Insurance Matters,” in the Notes to the Interim Consolidated Financial Statements.

Although we retain a third-party actuarial firm to assist us, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, our 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. Many factors could result in differences between amounts estimated and the ultimate amount of our loss for any period. One of the key assumptions in the actuarial analysis is that historical losses provide an accurate forecast of future losses. This assumption may not prove accurate, as changes in legislation such as tort reform, changes in our financial condition, changes in our risk management practices and other factors may affect the severity and frequency of claims incurred in future periods as compared to historical 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. 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 and that the expertise of a third- party actuary is required to estimate liabilities using this methodology.

Each quarter, we record in our consolidated statement of income for that period the estimated accrual for anticipated liability claims incurred in that period as well as any revisions in estimates and differences between actual settlements and accruals for prior periods. 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.

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, 2007, was $19.7 million, compared to current assets of $46.4 million and total assets of $111.1 million. For the nine months ended September 30, 2007 and 2006, our professional liability expense was a negative $3.0 million and a negative $5.5 million, respectively, with the negative amounts representing net benefits resulting from downward revisions in previous estimates. Our cash expenditures for self insured professional liability costs were $2.6 million and $2.2 million for the nine months ended September 30, 2007 and 2006, respectively. These amounts are material in relation to our reported net income from continuing operations for the related periods of $7.7 million and $20.0 million, respectively.

Accrual for Other Self-Insured Claim s-

With respect to workers compensation insurance, substantially all of our employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. 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 injuries 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 $0.4 million as of September 30, 2007.

From June 30, 2003 until June 30, 2007, we entered into workers compensation insurance programs that provided coverage for claims incurred, with premium adjustments depending on incurred losses. We account for premium expense under these policies based on our estimate of the level of claims expected to be incurred. As of September 30, 2007, we have recorded estimated premium refunds due under these programs totaling approximately $2.7 million, included in “insurance refunds receivable” in the accompanying balance sheet. 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. Effective July 1, 2007, we entered into a guaranteed cost policy for workers compensation insurance, under which expense will be equal to the premiums paid. As a result, there will be no premium refunds associated with this new policy.

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 $1.0 million at September 30, 2007. The differences between actual settlements and reserves are included in expense in the period finalized.

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 is based on estimated undiscounted future cash flows from a property compared to the carrying value of that property. If recognition of

impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property.

Accounting for Business Combinations

We account for our acquisitions in accordance with SFAS No. 141, “Business Combinations” and related interpretations. Our current acquisition has been accounted for as a purchase business combination. Purchase accounting requires that we make certain valuations based on our experience, including determining the fair value and useful lives of assets acquired and the expected settlement amount of liabilities assumed based upon their respective fair values. These valuations are subject to change during the twelve month period subsequent to the acquisition date. Such valuations require us to make significant estimates, judgments and assumptions, including projections of future events and operating performance.

Stock-Based Compensation

We account for our stock-based compensation in accordance with SFAS No. 123 (revised 2004), “Share-Based Payment,” using the modified prospective method, in which we recognize compensation cost for all share-based payments granted after the effective date, January 1, 2006. We record stock-based compensation expense by amortizing our unrecognized stock-based compensation on a straight-line basis over the remaining requisite service period. We calculated the recognized and unrecognized stock-based compensation using the Black-Scholes-Merton option valuation method, which 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 are 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 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.

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. The Centers for Medicare and Medicaid Services (“CMS”) established an exception process to permit therapy services in certain situations, and the majority of services provided by us are reimbursed under the exceptions. On December 9, 2006, Congress passed the Tax Relief and Health Care Act of 2006 (TRHCA), which includes an extension of the existing exceptions process through December 31, 2007. If the exception process is discontinued after 2007, it is expected that the reimbursement limitations will reduce therapy revenues, and negatively impact our operating results and cash flows. The TRHCA also reduces the maximum federal matching under Medicare provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in funding will become effective for fiscal years beginning after January 1, 2008.

