KINDRED HEALTHCARE INC - 10-Q Quarterly Report

Back to GetFilings.com

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2004

¨ 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: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)


Delaware		61-1323993
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

680 South Fourth Street Louisville, KY		40202-2412
(Address of principal executive offices)		(Zip Code)

(502) 596-7300

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes x No ¨

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x No ¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class of Common Stock		Outstanding at July 31, 2004
Common stock, $0.25 par value		36,898,396 shares

1 of 45

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX


		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements:
	Condensed Consolidated Statement of Operations — for the three months ended June 30, 2004 and 2003 and for the six months ended June 30, 2004 and 2003	3

	Condensed Consolidated Balance Sheet — June 30, 2004 and December 31, 2003	4

	Condensed Consolidated Statement of Cash Flows — for the three months ended June 30, 2004 and 2003 and for the six months ended June 30, 2004 and 2003	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40

Item 4.	Controls and Procedures	41

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	42

Item 4.	Submission of Matters to a Vote of Security Holders	43

Item 6.	Exhibits and Reports on Form 8-K	44

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Revenues	$	897,461		$	813,848		$	1,768,723		$	1,616,006

Salaries, wages and benefits		494,154			462,320			986,225			923,072
Supplies		120,563			104,440			237,296			208,622
Rent		65,958			64,215			130,417			127,293
Other operating expenses		150,358			140,776			295,764			287,615
Depreciation		22,612			19,927			44,658			39,122
Interest expense		4,714			2,992			8,370			5,880
Investment income		(1,826	)		(1,676	)		(3,044	)		(3,311	)

		856,533			792,994			1,699,686			1,588,293

Income from continuing operations before reorganization items and income taxes		40,928			20,854			69,037			27,713
Reorganization items		(304	)		–			(304	)		–

Income from continuing operations before income taxes		41,232			20,854			69,341			27,713
Provision for income taxes		17,012			7,710			28,846			12,058

Income from continuing operations		24,220			13,144			40,495			15,655
Discontinued operations, net of income taxes:
Loss from operations		(1,388	)		(20,555	)		(3,823	)		(36,190	)
Loss on divestiture of operations		(1,063	)		(36,019	)		(1,063	)		(36,019	)

Net income (loss)	$	21,769		$	(43,430	)	$	35,609		$	(56,554	)

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.68		$	0.38		$	1.14		$	0.45
Discontinued operations:
Loss from operations		(0.04	)		(0.59	)		(0.11	)		(1.04	)
Loss on divestiture of operations		(0.03	)		(1.04	)		(0.03	)		(1.04	)

Net income (loss)	$	0.61		$	(1.25	)	$	1.00		$	(1.63	)

Diluted:
Income from continuing operations	$	0.58		$	0.38		$	0.96		$	0.45
Discontinued operations:
Loss from operations		(0.03	)		(0.59	)		(0.09	)		(1.04	)
Loss on divestiture of operations		(0.03	)		(1.04	)		(0.03	)		(1.04	)

Net income (loss)	$	0.52		$	(1.25	)	$	0.84		$	(1.63	)

Shares used in computing earnings (loss) per common share:
Basic		35,536			34,813			35,475			34,784
Diluted		41,913			34,828			42,333			34,798

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	June 30, 2004			December 31, 2003
	June 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	65,069		$	66,524
Cash – restricted		6,152			7,339
Insurance subsidiary investments		200,889			146,325
Accounts receivable less allowance for loss of $71,421 – June 30 and $93,403 – December 31		430,804			429,304
Inventories		32,497			29,984
Deferred tax assets		89,836			89,836
Assets held for sale		19,023			27,400
Other		42,160			46,375

		886,430			843,087

Property and equipment		713,020			671,850
Accumulated depreciation		(234,305	)		(193,310	)

		478,715			478,540

Goodwill		31,417			31,417
Insurance subsidiary investments		55,931			74,618
Deferred tax assets		92,335			92,093
Other		63,307			65,659

	$	1,608,135		$	1,585,414

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	114,157		$	119,087
Salaries, wages and other compensation		219,509			214,113
Due to third party payors		15,872			31,406
Professional liability risks		72,729			83,725
Other accrued liabilities		82,730			88,333
Income taxes		59,560			36,684
Long-term debt due within one year		4,938			4,532

		569,495			577,880

Long-term debt		115,984			139,397
Professional liability risks		226,872			212,013
Deferred credits and other liabilities		56,307			58,559

Commitments and contingencies

Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 36,560 shares – June 30 and 36,340 shares – December 31		9,140			9,085
Capital in excess of par value		588,780			585,394
Deferred compensation		(4,688	)		(8,040	)
Accumulated other comprehensive income (loss)		(142	)		348
Retained earnings		46,387			10,778

		639,477			597,565

	$	1,608,135		$	1,585,414

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Cash flows from operating activities:
Net income (loss)	$	21,769		$	(43,430	)	$	35,609		$	(56,554	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		22,613			20,526			44,659			40,609
Amortization of deferred compensation costs		1,535			984			3,278			2,237
Provision for doubtful accounts		5,134			6,678			13,250			12,966
Loss on divestiture of discontinued operations		1,063			36,019			1,063			36,019
Reorganization items		(304	)		–			(304	)		–
Other		5,040			910			4,938			1,416
Change in operating assets and liabilities:
Accounts receivable		39,247			64,373			(15,057	)		11,057
Inventories and other assets		4,221			13,193			(5,247	)		6,806
Accounts payable		(1,625	)		1,202			(4,809	)		(1,796	)
Income taxes		13,823			(7,259	)		23,735			(12,716	)
Due to third party payors		(11,797	)		3,104			(15,534	)		6,655
Other accrued liabilities		15,543			48,231			6,481			76,166

Net cash provided by operating activities		116,262			144,531			92,062			122,865

Cash flows from investing activities:
Purchase of property and equipment		(17,657	)		(17,477	)		(35,538	)		(28,042	)
Acquisition of healthcare facilities		(8,346	)		(63,795	)		(8,346	)		(63,795	)
Sale of assets		6,514			7,659			6,884			7,659
Surety bond deposits		4,402			–			4,402			–
Purchase of insurance subsidiary investments		(4,767	)		(88,626	)		(14,543	)		(119,021	)
Sale of insurance subsidiary investments		8,209			24,177			13,881			26,510
Net change in insurance subsidiary cash and cash equivalents		(18,395	)		63,755			(35,215	)		(8,156	)
Net change in other investments		2,628			2,645			4,405			(2,040	)
Other		236			(1,702	)		374			(2,035	)

Net cash used in investing activities		(27,176	)		(73,364	)		(63,696	)		(188,920	)

Cash flows from financing activities:
Net change in revolving credit borrowings		63,100			–			80,000			–
Repayment of long-term debt		(101,615	)		(116	)		(102,647	)		(228	)
Payment of deferred financing costs		(3,355	)		(1,276	)		(3,355	)		(2,872	)
Issuance of common stock		3,049			–			3,516			–
Other		(3,023	)		189			(7,335	)		(4,778	)

Net cash used in financing activities		(41,844	)		(1,203	)		(29,821	)		(7,878	)

Change in cash and cash equivalents		47,242			69,964			(1,455	)		(73,933	)
Cash and cash equivalents at beginning of period		17,827			100,173			66,524			244,070

Cash and cash equivalents at end of period	$	65,069		$	170,137		$	65,069		$	170,137


Supplemental information:
Interest payments	$	3,469		$	2,910		$	6,741		$	5,745
Income tax payments		2,319			2,100			2,717			2,118

See accompanying notes.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. (“Kindred” or the “Company”) is a healthcare services company that operates hospitals, nursing centers, institutional pharmacies and a contract rehabilitation services business. At June 30, 2004, the Company’s hospital division operated 70 hospitals in 24 states. The Company’s health services division operated 252 nursing centers in 29 states. The Company’s pharmacy division operated an institutional pharmacy business with 30 pharmacies in 19 states. The Company also operated a contract rehabilitation services business which began operating as a separate division on January 1, 2004.

During 2003, the Company effected certain strategic transactions to improve its future operating results. These transactions included the divestiture of all of its Florida and Texas nursing center operations (the “Florida and Texas Divestiture”), the acquisition for resale of eight additional nursing centers and two hospitals (collectively, the “Ventas II Facilities”) formerly leased from Ventas, Inc. (“Ventas”) and certain other dispositions and contract terminations. For accounting purposes, the operating results of these businesses and the losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2004 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Notes 2 and 3.

On April 20, 2001, the Company and its subsidiaries emerged from proceedings under Chapter 11 of Title 11 of the United States Code (the “Bankruptcy Code”) pursuant to the terms of the Company’s Fourth Amended Joint Plan of Reorganization (the “Plan of Reorganization”), as modified at the confirmation hearing by the United States Bankruptcy Court for the District of Delaware. In connection with its emergence, the Company changed its name to Kindred Healthcare, Inc.

Stock Split

On April 26, 2004, the Board of Directors declared a 2-for-1 stock split in the form of a 100% stock dividend. The new shares were distributed on May 27, 2004 to stockholders of record at the close of business on May 10, 2004. Share and per share data for all periods presented in the accompanying unaudited condensed consolidated financial statements have been adjusted retroactively to reflect the stock split.

Impact of Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities – an interpretation of ARB No. 51.” The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (variable interest entities or “VIEs”) and how to determine when and which business enterprise should consolidate the VIE (the primary beneficiary). In December 2003, the FASB issued FIN 46-R (“FIN 46-R”), “Consolidation of Variable Interest Entities – an interpretation of ARB No. 51 (revised December 2003),” which replaces FIN 46. FIN 46-R incorporates certain modifications to FIN 46 adopted by the FASB subsequent to the issuance of FIN 46, including modifications to the scope of FIN 46. Additionally, FIN 46-R also incorporates much of the guidance previously issued in the form of FASB Staff Positions. The Company has adopted all of the provisions of FIN 46-R as of the first quarter ended March 31, 2004. The adoption of FIN 46-R did not have an impact on the presentation of the Company’s financial position, results of operations or liquidity.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Stock Option Accounting

The Company follows Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock options because the alternative fair value accounting provided for under Statement of Financial Accounting Standards (“SFAS”) No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation,” requires the use of option valuation models that were not developed for use in valuing stock options.

