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 September 30, 2004

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

For the transition period from to .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)


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

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

(502) 596-7300

(Registrant’s telephone number, including area code)

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

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

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

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


Class of Common Stock		Outstanding at October 31, 2004
Common stock, $0.25 par value		37,115,384 shares

1 of 46

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 September 30, 2004 and 2003 and for the nine months ended September 30, 2004 and 2003	3

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

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

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	41

Item 4.	Controls and Procedures	42

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	43

Item 6.	Exhibits	45

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Revenues	$	889,435		$	828,831		$	2,643,783		$	2,429,429

Salaries, wages and benefits		499,436			463,027			1,476,003			1,374,216
Supplies		122,151			107,152			358,516			314,688
Rent		66,805			64,248			196,262			190,495
Other operating expenses		146,452			142,381			438,442			426,021
Depreciation		23,176			20,065			67,401			58,616
Interest expense		2,535			1,054			10,905			6,934
Investment income		(1,605	)		(1,333	)		(4,649	)		(4,644	)

		858,950			796,594			2,542,880			2,366,326

Income from continuing operations before reorganization items and income taxes		30,485			32,237			100,903			63,103
Reorganization items		–			–			(304	)		–

Income from continuing operations before income taxes		30,485			32,237			101,207			63,103
Provision for income taxes		12,063			13,127			41,441			26,399

Income from continuing operations		18,422			19,110			59,766			36,704
Discontinued operations, net of income taxes:
Income (loss) from operations		4,703			(6,576	)		31			(44,705	)
Loss on divestiture of operations		(7,557	)		(827	)		(8,620	)		(36,846	)

Net income (loss)	$	15,568		$	11,707		$	51,177		$	(44,847	)

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.51		$	0.55		$	1.68		$	1.05
Discontinued operations:
Income (loss) from operations		0.13			(0.19	)		–			(1.28	)
Loss on divestiture of operations		(0.21	)		(0.02	)		(0.24	)		(1.06	)

Net income (loss)	$	0.43		$	0.34		$	1.44		$	(1.29	)

Diluted:
Income from continuing operations	$	0.44		$	0.54		$	1.41		$	1.05
Discontinued operations:
Income (loss) from operations		0.11			(0.19	)		–			(1.28	)
Loss on divestiture of operations		(0.18	)		(0.02	)		(0.20	)		(1.06	)

Net income (loss)	$	0.37		$	0.33		$	1.21		$	(1.29	)

Shares used in computing earnings (loss) per common share:
Basic		35,939			34,885			35,631			34,818
Diluted		42,293			35,143			42,322			34,853

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	September 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	29,739		$	66,524
Cash – restricted		6,055			7,339
Insurance subsidiary investments		222,989			146,325
Accounts receivable less allowance for loss of $67,500 – September 30 and $93,403 – December 31		434,279			429,304
Inventories		33,068			29,984
Deferred tax assets		88,764			89,836
Assets held for sale		9,637			27,400
Other		38,040			46,375

		862,571			843,087

Property and equipment		730,166			671,850
Accumulated depreciation		(256,821	)		(193,310	)

		473,345			478,540

Goodwill		30,928			31,417
Insurance subsidiary investments		47,497			74,618
Deferred tax assets		109,123			92,093
Other		58,099			65,659

	$	1,581,563		$	1,585,414

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	107,510		$	119,087
Salaries, wages and other compensation		232,854			214,113
Due to third party payors		20,869			31,406
Professional liability risks		78,176			83,725
Other accrued liabilities		79,266			88,333
Income taxes		62,531			36,684
Long-term debt due within one year		5,159			4,532

		586,365			577,880

Long-term debt		34,596			139,397
Professional liability risks		215,573			212,013
Deferred credits and other liabilities		61,426			58,559

Commitments and contingencies

Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 37,096 shares – September 30 and 36,340 shares – December 31		9,274			9,085
Capital in excess of par value		621,606			585,394
Deferred compensation		(9,379	)		(8,040	)
Accumulated other comprehensive income		147			348
Retained earnings		61,955			10,778

