ENSG 6.30.11 10Q
Table of Contents

 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 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, 2011.
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from                      to                     .
Commission file number: 001-33757
__________________________
THE ENSIGN GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)
Delaware
33-0861263
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
27101 Puerta Real, Suite 450
Mission Viejo, CA 92691
(Address of Principal Executive Offices and Zip Code)
(949) 487-9500
(Registrant’s Telephone Number, Including Area Code)
N/A
(Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)
_____________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o
 
 
(Do not check if a smaller reporting company)
 
Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No
As of July 29, 2011, 20,977,655 shares of the registrant’s common stock were outstanding.
 
 
 
 
 

THE ENSIGN GROUP, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE SIX MONTHS ENDED JUNE 30, 2011
TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

2

Table of Contents

Part I. Financial Information

Item 1.        Financial Statements

THE ENSIGN GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par values)
(Unaudited)

 
June 30,
2011
 
December 31,
2010

Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
38,111

 
$
72,088

Accounts receivable—less allowance for doubtful accounts of $11,068 and $9,793 at June 30, 2011 and December 31, 2010, respectively
77,696

 
69,437

Prepaid income taxes
1,427

 
1,333

Prepaid expenses and other current assets
7,072

 
7,175

Deferred tax asset—current
10,147

 
9,975

Total current assets
134,453

 
160,008

Property and equipment, net
321,745

 
262,527

Insurance subsidiary deposits and investments
16,261

 
16,358

Escrow deposits
1,450

 
14,422

Deferred tax asset
6,669

 
4,987

Restricted and other assets
10,504

 
6,509

Intangible assets, net
4,202

 
4,070

Goodwill
11,751

 
10,339

Other indefinite-lived intangibles
1,241

 
672

Total assets
$
508,276

 
$
479,892

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
19,455

 
$
17,897

Accrued wages and related liabilities
35,059

 
37,377

Accrued self-insurance liabilities—current
11,518

 
11,480

Other accrued liabilities
13,142

 
13,557

Current maturities of long-term debt
3,026

 
3,055

Total current liabilities
82,200

 
83,366

Long-term debt—less current maturities
137,124

 
139,451

Accrued self-insurance liabilities—less current portion
31,438

 
25,920

Deferred rent and other long-term liabilities
2,643

 
2,952

Commitments and contingencies (Note 15)

 

Stockholders’ equity:
 
 
 
Common stock; $0.001 par value; 75,000 shares authorized; 21,489 and 20,927 shares issued and outstanding at June 30, 2011, respectively, and 21,397 and 20,815 shares issued and outstanding at December 31, 2010, respectively
21

 
21

Additional paid-in capital
73,973

 
70,814

Retained earnings
184,572

 
161,168

Common stock in treasury, at cost, 564 and 582 shares at June 30, 2011 and December 31, 2010, respectively
(3,695
)
 
(3,800
)
Total stockholders’ equity
254,871

 
228,203

Total liabilities and stockholders’ equity
$
508,276

 
$
479,892

See accompanying notes to condensed consolidated financial statements.

3

Table of Contents

THE ENSIGN GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)

 
Three Months Ended
June 30,
 
Six Months Ended June 30,
 
2011
 
2010
 
2011
 
2010
Revenue
$
186,326

 
$
157,948

 
$
369,269

 
$
312,122

Expense:

 
 
 
 
 
 
Cost of services (exclusive of facility rent and depreciation and amortization shown separately below)
145,637

 
125,808

 
288,792

 
248,991

Facility rent—cost of services
3,433

 
3,616

 
7,049

 
7,191

General and administrative expense
7,592

 
6,407

 
14,993

 
12,181

Depreciation and amortization
5,546

 
4,023

 
10,605

 
7,978

Total expenses
162,208

 
139,854

 
321,439

 
276,341

Income from operations
24,118

 
18,094

 
47,830

 
35,781

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(2,739
)
 
(2,308
)
 
(5,466
)
 
(4,588
)
Interest income
75

 
63

 
130

 
130

Other expense, net
(2,664
)
 
(2,245
)
 
(5,336
)
 
(4,458
)
Income before provision for income taxes
21,454

 
15,849

 
42,494

 
31,323

Provision for income taxes
8,478

 
6,230

 
16,772

 
12,356

Net income
$
12,976

 
$
9,619

 
$
25,722

 
$
18,967

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.62

 
$
0.46

 
$
1.23

 
$
0.92

Diluted
$
0.60

 
$
0.46

 
$
1.19

 
$
0.90

Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
20,909

 
20,741

 
20,881

 
20,713

Diluted
21,579

 
21,126

 
21,535

 
21,103

See accompanying notes to condensed consolidated financial statements.

4

Table of Contents

THE ENSIGN GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

 
Six Months Ended
June 30,
 
2011
 
2010
Cash flows from operating activities:
 
 
 
Net income
$
25,722

 
$
18,967

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
10,605

 
7,978

Amortization of deferred financing fees and debt discount
327

 
327

Deferred income taxes
(1,854
)
 
(3,140
)
Provision for doubtful accounts
4,041

 
2,948

Stock-based compensation
1,677

 
1,266

Excess tax benefit from share based compensation
(532
)
 
(357
)
Impairment of software development costs

 
297

(Gain) loss on disposition of property and equipment
(1
)
 
22

Change in operating assets and liabilities
 
 
 
Accounts receivable
(12,300
)
 
(13,020
)
Prepaid income taxes
(94
)
 

Prepaid expenses and other current assets
103

 
(200
)
Insurance subsidiary deposits and investments
97

 
(1,587
)
Accounts payable
349

 
769

Accrued wages and related liabilities
(2,318
)
 
(1,218
)
Other accrued liabilities
107

 
(1,641
)
Accrued self-insurance
1,825

 
3,389

Deferred rent liability
(308
)
 
103

Net cash provided by operating activities
27,446

 
14,903

Cash flows from investing activities:
 
 
 
Purchase of property and equipment
(18,684
)
 
(13,753
)
Cash payment for business acquisitions
(45,029
)
 
(18,809
)
Cash payment for asset acquisitions
(7,339
)
 

Escrow deposits
(1,450
)
 

Escrow deposits used to fund business acquisitions
14,422

 
7,595

Cash proceeds from the sale of fixed assets
324

 
58

Restricted and other assets
(489
)
 
(244
)
Net cash used in investing activities
(58,245
)
 
(25,153
)
Cash flows from financing activities:
 
 
 
Payments on long term debt
(2,417
)
 
(1,039
)
Issuance of treasury stock upon exercise of options
105

 
159

Issuance of common stock upon exercise of options
949

 
348

Dividends paid
(2,308
)
 
(2,069
)
Excess tax benefit from share based compensation
532

 
357

Payments of deferred financing costs
(39
)
 
(8
)
Net cash used in financing activities
(3,178
)
 
(2,252
)
Net decrease in cash and cash equivalents
(33,977
)
 
(12,502
)
Cash and cash equivalents beginning of period
72,088

 
38,855

Cash and cash equivalents end of period
$
38,111

 
26,353

Supplemental disclosures of cash flow information:
 
 
 
Cash paid during the period for:
 
 
 
Interest
$
5,612

 
$
4,526

Income taxes
$
18,165

 
$
14,050

Non-cash investing activity:
 
 
 
Accrued capital expenditures
$
1,208

 
$

See accompanying notes to condensed consolidated financial statements.

5

Table of Contents

THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars and shares in thousands, except per share data)
(Unaudited)

1. DESCRIPTION OF BUSINESS
The Company — The Ensign Group, Inc., through its subsidiaries (collectively, Ensign or the Company), provides skilled nursing and rehabilitative care services through the operation of 87 facilities, two home health and three hospice operations as of June 30, 2011, located in California, Arizona, Texas, Washington, Utah, Colorado, Idaho and Nevada. All of these facilities are skilled nursing facilities, other than six stand-alone assisted living facilities in California, Arizona, Texas, Colorado and Nevada and seven campuses that offer both skilled nursing and assisted living services located in California, Texas, Arizona and Utah. The Company’s facilities, each of which strives to be the facility of choice in the community it serves, provide a broad spectrum of skilled nursing and assisted living services, physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. The Company’s facilities have a collective capacity of approximately 10,500 operational skilled nursing, assisted living and independent living beds. As of June 30, 2011, the Company owned 58 of its 87 facilities and operated an additional 29 facilities through long-term lease arrangements, and had options to purchase eight of those 29 facilities.
The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenue. All of the Company’s facilities are operated by separate, wholly-owned, independent subsidiaries, each of which has its own management, employees and assets. One of the Company’s wholly-owned subsidiaries, referred to as the Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other centralized services to the other operating subsidiaries through contractual relationships with such subsidiaries. The Company also has a wholly-owned captive insurance subsidiary (the Captive) that provides some claims-made coverage to the Company’s operating subsidiaries for general and professional liability, as well as coverage for certain workers’ compensation insurance liabilities.
Like the Company’s facilities, the Service Center and the Captive are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that The Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the Captive are operated by the same entity.
Other Information — The accompanying condensed consolidated financial statements as of June 30, 2011 and for the three and six months ended June 30, 2011 and 2010 (collectively, the Interim Financial Statements), are unaudited. Certain information and footnote disclosures normally included in annual consolidated financial statements have been condensed or omitted, as permitted under applicable rules and regulations. Readers of the Interim Financial Statements should refer to the Company’s audited consolidated statements and notes thereto for the year ended December 31, 2010 which are included in the Company’s annual report on Form 10-K, File No. 001-33757 (the Annual Report) filed with the Securities and Exchange Commission (the SEC). Management believes that the Interim Financial Statements reflect all adjustments which are of a normal and recurring nature necessary to present fairly the Company’s financial position and results of operations in all material respects. The results of operations presented in the Interim Financial Statements are not necessarily representative of operations for the entire year.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation — The accompanying Interim Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The Company is the sole member or shareholder of various consolidated limited liability companies and corporations; each established to operate various acquired skilled nursing, assisted living facilities, and home health and hospice operations. All intercompany transactions and balances have been eliminated in consolidation.
Estimates and Assumptions — The preparation of Interim Financial Statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The most significant estimates in the Company’s Interim Financial Statements relate to revenue, allowance for doubtful accounts, intangible assets and goodwill, impairment of long-lived assets, general and professional liability, worker’s compensation, and healthcare claims included in accrued self-insurance liabilities and income taxes. Actual results could differ from those estimates.

6

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Business Segments — The Company has a single reportable segment — long-term care services, which includes the operation of skilled nursing and assisted living facilities, home health, hospice, and related ancillary services. The Company’s single reportable segment is made up of several individual operating segments grouped together principally based on their geographical locations within the United States. Based on the similar economic and other characteristics of each of the operating segments, management believes the Company meets the criteria for aggregating its operating segments into a single reporting segment.
Fair Value of Financial Instruments — The Company’s financial instruments consist principally of cash and cash equivalents, debt security investments, accounts receivable, insurance subsidiary deposits, accounts payable and borrowings. The Company believes all of the financial instruments’ recorded values approximate fair values because of their nature and respective short durations. The Company’s fixed-rate debt instruments do not actively trade in an established market. The fair values of this debt are estimated by discounting the principal and interest payments at rates available to the Company for debt with similar terms and maturities. See further discussion of debt security investments at Note 4.
Revenue Recognition — The Company recognizes revenue when the following four conditions have been met: (i) there is persuasive evidence that an arrangement exists; (ii) delivery has occurred or service has been rendered; (iii) the price is fixed or determinable; and (iv) collection is reasonably assured. Revenue from the Medicare and Medicaid programs accounted for approximately 75% and 76% of the Company’s revenue for the three and six months ended June 30, 2011 and 76% for both periods during the three and six months ended June 30, 2010. The Company records revenue from these governmental and managed care programs as services are performed at their expected net realizable amounts under these programs. The Company’s revenue from governmental and managed care programs is subject to audit and retroactive adjustment by governmental and third-party agencies. Consistent with healthcare industry accounting practices, any changes to these governmental revenue estimates are recorded in the period the change or adjustment becomes known based on final settlements. The Company recorded retroactive adjustments that increased (decreased) revenue by $295 and $841 for the three and six months ended June 30, 2011 and $(561) and $(241) for the three and six months ended June 30, 2010, respectively. The decrease in revenue from retroactive adjustments in 2010 is attributable to the item disclosed in "Other Matters" in Note 15. Retroactive revenue adjustments increased (decreased) revenue by $(47) and $273 for the three and six months ended June 30, 2010 prior to the item disclosed in Note 15.
The Company’s service specific revenue recognition policies are as follows:
Skilled Nursing Revenue
The Company’s revenue is derived primarily from providing long-term healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis. The Company records revenue from private pay patients, at the agreed upon rate, as services are performed.
Home Health and Hospice Revenue Recognition
Episodic Based Revenue — Net service revenue is typically recorded on a 60-day episode payment rate. The Company makes adjustments to revenue on completed episodes to reflect differences between estimated and actual payment amounts, an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. The Company records an estimate for the impact of such payment adjustments based on its historical experience. In addition to revenue recognized on completed episodes, the Company also recognizes a portion of revenue associated with episodes in progress. Episodes in progress are 60-day episodes of care that begin during the reporting period, but were not completed as of the end of the period. The Company estimates this revenue on a monthly basis based upon historical trends. The primary factors underlying this estimate are the number of episodes in progress at the end of the reporting period, expected Medicare revenue per episode and the Company's estimate of the average percentage complete based on days completed of the episode of care.
Non-episodic Based Revenue — Gross revenue is recorded on an accrual basis based upon the date of service at amounts equal to our established or estimated per-visit rates, as applicable.
Hospice Revenue — Gross revenue is recorded on an accrual basis based upon the date of service at amounts equal to the estimated payment rates. The estimated payment rates are daily rates for each of the levels of care we deliver. The Company makes adjustments to revenue for an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. The Company estimates the impact of these adjustments based on its historical

