KINDRED HEALTHCARE INC - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2004

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

For the transition period from to .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)


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

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

(502) 596-7300

(Registrant’s telephone number, including area code)

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

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

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

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


Class of Common Stock		Outstanding at April 30, 2004
Common stock, $0.25 par value		18,189,328 shares

1 of 39

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX


		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements:
	Condensed Consolidated Statement of Operations — for the three months ended March 31, 2004 and 2003	3

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

	Condensed Consolidated Statement of Cash Flows — for the three months ended March 31, 2004 and 2003	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34

Item 4.	Controls and Procedures	34

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	36

Item 6.	Exhibits and Reports on Form 8-K	38

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended March 31,
	2004			2003

Revenues	$	871,262		$	802,158

Salaries, wages and benefits		492,071			460,752
Supplies		116,733			104,182
Rent		64,459			63,078
Other operating expenses		145,406			146,839
Depreciation		22,046			19,195
Interest expense		3,656			2,888
Investment income		(1,218	)		(1,635	)

		843,153			795,299

Income from continuing operations before income taxes		28,109			6,859
Provision for income taxes		11,834			4,348

Income from continuing operations		16,275			2,511
Loss from discontinued operations, net of income taxes		(2,435	)		(15,635	)

Net income (loss)	$	13,840		$	(13,124	)

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.46		$	0.07
Loss from discontinued operations		(0.07	)		(0.45	)

Net income (loss)	$	0.39		$	(0.38	)


Diluted:
Income from continuing operations	$	0.38		$	0.07
Loss from discontinued operations		(0.06	)		(0.45	)

Net income (loss)	$	0.32		$	(0.38	)


Shares used in computing earnings (loss) per common share:
Basic		35,414			34,755
Diluted		42,721			34,767

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	March 31, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	17,827		$	66,524
Cash – restricted		7,864			7,339
Insurance subsidiary investments		175,710			146,325
Accounts receivable less allowance for loss of $94,160 – March 31 and $93,403 – December 31		475,238			429,304
Inventories		31,135			29,984
Deferred tax assets		89,836			89,836
Assets held for sale		27,360			27,400
Other		54,455			46,375

		879,425			843,087

Property and equipment		688,959			671,850
Accumulated depreciation		(212,963	)		(193,310	)

		475,996			478,540

Goodwill		31,417			31,417
Insurance subsidiary investments		66,157			74,618
Deferred tax assets		91,991			92,093
Other		63,066			65,659

	$	1,608,052		$	1,585,414

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	119,057		$	119,087
Salaries, wages and other compensation		207,004			214,113
Due to third party payors		27,669			31,406
Professional liability risks		71,140			83,725
Other accrued liabilities		83,938			88,333
Income taxes		46,356			36,684
Long-term debt due within one year		4,729			4,532

		559,893			577,880

Long-term debt		154,708			139,397
Professional liability risks		220,714			212,013
Deferred credits and other liabilities		58,974			58,559

Commitments and contingencies

Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 36,369 shares – March 31 and 36,340 shares – December 31		9,092			9,085
Capital in excess of par value		585,853			585,394
Deferred compensation		(6,296	)		(8,040	)
Accumulated other comprehensive income		496			348
Retained earnings		24,618			10,778

		613,763			597,565

	$	1,608,052		$	1,585,414

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended March 31,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	13,840		$	(13,124	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation		22,046			20,083
Amortization of deferred compensation costs		1,743			1,253
Provision for doubtful accounts		8,116			6,288
Other		(102	)		506
Change in operating assets and liabilities:
Accounts receivable		(54,304	)		(53,316	)
Inventories and other assets		(9,468	)		(6,387	)
Accounts payable		(3,184	)		(2,998	)
Income taxes		9,912			(5,457	)
Due to third party payors		(3,737	)		3,551
Other accrued liabilities		(9,062	)		27,935

Net cash used in operating activities		(24,200	)		(21,666	)

Cash flows from investing activities:
Purchase of property and equipment		(17,881	)		(10,565	)
Purchase of insurance subsidiary investments		(9,776	)		(30,395	)
Sale of insurance subsidiary investments		5,672			2,333
Net change in insurance subsidiary cash and cash equivalents		(16,820	)		(71,911	)
Net change in other investments		1,777			(4,685	)
Other		508			(333	)

Net cash used in investing activities		(36,520	)		(115,556	)

Cash flows from financing activities:
Net change in revolving credit borrowings		16,900			–
Repayment of long-term debt		(1,032	)		(112	)
Payment of deferred financing costs		–			(1,596	)
Issuance of common stock		467			–
Other		(4,312	)		(4,967	)

Net cash provided by (used in) financing activities		12,023			(6,675	)

Change in cash and cash equivalents		(48,697	)		(143,897	)
Cash and cash equivalents at beginning of period		66,524			244,070

Cash and cash equivalents at end of period	$	17,827		$	100,173

Supplemental information:
Interest payments	$	3,272		$	2,835
Income tax payments		398			18

See accompanying notes.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. (“Kindred” or the “Company”) is a healthcare services company that operates hospitals, nursing centers, institutional pharmacies and a contract rehabilitation services business. At March 31, 2004, the Company’s hospital division operated 68 hospitals in 23 states. The Company’s health services division operated 254 nursing centers in 30 states. The Company’s pharmacy division operated an institutional pharmacy business with 30 pharmacies in 19 states. The Company also operated a contract rehabilitation services business which began operating as a separate division on January 1, 2004.

During 2003, the Company effected certain strategic transactions to improve its future operating results. These transactions included the divestiture of all of its Florida and Texas nursing center operations, the acquisition for resale of eight additional nursing centers and two hospitals formerly leased from Ventas, Inc. (“Ventas”) and certain other dispositions and contract terminations. For accounting purposes, the operating results of these businesses and the losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at March 31, 2004 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 2 for a summary of discontinued operations.

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

Stock Split

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

Impact of Recent Accounting Pronouncements

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Stock Option Accounting

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

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


	Three months ended March 31,
	2004			2003
Net income (loss)	$	13,840		$	(13,124	)
Adjustments:
Stock-based compensation expense included in reported net income (loss)		1,743			1,253
Stock-based compensation expense determined under fair value based method		(3,786	)		(2,511	)

Pro forma net income (loss)	$	11,797		$	(14,382	)

Earnings (loss) per common share:
As reported:
Basic	$	0.39		$	(0.38	)
Diluted	$	0.32		$	(0.38	)
Pro forma:
Basic	$	0.33		$	(0.41	)
Diluted	$	0.27		$	(0.41	)

Comprehensive income

The following table sets forth the computation of comprehensive income (loss) for the three months ended March 31, 2004 and 2003 (in thousands):


	Three months ended March 31,
	2004		2003
Net income (loss)	$	13,840	$	(13,124	)
Net unrealized investment gains (losses), net of taxes		148		(147	)

Comprehensive income (loss)	$	13,988	$	(13,271	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Other information

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

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the Company’s customary accounting practices. Management believes that financial information included herein reflects all adjustments necessary for a fair presentation of interim results and, except for the item discussed in Note 3, all such adjustments are of a normal and recurring nature.