		683,603			597,565

	$	1,581,563		$	1,585,414

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Cash flows from operating activities:
Net income (loss)	$	15,568		$	11,707		$	51,177		$	(44,847	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation		23,192			20,947			67,851			61,556
Amortization of deferred compensation costs		1,919			1,643			5,197			3,880
Provision for doubtful accounts		4,554			6,265			17,804			19,231
Loss on divestiture of discontinued operations		7,557			827			8,620			36,846
Reorganization items		–			–			(304	)		–
Other		(59	)		(393	)		4,879			1,023
Change in operating assets and liabilities:
Accounts receivable		(8,029	)		(58,630	)		(23,086	)		(47,573	)
Inventories and other assets		8,688			9,471			3,441			16,277
Accounts payable		271			(4,581	)		(4,538	)		(6,377	)
Income taxes		14,815			8,202			38,550			(4,514	)
Due to third party payors		4,997			(295	)		(10,537	)		6,360
Other accrued liabilities		8,328			(6,560	)		14,809			69,606

Net cash provided by (used in) operating activities		81,801			(11,397	)		173,863			111,468

Cash flows from investing activities:
Purchase of property and equipment		(22,390	)		(20,823	)		(57,928	)		(48,865	)
Acquisition of healthcare facilities		(11,814	)		–			(20,160	)		(63,795	)
Sale of assets		17,674			59,215			24,558			66,874
Surety bond deposits		–			–			4,402			–
Purchase of insurance subsidiary investments		(24,236	)		(27,233	)		(38,779	)		(146,254	)
Sale of insurance subsidiary investments		15,297			20,263			29,178			46,773
Net change in insurance subsidiary cash and cash equivalents		(4,727	)		12,704			(39,942	)		4,548
Net change in other investments		–			(447	)		4,405			(2,487	)
Other		(340	)		512			34			(1,523	)

Net cash provided by (used in) investing activities		(30,536	)		44,191			(94,232	)		(144,729	)

Cash flows from financing activities:
Net change in revolving credit borrowings		(80,000	)		–			–			–
Repayment of long-term debt		(1,167	)		(60,982	)		(103,814	)		(61,210	)
Payment of deferred financing costs		(693	)		–			(4,048	)		(2,872	)
Issuance of common stock		3,847			–			7,363			–
Other		(8,582	)		(9,990	)		(15,917	)		(14,768	)

Net cash used in financing activities		(86,595	)		(70,972	)		(116,416	)		(78,850	)

Change in cash and cash equivalents		(35,330	)		(38,178	)		(36,785	)		(112,111	)
Cash and cash equivalents at beginning of period		65,069			170,137			66,524			244,070

Cash and cash equivalents at end of period	$	29,739		$	131,959		$	29,739		$	131,959

Supplemental information:
Interest payments	$	2,174		$	3,292		$	8,915		$	9,037
Income tax payments		193			809			2,910			2,927

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 September 30, 2004, the Company’s hospital division operated 74 hospitals in 24 states. The Company’s health services division operated 249 nursing centers in 29 states. The Company’s pharmacy division operated an institutional pharmacy business with 31 pharmacies in 20 states and a pharmacy management business servicing substantially all of the Company’s hospitals. The Company also operated a contract rehabilitation services business which began operating as a separate division on January 1, 2004.

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

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

Stock Split

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

Impact of Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities – an interpretation of ARB No. 51.” The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (variable interest entities or “VIEs”) and how to determine when and which business enterprise should consolidate the VIE (the primary beneficiary). In December 2003, the FASB issued FIN 46-R (“FIN 46-R”), “Consolidation of Variable Interest Entities – an interpretation of ARB No. 51 (revised December 2003),” which replaced 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 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 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 September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Net income (loss)	$	15,568		$	11,707		$	51,177		$	(44,847	)
Adjustments:
Stock-based compensation expense included in reported net income (loss)		1,919			1,643			5,197			3,880
Stock-based compensation determined under fair value based method		(3,855	)		(3,107	)		(11,065	)		(7,681	)

Pro forma net income (loss)	$	13,632		$	10,243		$	45,309		$	(48,648	)

Earnings (loss) per common share:
As reported:
Basic	$	0.43		$	0.34		$	1.44		$	(1.29	)
Diluted	$	0.37		$	0.33		$	1.21		$	(1.29	)
Pro forma:
Basic	$	0.38		$	0.29		$	1.27		$	(1.40	)
Diluted	$	0.31		$	0.29		$	1.05		$	(1.40	)

