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, 2008

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 Number: 1-12996

Advocat Inc.

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

1621 Galleria Boulevard, Brentwood, TN 37027

(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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller reporting company þ
				(Do not check if a smaller reporting company)

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

5,670,987

 

 

TABLE OF CONTENTS

ADVOCAT INC.

interests in the facilities, inventory and certain equipment, but did not acquire working capital or assume liabilities, apart from certain obligations for employee paid-time-off benefits, specified lease related obligations and 2007 property taxes.

The facilities are leased from a subsidiary of Omega Healthcare Investors, Inc. (“Omega”). Prior to the SMSA Acquisition, the Company leased 28 facilities from Omega under a master lease agreement (the “Master Lease”). In connection with this acquisition, the Company amended the Master Lease to include the seven SMSA facilities. The substantive terms of the SMSA lease, including payment provisions and lease period including renewal options, were not changed by this amendment. The lease terms for the seven SMSA facilities provide for an initial term and 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, not to exceed 2.5%.

The SMSA Acquisition is accounted for using the purchase method of accounting. The purchase price of this transaction was allocated to the identifiable 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 was subject to change during the twelve month period subsequent to the acquisition date for items including actual settlement of the assumed liabilities and is now final. The operating results have been included in the Company’s consolidated financial statements since the date of the acquisition.

During the three months ended June 30, 2008, the Company received notification of payments due to the Centers for Medicare and Medicaid Services (“CMS”) related to Medicare reimbursement for 1997 and earlier periods for one of the acquired facilities. The total amount of the payments requested by CMS as of September 30, 2008 was approximately $1,436,000, including accrued interest of approximately $807,000. The Company intends to seek relief for this assessment from CMS, and is seeking to have the assessment declared to be the responsibility of previous owners of the facility in litigation pending in the United States Bankruptcy Court for the Northern District of Texas, which is the court in which SMSA’s bankruptcy case was filed. In the second quarter of 2008, the Company recorded a liability of $1,022,000 for its estimate of its ultimate liability for this assessment and defense costs, resulting in an increase in the acquired leasehold interest intangible asset. The Company’s estimate of the liability takes into consideration the facts and circumstances, including the number of operators of the property in the intervening period since the original assessment and delays by CMS in seeking collection.

The following table summarizes the final purchase price allocation of the net assets acquired, including the adjustment described above:

The purchase price allocation resulted in an acquired leasehold interest intangible asset of approximately $10,653,000. The intangible asset is subject to full amortization over the remaining life of the lease, including renewal periods, a period of approximately 28 years. Amortization expense of approximately $278,000 related to this intangible asset was recorded during the nine month period ended September 30, 2008.

4. AMENDMENT TO MASTER LEASE AGREEMENT FOR REPLACEMENT FACILITY

In November 2007, the Company entered into a short-term, single facility lease with Omega for an existing 102 bed skilled nursing center in Paris, Texas, and undertook an evaluation of the feasibility of entering into an agreement with Omega for the construction of a replacement facility. On March 14, 2008, the Company entered into an amendment to its master lease with Omega to provide for the construction and lease of a replacement facility. Upon the completion of the construction of the replacement facility, the existing building will be closed and the single facility lease terminated.

Under the terms of the lease amendment, Omega will provide funding and the Company will supervise the construction of the facility. Construction began during the second quarter of 2008, with completion expected in mid-2009. Rent will commence upon completion of the project, but no later than August 2009. Once construction is completed, annual rent will be equal to 10.25% of the total cost of the replacement facility, including direct costs of construction, carrying costs during the construction period, furnishings and equipment, land cost and the value of the related skilled nursing facility license. The total cost of the replacement facility was originally expected to be approximately $7.0 million and is currently expected to be approximately $7.9 million. Under the terms of the March 14, 2008 lease amendment and an October 24, 2008 lease amendment, costs incurred in excess of the current estimated cost of $7.9 million would be borne by the Company. The lease amendment provides for renewal options with respect to the new facility through 2035.

The replacement facility will be subject to the requirements of the Company’s current master lease, with certain exceptions for capital spending requirements. At the fifth anniversary of rent commencement for the replacement facility, the Company may terminate the lease with respect to this facility. Beginning 18 months after the facility commences operations and continuing until the fifth anniversary of rent commencement, Omega may terminate the lease for this facility if the cash flow of the facility (as defined in the lease amendment) is less than 1.2 times the then existing rent. If the Company elects to continue the lease, annual rentals for this facility may be increased by an amount equal to one half of the amount of the cash flow of the facility (as defined in the lease amendment) in excess of 1.2 times the then existing rent, effective as of the start of the sixth year after the completion of the building. If at any time beginning 18 months after the completion of the building the average annual cash flow of the facility exceeds 1.3 times the then existing rent, the termination options of both Omega and the Company are eliminated, and the rent reset provisions described above are eliminated.

5. 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 asserted prior to March 10, 2007. For claims made during the period from March 10, 2007 through March 9, 2009, the Company maintains insurance with coverage limits of $100,000 per medical incident and total annual aggregate policy coverage limits of $500,000. As of September 30, 2008, payments already made by the insurance provider for the period from March 10, 2007 through March 9, 2009 have reduced the remaining aggregate coverage amount in the policy period, but coverage has not been exhausted.

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 $17,038,000 as of September 30, 2008. 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 prepared by the Actuarial Division of Willis of Tennessee, Inc. (“Willis”). 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 Willis 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. 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 $3,806,000 and $2,589,000 for the nine months ended September 30, 2008 and 2007, respectively. In April 2008, the Company entered into individual agreements to settle eight professional liability cases for a total of $4,950,000, including $200,000 paid from insurance proceeds. The settlements will be paid in installments from April 2008 through January 2009. As of September 30, 2008, the Company is obligated to pay installments that total $2,050,000 related to these settlements. The remaining obligation for these claims is fully accrued and included in the accrual for professional liability claims. In addition to these settlement payments, the Company will have throughout the year additional cash expenditures for other settlements and self-insured professional liability costs.