Congress has implemented an annual market basket adjustment designed to increase Medicare reimbursement for the effects of inflation. CMS issued a final rule which includes a 3.3% market basket adjustment increase effective October 1, 2007. The actual amount of the market basket adjustment is based on several factors and varies for each individual center. The market basket adjustment became effective October 1, 2007, and is expected to result in an average increase in revenue of approximately 4.0% for our facilities as a group, and is expected to increase our revenue by approximately $0.3 million per month. However, the United States Congress is expected to pass a Medicare bill during the fourth quarter that may reduce or eliminate the market basket adjustment beginning January 1, 2008.

The Federal Deficit Reduction Act of 2005 mandates reducing 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 the Company.

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, 2007, we derived 31.2% and 56.2% of our total patient and resident 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 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.

Contractual Obligations and Commercial Commitments

We have certain contractual obligations of continuing operations as of September 30, 2007, summarized by the period in which payment is due, as follows (dollar amounts in thousands):

		(1) Long-term debt obligations include scheduled future payments of principal and interest of long-term debt.
		(2) Series C Preferred Stock includes quarterly dividend payments and redemption value at preferred shareholder’s earliest redemption date.
		(3) Payments for the elimination of preferred stock conversion feature.
		(4) Includes expenditure requirements for capital maintenance under mortgage loan covenants.
		(5) Includes capital 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 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 under these agreements is approximately $1.8 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, these 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 exercise price. Based on the closing price of our stock on September 30, 2007, the maximum contingent liability for the repurchase of the currently vested options is approximately $1.6 million. No amounts have been accrued for this contingent liability.

Results of Operations

As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed certain divestitures as well as a recent acquisition. We have reclassified our consolidated financial statements to present the divestitures as discontinued operations for all periods presented. We have also defined our same center operations in light of these divestitures and acquisition. Same center information excludes the operations of the SMSA facilities, and excludes all discontinued operations.

The following tables present the unaudited interim statements of income and related data for the three and nine month periods ended September 30, 2007 and 2006 for the Company, and include the results of the SMSA Acquisition beginning August 11, 2007, the effective date of the acquisition:

As a supplement to the tables above, the following tables present the unaudited interim statements of income from continuing operations before income taxes and related data for the three and nine month periods ended September 30, 2007 and 2006 on a same center basis, excluding the effects of the SMSA Acquisition and discontinued operations.

Three Months Ended September 30, 2007 Compared With Three Months Ended September 30, 2006

As noted in the overview, we have entered into certain divestiture transactions in recent periods, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.

Patient Revenues . Patient revenues increased to $63.9 million in 2007 from $53.4 million in 2006, an increase of $10.5 million, or 19.6%. Revenues related to the SMSA Acquisition were $6.6 million in 2007. Same center patient revenues increased to $57.3 million in 2007 from $53.4 million in 2006, an increase of $3.9 million, or 7.3%. This increase is due primarily to increased Medicaid rates in certain states and Medicare rate increases.

The following table summarizes key revenue and census statistics for the quarter and segregates effects of the SMSA Acquisition. Results for the SMSA Acquisition are included beginning August 11, 2007, the effective date of the acquisition.

On a same center basis, the Company’s average rate per day for Medicare Part A patients increased 9.7% in 2007 compared to 2006 as a result of annual inflation adjustments and the acuity levels of Medicare patients in our nursing centers, which were higher in 2007 than in 2006. Our average rate per day for Medicaid patients increased 6.3% in 2007 compared to 2006 as a result of increasing patient acuity levels, certain state increases to offset minimum wage adjustments, effects of stock based compensation charges and other rate increases in certain states.

Operating expense . Operating expense increased to $49.2 million in 2007 from $41.3 million in 2006, an increase of $7.9 million, or 19.1%. As a percentage of patient revenues, operating expense decreased to approximately 77.1% of revenue in 2007, compared to 77.4% of revenue in 2006. Operating expense related to the SMSA Acquisition was $5.9 million in 2007. Same center operating expense increased to $43.3 million in 2007 from $41.3 million in 2006, an increase of $2.0 million, or 4.8%. This increase is primarily attributable to cost increases related to wages and benefits.

