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UNITED STATES

FORM 10-K

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OR

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Commission File Numbers 333-97293; 333-116927

EXTENDICARE HEALTH SERVICES, INC.

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act: None

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

Yes x          No   

          Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to the Form 10-K.  x

          Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Act)

Yes        No x

          Common Stock — authorized 1,000 shares, $1.00 par value; issued and outstanding 947 shares as of March 15, 2005. All issued and outstanding shares of Common Stock were held on June 30, 2004 and continue to be held indirectly by Extendicare Inc., a publicly traded Canadian company.

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Cautionary Statement Regarding Forward Looking Statements

      This Annual Report on Form 10-K contains forward-looking statements that are intended to qualify for the safe harbors from liability established by the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including statements regarding anticipated financial performance, business strategy and goals for future operations, are forward-looking statements. These forward-looking statements can be identified as such because the statements generally include words such as “expect,” “intend,” “believe,” “anticipate,” “estimate,” “plan” or “objective” or other similar expressions. These forward-looking statements reflect our beliefs and assumptions, and are based on information currently available to us. Forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results, performance or achievements or industry results to be materially different from those expressed in, or implied by, these statements. Some, but not all, of the risks and uncertainties include those described in the “Risk Factors” section of this Form 10-K and the following:

	•	Medicare and Medicaid payment levels and reimbursement methodologies and the application of such methodologies and policies adopted by the government and its fiscal intermediaries;
	•	liabilities and claims asserted against us, such as resident care litigation, including our exposure for punitive damage claims and increased insurance costs;
	•	national and local economic conditions, including their effect on the ability to hire and retain qualified staff and employees and the associated costs;
	•	federal and state regulation of our business and change in such regulations, as well as our compliance with such regulations;
	•	actions by our competitors; and
	•	our ability to maintain and increase census levels.

      All forward-looking statements contained in this Annual Report on Form  10-K are expressly qualified in their entirety by the cautionary statements set forth or referred to above. We assume no obligation to update any forward-looking statement.

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PART I

General

      Extendicare Health Services, Inc. was incorporated in Delaware in 1984 and is an indirect, wholly owned subsidiary of Extendicare Inc. (hereafter referred to as “Extendicare”), a Canadian publicly traded company. As used herein, unless the context otherwise specifies or requires, the “Company”, “we”, or “us” refers to Extendicare Health Services, Inc. and its subsidiaries on a combined basis. We are subject to certain of the reporting requirements of the Securities Exchange Act of 1934, as amended, due to our public offerings of 9.5% Senior Notes Due 2010, and 6.875% Senior Subordinated Notes Due 2014, which have been registered under the Securities Act of 1933, as amended.

      Based upon number of beds, we are one of the largest providers of long-term care and related services in the United States. Through our network of geographically clustered facilities, we offer a continuum of healthcare services, including skilled nursing care, assisted living and related medical specialty services, such as subacute care and rehabilitative therapy. As of December 31, 2004, we operated or managed 185 long-term care facilities with 16,642 beds in 12 states, of which 148 were skilled nursing facilities with 14,882 beds and 37 were assisted living and retirement facilities with 1,760 units. We also provided consulting services to 77 facilities with 9,446 beds in five states. In addition, we operated 21 outpatient rehabilitation clinics in four states. We receive payment for our services from Medicare, Medicaid, private insurance, self-pay residents and other third-party payors.

      On January 31, 2005, we completed our acquisition of Assisted Living Concepts, Inc., or ALC, for a total of approximately $285 million, including the assumption of $141 million of ALC’s existing debt. ALC has a portfolio of 177 assisted living facilities, including 122 owned and 55 leased facilities representing 6,838 units located in 14 states, many in markets where we currently operate. Reflecting the impact of the acquisition, as of February 1, 2005 we operated or managed 362 long-term care facilities with 23,480 beds in 19 states, of which 148 were skilled nursing facilities with 14,882 beds and 214 were assisted living and retirement facilities with 8,598 units.

      We focus on our core skilled nursing and assisted living facility operations, while continuing to grow our complementary long-term care services. By emphasizing quality care of patients and by clustering several long-term care facilities together within the geographic areas we serve, our goal is to build upon our reputation as a leading provider of a full range of long-term care services in our communities.

      The principal elements of our business strategy are to:

	•	provide quality, clinically based services;
	•	increase our total and Medicare census through strategies such as focused marketing efforts, standardized admissions protocols and streamlined admitting procedures.
	•	expand non-government based revenue sources, thereby decreasing the risk and reliance on government funding;
	•	leverage presence in small urban markets to improve operating efficiencies and to offer our customers a broad range of long-term care services, including assisted living and related health services;
	•	expand asset portfolio through acquisition and internal growth;
	•	actively manage our asset portfolio so that we upgrade our facilities to meet the demands of the local market and customer base, or exit markets or sell facilities which do not meet our performance goals.
	•	diversify within long-term care industry through growth of facilities under full management and selected consulting services agreements and rehabilitation clinics; and
	•	increase our operating efficiency.

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The Long-term Care Industry

      According to the Centers for Medicare and Medicaid Services, or CMS, total healthcare spending is expected to grow at an annual rate of 7.1% from 2003 through 2014. Based on these estimates, healthcare expenditures will account for $3.6 trillion, or 18.7% of the gross domestic product by 2014. Nursing facility expenditures were approximately $110.8 billion in 2003, or 6.6% of total healthcare spending, representing one of the largest components of national healthcare spending. The spending related to nursing facilities is expected to grow at an annual rate of 8.4% through 2014.