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 $380,000 as of September 30, 2008.

From June 30, 2003 until June 30, 2007, the Company’s workers’ compensation insurance programs provided coverage for claims incurred with premium adjustments depending on incurred losses. The Company accounts for premium expense under these policies based on its estimate of the level of claims expected to be incurred, and had recorded insurance refunds receivable of $1,234,000 as of December 31, 2007. During the nine months ended September 30, 2008, the Company received the proceeds of these insurance refunds. 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.

From July 1, 2007 through June 30, 2008, the Company had a guaranteed cost policy for workers’ compensation insurance, under which expense was equal to the premiums paid. As a result, there will be no premium refunds for this policy period.

For the period from July 1, 2008 through June 30, 2009, the Company entered into a prefunded deductible workers’ compensation policy. Under this policy, the Company is self insured for the first $500,000 per claim, subject to an aggregate maximum of $3,000,000. The Company funds a loss fund account with the insurer to pay for claims below the deductible. The Company accounts for premium expense under this policy based on its estimate of the level of claims subject to the policy deductibles expected to be incurred. Any differences in estimated claims costs and actual amounts 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 $974,000 at September 30, 2008. The differences between actual settlements and reserves are included in expense in the period finalized.

6. STOCK-BASED COMPENSATION

The Company’s Board of Directors adopted and the shareholders approved at the Annual Meeting in June 2008 the Advocat Inc. 2008 Stock Purchase Plan for Key Personnel (“Stock Purchase Plan”). The Stock Purchase Plan provides for the granting of rights to purchase shares of the Company’s common stock to directors and officers and is administered by the compensation committee of the board of directors. The maximum number of shares of the Company’s common stock to be authorized and reserved for issuance under the Stock Purchase Plan is 150,000 shares, subject to equitable adjustment as set forth in the Stock Purchase Plan.

The plan allows participants to elect to utilize a specified portion of base salary, annual cash bonus, or director compensation to purchase restricted shares or restricted share units at a price equal to 85% of the fair market value of a share of the Company’s common stock on the date on which such restricted shares or restricted share units are purchased.

The restricted period for restricted shares or restricted share units issued under the Stock Purchase Plan is generally two years from the date of purchase. During the restricted period the shares will have all rights of other shares including voting rights and the rights to receive dividends, however, the restricted share certificates will not be delivered to the shareholder and the shares cannot be sold, assigned or disposed of during the restricted period. No grants of restricted shares or restricted share units can be made under the Stock Purchase Plan after April 25, 2018.

During the nine month period ended September 30, 2008, the Compensation Committee of the Board of Directors approved grants of 110,700 Stock only Stock Appreciation Rights (“SOSARs”) at a weighted average exercise price of $10.90. The SOSARs will vest one-third on the first, second, and third anniversaries of the grant date. As a result of the SOSARs granted the Company recorded an additional $151,000 and $325,000 in stock-based compensation expense for the three and nine month periods ended September 30, 2008. As of September 30, 2008, there was approximately $673,000 of remaining compensation costs related to these 2008 SOSARs 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.

This non-cash expense is included as a component of general and administrative expense or operating expense based upon the classification of cash compensation paid to the related employees. The Company recorded total stock-based compensation expense of $645,000 and $454,000 in the nine month periods ended September 30, 2008 and 2007, respectively.

In computing the fair value of these SOSARs, the Company estimated the SOSARs expected term based on the average of the vesting term and the original contractual terms of the grants, consistent with the interpretive guidance in Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) 107 and SAB 110 (the “Simplified Method”). The Company continues to use the Simplified Method since the Company’s exercise history is not representative of the expected term of the SOSARs granted in 2008. The Company’s recent exercise history is primarily from options granted in 2005 that were vested at grant date and were significantly in-the-money due to an increase in stock price during the period between grant date and formal approval by shareholders, and from older options granted several years ago that had fully vested.

7. RECLASSIFICATIONS

Certain amounts in the Company’s 2007 consolidated financial statements have been reclassified to conform to the 2008 presentation.

8. 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 Healthcare Investors, Inc., 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 the Omega master lease. Under the terms of that lease, the master lease rental payment was not reduced. This facility accounted for revenues of approximately $575,000 in the nine month period ended September 30, 2007.

The Company owns real estate related to an assisted living facility it closed in 2006 that is held for sale.

In accordance with the provisions of Financial Accounting Standards Board (“FASB”) Statements of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company has reclassified the operations of this facility and the real estate

described above as discontinued operations for all periods presented in the Company’s consolidated financial statements.

9. EARNINGS PER COMMON 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.

10. LONG-TERM DEBT

The Company has a $15,000,000 revolving credit facility that provides for revolving credit loans as well as the issuance of letters of credit. 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, expiring August 2010 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. The Company has a letter of credit of approximately $8,117,000 to serve as a security deposit for the Company’s leases with Omega. Considering the balance of eligible accounts receivable at September 30, 2008, the letter of credit and the current maximum loan amount of $15,000,000, the balance available for revolving credit loans as of September 30, 2008 was $6,467,000. As of September 30, 2008, the Company had no borrowings outstanding under the revolving credit facility.

The Company’s debt agreements require additional payments from proceeds received upon certain asset dispositions and excess cash flows, as defined in the debt agreements. In addition, the Company’s debt agreements allow for voluntary prepayments of principal outstanding, and during 2007, the Company made voluntary prepayments of $3,000,000. These prepayments reduce the required amounts that must be paid in the future from excess cash flows and asset dispositions.

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 all such covenants at September 30, 2008, with the exception of the Minimum Fixed Charge Coverage Covenant related to the Company’s term loan. The Minimum Fixed Charge Coverage Covenant was impacted by a combination of the decline in the Company’s operating performance and increased capital expenditures. On November 3, 2008 the Company received a covenant waiver from the bank effective for the period ending September 30, 2008 through the earlier of October 1, 2009 or the date the

Company amends the Minimum Fixed Charge Coverage Covenant. The Company and the bank are currently in discussions to amend the provisions of the Minimum Fixed Charge Coverage Covenant, and the terms of the waiver require that this amendment be completed by December 31, 2008. It is anticipated that the amendment will be completed in the fourth quarter of 2008 and that the Company would be in compliance with the proposed covenant for at least the next twelve months.