The largest component of operating expenses is wages, which increased to $29.4 million in 2007 from $25.0 million in 2006, an increase of $4.4 million, or 17.6%. Wages related to the SMSA Acquisition were approximately $3.4 million. Same center wages increased approximately $1.0 million, or 4.1%, primarily due to increases in wages as a result of competitive labor markets in most of the areas in which we operate, regular merit and inflationary raises for personnel,(increase of approximately 3.5% for the period) and labor costs associated with increases in patient acuity levels.

Employee health insurance costs were approximately $0.2 million higher in 2007 compared to 2006 on a same center basis, an increase of approximately 22%. The Company is self insured for the first $150,000 in claims per employee each year. Employee health insurance costs can vary significantly from year to year.

These increased costs were partially offset by reductions in workers compensation costs. Costs of workers compensation insurance were approximately $0.3 million lower in 2007 compared to 2006 on a same center basis, due to better than expected claims experience.

The remaining increases in same center operating expense are primarily due to increases in patient acuity levels.

Lease expense . Lease expense increased to $5.2 million in 2007 from $3.9 million in 2006. Lease expense related to the SMSA Acquisition was $0.5 million for 2007. Same center lease expense increased to $4.6 million in 2007 from $3.9 million in 2006, an increase of $0.7 million. Effective October 1, 2006, we renewed a master lease covering 28 nursing centers. This resulted in an increase in lease expense of $0.6 million during 2007 for the effects of recording scheduled rent increases on a straight-line basis over the term of the renewal period. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year. In addition, there was an increase in lease expense of $0.1 million resulting from rent increases for lessor funded property renovations.

Professional liability. Professional liability expense in 2007 resulted in a benefit of $6,000, compared to an expense of $782,000 in 2006, a decrease in expense of $788,000. Professional liability expense related to the SMSA Acquisition was $84,000. Same center professional liability expense in 2007 resulted in a benefit of $90,000, compared to an expense of $782,000 in 2006, a decrease in expense of $872,000. Our cash expenditures for professional liability costs were $0.7 million and $1.0 million for the three month periods ended September 30, 2007 and 2006, respectively. During 2007, our total recorded liabilities for self-insured professional liability risks declined to $19.7 million at September 30, 2007, down from $25.7 million at December 31, 2006.

General and administrative expense . General and administrative expense increased to $4.1 million in 2007 compared to $3.9 million in 2006, an increase of $0.2 million, or 4.3%. General and administrative expense related to the SMSA Acquisition was $0.1 million. Same center general and administrative expense increased to $4.0 million in 2007 from $3.9 million in 2006, an increase of $0.1 million, or 2.3%. There was an increase to compensation costs of approximately $0.2 million. This cost increase was partially offset by a reduction in costs of compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 of $0.3 million. The majority of our costs of Sarbanes-Oxley compliance in 2006 were incurred in the third and fourth quarters.

As a percentage of total net revenues, general and administrative expense decreased to approximately 6.4% in 2007, compared to 7.3% in 2006.

Stock-based compensation. During 2007, we recorded stock-based compensation expense of $0.2 million, compared to $0.1 million in stock-based compensation during the same period of 2006.

Depreciation and amortization . Depreciation and amortization expense was approximately $1.0 million in 2007 compared to $0.9 million during 2006. The increase in 2007 is primarily due to depreciation and amortization expenses related to the SMSA Acquisition.

Post acquisition integration costs. In connection with the SMSA Acquisition, we recognized a pre-tax charge for post acquisition integration costs of $0.3 million in the three months ended September 30, 2007. We incurred $0.2 million of travel and other out-of-pocket expenses incurred immediately following the acquisition related to integration activities and $0.1 million in severance and relocation costs resulting from the Texas regional office restructuring necessitated by the acquisition.

Foreign currency transaction gain . A foreign currency transaction gain of $330,000 was recorded in 2007, compared to $29,000 in 2006. These gains result primarily from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004.

Interest expense . Interest expense increased to $1.0 million in 2007 from $0.9 million in 2006, an increase of $0.1 million or 7.2%. The increased debt associated with the SMSA Acquisition resulted in an increase in interest expense of approximately $137,000, and fees for letters of credit issued in 2007 were approximately $26,000. These increases were partially offset by reductions in interest resulting from principal payments and reduced interest for debt refinanced in August 2007.