      The long-term care industry is changing as a result of several fundamental factors, on which we believe we can capitalize. These factors include:

      Aging Population. The aging of the U.S. population is a leading driver of demand for long-term care services. According to the 2000 census conducted by the U.S. Census Bureau, there were approximately 34.4 million Americans aged 65 or older. The U.S. Census Bureau has forecasted that the population of Americans aged 65 or older will increase to 37.7 million in 2005, 40.2 million in 2010, 54.6 million by 2020, and 86.7 million in 2050. As a result, the percentage of Americans aged 65 or older will increase from 12.4% in 2000 to 16.3% in 2020 and 20.7% by 2050. Based upon these projections, while the overall U.S. population growth rate is projected at approximately 4% every five years from 2005 to 2030, the 65 year and older segment of the U.S. population is expected to increase by approximately 10% to 17% during each of the same five-year periods. The following table indicates the expected growth rates within the elderly U.S. populations.

      Source: U.S. Census Bureau, International Data Base, published October 10, 2002

According to the MetLife Market Survey of Nursing Home report in August 2003 (“MetLife Report”), whereas in 2000, approximately 1.6 million or 4.5% of all persons aged 65 and over were living in a nursing facility, this number will increase to approximately 6.6 million, or 8.4% of all persons aged 65 by the year 2050.

      Supply/ Demand Imbalance. Acquisition and construction of additional nursing and assisted living facilities are subject to certain restrictions on supply, including government legislated moratoriums for nursing facilities on new capacity or licensing restrictions limiting the growth of services. Such restrictions on supply, coupled with an aging population, are causing a decline in the availability of long-term beds per person 85 years of age or older. Additionally, advances in medical technology are enabling the treatment of certain medical conditions outside the hospital setting. As a result, patients requiring a higher degree of monitoring, more intensive and specialized medical care, 24-hour per day nursing, and a comprehensive array of rehabilitative therapies are increasing, resulting in a need for long-term care. We believe that such specialty care can be provided in nursing homes at a significantly lower cost than in traditional acute care and rehabilitation hospitals. In addition, for an aging population seeking a higher quality living alternative, assisted living facilities offer an array of accommodations and selective long-term care and services on a more cost effective basis for the individual. According to American Senior Housing Association, or ASHA, the percentage of American seniors aged 65 or older that need assistance with at least one activity of daily living has been approximately 19% for each of the years 1998 to 2001.

      Cost Containment Pressures. According to the MetLife Report, the remaining life expectancy of a male age 65 has increased to 16.3 years in 2002 from 12.7 years in 1942; and the remaining life expectancy of a female age 65 has increased to 19.2 years in 2002 from 14.7 years in 1942. As the number of people over age 65 continues to grow and as advances in medicine and technology continue to increase life expectancies,

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      Changing Family Dynamics and Economics. Changing family dynamics play an important role in the need of seniors to live in a long-term care facility. As a result of the growing number of two-income families, we believe the immediate family has become less of a primary source of care-giving for the elderly. Our opinion is based upon a number of facts, including (1) according to the U.S. Department of Labor, women, who under more traditional roles were viewed as the primary caretakers of the family, have moved back into the workforce in increasing numbers as evidenced through their labor participation rates increasing from 38% in 1963 to 60% in 1998 and forecasted to reach 62% in 2015; and (2) according to the U.S. Census Bureau, the parent support ratio (the ratio of individuals over 85 to those 45 to 64 years of age) has increased from 3 to 100 in 1950 to 7 to 100 in 2000 and is expected to reach 22 to 100 by the year 2050. The expected increase is partly due to the fact that by 1990 approximately 26% of the baby boom generation was childless. At the same time, an increasing number of two-income families are better able to provide financial support for elderly parents to receive the care they need in a nursing or assisted living facility. In addition, we believe, there is an increasing number of seniors who are able to afford to live in an assisted living facility. According to a 2000 study by the Joint Center for Housing Studies of Harvard University, almost 20% of U.S. seniors have a net worth between $100,000 and $200,000, while another 18% have a net worth between $200,000 and $500,000. In our opinion, this study underestimated seniors’ wealth because it excluded social security and pension plans. In 1962, the mean net worth of Americans aged 65 to 74 was $165,000 (based on the value of the U.S. dollar in 1995), whereas in 1995 the net worth was $346,000.

Competitive Strengths

      The long-term care industry is highly fragmented with numerous local and regional operators and a select group of larger operators. According to information published by ASHA, as of June 2004, there were approximately 20,920 long-term care facilities in the U.S. containing approximately 2.3 million beds. As of December 31, 2003, fifty of the largest operators in the U.S. operated approximately 2,922 long-term care facilities, representing 14% of the total number of properties. Approximately 7,270 or 35% of the facilities are assisted living facilities, representing approximately 544,000 or 24% of the total number of long-term care beds, while the remaining consist of nursing facilities.

      According to the CMS Healthcare Industry Market Update report published in May 2003, the nursing facility portion of the long-term care industry is fragmented, with the 10 largest nursing facility companies accounting for 15.5% of the total facility beds as of April 2003. There are approximately 16,500 nursing facilities certified under the Medicare and/or Medicaid program with approximately 1.8 million available beds, and during 2002, approximately 3.5 million individuals lived in nursing facilities. Approximately 65% of nursing facilities are operated by for-profit companies, 28% are operated by non-profit organizations and 7% are operated by local government.