Reclassifications

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

NOTE 2 – DISCONTINUED OPERATIONS

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the divestitures discussed in Note 1 have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the losses related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. Assets and liabilities not sold at March 31, 2004 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet.

A summary of discontinued operations follows (in thousands):


	Three months ended March 31,
	2004			2003
Revenues	$	15,229		$	63,251

Salaries, wages and benefits		12,021			40,559
Supplies		802			5,914
Rent		284			5,314
Other operating expenses		6,307			36,001
Depreciation		–			888
Investment income		(226	)		(3	)

		19,188			88,673

Loss from operations before income taxes		(3,959	)		(25,422	)
Income tax benefit		(1,524	)		(9,787	)

Loss from operations	$	(2,435	)	$	(15,635	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

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


	Three months ended March 31,
	2004			2003
Revenues:
Hospital division:
Hospitals	$	2,231		$	8,993
Ancillary services		(91	)		1,760

		2,140			10,753

Health services division		13,121			49,726

Pharmacy division		(32	)		2,772

	$	15,229		$	63,251

Operating income (loss):
Hospital division:
Hospitals	$	(2,146	)	$	(234	)
Ancillary services		(186	)		180

		(2,332	)		(54	)

Health services division		(1,642	)		(19,369	)

Pharmacy division		73			200

	$	(3,901	)	$	(19,223	)

Rent:
Hospital division:
Hospitals	$	57		$	920
Ancillary services		(5	)		201

		52			1,121

Health services division		188			4,098

Pharmacy division		44			95

	$	284		$	5,314

Depreciation:
Hospital division:
Hospitals	$	–		$	201
Ancillary services		–			119

		–			320

Health services division		–			554

Pharmacy division		–			14

	$	–		$	888

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

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


	March 31, 2004			December 31, 2003
Current assets:
Property and equipment, net	$	26,912		$	26,912
Other		448			488

		27,360			27,400
Current liabilities (included in other accrued liabilities)		(1,167	)		(1,439	)

	$	26,193		$	25,961

NOTE 3 – REVENUES

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

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


	Three months ended March 31,
	2004			2003
Medicare	$	391,284		$	333,646
Medicaid		267,798			259,066
Private and other		267,005			224,610

		926,087			817,322
Eliminations:
Pharmacy		(18,136	)		(15,164	)
Rehabilitation		(36,689	)		–

		(54,825	)		(15,164	)

	$	871,262		$	802,158

In the first quarter of 2004, the Company recorded income of approximately $2 million related to settlements of prior year hospital Medicare cost reports.

NOTE 4 – EARNINGS PER SHARE

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

Share and per share data for all periods presented have been adjusted retroactively to reflect a 2-for-1 stock split (in the form of a 100% stock dividend) declared by the Board of Directors on April 26, 2004.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – EARNINGS PER SHARE (Continued)

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


	Three months ended March 31,
	2004			2003
Earnings (loss):
Income from continuing operations	$	16,275		$	2,511
Loss from discontinued operations, net of income taxes		(2,435	)		(15,635	)

Net income (loss)	$	13,840		$	(13,124	)

Shares used in the computation:
Weighted average shares outstanding – basic computation		35,414			34,755
Dilutive effect of warrants, stock options and non-vested restricted stock		7,307			12

Adjusted weighted average shares outstanding – diluted computation		42,721			34,767

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.46		$	0.07
Loss from discontinued operations		(0.07	)		(0.45	)

Net income (loss)	$	0.39		$	(0.38	)

Diluted:
Income from continuing operations	$	0.38		$	0.07
Loss from discontinued operations		(0.06	)		(0.45	)

Net income (loss)	$	0.32		$	(0.38	)

NOTE 5 – BUSINESS SEGMENT DATA

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

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

The Company identifies its segments in accordance with the aggregation provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This information is consistent with information used by the Company in managing its businesses and aggregates businesses with similar economic characteristics. The information provided in Note 5 should be read in conjunction with the discussion and analysis contained in “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – BUSINESS SEGMENT DATA (Continued)

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


	Three months ended March 31,
	2004			2003
Revenues:
Hospital division	$	348,648		$	331,862
Health services division		444,994			410,832
Rehabilitation division		52,699			8,502
Pharmacy division		79,746			66,126

		926,087			817,322
Eliminations:
Pharmacy		(18,136	)		(15,164	)
Rehabilitation		(36,689	)		–

		(54,825	)		(15,164	)

	$	871,262		$	802,158

Income from continuing operations:
Operating income (loss):
Hospital division	$	80,066		$	70,538
Health services division		49,469			43,424
Rehabilitation division		8,519			(959	)
Pharmacy division		7,609			6,702
Corporate:
Overhead		(26,834	)		(26,713	)
Insurance subsidiary		(1,777	)		(2,607	)

		(28,611	)		(29,320	)

Operating income		117,052			90,385
Rent		(64,459	)		(63,078	)
Depreciation		(22,046	)		(19,195	)
Interest, net		(2,438	)		(1,253	)

Income from continuing operations before income taxes		28,109			6,859
Provision for income taxes		11,834			4,348

	$	16,275		$	2,511

Rent:
Hospital division	$	22,844		$	23,284
Health services division		40,283			39,031
Rehabilitation division		611			69
Pharmacy division		662			630
Corporate		59			64

	$	64,459		$	63,078

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – BUSINESS SEGMENT DATA (Continued)


	Three months ended March 31,
	2004		2003
Depreciation:
Hospital division	$	8,464	$	7,054
Health services division		6,893		6,373
Rehabilitation division		33		16
Pharmacy division		530		517
Corporate		6,126		5,235

	$	22,046	$	19,195

Capital expenditures (including discontinued operations):
Hospital division	$	5,406	$	2,822
Health services division		8,450		3,222
Rehabilitation division		47		51
Pharmacy division		773		616
Corporate:
Information systems		2,651		3,207
Other		554		647

	$	17,881	$	10,565


	March 31, 2004		December 31, 2003
Assets at end of period:
Hospital division	$	544,086	$	526,029
Health services division		403,339		379,435
Rehabilitation division		9,340		8,009
Pharmacy division		47,133		43,198
Corporate		604,154		628,743

	$	1,608,052	$	1,585,414

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – INSURANCE RISKS

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

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

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


	Three months ended March 31,
	2004		2003
Professional liability:
Continuing operations	$	22,921	$	30,812
Discontinued operations		1,368		23,153

Workers compensation:
Continuing operations	$	12,569	$	11,751
Discontinued operations		533		1,470