The Company is subject to a covenant under its mortgage loan that requires the Company to maintain a combined occupancy for seven owned homes that serve as collateral for the mortgage loan. The Company is in compliance with the covenant at September 30, 2008, however, the covenant becomes more restrictive as of December 31, 2008, and based on occupancy at September 30, 2008, the Company would not be in compliance with the more restrictive covenant. The Company is currently in discussions with its mortgage lender to amend these covenants, and based on these discussions with the lender and forecasted occupancy at these facilities, it is anticipated that the Company will remain in compliance with the revised covenant for at least the next twelve months.

11. INCOME TAXES

In periods prior to 2001, the Company generated tax credits under the Work Opportunity Tax Credit program totaling approximately $328,000. As the Company was incurring taxable losses in those years the Company did not record tax assets related to these credits. During the three months ending March 31, 2008, the Company recorded these carryforward credits as deferred tax assets, as the Company anticipates using them to reduce its taxes payable in 2008. The impact of recording these assets reduced the effective tax rate for the nine months ending September 30, 2008.

The Canada Customs and Revenue Agency (“CCRA”) audited the 2003 and 2002 Canadian federal tax returns of Diversicare Canada Management Services Co., Inc. (“DCMS”), the Company’s Canadian subsidiary sold in 2004, and proposed certain adjustments to the DCMS tax returns. The adjustments related to deductions for the allocation of overhead charges of United States management to DCMS. Under the terms of the sale of DCMS, the Company is liable for any liability that arises from these adjustments. In 2005, the Company recorded a charge for its estimated liability for additional tax, interest and professional fees resulting from these proposed adjustments. During 2008, the Company paid $234,000 to settle the remaining tax liability with CCRA. The payment decreased the unrecognized tax benefits accrued in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109.”

12. AMENDMENT TO SHAREHOLDERS’ RIGHTS PLAN

On August 1, 2008, the Company’s Board of Directors approved amending its current Amended and Restated Rights Agreement (the “Rights Agreement”). The amendment provides for an increase of the exercise price of the rights under the Rights Agreement (the “Rights”) to $50 from $15 and for the extension of the Expiration Date of the Rights to August 2, 2018. In addition, the amendment includes a share exchange feature that provides the Company’s Board of Directors the option of exchanging, in whole or in part, each Right, other than those of the hostile acquiring holder, for one share of the Company’s common stock. This provision is intended to avoid requiring Rights holders to pay cash to exercise their Rights and to alleviate the uncertainty as to whether holders will exercise their Rights.

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 and Southwest. 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, 2008, our continuing operations consisted of 50 nursing centers with 5,773 licensed nursing beds and 31 assisted living units. As of September 30, 2008, our continuing operations included nine owned nursing centers and 41 leased nursing centers.

Acquisitions and New Lease . Effective August 11, 2007, we purchased the leasehold interests and operations of seven skilled nursing facilities from SMSA for a price of approximately $11.0 million. Effective November 1, 2007, we entered into an agreement to lease a single facility in Texas from a subsidiary of Omega. Together, these facilities are referred to as the “New Texas Facilities.”

Divestitures. Effective March 31, 2007, we terminated operations at a leased facility in Arkansas that had low occupancy and operated at a loss. The owner of the facility sold the property and we cooperated in an orderly transition to the new owner. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect this divestiture 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 amortization expenses, incurred in the operation of the nursing centers we own and lease. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our interest, depreciation and amortization expenses include all such expenses across the range of our operations.

Critical Accounting Policies and Judgments

A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often of the need to make estimates about the effect of matters that are inherently uncertain. Actual results could differ from those estimates and cause our reported net income to vary significantly from period to period. Our accounting policies that fit this definition include the following:

Revenues

Patient Revenues

The fees we charge patients in our nursing centers are recorded on an accrual basis. These rates are contractually adjusted with respect to individuals receiving benefits under federal and state-funded programs and other third-party payors. Our net revenues are derived substantially from Medicare, Medicaid and other government programs (approximately 85.0% and 87.4% for the nine month periods ended September 30, 2008 and 2007, respectively). Medicare intermediaries make retroactive adjustments based on changes in allowed claims. In addition, certain of the states in which we operate require

complicated and detailed cost reports which are subject to review and adjustments. In the opinion of management, adequate provision has been made for 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

We evaluate the collectability of our accounts receivable by reviewing current agings of accounts receivable, historical collections data and other factors. As a percentage of revenue, our provision for doubtful accounts was approximately 0.8% and 0.5% for the nine month periods ended September 30, 2008 and 2007, respectively. During 2007, bad debt expense was lower due to better than expected collections experience. On a full year basis, our provision for doubtful accounts was approximately 0.4%, 0.8% and 0.8% for 2007, 2006 and 2005, respectively. Historical bad debts have generally resulted from uncollectible private pay balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off.

Professional Liability and Other Self-Insurance Reserves

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 $17.0 million as of September 30, 2008. 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 Willis, a third-party actuarial firm, to estimate the appropriate accrual for incurred general and professional liability claims. The actuary, Willis, 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. 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 $3.8 million and $2.6 million for the nine months ended September 30, 2008 and 2007, respectively. In April 2008, the Company entered into individual agreements to settle eight professional liability cases for a total of $5.0 million, including $200,000 paid from insurance proceeds. The settlements will be paid in installments from April 2008 through January 2009. As of September 30, 2008, we are obligated to pay installments that total $2.1 million related to these settlements. The remaining obligation for these claims is fully accrued and is included in the accrual for professional liability claims. In addition to these settlement payments, we will have additional cash expenditures throughout the year for other settlements and self-insured professional liability costs.

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.