      Our major competitive strengths are:

      Leading Provider of Long-term Care Services. We are among the largest providers of long-term care services in the United States. As of December 31, 2004, we operated or managed 185 long-term care facilities with 16,642 beds. Effective February 1, 2005 reflecting the impact of the acquisition of ALC, we operated or

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      Focus on Core Business. In the past, we have successfully identified and disposed of portions of our business that did not fit within our core business or facilities located in states with unacceptable litigation risks. From 1998 through 2001, in response to the implementation of the Medicare Prospective Payment System, or PPS, increased litigation and insurance costs in certain states, and increased operational costs resulting from changes in legislation and regulatory scrutiny, we divested under-performing nursing and assisted living facilities and non-core healthcare assets. These asset divestitures primarily included the sale of our pharmacy to Omnicare, Inc., and the sales of facilities and/or the transfer of all operations in the states of Florida and Texas in 1999, 2000 and 2001 and Arkansas in 2004. We have more recently commenced a strategy to grow our business through selective acquisition and internal growth involving development projects, or undertake full management or selective consulting contracts to grow in states that are attractive and offer opportunities for us to expand our present base of operations. In 2004, we completed four construction projects which included a new free-standing assisted living facility (40 units), two additions to existing assisted living facilities (46 units) and an addition to an existing nursing facility (20 beds). We have eleven additional construction projects in progress which will expand or add to our nursing facilities (18 beds) and assisted living facilities (376 units). In December 2003, we acquired one nursing facility in Wisconsin (99 beds); in January 2004, we acquired a previously leased nursing facility and in June 2004 we acquired four nursing facilities (321 beds) in Indiana. On January 31, 2005, we acquired ALC, which operates 177 assisted living facilities (6,838 units). We intend to continue to focus on operating and managing long-term care facilities. In addition, we plan to continue to review the performance of our current facilities and exit markets or sell facilities that do not meet our performance goals. At the present time, we have no significant divestiture plans.

      Significant Facility Ownership. We own rather than lease a majority of our properties, unlike a number of other long-term care providers. As of December 31, 2004, we owned 163 facilities, or 94.2% of the total number of facilities we operated. We believe that owning properties increases our operating flexibility by allowing us to:

	•	refurbish facilities to meet changing consumer demands;
	•	add assisted living and retirement facilities adjacent to our skilled nursing facilities;
	•	adjust licensed capacity to avoid occupancy-based rate penalties;
	•	divest facilities and exit markets at our discretion; and
	•	more directly control our occupancy costs.

We maintained this strategy with the acquisition of ALC. Effective February 1, 2005, with the inclusion of ALC facilities we owned 285 facilities, or 81.4%, of the total number of facilities we operated.

      Dual Medicare and Medicaid Certification. We have certified substantially all of our beds for the provision of care to both Medicare and Medicaid patients. We believe that dual certification in nursing facilities increases the likelihood of higher occupancy rates by increasing the availability of beds to patients who require a specific bed certification. In addition, dual certification allows our facilities to easily shift patients from one level of care and reimbursement to another without physically moving the patient.

      Experienced and Proven Management Team. Our management team has demonstrated competency in dealing with significant changes in the reimbursement environment resulting from the shift to PPS, and identifying the significant exposures and risks of operating in the extremely litigious environments in Florida and Texas. We executed a planned divestiture program that reduced our level of debt, and reduced our exposure to liability claims and increased insurance costs. In 2002 and 2004, we refinanced a significant portion of our debt to reduce the leverage ratio from 71.0% in 2000 to 53.8% in 2004. We have been successful

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      Geographic Diversity. As of December 31, 2004, we operated or managed facilities located in specific markets across 12 states primarily throughout the Northeast, Midwest and Northwest regions of the United States. No state contains more than 20% of our facilities or 20% of our beds. With the addition of ALC, which has operations in 14 states, seven of which are new states for us, our operations continue to be primarily in the above mentioned regions. However we now also have a significant operation in the southern states of Texas and Arizona. Effective February 1, 2005, we operated or managed facilities located in specific markets across 19 states, with no state containing more than 14% of our facilities or 17% of our beds. Each state is unique in terms of its competitive dynamics as well as its political and regulatory environment. Each state administers its own Medicaid program, which constitutes a significant portion of our revenue. Our diversified market scope limits our exposure to events or trends that may occur in any individual state, including changes in any state’s Medicaid reimbursement program and in regional and local economic conditions and demographics.

      Diversify within the Long-term Care Industry. We continue to explore opportunities to expand in states where we currently operate to provide either full management, consulting or accounting services. We also plan to explore opportunities for new rehabilitation clinics in states where we currently operate. In 2004, we opened one new rehabilitation clinic. However due to changing demands in the local markets, we closed four other rehabilitation clinics during 2004. As of December 31, 2004, we operated 21 clinics, compared to 24 in 2003 and 22 in 2002.

      Management Focus on Key Performance Drivers. We believe that our senior management, as well as our field personnel, are proficient at focusing on the key areas that drive revenues, profits and cash flows. Our senior management has identified four critical drivers of operating and financial performance:

	•	improving census, particularly increasing our Medicare census in our nursing facilities;
	•	increasing cash flow from operations, through expedited billing and collections and other initiatives;
	•	improving income from operations, through control of labor and other costs; and
	•	diversifying within the long-term care industry through expansion of facilities under management and consulting agreements and expansion of our rehabilitation clinics

      Every level of management, starting with our Chief Executive Officer, devotes a significant portion of their time to improving these key performance drivers. We believe that this focused attention and commitment, along with hard work by our employees has resulted in substantial improvement in several of our key performance drivers.