Pro forma information regarding net income and earnings per share determined as if the Company had accounted for its stock options under the fair value method of SFAS 123 follows (in thousands, except per share amounts):


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net income (loss)	$	21,769		$	(43,430	)	$	35,609		$	(56,554	)
Adjustments:
Stock-based compensation expense included in reported net income (loss)		1,535			984			3,278			2,237
Stock-based compensation determined under fair value based method		(3,424	)		(2,063	)		(7,210	)		(4,574	)

Pro forma net income (loss)	$	19,880		$	(44,509	)	$	31,677		$	(58,891	)

Earnings (loss) per common share:
As reported:
Basic	$	0.61		$	(1.25	)	$	1.00		$	(1.63	)
Diluted	$	0.52		$	(1.25	)	$	0.84		$	(1.63	)
Pro forma:
Basic	$	0.56		$	(1.28	)	$	0.89		$	(1.69	)
Diluted	$	0.46		$	(1.28	)	$	0.73		$	(1.69	)

Comprehensive income

The following table sets forth the computation of comprehensive income (loss) for the three and six months ended June 30, 2004 and 2003 (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net income (loss)	$	21,769		$	(43,430	)	$	35,609		$	(56,554	)
Net unrealized investment gains (losses), net of taxes		(638	)		12			(490	)		(135	)

Comprehensive income (loss)	$	21,131		$	(43,418	)	$	35,119		$	(56,689	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Other information

The accompanying unaudited condensed consolidated financial statements do not include all of the disclosures normally required by generally accepted accounting principles or those normally required in annual reports on Form 10-K. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2003 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the Company’s customary accounting practices. Management believes that financial information included herein reflects all adjustments necessary for a fair presentation of interim results and, except for the items discussed in Notes 2 and 4, all such adjustments are of a normal and recurring nature.

Reclassifications

Certain prior period amounts have been reclassified to conform with the current period presentation.

NOTE 2 – DIVESTITURES

Florida and Texas Divestiture

The Company completed the Florida and Texas Divestiture on June 30, 2003. In connection with the Florida and Texas Divestiture, the Company acquired 15 Florida nursing centers and one Texas nursing center from Ventas on June 30, 2003 for approximately $60 million and a $4 million lease termination fee. In addition, the Company amended its master leases with Ventas to: (1) pay incremental rent aggregating $64 million in varying amounts generally over seven years, the net present value of which approximated $44 million using a discount rate of 11%, (2) provide that all annual escalators under the master leases will be paid in cash at all times, and (3) expand certain cooperation and information sharing provisions of the master leases. The annual rent of approximately $9 million on the acquired facilities terminated upon the closing of the purchase transaction. The Company financed its obligations at the closing of the purchase transaction through the use of existing cash.

For accounting purposes, the $44 million present value rent obligation to Ventas was recorded as long-term debt in the accompanying unaudited condensed consolidated balance sheet.

The Company completed the divestiture of all of its Florida nursing center operations on June 30, 2003. The Company sold the real estate related to the 15 nursing centers it acquired from Ventas and the two nursing centers previously owned by the Company in Florida. The sale price for the real estate and related personal property associated with all of the Florida nursing center operations aggregated approximately $64 million. The Company also sold its accounts receivable relating to the Florida nursing centers.

The Company also completed the sublease of the remaining Florida nursing center previously operated by the Company on June 30, 2003. The rental payments under the sublease approximate the Company’s annual rental obligations under the existing lease agreement. The sublease will expire upon the expiration of the primary lease in 2006, whereupon the Company’s obligation with respect to the primary lease also will terminate.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DIVESTITURES (Continued)

Florida and Texas Divestiture (Continued)

The Company also completed the divestiture of its two Texas nursing center operations in the second quarter of 2003. The Company terminated the lease with respect to one facility and entered into a lease with a third party to transfer the operations of the other Texas facility acquired from Ventas. In the second quarter of 2004, the Company sold the remaining leased Texas facility to its new operator.

In the second quarter of 2003, the Company recorded a pretax loss of $58.6 million ($36.0 million net of income taxes) in connection with the Florida and Texas Divestiture, calculated as follows (in thousands):


Cash proceeds from sale of Florida nursing centers:
Real estate	$	62,030
Personal property and inventory		2,335
Accounts receivable		9,000
Property and transfer tax settlements		(1,034	)
Employee benefit obligations assumed by buyer		(2,550	)

		69,781
Direct transaction costs		(3,211	)

		66,570
Sale of Texas nursing center net operating assets and liabilities		16
Cash payment to terminate the lease of a Texas nursing center		(1,066	)	$	65,520

Accounts receivable sold but not settled at closing					4,283
Net book value of assets and liabilities sold					(127,785	)
Fair value adjustment for assets held for sale at June 30					(585	)

Pretax loss on divestiture of operations					(58,567	)
Income tax benefit					22,548

Loss on divestiture of operations				$	(36,019	)

Purchase and resale of Ventas II Facilities

In December 2003, the Company completed the acquisition of the Ventas II Facilities. In the second quarter of 2004, the Company sold two of the Ventas II Facilities for approximately $4 million in cash.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the divestitures discussed in Notes 1 and 2 have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the losses related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. Assets and liabilities not sold at June 30, 2004 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet.

A summary of discontinued operations follows (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Revenues	$	13,907		$	60,680		$	29,136		$	123,931

Salaries, wages and benefits		9,986			39,803			22,007			80,362
Supplies		810			5,781			1,612			11,695
Rent		222			5,416			506			10,730
Other operating expenses		5,329			42,502			11,636			78,503
Depreciation		1			599			1			1,487
Investment income		(183	)		3			(409	)		–

		16,165			94,104			35,353			182,777

Loss from operations before income taxes		(2,258	)		(33,424	)		(6,217	)		(58,846	)
Income tax benefit		(870	)		(12,869	)		(2,394	)		(22,656	)

Loss from operations		(1,388	)		(20,555	)		(3,823	)		(36,190	)
Loss on divestiture of operations, net of income taxes		(1,063	)		(36,019	)		(1,063	)		(36,019	)

	$	(2,451	)	$	(56,574	)	$	(4,886	)	$	(72,209	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

The following table sets forth certain discontinued operating data by business segment (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Revenues:
Hospital division:
Hospitals	$	2,124		$	7,694		$	4,355		$	16,687
Ancillary services		(5	)		1,482			(96	)		3,242

		2,119			9,176			4,259			19,929

Health services division		11,820			49,154			24,941			98,880

Pharmacy division		(32	)		2,350			(64	)		5,122

	$	13,907		$	60,680		$	29,136		$	123,931

Operating income (loss):
Hospital division:
Hospitals	$	(1,016	)	$	(1,438	)	$	(3,162	)	$	(1,672	)
Ancillary services		35			(562	)		(151	)		(382	)

		(981	)		(2,000	)		(3,313	)		(2,054	)

Health services division		(1,340	)		(25,382	)		(2,982	)		(44,751	)

Pharmacy division		103			(24	)		176			176

	$	(2,218	)	$	(27,406	)	$	(6,119	)	$	(46,629	)

Rent:
Hospital division:
Hospitals	$	43		$	919		$	100		$	1,839
Ancillary services		(10	)		213			(15	)		414

		33			1,132			85			2,253

Health services division		186			4,193			374			8,291

Pharmacy division		3			91			47			186

	$	222		$	5,416		$	506		$	10,730

Depreciation:
Hospital division:
Hospitals	$	–		$	208		$	–		$	409
Ancillary services		–			(39	)		–			80

		–			169			–			489

Health services division		1			417			1			971

Pharmacy division		–			13			–			27

	$	1		$	599		$	1		$	1,487

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

A summary of the net assets held for sale follows (in thousands):


	June 30, 2004			December 31, 2003
Current assets:
Property and equipment, net	$	18,638		$	26,912
Other		385			488

		19,023			27,400
Current liabilities (included in other accrued liabilities)		(1,068	)		(1,439	)

	$	17,955		$	25,961

NOTE 4 – SIGNIFICANT QUARTERLY ADJUSTMENTS

For the second quarter and the six months ended June 30, 2004, the Company recorded income of approximately $3.9 million and $6.1 million, respectively, related to settlements of prior year hospital Medicare cost reports.

Operating results for the second quarter of 2004 included a credit of $5.9 million related to retroactive Medicaid rate increases in North Carolina.

Interest expense in the second quarter of 2004 included a pretax charge of $1.2 million resulting from the refinancing of the Company’s credit agreements. See Note 9.

Second quarter 2004 pretax income also included $0.6 million of investment income resulting from the recovery of certain surety deposits and a favorable adjustment of $0.3 million related to accrued reorganization costs.

NOTE 5 – REVENUES

Revenues are recorded based upon estimated amounts due from patients and third party payors for healthcare services provided, including anticipated settlements under reimbursement agreements with Medicare, Medicaid and other third party payors.

A summary of revenues by payor type follows (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Medicare	$	380,543		$	337,062		$	771,827		$	670,708
Medicaid		298,124			261,817			565,922			520,883
Private and other		273,657			229,894			540,662			454,504

		952,324			828,773			1,878,411			1,646,095
Eliminations:
Pharmacy		(17,717	)		(14,925	)		(35,853	)		(30,089	)
Rehabilitation		(37,146	)		–			(73,835	)		–

		(54,863	)		(14,925	)		(109,688	)		(30,089	)

	$	897,461		$	813,848		$	1,768,723		$	1,616,006

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – EARNINGS PER SHARE

Earnings per common share are based upon the weighted average number of common shares outstanding during the respective periods. The diluted calculation of earnings per common share for all periods includes the dilutive effect of warrants, stock options and non-vested restricted stock.

Share and per share data for all periods presented have been adjusted retroactively to reflect a 2-for-1 stock split (in the form of a 100% stock dividend) distributed on May 27, 2004 to stockholders of record at the close of business on May 10, 2004.

A computation of earnings (loss) per common share follows (in thousands, except per share amounts):


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Earnings (loss):
Income from continuing operations	$	24,220		$	13,144		$	40,495		$	15,655
Discontinued operations, net of income taxes:
Loss from operations		(1,388	)		(20,555	)		(3,823	)		(36,190	)
Loss on divestiture of operations		(1,063	)		(36,019	)		(1,063	)		(36,019	)

Net income (loss)	$	21,769		$	(43,430	)	$	35,609		$	(56,554	)

Shares used in the computation:
Weighted average shares outstanding – basic computation		35,536			34,813			35,475			34,784
Dilutive effect of warrants, stock options and non-vested restricted stock		6,377			15			6,858			14

Adjusted weighted average shares outstanding – diluted computation		41,913			34,828			42,333			34,798

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.68		$	0.38		$	1.14		$	0.45
Discontinued operations:
Loss from operations		(0.04	)		(0.59	)		(0.11	)		(1.04	)
Loss on divestiture of operations		(0.03	)		(1.04	)		(0.03	)		(1.04	)

Net income (loss)	$	0.61		$	(1.25	)	$	1.00		$	(1.63	)

Diluted:
Income from continuing operations	$	0.58		$	0.38		$	0.96		$	0.45
Discontinued operations:
Loss from operations		(0.03	)		(0.59	)		(0.09	)		(1.04	)
Loss on divestiture of operations		(0.03	)		(1.04	)		(0.03	)		(1.04	)

Net income (loss)	$	0.52		$	(1.25	)	$	0.84		$	(1.63	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA

The Company operates four business segments: the hospital division, the health services division, the rehabilitation division and the pharmacy division. The hospital division primarily operates long-term acute care hospitals. The health services division operates nursing centers. The rehabilitation division provides rehabilitation services primarily to long-term care providers. The pharmacy division provides institutional pharmacy services to nursing centers and other healthcare providers. The Company defines operating income as earnings before interest, income taxes, depreciation and rent. Operating income reported for each of the Company’s business segments excludes the allocation of corporate overhead.