7

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


experience, which primarily includes historical collection rates on Medicare claims, and records it during the period services are rendered as an estimated revenue adjustment and as a reduction to its outstanding patient accounts receivable. Additionally, as Medicare hospice revenue is subject to an inpatient cap limit and an overall payment cap, the Company monitors its provider numbers and estimate amounts due back to Medicare if a cap has been exceeded. The Company records these adjustments as a reduction to revenue and increases other accrued liabilities.
Accounts Receivable — Accounts receivable consist primarily of amounts due from Medicare and Medicaid programs, other government programs, managed care health plans and private payor sources. 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 collectability 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 and the status of ongoing disputes with third-party payors. The percentages applied to the aged receivable balances are based on the Company’s historical experience and time limits, if any, for managed care, Medicare, Medicaid and other payors. The Company periodically refines its estimates of the allowance for doubtful accounts based on experience with the estimation process and changes in circumstances.
Property and Equipment — Property and equipment are initially recorded at their historical cost. Repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the depreciable assets (ranging from three to 30 years). Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the remaining lease term.
Impairment of Long-Lived Assets — The Company reviews the carrying value of long-lived assets that are held and used in the Company’s operations for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined based upon expected undiscounted future net cash flows from the operations to which the assets relate, utilizing management’s best estimate, appropriate assumptions, and projections at the time. If the carrying value is determined to be unrecoverable from future operating cash flows, the asset is deemed impaired and an impairment loss would be recognized to the extent the carrying value exceeded the estimated fair value of the asset. The Company estimates the fair value of assets based on the estimated future discounted cash flows of the asset. Management has evaluated its long-lived assets and has not identified any impairment during the six months ended June 30, 2011 or 2010.
Intangible Assets and Goodwill — Intangible assets consist primarily of favorable lease, lease acquisition costs, patient base, trade names and other indefinite-lived intangibles. Favorable leases and lease acquisition costs are amortized over the life of the lease of the facility, typically ranging from ten to 20 years. Patient base is amortized over a period of four to twelve months, depending on the classification of the patients and the level of occupancy in a new acquisition on the acquisition date. Trade names at facilities are amortized over 30 years.
Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill is subject to annual testing for impairment. In addition, goodwill is tested for impairment if events occur or circumstances change that would reduce the fair value of a reporting unit below its carrying amount. The Company defines reporting units as the individual facilities. The Company performs its annual test for impairment during the fourth quarter of each year. The Company did not record any impairment charges during the six months ended June 30, 2011.
Self-Insurance — The Company is partially self-insured for general and professional liability up to a base amount per claim (the self-insured retention) with an aggregate, one time deductible above this limit. Losses beyond these amounts are insured through third-party policies with coverage limits per occurrence, per location and on an aggregate basis for the Company. For claims made after April 1, 2011, the combined self-insured retention was $500 per claim with an aggregate $1,750 deductible limit. For all facilities, except those located in Colorado, the third-party coverage above these limits was $1,000 per occurrence, $3,000 per facility, with a $10,000 blanket aggregate and an additional state-specific aggregate where required by state law. In Colorado, the third-party coverage above these limits was $1,000 per occurrence and $3,000 per facility, which is independent of the $10,000 blanket aggregate applicable to our other 82 facilities.
The self-insured retention and deductible limits for general and professional liability and worker’s compensation are self-insured through the Captive, the related assets and liabilities of which are included in the accompanying Interim Financial Statements. The Captive is subject to certain statutory requirements as an insurance provider. These requirements include, but are not limited to, maintaining statutory capital. The Company’s policy is to accrue amounts equal to the actuarially estimated costs to settle open claims of insureds, as well as an estimate of the cost of insured claims that have been incurred but not reported. The Company develops information about the size of the ultimate claims based on historical experience, current

8

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


industry information and actuarial analysis, and evaluates the estimates for claim loss exposure on a quarterly basis. Accrued general liability and professional malpractice liabilities recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets were $27,887 and $26,037 as of June 30, 2011 and December 31, 2010, respectively.
The Company’s operating subsidiaries are self-insured for workers’ compensation liability in California. To protect itself against loss exposure in California with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $500 for each claim. In Texas, the operating subsidiaries have elected non-subscriber status for workers’ compensation claims and, effective February 1, 2011, the Company has purchased individual stop-loss coverage that insures individual claims that exceed $750 for each claim. The Company’s operating subsidiaries in other states have third party guaranteed cost coverage. In California and Texas, the Company accrues amounts equal to the estimated costs to settle open claims, as well as an estimate of the cost of claims that have been incurred but not reported. The Company uses actuarial valuations to estimate the liability based on historical experience and industry information. Accrued workers’ compensation liabilities are recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets and were $9,156 and $9,203 as of June 30, 2011 and December 31, 2010, respectively.
The Company provides self-insured medical (including prescription drugs) and dental healthcare benefits to the majority of its employees. The Company is fully liable for all financial and legal aspects of these benefit plans. To protect itself against loss exposure with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $250 for each covered person with an aggregate individual stop loss deductible of $75. These limits reset every plan year subject to a lifetime maximum of $5,000 per each covered person on the Preferred Provider Organization (PPO) and Exclusive Provider Organization (EPO) plans and an unlimited lifetime plan maximum on the Health Maintenance Organization (HMO) plan. The aforementioned coverage only applies to claims paid during the plan year. The Company’s accrued liability under these plans recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets was $2,182 and $2,160 at June 30, 2011 and December 31, 2010, respectively.
In addition, in accordance with guidance provided by the Financial Accounting Standards Board (FASB) in August 2010, the Company has recorded an asset and equal liability of $3,731 at June 30, 2011, in order to present the ultimate costs of malpractice claims and the anticipated insurance recoveries on a gross basis. Prior to fiscal year 2011, these liabilities were recorded net of anticipated insurance recoveries. See additional discussion in "Adoption of New Accounting Pronouncements" below.
The Company believes that adequate provision has been made in the Interim Financial Statements for liabilities that may arise out of patient care, workers’ compensation, healthcare benefits and related services provided to date. The amount of the Company’s reserves was determined based on an estimation process that uses information obtained from both company-specific and industry data. This estimation process requires the Company to continuously monitor and evaluate the life cycle of the claims. Using data obtained from this monitoring and the Company’s assumptions about emerging trends, the Company, with the assistance of an independent actuary, develops information about the size of ultimate claims based on the Company’s historical experience and other available industry information. The most significant assumptions used in the estimation process include determining the trend in costs, the expected cost of claims incurred but not reported and the expected costs to settle or pay damage awards with respect to unpaid claims. The self-insured liabilities are based upon estimates, and while management believes that the estimates of loss are reasonable, the ultimate liability may be in excess of or less than the recorded amounts. Due to the inherent volatility of actuarially determined loss estimates, it is reasonably possible that the Company could experience changes in estimated losses that could be material to net income. If the Company’s actual liability exceeds its estimates of loss, its future earnings and financial condition would be adversely affected.

Income Taxes — Deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities at tax rates in effect when such temporary differences are expected to reverse. The Company generally expects to fully utilize its deferred tax assets; however, when necessary, the Company records a valuation allowance to reduce its net deferred tax assets to the amount that is more likely than not to be realized.

In determining the quarterly income tax rate for financial statements, the Company must consider expected annual income, permanent differences between financial reporting and tax recognition of income or expense and other factors. When the Company takes uncertain income tax positions that do not meet the recognition criteria, it records a liability for underpayment of income taxes and related interest and penalties, if any. In considering the need for and magnitude of a liability for such positions, the Company must consider the potential outcomes from a review of the positions by the taxing authorities.
In determining the need for a valuation allowance, the annual income tax rate for interim periods, or the need for and magnitude of liabilities for uncertain tax positions, the Company makes certain estimates and assumptions. These estimates and

9

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


assumptions are based on, among other things, knowledge of operations, markets, historical trends and likely future changes and, when appropriate, the opinions of advisors with knowledge and expertise in certain fields. Due to certain risks associated with the Company’s estimates and assumptions, actual results could differ.

Stock-Based Compensation — The Company measures and recognizes compensation expense for all share-based payment awards made to employees and directors including employee stock options based on estimated fair values, ratably over the requisite service period of the award. Net income has been reduced as a result of the recognition of the fair value of all stock options and restricted stock awards issued on and subsequent to January 1, 2006, the amount of which is contingent upon the number of future grants and other variables.

New Accounting Pronouncements — In December, 2010, the Financial Accounting Standards Board (FASB) amended its view on performing step two of a goodwill impairment analysis. The amendment does not prescribe a specific method of calculating the carrying value of a reporting unit in the performance of step one of the goodwill impairment test and requires entities with a zero or negative carrying value to assess, considering qualitative factors such as those listed in Accounting Standards Codification (ASC) 350-20-35-30 Intangibles - Goodwill and Other, whether it is more likely than not that a goodwill impairment exists. If an entity concludes that it is more likely than not that a goodwill impairment exists, the entity must perform step two of the goodwill impairment test. For public entities, these amendments are effective for impairment tests performed during entities' fiscal years that begin after December 15, 2010. The Company will adopt this amendment during its goodwill impairment analysis in the fourth quarter of the current year. The Company does not believe the adoption of this amendment will have a material effect on its financial statements.

In July, the FASB amended its view on how health care entities present revenue and bad debt expense. Under the new guidance, health care entities are required to present bad debt expense related to patient service revenue as a reduction of patient service revenue (net of contractual allowances and discounts) on the statement of income for entities that do not assess a patient's ability to pay prior to rendering services. Further, it was determined, net presentation of bad debt expense in revenue would only apply to bad debts that are related to patient service revenue, to entities that provide services prior to assessing a patient's ability to pay, or to entities that recognize revenue prior to deciding that collection is reasonably assured. In addition, the final consensus requires health care entities to disclose information about the activity in the allowance for doubtful accounts, such as recoveries and write-offs, by using a mixture of qualitative and quantitative data. It will also require disclosure of the Company's policies for (i) assessing the timing and amount of uncollectible revenue recognized as bad debt expense; and (ii) assessing collectability in the timing and amount of revenue (net of contractual allowances and discounts). The final consensus will be applied retrospectively effective for interim and annual periods beginning after December 15, 2011. The Company is evaluating the impact of the final consensus, but believes, if this standard is applicable, the final result will be an equivalent reduction in patient service revenue and cost of services (exclusive of facility rent and depreciation and amortization) with no net impact on the statement of income.
Adoption of New Accounting Pronouncements — In August 2010, the FASB clarified that health care entities should not net insurance recoveries against related claim liability. Further, such entities should determine the claim liability without considering insurance recoveries. Further, it was determined a cumulative-effect adjustment should be recognized in opening retained earnings in the period of adoption if a difference exists between any liabilities and insurance receivables recorded as a result of applying these amendments. These amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2010. The Company adopted this guidance during the quarter ended March 31, 2011. See further discussion in Note 2 to the Condensed Consolidated Financial Statements under "Self-Insurance."