      For 2004, total average daily census, or ADC, for our nursing facilities increased to 12,607, which is 0.9% higher than the 12,490 reported for 2003, and 2.3% higher than the 12,319 reported for 2002. The occupancy rate for 2004 was 92.1% compared to 91.4% in 2003 and 90.1% in 2002. For 2004, Medicare ADC increased to 2,100, which is 8.5% higher than the 1,935 reported for 2003, and 28.0% higher than the 1,639 reported for 2002. The occupancy of our assisted living facilities was 84.6% in 2004, compared to 85.8% in 2003 and 83.0% in 2002. All of the data presented in this paragraph is on a same facility basis.

      Cash flow from operations was $81.4 million in 2004, as compared to $56.0 million in 2003 and $38.8 million in 2002. Through consistent emphasis on admissions protocols, attention to older and larger account balances and proactive collection efforts at regional and head offices, we have improved our accounts receivable management. Days of revenues outstanding have dropped to approximately 36.5 days as of December 31, 2004, compared to 40.0 days in 2003 and 43.0 days in 2002.

      As discussed in our description of key performance drivers in the “Management’s Discussion and Analysis” section of this Annual Report on Form 10-K, we monitor income from operations by focusing on earnings before interest, taxes, depreciation and amortization, or EBITDA, and EBITDA expressed as a percentage of revenues. EBITDA increased to $133.0 million in 2004, compared to $99.3 million in 2003 and $80.4 million in 2002; and EBITDA as a percentage of revenues increased to 14.0% in 2004, compared to

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Business Strategy

      The principal elements of our business strategy are to:

      Provide Quality, Clinically Based Services. Our corporate clinical services group monitors quality of care indicators, survey results and drives continuous quality improvement processes at the facility and regional levels. Focused review meetings are held on a regular basis to monitor trends in facilities and to communicate new protocols and issues within the industry. The corporate clinical services group directs an internal team of field-based quality validation specialists who are responsible for mirroring the regulatory survey process and regularly communicating with our clinical service specialists in our corporate office. On-site data is integrated with clinical indicators, facility human resource data and state regulatory outcomes to provide a detailed picture of problems, challenges and successes in achieving performance at all levels of our organization. This information pool allows us to determine best practices for duplication in similarly situated facilities. We emphasize these programs when marketing our services to acute care providers, community organizations and physicians in the communities we serve.

      Increase Medicare Census. We continue to develop and implement strategies and capabilities to attract residents, with a focus on increasing Medicare census in our nursing facilities. In 2004, Medicare payments represented approximately 30% of our total net revenues, up from 24% in 2000. Senior management continually works with our regional and local management teams to develop strategies to continue to increase this percentage. Strategies, such as focused marketing efforts, standardized admissions protocols, streamlined admitting procedures, the dual certification of beds and improved management communication have driven this improvement. In addition to increasing the profitability of our nursing facilities, the increased Medicare census expands the market for our service related businesses as Medicare patients utilize significant ancillary services.

      Expand Non-government Based Revenue Sources. By increasing the level of non-government based revenue sources, we reduce our risk and reliance on government funding that in the future may be constrained. In addition, future generations will have increased wealth and an increased choice of long-term care alternatives. One of our goals is to target these markets. Through both our internal growth program involving the construction of assisted living facilities, and our recent acquisition of ALC we intend to increase the level of non-government based revenue sources. Based upon the ALC’s annual revenues for December 31, 2004, our percentage of non-government based revenue sources will increase from 23% to 31%.

      Leverage Presence in Small Urban Markets. We geographically cluster our long-term care facilities and services in small urban markets in order to improve operating efficiencies and to offer our customers a broad range of long-term care and related health services, including assisted living services. Future expansion of our owned nursing facility operations is anticipated to be through the selective acquisition and construction of new facilities in areas that are in close proximity to existing facilities, where management is experienced in dealing with the regulatory and reimbursement environments, where the facility can participate as an active member of the nursing facility association and where the facility’s reputation is established.

      Expand Asset Portfolio. We seek to expand our portfolio of nursing and assisted living facilities in states where we currently operate or that offer attractive reimbursement systems. We plan to expand through both acquisitions and internal growth. Opportunities exist to add-on to existing facilities and to develop new assisted living facilities in locations close to existing nursing facilities. We currently employ an internal design and development team that is well experienced in the design and construction of new facilities.

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      Actively Manage Our Asset Portfolio. We continually review our asset portfolio in terms of its physical condition, the facility meeting the needs of the marketplace, its financial performance and long-term outlook. When facilities do not meet our performance criteria, risks within the marketplace increase or litigation risk increases beyond acceptable limits, we exit the marketplace or sell facilities. Over the past five years, we have disposed of a number of facilities and exited three states, being Florida, Texas and Arkansas, while improving the performance of the balance of our asset portfolio.

      Increase Facilities under Management and Consulting Services Agreements and Rehabilitation Clinics. We seek to increase the number of our management and consulting contracts with third party operators. We have knowledge and expertise in both the operational and administrative aspects of the long-term care sector. We believe that the increasingly complex and administratively burdensome nature of the long-term care sector, coupled with our commitment and reputation as a leading, high-quality operator, will drive demand for new contracts. We believe this strategy is a logical extension of our business model and competencies and will drive growth without requiring substantial capital expenditures. In 2004, we had 89 facilities under management or consulting service agreements, compared to 33 in 2000.

      Increase Operating Efficiency. We are focused on reducing operating costs by improving our communications systems, streamlining documentation and strengthening the formalization of procedures to approve expenditures. We have reduced the duplication of roles at the corporate and regional levels and continue to seek to improve our utilization of regional resources by adding management and consulting contracts to our existing regions, thereby enabling us to spread the overhead costs of our regional structure over a wider base of operations.