On January 1, 2004, the Company reorganized its rehabilitation services business by transferring its internal rehabilitation personnel from its nursing centers and consolidating them with its external rehabilitation business (the “Rehabilitation Services Reorganization”). The historical operating results of the Company’s nursing center and rehabilitation services segments have not been restated to conform with the new business alignment.

The Company identifies its segments in accordance with the aggregation provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This information is consistent with information used by the Company in managing its businesses and aggregates businesses with similar economic characteristics. The information provided in Note 7 should be read in conjunction with the discussion and analysis contained in “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The following table sets forth certain data by business segment (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Revenues:
Hospital division	$	355,312		$	338,360		$	703,960		$	670,222
Health services division		460,078			416,768			905,072			827,600
Rehabilitation division		52,588			8,795			105,287			17,297
Pharmacy division		84,346			64,850			164,092			130,976

		952,324			828,773			1,878,411			1,646,095
Eliminations:
Pharmacy		(17,717	)		(14,925	)		(35,853	)		(30,089	)
Rehabilitation		(37,146	)		–			(73,835	)		–

		(54,863	)		(14,925	)		(109,688	)		(30,089	)

	$	897,461		$	813,848		$	1,768,723		$	1,616,006

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Income from continuing operations:
Operating income (loss):
Hospital division	$	86,483		$	75,455		$	166,549		$	145,993
Health services division		62,489			57,235			111,958			100,659
Rehabilitation division		7,265			(750	)		15,784			(1,709	)
Pharmacy division		7,729			6,133			15,338			12,835

Corporate:
Overhead		(30,356	)		(28,354	)		(57,190	)		(55,067	)
Insurance subsidiary		(1,224	)		(3,407	)		(3,001	)		(6,014	)

		(31,580	)		(31,761	)		(60,191	)		(61,081	)

		132,386			106,312			249,438			196,697
Reorganization items		304			–			304			–

Operating income		132,690			106,312			249,742			196,697
Rent		(65,958	)		(64,215	)		(130,417	)		(127,293	)
Depreciation		(22,612	)		(19,927	)		(44,658	)		(39,122	)
Interest, net		(2,888	)		(1,316	)		(5,326	)		(2,569	)

Income from continuing operations before income taxes		41,232			20,854			69,341			27,713
Provision for income taxes		17,012			7,710			28,846			12,058

	$	24,220		$	13,144		$	40,495		$	15,655

Rent:
Hospital division	$	23,529		$	23,706		$	46,373		$	46,990
Health services division		40,874			39,808			81,157			78,839
Rehabilitation division		708			95			1,319			164
Pharmacy division		790			547			1,452			1,177
Corporate		57			59			116			123

	$	65,958		$	64,215		$	130,417		$	127,293

Depreciation:
Hospital division	$	8,712		$	7,450		$	17,176		$	14,504
Health services division		6,951			6,569			13,844			12,942
Rehabilitation division		37			20			70			36
Pharmacy division		583			539			1,113			1,056
Corporate		6,329			5,349			12,455			10,584

	$	22,612		$	19,927		$	44,658		$	39,122

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	5,177	$	4,133	$	10,583	$	6,955
Health services division		6,487		6,375		14,937		9,597
Rehabilitation division		56		47		103		98
Pharmacy division		1,075		522		1,848		1,138
Corporate:
Information systems		4,033		5,992		6,684		9,199
Other		829		408		1,383		1,055

	$	17,657	$	17,477	$	35,538	$	28,042


	June 30, 2004		December 31, 2003
	June 30, 2004		December 31, 2003
Assets at end of period:
Hospital division	$	509,762	$	526,029
Health services division		391,494		379,435
Rehabilitation division		8,636		8,009
Pharmacy division		50,966		43,198
Corporate		647,277		628,743

	$	1,608,135	$	1,585,414


Goodwill:
Hospital division	$	31,417	$	31,417

NOTE 8 – INSURANCE RISKS

The Company insures a substantial portion of its professional liability and workers compensation risks through a wholly owned limited purpose insurance subsidiary. Provisions for loss for these risks are based upon independent actuarially determined estimates.

The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of or less than the amounts recorded. To the extent that subsequent expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE RISKS (Continued)

The provision for loss for insurance risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, follows (in thousands):


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
Professional liability:
Continuing operations	$	20,580	$	20,929	$	43,501	$	51,741
Discontinued operations		1,337		28,522		2,705		51,675

Workers compensation:
Continuing operations	$	12,914	$	11,897	$	25,483	$	23,648
Discontinued operations		589		1,470		1,122		2,940

A summary of the assets and liabilities related to insurance risks included in the accompanying unaudited condensed consolidated balance sheet follows (in thousands):


	June 30, 2004						December 31, 2003
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	132,946	$	67,943	$	200,889	$	93,989	$	52,336	$	146,325
Reinsurance recoverables		571		–		571		896		–		896

		133,517		67,943		201,460		94,885		52,336		147,221
Non-current:
Insurance subsidiary investments		55,931		–		55,931		74,618		–		74,618
Reinsurance recoverables		5,349		–		5,349		5,858		–		5,858
Deposits		6,250		2,235		8,485		7,250		2,222		9,472
Other		8		21		29		9		35		44

		67,538		2,256		69,794		87,735		2,257		89,992

	$	201,055	$	70,199	$	271,254	$	182,620	$	54,593	$	237,213

Liabilities:
Allowance for insurance risks:
Current	$	72,729	$	18,042	$	90,771	$	83,725	$	14,248	$	97,973
Non-current		226,872		49,721		276,593		212,013		49,463		261,476

	$	299,601	$	67,763	$	367,364	$	295,738	$	63,711	$	359,449

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $316 million at June 30, 2004 and $311 million at December 31, 2003.

Provisions for loss for workers compensation risks retained by the limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9 – LONG-TERM DEBT

On June 28, 2004, the Company entered into a five-year $300 million revolving credit facility (the “Credit Facility”) to refinance its existing credit agreements. In connection with the refinancing, the Company prepaid in full the outstanding balance of its senior secured notes with borrowings under the Credit Facility. Amounts borrowed under the Credit Facility bear interest, at the Company’s option, at (a) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (b) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based on the Company’s adjusted leverage ratio as defined in the Credit Facility. At June 30, 2004, the interest rate under the Credit Facility was 4.4%. The Credit Facility is collateralized by substantially all of the Company’s assets including certain owned real property and is guaranteed by substantially all of the Company’s subsidiaries. The Credit Facility constitutes a working capital facility for general corporate purposes and permits acquisitions and investments in healthcare facilities and companies up to an aggregate of $150 million. The Credit Facility also allows the Company, to a limited extent, to pay cash dividends and to repurchase its common stock. At June 30, 2004, the outstanding balance under the Credit Facility aggregated $80 million.

NOTE 10 – CONTINGENCIES

Management continually evaluates contingencies based upon the best available information. In addition, allowances for loss are provided currently for disputed items that have continuing significance, such as certain third party reimbursements and deductions that continue to be claims in current cost reports and tax returns.

Management believes that allowances for losses have been provided to the extent necessary and that its assessment of contingencies is reasonable.

Principal contingencies are described below:

Revenues–Certain third party payments are subject to examination by agencies administering the various programs. The Company is contesting certain issues raised in audits of prior year cost reports.

Professional liability risks–The Company has provided for loss for professional liability risks based upon actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Note 8.

Guarantees of indebtedness–Letters of credit and guarantees of indebtedness approximated $7 million at June 30, 2004.

Income taxes–The Internal Revenue Service is conducting its examination of the Company’s 2000 and 2001 federal income tax returns.

Litigation–The Company is a party to certain material litigation and regulatory actions as well as various suits and claims arising in the ordinary course of business. See Note 11.

Ventas indemnification–On May 1, 1998, Ventas completed the spin-off of its healthcare operations to its shareholders through the distribution of the Company’s former common stock (the “Spin-off”). In connection with the Spin-off, liabilities arising from various legal proceedings and other actions were assumed by the Company and the Company agreed to indemnify Ventas against any losses, including any

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – CONTINGENCIES (Continued)

costs or expenses, it may incur arising out of or in connection with such legal proceedings and other actions. The indemnification provided by the Company also covers losses, including costs and expenses, which may arise from any future claims asserted against Ventas based on the former healthcare operations of Ventas. In connection with the Company’s indemnification obligation, the Company assumed the defense of various legal proceedings and other actions. The Company also has agreed to hold Ventas harmless from all claims against Ventas arising from third party leases and guarantee arrangements entered into before the Spin-off. Under the Plan of Reorganization, the Company agreed to continue to fulfill the Company’s indemnification obligations arising from the Spin-off.

Other indemnifications–In the ordinary course of business, the Company enters into contracts containing standard indemnification provisions and indemnifications specific to a transaction such as a disposal of an operating facility. These indemnifications may cover claims against employment-related matters, governmental regulations, environmental issues, and tax matters, as well as patient, third party payor, supplier and contractual relationships. Obligations under these indemnities generally would be initiated by a breach of the terms of the contract or by a third party claim or event.

NOTE 11 – LITIGATION

Summary descriptions of various significant legal and regulatory activities follow.

A shareholder derivative suit entitled Thomas G. White on behalf of Vencor, Inc. and Ventas, Inc. v. W. Bruce Lunsford, et al., Case No. 98CI03669, was filed on July 2, 1998 in the Jefferson County, Kentucky, Circuit Court. The suit was brought on behalf of the Company and Ventas against certain former executive officers and directors of the Company and Ventas. The complaint alleges that the defendants damaged the Company and Ventas by engaging in violations of the securities laws, engaging in insider trading, fraud and securities fraud and damaging the reputation of the Company and Ventas. The plaintiff asserts that such actions were taken deliberately, in bad faith and constitute breaches of the defendants’ duties of loyalty and due care. The complaint alleges that certain of the Company’s and Ventas’s former executive officers during a specified time frame violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), by, among other things, issuing to the investing public a series of false and misleading statements concerning Ventas’s then current operations and the inherent value of its common stock. The complaint further alleges that as a result of these purported false and misleading statements concerning Ventas’s revenues and successful acquisitions, the price of its common stock was artificially inflated. In particular, the complaint alleges that the defendants issued false and misleading financial statements during the first, second and third calendar quarters of 1997 which misrepresented and understated the impact that changes in Medicare reimbursement policies would have on Ventas’s core services and profitability. The complaint further alleges that the defendants issued a series of materially false statements concerning the purportedly successful integration of Ventas’s acquisitions and prospective earnings per share for 1997 and 1998, which the defendants knew lacked any reasonable basis and were not being achieved. The suit seeks unspecified damages, interest, punitive damages, reasonable attorneys’ fees, expert witness fees and other costs, and any extraordinary equitable and/or injunctive relief permitted by law or equity to assure that the Company and Ventas have an effective remedy. In October 2002, the defendants filed a motion to dismiss for failure to prosecute the case. The court granted the motion to dismiss but the plaintiff subsequently moved the court to vacate the dismissal. The defendants filed an opposition to the plaintiff’s motion to vacate the dismissal, but in August 2003 the court reinstated the lawsuit. In September 2003, the Company filed a renewed motion to dismiss, as to all defendants, based on the plaintiff’s failure to make a demand for remedy upon the appropriate board of directors. The Company also has argued that it is an improper party to this lawsuit. In March 2004, the judge who had been presiding over this lawsuit