In November 2010, the FASB provided clarification regarding pro forma revenue and earnings disclosure requirements for business combinations. These amendments specify that if a public entity presents comparative financial statements, the entity should disclose only revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year has occurred as of the beginning of the comparable prior annual reporting period. The amendments also expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The amendments are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period on or after December 15, 2010. The Company adopted these amendments on January 1, 2011. See further discussion in Note 7 to the Condensed Consolidated Financial Statements.



10

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


3. COMPUTATION OF NET INCOME PER COMMON SHARE

Basic net income per share is computed by dividing net income attributable to common shares by the weighted average number of outstanding common shares for the period. The computation of diluted net income per share is similar to the computation of basic net income per share except that the denominator is increased to include contingently returnable shares and the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued.

A reconciliation of the numerator and denominator used in the calculation of basic net income per common share follows:
 
Three Months Ended
June 30,
Six Months Ended
June 30,
 
2011
 
2010
2011
 
2010
Numerator:
 
 
 
 
 
 
Net income
$
12,976

 
$
9,619

$
25,722

 
$
18,967

Denominator:
 
 
 
 
 
 
Weighted average shares outstanding for basic net income per share
20,909

 
20,741

20,881

 
20,713

Basic net income per common share
$
0.62

 
$
0.46

$
1.23

 
$
0.92


A reconciliation of the numerator and denominator used in the calculation of diluted net income per common share follows:
 
Three Months Ended
June 30,
Six Months Ended
June 30,
 
2011
 
2010
2011
 
2010
Numerator:
 
 
 
 
 
 
Net income
$
12,976

 
$
9,619

$
25,722

 
$
18,967

Denominator:
 
 
 
 
 
 
Weighted average common shares outstanding
20,909

 
20,741

20,881

 
20,713

Plus: incremental shares from assumed conversion (1)
670

 
385

654

 
390

Adjusted weighted average common shares outstanding
21,579

 
21,126

21,535

 
21,103

Diluted net income per common share
$
0.60

 
$
0.46

$
1.19

 
$
0.90

(1)
Options outstanding which are anti-dilutive and therefore not factored into the weighted average common shares amount above was 32 for both periods during the three and six months ended June 30, 2011, and 765 and 785 for the three and six months ended June 30, 2010.


4. INSURANCE SUBSIDIARY DEPOSITS AND INVESTMENTS

On February 10, 2009, the Company purchased three separate AAA rated debt security investments for an aggregate purchase price of $12,183 with insurance subsidiary deposits and cash from the Captive. The debt securities had maturity dates in December 2010, July 2011 and December 2011 and were guaranteed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program upon maturity.

On December 1, 2010, the first of the three debt security investments matured and the funds of $4,000 were reinvested in a new debt security which matures on June 8, 2012. In addition, on July15, 2011, the second of three debt securities matured and funds of $6,000 were reinvested in a new debt security which matures on December 12, 2012. The new debt security investments are also AAA rated, and is backed by the FDIC.
At June 30, 2011, the Company had approximately $12,074 in debt security investments, which are held to maturity and carried at amortized cost. The fair value of the investments is determined based on “Level 1” inputs, which consist of unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets. The carrying value of the debt securities approximates fair value. The Company has the intent and the ability to hold these debt securities to maturity.

11

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



5. REVENUE AND ACCOUNTS RECEIVABLE

Revenue for the three and six months ended June 30, 2011 and 2010 is summarized in the following tables:
 
Three Months Ended June 30,
 
2011
 
2010
 
Revenue
 
% of
Revenue
 
Revenue
 
% of
Revenue
Medicaid
$
67,080

 
36.0
%
 
$
64,002

 
40.5
%
Medicare
68,964

 
37.0

 
50,589

 
32.1

Medicaid — skilled
4,296

 
2.3

 
4,624

 
2.9

Total Medicaid and Medicare
140,340

 
75.3

 
119,215

 
75.5

Managed care
24,175

 
13.0

 
20,222

 
12.8

Private and other payors
21,811

 
11.7

 
18,511

 
11.7

Revenue
$
186,326

 
100.0
%
 
$
157,948

 
100.0
%

 
Six Months Ended June 30,
 
2011
 
2010
 
Revenue
 
% of
Revenue
 
Revenue
 
% of
Revenue
Medicaid
$
133,306

 
36.1
%
 
$
125,656

 
40.3
%
Medicare
136,605

 
37.0

 
101,711

 
32.6

Medicaid — skilled
8,706

 
2.4

 
9,041

 
2.9

Total Medicaid and Medicare
278,617

 
75.5

 
236,408

 
75.8

Managed care
48,317

 
13.1

 
40,791

 
13.0

Private and other payors
42,335

 
11.4

 
34,923

 
11.2

Revenue
$
369,269

 
100.0
%
 
$
312,122

 
100.0
%

Accounts receivable as of June 30, 2011 and December 31, 2010 is summarized in the following table:
 
June 30,
2011
 
December 31,
2010

Medicaid
$
21,722

 
$
20,712

Managed care
22,825

 
22,764

Medicare
29,543

 
22,826

Private and other payors
14,674

 
12,928

 
88,764

 
79,230

Less allowance for doubtful accounts
(11,068
)
 
(9,793
)
Accounts receivable
$
77,696

 
$
69,437




12

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


6. ACQUISITIONS
The Company’s acquisition policy is generally to purchase or lease facilities to complement the Company’s existing portfolio of long-term care facilities. The results of all the Company’s operations are included in the accompanying Interim Financial Statements subsequent to the date of acquisition. Acquisitions are typically paid for in cash and are accounted for using the acquisition method of accounting. Where the Company enters into facility lease agreements, the Company typically does not pay any material amount to the prior facility operator nor does the Company acquire any assets or assume any liabilities, other than rights and obligations under the lease and operations transfer agreement, as part of the transaction. Some leases include options to purchase the facilities. As a result, from time to time, the Company will acquire facilities that the Company has been operating under third-party leases.
During the six months ended June 30, 2011, the Company acquired two skilled nursing facilities which also offer assisted living and independent living services, one independent living facility, two assisted living facilities and one home health and hospice operation. The aggregate purchase price of the six business acquisitions was approximately $45,029, which was paid in cash. The facilities acquired during the six months ended June 30, 2011 are as follows:
On January 1, 2011, the Company purchased one skilled nursing facility which also offers assisted living and independent living services and one independent living facility in Texas for approximately $14,580 which was paid in cash. This acquisition added 123 operational skilled nursing beds, 77 assisted living units, 72 independent living units and 20 independent living cottages to the Company's operations. The Company also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.
On February 1, 2011, the Company purchased one skilled nursing facility in Utah, which also offers assisted living and independent living services for approximately $16,569 which was paid in cash. This acquisition added 233 operational skilled nursing beds, 48 assisted living units and 68 independent living apartments to the Company's operations. The Company also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.
On March 18, 2011, the Company purchased one assisted living facility in California for approximately $5,925, which was paid in cash. This acquisition added 125 assisted living units to the Company's operations. The Company also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.
On May 15, 2011, the Company purchased a home health and hospice operation in Utah for approximately $2,001, which was paid in cash. The acquisition did not have an impact on the Company's operational bed count. The Company also entered into a separate operations transfer agreement with the prior owner as part of this transaction. Approximately $1,412 and $569 was recognized as goodwill and other indefinite lived intangibles, respectively, as a part of this transaction.
On June 1, 2011, the Company purchased an assisted living facility in Nevada for approximately $5,954, which was paid in cash. The acquisition added 100 assisted living and 52 independent living units to the Company's operations. The Company also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.
In addition, the Company purchased the underlying assets of one of its skilled nursing facilities in Ventura, California as part of the March 18 transaction. The facility was purchased for approximately $7,339, which was paid in cash. This acquisition did not impact the Company's operational skilled nursing bed count.
The Company expensed $204 in acquisition related costs during the six months ended June 30, 2011.

13

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


The table below presents the allocation of the purchase price for the facilities acquired in business combinations during the six months ended June 30, 2011 and 2010:
 
June 30,
 
2011
 
2010
Land
$
5,814

 
$
2,709

Building and improvements
35,270

 
11,029

Equipment, furniture, and fixtures
1,127

 
1,003

Goodwill
1,412

 
3,092

Other indefinite lived intangible assets
569

 
672

Other intangible assets
837

 
304

 
$
45,029

 
$
18,809

Subsequent to the quarter ended June 30, 2011, the Company has acquired 11 skilled nursing facilities, one independent living facility which also offers assisted living services and one home health operation, increasing the Company's collective capacity to approximately 11,400 operational skilled nursing, assisted living and independent living beds. The Company entered into a separate operations transfer agreement with the prior tenant as part of each transaction. As of the date of this filing, the preliminary allocation of the purchase price was not completed as necessary valuation information has not yet been finalized.
On July 18, 2011, the Company acquired nine skilled nursing facilities, of which four also offer assisted living services, and a home health operation in Nebraska and Iowa for approximately $27,700, which was paid in cash. This acquisition added 549 operational skilled nursing beds and 72 operational assisted living units.
On August 1, 2011, the Company acquired an independent living facility which also offers assisted living services in Texas for approximately $5,800, which was paid in cash. This acquisition added 128 independent living and 39 assisted living units to the Company's operations.
In addition, on August 1, 2011, the Company acquired a skilled nursing facility in Texas for approximately $5,200, which was paid in cash. This acquisition added 134 operational skilled nursing beds to the Company's operations.
Lastly, on August 1, 2011, the Company acquired a skilled nursing facility in Utah for approximately $2,600, which was paid in cash. This acquisition added 48 operational skilled nursing beds to the Company's operations.



14

Table of Contents

7. ACQUISITIONS - UNAUDITED PRO FORMA FINANCIAL INFORMATION

The Company has established an acquisition strategy that is focused on identifying acquisitions within its target markets that offer the greatest opportunity for investment return at attractive prices. The facilities acquired by the Company are frequently underperforming financially and can have regulatory and clinical challenges to overcome. Financial information, especially with underperforming facilities, is often inadequate, inaccurate or unavailable. As a result, the Company has developed an acquisition assessment program that is based on existing and potential resident mix, the local available market, referral sources and operating expectations based on the Company's experience with its existing facilities. Following an acquisition, the Company implements a well-developed integration program to provide a plan for transition and generation of profits from facilities that have a history of significant operating losses. Consequently, the Company believes that prior operating results are not meaningful as the information is not representative of the Company's current operating results or indicative of the integration potential of its newly acquired facilities.

The following table represents pro forma results of consolidated operations as if the 2011 acquisitions through August 1, 2011 had occurred at the beginning of the six months ended June 30, 2011 and 2010, after giving effect to certain adjustments.
 
Six Months Ended
 
June 30,
 
2011
 
2010
Revenue
$
392,583

 
$
350,274

Net income
25,873

 
19,444

Diluted net income per common share
$
1.20

 
$
0.92

Our pro forma assumptions are as follows:

Revenues and operating costs were based on actual results from the prior operator or from regulatory filings where available. If actual results were not available, revenues and operating costs were estimated based on available partial operating results of the prior operator of the facility, or if no information was available, estimates were derived from the Company’s operating results for that particular facility. Prior year results for the 2011 acquisitions were obtained from available financial statements provided by prior operators or available cost reports filed by the prior operators.
 
Interest expense is based upon the purchase price and average cost of debt borrowed during each respective year when applicable and depreciation is calculated using the actual allocated purchase price applicable.

The foregoing pro forma information is not indicative of what the results of operations would have been if the acquisitions had actually occurred at the beginning of the periods presented, and is not intended as a projection of future results or trends. Included in the amounts in the table above are revenue and earnings recorded since the date of acquisition, for the six months ended June 30, 2011, generated by individually immaterial business acquisitions completed during the current period of $13,710 and $1,999 , respectively.


8. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
 
June 30,
2011
 
December 31,
2010

Land
$
54,518

 
$
46,900

Buildings and improvements
228,791

 
179,189

Equipment
57,113

 
47,983

Furniture and fixtures
8,677

 
8,271

Leasehold improvements
26,346

 
24,147

Construction in progress
7,729

 
7,587

 
383,174

 
314,077

Less accumulated depreciation
(61,429
)
 
(51,550
)
Property and equipment, net
$
321,745

 
$
262,527


15

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)




9. INTANGIBLE ASSETS — Net
 
 
Weighted
 
June 30, 2011
 
December 31, 2010
 
 
Average
Life
 
Gross
Carrying
 
Accumulated
 
 
 
Gross
Carrying
 
Accumulated
 
 
Intangible Assets
 
(Years)
 
Amount
 
Amortization
 
Net
 
Amount
 
Amortization
 
Net
Lease acquisition costs
 
15.5

 
$
910

 
$
(622
)
 
$
288

 
$
910

 
$
(592
)
 
$
318

Favorable lease
 
20.0

 
3,573

 
(586
)
 
2,987

 
3,573

 
(482
)
 
3,091

Patient base
 
0.6

 
1,615

 
(1,287
)
 
328

 
778

 
(728
)
 
50

Trade name
 
30.0

 
733

 
(134
)
 
599

 
733

 
(122
)
 
611

Total
 
 
 
$
6,831

 
$
(2,629
)
 
$
4,202

 
$
5,994

 
$
(1,924
)
 
$
4,070

Amortization expense was $411 and $705 for the three and six months ended June 30, 2011 and $186 and $514 for the three and six months ended June 30, 2010, respectively. Of the $705 in amortization expense incurred during the six months ended June 30, 2011, approximately $559 related to the amortization of patient base intangible assets at recently acquired facilities, which is typically amortized over a period of four to twelve months, depending on the classification of the patients and the level of occupancy in a new acquisition on the acquisition date.
Estimated amortization expense for each of the years ending December 31 is as follows:
Year
Amount
2011 (remainder)
$
449

2012
314

2013
291

2014
290

2015
269

2016
248

Thereafter
2,341

 
$
4,202



10. RESTRICTED AND OTHER ASSETS
Restricted and other assets consist primarily of capital reserves and deposits. Capital reserves are maintained as part of the mortgage agreements of the Company and certain of its landlords with the U.S. Department of Housing and Urban Development. These capital reserves are restricted for capital improvements and repairs to the related facilities.
Restricted and other assets consist of the following:
 
June 30,
2011
 
December 31,
2010

Deposits with landlords
$
750

 
$
736

Capital improvement reserves with landlords and lenders
3,954

 
3,477

Debt issuance costs, net
2,069

 
2,296

Other assets
3,731

 

Restricted and other assets
$
10,504

 
$
6,509

Included in other assets, as of June 30, 2011, are anticipated insurance recoveries related to the Company's general and professional liability claims that are recorded on a gross rather than net basis in accordance with an Accounting Standards Update issued by the FASB. Prior to fiscal year 2011, insurance claims liabilities were recorded net of anticipated recoveries.


16

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)




11. OTHER ACCRUED LIABILITIES

Other accrued liabilities consist of the following:
 
June 30,
2011
 
December 31,
2010

Quality assurance fee
$
1,407

 
$
1,706

Resident refunds payable
2,668

 
3,122

Deferred resident revenue
1,263

 
1,313

Cash held in trust for residents
1,553

 
1,523

Resident deposits
1,350

 
68

Dividends payable
1,161

 
1,152

Property taxes
1,491

 
1,325

Other
2,249

 
3,348

Other accrued liabilities
$
13,142

 
$
13,557

Quality assurance fee represents amounts payable to California, Utah and Idaho in respect of a mandated fee based on resident days. Resident refunds payable includes amounts due to residents for overpayments and duplicate payments. Deferred resident revenue occurs when the Company receives payments in advance of services provided. Cash held in trust for residents reflects monies received from, or on behalf of, residents. Maintaining a trust account for residents is a regulatory requirement and, while the trust assets offset the liability, the Company assumes a fiduciary responsibility for these funds. The cash balance related to this liability is included in other current assets in the accompanying condensed consolidated balance sheets.


12. INCOME TAXES

The provision for income taxes for the three and six months ended June 30, 2011 and 2010 is summarized as follows:

 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2011
 
2010
 
2011
 
2010
Current:
 
 
 
 
 
 
 
Federal
$
9,013

 
$
7,459

 
$
15,636

 
$
13,230

State
1,612

 
1,196

 
2,990

 
2,266

 
10,625

 
8,655

 
18,626

 
15,496

Deferred:
 
 
 
 
 
 
 
Federal
(1,931
)
 
(2,238
)
 
(1,613
)
 
(2,805
)
State
(216
)
 
(187
)
 
(241
)
 
(335
)
 
(2,147
)
 
(2,425
)
 
(1,854
)
 
(3,140
)
Total
$
8,478

 
$
6,230

 
$
16,772

 
$
12,356



17

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


The Company’s deferred tax assets and liabilities as of June 30, 2011 and December 31, 2010 are summarized as follows:
 
June 30,
2011
 
December 31,
2010

Deferred tax assets (liabilities):
 
 
 
Accrued expenses
$
17,967

 
$
15,968

Allowance for doubtful accounts
4,613

 
4,082

State taxes

 
533

Tax credits
1,002

 
1,063

Total deferred tax assets
23,582

 
21,646

State taxes
(165
)
 

Depreciation and amortization
(4,909
)
 
(4,973
)
Prepaid expenses
(1,692
)
 
(1,711
)
Total deferred tax liabilities
(6,766
)
 
(6,684
)
Net deferred tax assets
$
16,816

 
$
14,962

The Company is not currently under examination by any major income tax jurisdiction. In 2011, the statute of limitations will lapse on the Company's 2006 and 2007 income tax years for state and Federal purposes, respectively; however, the Company does not believe this lapse will significantly impact unrecognized tax benefits for any uncertain tax positions. The Company is not aware of any other event that might significantly impact the balance of unrecognized tax benefits in the next twelve months. The net balance of unrecognized tax benefits was not material to the Interim Financial Statements for the three and six months ended June 30, 2011 or 2010.


13. DEBT

Senior Credit Facility with Five-Bank Lending Consortium Arranged by SunTrust and Wells Fargo

On July 15, 2011, the Company entered into a Senior Credit Facility with SunTrust Bank (the Facility) in an aggregate principal amount of up to $150,000 comprised of a $75,000 revolving credit facility and a $75,000 term loan advanced in one drawing on the July 15, 2011. Borrowings under the term loan portion of the Facility will amortize in equal quarterly installments commencing on September 30, 2011, in an aggregate annual amount equal to 5.0% per annum of the original principal amount, with the remaining principal balance to be due and payable in full on July 15, 2016. Borrowings under the revolving credit facility portion of the Facility shall be due and payable in full on July 15, 2016. Interest rates per annum applicable to the Facility will be, at the option of the Company, (i) LIBOR plus an initial margin of 2.5% or (ii) the Base Rate (as defined by the plan) plus an initial margin of 1.5%. Under the terms of the Facility, the applicable margin adjusts based on the Company’s leverage ratio as set forth in further detail in the agreement. In connection with the Facility, we incurred financing costs of approximately $2,500. Further, we incurred a one-time charge of approximately $2,500 in termination and early extinguishment fees in connection with exiting the Six Project Loan (described below) which will be recognized in the third quarter of 2011. In addition, the Company has a commitment fee on the unused portion of the revolving credit facility that ranges from 0.3% to 0.5% based on the Company’s leverage ratio for the applicable four-quarter period. Amounts borrowed pursuant to the Facility are guaranteed by certain of the Company’s wholly-owned subsidiaries and secured by substantially all of the Company’s personal property.

Among other things, under the Facility, the Company must maintain compliance with specified financial covenants measured on a quarterly basis, including a maximum net leverage ratio, minimum interest coverage ratio and minimum asset coverage ratio. The loan documents also include certain additional reporting, affirmative and negative covenants including limitations on the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures.

Proceeds of the term loan portion of the Facility and any initial borrowings under the revolver portion of the Facility shall be used to refinance the Six Project Note with General Electric Capital Corporation (GECC) and the Revolver (both defined below), fund facility acquisitions and other general working capital requirements.

In connection with the Facility, in July 2011, the Company entered into an interest rate swap agreement in accordance with Company policy to reduce risk from volatility in the income statement due to changes in the LIBOR interest rate. The

18

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


swap agreement, with a notional amount of $75,000, amortizing concurrently with the related term loan portion of the Facility, was five years in length and set to mature on July 15, 2016. The interest rate swap qualifies as a cash flow hedge and will be recorded in other comprehensive income in accordance with hedge accounting. Under the terms of this agreement, the net effect of the hedges was to record swap interest expense of 1.8%, which would result in a fixed rate of approximately 4.3%, using the initial margin of 2.5%, exclusive of fees.

Promissory Notes with RBS Asset Finance, Inc.

On December 31, 2010, four of the Company's real estate holding subsidiaries executed a promissory note with RBS Asset Finance, Inc. (RBS) as Lender for an aggregate of $35,000 (RBS Loan). The RBS Loan was secured by Commercial Deeds of Trust, Security Agreements, Assignment of Leases and Rents and Fixture Fillings on the four properties and other related instruments and agreements, including without limitation a promissory note and a Company guaranty. The RBS Loan bears interest at a fixed rate of 6.04%. Amounts borrowed under the RBS Loan may be prepaid starting after the second anniversary of the note subject to prepayment fees of 5.0% of the principal balance on the date of prepayment. These prepayment fees are reduced by 1.0% a year for years three through seven of the loan. The term of the RBS Loan is for seven years, with monthly principal and interest payments commencing on February 1, 2011 and the balance due on January 1, 2018.

Among other things, under the RBS Loan, the Company must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum debt service coverage ratio, an average occupancy rate and a minimum project yield. The loan documents also include certain additional affirmative and negative covenants, including limitations on the disposition of the Borrowers and the collateral.
Term Loan with General Electric Capital Corporation

On November 6, 2009, the Company finalized the Fourth Amended and Restated Loan Agreement (Amended Term Loan) with GECC which increased the borrowing capacity of the Amended Term Loan by $40,000, further referred to as the Six Project Loan. The Six Project Loan was set to mature on September 30, 2014 and was secured by, among other things, a perfected first priority mortgage/deed of trust on the fee simple interest in six of the Company’s skilled nursing facilities (the Property). The Amended Term Loan, which includes both the Ten Project Note (as described below) and the Six Project Loan, was cross collateralized and cross defaulted with the existing Second Amended and Restated Loan and Security Agreement (the Revolver). The interest rate on the loan is calculated at the current five year swap rate on the date of closing plus 585 basis points for half of the loan balance and the three year swap rate on the date of closing plus 585 basis points and thereafter floating at 90-day LIBOR plus 575 basis points, reset monthly and subject to a LIBOR floor of 2.0% for the remaining half of the loan balance. The Amended Term Loan did not modify any of the existing terms of the Ten Project Note. On July 15, 2011, the Six Project Loan was paid in full with funds received from the $75,000 term loan portion of the Facility described above.
Promissory Notes with Johnson Land Enterprises, Inc.

On October 1, 2009, four subsidiaries of The Ensign Group, Inc. entered into four separate promissory notes with Johnson Land Enterprises, LLC, for an aggregate of $10,000, as a part of the Company’s acquisition of three skilled nursing facilities in Utah. The unpaid balance of principal and accrued interest from these notes is due on September 30, 2019. The notes bear interest at a rate of 6.0% per annum. As a part of this transaction, the Company recorded a discount to the debt balance in the form of imputed interest of $1,218. This amount will be amortized over the term of the promissory notes, or ten years.
Bonds Payable to Lynn Family Partnership

In addition, on October 1, 2009, a subsidiary of The Ensign Group, Inc. in West Jordan, Utah assumed the obligation to pay the remaining principal and interest on bonds which were originally sold to finance the construction of the facility. These bonds were assumed as a part of the Company’s acquisition of three skilled nursing facilities in Utah. The unpaid balance of principal and accrued interest from these bonds were due on July 1, 2015. The bonds bore interest at an annual rate equal to sixty percent of the rate announced from time to time by Bank of America as its prime rate, which was 2.1% on June 30, 2011. The Company paid this bond in full as of June 30, 2011.