Risk Factors

      The risk factors and uncertainties facing us and our industry include:

      We depend upon reimbursement for our services by third-party payors, and changes in their reimbursement levels could adversely affect our revenues, results of operations and financial position. Approximately 77% of our revenues are derived from governmental third-party payors with the remainder being derived from commercial insurers, managed care plans, the Department of Veteran Affairs, private individuals, and third parties for whom we provide management or consulting services. In 2004, approximately 30% of our revenues were derived from Medicare and 47% from Medicaid. There are ongoing pressures from many payors to control healthcare costs and to reduce or limit increases in reimbursement rates for medical services. Governmental payment programs are subject to statutory and regulatory changes, retroactive rate adjustments, administrative or executive orders and government funding restrictions, all of which may materially change the amount of payments to us for our services.

      Our revenues may be adversely affected by changes or elimination of temporary Medicare funding provisions or reductions in Medicare rates through new rules introduced by CMS. In 1999 the industry experienced a decline in revenues primarily attributable to declines in government reimbursement as a result of the Balanced Budget Act of 1997, or BBA. The revenue rate reductions from the BBA were partially offset by $2.7 billion in temporary relief funding enhancements received through the Balanced Budget Refinement Act of 1999, or BBRA, and the Benefits Improvement Protection Act of 2000, or BIPA. The funding enhancements implemented by the BBRA and BIPA fall into two categories. The first category is “Legislative Add-ons” which included a 16.66% add-on to the nursing component of the Resource Utilization Groupings, or RUGs rate and a 4% base adjustment. Despite intensive lobbying by the long-term care industry, Congress did not extend these Medicare funding enhancements. On September 30, 2002, the temporary relief funding enhancements, referred to as the Legislative Add-ons, expired (referred to as the “Medicare Cliff”), resulting in a reduction in Medicare rates for all long-term care providers. Based upon the Medicare case mix and census for the twelve months period October 1, 2002 to September 30, 2003, we estimate that the net impact of the Medicare Cliff and the market basket increase received on October 1, 2002 was a reduction in revenues of approximately $16.7 million.

      The second category is “RUGs Refinements” which involves an initial 20% add-on for 15 RUGs categories identified as having high intensity, non-therapy ancillary services. The 20% add-ons from three

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      In February 2003, CMS announced its plan to reduce its level of reimbursement for uncollectible Part A co-insurance. Under the plan announced by CMS, the reimbursement level would be reduced to 70% over a three year period as follows: 90% effective for the government fiscal year commencing October 1, 2003; 80% effective for the government fiscal year commencing October 1, 2004; and 70% effective for government fiscal years commencing on or after October 1, 2005. This plan is consistent with the Part A co-insurance reimbursement plan applicable to hospitals. CMS did not implement the rule change effective October 1, 2003, and continues to review the proposed plan. In February 2005, the President’s Proposed Budget provides for the implementation of the reduced reimbursement plan over a three year period commencing October 1, 2005. The President’s Proposed Budget is subject to legislative review and the budget being passed by the United States Government. Should that occur, we estimate that the negative impact to our pre-tax net income would be $0.4 million in 2005, $1.7 million in 2006, $2.9 million in 2007, and $3.8 million in 2008.

      In January 2003, CMS announced that the moratorium on implementing payment caps for outpatient Part B therapy services, which was scheduled to take effect on January 1, 2003, would be extended. CMS subsequently extended the moratorium until September 1, 2003. The therapy caps were made effective from September 1, 2003 until December 8, 2003. On December 8, 2003, as a result of the Medicare Prescription Drug, Improvement and Modernization Act of 2003, the moratorium was re-instated for an additional two-year period until December 2005. The impact of a payment cap cannot be reasonably estimated based on the information available to us at this time, however, we believe that such a cap would reduce therapy revenues.

      We cannot assure you that Medicare payments will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for reimbursement pursuant to such programs.

      Financial pressures on state budgets will directly impact the level of available Medicaid funding and hence the level of available funding for inflationary increases. A majority of states were faced with serious financial budgetary constraints in 2002, 2003 and 2004 as a result of a reduction in state revenues from the slowdown in the economy. In response, budgetary constraints were placed on Medicaid programs, which represent a significant portion of state budgets. A study issued by the Kaiser Commission on Medicaid and the Uninsured in October 2004, indicated that all of the states had made, or planned to make, Medicaid cuts in fiscal year 2004 and plan new actions for fiscal year 2005. A number of states did implement reductions or freezes in Medicaid rates, or limited their increases to below inflationary levels in 2004. With respect to the states in which we operate, Ohio and Minnesota did not provide any Medicaid rate increases, and revenues only increased in response to the higher acuity of residents we admitted.