Professional liability costs are material to our financial position, and changes in estimates as well as differences between estimates and the ultimate amount of loss may cause a material fluctuation in our reported results of operations. Our professional liability expense was $0.6 million for the nine month period ended September 30, 2008, compared to negative $3.0 million for the nine months ended September 30, 2007, 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 $4.5 million and $7.7 million, respectively. The total liability recorded at September 30, 2008, was $17.0 million, compared to current assets of $44.0 million and total assets of $109.0 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.

Accrual for Other Self-Insured Claim s-

From June 30, 2003 until June 30, 2007, our workers’ compensation insurance programs provided coverage for claims incurred with premium adjustments on incurred losses. We account for premium expense under these policies based on our estimate of the level of claims expected to be incurred and had recorded insurance refunds receivable of $1.2 million as of December 31, 2007. During the nine months ended September 30, 2008, we received the proceeds of these insurance refunds. 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.

From July 1, 2007 through June 30, 2008, we had a guaranteed cost policy for workers’ compensation insurance, under which expense was equal to the premiums paid. As a result, there will be no premium refunds for this policy period.

For the period from July 1, 2008 through June 30, 2009, we entered into a prefunded deductible workers’ compensation policy. Under this policy, we are self insured for the first $500,000 per claim, subject to an aggregate maximum of $3,000,000. We fund a loss fund account with the insurer to pay for claims below the deductible. We account for premium expense under this policy based on our estimate of the level of claims subject to the policy deductibles expected to be incurred. Any differences in estimated claims costs and actual amounts are included in expense in the period finalized.

We are self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually under a self-insurance plan. We provide reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate, based on known claims and estimates of unknown claims based on historical information. The liability for reported claims and estimates for incurred but unreported claims is $1.0 million at September 30, 2008. The differences between actual settlements and reserves are included in expense in the period finalized. Our reserves for health insurance benefits can fluctuate materially from one year to the next depending on the number of significant health issues of our covered employees and their dependants.

Asset Impairment

We evaluate our property and equipment on a quarterly basis to determine if facts and circumstances suggest that the assets may be impaired or that the estimated depreciable life of the asset may need to be changed such as significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property. 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 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. We did not record any asset impairments in the nine month periods ended September 30, 2008 and 2007. If our estimates or assumptions with respect to a property change in the future, we may be required to record additional impairment charges for our assets.

Business Combinations

We account for our acquisitions in accordance with SFAS No. 141, “Business Combinations” and related interpretations. The SMSA Acquisition in 2007 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 recognize compensation cost for all share-based payments granted after January 1, 2006 on a straight-line basis over the vesting period. We calculated the recognized and unrecognized stock-based compensation using the BSM 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. During the nine month periods ended September 30, 2008 and 2007, we recorded charges of approximately $0.6 million and $0.5 million, respectively, in stock-based compensation. Stock-based compensation expense is a non-cash expense, and such amounts are included as a component of general and administrative expense or

operating expense based upon the classification of cash compensation paid to the related employees.

Income Taxes

We determine deferred tax assets and liabilities based upon differences between financial reporting and tax bases of assets and liabilities and measure them using the enacted tax laws that will be in effect when the differences are expected to reverse. We maintain a valuation allowance of approximately $0.9 million to reduce deferred tax assets by the amount we believe is more likely than not to not be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance.

Health Care Industry

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse laws and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as the requirement to make 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, private pay and other third party 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 current limits impose a $1,810 per patient annual ceiling on physical and speech therapy services, and a separate $1,810 per patient annual ceiling on occupational therapy 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. In July 2008, Congress passed the Medicare Improvements for Patients and Providers Act of 2008, which extends the exceptions process through December 31, 2009. If the exception process is discontinued after December 31, 2009, it is expected that the reimbursement limitations will reduce therapy revenues and negatively impact our operating results and cash flows.

In December 2006, Congress passed the Tax Relief and Health Care Act of 2006 (TRHCA). The TRHCA reduces the maximum federal matching under Medicare provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in funding became effective for fiscal years beginning after January 1, 2008. This change has not had a material impact on our results of operations.

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. This provision has not had 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. As discussed previously, on May 1, 2008, CMS issued a draft regulation that would have reduced Medicare payments to skilled nursing facilities by approximately 0.3% effective October 1, 2008. The decrease was the net effect of a 3.3% decrease intended to correct CMS forecasting errors that resulted when the current Resource Utilization Group (“RUG”) system went into effect in 2006, partially offset by an inflation increase as measured by the SNF “market basket.” However, on July 31, 2008, CMS issued its final rule, providing for a 3.4% market basket increase, and indefinitely deferring the discussion of possible decreases related to any CMS perceived forecasting errors.

The 3.4% market basket increase is effective October 1, 2008. The actual amount of the market basket increase is based on several factors and varies for each individual center. It is estimated that the market basket adjustment will result in an average increase of approximately 3.5% for our facilities as a group, increasing the Company’s revenue by approximately $0.2 million per month.

We are unable to predict what, if any, reform proposals or reimbursement limitations will be implemented in the future, or the effect such changes would have on our operations. For the nine months ended September 30, 2008, we derived 31.7% and 53.3% 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 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, 2008, summarized by the period in which payment is due, as follows (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 in each employment agreement), or upon a change of control of the Company (as defined in each employment agreement). The maximum contingent liability under these agreements is approximately $2.0 million as of September 30, 2008. 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, those certain members of management may elect to require that we purchase equity awards granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated equity award exercise price. Based on the closing price of our stock on September 30, 2008, the maximum contingent liability for the repurchase of the equity grants is approximately $0.3 million. No amounts have been accrued for this contingent liability.

As a supplement to the tables above, the following tables present the unaudited statements of income from continuing operations before income taxes and related data for the three and nine month periods ended September 30, 2008 and 2007 on a same center basis, excluding the effects of the New Texas Facilities and discontinued operations.