Debt retirement costs. Debt retirement costs of $0.1 and $0.2 million in 2007 and 2006 are related to unamortized deferred finance costs of refinanced loans that were written off following the refinancing transactions we completed in August 2007 and August 2006.

Income from continuing operations before income taxes; income from continuing operations per common share . As a result of the above, continuing operations reported income before income taxes of $3.4 million in 2007 compared to $1.6 million in 2006. The provision for income taxes was $1.4 million in 2007, compared to a benefit for income taxes of $8.0 million in 2006. Our effective tax rate differs materially from the statutory rate in 2006 mainly due to changes in our valuation allowance for net deferred tax assets. During 2006, we recorded a deferred tax benefit to reduce deferred tax asset valuation allowances, based on improvements in our financial position and our updated forecast of income available to support the turnaround of existing net operating loss carryforward credits. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. The basic and

diluted income per common share from continuing operations were $0.33 and $0.32, respectively, in 2007, as compared to a basic and diluted income per common share from continuing operations of $1.64 and $1.41, respectively, in 2006.

Income from discontinued operations . As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed certain divestitures, and have reclassified our consolidated financial statements to present these divestitures as discontinued operations for all periods presented. The operating loss from discontinued operations, net of taxes, was approximately $100,000 in 2007, compared to a loss of $143,000 in 2006. The disposition of discontinued operations resulted in a gain of $28,000 in 2007 and a loss of $2,000 in 2006.

Nine Months Ended September 30, 2007 Compared With Nine Months Ended September 30, 2006

As noted in the overview, we have entered into certain divestiture transactions in recent periods, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.

Patient Revenues . Patient revenues increased to $173.9 million in 2007 from $159.5 million in 2006, an increase of $14.4 million, or 9.0%. Revenues related to the SMSA Acquisition were $6.6 million in 2007. Same center patient revenues increased to $167.3 million in 2007 from $159.5 million in 2006, an increase of $7.8 million, or 4.9%. This increase is primarily due to increased Medicaid rates in certain states and Medicare rate increases.

The following table summarizes key revenue and census statistics for the quarter and segregates effects of the SMSA Acquisition. Results for the SMSA Acquisition are included beginning August 11, 2007, the effective date of the acquisition.

On a same center basis, the Company’s average rate per day for Medicare Part A patients increased 7.1% in 2007 compared to 2006 as a result of annual inflation adjustments and the acuity levels of Medicare patients in our nursing centers, which were higher in 2007 than in 2006. Our average rate per day for Medicaid patients increased 4.7% in 2007 compared to 2006 as a result of increasing patient acuity levels, certain state increases to offset minimum wage adjustments, effects of stock based compensation charges and other rate increases in certain states.

Operating expense . Operating expense increased to $132.9 million in 2007 from $121.6 million in 2006, an increase of $11.3 million, or 9.3%. As a percentage of patient revenues, operating expense increased to 76.4% of revenue in 2007 compared to 76.3% of revenue in 2006. Operating expense related to the SMSA Acquisition was $5.9 million in 2007. Same center operating expense increased to $126.9 million in 2007 from $121.6 million in 2006, an increase of $5.3 million, or 4.4%. This increase is primarily attributable to cost increases related to wages and benefits, partially offset by reductions in bad debt expenses and costs of workers compensation insurance.

The largest component of operating expenses is wages, which increased to $79.3 million in 2007 from $72.4 million in 2006, an increase of $6.9 million, or 9.5%. Wages related to the SMSA Acquisition were approximately $3.4 million. Same center wages increased approximately $3.5 million, or 4.8%, primarily due to increases in wages as a result of competitive labor markets in most of the areas in which we operate, regular merit and inflationary raises for personnel (increase of approximately 3.7% for the period), and labor costs associated with increases in patient acuity levels.

Employee health insurance costs were approximately $0.5 million higher in 2007 compared to 2006 on a same center basis, an increase of approximately 16.2%. The Company is self insured for the first $150,000 in claims per employee each year. Employee health insurance costs can vary significantly from year to year.