      In an effort to counter reduced state revenues, a number of states have submitted proposed state plan amendments and waivers to seek an increase in the level of federal funding for their Medicaid programs, and result in providing nursing facilities with a revenue rate increase to offset new or increased provider taxes or state assessment fees. Such programs have been approved in the past, however CMS announced in December 2003 that all such plans were to be reviewed in detail and in January 2004, the General Accounting Office was contacted to review all such programs being introduced. As a result, during 2004 a number of states had to retract and resubmit their proposed plans to CMS and Medicaid rate increases were delayed. In June 2004,

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      In January 2005, the States of Pennsylvania and Washington received approval from CMS of their submitted state plan amendments and waivers. The Washington approval will have no impact on our earnings. As a result of the Pennsylvania approval, we anticipate that we will receive, subject to finalization, retroactive revenues of approximately $11.3 million in 2005 and be required to pay provider taxes of approximately $8.7 million pertaining to the period July 1, 2003 to June 30, 2004. As a result, the impact on income before income taxes is estimated to be $2.6 million. In addition, subject to state budgetary approval and certain other actions, we anticipate receiving retroactive revenues to fund provider taxes for the period July 1, 2004 to December 31, 2004. These amounts are subject to finalization, however, current estimates indicate that the impact on income before income taxes of the July 1, 2004 to December 31, 2004 settlement will be approximately $0.5 million. We will record the above settlements when the plans are finalized in 2005.

      The State of Indiana has submitted a proposed state plan amendment and waiver pertaining to the fiscal year commencing July 1, 2003, which is awaiting review and approval by CMS. Since the plan amendment and waiver has not been approved, we have recorded revenues based upon amounts received. Approval of the retrospective amendment and waiver as submitted could result in the recording of incremental income before income taxes of $4.6 million in 2005 pertaining to the 18-month period ended December 31, 2004. There would be no impact to us if the plan were not approved. We anticipate that amendments will be made to the original plan submitted to CMS and cannot, therefore, predict the outcome of this plan submission or its impact on us and our results of operation. Based upon the final CMS approved state plan amendment and waiver, changes in Medicaid rates and any associated provider taxes could result in adjustments to income for the period from July 1, 2003 to December 31, 2004.

      Legislative and regulatory actions have resulted in continuing changes to Medicare and Medicaid reimbursement programs. Medicare and Medicaid reimbursement programs are complicated and constantly changing as CMS continues to refine its programs. There are considerable administrative costs incurred in monitoring the changes made within the programs, determining the appropriate actions to be taken to respond to those changes, and implementing the required actions to meet the new requirements and minimize the repercussions of the changes to our organization, reimbursement rates and costs. Examples of changes adopted by either CMS or certain states, which have impacted our industry, include:

	•	the repeal of the Boren Amendment federal payment standard for Medicaid payments, which required states to provide skilled nursing facilities with reasonable and adequate reimbursement rates to cover the costs of efficiently and economically operated healthcare facilities. As a result, budget constraints may cause states to reduce Medicaid reimbursement to skilled nursing facilities or delay payments to providers;
	•	the limitation of costs being reimbursed under Medicaid reimbursement programs when operators use a certain level of agency staffing, or incur leasing costs, which have an imputed lease interest cost greater than the current market rate;
	•	the establishment of a minimum occupancy requirement in certain Medicaid programs, which effectively reduces the eligible Medicaid reimbursement rate that a skilled nursing facility can receive; and
	•	an increasing number of states have adopted policies to discontinue the reimbursement of Part A co-insurance payments for dually eligible residents.

      The Medicare Prescription Drug, Improvement and Modernization Act of 2003 created Part D, a new drug benefit for Medicare beneficiaries, which will be implemented January 1, 2006. Although optional for individuals entitled to or enrolled in Medicare benefits under Part A or Part B, CMS will auto-enroll individuals who qualify for both Medicare and Medicaid, or dual-eligible individuals, into privately run

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      The cost of general and professional liability claims are significant and escalating in certain states, resulting in significant increases in insurance or the availability of insurance. The industry has experienced an increasing trend in the number and severity of litigation claims and punitive settlements. We believe that this trend is endemic to the long-term care industry and is a result of the increasing number of large judgments, including large punitive damage awards, against long-term care providers in recent years resulting in an increased awareness by plaintiff’s lawyers of potentially large recoveries. According to a report issued by AON Risk Consultants in June 2004 on long-term care operators’ general liability and professional liability costs, such costs are seven times higher in 2003, as compared to the early 1990’s. The average cost per bed for general liability and professional liability costs has increased from $310 in 1992, to $2,290 per bed in 2003. The average general and professional liability claim has more than doubled from $65,000 in 1992 to $149,000 in 2003, whereas the average number of claims per 1,000 beds has increased at an average annual rate of 13% from 4.8 in 1992 to 15.3 in 2003 in the long-term care industry. As a result, general and professional claim costs have absorbed a significant percentage of the average Medicaid reimbursement rate increase for the period 1992 through 2003. The States of Florida and Texas are the leaders where general and professional liability claims are being incurred; however, the States of Arkansas, California, Mississippi, Tennessee and Alabama are showing similar signs. Industry sources report the average cost of a claim in Florida in 2000 was three times higher than most of the rest of the United States. Florida healthcare providers experienced three times the number of claims that were experienced by providers in most other states. As a result of the litigious environment, insurance premiums for general and professional liability claims have increased, and in certain states coverage is unavailable to skilled nursing facility operators, since insurance companies have refrained from providing insurance.

      As a result of the adverse development of claims experienced by us and the industry in the states of Florida and Texas, we divested all of our nursing facility operations in these states by the end of December 2000 and September 2001, respectively. Exclusive of claims pertaining to our past operations in Florida and Texas, we are experiencing an increasing trend in the number and severity of litigation claims against us, but this has been within our projections and accrued accordingly. We continually review requests for medical records and claims by facility and by state, and use that information, along with operational performance measures, to assess whether we should dispose of additional facilities. At the present time, we have no significant divestiture plans.

