The following table presents data about the facilities we operated as part of our continuing operations as of the dates or for the years indicated:

		December 31,
		2008				2007				2006
Licensed Nursing Home Beds:
Owned			942				942				942
Leased			4,831				4,831				3,463
Total			5,773				5,773				4,405
Assisted Living Units:
Owned			—				17				17
Leased			14				49				49
Total			14				66				66
Total Beds/Units:
Owned			942				959				959
Leased			4,845				4,880				3,512
Total			5,787				5,839				4,471
Facilities:
Owned			9				9				9
Leased			41				41				33
Total			50				50				42
Average Occupancy:
Nursing centers			75.3	% (1)			77.6	% (2)			78.8	%
Assisted living units			64.3	%			63.1				60.0
Total			75.2	%			77.4	%			78.5	%

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 84.8%, 86.9% and 87.0% for 2008, 2007 and 2006, respectively). Medicare intermediaries make retroactive adjustments based on changes in allowed claims. In addition, certain of the states in which we operate require complicated 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 collectibility 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%, 0.4% and 0.8% for 2008, 2007 and 2006, respectively. During 2007, bad debt expense was lower due to better than expected collections experience. 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 $15.0 million as of December 31, 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 the Actuarial Division of Willis of Tennessee, Inc. (“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 our accrual for professional liability and other claims for each policy year as of the end of the period:

Our cash expenditures for self-insured professional liability costs were $6.8 million and $2.8 million for the years ending December 31, 2008 and 2007, respectively. In December 2008, we entered into agreements to settle seven professional liability cases for $4.3 million including $0.4 million paid from insurance proceeds. These settlements will be paid in installments from December 2008 through March 2010, with an initial payment of $1.6 million in December 2008 and quarterly payments of $0.4 million to $0.5 million beginning the first quarter of 2009 and continuing through the first quarter of 2010. As of December 31, 2008, we are obligated to pay installments that total $3.5 million related to the December 2008 and other outstanding case 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, we will have throughout the year additional cash expenditures 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 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 $1.7 million, negative $1.7 million and negative $5.4 million, for the years ended December 31, 2008, 2007 and 2006, respectively, with negative amounts representing net benefits resulting from downward revisions in previous estimates. These amounts are material in relation to our reported net income from continuing operations for the related periods of $5.8 million, $9.5 million and $22.4 million, respectively. We believe that the primary reason that we experienced the net benefits during 2006 and 2007 is that we were able during the period to settle outstanding claims on more favorable terms than we have historically. These settlements impact our professional liability in two ways. They reduce the amount of anticipated liability that was recorded in prior periods, and they may result in a lower estimate of the anticipated liability expense for unreported claims in more recent periods. However, the fact that these settlements have reduced our professional liability expense does not guarantee that future claims will be resolved on favorable terms and we may incur professional liability expenses in the future significantly in excess of those currently recorded, which could have a material adverse impact on our financial position and cash flows. The total liability recorded at December 31, 2008, was $15.0 million,

compared to current assets of $38.9 million and total assets of $105.9 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, we were party to workers’ compensation insurance programs that provided coverage for claims incurred, with premium adjustments on incurred losses. We accounted for premium expense under these policies based on our estimate of the level of claims expected to be incurred and at December 31, 2007, we had recorded estimated premium refunds due totaling approximately $1.2 million. During the year ended December 31, 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 associated with this new policy.

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 insured. 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. Effective January 1, 2009 the self-insured threshold rose to $160,000 per individual annually. 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 $1.2 million at December 31, 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, equipment and other long-lived assets 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 or fair values of the property. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property. We did not record any asset impairments in 2008, 2007 or 2006. If our estimates or assumptions with respect to a property change in the future, we may be required to record 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. In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141R”). SFAS No. 141R revises the principles and requirements for how an acquirer recognizes and measures a business combination in its financial statements, as well as providing revised disclosures of the business combination. The provisions of SFAS No. 141R will be effective for us beginning January 1, 2009. During the fourth quarter of 2008, we expensed $0.2 million in acquisition costs for a potential acquisition transaction in West Virginia that was in process but not completed as of December 31, 2008. Under SFAS No. 141, these costs were considered part of the purchase price and as such were capitalized, but under SFAS No. 141R these costs are expensed as incurred.