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


	March 31, 2004						December 31, 2003
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	109,322	$	66,388	$	175,710	$	93,989	$	52,336	$	146,325
Reinsurance recoverables		991		–		991		896		–		896

		110,313		66,388		176,701		94,885		52,336		147,221
Non-current:
Insurance subsidiary investments		66,157		–		66,157		74,618		–		74,618
Reinsurance recoverables		5,245		–		5,245		5,858		–		5,858
Deposits		6,250		2,228		8,478		7,250		2,222		9,472
Other		8		16		24		9		35		44

		77,660		2,244		79,904		87,735		2,257		89,992

	$	187,973	$	68,632	$	256,605	$	182,620	$	54,593	$	237,213

Liabilities:
Allowance for insurance risks:
Current	$	71,140	$	16,408	$	87,548	$	83,725	$	14,248	$	97,973
Non-current		220,714		49,909		270,623		212,013		49,463		261,476

	$	291,854	$	66,317	$	358,171	$	295,738	$	63,711	$	359,449

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – INSURANCE RISKS (Continued)

Provisions for loss for professional liability risks retained by the Company’s limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $308 million at March 31, 2004 and $311 million at December 31, 2003.

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

NOTE 7 – CONTINGENCIES

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

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

Principal contingencies are described below:

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

Professional liability risks–The Company has provided for loss for professional liability risks based upon actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Note 6.

Guarantees of indebtedness–Letters of credit and guarantees of indebtedness approximated $7 million at March 31, 2004.

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

Litigation–The Company is a party to certain material litigation and regulatory actions as well as various suits and claims arising in the ordinary course of business. See Note 8.

Ventas indemnification–On May 1, 1998, Ventas completed the spin-off of its healthcare operations to its shareholders through the distribution of the Company’s former common stock (the “Spin-off”). In connection with the Spin-off, liabilities arising from various legal proceedings and other actions were assumed by the Company and the Company agreed to indemnify Ventas against any losses, including any costs or expenses, it may incur arising out of or in connection with such legal proceedings and other actions. The indemnification provided by the Company also covers losses, including costs and expenses, which may arise from any future claims asserted against Ventas based on the former healthcare operations of Ventas. In connection with the Company’s indemnification obligation, the Company assumed the defense of various legal proceedings and other actions. The Company also has agreed to hold Ventas harmless from all claims

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – CONTINGENCIES (Continued)

against Ventas arising from third party leases and guarantee arrangements entered into before the Spin-off. Under the Plan of Reorganization, the Company agreed to continue to fulfill the Company’s indemnification obligations arising from the Spin-off.

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

NOTE 8 – LITIGATION

Summary descriptions of various significant legal and regulatory activities follow.

A shareholder derivative suit entitled Thomas G. White on behalf of Vencor, Inc. and Ventas, Inc. v. W. Bruce Lunsford, et al., Case No. 98CI03669, was filed on July 2, 1998 in the Jefferson County, Kentucky, Circuit Court. The suit was brought on behalf of the Company and Ventas against certain former executive officers and directors of the Company and Ventas. The complaint alleges that the defendants damaged the Company and Ventas by engaging in violations of the securities laws, engaging in insider trading, fraud and securities fraud and damaging the reputation of the Company and Ventas. The plaintiff asserts that such actions were taken deliberately, in bad faith and constitute breaches of the defendants’ duties of loyalty and due care. The complaint alleges that certain of the Company’s and Ventas’s former executive officers during a specified time frame violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), by, among other things, issuing to the investing public a series of false and misleading statements concerning Ventas’s then current operations and the inherent value of its common stock. The complaint further alleges that as a result of these purported false and misleading statements concerning Ventas’s revenues and successful acquisitions, the price of its common stock was artificially inflated. In particular, the complaint alleges that the defendants issued false and misleading financial statements during the first, second and third calendar quarters of 1997 which misrepresented and understated the impact that changes in Medicare reimbursement policies would have on Ventas’s core services and profitability. The complaint further alleges that the defendants issued a series of materially false statements concerning the purportedly successful integration of Ventas’s acquisitions and prospective earnings per share for 1997 and 1998, which the defendants knew lacked any reasonable basis and were not being achieved. The suit seeks unspecified damages, interest, punitive damages, reasonable attorneys’ fees, expert witness fees and other costs, and any extraordinary equitable and/or injunctive relief permitted by law or equity to assure that the Company and Ventas have an effective remedy. In October 2002, the defendants filed a motion to dismiss for failure to prosecute the case. The court granted the motion to dismiss but the plaintiff subsequently moved the court to vacate the dismissal. The defendants filed an opposition to the plaintiff’s motion to vacate the dismissal, but in August 2003 the court reinstated the lawsuit. In September 2003, the Company filed a renewed motion to dismiss, as to all defendants, based on the plaintiff’s failure to make a demand for remedy upon the appropriate board of directors. The Company also has argued that it is an improper party to this lawsuit. In March 2004, the judge who had been presiding over this lawsuit recused himself because of a possible conflict of interest. The case was then assigned to another judge, who has not yet ruled on the renewed motion to dismiss. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – LITIGATION (Continued)

the Western District of Kentucky, Louisville Division. The complaint alleges that from August 14, 2001 to October 10, 2002 the defendants violated Sections 10(b) and 20(a) of the Exchange Act by, among other things, issuing to the investing public a series of allegedly false and misleading statements that inaccurately indicated that the Company was successfully emerging from bankruptcy and implementing a growth plan. In particular, the complaint alleges that these statements were materially false and misleading because they failed to disclose that the 2001 Florida tort reform legislation had resulted in a marked increase in claims against the Company in Florida, and also because the statements reflected a materially understated reserve for professional liability costs. The complaint further alleges that as a result of the purportedly false and misleading statements, the price of the Company’s common stock was artificially inflated, the investing public was deceptively induced to purchase the stock at those inflated prices, and the defendants profited by selling shares at those prices. The suit seeks an unspecified amount of monetary damages plus interest, reasonable attorneys’ fees and other costs, and any other equitable, injunctive or other relief that the court deems just and proper. After October 16, 2002, several other purported class action complaints, which assert essentially similar allegations as those contained in the Massachusetts State Carpenters Pension Fund complaint discussed above, also were filed against the same defendants in the United States District Court for the Western District of Kentucky, Louisville Division, including but not limited to the cases entitled Mark Ramsdell v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-625-R; Paula Hillenbrand v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-654-R; Marilyn Buck v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-732-S; and Eastside Holdings Ltd. v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-617-H. All of these actions were consolidated by the District Court. In May 2003, the defendants filed a motion to dismiss the consolidated lawsuits, and on January 9, 2004, the District Court granted that motion with prejudice. The plaintiffs did not appeal the District Court’s dismissal, which became final on February 12, 2004 when the appeal period expired.