      As of December 31, 2004, we have provided for $37.0 million in accruals for known or potential general and professional liability claims based on claims experience and an independent actuarial review; however, we may need to increase our accruals in excess of the amounts we have accrued as a result of future actuarial reviews and claims that may develop. An adverse determination in legal proceedings, whether currently asserted or arising in the future, could have a material adverse effect on our business. See the “Business — Insurance” section in this Annual Report on Form 10-K.

      The shortage of qualified registered nursing staff and other healthcare workers could adversely affect our ability to attract, train and retain qualified personnel and could increase operating costs. A national shortage of nurses and other trained personnel, and general inflationary pressures have forced us to enhance our wage and benefits packages in order to compete for qualified personnel. According to a survey by the American Healthcare Association, or AHCA, issued in February 2003, there were over 96,000 vacant positions in the long-term care sector, of which 39,000 were professional nursing staff and the remainder certified nursing assistants, or CNAs. The survey reported that average turnover within the industry was 50% with a 36% turnover rate for professional staff, and 71% turnover rate for CNAs. However, the report sited that these turnover and vacancy levels varied by state and location of the facility. Looking into the future, the shortage of

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      As a result of the shortage of nursing and healthcare workers, our average wage rate has increased above inflationary levels during the past few years. Wages increased by approximately 4.8% in 2004 over 2003, and 3.8% in 2003 over 2002. However overall wage costs, as a percentage of revenues, have been reduced due to the wage strategies that we have implemented particularly in 2003. In order to supplement staffing levels, we periodically are forced to utilize costly temporary help from staffing agencies, which results in wage premiums of 25% to 60%. We attempt to limit the use of temporary help from staffing agencies to maintain a higher quality of care. In 2004, we incurred temporary agency costs of $2.9 million compared to $3.4 million in 2003 and $10.2 million in 2002.

      We conduct our business in a heavily regulated industry and our failure to comply with laws and government regulation could lead to fines and penalties. We must comply with complex laws and regulations at the federal, state and local government levels relating to, among other things:

	•	licensure and certification;
	•	qualifications of healthcare and support personnel;
	•	maintenance of physical plant and equipment;
	•	staffing levels and quality of healthcare services;
	•	maintenance, confidentiality and security issues associated with medical records;
	•	relationships with physicians and referral sources;
	•	billing for services;
	•	operating policies and procedures; and
	•	additions or changes to facilities and services.

      There are ongoing initiatives at the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services. In addition, regulations and policies of regulatory agencies are subject to change. Aspects of some of these healthcare initiatives, such as the termination of Medicare funding improvements and limitations on Medicare coverage, other pressures to contain healthcare costs by Medicare, Medicaid and other payors, as well as increased operational requirements in the administration of Medicaid, could adversely affect our financial condition or our results of operations. Revisions to regulatory requirements, changes in scope and quality of care to residents and revisions to licensure and certification standards also could potentially have a material impact on us. In the future, different interpretations or enforcement of existing, new or amended laws and regulations could result in allegations of impropriety or illegality or could result in changes requiring capital expenditure programs and higher operating expenses.

      If we do not comply with applicable laws and regulations, then we could be subject to liabilities, including criminal penalties and civil penalties and exclusion of one or more of our facilities from participation in Medicare, Medicaid and other federal and state healthcare programs. If one of our facilities lost its certification under either the Medicare or Medicaid program, then it would have to cease future admissions and displace residents funded by the programs from the facility. In order to become re-certified, a facility must rectify all identified deficiencies and, over a specified period of time, pass a survey conducted by representatives of the respective program through demonstrated care and operations for residents in the facility. Until the appropriate agency has verified through the “reasonable assurance” process that the facility can achieve and maintain substantial compliance with all applicable participation requirements, the facility will not be admitted back into either the Medicare or Medicaid programs. Medicare and Medicaid re-certification processes, while similar, are conducted separately. Re-certification requires considerable staff resources. The

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      In August 2004, we transferred the operations of a nursing facility (336 beds) in Chippewa Falls, Wisconsin to Lakeside Health L.L.C., or Lakeside Health, a subsidiary of Benedictine Health Dimensions, Inc., or Benedictine, for a term of three years. The transfer of operations was in response to facility citations for survey deficiencies and an agreement with the State of Wisconsin to transfer the operations to a new licensee.

      If we do not achieve and maintain competitive quality of care ratings from CMS our business may be negatively affected. CMS provides comparative data available to the public on its website rating every nursing facility operating in each state based upon nine quality of care indicators. These quality of care indicators include such measures as percentages of patients with infections, bedsores and unplanned weight loss. We currently monitor the comparative data posted on the website to respond to potential consumers should questions arise. If we are unable to achieve quality of care ratings that are comparable or superior to those of our competitors, our ability to attract and retain patients could be affected and, as a result, our occupancy levels could decline.

      Changes in the case mix of residents, the mix of residents by payor type and payment methodologies may significantly affect our profitability. The sources and amounts of our resident revenues will be determined by a number of factors, including licensed bed capacity and occupancy rates of our nursing facilities, average length of stay of our residents, the mix of residents by payor type (for example, Medicare versus Medicaid or private), and, within the Medicare and certain Medicaid programs, the distribution of residents assessed within the RUGs. Changes that increase the percentage of Medicaid residents within our facilities can have a material adverse effect on our financial operations, especially in states whose reimbursement levels are below the cost of providing care.

      If we fail to cultivate new or maintain existing relationships with the physicians in the communities in which we operate, our patient base may decrease. Our success depends in part upon the admissions and referral practices of the physicians in the communities in which we operate and our ability to cultivate and maintain relationships with these physicians. Physicians referring patients to our facilities are not our employees and are free to refer their patients to other providers. If we are unable to successfully cultivate and maintain strong relationships with these physicians, our patient population may decline.