SAME CENTER		Three Months Ended September 30,
(in thousands)		2008				2007				Change				%
PATIENT REVENUES, net		$	58,919			$	57,289			$	1,630				2.8
EXPENSES:
Operating			46,139				43,313				2,826				6.5
Lease			4,731				4,634				97				2.1
Professional liability			139				(90	)			229				254.4
General and administrative			4,412				4,174				238				5.7
Depreciation and amortization			1,065				944				121				12.8
Total expenses			56,486				52,975				3,511				6.6
OPERATING INCOME			2,433				4,314				(1,881	)			(43.6	)
OTHER INCOME (EXPENSE):
Foreign currency transaction gain (loss)			(126	)			330				(456	)			(138.2	)
Interest income			91				264				(173	)			(65.5	)
Interest expense			(560	)			(819	)			259				31.6
Debt retirement costs			—				(116	)			116				100.0
			(595	)			(341	)			(254	)			(74.5	)
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		$	1,838			$	3,973			$	(2,135	)			(53.7	)

SAME CENTER		Nine Months Ended September 30,
(in thousands)		2008				2007				Change				%
PATIENT REVENUES, net		$	175,744			$	167,262			$	8,482				5.1
EXPENSES:
Operating			134,767				126,964				7,803				6.1
Lease			14,168				13,841				327				2.4
Professional liability			556				(3,045	)			3,601				118.3
General and administrative			13,177				12,513				664				5.3
Depreciation and amortization			3,093				2,785				308				11.1
Total expenses			165,761				153,058				12,703				8.3
OPERATING INCOME			9,983				14,204				(4,221	)			(29.7	)
OTHER INCOME (EXPENSE):
Foreign currency transaction gain (loss)			(293	)			743				(1,036	)			(139.4	)
Interest income			371				771				(400	)			(51.9	)
Interest expense			(1,784	)			(2,411	)			627				26.0
Debt retirement costs			—				(116	)			116				100.0
			(1,706	)			(1,013	)			(693	)			(68.4	)
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		$	8,277			$	13,191			$	(4,914	)			(37.3	)

Three Months Ended September 30, 2008 Compared With Three Months Ended September 30, 2007

As noted in the overview, during 2007 we completed the SMSA Acquisition and entered into a lease for an additional facility in Texas (together, the “New Texas Facilities”). All results for the New Texas Facilities are included from the effective date of acquisition or inception of lease. Accordingly, the third quarter data referenced in the comparisons below for the New Texas Facilities is comparing the full quarter of 2008 to a partial quarter in 2007.

In addition, 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 $72.2 million in 2008 from $63.9 million in 2007, an increase of $8.3 million, or 13.0%. Revenues related to the New Texas Facilities were $13.3 million in 2008 and $6.6 million in 2007. Same center patient revenues increased to $58.9 million in 2008 from $57.3 million in 2007, an increase of $1.6 million, or 2.8%. This increase is primarily due to Medicare rate increases, increased Medicaid rates in certain states and increased private pay and managed care rates and census, partially offset by the effects of lower Medicaid and Medicare census.

The following table summarizes key revenue and census statistics for continuing operations for each period and segregates effects of the New Texas Facilities:

On a same center basis, the Company’s average rate per day for Medicare Part A patients increased 8.9% in 2008 compared to 2007 as a result of annual inflation adjustments and increased acuity levels of Medicare patients in our nursing centers, as indicated by RUG level scores, which were higher in 2008 than in 2007. Our average rate per day for Medicaid patients increased 3.3% in 2008 compared to 2007 as a result of increasing patient acuity levels and other rate increases in certain states.

Operating expense . Operating expense increased to $58.3 million in 2008 from $49.3 million in 2007, an increase of $9.0 million, or 18.4%. Operating expense related to the New Texas Facilities was $12.2 million in 2008 and $5.9 million in 2007. Same center operating expense increased to $46.1 million in 2008 from $43.3 million in 2007, an increase of $2.8 million, or 6.5%. This increase is primarily attributable to cost increases related to wages and benefits and other cost increases as discussed below. On a same center basis, operating expense increased to 78.3% of revenue in 2008, compared to 75.6% of revenue in 2007.

The largest component of operating expenses is wages, which increased to $34.6 million in 2008 from $29.4 million in 2007, an increase of $5.2 million, or 17.8%. Wages related to the New Texas Facilities were approximately $7.4 million in 2008 and $3.4 million in 2007. Same center wages increased approximately $1.2 million, or 4.6%, 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 4.6% for the period).

Workers’ compensation insurance expense was approximately $0.2 million higher in 2008 compared to 2007. We have had increases in claims costs related to certain prior year claims during 2008, resulting in higher expense.

Operating costs were impacted by higher food and utility expenses. Food costs were approximately $0.2 million higher on a same center basis, an increase in expense per patient day of 17.9%. Utility costs were approximately $0.1 million higher, or approximately 8.6%.

Our three Houston area nursing centers incurred additional costs in 2008 as a result of Hurricane Ike. We incurred approximately $0.2 million in incremental operating costs.

The remaining increases in same center operating expense are primarily due to the effects of increases in patient acuity levels as indicated by RUG level scores, which were higher in 2008, resulting in greater costs to care for these patients.

Lease expense . Lease expense increased to $5.8 million in 2008 from $5.2 million in 2007. Lease expense related to the New Texas Facilities was $1.0 million for 2008 and $0.5 million in 2007. Same center lease expense increased to $4.7 million in 2008 from $4.6 million in 2007, primarily due to increases for lessor funded property renovations.

Professional liability. Professional liability in 2008 was an expense of $0.3 million, compared to a benefit of $6,000 in 2007, an increase in expense of $0.3 million. Professional liability expense related to the New Texas Facilities was $0.1 million in 2008 and $0.1 million in 2007. Our cash expenditures for professional liability costs were $1.7 million and $0.7 million for 2008 and 2007, respectively. These cash expenditures can fluctuate from year to year. Our total recorded liabilities for self-insured professional liability declined to $17.0 million at September 30, 2008, down from $18.6 million at June 30, 2008.