Three shareholder derivative suits entitled Elizabeth Sommerfeld v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 08476; Ilse Denchfield v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 09475; and Fedorka v. Edward L. Kuntz, et al., Civil Action No. 03 CI 02015, were filed in November 2002, December 2002 and March 2003, respectively, in the Jefferson Circuit Court in Kentucky. In May 2003, the Fedorka plaintiffs voluntarily dismissed their state court derivative lawsuit and refiled that lawsuit in the United States District Court for the Western District of Kentucky, Louisville Division, Civil Action No. 3:03CV-272-S. On May 14, 2003, a separate but nearly identical derivative lawsuit, Tin Win v. Edward L. Kuntz, et al., Civil Action No. 3:03CV-292-J, also was filed in the United States District Court for the Western District of Kentucky, Louisville Division. On May 12, 2003, the Jefferson Circuit Court entered an order consolidating the Sommerfeld and Denchfield derivative actions and staying all proceedings in the consolidated derivative action pending the U.S. District Court’s ruling on the defendants’ motion to dismiss the consolidated putative class action. On July 24, 2003, the District Court entered a similar order concerning the Fedorka and Win derivative actions. The federal and state derivative complaints, which recite purported facts substantially similar to those set forth in the Massachusetts State Carpenters Pension Fund putative class action and the other securities fraud class actions discussed above, attempt to assert a claim against the individual defendants for breach of fiduciary duties for insider selling and misappropriation of information. Specifically, the complaints allege that each of the individual defendants knew that the price of the Company’s common stock would dramatically decrease when the Company’s inadequate reserves for professional liability risks were disclosed and that the individual defendants’ sales of the Company’s common stock with knowledge of this material non-public information constituted a breach of their fiduciary duties of loyalty and good faith. The suits seek to impose a constructive trust in favor of the Company for the amount of profits each of the individual defendants or their firms may have received from their November 2001 sales of the Company’s common stock, as well as attorneys’ fees and other expenses. The Company believes that the allegations in the complaints are without merit and intends to defend these actions vigorously.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – LITIGATION (Continued)

The Company was previously informed by the Kentucky Attorney General’s Office that the Company and certain of its present and former officers and employees are the subject of several investigations into care issues at the Company’s Kentucky-based nursing facilities that could lead to civil and/or criminal charges against the Company and/or the individual officers and employees. Subsequently, the Company was informed that the Kentucky Attorney General’s Office had transferred these investigations to the Fayette County, Kentucky prosecutor as a special prosecutor with statewide jurisdiction. On February 10, 2004, the Company announced a civil settlement with the Kentucky Attorney General’s Office to resolve all issues associated with these investigations on terms which were not material to the Company’s consolidated financial results.

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

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

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

Cautionary Statement

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

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

•

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

•

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

•

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

•

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

•

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

•

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

•

changes in the reimbursement rates or methods of payment from third party payors, including the Medicare and Medicaid programs, and changes arising from the Medicare prospective payment system for long-term acute care hospitals and the recently enacted Medicare Prescription Drug, Improvement, and Modernization Act of 2003,

•

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

•

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

•

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

•

the Company’s ability to integrate operations of acquired facilities,

•

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

•

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

•

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

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

RESULTS OF OPERATIONS (Continued)

Cautionary Statement (Continued)

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

General

The business segment data in Note 5 of the accompanying Notes to Condensed Consolidated Financial Statements should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that operates hospitals, nursing centers, institutional pharmacies and a contract rehabilitation services business. At March 31, 2004, the Company’s hospital division operated 68 hospitals (5,323 licensed beds) in 23 states. The Company’s health services division operated 254 nursing centers (32,812 licensed beds) in 30 states. The Company’s pharmacy division operated an institutional pharmacy business with 30 pharmacies in 19 states. The Company also operated a contract rehabilitation services business which began operating as a separate division on January 1, 2004.

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

During 2003, the Company effected certain strategic transactions to improve its future operating results. These transactions included the divestiture of all of its Florida and Texas nursing center operations, the acquisition for resale of eight additional nursing centers and two hospitals formerly leased from Ventas and certain other dispositions and contract terminations. For accounting purposes, the operating results of these businesses and the losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at March 31, 2004 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 2 of the accompanying Notes to Condensed Consolidated Financial Statements for a summary of discontinued operations.

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

Critical Accounting Policies

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

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

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Revenue recognition

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

In the first quarter of 2004, the Company recorded income of approximately $2 million related to settlements of prior year hospital Medicare cost reports. See Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements.

Collectibility of accounts receivable

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

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

The provision for doubtful accounts totaled $8 million and $5 million for the three months ended March 31, 2004 and 2003, respectively.

Allowances for insurance risks

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

professional liability risks recorded in the accompanying unaudited condensed consolidated financial statements aggregated $292 million at March 31, 2004 and $296 million at December 31, 2003. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $308 million at March 31, 2004 and $311 million at December 31, 2003.

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

Changes in the number of professional liability claims and the increasing cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and ultimate actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at March 31, 2004 would impact the Company’s operating income by approximately $3 million.

The provision for professional liability risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $23 million and $31 million for the three months ended March 31, 2004 and 2003, respectively. While the Company expects that professional liability costs for 2004 may be higher than the costs recorded in 2003, management believes that the annual growth rates for professional liability costs appear to be moderating.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $66 million at March 31, 2004 and $64 million at December 31, 2003. The provision for loss for workers compensation risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $12 million for both the three months ended March 31, 2004 and 2003.

See Note 6 of the accompanying Notes to Condensed Consolidated Financial Statements.

Accounting for income taxes

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

There are significant uncertainties with respect to professional liability costs and future government payments to both the Company’s hospitals and nursing centers which could affect materially the realization of

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Accounting for income taxes (Continued)

certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized. A valuation allowance is provided for deferred tax assets to the extent the realizability of the deferred tax assets is uncertain. The Company recognized deferred tax assets totaling $182 million at March 31, 2004 and December 31, 2003.

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

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

Valuation of long-lived assets and goodwill

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

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

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

Results of Operations – Continuing Operations

Hospital Division

Revenues increased 5% to $348 million in the first quarter of 2004 from $332 million in the same period a year ago, primarily as a result of growth in admissions and new hospital development. On a same-store basis, revenues increased 3% compared to the same period a year ago.

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Hospital Division (Continued)

Admissions rose 6% in the first quarter of 2004 compared to the same period a year ago, while patient days declined 6% in the first quarter of 2004 compared to the same period last year. Average length of stay declined to 32 days in the first quarter of 2004 compared to 36 days in the same period a year ago. On a same-store basis, admissions rose 5% in the first quarter of 2004 compared to the same period a year ago, while patient days declined 7% in the first quarter of 2004 compared to the same period a year ago.

Hospital operating income rose 14% to $80 million in the first quarter of 2004 from $70 million in the same period a year ago. Operating margins were 23.0% in the first quarter of 2004 compared to 21.3% in the first quarter of 2003.