Comprehensive income (loss)

The following table sets forth the computation of comprehensive income (loss) (in thousands):


	Three months ended September 30,					Nine months ended September 30,
	2004		2003			2004			2003
Net income (loss)	$	15,568	$	11,707		$	51,177		$	(44,847	)
Net unrealized investment gains (losses), net of tax		289		(153	)		(201	)		(288	)

Comprehensive income (loss)	$	15,857	$	11,554		$	50,976		$	(45,135	)

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.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Other information (Continued)

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the Company’s customary accounting practices. Management believes that financial information included herein reflects all adjustments necessary for a fair presentation of interim results and, except for the items discussed in Notes 2, 3 and 4, all such adjustments are of a normal and recurring nature.

Reclassifications

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

NOTE 2 – DIVESTITURES

Nursing center divestitures in 2004

During the third quarter of 2004, the Company purchased for resale three leased nursing centers in exchange for total consideration of $18.7 million. Based upon the expected net realizable value of these properties, the Company recorded a pretax loss of $12.3 million ($7.5 million net of income taxes). Two of the three nursing centers were sold in the third quarter for $7.2 million in cash.

During the first nine months of 2004, the Company allowed leases on three other nursing centers to expire. No gain or loss resulted from these transactions.

Florida and Texas Divestiture

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

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

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

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DIVESTITURES (Continued)

Florida and Texas Divestiture (Continued)

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

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


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

		69,781
Direct transaction costs		(3,211	)

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

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

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

Loss on divestiture of operations				$	(36,019	)

Purchase and resale of Ventas II Facilities

In December 2003, the Company completed the acquisition of the Ventas II Facilities. During the nine months ended September 30, 2004, the Company sold five of the Ventas II Facilities for approximately $14.8 million in cash, including the sale of three facilities in the third quarter for approximately $10.5 million.

Other divestitures in 2003

In the third quarter of 2003, the Company wrote down the carrying value of a hospital division ancillary services business held for sale by $1.3 million ($0.8 million net of income taxes).

NOTE 3 – DISCONTINUED OPERATIONS

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the divestitures discussed in Notes 1 and 2 have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the losses related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

consolidated statement of operations. Assets and liabilities not sold at September 30, 2004 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. At September 30, 2004, the Company held for sale five nursing centers and one hospital.

Net income from discontinued operations in the third quarter of 2004 included a favorable pretax adjustment of approximately $11 million ($6.8 million net of income taxes) resulting from a change in estimate for professional liability reserves related to the Company’s former nursing centers in Florida and Texas.

A summary of discontinued operations follows (in thousands):


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Revenues	$	12,634		$	32,367		$	58,024		$	172,213

Salaries, wages and benefits		9,443			23,514			41,110			115,768
Supplies		766			3,697			3,321			16,506
Rent		341			3,009			1,807			14,784
Other operating expenses		(5,415	)		12,182			11,860			95,131
Depreciation		16			882			450			2,940
Interest expense		–			–			–			3
Investment income		(165	)		(225	)		(574	)		(228	)

		4,986			43,059			57,974			244,904

Income (loss) from operations before income taxes		7,648			(10,692	)		50			(72,691	)
Income tax provision (benefit)		2,945			(4,116	)		19			(27,986	)

Income (loss) from operations		4,703			(6,576	)		31			(44,705	)
Loss on divestiture of operations, net of income taxes		(7,557	)		(827	)		(8,620	)		(36,846	)

	$	(2,854	)	$	(7,403	)	$	(8,589	)	$	(81,551	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

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


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Revenues:
Hospital division:
Hospitals	$	1,816		$	4,759		$	6,171		$	21,446
Ancillary services		(4	)		1,389			(100	)		4,631

		1,812			6,148			6,071			26,077

Health services division		10,823			23,805			52,018			138,600

Pharmacy division		(1	)		2,414			(65	)		7,536

	$	12,634		$	32,367		$	58,024		$	172,213

Operating income (loss):
Hospital division:
Hospitals	$	(790	)	$	(2,654	)	$	(3,952	)	$	(4,326	)
Ancillary services		8			6			(143	)		(376	)