19

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Revolving Credit Facility with General Electric Capital Corporation

Prior to the closing of the Facility on July 15, 2011, the Company had the Revolver with GECC under which the Company may borrow up to the lesser of $50,000 or 85% of the eligible accounts receivable. The Revolver was set to expire on February 21, 2013. As of June 30, 2011 and December 31, 2010, there were no outstanding borrowings under the Revolver. As of June 30, 2011, the amount of borrowing capacity pledged to secure outstanding letters of credit and reserves against collateral for actual and contingent liabilities was $2,133 and $6,000, respectively. In addition, in the event of the Company’s default under the Amended Term Loan, GECC had the right to take control of the Company’s facilities encumbered by the loan to the extent necessary to make such payments and perform such acts that are required under the loan. On July 15, 2011, the Revolver was replaced by the $75,000 revolving credit facility portion of the Facility described above.

Long-term debt consists of the following:
 
June 30,
2011
 
December 31,
2010

Ten Project Note with GECC, multiple-advance term loan, principal and interest payable monthly; interest is fixed at time of draw at 10-year treasury note rate plus 2.25% (rates in effect at June 30, 2011 range from 6.95% to 7.50%), balance due June 2016, collateralized by deeds of trust on real property, assignments of rents, security agreements and fixture financing statements.
$
51,711

 
$
52,229

Six Project Loan with GECC, principal and interest payable monthly, interest defined above, balance due September 30, 2014, collateralized by deeds of trust on real property, assignments of rents, security agreements and fixture financing statements, repaid on July 15, 2011.
39,238

 
39,495

Promissory note with RBS, principal and interest payable monthly and continuing through January 2018, interest at a fixed rate of 6.04%, collateralized by real property, assignment of rents and Company guaranty.
34,619

 
35,000

Promissory notes, principal, and interest of $69 payable monthly and continuing through September 2019, interest at fixed rate of 6.0%, collateralized by deed of trust on real property, assignment of rents and security agreement.
9,600

 
9,724

Bond, principal and interest of $20 payable monthly and continuing through July 2015, interest at a fixed rate of 60% of the Prime Rate (as defined by the agreement), repaid on June 21 2011.

 
1,038

Mortgage note, principal, and interest of $54 payable monthly and continuing through February 2027, interest at fixed rate of 7.5%, collateralized by deed of trust on real property, assignment of rents and security agreement.
5,987

 
6,086

 
141,155

 
143,572

Less current maturities
(3,026
)
 
(3,055
)
Less debt discount
(1,005
)
 
(1,066
)
 
$
137,124

 
$
139,451

The Company is subject to standard reporting requirements and other typical covenants for loans of these types. As of June 30, 2011, the Company was in compliance with such loan covenants.
The carrying value of the Company’s long-term debt is considered to approximate the fair value of such debt for all periods presented based upon the interest rates that the Company believes it can currently obtain for similar debt.



20

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


14. OPTIONS AND AWARDS
Stock-based compensation expense consists of share-based payment awards made to employees and directors, including employee stock options and restricted stock awards, based on estimated fair values. Stock-based compensation expense recognized in the Company’s condensed consolidated statements of income for the three and six months ended June 30, 2011 and 2010 does not include compensation expense for share-based payment awards granted prior to, but not yet vested as of, January 1, 2006, but does include compensation expense for the share-based payment awards granted on or subsequent to January 1, 2006 based on the grant date fair value. As stock-based compensation expense recognized in the Company’s condensed consolidated statements of income for the three and six months ended June 30, 2011 and 2010 was based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. The Company estimates forfeitures at the time of grant and, if necessary, revises the estimate in subsequent periods if actual forfeitures differ.
The Company has three option plans, the 2001 Stock Option, Deferred Stock and Restricted Stock Plan (2001 Plan), the 2005 Stock Incentive Plan (2005 Plan) and the 2007 Omnibus Incentive Plan (2007 Plan), all of which have been approved by the stockholders. In the 2001 Plan and the 2005 Plan, options may be exercised for unvested shares of common stock, which have full stockholder rights including voting, dividend and liquidation rights. The Company retains the right to repurchase any or all unvested shares at the exercise price paid per share of any or all unvested shares should the optionee cease to remain in service while holding such unvested shares. The total number of shares available under all of the Company’s stock incentive plans was 1,588 as of June 30, 2011.

The Company uses the Black-Scholes option-pricing model to recognize the value of stock-based compensation expense for all share-based payment awards. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. The Company develops estimates based on historical data and market information, which can change significantly over time. The Company granted 32 options and 82 restricted stock awards during the six months ended June 30, 2011.

The Company used the following assumptions for stock options granted during the six months ended June 30, 2011 and 2010:
 
 
 
 
 
 
Weighted
 
 
 
 
Weighted
 
 
Weighted
 
 
 
 
 
Options
 
Average Risk-
 
 
 
 
Average
 
 
Average
 
Grant Year
 
Plan
 
Granted
 
Free Rate
 
 
Expected Life
 
Volatility
 
 
Dividend Yield
 
2011
 
2007
 
32

 
2.13 - 2.53
%
 
6.5 years
 
55

%
 
0.93

%
2010
 
2007
 
113

 
2.36 - 2.82
%
 
6.5 years
 
55

%
 
1.08

%

The Company used the following assumptions for stock options granted during the three months ended June 30, 2011 and 2010:
 
 
 
 
 
 
Weighted
 
 
 
 
Weighted
 
 
Weighted
 
 
 
 
 
Options
 
Average Risk-
 
 
 
 
Average
 
 
Average
 
Grant Year
 
Plan
 
Granted
 
Free Rate
 
 
Expected Life
 
Volatility
 
 
Dividend Yield
 
2011
 
2007
 
23

 
2.13

%
 
6.5 years
 
55

%
 
0.93

%
2010
 
2007
 
7

 
2.36

%
 
6.5 years
 
55

%
 
1.08

%
For the six months ended June 30, 2011 and 2010, the following represents the weighted average exercise price and fair value displayed at grant date for stock option grants:
 
 
 
 
Weighted Average
 
Weighted Average
Grant Year
 
Granted
 
Exercise Price
 
Fair Value of Options
2011
 
32

 
$
27.91

 
$
14.11

2010
 
113

 
$
17.51

 
$
8.87



21

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


The weighted average exercise price equaled the weighted average fair value of common stock on the grant date for all options granted during the periods ended June 30, 2011 and 2010 and therefore, the intrinsic value was $0 at date of grant.

The following table represents the employee stock option activity during the six months ended June 30, 2011:
 
Number of
Options
Outstanding
 
Weighted
Average
Exercise Price
 
Number of
Options Vested
 
Weighted
Average
Exercise Price
of Options
Vested
January 1, 2011
1,904

 
$
11.55

 
921

 
$
9.07

Granted
32

 
27.91

 
 
 
 
Forfeited
(18
)
 
13.05

 
 
 
 
Exercised
(80
)
 
8.43

 
 
 
 
June 30, 2011
1,838

 
$
11.96

 
989

 
$
9.86


The following summary information reflects stock options outstanding, vested and related details as of June 30, 2011:
 
 
 
 
 
 
 
 
 
 
Stock Options
 
 
Stock Options Outstanding
 
Vested
 
 
 
 
Number
 
Black-Scholes
 
Remaining
Contractual Life
 
Vested and
Year of Grant
 
Exercise Price
 
Outstanding
 
Fair Value
 
(Years)
 
Exercisable
2003
 
0.67 – 0.81
 
4

 
*

 
2

 
4

2004
 
1.96 – 2.46
 
29

 
*

 
3

 
29

2005
 
4.99 – 5.75
 
142

 
*

 
4

 
142

2006
 
7.05 – 7.50
 
417

 
3,997

 
5

 
328

2008
 
9.38 – 14.87
 
629

 
3,391

 
7

 
329

2009
 
14.92 – 16.70
 
455

 
3,599

 
8

 
136

2010
 
17.47 – 18.16
 
131

 
1,165

 
9

 
21

2011
 
24.36 - 29.30
 
31

 
439

 
10

 

Total
 
 
 
1,838

 
$
12,591

 
 
 
989

* The Company will not recognize the Black-Scholes fair value for awards granted prior to January 1, 2006 unless such awards are modified.
In addition to the above, during the three and six month periods ended June 30, 2011 and 2010, the Company granted 82 and 0 restricted stock awards, respectively. All awards were granted at an exercise price of $0 and vest over five years.

A summary of the status of the Company's nonvested restricted stock awards as of June 30, 2011, and changes during the six month period ended June 30, 2011 is presented below:
 
Nonvested Restricted Awards
 
Weighted Average Grant Date Fair Value
Nonvested at January 1, 2011
102

 
$
18.05

Granted
82

 
26.47

Vested
(7
)
 
18.03

Forfeited
(3
)
 
19.83

Nonvested at June 30, 2011
174

 
$
21.98



22

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Total share-based compensation expense recognized for the three and six months ended June 30, 2011 and 2010 was as follows:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2011
 
2010
 
2011
 
2010
Share-based compensation expense related to stock options
$
574

 
$
607

 
$
1,218

 
$
1,256

Share-based compensation expense related to restricted stock awards
272

 
10

 
459

 
10

Total
$
846

 
$
617

 
$
1,677

 
$
1,266

In future periods, the Company expects to recognize approximately $5,228 and $3,574 in stock-based compensation expense for unvested options and unvested restricted stock awards, respectively, that were outstanding as of June 30, 2011. Future stock based compensation expense will be recognized over 2.9 and 4.5 weighted average years for unvested options and restricted stock awards, respectively. There were 849 unvested and outstanding options at June 30, 2011, of which 803 are expected to vest. The weighted average contractual life for options vested at June 30, 2011 was 6.6 years.

The aggregate intrinsic value of options outstanding, vested, expected to vest and exercised as of June 30, 2011 and December 31, 2010 is as follows:
Options
 
June 30,
2011
 
December 31,
2010
Outstanding
 
$
33,892

 
$
25,366

Vested
 
20,309

 
14,545

Expected to vest
 
12,122

 
9,630

Exercised
 
1,752

 
1,955

The intrinsic value is calculated as the difference between the market value of the underlying common stock and the exercise price of the options.

15. COMMITMENTS AND CONTINGENCIES
Leases — The Company leases certain facilities and its administrative offices under non-cancelable operating leases, most of which have initial lease terms ranging from five to 20 years. The Company also leases certain of its equipment under non-cancelable operating leases with initial terms ranging from three to five years. Most of these leases contain renewal options, certain of which involve rent increases. Total rent expense, inclusive of straight-line rent adjustments, was $3,548 and $7,279 for the three and six months ended June 30, 2011 and $3,715 and $7,385 for the three and six months ended June 30, 2010, respectively.
Six of the Company’s facilities are operated under two separate three-facility master lease arrangements. Under these master leases, a breach at a single facility could subject one or more of the other facilities covered by the same master lease to the same default risk. Failure to comply with Medicare and Medicaid provider requirements is a default under several of the Company’s leases, master lease agreements and debt financing instruments. In addition, other potential defaults related to an individual facility may cause a default of an entire master lease portfolio and could trigger cross-default provisions in the Company’s outstanding debt arrangements and other leases. With an indivisible lease, it is difficult to restructure the composition of the portfolio or economic terms of the lease without the consent of the landlord.
In addition, a number of the Company’s individual facility leases are held by the same or related landlords, and some of these leases include cross-default provisions that could cause a default at one facility to trigger a technical default with respect to others, potentially subjecting certain leases and facilities to the various remedies available to the landlords under separate but cross-defaulted leases. The Company is not aware of any defaults as of June 30, 2011.
Regulatory Matters — Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. Compliance with such laws and regulations can be subject to future governmental review and interpretation, as well as significant regulatory action including fines, penalties, and exclusion from certain governmental programs. The Company believes that it is in compliance in all material respects with all applicable laws and regulations.
A significant portion of the Company’s revenue is derived from Medicaid and Medicare, for which reimbursement rates