General and administrative expense . General and administrative expense was approximately $4.6 million in 2008 and 2007. As a percentage of revenue, general and administrative expense decreased to 6.4% in 2008 from 7.2% in 2007. General and administrative expense related to the New Texas Facilities was $0.2 million in 2008 and $0.4 million in 2007, including $0.3 million for post acquisition integration costs in 2007. Same center general and administrative expense increased to $4.4 million in 2008 from $4.2 million in 2007, an increase of $0.2 million, or 5.7%. Compensation costs increased by approximately $0.2 million, including normal merit and inflationary increases and new positions added to improve operating and financial controls. Travel costs increased by approximately $0.1 million. These increases were offset by a decrease in incentive compensation expense of $0.3 million.

Depreciation and amortization . Depreciation and amortization expense was approximately $1.4 million in 2008 and $1.0 million in 2007. The increase in 2008 is primarily due to depreciation and amortization expenses related to the New Texas Facilities.

Foreign currency transaction gain (loss) . A foreign currency transaction loss of $0.1 million was recorded in 2008, compared to a gain of $0.3 million in 2007. Such gains and losses 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 $0.7 million in 2008 compared to $1.0 million in 2007. The effects of additional borrowings to complete the SMSA Acquisition were offset by principal payments made during 2007 and 2008, the effects of lower interest rates following our refinancing transaction in 2007, and reductions in variable interest rates during the periods.

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 $1.2 million in 2008 compared to $3.4 million in 2007. The provision for income taxes was $0.5 million in 2008, an effective rate of 41.6%, compared to $1.4 million in 2007, an effective rate of 40.3%. The basic and diluted income per common share from continuing operations were $0.10 each in 2008, as compared to a basic and diluted income per common share from continuing operations of $0.33 and $0.32, respectively, in 2007.

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 $4,000 in 2008 and $100,000 in 2007. The disposition of discontinued operations and completions of lease terminations resulted in no gain or loss in 2008 and a gain of $28,000, net of taxes, in 2007.

Nine Months Ended September 30, 2008 Compared With Nine Months Ended September 30, 2007

As noted in the overview, during 2007 we completed the SMSA Acquisition and entered into a lease for an additional facility in Texas (together, the “New Texas Facilities”). All results for the New Texas Facilities are included from the effective date of acquisition or inception of lease. Accordingly, the data referenced in comparisons below for the New Texas Facilities is comparing the full nine months of 2008 to a partial period in 2007.

In addition, 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 $214.5 million in 2008 from $173.9 million in 2007, an increase of $40.7 million, or 23.4%. Revenues related to the New Texas Facilities were $38.8 million in 2008 and $6.6 million in 2007. Same center patient revenues increased to $175.7 million in 2008 from $167.3 million in 2007, an increase of $8.4 million, or 5.1%. This increase is primarily due to Medicare rate increases, increased Medicaid rates in certain states and increased private pay and managed care rates and census, partially offset by the effects of lower Medicare and Medicaid census.

The following table summarizes key revenue and census statistics for continuing operations for each period and segregates effects of the New Texas Facilities:

On a same center basis, the Company’s average rate per day for Medicare Part A patients increased 10.0% in 2008 compared to 2007 as a result of annual inflation adjustments and increased acuity levels of Medicare patients in our nursing centers, as indicated by RUG level scores, which were higher in 2008 than in 2007. Our average rate per day for Medicaid patients increased 4.1% in 2008 compared to 2007 as a result of increasing patient acuity levels and other rate increases in certain states.

Operating expense . Operating expense increased to $169.8 million in 2008 from $132.9 million in 2007, an increase of $36.9 million, or 27.8%. Operating expense related to the New Texas Facilities was $35.1 million in 2008 and $5.9 million in 2007. Same center operating expense increased to $134.8 million in 2008 from $127.0 million in 2007, an increase of $7.8 million, or 6.1%. This increase is primarily attributable to cost increases related to wages and other cost increases discussed below. On a same center basis, operating expense increased to 76.7% of revenue in 2008, compared to 75.9% of revenue in 2007.

The largest component of operating expenses is wages, which increased to $100.9 million in 2008 from $79.3 million in 2007, an increase of $21.6 million, or 27.2%. Wages related to the New Texas Facilities were approximately $21.4 million in 2008 and $3.4 million in 2007. Same center wages increased approximately $3.6 million, or 4.7%, 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 4.3% for the period), and labor costs associated with increases in patient acuity levels.

Bad debt expense was $0.4 million higher in 2008 compared to 2007 on a same center basis. During 2007, bad debt expense was lower due to better than expected collections experience.

Workers’ compensation insurance expense was approximately $0.5 million higher in 2008 compared to 2007. We have had increases in claims costs related to certain prior year claims during 2008, resulting in higher expense.

Employee health insurance costs were approximately $0.4 million higher in 2008 compared to 2007 on a same center basis. 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.

Operating costs were impacted by higher food and utility expenses. Food costs were approximately $0.4 million higher on a same center basis, an increase in expense per patient day of 11.3%. Utility costs were approximately $0.3 million higher, or approximately 7.8%.

Our three Houston area nursing centers incurred additional costs in 2008 as a result of Hurricane Ike. We incurred approximately $0.2 million in incremental operating costs.

The remaining increases in same center operating expense are primarily due to the effects of increases in patient acuity levels as indicated by RUG level scores, which were higher in 2008, resulting in greater costs to care for these patients.

Lease expense . Lease expense increased to $17.2 million in 2008 from $14.4 million in 2007. Lease expense related to the New Texas Facilities was $3.0 million for 2008 and $0.5 million in 2007. Same center lease expense increased to $14.2 million in 2008 from $13.8 million in 2007, primarily due to increases for lessor funded property renovations.

Professional liability. Professional liability in 2008 was an expense of $0.6 million, compared to a benefit of $3.0 million in 2007, an increase in expense of $3.6 million. Professional liability expense related to the New Texas Facilities was $0.1 million in 2008 and $0.1 million in 2007. Our cash expenditures for professional liability costs were $3.8 million and $2.6 million for 2008 and 2007, respectively. These cash expenditures can fluctuate from year to year. During 2008, our total recorded liabilities for self-insured professional liability declined to $17.0 million at September 30, 2008, a decrease from $20.7 million at December 31, 2007.