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – LITIGATION (Continued)

recused himself because of a possible conflict of interest. The case was then assigned to another judge, who has not yet ruled on the renewed motion to dismiss. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

Three shareholder derivative suits entitled Elizabeth Sommerfeld v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 08476; Ilse Denchfield v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 09475; and Fedorka v. Edward L. Kuntz, et al., Civil Action No. 03 CI 02015, were filed in November 2002, December 2002 and March 2003, respectively, in the Jefferson Circuit Court in Kentucky. The complaints in those lawsuits are nearly identical to the complaint in a putative class action lawsuit entitled Massachusetts State Carpenters Pension Fund v. Kindred Healthcare, Inc., et al, Civil Action No. 3:02CV-600-J, which was filed against the Company and certain of the Company’s current and former officers and directors on October 16, 2002 in the United States District Court for the Western District of Kentucky, Louisville Division (the “District Court”) and was dismissed with prejudice on January 12, 2004. Specifically, the derivative suits allege that from August 14, 2001 to October 10, 2002 the defendants violated Sections 10(b) and 20(a) of the Exchange Act by, among other things, issuing to the investing public a series of allegedly false and misleading statements that inaccurately indicated that the Company was successfully emerging from bankruptcy and implementing a growth plan. In particular, the complaint alleges that these statements were materially false and misleading because they failed to disclose that the 2001 Florida tort reform legislation had resulted in a marked increase in claims against the Company in Florida, and also because the statements reflected a materially understated reserve for professional liability costs. The complaints further allege that as a result of the purportedly false and misleading statements, the price of the Company’s common stock was artificially inflated, the investing public was deceptively induced to purchase the stock at those inflated prices, and the defendants profited by selling shares at those prices. In May 2003, the Fedorka plaintiffs voluntarily dismissed their state court derivative lawsuit and refiled that lawsuit in the United States District Court for the Western District of Kentucky, Louisville Division, Civil Action No. 3:03CV-272-S. On May 14, 2003, a separate but nearly identical derivative lawsuit, Tin Win v. Edward L. Kuntz, et al., Civil Action No. 3:03CV-292-J, also was filed in the United States District Court for the Western District of Kentucky, Louisville Division. On May 12, 2003, the Jefferson Circuit Court entered an order consolidating the Sommerfeld and Denchfield derivative actions and staying all proceedings in the consolidated derivative action pending the District Court’s ruling on the defendants’ motion to dismiss the consolidated putative class action. On July 24, 2003, the District Court entered a similar order concerning the Fedorka and Win federal derivative actions. After the District Court’s dismissal of the Massachusetts State Carpenters Pension Fund putative class action became final in February 2004, the plaintiffs in the consolidated Fedorka and Win federal derivative action voluntarily dismissed that consolidated derivative action, with prejudice. Subsequently, on June 18, 2004, the Jefferson Circuit Court entered a sua sponte order stating that the Sommerfeld consolidated derivative action would be dismissed within 30 days unless the plaintiffs filed a verified statement showing good cause why that case should not be dismissed. On July 12, 2004, the Sommerfeld plaintiffs’ counsel responded to that sua sponte order. The Sommerfeld consolidated derivative complaint attempts to assert a claim against the individual defendants for breach of fiduciary duties for insider selling and misappropriation of information. Specifically, the complaint alleges that each of the individual defendants knew that the price of the Company’s common stock would dramatically decrease when the Company’s inadequate reserves for professional liability risks were disclosed and that the individual defendants’ sales of the Company’s common stock with knowledge of this material non-public information constituted a breach of their fiduciary duties of loyalty and good faith. The suit seeks to impose a constructive trust in favor of the Company for the amount of profits which each defendant or their firms may have received from their November 2001 sales of the Company’s common stock, as well as attorneys’ fees and other expenses. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – LITIGATION (Continued)

In connection with the Spin-off, liabilities arising from various legal proceedings and other actions were assumed by the Company and the Company agreed to indemnify Ventas against any losses, including any costs or expenses, it may incur arising out of or in connection with such legal proceedings and other actions. The indemnification provided by the Company also covers losses, including costs and expenses, which may arise from any future claims asserted against Ventas based on the former healthcare operations of Ventas. In connection with the Company’s indemnification obligation, the Company assumed the defense of various legal proceedings and other actions. Under the Plan of Reorganization, the Company agreed to continue to fulfill the Company’s indemnification obligations arising from the Spin-off.

The Company is a party to various legal actions (some of which are not insured), and regulatory investigations and sanctions arising in the ordinary course of its business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory investigations. In addition, there can be no assurance that the U.S. Department of Justice (the “DOJ”), the Centers for Medicare and Medicaid Services (“CMS”) or other federal and state enforcement and regulatory agencies will not initiate additional investigations related to the Company’s businesses in the future, nor can there be any assurance that the resolution of any litigation or investigations, either individually or in the aggregate, would not have a material adverse effect on the Company’s financial position, results of operations and liquidity. In addition, the litigation and investigations discussed above (as well as future litigation and investigations) are expected to consume the time and attention of management and may have a disruptive effect upon the Company’s operations.

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

Cautionary Statement

This Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. All statements regarding the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities, plans and objectives of management and statements containing the words such as “anticipate,” “approximate,” “believe,” “plan,” “estimate,” “expect,” “project,” “could,” “should,” “will,” “intend,” “may” and other similar expressions, are forward-looking statements.

Such forward-looking statements are inherently uncertain, and stockholders and other potential investors must recognize that actual results may differ materially from the Company’s expectations as a result of a variety of factors, including, without limitation, those discussed below. Such forward-looking statements are based on management’s current expectations and include known and unknown risks, uncertainties and other factors, many of which the Company is unable to predict or control, that may cause the Company’s actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements. These statements involve risks, uncertainties and other factors discussed below and detailed from time to time in the Company’s filings with the SEC. Factors that may affect the Company’s plans or results include, without limitation:

•

the Company’s ability to operate pursuant to the terms of its debt obligations and its master lease agreements with Ventas,

•

the Company’s ability to meet its rental and debt service obligations,

•

adverse developments with respect to the Company’s results of operations or liquidity,

•

the Company’s ability to attract and retain key executives and other healthcare personnel,

•

increased operating costs due to shortages in qualified nurses and other healthcare personnel,

•

the effects of healthcare reform and government regulations, interpretation of regulations and changes in the nature and enforcement of regulations governing the healthcare industry,

•

changes in the reimbursement rates or methods of payment from third party payors, including the Medicare and Medicaid programs, and changes arising from the Medicare prospective payment system for long-term acute care hospitals and the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, and potential changes in nursing center Medicare reimbursement resulting from revised resource utilization groupings (“RUGs”) payments,

•

national and regional economic conditions, including their effect on the availability and cost of labor, materials and other services,

•

the Company’s ability to control costs, including labor and employee benefit costs,

•

the Company’s ability to comply with the terms of its Corporate Integrity Agreement,

•

the Company’s ability to successfully pursue its development activities and integrate operations of new facilities,

•

the increase in the costs of defending and insuring against alleged professional liability claims and the Company’s ability to predict the estimated costs related to such claims,

•

the Company’s ability to successfully reduce (by divestiture of operations or otherwise) its exposure to professional liability claims, and

•

the Company’s ability to successfully dispose of unprofitable facilities.

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

RESULTS OF OPERATIONS (Continued)

Cautionary Statement (Continued)

Many of these factors are beyond the Company’s control. The Company cautions investors that any forward-looking statements made by the Company are not guarantees of future performance. The Company disclaims any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments.

General

The business segment data in Note 7 of the accompanying Notes to Condensed Consolidated Financial Statements should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that operates hospitals, nursing centers, institutional pharmacies and a contract rehabilitation services business. At June 30, 2004, the Company’s hospital division operated 70 hospitals (5,474 licensed beds) in 24 states. The Company’s health services division operated 252 nursing centers (32,589 licensed beds) in 29 states. The Company’s pharmacy division operated an institutional pharmacy business with 30 pharmacies in 19 states. The Company also operated a contract rehabilitation services business which began operating as a separate division on January 1, 2004.

On January 1, 2004, the Company completed the Rehabilitation Services Reorganization. The historical operating results of the Company’s nursing center and rehabilitation services segments have not been restated to conform with the new business alignment.

During 2003, the Company effected certain strategic transactions to improve its future operating results. These transactions included the Florida and Texas Divestiture on June 30, 2003, the acquisition for resale of the Ventas II Facilities and certain other dispositions and contract terminations. For accounting purposes, the operating results of these businesses and the losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2004 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Notes 2 and 3 of the accompanying Notes to Condensed Consolidated Financial Statements.

On April 20, 2001, the Company and its subsidiaries emerged from proceedings under Chapter 11 of Title 11 of the Bankruptcy Code pursuant to the terms of the Plan of Reorganization.

Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of commitments and contingencies. The Company relies on historical experience and on various other assumptions that management believes to be reasonable under the circumstances to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.

The Company believes the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of its consolidated financial statements.

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Revenue recognition

The Company has agreements with third party payors that provide for payments to each of its operating divisions. These payment arrangements may be based upon prospective rates, reimbursable costs, established charges, discounted charges or per diem payments. Net patient service revenue is reported at the estimated net realizable amounts from Medicare, Medicaid, other third party payors and individual patients for services rendered. Retroactive adjustments that are likely to result from future examinations by third party payors are accrued on an estimated basis in the period the related services are rendered and adjusted as necessary in future periods based upon final settlements.

For the second quarter and the six months ended June 30, 2004, the Company recorded income of approximately $4 million and $6 million, respectively, related to settlements of prior year hospital Medicare cost reports. In addition, the Company recorded approximately $6 million of income in the second quarter of 2004 related to retroactive nursing center Medicaid rate increases in North Carolina that were approved in April 2004. See Note 4 of the accompanying Notes to Condensed Consolidated Financial Statements.

Collectibility of accounts receivable

Accounts receivable consist primarily of amounts due from the Medicare and Medicaid programs, other government programs, managed care health plans, commercial insurance companies and individual patients. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.

In evaluating the collectibility of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type, the status of ongoing disputes with third party payors and general industry conditions. Actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of the change.

The provision for doubtful accounts totaled $5 million for the second quarter of both 2004 and 2003 and totaled $13 million and $10 million for the six months ended June 30, 2004 and 2003, respectively.

Allowances for insurance risks

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks recorded in the accompanying unaudited condensed consolidated balance sheet aggregated $300 million at June 30, 2004 and $296 million at December 31, 2003. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $316 million at June 30, 2004 and $311 million at December 31, 2003.

During the past two years, the Company has recorded substantial cost increases related to professional liability risks. A portion of these costs were not funded into the limited purpose insurance subsidiary until the following fiscal year. Based upon actuarially determined estimates, the Company funded approximately $5 million into its limited purpose insurance subsidiary in March 2004 and intends to fund an additional $10 million into its limited purpose insurance subsidiary by December 31, 2004 to satisfy fiscal 2003 funding requirements. In March 2003, the Company funded approximately $63 million into its limited purpose insurance subsidiary to satisfy fiscal 2002 funding requirements.