These increased costs were partially offset by reductions in bad debt expense and workers compensation insurance. Bad debt expense was $0.4 million lower in 2007 compared to 2006, on a same center basis. Costs of workers compensation insurance were approximately $0.5 million lower in 2007 compared to 2006 on a same center basis, due to better than expected claims experience.

The remaining increases in operating expense are primarily due to the effects of increases in patient acuity levels.

Lease expense . Lease expense increased to $14.4 million in 2007 from $11.5 million in 2006. Lease expense related to the SMSA Acquisition was $0.5 million for 2007. Same center lease expense increased to $13.8 million in 2007 from $11.5 million in 2006. Effective October 1, 2006, we renewed a master lease covering 28 nursing centers. This resulted in an increase in lease expense of $1.8 million during 2007 for the effects of recording scheduled rent increases on a straight-line basis over the term of the renewal period. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year. In addition, there was an increase in lease expense of $0.4 million resulting from rent increases for lessor funded property renovations.

Professional liability. Professional liability expense in 2007 resulted in a benefit of $3.0 million, compared to a benefit of $5.5 million in 2006, a decrease in benefit of $2.5 million. Professional liability expense related to the SMSA Acquisition was $0.1 million. Our cash expenditures for professional liability costs were $2.6 million and $2.2 million for the nine month periods ended September 30, 2007 and 2006, respectively. During 2007, our total recorded liabilities for self-insured professional liability declined to $19.7 million at September 30, 2007, down from $25.7 million at December 31, 2006.

General and administrative expense . General and administrative expense increased to $12.2 million in 2007 from $11.1 million in 2006, an increase of $1.1 million or 9.6%. General and administrative expense related to the SMSA Acquisition was $0.1 million in 2007. Same center general and administrative expense increased to $12.1 million in 2007 from $11.1 million in 2006, an increase of $1.0 million, or 8.9%. The increase is primarily attributable to increased compensation costs.

As a percentage of total net revenues, general and administrative expense was approximately 7.0% of revenue in both 2007 and 2006.

Stock-based compensation. During 2007, we recorded stock-based compensation expense of $0.5 million, compared to $5.1 million in stock-based compensation during the same period of 2006.

Depreciation and amortization . Depreciation and amortization expense was approximately $2.9 million in 2007 and $2.8 million in 2006. The increase in 2007 is primarily due to depreciation and amortization expenses related to the SMSA Acquisition.

Post acquisition integration costs. In connection with the SMSA Acquisition, we recognized a pre-tax charge for post acquisition integration costs of $0.3 million in the three months ended September 30, 2007. We incurred $0.2 million of travel and other out-of-

pocket expenses incurred immediately following the acquisition related to integration activities and $0.1 million in severance and relocation costs resulting from the Texas regional office restructuring necessitated by the acquisition.

Foreign currency transaction gain . A foreign currency transaction gain of $743,000 was recorded in 2007, compared to $269,000 in 2006. These gains result primarily from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004.

Interest expense . Interest expense decreased to $2.5 million in 2007 from $2.8 million in 2006, a decrease of $0.3 million or 7.9%. Interest expense decreased as a result of payments of debt from proceeds of the sale of discontinued operations, principal payments made in connection with a refinancing transaction in August 2006, and other principal payments. These decreases were partially offset by debt increases associated with our SMSA Acquisition, which resulted in interest expense increases of approximately $0.1 million in 2007, and fees for letters of credit issued in 2007.

Debt retirement costs. Debt retirement costs of $0.1 and $0.2 million in 2007 and 2006 are related to unamortized deferred finance costs of refinanced loans that were written off following the refinancing transactions we completed in August 2007 and August 2006.