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 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. During 2008, 2007 and 2006, we recorded charges of approximately $0.9 million, $0.6 million and $5.2 million, respectively, in stock-based compensation. The 2006 charge related to vested stock option grants awarded in December 2005 that were approved by shareholders at our annual meeting on June 1, 2006. For several years prior to 2006, we did not have available stock to be granted under a shareholder approved plan. Similar to the 2008 and 2007 expense amounts, we anticipate that expenses related to future grants will be significantly smaller than in 2006 due to longer vesting schedules and smaller number of shares granted. 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. In 2006, we recorded a deferred tax benefit to release approximately $14.6 million of the previously recorded valuation allowance on deferred tax assets. During 2006, we assessed the valuation allowance on deferred tax assets and concluded that it is more likely than not that a significant portion of our remaining net deferred tax assets will be realized due to our achieved earnings trend and improved liquidity and financial position. We considered many factors, including recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carryforward periods available, and the comprehensive refinancing of debt in August 2006. Prior to the refinancing, we had net working capital deficits, short-term debt maturities and were in default under debt agreements. As a result of the above factors, we believe that we have addressed the uncertainties surrounding our ability to realize the benefits of our deferred tax assets in future periods. We continue to maintain a valuation allowance of approximately $1.0 million to reduce the 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. Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48” or “the interpretation”). The 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.

Contractual Obligations and Commercial Commitments

We have certain contractual obligations of continuing operations as of December 31, 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), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $2.0 million as of December 31, 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 December 31, 2008, the maximum contingent liability for the repurchase of the equity grants is approximately $0.2 million. No amounts have been accrued for this contingent liability.

Payor Sources

We classify our revenues from patients into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, we include within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. We classify payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.

Medicare represented approximately 31.5%, 31.2%, and 30.6% of our net revenues during 2008, 2007, and 2006, respectively. Approximately 53.3%, 55.7%, and 56.4% of our net revenues were derived from Medicaid during 2008, 2007, and 2006, respectively. Private pay represented approximately 15.2%, 13.1% and 13.0% of our net revenues during 2008, 2007, and 2006, respectively.

Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare and private pay can significantly affect the profitability of the facility’s operations.

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 and a new lease agreement. 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, acquisition and new lease agreement. Same center information excludes the operations of the New Texas Facilities and all discontinued operations.

As a supplement to the tables above, the following table presents the unaudited statements of income from continuing operations before income taxes and related data on a same center basis, excluding the effects of the acquired facilities and discontinued operations.

Year Ended December 31, 2008 Compared with Year Ended December 31, 2007

As noted in the overview, during 2007 we completed the SMSA Acquisition and entered into a lease for an additional facility in Texas. 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 year of 2008 to a partial period in 2007.

In addition, we 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 $288.8 million in 2008 from $245.1 million in 2007, an increase of $43.7 million, or 17.8%. Revenues related to the New Texas Facilities were $53.0 million in 2008 and $19.6 million in 2007. Same center patient revenues increased to $235.8 million in 2008 from $225.5 million in 2007, an increase of $10.3 million, or 4.6%. 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 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 3.7% 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 $228.2 million in 2008 from $187.5 million in 2007, an increase of $40.7 million, or 21.7%. Operating expense related to the New Texas Facilities was $47.4 million in 2008 and $17.1 million in 2007. Same center operating expense increased to $180.8 million in 2008 from $170.4 million in 2007, an increase of $10.4 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 75.6% of revenue in 2007.

The largest component of operating expenses is wages, which increased to $135.9 million in 2008 from $111.8 million in 2007, an increase of $24.1 million, or 21.5%. Wages related to the New Texas Facilities were approximately $29.0 million in 2008 and $9.7 million in 2007. Same center wages increased approximately $4.8 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 4.2% for the year), and labor costs associated with increases in patient acuity levels. Effective January 1, 2009 we have instituted a wage freeze for our corporate and regional management teams, with reduced wage increases for the balance of our employees, and estimate these wage policy changes will help us save approximately $0.7 million in operating expense in 2009. These policies will be reevaluated as business and economic conditions improve.