Changes in the number of professional liability claims and the increasing cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and ultimate actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at June 30, 2004 would impact the Company’s operating income by approximately $3 million.

The provision for professional liability risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $21 million for the second quarter of both 2004 and 2003 and $44 million and $52 million for the six months ended June 30, 2004 and 2003, respectively.

Provisions for loss for workers compensation risks retained by the limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $68 million at June 30, 2004 and $64 million at December 31, 2003. The provision for workers compensation risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $13 million and $12 million for the three months ended June 30, 2004 and 2003, respectively, and $25 million and $24 million for the six months ended June 30, 2004 and 2003, respectively.

See Note 8 of the accompanying Notes to Condensed Consolidated Financial Statements.

Accounting for income taxes

The provision for income taxes is based upon the Company’s estimate of taxable income or loss for each respective accounting period. The Company recognizes an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. The Company also recognizes as deferred tax assets the future tax benefits from net operating and capital loss carryforwards. A valuation allowance is provided for these deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Accounting for income taxes (Continued)

There are significant uncertainties with respect to professional liability costs and future government payments to both the Company’s hospitals and nursing centers which could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized. A valuation allowance is provided for deferred tax assets to the extent the realizability of the deferred tax assets is uncertain. The Company recognized deferred tax assets totaling $182 million at June 30, 2004 and December 31, 2003.

In 2003, the pre-reorganization deferred tax assets realized, amounts which have been considered “more likely than not” to be realized by the Company, and the resolution of certain income tax contingencies fully eliminated the goodwill recorded in connection with the Plan of Reorganization. Since the Company’s emergence from bankruptcy, goodwill has been reduced by $152 million related primarily to the recognition of pre-reorganization deferred tax assets. After the fresh-start accounting goodwill was eliminated in full in 2003, the excess of approximately $27 million was treated as an increase to capital in excess of par value.

The Company is subject to various income tax audits at the federal and state levels in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties. While the Company believes its tax positions are appropriate, there can be no assurance that the various authorities engaged in the examination of its income tax returns will not challenge the Company’s positions.

In April 2003, the Company received approximately $14 million of previously escrowed tax refunds as a result of the favorable conclusion of certain federal income tax examinations for the 1996, 1997 and 1998 tax years that were shared with Ventas. The receipt of the $14 million had no impact on the Company’s second quarter 2003 earnings because fresh-start accounting rules adopted in connection with the Company’s emergence from bankruptcy required that this transaction be recorded as a reduction of goodwill.

Valuation of long-lived assets and goodwill

The Company regularly reviews the carrying value of certain long-lived assets and the related identifiable intangible assets with respect to any events or circumstances that indicate an impairment or an adjustment to the amortization period is necessary. If circumstances suggest the recorded amounts cannot be recovered based upon estimated future undiscounted cash flows, the carrying values of such assets are reduced to fair value.

In assessing the carrying values of long-lived assets, the Company estimates future cash flows at the lowest level for which there are independent, identifiable cash flows. For this purpose, these cash flows are aggregated based upon the contractual agreements underlying the operation of the facility or group of facilities. Generally, an individual facility is considered the lowest level for which there are independent, identifiable cash flows. However, to the extent that groups of facilities are leased under a master lease agreement in which the operations of a facility and compliance with the lease terms are interdependent upon other facilities in the agreement (including the Company’s ability to renew the lease or divest a particular property), the Company defines the group of facilities under the master lease as the lowest level for which there are independent, identifiable cash flows. Accordingly, the estimated cash flows of all facilities within a master lease are aggregated for purposes of evaluating the carrying values of long-lived assets.

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Valuation of long-lived assets and goodwill (Continued)

In connection with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company is required to perform an impairment test for goodwill at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company performs its annual impairment test at the end of each year. No impairment charge was recorded at December 31, 2003 in connection with the annual impairment test.

Recent Developments

The Company has contracts with non-Kindred short-term acute care and other hospitals to operate long-term acute care hospitals within the host hospital. Under these arrangements, the Company leases space and purchases a limited amount of ancillary services from the host hospital and provides it with the option to discharge a portion of its clinically appropriate patients into the care of the Company’s hospital. These hospitals-in-hospitals (“HIHs”) also receive patients from general short-term acute care hospitals other than the host hospital. At June 30, 2004, the Company operated 59 free-standing hospitals (5,019 licensed beds) and 11 HIHs (455 licensed beds).

On August 2, 2004, CMS announced regulatory changes applicable to long-term acute care hospitals that are operated as an HIH. Once fully phased in, the new rules generally limit Medicare payments to the HIH if the Medicare admissions to the HIH from the host hospital exceed 25% of the total Medicare discharges for the HIH’s cost reporting period. There are limited exceptions for admissions from rural and urban medical centers.

The final rule establishes a four-year transition period. In the first year (beginning for cost reporting periods after October 1, 2004), HIHs are not subject to the Medicare payment limitation as long as the percent of Medicare admissions from the host hospital during the cost reporting period are less than the percentage of Medicare admissions from the host hospital for the fiscal 2004 cost reporting period (the “Base Year Percentage”). In the second year, the admission threshold will be the lesser of (a) the Base Year Percentage or (b) 75%. The third year admission threshold will be the lesser of (a) the Base Year Percentage or (b) 50% and the final year admission threshold will limit Medicare admissions from the host hospital to 25%. For eight of the Company’s HIHs, the first year of transition would not begin until September 1, 2005 because of their respective cost reporting periods.

Patients transferred once they have reached the short-term acute care outlier payment status are not counted toward the admission threshold. Patients admitted prior to meeting the admission threshold, as well as Medicare patients admitted from a non-host hospital, are eligible for the full payment under the prospective payment system for long-term acute care hospitals (“LTAC PPS”). The final rules allow HIHs that are currently under development to qualify for the four-year transition if the HIH is certified as an acute care hospital before October 1, 2004 and is designated as a long-term acute care hospital before October 1, 2005. HIHs certified after October 1, 2004 will be subject to the 25% admission threshold immediately.

If the HIH’s admissions from the host hospital exceed 25% (or the applicable transition percentages) in a cost reporting period, Medicare will pay the lesser of (1) the amount payable under LTAC PPS or (2) an amount equivalent to what Medicare would otherwise pay under the prospective payment system for short-term acute care hospitals.

The Company is continuing to evaluate the impact of the final regulations on its operations and is awaiting additional payment instructions to be issued by CMS. At this time, the Company does not believe that the new

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

RESULTS OF OPERATIONS (Continued)

Recent Developments (Continued)

rules will significantly impact its ongoing operations since only 8% of its existing hospital licensed beds would be subject to the new rules. For the second quarter of 2004, the Company’s HIHs generated revenues of approximately $23 million, operating income of approximately $5 million and pretax income of approximately $2 million. The Company also is considering the impact of the final regulations on its HIH development activities.

Results of Operations – Continuing Operations

Hospital Division

Revenues increased 5% to $356 million in the second quarter of 2004 from $338 million in the same period a year ago and 5% to $704 million for the six months ended June 30, 2004 from $670 million in the same period last year. Revenue growth in both periods was a result of growth in admissions and new hospital development. Revenues for the second quarter and six months ended June 30, 2004 included credits of $4 million and $6 million, respectively, related to settlements of prior year Medicare cost reports. On a same-store basis, revenues increased 1% in the second quarter of 2004 and 2% for the six months ended June 30, 2004 compared to the same periods a year ago.

In May 2004, CMS issued final regulations related to the annual update to long-term acute care reimbursement rates for patient discharges after July 1, 2004. These rate increases are expected to approximate 7% to 8% per Medicare admission. The application of the new payment rates to in-house Medicare hospital patients at June 30, 2004 increased second quarter 2004 hospital revenues by approximately $5 million.

Admissions rose 12% in the second quarter of 2004 and 9% for the first six months of 2004 compared to the respective prior year periods. On a same-store basis, admissions increased 5% in both the second quarter and six months ended June 30, 2004 compared to the respective periods in 2003. Declines in patient days in both periods resulted primarily from reduced average length of stay.

Hospital operating income rose 15% to $86 million in the second quarter of 2004 from $76 million in the second quarter of 2003. For the six months ended June 30, 2004, operating income rose 14% to $166 million from $146 million for the same period a year ago. Operating margins were 24.3% in the second quarter of 2004 compared to 22.3% in the second quarter of 2003. For the six months ended June 30, 2004, operating margins were 23.7% compared to 21.8% in the same period last year.

Growth in hospital operating income for the second quarter and six months ended June 30, 2004 was attributable to growth in admissions, improved labor cost efficiencies and settlements of prior year Medicare cost reports. Wage and benefit costs (including contract labor) increased 2% in both the second quarter and six months ended June 30, 2004 compared to the same periods in 2003, while average wage rates increased approximately 3% in each respective period from a year ago. Contract labor costs were relatively unchanged in the second quarter and six months ended June 30, 2004 compared to the same periods in 2003.

Professional liability costs were $5 million in the second quarter of 2004 and $11 million for the six months ended June 30, 2004, relatively unchanged from the same periods in 2003.

Effective July 1, 2004, the Company reorganized substantially all of the operations of its hospital pharmacy and rehabilitation departments by transferring the related personnel and operations to the Company’s pharmacy division and rehabilitation division.

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Health Services Division

Revenues increased 10% to $460 million in the second quarter of 2004 compared to $417 million in the same period a year ago. For the six months ended June 30, 2004, revenues increased 9% to $905 million compared to $828 million in the same period a year ago. Patient days on both a reported and same-store basis declined approximately 1% in the second quarter of 2004 compared to the second quarter of 2003. For the six months ended June 30, 2004, patient days on both a reported and same-store basis were relatively unchanged compared to the same period a year ago. Medicare census increased 2% in the second quarter of 2004 compared to the same period a year ago, while Medicaid and private census declined 1% and 2%, respectively, in the second quarter of 2004 compared to the same period a year ago. For the six months ended June 30, 2004, Medicare census increased 5% compared to the same period a year ago, while Medicaid and private census both declined 1% compared to the same period a year ago.

Aggregate revenues per patient day increased 11% in the second quarter of 2004 compared to the same period in 2003. For the six months ended June 30, 2004, aggregate revenues per patient day increased 10% compared to the same period in 2003. Medicare rates grew 10% in the second quarter and first six months of 2004 compared to the same periods last year, primarily as a result of rate adjustments that became effective on October 1, 2003. Medicaid rates grew 14% in the second quarter of 2004 compared to the same period a year ago and grew 9% for the six months ended June 30, 2004 compared to the same period a year ago. Medicaid rates in the second quarter of 2004 included the benefit of a retroactive Medicaid rate increase in North Carolina. Private rates grew 4% in both the second quarter and first six months of 2004 compared to the same periods a year ago.