		(782	)		(2,648	)		(4,095	)		(4,702	)

Health services division		8,534			(4,429	)		5,564			(50,717	)

Pharmacy division		88			51			264			227

	$	7,840		$	(7,026	)	$	1,733		$	(55,192	)

Rent:
Hospital division:
Hospitals	$	28		$	840		$	128		$	2,678
Ancillary services		(6	)		234			(21	)		648

		22			1,074			107			3,326

Health services division		318			1,844			1,652			11,181

Pharmacy division		1			91			48			277

	$	341		$	3,009		$	1,807		$	14,784

Depreciation:
Hospital division:
Hospitals	$	–		$	208		$	–		$	618
Ancillary services		–			107			–			187

		–			315			–			805

Health services division		16			553			450			2,094

Pharmacy division		–			14			–			41

	$	16		$	882		$	450		$	2,940

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

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


	September 30, 2004			December 31, 2003
Current assets:
Property and equipment, net	$	9,427		$	26,912
Other		210			488

		9,637			27,400
Current liabilities (included in other accrued liabilities)		(303	)		(1,439	)

	$	9,334		$	25,961

NOTE 4 – SIGNIFICANT QUARTERLY ADJUSTMENTS

The Company’s operating results from continuing operations for the third quarter and nine months ended September 30, 2004 and 2003 included certain adjustments discussed below.

2004 adjustments

Certain third party payments are subject to examination by agencies administering the various programs. Favorable settlements of prior year hospital Medicare cost reports aggregated $2.2 million, $3.9 million and $1.6 million in the first, second and third quarters of 2004, respectively.

In the third quarter of 2004, corporate overhead included a pretax charge of $3.4 million related to a terminated pension plan.

In the second quarter of 2004, the Company recorded pretax income of $5.9 million related to retroactive Medicaid rate increases in North Carolina, approximately one-half of which related to the fourth quarter of 2003 and one-half of which related to the first quarter of 2004.

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

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

2003 adjustments

During the third quarter of 2003, the Company recorded income of approximately $10 million related to settlements of prior year hospital Medicare cost reports.

On September 1, 2003, the Medicare prospective payment system for long-term acute care hospitals (“LTAC PPS”) became effective for all but two of the Company’s long-term acute care hospitals. The Company’s hospital operating results in the third quarter of 2003 included favorable Medicare reimbursement adjustments of approximately $3.8 million that resulted from the conversion to LTAC PPS.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – SIGNIFICANT QUARTERLY ADJUSTMENTS (Continued)

2003 adjustments (Continued)

Interest expense in the third quarter of 2003 included approximately $2.4 million of gains realized in connection with the prepayment of long-term debt.

Operating results in the first quarter of 2003 included a pretax charge of $7.9 million related to changes in estimates of prior year professional liability costs.

NOTE 5 – REVENUES

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

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


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Medicare	$	369,586		$	346,214		$	1,135,827		$	1,012,229
Medicaid		298,489			272,669			856,462			785,240
Private and other		295,607			225,106			833,550			676,700

		963,682			843,989			2,825,839			2,474,169
Eliminations:
Rehabilitation		(46,779	)		–			(119,381	)		–
Pharmacy		(27,468	)		(15,158	)		(62,675	)		(44,740	)

		(74,247	)		(15,158	)		(182,056	)		(44,740	)

	$	889,435		$	828,831		$	2,643,783		$	2,429,429

NOTE 6 – EARNINGS PER SHARE

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

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – EARNINGS PER SHARE (Continued)

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


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Earnings (loss):
Income from continuing operations	$	18,422		$	19,110		$	59,766		$	36,704
Discontinued operations, net of income taxes:
Income (loss) from operations		4,703			(6,576	)		31			(44,705	)
Loss on divestiture of operations		(7,557	)		(827	)		(8,620	)		(36,846	)

Net income (loss)	$	15,568		$	11,707		$	51,177		$	(44,847	)

Shares used in the computation:
Weighted average shares outstanding – basic computation		35,939			34,885			35,631			34,818
Dilutive effect of warrants, stock options and non-vested restricted stock		6,354			258			6,691			35