General and administrative expense . General and administrative expense increased to $13.8 million in 2008 from $12.9 million in 2007, an increase of $0.9 million or 7.2%. As a percentage of revenue, general and administrative expense decreased to 6.5% in 2008 from 7.4% in 2007. General and administrative expense related to the New Texas Facilities was $0.7 million in 2008 and $0.4 million in 2007, including $0.3 million for post acquisition integration costs in 2007. Same center general and administrative expense increased to $13.2 million in 2008 from $12.5 million in 2007, an increase of $0.7 million, or 5.3%. Compensation costs increased by approximately $0.7 million, including normal merit and inflationary increases and new positions added to improve operating and financial controls. Travel costs increased by approximately $0.3 million. Stock- based compensation costs increased by approximately $0.1 million. These increases were partially offset by a decrease in incentive compensation expense of $0.9 million.

Depreciation and amortization . Depreciation and amortization expense was approximately $3.9 million in 2008 and $2.9 million in 2007. The increase in 2008 is primarily due to depreciation and amortization expenses related to the New Texas Facilities.

Foreign currency transaction gain (loss) . A foreign currency transaction loss of $0.3 million was recorded in 2008, compared to a gain of $0.7 million in 2007. Such gains and losses 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 $2.2 million in 2008 from $2.5 million in 2007. The effects of additional borrowings to complete the SMSA Acquisition were offset by principal payments made during 2007 and 2008, the effects of lower interest rates following our refinancing transaction in 2007, and reductions in variable interest rates during the periods.

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 $6.9 million in 2008 compared to $12.6 million in 2007. The provision for income taxes was $2.5 million in 2008, an effective rate of 35.4%, compared to $4.9 million in 2007, an effective rate of 39.2%. In periods prior to 2001, we generated tax credits under the Work Opportunity Tax Credit program totaling approximately $0.3 million. As we were incurring taxable losses in those years we did not record tax assets related to these credits. During the three months ending March 31, 2008, we recorded these carryforward credits as deferred tax assets as we anticipate using them to reduce our taxes payable in 2008. The impact of recording these assets reduced the effective tax rate for the nine months ending September 30, 2008. The basic and diluted income per common share from continuing operations were $0.74 and $0.71, respectively, in 2008, as compared to a basic and diluted income per common share from continuing operations of $1.26 and $1.21, respectively, in 2007.

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 $35,000 in 2008, compared to $101,000 in 2007. The disposition of discontinued operations and completions of lease terminations resulted in no gain or loss in 2008 and a loss of $7,000, net of taxes, in 2007.

Liquidity and Capital Resources

Capital Resources

As of September 30, 2008, we had $32.9 million of outstanding borrowings, including $4.1 million in payments scheduled to be made in the next twelve months. The $4.1 million in payments to be made during the next twelve months includes approximately $2.0 million to be paid on our term loan upon collection of a note receivable.

In August 2007, we entered into an agreement with a bank 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%, 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 and matures in August 2012. 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. This term loan has an outstanding balance of $11.1 million as of September 30, 2008.

The bank loan agreement also includes a $15 million revolving credit facility that provides for revolving credit loans as well as the issuance of letters of credit. The revolver is secured by accounts receivable and provides for a maximum draw of up 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, expiring in August 2010, 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. We have issued a letter of credit of approximately $8.1 million to serve as a security deposit for our leases with Omega. Considering the balance of eligible accounts receivable at September 30, 2008, the letter of credit and the current maximum loan of $15 million, the balance available for future revolving credit loans would

be $6.5 million. As of September 30, 2008, 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, 2008, with the exception of the Minimum Fixed Charge Coverage Covenant related to our term loan. The Minimum Fixed Charge Coverage Covenant was impacted by a combination of the decline in our operating performance and increased capital expenditures. On November 3, 2008 we received a covenant waiver from the bank effective for the period ending September 30, 2008 through the earlier of October 1, 2009 or the date we amend the Minimum Fixed Charge Coverage Covenant. We are currently in discussions with the bank to amend the provisions of the Minimum Fixed Charge Coverage Covenant, and the terms of the waiver require that this amendment be completed by December 31, 2008. It is anticipated that the amendment will be completed in the fourth quarter of 2008 and that we will be in compliance with the proposed covenant for at least the next twelve months.

We are subject to a covenant under our mortgage loan that requires us to maintain a combined occupancy for seven owned homes that serve as collateral for the mortgage loan. We are in compliance with the covenant at September 30, 2008, however, the covenant becomes more restrictive as of December 31, 2008 and based on our occupancy at September 30, 2008, we would not be in compliance with the more restrictive covenant. We are currently in discussions with the mortgage lender to amend these covenants, and based on our discussions with the lender and forecasted occupancy at these facilities, we anticipate we will remain in compliance with the revised covenant for at least the next twelve months.

There can be no assurances that we will be able to successfully negotiate these proposed amendments to our debt agreements, or meet all of the covenants set forth in our amended debt agreements. A failure to meet any such covenant could have a material adverse effect on us.

New Facility Construction

In November 2007, we entered into a short-term, single facility lease with Omega for an existing 102 bed skilled nursing center in Paris, Texas, and undertook an evaluation of the feasibility of entering into an agreement with Omega for the construction of a replacement facility. On March 14, 2008, we entered into an amendment to our master lease with Omega to provide for the construction and lease of a replacement facility. Upon the completion of the construction of the replacement facility, the existing building will be closed and the single facility lease terminated.

Under the terms of the lease amendment, Omega will provide funding and we will supervise the construction of the facility. Construction began during the second quarter of 2008, with completion expected in mid-2009. Rent will commence upon completion of the project, but no later than August 2009. Once construction is completed, annual rent will be equal to 10.25% of the total cost of the replacement facility, including direct costs of construction, carrying costs during the construction period, furnishings and equipment, land cost and the value of the related skilled nursing facility license. The total cost of the replacement facility was originally expected to be approximately $7.0 million and is currently expected to be approximately $7.9 million. Under the terms of the March 14, 2008 lease amendment and an October 24, 2008 lease amendment, costs incurred in excess of the current estimated cost of $7.9 million would be borne by us. The lease amendment provides for renewal options with respect to the new facility through 2035.