23

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


are subject to regulatory changes and government funding restrictions. Any significant future change to reimbursement rates could have a material effect on the Company’s operations.
Cost-Containment Measures — Both government and private pay sources have instituted cost-containment measures designed to limit payments made to providers of healthcare services, and there can be no assurance that future measures designed to limit payments made to providers will not adversely affect the Company.
Indemnities — From time to time, the Company enters into certain types of contracts that contingently require the Company to indemnify parties against third-party claims. These contracts primarily include (i) certain real estate leases, under which the Company may be required to indemnify property owners or prior facility operators for post-transfer environmental or other liabilities and other claims arising from the Company’s use of the applicable premises, (ii) operations transfer agreements, in which the Company agrees to indemnify past operators of facilities the Company acquires against certain liabilities arising from the transfer of the operation and/or the operation thereof after the transfer, (iii) certain lending agreements, under which the Company may be required to indemnify the lender against various claims and liabilities, (iv) agreements with certain lenders under which the Company may be required to indemnify such lenders against various claims and liabilities, and (v) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationships. The terms of such obligations vary by contract and, in most instances, a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, because no claims have been asserted, no liabilities have been recorded for these obligations on the Company’s balance sheets for any of the periods presented.
Litigation — The skilled nursing business involves a significant risk of liability given the age and health of the Company’s patients and residents and the services the Company provides. The Company and others in the industry are subject to an increasing number of claims and lawsuits, including professional liability claims, alleging that services have resulted in personal injury, elder abuse, wrongful death or other related claims. The defense of these lawsuits may result in significant legal costs, regardless of the outcome, and can result in large settlement amounts or damage awards.
In addition to the potential lawsuits and claims described above, the Company is also subject to potential lawsuits under the Federal False Claims Act and comparable state laws alleging submission of fraudulent claims for services to any healthcare program (such as Medicare) or payor. A violation may provide the basis for exclusion from federally-funded healthcare programs. Such exclusions could have a correlative negative impact on the Company’s financial performance. Some states, including California, Arizona and Texas, have enacted similar whistleblower and false claims laws and regulations. In addition, the Deficit Reduction Act of 2005 created incentives for states to enact anti-fraud legislation modeled on the Federal False Claims Act. As such, the Company could face increased scrutiny, potential liability and legal expenses and costs based on claims under state false claims acts in markets in which it does business.
In May 2009, Congress passed the Fraud Enforcement and Recovery Act (FERA) of 2009 which made significant changes to the Federal False Claims Act (FCA), expanding the types of activities subject to prosecution and whistleblower liability. Following changes by FERA, health care providers face significant penalties for the knowing retention of government overpayments, even if no false claim was involved. Health care providers can now be liable for knowingly and improperly avoiding or decreasing an obligation to pay money or property to the government. This includes the retention of any government overpayment. The government can argue, therefore, that a FCA violation can occur without any affirmative fraudulent action or statement, as long as it is knowingly improper. In addition, FERA extended protections against retaliation for whistleblowers, including protections not only for employees, but also contractors and agents. Thus, there is generally no need for an employment relationship in order to qualify for protection against retaliation for whistleblowing.
In July 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The Dodd-Frank Act establishes rigorous standards and supervision to protect the economy and American consumers, investors and businesses. Included under Section 922 of the Dodd-Frank Act, the Securities and Exchange Commission (SEC) will be required to pay a reward to individuals who provide original information to the SEC resulting in monetary sanctions exceeding $1,000 in civil or criminal proceedings. The award will range from 10 to 30 percent of the amount recouped and the amount of the award shall be at the discretion of the SEC. The purpose of this reward program is to “motivate those with inside knowledge to come forward and assist the Government to identify and prosecute persons who have violated securities laws and recover money for victims of financial fraud.”
The State of California has established minimum staffing requirements for facilities operating in the state. Failure to meet these requirements can, among other things, jeopardize a facility’s compliance with the conditions of participation as established under relevant state and federal healthcare programs; it may also subject the facility to a notice of deficiency, a

24

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


citation, civil money penalty, or the possibility of litigation.
For example, a class action suit was previously filed against us in the State of California, alleging, among other things, violations of certain Health and Safety Code provisions and a violation of the Consumer Legal Remedies Act at certain of the Company’s California facilities. In 2007, the Company settled this class action suit and the settlement was approved by the affected class and the Court. The Company has been, and continues to be, subject to similar claims and legal actions, which could possibly result in large damage awards and settlements. In the wake of the substantial judgment awarded to a group of plaintiffs in a recent case against one of the Company’s competitors, the Company expects that plaintiff’s attorneys will become increasingly more aggressive in their pursuit of claims alleging non-compliance with such minimum staffing requirements. The Company does not believe that the ultimate resolution of any known such action will have a material adverse effect on the Company’s business, financial condition or results of operations. However, if there were a significant increase in the number of these claims or an increase in amounts owing should plaintiffs be successful in their prosecution of these claims, this could materially adversely affect the Company’s business, financial condition, results of operations and cash flows.
The Company has been, and continues to be, subject to claims and legal actions that arise in the ordinary course of business, including potential claims related to care and treatment provided at its facilities as well as employment related claims. The Company does not believe that the ultimate resolution of these actions will have a material adverse effect on the Company’s business, financial condition or results of operations. A significant increase in the number of these claims or an increase in amounts owing should plaintiffs be successful in their prosecution of these claims, could materially adversely affect the Company’s business, financial condition, results of operations and cash flows.
Medicare Revenue Recoupments — The Company is subject to reviews relating to Medicare services, billings and potential overpayments. The Company had one operation subject to probe review during the six months ended June 30, 2011. The Company anticipates that these probe reviews will increase in frequency in the future. Further, the Company currently has no facilities on prepayment review; however, others may be placed on prepayment review in the future. If a facility fails prepayment review, the facility could then be subject to undergo targeted review, which is a review that targets perceived claims deficiencies. The Company has no facilities that are currently undergoing targeted review.
Other Matters — In November 2006 the Company initiated an internal investigation after becoming aware of an allegation of possible reimbursement irregularities at one or more of the Company's facilities. The Company retained outside investigatory counsel to conduct the investigation, which continued until February 2008.
In March 2007, the Company learned that the United States Attorney for the Central District of California (DOJ) was seeking financial information regarding the Company, ten of its operating subsidiaries, certain of its then-current and former officers, and an outside investor group, when the Company received from its bank a copy of an authorized investigative demand, a request for records similar to a subpoena, issued to the bank by the U.S. Attorney.
On December 17, 2007, the Company was informed by Deloitte & Touche LLP, its independent registered public accounting firm, that the U.S. Attorney had served them with a grand jury subpoena relating to the Company and several of its operating subsidiaries. All together, the March 2007 authorized investigative demand and the December 2007 subpoena covered information from a total of 18 of the Company's 87 facilities.
On December 17, 2008, representatives from the DOJ served search warrants on the Company's Service Center and six skilled nursing facilities located in Southern California. The six facilities were part of the 12-facility sample then being examined by outside investigatory counsel. Among other things, the warrants authorized the seizure of specific patient records at the six facilities. Following the execution of the warrants, a subpoena was issued covering eight additional facilities. A subsequent subpoena requesting patient records pertaining to the same patients listed in the original search warrants was received on May 4, 2009.
In February 2008, outside investigatory counsel issued their final investigation report. Information gained from each contact with the DOJ up to that date, though limited, was considered by outside investigatory counsel. Without knowing the exact nature of the allegations or concerns underlying the DOJ's inquiry, outside investigatory counsel were not able to affirm that the investigation had addressed specific DOJ concerns, but their investigation did attempt to address issues believed to be relevant to the inquiry. The report did not find any systemic or patterns or practices of fraudulent or intentional misconduct, but it included observations at certain facilities regarding areas of potential improvement in recordkeeping and billing practices, which the Company used to implement measures designed to strengthen these processes.
Medicare claims reviewed in the course of the outside investigation, for which adequate backup documentation could not be located or for which other billing deficiencies existed, were treated by the Company as overpayments and refunded to the

25

Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Medicare program in normal course. Consistent with healthcare industry accounting practices, the Company records any charge for refunded payments against revenue in the period in which the claim adjustment becomes known.
In September 2010 the Company's board of directors appointed a special committee consisting solely of independent directors to address the investigations being conducted by the DOJ and to bring the matter to conclusion. Consistent with the Company's prior and ongoing efforts, the special committee's mandate is to attempt to expedite resolution of the investigations. In furtherance of that objective, the special committee has retained independent counsel, and counsel has retained third party consultants, to facilitate its work. The special committee's work is ongoing, and the Company expects that it will continue until its mandate is fulfilled.
The Company and the special committee of the Board are cooperating with the U.S. Attorney's office, and intend to continue cooperating. Neither The Ensign Group, Inc. nor any of its operating subsidiaries or employees has been charged with any wrongdoing . The Company cannot predict or provide any assurance as to the possible outcome of the investigations or any possible related proceedings, or as to the possible outcome of any qui tam litigation that may have been filed, nor can the Company estimate the possible loss or range of loss that may result from any such proceedings and, therefore, the Company has not recorded any related accruals. To the extent the U.S. Attorney's office elects to pursue this matter, or if the investigation has been instigated by a qui tam relator who elects to pursue the matter, and the Company is subjected to or alleged to be liable for claims or obligations under federal Medicare statutes, the federal False Claims Act, or similar state and federal statutes and related regulations, the Company's business, financial condition and results of operations could be materially and adversely affected and its stock price could decline.
From time to time our systems and controls highlight potential compliance issues, which the Company investigates as they arise. As a result of the detection by management at one of the Company’s facilities, and its Service Center support personnel, of possible recordkeeping and related irregularities at that facility, the Company initiated an internal inquiry in the second quarter of 2010.

The Company concluded the investigatory phase of this inquiry and completed a billing review of potentially affected claims in the third quarter of 2010. As a result of its billing reviews, the Company identified a limited number of selected Medicare claims for which adequate backup documentation could not be located, or for which other billing deficiencies existed. Where accepted procedures and necessary data for reviewing and calculating potential overpayments were available, the Company followed such procedures and completed a billing review. Where such procedures and/or data were not available the Company developed a methodology for making a good faith estimate of potential overpayments with the assistance of independent consultants experienced in Medicare billing. During the quarter ended June 30, 2010, the Company accrued for a revenue adjustment of approximately $553, plus interest, for the estimated overpayments described above, with a resulting impact to net income of approximately $251. The Company remitted payment of the above overpayments during the quarter ended September 30, 2010.
Concentrations
Credit Risk — The Company has significant accounts receivable balances, the collectability of which is dependent on the availability of funds from certain governmental programs, primarily Medicare and Medicaid. These receivables represent the only significant concentration of credit risk for the Company. The Company does not believe there are significant credit risks associated with these governmental programs. The Company believes that an appropriate allowance has been recorded for the possibility of these receivables proving uncollectible, and continually monitors and adjusts these allowances as necessary. The Company’s receivables from Medicare and Medicaid payor programs accounted for approximately 58% and 55% of its total accounts receivable as of June 30, 2011 and December 31, 2010, respectively. Revenue from reimbursements under the Medicare and Medicaid programs accounted for approximately 75% and 76% of the Company’s revenue for the three and six months ended June 30, 2011 and 76% for both periods during the three and six months ended June 30, 2010.
Cash in Excess of FDIC Limits — The Company currently has bank deposits with financial institutions in the U.S. that exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. As of August 1, 2011, the Company had approximately $2,343 in uninsured cash deposits. All uninsured bank deposits are held at high quality credit institutions.