Adjusted weighted average shares outstanding – diluted computation		42,293			35,143			42,322			34,853

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.51		$	0.55		$	1.68		$	1.05
Discontinued operations:
Income (loss) from operations		0.13			(0.19	)		–			(1.28	)
Loss on divestiture of operations		(0.21	)		(0.02	)		(0.24	)		(1.06	)

Net income (loss)	$	0.43		$	0.34		$	1.44		$	(1.29	)

Diluted:
Income from continuing operations	$	0.44		$	0.54		$	1.41		$	1.05
Discontinued operations:
Income (loss) from operations		0.11			(0.19	)		–			(1.28	)
Loss on divestiture of operations		(0.18	)		(0.02	)		(0.20	)		(1.06	)

Net income (loss)	$	0.37		$	0.33		$	1.21		$	(1.29	)

NOTE 7 – BUSINESS SEGMENT DATA

The Company operates four business segments: the hospital division, the health services division, the rehabilitation division and the pharmacy division. The hospital division primarily operates long-term acute care hospitals. The health services division operates nursing centers. The rehabilitation division provides rehabilitation services primarily to long-term care providers. The pharmacy division provides 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 into a separate operating division 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 were not restated to conform with the new business alignment.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)

On July 1, 2004, the rehabilitation division and pharmacy division began providing services to the Company’s hospital division. Internal personnel from the hospital division were transferred to the rehabilitation division and pharmacy division in conjunction with the realignment of these services (the “Hospital Services Reorganization”).

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

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


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Revenues:
Hospital division	$	356,260		$	341,368		$	1,060,220		$	1,011,590
Health services division		449,674			423,481			1,338,492			1,235,166
Rehabilitation division		61,157			12,065			166,444			29,362
Pharmacy division		96,591			67,075			260,683			198,051

		963,682			843,989			2,825,839			2,474,169
Eliminations:
Rehabilitation		(46,779	)		–			(119,381	)		–
Pharmacy		(27,468	)		(15,158	)		(62,675	)		(44,740	)

		(74,247	)		(15,158	)		(182,056	)		(44,740	)

	$	889,435		$	828,831		$	2,643,783		$	2,429,429

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Income from continuing operations:
Operating income (loss):
Hospital division	$	79,616		$	87,171		$	246,165		$	233,164
Health services division		57,978			55,361			169,924			157,556
Rehabilitation division		7,737			261			23,521			(1,448	)
Pharmacy division		10,853			6,150			26,191			18,985
Corporate:
Overhead		(33,028	)		(28,670	)		(90,218	)		(83,737	)
Insurance subsidiary		(1,760	)		(4,002	)		(4,761	)		(10,016	)

		(34,788	)		(32,672	)		(94,979	)		(93,753	)

		121,396			116,271			370,822			314,504
Reorganization items		–			–			304			–

Operating income		121,396			116,271			371,126			314,504
Rent		(66,805	)		(64,248	)		(196,262	)		(190,495	)
Depreciation		(23,176	)		(20,065	)		(67,401	)		(58,616	)
Interest, net		(930	)		279			(6,256	)		(2,290	)

Income from continuing operations before income taxes		30,485			32,237			101,207			63,103
Provision for income taxes		12,063			13,127			41,441			26,399

	$	18,422		$	19,110		$	59,766		$	36,704

Rent:
Hospital division	$	24,262		$	23,441		$	70,635		$	70,431
Health services division		40,923			39,924			121,120			117,717
Rehabilitation division		747			123			2,066			287
Pharmacy division		812			698			2,264			1,875
Corporate		61			62			177			185

	$	66,805		$	64,248		$	196,262		$	190,495

Depreciation:
Hospital division	$	9,139		$	7,684		$	26,315		$	22,188
Health services division		6,901			6,346			20,312			18,717
Rehabilitation division		38			22			108			58
Pharmacy division		603			561			1,716			1,617
Corporate		6,495			5,452			18,950			16,036

	$	23,176		$	20,065		$	67,401		$	58,616

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)