Bad debt expense was $0.7 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 $0.7 million higher in 2008 compared to 2007. We had better claims experience in 2007 and have had increases in claims costs related to certain prior year claims during 2008, resulting in higher expense.

Employee health insurance costs were approximately $0.5 million, or 10.2% higher in 2008 compared to 2007 on a same center basis. The Company was 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 $0.5 million higher on a same center basis, an increase in expense per patient day of 10.2%. Utility costs were approximately $0.4 million higher, or approximately 8.3%.

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. In addition, during the fourth quarter of 2008, we expensed $0.2 million in acquisition costs for a potential acquisition in West Virginia that was in process but not completed as of December 31, 2008. Under SFAS No. 141, these costs were considered part of the purchase price and appropriately capitalized, but under SFAS No. 141R they are expensed as incurred. During 2008, in connection with this potential West Virginia acquisition, we advanced $0.2 million to the operator of the existing facility amounts in excess of the agreed upon purchase price. We accounted for these advances in excess of the purchase price as operating expenses during 2008.

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 $23.0 million in 2008 from $20.0 million in 2007. Lease expense related to the New Texas Facilities was $4.1 million for 2008 and $1.5 million in 2007. Same center lease expense increased to $18.9 million in 2008 from $18.5 million in 2007, primarily due to increases for lessor funded property renovations.

Professional liability. Professional liability in 2008 was an expense of $1.7 million, compared to a benefit of $1.7 million in 2007, an increase in expense of $3.4 million. Professional liability expense related to the New Texas Facilities was $0.2 million in both 2008 and 2007. Our cash expenditures for professional liability costs were $6.8 million and $2.8 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 $15.0 million at December 31, 2008 from $20.7 million at December 31, 2007.

General and administrative expense . General and administrative expense increased to $18.5 million in 2008 from $17.6 million in 2007, an increase of $0.9 million or 5.3%. 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 $0.9 million in 2008 and $0.7 million in 2007, including $0.3 million for post acquisition integration costs in 2007. Same center general and administrative expense increased to $17.6 million in 2008 from $16.9 million in 2007, an increase of $0.7 million, or 4.4%. Compensation costs increased by approximately $0.9 million, including normal merit and inflationary increases and new positions added to improve operating and financial controls. Effective January 1, 2009 we have instituted a wage freeze for our corporate and regional management teams, with reduced wage increases for the balance of our employees, and estimate these wage policy changes will help us save approximately $0.2 million in general and administrative expense in 2009. These policies will be reevaluated as business and economic conditions improve. Travel costs increased by approximately $0.3 million. Stock-based compensation costs increased by approximately $0.2 million. These increases were partially offset by a decrease in incentive compensation expense of $1.2 million.

Depreciation and amortization . Depreciation and amortization expense was approximately $5.3 million in 2008 and $4.1 million in 2007. Depreciation and amortization related to the New Texas Facilities was $1.1 million in 2008 and $0.3 million in 2007. Same center depreciation and amortization increased approximately $0.4 million, primarily due to $0.2 million in amortization of new accounting software.

Foreign currency transaction gain (loss) . A foreign currency transaction loss of $1.0 million was recorded in 2008, compared to a gain of $0.8 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 $2.9 million in 2008 from $3.5 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 transactions 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 $8.7 million in 2008 compared to $15.8 million in 2007. The provision for income taxes was $3.0 million in 2008, an effective rate of 33.9%, compared to $6.3 million in 2007, an effective rate of 39.8%. Our 2008 income taxes have been reduced by tax credits generated under the Work Opportunity Tax Credit program. The

basic and diluted income per common share from continuing operations were $0.95 and $0.92, respectively, in 2008, as compared to a basic and diluted income per common share from continuing operations of $1.56 and $1.49, respectively, in 2007.

Income from discontinued 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 $91,000 in 2007. The disposition of discontinued operations and completions of lease terminations resulted in no gain or loss in 2008 and a loss of $8,000, net of taxes, in 2007.