Growth in hospital operating income was primarily attributable to growth in admissions, improved labor cost efficiencies and a $2 million favorable Medicare cost report settlement in the first quarter of 2004. Wage and benefit costs (including contract labor) increased 2% to $173 million in the first quarter of 2004 from $169 million in the same period a year ago. Average wage rates rose 3% in the first quarter of 2004 compared to the same period last year, while contract labor costs of $7 million in the first quarter of 2004 were relatively unchanged from the same period a year ago.

Professional liability costs were $6 million in the first quarter of 2004 compared to $7 million in the same period a year ago.

Health Services Division

Revenues increased 8% to $445 million in the first quarter of 2004 compared to $411 million in the same period a year ago. Patient days on both a reported and same-store basis were relatively unchanged in the first quarter of 2004 compared to the first quarter of 2003. Medicare census increased 9% in the first quarter of 2004 compared to the same period a year ago, while Medicaid and private census both declined 1% in the first quarter of 2004 compared to the same period a year ago.

Aggregate revenues per patient day increased 8% in the first quarter of 2004 compared to the same period in 2003. Medicare rates grew 10% in the first quarter of 2004 compared to the same period last year primarily as a result of rate adjustments that became effective on October 1, 2003. Medicaid and private rates both grew 4% in the first quarter of 2004 compared to the same period a year ago.

Nursing center operating income increased 14% to $49 million in the first quarter of 2004 compared to $43 million in the first quarter of 2003. Operating margins increased to 11.1% in the first quarter of 2004 compared to 10.6% in the first quarter of 2003.

In connection with the Rehabilitation Services Reorganization, the Company transferred approximately 4,000 employees from its nursing centers to the new rehabilitation division. As a result, nursing center wage and benefit costs (including contract labor) declined 3% to $242 million in the first quarter of 2004 compared to $251 million for the same period a year ago. In addition, average hourly wage rates declined 1% in the first quarter of 2004 compared to the same period a year ago, while employee benefit costs declined 3% for the same time period. Intercompany charges for rehabilitation services provided by the rehabilitation division to the Company’s nursing centers in the first quarter of 2004 totaled $37 million.

Professional liability costs totaled $17 million in the first quarter of 2004 compared to $24 million for the same period a year ago. In the first quarter of 2003, the Company recorded approximately $7 million of

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Health Services Division (Continued)

additional professional liability costs in its nursing center business related to changes in estimates of prior year costs.

Rehabilitation Division

Revenues increased to $53 million in the first quarter of 2004 (of which approximately $16 million related to the Company’s non-affiliated customers) from $8 million for the same period a year ago, while operating income totaled $9 million in the first quarter of 2004 compared to operating losses of $1 million in the first quarter of 2003. The increase in revenues and operating income in the first quarter of 2004 was primarily attributable to the Rehabilitation Services Reorganization. Intercompany revenues for services provided to the Company’s nursing centers totaled $37 million in the first quarter of 2004.

Pharmacy Division

Revenues increased 21% to $80 million in the first quarter of 2004 compared to $66 million for the first quarter a year ago. The increased revenues resulted primarily from price increases, increased utilization of higher priced drugs and the growth in the number of non-affiliated customers. At March 31, 2004, the Company provided pharmacy services to nursing facilities containing 63,300 licensed beds, including 28,200 licensed beds that it operates. At March 31, 2003, the Company provided pharmacy services to nursing facilities containing 58,200 licensed beds, including 29,800 licensed beds that it operates.

Pharmacy operating income totaled $8 million in the first quarter of 2004 compared to $7 million in the same period a year ago. Operating margins were 9.5% in the first quarter of 2004 compared to 10.1% for the same period a year ago. The cost of goods sold as a percentage of revenues rose to 64.7% in the first quarter of 2004 compared to 62.4% for the same period a year ago, primarily as a result of Medicaid reimbursement reductions in certain states and competitive customer pricing.

Corporate Overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $27 million in the first quarters of both 2004 and 2003. As a percentage of consolidated revenues, corporate overhead totaled 3.1% in the first quarter of 2004 compared to 3.3% for the same period a year ago.

Corporate expenses included the operating losses of the Company’s limited purpose insurance subsidiary of $2 million in the first quarters of both 2004 and 2003.

Capital Costs

Rent expense increased 2% to $64 million in the first quarter of 2004 compared to $63 million for the same period a year ago. A substantial portion of the increase resulted from contractual inflation increases, including those associated with the master lease agreements with Ventas.

Depreciation expense increased 15% to $22 million in the first quarter of 2004 compared to $19 million for the same period a year ago. The increase was primarily a result of the Company’s ongoing capital expenditure program.

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Capital Costs (Continued)

Interest expense aggregated $4 million in the first quarter of 2004 compared to $3 million for the same period a year ago. For accounting purposes, the $44 million present value rent obligation to Ventas incurred in connection with the divestiture of the Company’s Florida and Texas nursing centers bears interest at a rate of 11%.

Investment income related to the Company’s excess cash balances and insurance subsidiary investments totaled $1 million in the first quarter of 2004 compared to $2 million for the same period a year ago.

Consolidated Results

The Company reported income from continuing operations before income taxes of $28 million for the first quarter of 2004 compared to $7 million for the first quarter of 2003. Income from continuing operations in the first quarter of 2004 aggregated $16 million compared to $3 million in the first quarter of 2003.

The effective income tax rate for the first quarter of 2004 was 42.1% as compared to 63.4% in the first quarter of 2003. The lower effective income tax rate in the first quarter of 2004 resulted primarily from a higher amount of estimated 2004 annual pretax income at the end of the first quarter of 2004 as compared to the estimated 2003 annual pretax income at the end of the first quarter of 2003.

Discontinued Operations

Net operating losses for discontinued operations decreased to $2 million in the first quarter of 2004 from $16 million in the first quarter of 2003. Professional liability costs in the first quarter of 2004 approximated $1 million compared to $23 million in the first quarter of 2003. See Notes 2 and 6 of the accompanying Notes to Condensed Consolidated Financial Statements.

Liquidity

Cash flows used in operations (including discontinued operations) aggregated $24 million for the three months ended March 31, 2004 compared to $22 million for the same period a year ago. Operating cash flows in both periods were negatively impacted by growth in accounts receivable. Collections of accounts receivable are expected to improve in the second quarter of 2004. During both periods, the Company maintained sufficient liquidity to fund its ongoing capital expenditure program.

Cash and cash equivalents totaled $18 million at March 31, 2004 compared to $67 million at December 31, 2003. Based upon existing cash levels, expected operating cash flows and capital spending, and the availability of borrowings under the Company’s revolving credit facility, management believes that the Company has the necessary financial resources to satisfy expected short-term and long-term liquidity needs.