	Three months ended September 30,				Nine months ended September 30,
	2004		2003		2004		2003
Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	8,867	$	5,773	$	19,450	$	12,728
Health services division		7,074		9,768		22,011		19,365
Rehabilitation division		19		35		122		133
Pharmacy division		1,004		815		2,852		1,953
Corporate:
Information systems		4,251		4,071		10,935		13,270
Other		1,175		361		2,558		1,416

	$	22,390	$	20,823	$	57,928	$	48,865


	September 30, 2004		December 31, 2003
Assets at end of period:
Hospital division	$	516,858	$	526,029
Health services division		362,120		379,435
Rehabilitation division		8,790		8,009
Pharmacy division		55,459		43,198
Corporate		638,336		628,743

	$	1,581,563	$	1,585,414

Goodwill:
Hospital division	$	30,928	$	31,417

NOTE 8 – INSURANCE RISKS

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

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE RISKS (Continued)

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


	Three months ended September 30,					Nine months ended September 30,
	2004			2003		2004			2003
Professional liability:
Continuing operations	$	18,778		$	20,644	$	61,386		$	71,278
Discontinued operations		(9,625	)		3,407		(6,027	)		56,189

Workers compensation:
Continuing operations	$	12,568		$	10,580	$	37,654		$	33,692
Discontinued operations		689			732		2,208			4,208

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


	September 30, 2004						December 31, 2003
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	151,680	$	71,309	$	222,989	$	93,989	$	52,336	$	146,325
Reinsurance recoverables		1,713		–		1,713		896		–		896

		153,393		71,309		224,702		94,885		52,336		147,221

Non-current:
Insurance subsidiary investments		47,497		–		47,497		74,618		–		74,618
Reinsurance recoverables		5,878		–		5,878		5,858		–		5,858
Deposits		6,250		1,702		7,952		7,250		2,222		9,472
Other		7		182		189		9		35		44

		59,632		1,884		61,516		87,735		2,257		89,992

	$	213,025	$	73,193	$	286,218	$	182,620	$	54,593	$	237,213

Liabilities:
Allowance for insurance risks:
Current	$	78,176	$	18,797	$	96,973	$	83,725	$	14,248	$	97,973
Non-current		215,573		51,590		267,163		212,013		49,463		261,476

	$	293,749	$	70,387	$	364,136	$	295,738	$	63,711	$	359,449

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE RISKS (Continued)

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

NOTE 9 – LONG-TERM DEBT

In June 2004, the Company entered into a five-year $300 million revolving credit facility (the “Credit Facility”) to refinance its existing credit agreements. In connection with the refinancing, the Company prepaid in full the outstanding balance of its senior secured notes with borrowings under the Credit Facility. Amounts borrowed under the Credit Facility bear interest, at the Company’s option, at (a) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (b) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based on the Company’s adjusted leverage ratio as defined in the Credit Facility. During the third quarter of 2004, the interest rate under the Credit Facility was 4.4%. The Credit Facility is collateralized by substantially all of the Company’s assets including certain owned real property and is guaranteed by substantially all of the Company’s subsidiaries. The Credit Facility constitutes a working capital facility for general corporate purposes and permits acquisitions and investments in healthcare facilities and companies up to an aggregate of $150 million. The Credit Facility also allows the Company, to a limited extent, to pay cash dividends and to repurchase its common stock. There were no outstanding borrowings under the Credit Facility at September 30, 2004.

NOTE 10 – LEASES

The following table sets forth rent expense by business segment (in thousands):


	Three months ended September 30,				Nine months ended September 30,
	2004		2003		2004		2003
Hospital division:
Buildings:
Ventas	$	15,633	$	15,104	$	46,194	$	44,631
Other landlords		3,488		2,411		9,182		7,166
Equipment		5,141		5,926		15,259		18,634

		24,262		23,441		70,635		70,431

Health services division:
Buildings:
Ventas		30,536		29,504		90,230		87,179
Other landlords		9,648		9,302		28,622		27,389
Equipment		739		1,118		2,268		3,149

		40,923		39,924		121,120		117,717

Rehabilitation division:
Equipment		747		123		2,066		287

Pharmacy division:
Buildings		706		616		1,959		1,631
Equipment		106		82		305		244

		812		698		2,264		1,875

Corporate:
Equipment		61		62		177		185

	$	66,805	$	64,248	$	196,262	$	190,495

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – LEASES (Continued)

At September 30, 2004, the Company leased from Ventas 41 long-term acute care hospitals and 186 nursing centers.