Year Ended December 31, 2007 Compared With Year Ended December 31, 2006

During 2007, we completed the SMSA Acquisition and entered into a lease for an additional facility in Texas. All results for the New Texas Facilities are included from the effective date of acquisition or inception of lease.

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 $245.1 million in 2007 from $214.7 million in 2006, an increase of $30.4 million, or 14.2%. Revenues related to the New Texas Facilities were $19.6 million in 2007. Same center patient revenues increased to $225.5 million in 2007 from $214.7 million in 2006, an increase of $10.8 million, or 5.0%. 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 continuing operations for the year 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 8.4% 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 $187.5 million in 2007 from $163.4 million in 2006, an increase of $24.1 million, or 14.7%. Operating expense related to the New Texas Facilities was $17.1 million in 2007. Same center operating expense increased to $170.4 million in 2007 from $163.4 million in 2006, an increase of $7.0 million, or 4.3%. 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. On a same center basis, operating expense decreased to 75.6% of revenue in 2007, compared to 76.1% of revenue in 2006.

The largest component of operating expenses is wages, which increased to $111.7 million in 2007 from $97.5 million in 2006, an increase of $14.2 million, or 14.6%. Wages related to the New Texas Facilities were approximately $9.7 million. Same center wages increased approximately $4.5 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 3.8% for the period), and labor costs associated with increases in patient acuity levels. Although overall Medicare census declined slightly, the acuity levels of the Company’s patients, as indicated by RUG level scores, were higher than in 2006, resulting in greater costs to care for these patients.

Employee health insurance costs were approximately $0.6 million higher in 2007 compared to 2006 on a same center basis, an increase of approximately 14.3%. During 2007 and 2006, the Company was 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 $0.6 million lower in 2007 compared to 2006 on a same center basis. Costs of workers’ compensation insurance were approximately $0.7 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 $20.0 million in 2007 from $16.1 million in 2006. Lease expense related to the New Texas Facilities was $1.5 million for 2007. Same center lease expense increased to $18.5 million in 2007 from $16.1 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 $2.0 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 $0.5 million resulting from rent increases for lessor funded property renovations.

Professional liability. Professional liability in 2007 was a benefit of $1.7 million, compared to a benefit of $5.4 million in 2006, a decrease in benefit of $3.7 million. Professional liability expense related to the New Texas Facilities was $0.2 million. Our cash expenditures for professional liability costs were $2.8 million and $3.4 million for 2007 and 2006, respectively. These cash expenditures can fluctuate from year to year. During 2007, our total recorded liabilities for self-insured professional liability declined to $20.7 million at December 31, 2007, down from $25.7 million at December 31, 2006.

General and administrative expense . General and administrative expense decreased to $17.6 million in 2007 from $21.0 million in 2006, a decrease of $3.4 million or 16.5%. General and administrative expense related to the New Texas Facilities was $0.7 million in 2007 and included $0.3 million incurred for post acquisition integration costs. Same center general and administrative expense decreased to $16.9 million in 2007 from $21.0 million in 2006, a decrease of $4.1 million, or 19.8%.

The majority of the decrease in general and administrative expense is related to non-cash stock-based compensation, which was $4.4 million lower in 2007. Prior to 2007, such charges were reported as a separate income statement caption, but were reclassified for current and prior periods in the 2007 financial statements. Costs of compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 were $0.7 million lower in 2007 compared to 2006.

Partially offsetting these reduced costs were increased compensation costs of approximately $0.9 million, resulting from normal merit and inflationary increases ($0.3 million, approximately 4.3%), new positions added to improve marketing, operational and financial controls ($0.3 million), and higher incentive compensation costs ($0.3 million) as a result of operating performance.

Depreciation and amortization . Depreciation and amortization expense was approximately $4.1 million in 2007 and $3.6 million in 2006. The increase in 2007 is primarily due to depreciation and amortization expenses related to the New Texas Facilities.

Foreign currency transaction gain . A foreign currency transaction gain of $808,000 was recorded in 2007, compared to $21,000 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 $3.5 million in 2007 from $3.7 million in 2006, a decrease of $0.2 million or 4.3%. 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 $0.3 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, respectively, 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 $15.8 million in 2007 compared to $12.9 million in 2006. The provision for income taxes was $6.3 million in 2007, compared to a benefit for income taxes of $9.5 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 $1.56 and $1.49, respectively, in 2007, as compared to a basic and diluted income per common share from continuing operations of $3.81 and $3.42, respectively, in 2006.