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

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

RESULTS OF OPERATIONS (Continued)

Liquidity (Continued)

Long-term debt at March 31, 2004 aggregated $155 million (including $17 million of borrowings under the Company’s revolving credit facility) compared to $139 million at December 31, 2003. The Company expects that operating cash flows in the second and third quarters of 2004 will be sufficient to repay all outstanding revolving credit borrowings at March 31, 2004. Available borrowings under the Company’s revolving credit facility aggregated $84 million at March 31, 2004. The Company was in compliance with the terms of its revolving credit facility and senior secured notes at March 31, 2004.

In November 2003, the Company entered into an agreement to purchase ten unprofitable facilities that were leased from Ventas for $85 million in cash. The Company intends to dispose of these properties as soon as practicable. Proceeds from these transactions are expected to approximate $27 million.

Capital Resources

Capital expenditures totaled $18 million for the three months ended March 31, 2004 compared to $11 million for the three months ended March 31, 2003. Capital expenditures (excluding acquisitions) could approximate $80 million in 2004. Management believes that its capital expenditure program is adequate to improve and equip existing facilities.

The Company’s capital expenditure program is financed generally through the use of operating cash flows. At March 31, 2004, the estimated cost to complete and equip construction in progress approximated $16 million.

The terms of the Company’s revolving credit facility and senior secured notes include certain covenants which limit the Company’s annual capital expenditures. In addition, these agreements limit the ability of the Company’s subsidiaries to transfer funds to the parent company and generally prohibit repurchases of common stock and the payment of cash dividends.

Other Information

Effects of Inflation and Changing Prices

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

Most of the Company’s hospitals have been operating under the Medicare prospective payment system since September 1, 2003. Operating results under this system are subject to changes in patient acuity and expense levels in the Company’s hospitals. These factors, among others, are subject to significant change. Slight variations in patient acuity could significantly change Medicare revenues generated under the Medicare prospective payment system. In addition, the Company’s hospitals may not be able to appropriately adjust their operating costs as patient acuity levels change. As previously discussed, Medicare reimbursements to the Company’s hospitals are based on a fixed payment system. Operating margins in the hospital division could be negatively impacted if the Company is unable to control its operating costs. As a result of these uncertainties, the Company cannot predict the ultimate long-term impact of the Medicare prospective payment system on its

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

RESULTS OF OPERATIONS (Continued)

Other Information (Continued)

Effects of Inflation and Changing Prices (Continued)

hospital operating results and the Company can make no assurances that such regulations or operational changes resulting from these regulations will not have a material adverse impact on its financial position, results of operations or liquidity. In addition, the Company can make no assurances that the new system will not have a material adverse effect on revenues from non-government third party payors. Various factors, including a reduction in average length of stay, could negatively impact revenues from non-government third party payors.

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

Litigation

The Company is a party to certain material litigation. See Note 8 of the accompanying Notes to Condensed Consolidated Financial Statements.

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

RESULTS OF OPERATIONS (Continued)

Condensed Consolidated Statement of Operations (a)

(Unaudited)

(In thousands, except per share amount)


	2003 Quarters												Year			First Quarter 2004
	First			Second			Third			Fourth			Year			First Quarter 2004
Revenues	$	802,158		$	813,848		$	837,035		$	830,978		$	3,284,019		$	871,262

Salaries, wages and benefits		460,752			462,320			469,112			473,263			1,865,447			492,071
Supplies		104,182			104,440			107,701			113,293			429,616			116,733
Rent		63,078			64,215			64,783			64,230			256,306			64,459
Other operating expenses		146,839			140,776			144,368			131,524			563,507			145,406
Depreciation		19,195			19,927			20,407			21,328			80,857			22,046
Interest expense		2,888			2,992			1,054			3,388			10,322			3,656
Investment income		(1,635	)		(1,676	)		(1,333	)		(1,491	)		(6,135	)		(1,218	)

		795,299			792,994			806,092			805,535			3,199,920			843,153

Income from continuing operations before reorganization items and income taxes		6,859			20,854			30,943			25,443			84,099			28,109
Reorganization items		–			–			–			1,010			1,010			–

Income from continuing operations before income taxes		6,859			20,854			30,943			26,453			85,109			28,109
Provision for income taxes		4,348			7,710			12,629			10,968			35,655			11,834

Income from continuing operations		2,511			13,144			18,314			15,485			49,454			16,275
Discontinued operations, net of income taxes:
Loss from operations		(15,635	)		(20,555	)		(5,780	)		(3,407	)		(45,377	)		(2,435	)
Loss on divestiture of operations		–			(36,019	)		(827	)		(42,567	)		(79,413	)		–

Net income (loss)	$	(13,124	)	$	(43,430	)	$	11,707		$	(30,489	)	$	(75,336	)	$	13,840

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.07		$	0.38		$	0.53		$	0.44		$	1.42		$	0.46
Discontinued operations:
Loss from operations		(0.45	)		(0.59	)		(0.17	)		(0.10	)		(1.30	)		(0.07	)
Loss on divestiture of operations		–			(1.04	)		(0.02	)		(1.21	)		(2.28	)		–

Net income (loss)	$	(0.38	)	$	(1.25	)	$	0.34		$	(0.87	)	$	(2.16	)	$	0.39

Diluted:
Income from continuing operations	$	0.07		$	0.38		$	0.52		$	0.38		$	1.41		$	0.38
Discontinued operations:
Loss from operations		(0.45	)		(0.59	)		(0.17	)		(0.08	)		(1.29	)		(0.06	)
Loss on divestiture of operations		–			(1.04	)		(0.02	)		(1.05	)		(2.27	)		–

Net income (loss)	$	(0.38	)	$	(1.25	)	$	0.33		$	(0.75	)	$	(2.15	)	$	0.32

Shares used in computing earnings (loss) per common share:
Basic		34,755			34,813			34,885			35,062			34,880			35,414
Diluted		34,767			34,828			35,143			40,685			35,047			42,721

(a)

Share and per share data for all periods presented have been adjusted retroactively to reflect a 2-for-1 stock split to be distributed in May 2004.