Nursing center operating income increased 9% to $63 million in the second quarter of 2004 compared to $58 million in the second quarter of 2003. For the six months ended June 30, 2004, operating income increased 11% to $112 million compared to $101 million for the same period a year ago. Operating margins of 13.6% in the second quarter of 2004 were relatively unchanged from 13.7% in the second quarter of 2003. For the six months ended June 30, 2004, operating margins increased to 12.4% compared to 12.2% for the same period a year ago. The improvement in nursing center operating income for the second quarter and six months ended June 30, 2004 was primarily attributable to favorable reimbursement rates and continued operating efficiencies.

In connection with the Rehabilitation Services Reorganization, the Company transferred approximately 4,000 employees from its nursing centers to the new rehabilitation division. As a result, nursing center wage and benefit costs (including contract labor) declined 4% to $242 million in the second quarter of 2004 compared to $253 million for the same period a year ago. Average hourly wage rates declined 1% in the second quarter and first six months of 2004 compared to the same periods a year ago, while employee benefit costs declined 3% for the same periods. Intercompany charges for rehabilitation services provided by the rehabilitation division to the Company’s nursing centers in the second quarter and six months ended June 30, 2004 totaled $37 million and $74 million, respectively.

Professional liability costs totaled $16 million for the second quarter of both 2004 and 2003. For the six months ended June 30, 2004, professional liability costs totaled $33 million compared to $40 million for the same period a year ago.

Rehabilitation Division

Revenues increased to $52 million in the second quarter of 2004 from $9 million for the same period a year ago, while operating income totaled $7 million in the second quarter of 2004 compared to an operating loss of $1 million in the second quarter of 2003. For the six months ended June 30, 2004, revenues increased to $105 million from $17 million for the same period a year ago, while operating income totaled $16 million

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Rehabilitation Division (Continued)

compared to an operating loss of $2 million for the same period a year ago. The increase in revenues and operating income in the second quarter and first six months of 2004 was primarily attributable to the Rehabilitation Services Reorganization. Intercompany revenues for services provided to the Company’s nursing centers totaled $37 million and $74 million in the second quarter and first six months of 2004, respectively.

Pharmacy Division

Revenues increased 30% to $84 million in the second quarter of 2004 compared to $65 million for the second quarter a year ago. For the six months ended June 30, 2004, revenues increased 25% to $164 million compared to $131 million for the same period a year ago. The increased revenues resulted primarily from growth in the number of non-affiliated customers, price increases and increased utilization of higher priced drugs. At June 30, 2004, the Company provided pharmacy services to nursing facilities containing 64,500 licensed beds, including 28,200 licensed beds that it operates. At June 30, 2003, the Company provided pharmacy services to nursing facilities containing 56,400 licensed beds, including 27,600 licensed beds that it operates.

Pharmacy operating income totaled $7 million in the second quarter of 2004 compared to $6 million in the same period a year ago. For the six months ended June 30, 2004, operating income totaled $15 million compared to $13 million in the same period a year ago. Operating margins were 9.2% in the second quarter of 2004 compared to 9.5% for the same period a year ago. For the six months ended June 30, 2004, operating margins were 9.3% compared to 9.8% for the same period a year ago. The cost of goods sold as a percentage of revenues rose to 65.5% in the second quarter of 2004 compared to 63.0% for the same period a year ago. For the six months ended June 30, 2004, the cost of goods sold as a percentage of revenues rose to 65.1% compared to 62.7% for the same period a year ago. The increase in the cost of goods sold ratio was primarily attributable to Medicaid reimbursement reductions in certain states and competitive customer pricing.

Corporate Overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $30 million in the second quarter of 2004 compared to $28 million in the second quarter of 2003. For the six months ended June 30, 2004, corporate overhead aggregated $57 million compared to $55 million for the same period a year ago. As a percentage of consolidated revenues, corporate overhead totaled 3.4% in the second quarter of 2004 compared to 3.5% for the same period a year ago. For the six months ended June 30, 2004, as a percentage of consolidated revenues, corporate overhead totaled 3.2% compared to 3.4% for the same period a year ago.

Corporate expenses included the operating losses of the Company’s limited purpose insurance subsidiary of $1 million in the second quarter of 2004 compared to $4 million in the second quarter of 2003. Corporate expenses included the operating losses of the limited purpose insurance subsidiary of $3 million and $6 million for the six months ended June 30, 2004 and 2003, respectively.

Capital Costs

Rent expense increased 3% to $66 million in the second quarter of 2004 compared to $64 million for the same period a year ago. For the six months ended June 30, 2004, rent expense increased 2% to $130 million compared to $127 million for the same period a year ago. A substantial portion of the increase in both periods resulted from contractual inflation increases, including those associated with the master lease agreements with Ventas.

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Capital Costs (Continued)

Depreciation expense increased 13% to $23 million in the second quarter of 2004 compared to $20 million for the same period a year ago. For the six months ended June 30, 2004, depreciation expense increased 14% to $45 million compared to $39 million for the same period a year ago. The increase was primarily a result of the Company’s ongoing capital expenditure program.

Interest expense aggregated $4 million in the second quarter of 2004 compared to $3 million for the same period a year ago. Interest expense in the second quarter of 2004 included a pretax charge of approximately $1 million resulting from the refinancing of the Company’s credit agreements. For the six months ended June 30, 2004, interest expense aggregated $8 million compared to $6 million for the same period a year ago. For accounting purposes, the $44 million present value rent obligation to Ventas incurred in connection with the Florida and Texas Divestiture bears interest at a rate of 11%. See Note 9 of the accompanying Notes to Condensed Consolidated Financial Statements.

Investment income, related primarily to the Company’s excess cash balances and insurance subsidiary investments, approximated $2 million in the second quarter of 2004 compared to $1 million for the same period a year ago. Investment income in the second quarter of 2004 included a credit of $0.6 million related to the recovery of certain surety deposits. Investment income totaled $3 million for both the six months ended June 30, 2004 and the same period a year ago.

Consolidated Results

The Company reported income from continuing operations before income taxes of $41 million for the second quarter of 2004 compared to $20 million for the second quarter of 2003. For the six months ended June 30, 2004, income from continuing operations before income taxes aggregated $69 million compared to $27 million for the same period a year ago. Income from continuing operations in the second quarter of 2004 aggregated $24 million compared to $12 million in the second quarter of 2003. For the second quarter of 2003, the income tax provision of $8 million included an income tax benefit of approximately $1 million resulting from a change in estimate of the 2003 annual income tax provision. For the six months ended June 30, 2004, income from continuing operations aggregated $40 million compared to $15 million for the same period a year ago.

Discontinued Operations

Net operating losses for discontinued operations decreased to $1 million in the second quarter of 2004 from $20 million in the second quarter of 2003. For the six months ended June 30, 2004, net operating losses for discontinued operations decreased to $3 million from $36 million for the same period a year ago. Professional liability costs in the second quarter of 2004 totaled $1 million compared to $28 million in the second quarter of 2003. For the six months ended June 30, 2004, professional liability costs totaled $2 million compared to $51 million for the same period last year. See Notes 3 and 8 of the accompanying Notes to Condensed Consolidated Financial Statements.

Net losses associated with the divestiture of discontinued operations totaled approximately $1 million in the second quarter of 2004 and $36 million in the second quarter of 2003.

Liquidity

Cash flows provided by operations (including discontinued operations) aggregated $92 million for the six months ended June 30, 2004 compared to $123 million for the same period a year ago. During both periods, the Company maintained sufficient liquidity from operations to fund its ongoing capital expenditure program and finance acquisitions.

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

RESULTS OF OPERATIONS (Continued)

Liquidity (Continued)

Cash and cash equivalents totaled $65 million at June 30, 2004 compared to $67 million at December 31, 2003. Based upon existing cash levels, expected operating cash flows and capital spending, and the availability of borrowings under the Credit Facility, management believes that the Company has the necessary financial resources to satisfy expected short-term and long-term liquidity needs. The Company expects that excess cash flows, if any, during the second half of 2004 will be used to fund its ongoing development activities or reduce borrowings under the Credit Facility. See Note 9 of the accompanying Notes to Condensed Consolidated Financial Statements.

As previously discussed, the Company funded approximately $5 million into its limited purpose insurance subsidiary in March 2004 and intends to fund an additional $10 million into its limited purpose insurance subsidiary by December 31, 2004 to satisfy fiscal 2003 funding requirements. In March 2003, the Company funded approximately $63 million into its limited purpose insurance subsidiary to satisfy fiscal 2002 funding requirements.

In June 2004, the Company entered into the Credit Facility to refinance its existing credit agreements. In connection with the refinancing, the Company prepaid in full the outstanding balance of its senior secured notes with borrowings under the Credit Facility. Amounts borrowed under the Credit Facility bear interest, at the Company’s option, at (a) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (b) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based on the Company’s adjusted leverage ratio as defined in the Credit Facility. At June 30, 2004, the interest rate under the Credit Facility was 4.4%. The Credit Facility is collateralized by substantially all of the Company’s assets including certain owned real property and is guaranteed by substantially all of the Company’s subsidiaries. The Credit Facility constitutes a working capital facility for general corporate purposes and permits acquisitions and investments in healthcare facilities and companies up to an aggregate of $150 million. The Credit Facility also allows the Company, to a limited extent, to pay cash dividends and to repurchase its common stock. At June 30, 2004, the outstanding balance under the Credit Facility aggregated $80 million. The Company was in compliance with the terms of its Credit Facility at June 30, 2004.

In December 2003, the Company completed the acquisition of the Ventas II Facilities for $85 million in cash. The Company disposed of two Ventas II Facilities for approximately $4 million in the second quarter of 2004. The Company intends to dispose of the remaining properties as soon as practicable. Net proceeds from the sale of the remaining properties are expected to approximate $19 million.

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

RESULTS OF OPERATIONS (Continued)

Capital Resources

Capital expenditures totaled $36 million for the six months ended June 30, 2004 compared to $28 million for the six months ended June 30, 2003. Capital expenditures (excluding acquisitions) could approximate $100 million in 2004. Management believes that its capital expenditure program is adequate to improve and equip existing facilities.

In the second quarter of 2004, the Company paid $8 million to acquire a hospital. In the second quarter of 2003, the Company paid $64 million to Ventas and incurred certain debt obligations to acquire 15 nursing centers in Florida and one nursing center in Texas.

The Company’s capital expenditure program is financed generally through the use of operating cash flows. At June 30, 2004, the estimated cost to complete and equip construction in progress approximated $18 million.

The terms of the Credit Facility include certain covenants which limit the Company’s annual capital expenditures.

Other Information

Effects of Inflation and Changing Prices

The Company derives a substantial portion of its revenues from the Medicare and Medicaid programs. In recent years, significant cost containment measures enacted by Congress and certain state legislatures have limited the Company’s ability to recover its cost increases through increased pricing of its healthcare services. Medicare revenues in the Company’s long-term acute care hospitals and nursing centers are subject to fixed payments under the Medicare prospective payment systems. Medicaid reimbursement rates in many states in which the Company operates nursing centers also are based on fixed payment systems. Generally, these rates are adjusted annually for inflation. However, these adjustments may not reflect the actual increase in the costs of providing healthcare services.