Income from discontinued 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 $91,000 in 2007, compared to a loss of $337,000 in 2006. The disposition of discontinued operations and completions of lease terminations resulted in a loss of $8,000, net of taxes, in 2007, compared to a loss of $114,000 in 2006.

Liquidity and Capital Resources

Liquidity

Net cash provided by operating activities of continuing operations totaled $9.5 million, $12.7 million and $15.4 million in 2008, 2007 and 2006, respectively. Discontinued operations provided cash of $22,000 in 2007 and $0.3 million in 2006 and used $35,000 of cash in 2008.

Investing activities of continuing operations used cash of $9.1 million and $14.1 million in 2008 and 2007, respectively, and provided $6.0 million of cash in 2006. These amounts primarily represent proceeds from the sale of discontinued operations, cash used for purchases of property, plant and equipment, and cash used for the SMSA Acquisition in 2007. We have used between $4.1 million and $9.7 million for capital expenditures of continuing operations in each of the three calendar years ending December 31, 2008. Capital expenditures during 2008 included approximately $2.8 million for renovation projects funded with internal cash flow and approximately $0.4 million to complete certain facility improvements we identified during the process of acquiring the New Texas Facilities. The capital expenditures we made during 2007 were driven by three 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, 2009, 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. Investing activities of discontinued operations used no cash in 2007 and used $49,000 and $28,000 in 2008 and 2006, respectively.

Financing activities of continuing operations used cash of $4.4 million in 2008 and $16.4 million in 2006, respectively, and provided cash of $0.7 million in 2007. Cash used in 2008 primarily resulted from payment of existing debt obligations of $2.0 million and the repurchase of $1.7 million of our common stock. The cash provided in 2007 primarily represents the net funds from loan proceeds to acquire the SMSA leasehold interests, offset by the payment of existing debt and the repurchase of $0.8 million of our common stock. In 2006, proceeds from the sale of discontinued operations were used to repay debt. There were no cash flows from financing activities of discontinued operations in 2008, 2007 or 2006. No interest costs or debt were allocated to discontinued operations.

Note Receivable

We have a note receivable denominated in Canadian dollars from the sale of our Canadian subsidiary in 2004. The balance of the note at December 31, 2008 is approximately $4.9 million Canadian ($4.0 million US). During 2009 we entered into negotiations to extend the maturity of this note to May 2010 while the borrower seeks replacement financing. While no formal amendment has been executed, we expect an installment of at least $600,000 Canadian plus accrued interest would be paid on May 11, 2009. Based on preliminary discussion with the borrower, if the entire principal amount is not paid by May 11, 2009, the interest rate on the note will be based on LIBOR plus 4%, but not less than 5%, and the balance of the note will be due in full on May 11, 2010. All other terms of the note would remain the same.

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, 2010, we maintain insurance coverage limits of $100,000 per medical incident and total annual aggregate policy coverage limits of $500,000. As of December 31, 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 December 31, 2008, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $15.0 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 December 2008, we entered into agreements to settle seven professional liability cases for $4.3 million including $0.4 million paid from insurance proceeds. The settlements will be paid in installments from December 2008 through March 2010, with an initial payment of $1.6 million in December 2008 and quarterly payments of $0.4 million to $0.5 million beginning the first quarter of 2009 and continuing through the first quarter of 2010. As of December 31, 2008, we are obligated to pay installments that total $3.5 million related to the December 2008 and other outstanding case 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, we will have throughout the year additional cash expenditures for other settlements and self-insured professional liability costs.

Capital Resources

As of December 31, 2008, we had $32.4 million of outstanding borrowings, including $2.2 million in current scheduled payments of long-term debt.

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%, a maturity of five years, 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 matures in August 2012 and is secured by receivables and all other unencumbered assets of the company, including land held for sale and notes receivable. In addition to financing the SMSA 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%.