26

Table of Contents

Item 2.        Management's Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission (SEC), including our Annual Report on Form 10-K (Annual Report), which discusses our business and related risks in greater detail, as well as subsequent reports we may file from time to time on Forms 10-Q and 8-K, for additional information. The section entitled “Risk Factors” contained in Part II, Item 1A of this Report, and similar discussions in our other SEC filings, also describe some of the important risk factors that may affect our business, financial condition, results of operations and/or liquidity. You should carefully consider those risks, in addition to the other information in this Report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.
This Report contains forward-looking statements, which include, but are not limited to the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities and plans and objectives of management. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions, and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are listed under the section “Risk Factors” contained in Part II, Item 1A of this Report. These forward-looking statements speak only as of the date of this Report, and are based on our current expectations, estimates and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law. As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our” and “us” refer to The Ensign Group, Inc. and its consolidated subsidiaries. All of our facilities, the Service Center and the Captive are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. The use of “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that any of our facilities, the Service Center or the Captive are operated by the same entity. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes included in the Annual Report.
Overview
We are a provider of skilled nursing and rehabilitative care services through the operation of 87 facilities located in California, Arizona, Texas, Washington, Utah, Colorado, Idaho and Nevada and two home health and hospice operations located in Utah and Idaho as of June 30, 2011. All of these facilities are skilled nursing facilities, other than six stand-alone assisted living facilities in California, Arizona, Texas, Colorado and Nevada and seven campuses that offer both skilled nursing and assisted living services in California, Texas, Arizona and Utah. Our facilities provide a broad spectrum of skilled nursing and assisted living services, physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. We encourage and empower our facility leaders and staff to make their facility the “facility of choice” in the community it serves. This means that our facility leaders and staff are generally free to discern and address the unique needs and priorities of healthcare professionals, customers and other stakeholders in the local community or market, and then work to create a superior service offering and reputation for that particular community or market to encourage prospective customers and referral sources to choose or recommend the facility. As of June 30, 2011, we owned 58 of our 87 facilities and operated an additional 29 facilities under long-term lease arrangements, and had options to purchase eight of those 29 facilities. The following table summarizes our facilities and operational skilled nursing, assisted living and independent living beds by ownership status as of June 30, 2011:
 
Owned
 
Leased (with a Purchase Option)
 
Leased (without a Purchase Option)
 
Total
Number of facilities
58

 
8

 
21

 
87

Percent of total
66.7
%
 
9.2
%
 
24.1
%
 
100
%
Operational skilled nursing, assisted living and independent living beds
7,065

 
957

 
2,439

 
10,461

Percent of total
67.5
%
 
9.2
%
 
23.3
%
 
100
%

27

Table of Contents

The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenues. All of our facilities are operated by separate, wholly-owned, independent subsidiaries, which have their own management, employees and assets. In addition, one of our wholly-owned independent subsidiaries, which we call our Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other services to each operating subsidiary through contractual relationships between such subsidiaries. In addition, we have the Captive that provides some claims-made coverage to our operating subsidiaries for general and professional liability, as well as for certain workers’ compensation insurance liabilities. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that The Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the Captive are operated by the same entity.
Facility Acquisition History
 
December 31,
 
June 30,
 
2005
 
2006
 
2007
 
2008
 
2009
 
2010
 
2011
Cumulative number of facilities
46

 
57

 
61

 
63

 
77

 
82

 
87

Cumulative number of operational skilled nursing, assisted living and independent living beds
5,585

 
6,667

 
7,105

 
7,324

 
8,948

 
9,539

 
10,461


The following table sets forth the location of our facilities and the number of operational beds located at our facilities as of June 30, 2011:
 
CA
 
AZ
 
TX
 
UT
 
CO
 
WA
 
ID
 
NV
 
Total
Number of facilities
34

 
12

 
19

 
10

 
5

 
3

 
3

 
1

 
87

Operational skilled nursing, assisted living and independent living beds
3,820

 
1,830

 
2,360

 
1,316

 
463

 
274

 
246

 
152

 
10,461


On January 1, 2011, we purchased one skilled nursing facility which also offers assisted living and independent living services and one independent living facility in Texas for approximately $14.6 million which was paid in cash. This acquisition added 123 operational skilled nursing beds, 77 assisted living units, 72 independent living units and 20 independent living cottages to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.

On February 1, 2011, we purchased one skilled nursing facility in Utah, which also offers assisted living and independent living services for approximately $16.6 million which was paid in cash. This acquisition added 233 operational skilled nursing beds, 48 assisted living units and 68 independent living apartments to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.

On March 18, 2011, we purchased one assisted living facility in California for approximately $5.9 million, which was paid in cash. This acquisition added 125 assisted living units to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.

In addition, we purchased the underlying assets of one of our skilled nursing facilities in Ventura, California as part of the March 18 transaction. The facility was purchased for approximately $7.3 million, which was paid in cash. This acquisition did not impact our operational skilled nursing bed count.

On May 15, 2011, we purchased a home health and hospice operation in Utah for approximately $2.0 million, which was paid in cash. The acquisition did not have an impact on our operational bed count. We also entered into a separate operations transfer agreement with the prior owner as part of this transaction. Approximately $1.4 million and $0.6 million was recognized as goodwill and other indefinite lived intangibles, respectively, as a part of this transaction.

On June 1, 2011, we purchased an assisted living facility in Nevada for approximately $6.0 million, which was paid in cash. The acquisition added 100 assisted living and 52 independent living units to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.

28

Table of Contents

Subsequent to the quarter ended June 30, 2011, the Company has acquired 11 skilled nursing facilities and one independent living facility which also offers assisted living services, increasing the Company's collective capacity to approximately 11,400 operational skilled nursing, assisted living and independent living beds.
On July 18, 2011, we acquired nine skilled nursing facilities, of which four also offer assisted living services, and a home health and hospice operation in Nebraska and Iowa for approximately $27.7 million, which was paid in cash. This acquisition added 549 operational skilled nursing beds and 72 operational assisted living units to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of this transaction.

Lastly, on August 1, 2011, we acquired two skilled nursing facilities in Texas and Utah and one independent living facility which also offers assisted living services in Texas for an aggregate purchase price of approximately $13.6 million, which was paid in cash. These acquisitions added 182 operational skilled nursing beds, 128 independent living units and 39 assisted living units to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of each transaction.
  
Taking the above noted acquisitions into account, the tables below set forth the total number of facilities and bed counts, along with their location and bed count by state as of August 1, 2011:
 
December 31,
 
Aug. 1,
 
2005
 
2006
 
2007
 
2008
 
2009
 
2010
 
2011
Cumulative number of facilities
46

 
57

 
61

 
63

 
77

 
82

 
99

Cumulative number of operational skilled nursing, assisted living and independent living beds
5,585

 
6,667

 
7,105

 
7,324

 
8,948

 
9,539

 
11,431


 
CA
 
AZ
 
TX
 
UT
 
CO
 
WA
 
ID
 
NV
 
NE
 
IA
 
Total
Number of facilities
34

 
12

 
21

 
11

 
5

 
3

 
3

 
1

 
4

 
5

 
99

Operational skilled nursing, assisted living and independent living beds
3,820

 
1,830

 
2,661

 
1,364

 
463

 
274

 
246

 
152

 
296

 
325

 
11,431

See further discussion of facility acquisitions in Note 6 in Notes to Condensed Consolidated Financial Statements.
Key Performance Indicators
We manage our skilled nursing business by monitoring key performance indicators that affect our financial performance. These indicators and their definitions include the following:
Routine revenue: Routine revenue is generated by the contracted daily rate charged for all contractually inclusive services. The inclusion of therapy and other ancillary treatments varies by payor source and by contract. Services provided outside of the routine contractual agreement are recorded separately as ancillary revenue, including Medicare Part B therapy services, and are not included in the routine revenue definition.
Skilled revenue: The amount of routine revenue generated from patients in our skilled nursing facilities who are receiving higher levels of care under Medicare, managed care, Medicaid, or other skilled reimbursement programs. The other skilled residents that are included in this population represent very high acuity residents who are receiving high levels of nursing and ancillary services which are reimbursed by payors other than Medicare or managed care. Skilled revenue excludes any revenue generated from our assisted living services.
Skilled mix: The amount of our skilled revenue as a percentage of our total routine revenue. Skilled mix (in days) represents the number of days our Medicare, managed care, or other skilled patients are receiving services at our skilled nursing facilities divided by the total number of days patients (less days from assisted living services) from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).
Quality mix: The amount of routine non-Medicaid revenue as a percentage of our total routine revenue. Quality mix (in days) represents the number of days our non-Medicaid patients are receiving services at our skilled nursing facilities divided by the total number of days patients from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).
Average daily rates: The routine revenue by payor source for a period at our skilled nursing facilities divided by actual patient days for that revenue source for that given period.

29

Table of Contents

Occupancy percentage (operational beds): The total number of residents occupying a bed in a skilled nursing, assisted living or independent living facility as a percentage of the beds in a facility which are available for occupancy during the measurement period.
Number of facilities and operational beds: The total number of skilled nursing, assisted living and independent living facilities that we own or operate and the total number of operational beds associated with these facilities.
Skilled and Quality Mix. Like most skilled nursing providers, we measure both patient days and revenue by payor. Medicare, managed care and other skilled patients, whom we refer to as high acuity patients, typically require a higher level of skilled nursing and rehabilitative care. Accordingly, Medicare and managed care reimbursement rates are typically higher than from other payors. In most states, Medicaid reimbursement rates are generally the lowest of all payor types. Changes in the payor mix can significantly affect our revenue and profitability.

The following table summarizes our overall skilled mix and quality mix for the periods indicated as a percentage of our total routine revenue (less revenue from assisted living services) and as a percentage of total patient days (less days from assisted living services):
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2011
 
2010
 
2011
 
2010
Skilled Mix:
 
 
 
 
 
 
 
Days
26.3
%
 
24.8
%
 
26.3
%
 
25.4
%
Revenue
52.7
%
 
48.2
%
 
52.8
%
 
49.0
%
Quality Mix:
 
 
 
 
 
 
 
Days
38.1
%
 
36.8
%
 
38.2
%
 
37.2
%
Revenue
60.9
%
 
57.3
%
 
61.0
%
 
57.8
%
Occupancy. We define occupancy as the ratio of actual patient days (one patient day equals one resident occupying one bed for one day) during any measurement period to the number of beds in facilities which are available for occupancy during the measurement period. The number of licensed and independent living beds in a skilled nursing, assisted living or independent living facility that are actually operational and available for occupancy may be less than the total official licensed bed capacity. This sometimes occurs due to the permanent dedication of bed space to alternative purposes, such as enhanced therapy treatment space or other desirable uses calculated to improve service offerings and/or operational efficiencies in a facility. In some cases, three- and four-bed wards have been reduced to two-bed rooms for resident comfort, and larger wards have been reduced to conform to changes in Medicare requirements. These beds are seldom expected to be placed back into service. We define occupancy in operational beds as the ratio of actual patient days during any measurement period to the number of available patient days for that period. We believe that reporting occupancy based on operational beds is consistent with industry practices and provides a more useful measure of actual occupancy performance from period to period.
The following table summarizes our overall occupancy statistics for the periods indicated:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2011
 
2010
 
2011
 
2010
Occupancy:
 
 
 
 
 
 
 
Operational beds at end of period
10,461

 
9,344

 
10,461

 
9,344

Available patient days
942,679

 
841,994

 
1,850,495

 
1,658,834

Actual patient days
746,995

 
667,858

 
1,478,480

 
1,316,942

Occupancy percentage (based on operational beds)
79.2
%
 
79.3
%
 
79.9
%
 
79.4
%

30

Table of Contents

Revenue Sources
Our total revenue represents revenue derived primarily from providing services to patients and residents of skilled nursing facilities, and to a lesser extent from assisted living facilities and ancillary services. We receive service revenue from Medicaid, Medicare, private payors and other third-party payors, and managed care sources. The sources and amounts of our revenue are determined by a number of factors, including bed capacity and occupancy rates of our healthcare facilities, the mix of patients at our facilities and the rates of reimbursement among payors. Payment for ancillary services varies based upon the service provided and the type of payor. The following table sets forth our total revenue by payor source and as a percentage of total revenue for the periods indicated:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2011
 
2010
 
2011
 
2010
 
 
$
 
%
 
$
 
%
 
$
 
%
 
$
 
%
 
 
(Dollars in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicaid
 
$
67,080

 
36.0
%
 
$
64,002

 
40.5
%
 
$
133,306

 
36.1
%
 
$
125,656

 
40.3
%
Medicare
 
68,964

 
37.0

 
50,589

 
32.1

 
136,605

 
37.0

 
101,711

 
32.6

Medicaid-skilled
 
4,296

 
2.3

 
4,624

 
2.9

 
8,706

 
2.4

 
9,041

 
2.9

Total
 
140,340

 
75.3

 
119,215

 
75.5

 
278,617

 
75.5

 
236,408

 
75.8

Managed Care
 
24,175

 
13.0

 
20,222

 
12.8

 
48,317

 
13.1

 
40,791

 
13.0

Private and Other(1)
 