Most of the Company’s hospitals have been operating under the Medicare prospective payment system since September 1, 2003. Operating results under this system are subject to changes in patient acuity and expense levels in the Company’s hospitals. These factors, among others, are subject to significant change. Slight variations in patient acuity could significantly change Medicare revenues generated under the Medicare prospective payment system. In addition, the Company’s hospitals may not be able to appropriately adjust their operating costs as patient acuity levels change. Under this system, Medicare reimbursement to the Company’s hospitals are based on a fixed payment system. Operating margins in the hospital division could be negatively impacted if the Company is unable to control its operating costs. As a result of these uncertainties, the Company cannot predict the ultimate long-term impact of the Medicare prospective payment system on its hospital operating results and the Company can make no assurances that such regulations or operational changes resulting from these regulations will not have a material adverse impact on its financial position, results of operations or liquidity. In addition, the Company can make no assurances that the new system will not have a material adverse effect on revenues from non-government third party payors. Various factors, including a reduction in average length of stay, have had a negative impact on revenues from non-government third party payors.

Medicare payments to the Company’s nursing centers are based on certain RUGs developed by CMS that provide various levels of reimbursement based on patient acuity. These payment rates could be reduced in the future and may result in a substantial reduction in nursing center revenues and operating margins.

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of Inflation and Changing Prices (Continued)

Management believes that the Company’s operating margins may continue to be under pressure as the growth in operating expenses, particularly professional liability, labor and employee benefits costs, exceeds payment increases from third party payors. In addition, as a result of competitive pressures, the Company’s ability to maintain operating margins through price increases to private patients is limited.

Litigation

The Company is a party to certain material litigation. See Note 11 of the accompanying Notes to Condensed Consolidated Financial Statements.

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

RESULTS OF OPERATIONS (Continued)

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)


	2003 Quarters												2004 Quarters
	First			Second			Third			Fourth			First			Second
Revenues	$	802,158		$	813,848		$	837,035		$	830,978		$	871,262		$	897,461

Salaries, wages and benefits		460,752			462,320			469,112			473,263			492,071			494,154
Supplies		104,182			104,440			107,701			113,293			116,733			120,563
Rent		63,078			64,215			64,783			64,230			64,459			65,958
Other operating expenses		146,839			140,776			144,368			131,524			145,406			150,358
Depreciation		19,195			19,927			20,407			21,328			22,046			22,612
Interest expense		2,888			2,992			1,054			3,388			3,656			4,714
Investment income		(1,635	)		(1,676	)		(1,333	)		(1,491	)		(1,218	)		(1,826	)

		795,299			792,994			806,092			805,535			843,153			856,533

Income from continuing operations before reorganization items and income taxes		6,859			20,854			30,943			25,443			28,109			40,928
Reorganization items		–			–			–			(1,010	)		–			(304	)

Income from continuing operations before income taxes		6,859			20,854			30,943			26,453			28,109			41,232
Provision for income taxes		4,348			7,710			12,629			10,968			11,834			17,012

Income from continuing operations		2,511			13,144			18,314			15,485			16,275			24,220
Discontinued operations, net of income taxes:
Loss from operations		(15,635	)		(20,555	)		(5,780	)		(3,407	)		(2,435	)		(1,388	)
Loss on divestiture of operations		–			(36,019	)		(827	)		(42,567	)		–			(1,063	)

Net income (loss)	$	(13,124	)	$	(43,430	)	$	11,707		$	(30,489	)	$	13,840		$	21,769

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.07		$	0.38		$	0.53		$	0.44		$	0.46		$	0.68
Discontinued operations:
Loss from operations		(0.45	)		(0.59	)		(0.17	)		(0.10	)		(0.07	)		(0.04	)
Loss on divestiture of operations		–			(1.04	)		(0.02	)		(1.21	)		–			(0.03	)

Net income (loss)	$	(0.38	)	$	(1.25	)	$	0.34		$	(0.87	)	$	0.39		$	0.61

Diluted:
Income from continuing operations	$	0.07		$	0.38		$	0.52		$	0.38		$	0.38		$	0.58
Discontinued operations:
Loss from operations		(0.45	)		(0.59	)		(0.17	)		(0.08	)		(0.06	)		(0.03	)
Loss on divestiture of operations		–			(1.04	)		(0.02	)		(1.05	)		–			(0.03	)

Net income (loss)	$	(0.38	)	$	(1.25	)	$	0.33		$	(0.75	)	$	0.32		$	0.52

Shares used in computing earnings (loss) per common share:
Basic		34,755			34,813			34,885			35,062			35,414			35,536
Diluted		34,767			34,828			35,143			40,685			42,721			41,913

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

Operating Data

(Unaudited)

(In thousands)


	2003 Quarters												2004 Quarters
	First			Second			Third			Fourth			First			Second
Revenues:
Hospital division	$	331,862		$	338,360		$	341,368		$	325,619		$	348,648		$	355,312
Health services division (a)		410,832			416,768			431,978			433,532			444,994			460,078
Rehabilitation division (a)		8,502			8,795			12,065			14,121			52,699			52,588
Pharmacy division		66,126			64,850			67,075			74,382			79,746			84,346

		817,322			828,773			852,486			847,654			926,087			952,324

Eliminations:
Pharmacy		(15,164	)		(14,925	)		(15,451	)		(16,676	)		(18,136	)		(17,717	)
Rehabilitation (a)		–			–			–			–			(36,689	)		(37,146	)

		(15,164	)		(14,925	)		(15,451	)		(16,676	)		(54,825	)		(54,863	)

	$	802,158		$	813,848		$	837,035		$	830,978		$	871,262		$	897,461

Income from continuing operations:
Operating income (loss):
Hospital division	$	70,538		$	75,455		$	87,171		$	73,702		$	80,066		$	86,483
Health services division (a)		43,424			57,235			54,944			64,436			49,469			62,489
Rehabilitation division (a)		(959	)		(750	)		261			(315	)		8,519			7,265
Pharmacy division		6,702			6,133			6,150			7,508			7,609			7,729
Corporate:
Overhead		(26,713	)		(28,354	)		(28,670	)		(28,898	)		(26,834	)		(30,356	)
Insurance subsidiary		(2,607	)		(3,407	)		(4,002	)		(3,535	)		(1,777	)		(1,224	)

		(29,320	)		(31,761	)		(32,672	)		(32,433	)		(28,611	)		(31,580	)

		90,385			106,312			115,854			112,898			117,052			132,386
Reorganization items		–			–			–			1,010			–			304

Operating income		90,385			106,312			115,854			113,908			117,052			132,690
Rent		(63,078	)		(64,215	)		(64,783	)		(64,230	)		(64,459	)		(65,958	)
Depreciation		(19,195	)		(19,927	)		(20,407	)		(21,328	)		(22,046	)		(22,612	)
Interest, net		(1,253	)		(1,316	)		279			(1,897	)		(2,438	)		(2,888	)

Income from continuing operations before income taxes		6,859			20,854			30,943			26,453			28,109			41,232
Provision for income taxes		4,348			7,710			12,629			10,968			11,834			17,012

	$	2,511		$	13,144		$	18,314		$	15,485		$	16,275		$	24,220

(a)

Financial data presented for periods prior to January 1, 2004 have not been restated to reflect the Rehabilitation Services Reorganization.

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

Operating Data (Continued)

(Unaudited)

(In thousands)


	2003 Quarters								2004 Quarters
	First		Second		Third		Fourth		First		Second
Rent:
Hospital division	$	23,284	$	23,706	$	23,441	$	22,753	$	22,844	$	23,529
Health services division (a)		39,031		39,808		40,459		40,530		40,283		40,874
Rehabilitation division (a)		69		95		123		185		611		708
Pharmacy division		630		547		698		703		662		790
Corporate		64		59		62		59		59		57

	$	63,078	$	64,215	$	64,783	$	64,230	$	64,459	$	65,958

Depreciation:
Hospital division	$	7,054	$	7,450	$	7,684	$	8,257	$	8,464	$	8,712
Health services division (a)		6,373		6,569		6,688		6,740		6,893		6,951
Rehabilitation division (a)		16		20		22		25		33		37
Pharmacy division		517		539		561		560		530		583
Corporate		5,235		5,349		5,452		5,746		6,126		6,329

	$	19,195	$	19,927	$	20,407	$	21,328	$	22,046	$	22,612

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	2,822	$	4,133	$	5,773	$	13,388	$	5,406	$	5,177
Health services division (a)		3,222		6,375		9,768		9,804		8,450		6,487
Rehabilitation division (a)		51		47		35		11		47		56
Pharmacy division		616		522		815		2,254		773		1,075
Corporate:
Information systems		3,207		5,992		4,071		8,223		2,651		4,033
Other		647		408		361		1,551		554		829

	$	10,565	$	17,477	$	20,823	$	35,231	$	17,881	$	17,657

(a)

Financial data presented for periods prior to January 1, 2004 have not been restated to reflect the Rehabilitation Services Reorganization.

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

Operating Data (Continued)

(Unaudited)


	2003 Quarters								2004 Quarters
	First		Second		Third		Fourth		First		Second
Hospital data:
End of period data:
Number of hospitals		63		63		64		66		68		70
Number of licensed beds		5,076		5,098		5,129		5,219		5,323		5,474
Revenue mix % (a):
Medicare		60		59		62		63		66		64
Medicaid		8		8		7		8		7		8
Private and other		32		33		31		29		27		28
Admissions:
Medicare		6,612		6,346		6,053		6,681		6,900		6,816
Medicaid		648		604		670		661		715		820
Private and other		1,281		1,322		1,333		1,359		1,460		1,588

		8,541		8,272		8,056		8,701		9,075		9,224

Admissions mix %:
Medicare		77		77		75		77		76		74
Medicaid		8		7		8		7		8		9
Private and other		15		16		17		16		16		17
Patient days:
Medicare		216,266		214,116		193,069		191,904		207,052		201,580
Medicaid		31,764		32,470		31,362		29,488		27,754		29,293
Private and other		56,225		59,339		54,080		52,725		52,391		53,031

		304,255		305,925		278,511		274,117		287,197		283,904

Average length of stay:
Medicare		32.7		33.7		31.9		28.7		30.0		29.6
Medicaid		49.0		53.8		46.8		44.6		38.8		35.7
Private and other		43.9		44.9		40.6		38.8		35.9		33.4
Weighted average		35.6		37.0		34.6		31.5		31.6		30.8
Revenues per admission (a):
Medicare	$	30,050	$	31,594	$	35,157	$	30,987	$	33,321	$	33,397
Medicaid		40,547		44,766		36,974		37,825		33,228		32,952
Private and other		83,449		83,830		77,860		68,870		65,054		63,384
Weighted average		38,855		40,904		42,374		37,423		38,419		38,520
Revenues per patient day (a):
Medicare	$	919	$	936	$	1,102	$	1,079	$	1,110	$	1,129
Medicaid		827		833		790		848		856		922
Private and other		1,901		1,868		1,919		1,775		1,813		1,898
Weighted average		1,091		1,106		1,226		1,188		1,214		1,252
Medicare case mix index (discharged patients only)		N/A		N/A		N/A		1.20		1.26		1.25

Average daily census		3,381		3,362		3,027		2,980		3,156		3,120
Occupancy %		69.8		69.0		61.9		59.9		62.4		60.1

(a)

Includes income of $14 million in the third quarter of 2003, $2 million in the first quarter of 2004 and $4 million in the second quarter of 2004 related to certain Medicare reimbursement issues.