Income from continuing operations before income taxes; income from continuing operations per common share . As a result of the above, continuing operations reported income before income taxes of $12.6 million in 2007 compared to $10.9 million in 2006. The provision for income taxes was $4.9 million in 2007, compared to a benefit for income taxes of $9.1 million in 2006. Our effective tax rate differs materially from the statutory rate in 2006 mainly due to changes in our valuation allowance for net deferred tax assets. During 2006, we recorded a deferred tax benefit to reduce deferred tax asset valuation allowances, based on improvements in our financial position and our updated forecast of income available to support the turnaround of existing net operating loss carryforward credits. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. The basic and diluted income per common share from continuing operations were $1.26 and $1.21, respectively, in 2007, as compared to a basic and diluted income per common share from continuing operations of $3.42 and $3.00, respectively, in 2006.

Income from discontinued operations . As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed certain divestitures, and have reclassified our consolidated financial statements to present these divestitures as discontinued operations for all periods presented. Operating loss of discontinued operations, net of taxes, was approximately $101,000 in 2007, compared to a loss of $257,000 in 2006. The disposition of discontinued operations and completions of lease terminations resulted in a loss of $7,000, net of taxes, in 2007, compared to a loss of $122,000 in 2006.

Liquidity and Capital Resources

As of September 30, 2007, we had $38.5 million of outstanding borrowings, including $3.9 million in current scheduled payments of long-term debt. Current scheduled payments of long-term debt include payments required by our loan agreements from net proceeds received upon certain asset dispositions and operating cash flow. During the nine months ending September 30, 2007, additional principal payments of $2.4 million were made from such proceeds.

In August 2007, we entered into an agreement with LaSalle Bank NA, for a $16.5 million term loan to finance the SMSA acquisition and repay certain existing indebtedness. The term loan has an interest rate of LIBOR plus 2.5%, a maturity of five years, and principal payments based on a ten year amortization, with additional payments based on cash flow from operations and amounts realized related to certain collateral. The term loan is secured by receivables and all other unencumbered assets of the company, including land held for sale, insurance refunds receivable and notes receivable. In addition to financing the acquisition, we used proceeds from this term loan to retire a $4.0 million term loan that had an interest rate of LIBOR plus 6.25%, and a $2.5 million subordinated note due in September 2007 that had an interest rate of 7%.

In addition, the agreement with LaSalle also includes a $15 million revolving credit facility that provides revolving credit loans as well as the issuance of letters of credit. The revolver is secured by accounts receivable and replaced our previous $2.3 million line of credit. The revolver provides for a maximum draw of up to $21 million during the first six months to finance start up working capital requirements of the SMSA Acquisition, after which period the maximum draw is reduced to $15 million. There are limits on the maximum amount of loans that may be outstanding under the revolver based on borrowing base restrictions. The revolver has a term of three years and bears interest at our option of LIBOR plus 2.25% or the bank’s prime lending rate. Annual fees for letters of credit issued under this revolver are 2.25% of the amount outstanding. Historically, our accounts receivable had been pledged as security primarily for our leases with Omega. Under this refinancing, the accounts receivable serve as the collateral for the new revolver and we have issued a letter of credit of approximately $8.1 million to serve as a replacement security deposit for all of our leases with Omega. Considering this letter of credit

and the borrowing base limits at September 30, 2007, the balance available for future revolving credit loans would be $7.1 million. Such amounts are available to fund the working capital needs of this transaction and future expansion opportunities. As of September 30, 2007, we had no borrowings outstanding under our revolving credit facility.

Our debt agreements contain various financial covenants the most restrictive of which relate to cash flow, debt service coverage ratios, liquidity and limits on the payment of dividends to shareholders. We are in compliance with such covenants at September 30, 2007.

We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. Due to our past claim 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, since 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, 2007. For claims made during the period from March 10, 2007 through March 9, 2008, we maintain insurance coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.

As of September 30, 2007, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $19.7 million. 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. Settlements of currently pending claims will require additional cash expenditures.

In November 2007, the Company’s Board of Directors authorized the repurchase of up to $2.5 million of our common stock pursuant to a plan under Rule 10b5-1 and in compliance with Rule 10b-18 of the Securities Exchange Act of 1934, as amended. As of November 1, 2007, there were approximately 5.9 million shares of common stock outstanding.

Share repurchases under this program are authorized through the earlier of one year from November 6, 2007 or the repurchase of the full amount authorized to be repurchased under the plan, subject to conditions specified in the plan. Repurchases may be made through open market or privately negotiated transactions in accordance with all applicable securities laws, rules, and regulations and will be funded from available working capital. The share repurchase program may be terminated at any time without prior notice.