21,811

 
11.7

 
18,511

 
11.7

 
42,335

 
11.4

 
34,923

 
11.2

Total revenue
 
$
186,326

 
100.0
%
 
$
157,948

 
100.0
%
 
$
369,269

 
100.0
%
 
$
312,122

 
100.0
%
_______________________
(1)
Includes revenue from assisted living facilities and home health and hospice operations.
Critical Accounting Policies Update
There have been no significant changes during the three month period ended June 30, 2011 to the items that we disclosed as our critical accounting policies and estimates in our discussion and analysis of financial condition and results of operations in our Annual Report on Form 10-K filed with the SEC.
Industry Trends
The skilled nursing industry has evolved to meet the growing demand for post-acute and custodial healthcare services generated by an aging population, increasing life expectancies and the trend toward shifting of patient care to lower cost settings. The skilled nursing industry has evolved in recent years, which we believe has led to a number of favorable improvements in the industry, as described below:
Shift of Patient Care to Lower Cost Alternatives. The growth of the senior population in the United States continues to increase healthcare costs, often faster than the available funding from government-sponsored healthcare programs. In response, federal and state governments have adopted cost-containment measures that encourage the treatment of patients in more cost-effective settings such as skilled nursing facilities, for which the staffing requirements and associated costs are often significantly lower than acute care hospitals, inpatient rehabilitation facilities and other post-acute care settings. As a result, skilled nursing facilities are generally serving a larger population of higher-acuity patients than in the past.
Significant Acquisition and Consolidation Opportunities. The skilled nursing industry is large and highly fragmented, characterized predominantly by numerous local and regional providers. We believe this fragmentation provides significant acquisition and consolidation opportunities for us.
Improving Supply and Demand Balance. The number of skilled nursing facilities has declined modestly over the past several years. We expect that the supply and demand balance in the skilled nursing industry will continue to improve due to the shift of patient care to lower cost settings, an aging population and increasing life expectancies.
Increased Demand Driven by Aging Populations and Increased Life Expectancy. As life expectancy continues to increase in the United States and seniors account for a higher percentage of the total U.S. population, we believe the

31

Table of Contents

overall demand for skilled nursing services will increase. At present, the primary market demographic for skilled nursing services is primarily individuals age 75 and older. According to U.S. Census Bureau Interim Projections, there will be 46 million people in the United States in 2010 that are over 65 years old. The U.S. Census Bureau estimates this group is one of the fastest growing segments of the United States population and is expected to more than double between 2000 and 2030.
We believe the skilled nursing industry has been and will continue to be impacted by several other trends. The use of long-term care insurance is increasing among seniors as a means of planning for the costs of skilled nursing services. In addition, as a result of increased mobility in society, reduction of average family size, and the increased number of two-wage earner couples, more seniors are looking for alternatives outside the family for their care.
Effects of Changing Prices. Medicare reimbursement rates and procedures are subject to change from time to time, which could materially impact our revenue. Medicare reimburses our skilled nursing facilities under a prospective payment system (PPS) for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group (RUG) category that is based upon each patient’s acuity level. As of October 1, 2010, the RUG categories were expanded from 53 to 66 with the introduction of minimum data set (MDS) 3.0. Should future changes in skilled nursing facility payments reduce rates or increase the standards for reaching certain reimbursement levels, our Medicare revenues could be reduced, with a corresponding adverse impact on our financial condition or results of operation.
On July 29, 2011, the Centers for Medicare and Medicaid Services (CMS) announced a final rule reducing Medicare skilled nursing facility PPS payments in fiscal year 2012 by $3.87 billion, or 11.1% lower than payments for fiscal year 2011. CMS announced it is recalibrating the case-mix indexes (CMIs) for fiscal year 2012 to restore overall payments to their intended levels on a prospective basis. Each RUG group consists of CMIs that reflect a patient's severity of illness and the services that a patient requires in the skilled nursing facility. In transitioning from the previous classification system to the new RUG-IV, CMS adjusted the CMIs for fiscal year 2011 based on forecasted utilization under this new classification system to establish parity in overall payments. The fiscal year 2011 recalibration of the CMIs will result in a reduction to skilled nursing facility payments of $4.47 billion or 12.6%. However, this reduction would be partially offset by the fiscal year 2012 update to Medicare payments to skilled nursing facilities. The update, a 1.7% or $600 million increase, reflects a 2.7% market basket increase, reduced by a 1.0% multi-factor productivity (MFP) adjustment mandated by the Affordable Care Act. The Combined MFP-adjusted market basket increase and the fiscal year 2012 recalibration will yield a net reduction of $3.87 billion, or 11.1%.
The Deficit Reduction Act of 2005 (DRA) added Sec. 1833(g)(5) of the Social Security Act and directed the Centers for Medicare and Medicaid Services to develop a process that allows exceptions for Medicare beneficiaries to therapy caps when continued therapy is deemed medically necessary. The therapy cap exception was reauthorized in a number of subsequent laws, most recently as part of the Medicare and Medicaid Extenders Act of 2010, which extends the exceptions process through December 31, 2011. The application of annual caps, or the discontinuation of exceptions to the annual caps, could have an adverse effect on our rehabilitation therapy revenue. Additionally, the exceptions to these caps may not be extended beyond December 31, 2011, which could also have an adverse effect on our revenue after that date.

On March 24, 2011, the governor of California signed Assembly Bill 97 (AB 97), the budget trailer bill on health, into law.  AB 97 outlines significant cuts to  state  health and human services programs.  Specifically, the law reduces provider payments by 10 percent for physicians, pharmacy, clinics, medical transportation, certain hospitals, home health, and nursing facilities .  AB X1 19 Long Term Care  was subsequently approved by the governor on June 28, 2011.  AB X1 19 limits  the 10% payment reduction to skilled-nursing providers to 14 months for the services provided on June 1, 2011 through July 31, 2012 with a promise to repay by December 31, 2012.  However, the law is not be implemented until the Centers for Medicare and Medicaid Services provides federal approval.  When federal approval is obtained, the payments resulting from the application  of  the new law shall be implemented retroactively to June 1, 2011, or on such other date or dates as may be applicable.  The potential impact of this new law, if approved by CMS, on the Corporation cannot be predicted with certainty.  There can be no assurance that the reduction in provider payments will not lead to material adverse consequences in the future.
Federal Health Care Reform. On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act (PPACA), which contained several sweeping changes to America’s health insurance system. Among other reforms contained in PPACA, many Medicare providers received reductions in their market basket updates. Unlike for some other Medicare providers, PPACA makes no reduction to the market basket update for skilled nursing facilities in fiscal years 2010 or 2011. However, under PPACA, the skilled nursing facility market basket update will be subject to a full productivity adjustment beginning in fiscal year 2012. In addition, PPACA enacted several reforms with respect to skilled nursing facilities and hospice organizations, including payment measures to realize significant savings of federal and state funds by deterring and prosecuting fraud and abuse in both the Medicare and Medicaid programs. While many of the provisions of PPACA will not take effect for

32

Table of Contents

several years or are subject to further refinement through the promulgation of regulations, some key provisions of PPACA are effective immediately or within six to twelve months of PPACA’s enactment date.
Enhanced CMPs and Escrow Provisions — Effective March 23, 2010, PPACA includes expanded civil monetary penalty (CMP) provisions applicable to all Medicare and Medicaid providers. PPACA provides for the imposition of CMPs of up to $50,000 and, in some cases, treble damages, for actions relating to alleged false statements to the federal government.
Nursing Home Transparency Requirements — In addition to expanded CMP provisions, PPACA imposes substantial new transparency requirements for Medicare-participating nursing facilities. Existing law requires Medicare providers to disclose to CMS: (1) any person or entity that owns directly or indirectly an ownership interest of five percent or more in a provider; (2) officers and directors (if a corporation) and partners (if a partnership); and (3) holders of a mortgage, deed of trust, note or other obligation secured by the entity or the property of the entity. PPACA expands the information required to be disclosed to include: (4) the facility’s organizational structure; (5) additional information on officers, directors, trustees, and “managing employees” of the facility (including their names, titles, and start dates of services); and (6) information on any “additional disclosable party” of the facility. CMS has not yet promulgated regulations to implement these provisions.
Suspension of Payments During Pending Fraud Investigations — PPACA also provides the federal government with expanded authority to suspend payment if a provider is investigated for allegations or issues of fraud. Section 6402 of the PPACA provides that Medicare and Medicaid payments may be suspended pending a “credible investigation of fraud,” unless the Secretary of Health and Human Services determines that good cause exists not to suspend payments. “Credible investigation of fraud” is undefined, although the Secretary must consult with the Office of the Inspector General (OIG) in determining whether a credible investigation of fraud exists. This suspension authority creates a new mechanism for the federal government to suspend both Medicare and Medicaid payments for allegations of fraud, independent of whether a state exercises its authority to suspend Medicaid payments pending a fraud investigation. To the extent the Secretary applies this suspension of payments provision to one or more of our facilities for allegations of fraud, such a suspension could adversely affect our results of operations. OIG promulgated regulations making these provisions effective as of March 25, 2011.
Overpayment Reporting and Repayment; Expanded False Claims Act Liability — PPACA also enacted several important changes that expand potential liability under the federal False Claims Act. Effective March 23, 2010, PPACA provides that overpayments related to services provided to both Medicare and Medicaid beneficiaries must be reported and returned to the applicable payor within the later of sixty days of identification of the overpayment, or the date the corresponding cost report (if applicable) is due. Any overpayment retained after the deadline is considered an “obligation” for purposes of the federal False Claims Act.
Voluntary Pilot Program — Bundled Payments — To support the policies of making all providers responsible during an episode of care and rewarding value over volume, HHS will establish, test and evaluate alternative payment methodologies for Medicare services through a five-year, national, voluntary pilot program starting in 2013. This program will provide incentives for providers to coordinate patient care across the continuum and to be jointly accountable for an entire episode of care centered around a hospitalization. HHS will develop qualifying provider payment methods that may include bundled payments and bids from entities for episodes of care that begins three days prior to hospitalization and spans 30 days following discharge. The bundled payment will cover the costs of acute care inpatient services; physicians’ services delivered in and outside of an acute care hospital; outpatient hospital services including emergency department services; post-acute care services, including home health services, skilled nursing services, inpatient rehabilitation services; and inpatient hospital services. The payment methodology will include payment for services, such as care coordination, medication reconciliation, discharge planning and transitional care services, and other patient-centered activities. Payments for items and services cannot result in spending more than would otherwise be expended for such entities if the pilot program were not implemented. As with Medicare’s shared savings program discussed above, payment arrangements among providers on the backside of the bundled payment must take into account significant hurdles under the Anti-kickback Law, the Stark Law and the Civil Monetary Penalties Law. This pilot program may expand in 2016 if expansion would reduce Medicare spending without also reducing quality of care.
The provisions of PPACA discussed above are examples of recently-enacted federal health reform provisions that we believe may have a material impact on the long-term care industry and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of PPACA. It is possible that these and other provisions of PPACA may be interpreted, clarified, or applied to our facilities or operations in a way that could have a material adverse impact on the results of operations.


33

Table of Contents

Historically, adjustments to reimbursement under Medicare have had a significant effect on our revenue. For a discussion of historic adjustments and recent changes to the Medicare program and related reimbursement rates see Risk Factors — Risks Related to Our Business and Industry — “Our revenue could be impacted by federal and state changes to reimbursement and other aspects of Medicaid and Medicare,” “Our future revenue, financial condition and results of operations could be impacted by continued cost containment pressures on Medicaid spending,” “We may not be fully reimbursed for all services for which each facility bills through consolidated billing, which could adversely affect our revenue, financial condition and results of operations” and “Reforms to the U.S. healthcare system will impose new requirements upon us and may lower our reimbursements." The federal government and state governments continue to focus on efforts to curb spending on healthcare programs such as Medicare and Medicaid. We are not able to predict the outcome of the legislative process. We also cannot predict the extent to which proposals will be adopted or, if adopted and implemented, what effect, if any, such proposals and existing new legislation will have on us. Efforts to impose reduced allowances, greater discounts and more stringent cost controls by government and other payors are expected to continue and could adversely affect our business, financial condition and results of operations.



34

Table of Contents

Results of Operations

The following table sets forth details of our revenue, expenses and earnings as a percentage of total revenue for the periods indicated:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2011
 
2010
 
2011
 
2010
Revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Expenses:
 
 
 
 
 
 
 
Cost of services (exclusive of facility rent and depreciation and amortization shown separately below)
78.2

 
79.7

 
78.2

 
79.8

Facility rent—cost of services
1.8

 
2.3

 
1.9

 
2.3

General and administrative expense
4.1

 
4.0

 
4.1

 
3.9

Depreciation and amortization
3.0

 
2.5

 
2.9

 
2.5

Total expenses
87.1

 
88.5