      We face national, regional and local competition. Our nursing and assisted living facilities compete on a local and regional basis with other long-term care providers. The number of competing centers in the local market, the types of services available, quality of care, reputation, age and appearance of each center and the cost of care in each locality all affect our ability to compete successfully. The availability and quality of competing facilities significantly influence occupancy levels in assisted living facilities. There are relatively few barriers to entry in the assisted living industry and, therefore, future development of assisted living facilities in the markets we serve could limit our ability to attract and retain residents, to maintain or increase resident service fees or to expand our business. See the “Business — Competition” section in this Annual Report on Form 10-K.

      State efforts to regulate the construction or expansion of healthcare providers could impair our ability to expand through construction and redevelopment. Most of the states in which we currently operate have adopted laws to regulate expansion of nursing facilities. Certificate of need laws generally require that a state agency approve certain acquisitions or physical plant changes and determine that a need exists prior to the addition of beds or services, the implementation of the physical plant changes or the incurrence of capital expenditures exceeding a prescribed amount. Some states also prohibit, restrict or delay the issuance of certificates of need. Many states have established similar certificate of need processes to regulate the expansion of assisted living facilities.

      If certificates of need or other similar approvals are required in order to expand our operations, our failure or inability to obtain the necessary approvals, changes in the standards applicable to such approvals and

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      Many states in which we operate have implemented moratoriums on the granting of licenses for any additional nursing facility beds. In these states we may only expand by acquiring existing operations and licensure rights from other nursing care providers. We cannot guarantee that we will be able to find acceptable acquisition targets in these states and, as a result, we may not be able to expand in these states.

      We face periodic reviews, audits and investigations under our contracts with federal and state government agencies, and these audits could have adverse findings that may negatively impact our business. As a result of our participation in the Medicare and Medicaid programs, we are subject to various governmental reviews, audits and investigations to verify our compliance with these programs and applicable laws and regulations. Private pay sources also reserve the right to conduct audits. An adverse review, audit or investigation could result in:

	•	refunding amounts we have been paid pursuant to the Medicare or Medicaid programs or from private payors;
	•	state or federal agencies imposing fines, penalties and other sanctions on us;
	•	loss of our right to participate in the Medicare or Medicaid programs or one or more private payor networks; or
	•	damages to our reputation in various markets.

      Both federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare companies and, in particular, skilled nursing facilities. The focus of these investigations includes:

	•	cost reporting and billing practices;
	•	quality of care;
	•	financial relationships with referral sources; and
	•	medical necessity of services provided.

      We also are subject to potential lawsuits under a federal whistleblower statute designed to combat fraud and abuse in the healthcare industry. These lawsuits can involve significant monetary and award bounties to private plaintiffs who successfully bring these suits.

      We are required to comply with laws governing the transmission and privacy of health information. The Health Insurance Portability and Accountability Act of 1996, or HIPAA, requires us to comply with standards relating to the privacy of protected health information, the exchange of health information within our company and with third parties and protect the confidentiality and security of electronic protected health information. The privacy standards became effective in April 2003, and we believe we are currently in compliance with these standards. The standards for electronic data transactions and code sets became effective in October 2003. We have implemented the new transaction and code sets with all fiscal intermediaries and the states that are currently ready to accept them. We believe we are in compliance with the transaction and code sets standards. Compliance for the standard governing the security of health information is required by April 21, 2005.

      We established a HIPAA task force consisting of clinical, legal, financial and information services professionals to monitor our implementation of and compliance with the HIPAA standards. At this time, we believe we comply with the HIPAA privacy and transactions and code set standards and continue to implement procedures to comply with the security standards. Our ability to comply with the transactions standards and security standards are in part, dependent upon other third parties, including the fiscal intermediaries and state program providers also complying with the HIPAA requirements and timetables. Should it be determined that we have not complied with the new standards, we could be subject to criminal

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      We may make acquisitions and undertake management and consulting contracts that could subject us to a number of operating risks. We anticipate that we may continue to make acquisitions of, investments in, and strategic alliances with, complementary businesses which will enable us to provide additional services for our customer base and for adjacent markets, and to expand each of our businesses geographically. In addition, we may undertake management and consulting service arrangements with other organizations. Implementation of these strategies entails a number of risks including:

	•	inaccurate assessment of undisclosed liabilities;
	•	entry into markets in which we may have limited or no experience;
	•	diversion of management’s attention from our existing core business;
	•	difficulties in assimilating the acquired business or in realizing projected efficiencies and cost savings; and
	•	increasing our indebtedness and limiting our ability to access additional capital when needed.

Additionally, certain changes to our existing operation may be necessary to integrate the acquired businesses, to assimilate new employees and to implement reporting, monitoring, compliance and forecasting procedures.

      On January 31, 2005, we completed our acquisition of ALC for a total of approximately $285 million, including the assumption of ALC’s existing debt of $141 million. Prior to the completion of the acquisition, we conducted a due diligence review to ascertain the risks associated in the acquisition. Though we believe these due diligence efforts identified and correctly quantified those risks, by virtue of this acquisition we assume all current and former financial, legal, regulatory and environmental risks associated with ALC by virtue of this acquisition. In addition, there are risks associated with the integration of ALC within our company. During the integration process, there will be considerable resources deployed which may divert our attention from other portions of our operations. The integration may result in changes in senior and middle management personnel at ALC, and changes or modifications to the accounting systems, information software and hardware, and other business processes. Those risks c