Net cash provided by operating activities of continuing operations before changes in other assets and liabilities totaled $10.8 million and $11.4 million in the nine month periods ended September 30, 2007 and 2006, respectively. These amounts primarily represent the net cash flows from operations. The effects of working capital changes were to use $4.2 million and $4.0 million of cash, respectively, in the nine month periods ended September 30, 2007 and 2006, resulting in net cash provided by continuing operations of $6.6 million and $7.4 million, respectively, in the nine month periods ended September 30, 2007 and 2006. Discontinued operations used cash of $21,000 and provided cash of $0.2 million in the nine month periods ended September 30, 2007 and 2006, respectively.

Investing activities of continuing operations used cash of $10.8 million and provided cash of $7.7 million in the nine month periods ended September 30, 2007 and 2006, respectively. These amounts primarily represent proceeds from the sale of discontinued operations in 2006, net of cash used for the SMSA Acquisition and for purchases of property, plant and equipment. We have used between $3.0 million and $4.1 million for capital expenditures of continuing operations in each of the three calendar years ending December 31, 2006. Such expenditures were primarily for facility improvements and equipment, which were financed principally through working capital. For the year ending December 31, 2007, we anticipate that capital expenditures for improvements and equipment for our existing facility operations will be higher as we complete facility renovations at certain owned facilities. Investing activities of discontinued operations used no cash in the first nine months of 2007 and $24,000 in cash in 2006.

Financing activities of continuing operations provided cash of $5.8 million and used cash of $14.4 million in the nine month periods ended September 30, 2007 and 2006, respectively. These amounts include proceeds from the issuance of debt and payments to retire existing debt. Proceeds from the sale of discontinued operations were used to repay debt. There were no cash flows from financing activities of discontinued operations in 2007 or 2006. No interest costs or debt were allocated to discontinued operations.

Facility Renovations

During 2005 we began an initiative to complete strategic renovations of certain facilities to improve occupancy, quality of care and profitability. We developed a plan to that began with those facilities with the greatest potential for benefit, and began the renovation program during the third quarter of 2005. As of September 30, 2007, we have completed renovation projects at seven facilities. We have 3 additional renovation projects in progress.

A total of $9.3 million has been spent on these renovation programs to date, with $7.2 million spent on facilities leased from Omega and $2.1 million spent on owned facilities. The amounts spent on the facilities leased from Omega are financed through increased rent, and are not reflected as capital expenditures.

For the six facilities with renovations completed before the beginning of the third quarter 2007, third quarter occupancy improved from 61.5% in 2006 to 68.1% in 2007, and Medicare census as a percent of total increased from 13.9% in 2006 to 16.4% in 2007. No

assurance can be given that these facilities will continue to show such occupancy or revenue mix improvement or that the other renovated facilities will experience similar improvements.

West Virginia Facility Option Agreement

We have entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia. During 2007, we made an application to state regulatory authorities to allow us to operate the facility, and construct a new 90 bed replacement facility. In the event our application is approved, we will seek to arrange financing and begin construction of the replacement facility.

Receivables

Our operations could be adversely affected if we experience significant delays in reimbursement from Medicare, Medicaid and 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 $25.4 million at September 30, 2007, compared to $18.5 million at December 31, 2006, representing approximately 32 and 31 days in accounts receivable at each period end, respectively. The SMSA Acquisition resulted in an increase in accounts receivable of approximately $4.8 million at September 30, 2007. As part of the procedural Medicare and Medicaid change of ownership process, payments from Medicaid and Medicare for SMSA facilities were temporarily delayed, resulting in an increase in receivables as of September 30, 2007. Without the effects of these payment delays, accounts receivable would have represented approximately 29 days at September 30, 2007.

The allowance for bad debt was $2.3 million at September 30, 2007, compared to $2.1 million at December 31, 2006. 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.

Inflation

We do not believe that our operations have been materially affected by inflation. We expect salary and wage increases for our skilled staff to continue to be higher than average salary and wage increases, as is common in the health care industry.