N/A

– not available.

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

Operating Data (Continued)

(Unaudited)


	2003 Quarters								2004 Quarters
	First		Second		Third		Fourth		First		Second
Nursing center data:
End of period data:
Number of nursing centers:
Owned or leased		248		248		248		248		247		245
Managed		7		7		7		7		7		7

		255		255		255		255		254		252

Number of licensed beds:
Owned or leased		32,293		32,124		32,118		32,124		32,009		31,786
Managed		803		803		803		803		803		803

		33,096		32,927		32,921		32,927		32,812		32,589

Revenue mix %:
Medicare		33		33		32		33		36		33
Medicaid		48		48		50		48		46		49	(a)
Private and other		19		19		18		19		18		18
Patient days (excludes managed facilities):
Medicare		398,646		399,150		394,957		397,254		433,162		407,285
Medicaid		1,699,726		1,707,907		1,757,580		1,737,615		1,675,706		1,689,795
Private and other		410,378		418,824		422,529		426,890		407,684		409,346

		2,508,750		2,525,881		2,575,066		2,561,759		2,516,552		2,506,426

Patient day mix %:
Medicare		16		16		15		15		17		16
Medicaid		68		68		68		68		67		68
Private and other		16		16		17		17		16		16
Revenues per patient day:
Medicare	$	338	$	342	$	344	$	364	$	372	$	375
Medicaid		117		118		123		120		121		134	(a)
Private and other		188		189		188		190		197		197
Weighted average		164		165		168		169		177		184
Average daily census		27,875		27,757		27,990		27,845		27,654		27,543
Occupancy %		86.0		85.6		86.8		86.4		86.0		85.8

Rehabilitation data:
Revenue mix %:
Company-operated		N/A		N/A		N/A		N/A		70		71
Non-affiliated		N/A		N/A		N/A		N/A		30		29

Pharmacy data:
Number of customer licensed beds at end of period:
Company-operated		29,804		27,566		27,886		28,280		28,188		28,164
Non-affiliated		28,365		28,848		29,507		33,127		35,102		36,385

		58,169		56,414		57,393		61,407		63,290		64,549

(a)

Includes income of $9 million related to prior period North Carolina provider tax program revenues. Prior period provider tax expense of $3 million related to this program was recorded in other operating expenses.

N/A

– not available.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion of the Company’s exposure to market risk contains “forward-looking statements” that involve risks and uncertainties. The information presented has been prepared utilizing certain assumptions considered reasonable in light of information currently available to the Company. Given the unpredictability of interest rates as well as other factors, actual results could differ materially from those projected in such forward-looking information.

The Company’s exposure to market risk relates to changes in the prime rate, federal funds rate and the London Interbank Offered Rate, which affect the interest paid on certain borrowings.

The following table provides information about the Company’s financial instruments that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted average interest rates by expected maturity date.

Interest Rate Sensitivity

Principal (Notional) Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)


	Expected maturities																				Fair value 6/30/04
	2004			2005			2006			2007			2008			Thereafter			Total		Fair value 6/30/04
Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate:
Ventas debt obligation:
Principal	$	2,346		$	5,311		$	6,264		$	7,338		$	5,660		$	12,880		$	39,799	$	39,799
Interest		2,095			3,778			3,143			2,399			1,646			2,376			15,437		–

		4,441			9,089			9,407			9,737			7,306			15,256			55,236		39,799
Other		26			63			67			71			76			820			1,123		1,076

	$	4,467		$	9,152		$	9,474		$	9,808		$	7,382		$	16,076		$	56,359	$	40,875

Average interest rate		10.9	%		10.9	%		10.9	%		11.0	%		10.9	%		10.7	%
Variable rate	$	–		$	–		$	–		$	–		$	–		$	80,000	(a)	$	80,000	$	78,800

(a)

Interest is payable, at the Company’s option, at (a) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (b) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based on the Company’s adjusted leverage ratio as defined in the Credit Facility.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2004, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended June 30, 2004, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Summary descriptions of various significant legal and regulatory activities follow.

Three shareholder derivative suits entitled Elizabeth Sommerfeld v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 08476; Ilse Denchfield v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 09475; and Fedorka v. Edward L. Kuntz, et al., Civil Action No. 03 CI 02015, were filed in November 2002, December 2002 and March 2003, respectively, in the Jefferson Circuit Court in Kentucky. The complaints in those lawsuits are nearly identical to the complaint in a putative class action lawsuit entitled Massachusetts State Carpenters Pension Fund v. Kindred Healthcare, Inc., et al, Civil Action No. 3:02CV-600-J, which was filed against the Company and certain of the Company’s current and former officers and directors on October 16, 2002 in the United States District Court for the Western District of Kentucky, Louisville Division and was dismissed with prejudice on January 12, 2004. Specifically, the derivative suits allege that from August 14, 2001 to October 10, 2002 the defendants violated Sections 10(b) and 20(a) of the Exchange Act by, among other things, issuing to the investing public a series of allegedly false and misleading statements that inaccurately indicated that the Company was successfully emerging from bankruptcy and implementing a growth plan. In particular, the complaint alleges that these statements were materially false and misleading because they failed to disclose that the 2001 Florida tort reform legislation had resulted in a marked increase in claims against the Company in Florida, and also because the statements reflected a materially understated reserve for professional liability costs. The complaints further allege that as a result of the purportedly false and misleading statements, the price of the Company’s common stock was artificially inflated, the investing public was deceptively induced to purchase the stock at those inflated prices, and the defendants profited by selling shares at those prices. In May 2003, the Fedorka plaintiffs voluntarily dismissed their state court derivative lawsuit and refiled that lawsuit in the United States District Court for the Western District of Kentucky, Louisville Division, Civil Action No. 3:03CV-272-S. On May 14, 2003, a separate but nearly identical derivative lawsuit, Tin Win v. Edward L. Kuntz, et al., Civil Action No. 3:03CV-292-J, also was filed in the United States District Court for the Western District of Kentucky, Louisville Division. On May 12, 2003, the Jefferson Circuit Court entered an order consolidating the Sommerfeld and Denchfield derivative actions and staying all proceedings in the consolidated derivative action pending the District Court’s ruling on the defendants’ motion to dismiss the consolidated putative class action. On July 24, 2003, the District Court entered a similar order concerning the Fedorka and Win federal derivative actions. After the District Court’s dismissal of the Massachusetts State Carpenters Pension Fund putative class action became final in February 2004, the plaintiffs in the consolidated Fedorka and Win federal derivative action voluntarily dismissed that consolidated derivative action, with prejudice. Subsequently, on June 18, 2004, the Jefferson Circuit Court entered a sua sponte order stating that the Sommerfeld consolidated derivative action would be dismissed within 30 days unless the plaintiffs filed a verified statement showing good cause why that case should not be dismissed. On July 12, 2004, the Sommerfeld plaintiffs’ counsel responded to that sua sponte order. The Sommerfeld consolidated derivative complaint attempts to assert a claim against the individual defendants for breach of fiduciary duties for insider selling and misappropriation of information. Specifically, the complaint alleges that each of the individual defendants knew that the price of the Company’s common stock would dramatically decrease when the Company’s inadequate reserves for professional liability risks were disclosed and that the individual defendants’ sales of the Company’s common stock with knowledge of this material non-public information constituted a breach of their fiduciary duties of loyalty and good faith. The suit seeks to impose a constructive trust in favor of the Company for the amount of profits which each defendant or their firms may have received from their November 2001 sales of the Company’s common stock, as well as attorneys’ fees and other expenses. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

PART II. OTHER INFORMATION (Continued)

Item 1. Legal Proceedings (Continued)

The Company is a party to various legal actions (some of which are not insured), and regulatory investigations and sanctions arising in the ordinary course of its business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory investigations. In addition, there can be no assurance that the DOJ, CMS or other federal and state enforcement and regulatory agencies will not initiate additional investigations related to the Company’s businesses in the future, nor can there be any assurance that the resolution of any litigation or investigations, either individually or in the aggregate, would not have a material adverse effect on the Company’s financial position, results of operations and liquidity. In addition, the litigation and investigations discussed above (as well as future litigation and investigations) are expected to consume the time and attention of management and may have a disruptive effect upon the Company’s operations.

Item 4. Submission of Matters to a Vote of Security Holders

The Company’s Annual Meeting of Shareholders was held on May 18, 2004 in Louisville, Kentucky. At the meeting, shareholders elected a board of eight directors pursuant to the following votes:


Director	Votes in Favor	Votes Withheld
Thomas P. Cooper, M.D.	15,159,061	1,925,212
Paul J. Diaz	15,969,374	1,114,899
Michael J. Embler	15,693,131	1,391,142
Garry N. Garrison	15,395,246	1,689,027
Isaac Kaufman	15,705,131	1,379,142
John H. Klein	15,717,967	1,366,306
Edward L. Kuntz	15,630,714	1,453,559
Eddy J. Rogers, Jr.	15,809,731	1,274,542

In addition to electing directors, shareholders of the Company approved the following actions:

(a)

A proposal to approve the Kindred Healthcare, Inc. 2001 Stock Incentive Plan, Amended and Restated, by the vote of 9,985,696 in favor, 4,799,160 against, 37,634 abstentions and 2,261,783 non-votes; and

(b)

A proposal to approve the Kindred Healthcare, Inc. 2001 Stock Option Plan for Non-Employee Directors, Amended and Restated, by the vote of 10,364,933 in favor, 4,450,027 against, 7,530 abstentions and 2,261,783 non-votes.

All vote totals represent shares prior to the Company’s 2-for-1 stock split that was effective on May 27, 2004.

PART II. OTHER INFORMATION (Continued)

Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits:



10.1		$300,000,000 Amended and Restated Credit Agreement dated as of June 28, 2004 among Kindred Healthcare, Inc., the Lenders Party Hereto, and JPMorgan Chase Bank, as Administrative Agent and Collateral Agent, J.P. Morgan Securities, Inc., as Sole Bookrunner and Sole Lead Arranger, Citicorp USA, Inc., as Syndication Agent, General Electric Capital Corporation, The CIT Group/Business Credit, Inc. and Wells Fargo Foothill, as Co-Documentation Agents.

31		Rule 13a-14(a)/15d-14(a) Certifications.

32		Section 1350 Certifications.

(b)

Reports on Form 8-K:

On April 27, 2004, the Company filed a Current Report on Form 8-K announcing its financial results for the quarter ended March 31, 2004 and providing earnings guidance for 2004. On June 29, 2004, the Company filed a Current Report on Form 8-K announcing that it had entered into a five-year $300 million revolving credit facility to replace its former credit agreements.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


						KINDRED HEALTHCARE, INC.

Date: August 6, 2004						/s/ PAUL J. DIAZ
						Paul J. Diaz President and Chief Executive Officer

Date: August 6, 2004						/s/ RICHARD A. LECHLEITER
						Richard A. Lechleiter Senior Vice President and Chief Financial Officer