The bank loan agreement 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 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 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 a letter of credit of approximately $8.1 million to serve as a security deposit for all of our leases with Omega. Considering the balance of eligible accounts receivable at December 31, 2008, the letter of credit and the current maximum loan of $15 million, the balance available for future revolving credit loans would be $6.9 million. As of December 31, 2008, we had no borrowings outstanding under our revolving credit facility.

On August 7, 2006, we entered into an agreement with our commercial mortgage lender to refinance our mortgage debt. Under the terms of the mortgage loan, the lender provided mortgage debt of approximately $22.5 million with a five year maturity. The

proceeds of the mortgage loan were used to retire the existing debt and to fund a $1.1 million renovation of a nursing center that is part of the collateral for the mortgage loans. The renovation was completed during 2007.

The Company’s bank term loan agreement requires additional payments from proceeds received upon certain asset dispositions and excess cash flows, as defined in the term loan agreement. In addition, our term loan agreement allows for voluntary prepayments of principal outstanding, and during 2007, we made voluntary prepayments of $3.0 million. These prepayments reduce the required amounts that must be paid in future periods from excess cash flows and asset dispositions.

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 all such covenants at December 31, 2008. During December 2008 we amended certain provisions of our term loan agreement related to the definition of a Minimum Fixed Charge Coverage Covenant. The amendment changed the measurement of the Minimum Fixed Charge Coverage Covenant by substituting “maintenance capital expenditures,” as defined, for substantially all fixed asset expenditures as previously defined in the agreement.

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 were in compliance with the covenant at September 30, 2008, however, the covenant was to become more restrictive as of December 31, 2008, and based on occupancy at September 30, 2008, we would not be in compliance with the more restrictive covenant. We amended this covenant with our mortgage lender in December 2008.

We are in compliance with all covenants, as amended, as of December 31, 2008. There can be no assurances that we will be able to 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.

Transaction with Omega .

On October 20, 2006, we entered into a Restructuring Stock Issuance and Subscription Agreement (“Restructuring Agreement”) to restructure our Series B Redeemable Convertible Preferred Stock held by Omega.

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

Advocat and Omega also entered into the Lease Amendment to extend the term and amend the Omega Master Lease covering 28 nursing centers. The initial term of the lease was set to expire in September 2010, with a ten year renewal option. The amended master lease commenced on October 1, 2006, and extends to September 30, 2018. The Lease Amendment also provides for a renewal option of an additional twelve years. Other than the change in rent associated with the restructuring of the preferred stock described above, there was no change in the base rental amounts as a result of the Lease Amendment. Consistent with prior terms, the lease provides for annual increases in lease payments equal to the lesser of two times the increase in the Consumer Price Index or 3 percent. Under generally accepted accounting principles, we are required to report these scheduled rent increases on a straight line basis over the 12 year term of the renewal period. As a result of accruing the scheduled rent increases, our annual rent expense increased by approximately $2.7 million effective October 1, 2006. 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.

This Lease Amendment, together with an earlier amendment in 2005, provides financing of up to $10 million to fund capital improvements made to certain nursing centers leased from Omega. The annual base rent related to these nursing centers will be increased to reflect the amount of capital improvements made to the facilities. The increase in rent is based on a rate of 10.25% per year of the amount financed under this amendment. As of December 31, 2008, we had incurred expenditures of $10.0 million for these improvements.

New Facility Construction

Texas Facility . 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 March 14, 2008 lease amendment and an October 24, 2008 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 is expected to be approximately $7.9 million. Under the terms of the lease amendments, costs incurred in excess of the current estimated cost of $7.9 million would be borne by us. The lease amendments provide 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.

West Virginia Facility. We entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia for $850,000. 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 and we expect to complete the acquisition of these assets and arrange financing for the construction of a new 90 bed replacement facility in 2009. The existing facility closed in February 2009, and will remain closed until the replacement facility is completed. No assurances can be given we will be able to complete the acquisition or 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.

Amendment to Shareholders’ Rights Plan

On August 1, 2008, the Company’s Board amended 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 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 December 31, 2008, we have completed renovation projects at ten facilities. We expect to complete another renovation in the first quarter of 2009. We are developing plans for additional renovation projects.