The replacement facility will be subject to the requirements of our current master lease, with certain exceptions for capital spending requirements. At the fifth anniversary of rent commencement for the replacement facility, we may terminate the lease with respect to this facility. Beginning 18 months after the facility commences operations and continuing until the fifth anniversary of rent commencement, Omega may terminate the lease for this facility if the cash flow of the facility (as

defined in the lease amendment) is less than 1.2 times the then existing rent. If we elect to continue the lease, annual rentals for this facility may be increased by an amount equal to one half of the amount of the cash flow of the facility (as defined in the lease amendment) in excess of 1.2 times the then existing rent, effective as of the start of the sixth year after the completion of the building. If at any time beginning 18 months after the completion of the building the average annual cash flow of the facility exceeds 1.3 times the then existing rent, the termination options of both Omega and the Company are eliminated, and the rent reset provisions described above are eliminated.

As previously disclosed, we have entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia. We made an application to state regulatory authorities to allow us to operate the facility, and this application was approved in February 2008, subject to rights of appeal by contesting parties. The period for appeal terminated during 2008. As of September 30, 2008, we have advanced a total of $0.9 million toward the purchase of these assets. We plan to arrange financing and construct a new 90 bed replacement facility. However, no assurances can be given we will be able to arrange construction financing on suitable terms for this project.

Share Repurchase

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.

From the inception of the plan in November 2007 through April 2008, we purchased a total of 231,800 shares for $2.5 million, the maximum amount authorized by our plan. Repurchases were made through open market or privately negotiated transactions in accordance with all applicable securities laws, rules, and regulations and were funded from available working capital.

Professional Liability

We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. For several years, 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 exceeded the coverage purchased so that it cost more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we purchased professional liability insurance coverage for our facilities that, based on historical claims experience, was substantially less than the amount required to satisfy claims that were incurred. As a result, we have been effectively self-insured. We have essentially exhausted all general and professional liability insurance available for claims first asserted prior to March 10, 2007. For claims made during the period from March 10, 2007 through March 9, 2009, we maintain insurance coverage limits of $100,000 per medical incident and total annual aggregate policy coverage limits of $500,000. As of September 30, 2008, payments already made by the insurance provider for the period from March 10, 2007 through March 9, 2009 have reduced the remaining aggregate coverage amount in the policy period, but coverage has not been exhausted.

As of September 30, 2008, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $17.0 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. In April 2008, we entered into individual agreements to settle eight professional liability cases for a total of $5.0 million, including $200,000 paid from insurance proceeds. These settlements will be paid in installments from April 2008 through January 2009. As of September 30, 2008, we are obligated to pay installments that total $2.1 million related to these settlements. The remaining obligation for these claims is fully accrued

and included in the accrual for professional liability claims. The defense of and settlements related to other pending claims will require additional cash expenditures.

Liquidity

Net cash provided by operating activities of continuing operations totaled $8.9 million and $7.1 million in 2008 and 2007, respectively. Discontinued operations used cash of $35,000 and $21,000 in 2008 and 2007, respectively.

Investing activities of continuing operations used cash of $6.9 million and $11.2 million in 2008 and 2007, respectively. These amounts primarily represent cash used for purchases of property and equipment and the SMSA Acquisition in 2007. We have used between $3.4 million and $6.8 million for capital expenditures of continuing operations in each of the three calendar years ended December 31, 2007. The capital expenditures we made during 2007 were driven by three nursing center renovation projects or initiatives that totaled $3.6 million of the $6.8 million spent in total. We spent $0.6 million and $0.8 million at owned facilities in Arkansas and Texas, respectively, as well as $2.2 million at our New Texas facilities. Such expenditures were primarily for facility improvements and equipment, which were financed principally through working capital. For the year ending December 31, 2008, we anticipate that capital expenditures for improvements and equipment for our existing facility operations will be higher as we complete facility renovations and significant projects at certain owned and leased facilities. We expect to use approximately $3.3 million of working capital for facility renovation projects in 2008. Cash used in investing activities of continuing operations were offset by collections of a note receivable of $0.8 million and $0.7 million in 2008 and 2007, respectively. Discontinued operations used cash of $49,000 in 2008 and there were no cash flows from investing activities of discontinued operations in 2007.

Financing activities of continuing operations used cash of $3.6 million in 2008 and provided cash of $5.8 million in 2007. The cash used in 2008 resulted primarily from the repayment of debt obligations as well as the repurchase of $1.7 million of our common stock in 2008. The cash provided in 2007 resulted from the issuance of debt offset by payments to retire existing debt. There were no cash flows from financing activities of discontinued operations in 2008 or 2007. No interest costs or debt were allocated to discontinued operations.

Amendment to Shareholders’ Rights Plan

On August 1, 2008, the Company’s Board of Directors approved amending our current Amended and Restated Rights Agreement (the “Rights Agreement”). The amendment provides for an increase of the exercise price of the rights under the Rights Agreement (the “Rights”) to $50 from $15 and for the extension of the Expiration Date of the Rights to August 2, 2018. In addition, the amendment includes a share exchange feature that provides the Company’s Board of Directors the option of exchanging, in whole or in part, each Right, other than those of the hostile acquiring holder, for one share of our common stock. This provision is intended to avoid requiring Rights holders to pay cash to exercise their Rights and to alleviate the uncertainty as to whether holders will exercise their Rights.

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 begin with those facilities with the greatest potential for benefit, and began the renovation program during the third quarter of 2005. As of September 30, 2008, we have completed renovation projects at eight facilities and have three additional renovation projects in progress, with one completed in October 2008 and expected completion of another in November 2008. The third facility renovation is expected to be completed in 2009.