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

RESULTS OF OPERATIONS (Continued)

Operating Data

(Unaudited)

(In thousands)


	2003 Quarters												Year			First Quarter 2004
	First			Second			Third			Fourth			Year			First Quarter 2004

Revenues:
Hospital division	$	331,862		$	338,360		$	341,368		$	325,619		$	1,337,209		$	348,648
Health services division (a)		410,832			416,768			431,978			433,532			1,693,110			444,994
Rehabilitation division (a)		8,502			8,795			12,065			14,121			43,483			52,699
Pharmacy division		66,126			64,850			67,075			74,382			272,433			79,746

		817,322			828,773			852,486			847,654			3,346,235			926,087

Eliminations:
Pharmacy		(15,164	)		(14,925	)		(15,451	)		(16,676	)		(62,216	)		(18,136	)
Rehabilitation (a)		–			–			–			–			–			(36,689	)

		(15,164	)		(14,925	)		(15,451	)		(16,676	)		(62,216	)		(54,825	)

	$	802,158		$	813,848		$	837,035		$	830,978		$	3,284,019		$	871,262


Income from continuing operations:
Operating income (loss):
Hospital division	$	70,538		$	75,455		$	87,171		$	73,702		$	306,866		$	80,066
Health services division (a)		43,424			57,235			54,944			64,436			220,039			49,469
Rehabilitation division (a)		(959	)		(750	)		261			(315	)		(1,763	)		8,519
Pharmacy division		6,702			6,133			6,150			7,508			26,493			7,609

Corporate:
Overhead		(26,713	)		(28,354	)		(28,670	)		(28,898	)		(112,635	)		(26,834	)
Insurance subsidiary		(2,607	)		(3,407	)		(4,002	)		(3,535	)		(13,551	)		(1,777	)

		(29,320	)		(31,761	)		(32,672	)		(32,433	)		(126,186	)		(28,611	)

		90,385			106,312			115,854			112,898			425,449			117,052

Reorganization items		–			–			–			1,010			1,010			–

Operating income		90,385			106,312			115,854			113,908			426,459			117,052
Rent		(63,078	)		(64,215	)		(64,783	)		(64,230	)		(256,306	)		(64,459	)
Depreciation		(19,195	)		(19,927	)		(20,407	)		(21,328	)		(80,857	)		(22,046	)
Interest, net		(1,253	)		(1,316	)		279			(1,897	)		(4,187	)		(2,438	)

Income from continuing operations before income taxes		6,859			20,854			30,943			26,453			85,109			28,109
Provision for income taxes		4,348			7,710			12,629			10,968			35,655			11,834

	$	2,511		$	13,144		$	18,314		$	15,485		$	49,454		$	16,275

(a)

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

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)

(In thousands)


	2003 Quarters								Year		First Quarter 2004
	First		Second		Third		Fourth		Year		First Quarter 2004
Rent:
Hospital division	$	23,284	$	23,706	$	23,441	$	22,753	$	93,184	$	22,844
Health services division (a)		39,031		39,808		40,459		40,530		159,828		40,283
Rehabilitation division (a)		69		95		123		185		472		611
Pharmacy division		630		547		698		703		2,578		662
Corporate		64		59		62		59		244		59

	$	63,078	$	64,215	$	64,783	$	64,230	$	256,306	$	64,459


Depreciation:
Hospital division	$	7,054	$	7,450	$	7,684	$	8,257	$	30,445	$	8,464
Health services division (a)		6,373		6,569		6,688		6,740		26,370		6,893
Rehabilitation division (a)		16		20		22		25		83		33
Pharmacy division		517		539		561		560		2,177		530
Corporate		5,235		5,349		5,452		5,746		21,782		6,126

	$	19,195	$	19,927	$	20,407	$	21,328	$	80,857	$	22,046


Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	2,822	$	4,133	$	5,773	$	13,388	$	26,116	$	5,406
Health services division (a)		3,222		6,375		9,768		9,804		29,169		8,450
Rehabilitation division (a)		51		47		35		11		144		47
Pharmacy division		616		522		815		2,254		4,207		773
Corporate:
Information systems		3,207		5,992		4,071		8,223		21,493		2,651
Other		647		408		361		1,551		2,967		554

	$	10,565	$	17,477	$	20,823	$	35,231	$	84,096	$	17,881

(a)

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

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)


	2003 Quarters								Year		First Quarter 2004
	First		Second		Third		Fourth		Year		First Quarter 2004
Hospital data:
End of period data:
Number of hospitals		63		63		64		66				68
Number of licensed beds		5,076		5,098		5,129		5,219				5,323

Revenue mix % (a):
Medicare		60		59		62		63		61		66
Medicaid		8		8		7		8		8		7
Private and other		32		33		31		29		31		27

Admissions:
Medicare		6,612		6,346		6,053		6,681		25,692		6,900
Medicaid		648		604		670		661		2,583		715
Private and other		1,281		1,322		1,333		1,359		5,295		1,460

		8,541		8,272		8,056		8,701		33,570		9,075

Admissions mix %:
Medicare		77		77		75		77		76		76
Medicaid		8		7		8		7		8		8
Private and other		15		16		17		16		16		16

Patient days:
Medicare		216,266		214,116		193,069		191,904		815,355		207,052
Medicaid		31,764		32,470		31,362		29,488		125,084		27,754
Private and other		56,225		59,339		54,080		52,725		222,369		52,391

		304,255		305,925		278,511		274,117		1,162,808		287,197


Average length of stay:
Medicare		32.7		33.7		31.9		28.7		31.7		30.0
Medicaid		49.0		53.8		46.8		44.6		48.4		38.8
Private and other		43.9		44.9		40.6		38.8		42.0		35.9
Weighted average		35.6		37.0		34.6		31.5		34.6		31.6

Revenues per admission (a):
Medicare	$	30,050	$	31,594	$	35,157	$	30,987	$	31,878	$	33,321
Medicaid		40,547		44,766		36,974		37,825		39,910		33,228
Private and other		83,449		83,830		77,860		68,870		78,395		65,054
Weighted average		38,855		40,904		42,374		37,423		39,833		38,419

Revenues per patient day (a):
Medicare	$	919	$	936	$	1,102	$	1,079	$	1,004	$	1,110
Medicaid		827		833		790		848		824		856
Private and other		1,901		1,868		1,919		1,775		1,867		1,813
Weighted average		1,091		1,106		1,226		1,188		1,150		1,214

Medicare case mix index (discharged patients only)		N/A		N/A		N/A		1.20		N/A		1.26

Average daily census		3,381		3,362		3,027		2,980		3,186		3,156
Occupancy %		69.8		69.0		61.9		59.9		65.1		62.4

(a)

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

N/A

– not available.

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)


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

		255		255		255		255				254

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

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

Revenue mix %:
Medicare		33		33		32		33		32		36
Medicaid		48		48		50		48		49		46
Private and other		19		19		18		19		19		18

Patient days (excludes managed facilities):
Medicare		398,646		399,150		394,957		397,254		1,590,007		433,162
Medicaid		1,699,726		1,707,907		1,757,580		1,737,615		6,902,828		1,675,706
Private and other		410,378		418,824		422,529		426,890		1,678,621		407,684

		2,508,750		2,525,881		2,575,066		2,561,759		10,171,456		2,516,552


Patient day mix %:
Medicare		16		16		15		15		16		17
Medicaid		68		68		68		68		68		67
Private and other		16		16		17		17		16		16

Revenues per patient day:
Medicare	$	338	$	342	$	344	$	364	$	347	$	372
Medicaid		117		118		123		120		119		121
Private and other		188		189		188		190		189		197
Weighted average		164		165		168		169		167		177

Average daily census		27,875		27,757		27,990		27,845		27,867		27,654
Occupancy %		86.0		85.6		86.8		86.4		86.2		86.0