Off-Balance Sheet Arrangements

We had letters of credit outstanding of approximately $8.1 million as of September 30, 2007, which serve as a security deposit for our facility leases with Omega. The letters of credit were issued in connection with our revolving credit facility. Our accounts receivable serve as the collateral for this revolving credit facility.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157; “Fair Value Measurements” (“SFAS No. 157”). This new standard provides guidance for using fair value to measure assets and liabilities and establishes a fair value hierarchy that prioritizes the information used to develop the measurements. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. The provisions of SFAS No. 157 are effective for entities as of the beginning of a fiscal year that begins after November 15, 2007. Earlier application is permitted, provided that the reporting entity has not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. We do not expect the adoption of this new standard to have a material impact on our financial position.

In February 2007, the FASB issued SFAS No. 159; “The Fair Value Option for Financial Assets and Financial Liabilities — including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). This new standard permits entities to choose to measure many financial instruments and certain other items at fair value. Most provisions of SFAS No. 159 will only impact those entities that elect the fair value option or have investments accounted for under FASB Statement No. 115. The provisions of SFAS No. 159 are effective for entities as of the beginning of a fiscal year that begins after November 15, 2007. Earlier application is permitted,

provided that the reporting entity also elects to apply the provisions of SFAS No. 157. We do not expect the adoption of this new standard to have a material impact on our financial position.

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 Annual Report on Form 10-K for the year ended December 31, 2006. 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 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 integrate the seven skilled nursing facilities acquired from Senior Management Services of America North Texas, Inc. into our business and achieve the anticipated cost savings, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under our credit agreements, 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 regulatory proceedings alleging violations of laws and regulations governing quality of care or violations of other laws and regulations applicable to our business, our ability to control costs, changes to our valuation of deferred tax assets, changes in occupancy rates in our facilities, changing economic conditions 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” and in Part II “Item 1A — Risk Factors” below as well as risks identified in our Form 10-K for the year ended December 31, 2006 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.

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, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

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.

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		Bylaws of the Registrant (incorporated by reference to Exhibit 3.2 to the Company’s Registration Statement No. 33-76150 on Form S-1)
3.3		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)
3.4		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)
3.5		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).
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)
10.1		Operations Transfer Agreement effective as of July 20, 2007, by and among certain subsidiaries of the Company, and Senior Management Services of America North Texas, Inc., a Texas corporation, Senior Management Services of Estates at Fort Worth, Inc., a Texas corporation, Senior Management Services of Doctors at Dallas, Inc., a Texas corporation, Senior Management Services of Humble, Inc., a Texas corporation, Senior Management Services of Katy, Inc., a Texas corporation, Senior Management Services of Treemont, Inc., a Texas corporation, Senior Management Services of Heritage Oaks at Ballinger, Inc., a Texas corporation, and Senior Management Services of Normandy at San Antonio, Inc., a Texas corporation
10.2		Loan and Security Agreement made as of August 10, 2007, between Diversicare Leasing Corp., a Tennessee corporation, and Bridge Associates LLC, as trustee for the SMSA Creditors’ Trust, a Texas trust.

Exhibit
Number		Description of Exhibits
10.3		Loan and Security Agreement dated as of August 10, 2007, is by and among the Company and certain subsidiaries and LaSalle Bank National Association, a national banking association
10.4		Guaranty dated as of August 10, 2007, by Advocat Inc., a Delaware corporation to and for the benefit of LaSalle Bank National Association, a national banking association
10.5		Revolving Credit Note dated August 10, 2007 in the principal amount of $21,000,000.00 from the Company and certain subsidiaries to LaSalle Bank National Association, a national banking association
10.6		Term Loan Note dated August 10, 2007 in the principal amount of $16,500,000.00 from the Company and certain subsidiaries to LaSalle Bank National Association, a national banking association
10.7		Fifth Amendment to Consolidated Amended and Restated Master Lease dated as of August 10, 2007 by and between Sterling Acquisition Corp., a Kentucky corporation and Diversicare Leasing Corp., a Tennessee corporation
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).