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

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

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

N/A

– not applicable.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

Interest Rate Sensitivity

Principal (Notional) Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)


	Expected maturities																				Fair value 3/31/04
	2004			2005			2006			2007			2008			Thereafter			Total		Fair value 3/31/04

Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate:
Ventas debt obligation:
Principal	$	3,447		$	5,311		$	6,264		$	7,338		$	5,660		$	12,880		$	40,900	$	40,900
Interest		3,190			3,778			3,143			2,399			1,646			2,376			16,532		–

		6,637			9,089			9,407			9,737			7,306			15,256			57,432		40,900
Other		40			63			67			71			76			820			1,137		1,096

	$	6,677		$	9,152		$	9,474		$	9,808		$	7,382		$	16,076		$	58,569	$	41,996

Average interest rate		10.9	%		10.9	%		10.9	%		11.0	%		10.9	%		10.7	%
Variable rate	$	–		$	–		$	16,900	(a)	$	–		$	100,500	(b)	$	–		$	117,400	$	118,154

(a)

Interest is payable, at the Company’s option, at prime (or, if higher, the federal funds rate plus ½%) plus 3% or the London Interbank Offered Rate plus 4%.

(b)

Interest is payable, at the Company’s option, at one, two, three or six month London Interbank Offered Rate plus 4½%.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention

ITEM 4. CONTROLS AND PROCEDURES (Continued)

Evaluation of Disclosure Controls and Procedures (Continued)

or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of March 31, 2004, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended March 31, 2004, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Summary descriptions of various significant legal and regulatory activities follow.

A shareholder derivative suit entitled Thomas G. White on behalf of Vencor, Inc. and Ventas, Inc. v. W. Bruce Lunsford, et al., Case No. 98CI03669, was filed on July 2, 1998 in the Jefferson County, Kentucky, Circuit Court. The suit was brought on behalf of the Company and Ventas against certain former executive officers and directors of the Company and Ventas. The complaint alleges that the defendants damaged the Company and Ventas by engaging in violations of the securities laws, engaging in insider trading, fraud and securities fraud and damaging the reputation of the Company and Ventas. The plaintiff asserts that such actions were taken deliberately, in bad faith and constitute breaches of the defendants’ duties of loyalty and due care. The complaint alleges that certain of the Company’s and Ventas’s former executive officers during a specified time frame violated Sections 10(b) and 20(a) of the Exchange Act by, among other things, issuing to the investing public a series of false and misleading statements concerning Ventas’s then current operations and the inherent value of its common stock. The complaint further alleges that as a result of these purported false and misleading statements concerning Ventas’s revenues and successful acquisitions, the price of its common stock was artificially inflated. In particular, the complaint alleges that the defendants issued false and misleading financial statements during the first, second and third calendar quarters of 1997 which misrepresented and understated the impact that changes in Medicare reimbursement policies would have on Ventas’s core services and profitability. The complaint further alleges that the defendants issued a series of materially false statements concerning the purportedly successful integration of Ventas’s acquisitions and prospective earnings per share for 1997 and 1998, which the defendants knew lacked any reasonable basis and were not being achieved. The suit seeks unspecified damages, interest, punitive damages, reasonable attorneys’ fees, expert witness fees and other costs, and any extraordinary equitable and/or injunctive relief permitted by law or equity to assure that the Company and Ventas have an effective remedy. In October 2002, the defendants filed a motion to dismiss for failure to prosecute the case. The court granted the motion to dismiss but the plaintiff subsequently moved the court to vacate the dismissal. The defendants filed an opposition to the plaintiff’s motion to vacate the dismissal, but in August 2003 the court reinstated the lawsuit. In September 2003, the Company filed a renewed motion to dismiss, as to all defendants, based on the plaintiff’s failure to make a demand for remedy upon the appropriate board of directors. The Company also has argued that it is an improper party to this lawsuit. In March 2004, the judge who had been presiding over this lawsuit recused himself because of a possible conflict of interest. The case was then assigned to another judge, who has not yet ruled on the renewed motion to dismiss. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

A putative class action lawsuit entitled Massachusetts State Carpenters Pension Fund v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-600-J, was filed against the Company and certain of the Company’s current and former officers and directors on October 16, 2002, in the United States District Court for the Western District of Kentucky, Louisville Division. The complaint alleges that from August 14, 2001 to October 10, 2002 the defendants violated Sections 10(b) and 20(a) of the Exchange Act by, among other things, issuing to the investing public a series of allegedly false and misleading statements that inaccurately indicated that the Company was successfully emerging from bankruptcy and implementing a growth plan. In particular, the complaint alleges that these statements were materially false and misleading because they failed to disclose that the 2001 Florida tort reform legislation had resulted in a marked increase in claims against the Company in Florida, and also because the statements reflected a materially understated reserve for professional liability costs. The complaint further alleges that as a result of the purportedly false and misleading statements, the price of the Company’s common stock was artificially inflated, the investing public was deceptively induced to purchase the stock at those inflated prices, and the defendants profited by selling shares at those prices. The suit seeks an unspecified amount of monetary damages plus interest, reasonable attorneys’ fees and other costs, and any other equitable, injunctive or other relief that the court deems just and proper. After October 16, 2002, several other purported class action complaints, which assert essentially similar allegations as those contained in the

PART II. OTHER INFORMATION (Continued)

Item 1. Legal Proceedings (Continued)

Massachusetts State Carpenters Pension Fund complaint discussed above, also were filed against the same defendants in the United States District Court for the Western District of Kentucky, Louisville Division, including but not limited to the cases entitled Mark Ramsdell v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-625-R; Paula Hillenbrand v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-654-R; Marilyn Buck v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-732-S; and Eastside Holdings Ltd. v. Kindred Healthcare, Inc., et al., Civil Action No. 3:02CV-617-H. All of these actions were consolidated by the District Court. In May 2003, the defendants filed a motion to dismiss the consolidated lawsuits, and on January 9, 2004, the District Court granted that motion with prejudice. The plaintiffs did not appeal the District Court’s dismissal, which became final on February 12, 2004 when the appeal period expired.

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

PART II. OTHER INFORMATION (Continued)

Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits:


		3.1		Amended and Restated By-Laws of Kindred Healthcare, Inc. Exhibit 3.3 to the Company’s Form 10-K for the year ended December 31, 2003 (Comm. File No. 001-14057) is hereby incorporated by reference.

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

		32		Section 1350 Certifications.

(b)

Reports on Form 8-K:

On March 9, 2004, the Company filed a Current Report on Form 8-K announcing its financial results for the year ended December 31, 2003.

SIGNATURES

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


						KINDRED HEALTHCARE, INC.

Date: May 7, 2004						/s/ PAUL J. DIAZ

						Paul J. Diaz President and Chief Executive Officer

Date: May 7, 2004						/s/ RICHARD A. LECHLEITER

						Richard A. Lechleiter Senior Vice President and Chief Financial Officer

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