Ventas has a one-time option to reset the rent and the related rent escalators under each of its master lease agreements with the Company (the “Master Lease Agreements”) to the “Fair Market Rental” of the leased properties. Fair Market Rental is determined through an appraisal procedure set forth in the Master Lease Agreements.

Generally, the Master Lease Agreements provide that Ventas can initiate the rent reset procedure under each Master Lease Agreement at any time between January 20, 2006 and July 19, 2007 by delivering a notice to the Company proposing the Fair Market Rental for the balance of the lease term (the “Reset Proposal Notice”). If the Company and Ventas are unable to reach an agreement on the Fair Market Rental within 30 days following delivery of the Reset Proposal Notice, the Company and Ventas each must select an appraiser. These two appraisers then will have ten days to select a third independent appraiser (the “Independent Appraiser”). The Independent Appraiser will have 60 days to complete its determination of Fair Market Rental, which determination will be final and binding on the parties. Within 30 days following the Independent Appraiser’s determination, Ventas may elect to exercise its right to reset Fair Market Rental by sending the Company a final exercise notice (the “Final Exercise Notice”).

Alternatively, Ventas may decide not to exercise its rental reset option, in which event the rent and the existing 3¹/2% annual escalator would remain at their then current levels under the Master Lease Agreements. Provided that Ventas exercises its reset right in accordance with the Master Lease Agreements, the rent reset will become effective on the later of July 19, 2006 or the date of delivery of the Reset Proposal Notice (the “Reset Date”), which can be no later than July 19, 2007.

As a condition to exercising its rent reset right, upon delivery of the Final Exercise Notice, Ventas is required to pay the Company a reset fee equal to a prorated portion of $5 million based upon the proportion of base rent payable under the Master Lease Agreement(s) with respect to which rent is reset to the total base rent payable under all of the Master Lease Agreements.

“Fair Market Rental” is generally defined under the Master Lease Agreements as the amount (including escalations) that a willing tenant would pay, and a willing landlord would accept, for leasing the leased properties for the term (including renewal terms). Fair Market Rental is to be determined on the basis of certain assumptions, including (1) all leased properties are in good condition and repair (given their respective ages and prevailing healthcare industry standards with respect to what is considered good condition and repair), without any deferred maintenance (but allowing for ordinary wear and tear), (2) all leased properties are in material compliance with applicable laws and have all authorizations necessary for use as a nursing center or hospital, as applicable, and (3) the replacement cost of the leased properties are not determinative of Fair Market Rental. In addition, Fair Market Rental shall take into account market conditions, market levels of earnings before interest, income taxes, depreciation, amortization, rent and management fees (“EBITDARM”), the ratio of market levels of EBITDARM to market levels of rent and the actual levels of EBITDARM at the applicable leased properties, as well as historical levels of EBITDARM at the applicable leased properties (including the EBITDARM of the leased properties measured as of April 20, 2001).

Under the Master Lease Agreements, Ventas has a right to sever properties from the existing leases in order to create additional leases, a device adopted to facilitate its financing flexibility. For purposes of the reset right, the additional leases are disregarded and the Fair Market Rental is determined on the four original Master Lease Agreements.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – LEASES (Continued)

Additional information regarding the Master Lease Agreements is contained in the Company’s Form 10-K for the year ended December 31, 2003 and copies of the Master Lease Agreements filed with the SEC.

NOTE 11 – CONTINGENCIES

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

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

Principal contingencies are described below:

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

Professional liability risks–The Company has provided for loss for professional liability risks based upon actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Notes 3, 4 and 8.

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

Income taxes–The Internal Revenue Service has proposed certain adjustments to the Company’s 2000 and 2001 federal income tax returns which the Company intends to contest.

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 12.

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 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.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – 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 issued an order on July 29, 2004, vacating the previous judge’s denial of the defendants’ motion to dismiss. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

Three shareholder derivative suits entitled Elizabeth Sommerfeld v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 08476; Ilse Denchfield v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 09475; and Fedorka v. Edward L. Kuntz, et al., Civil Action No. 03 CI 02015, were filed in November 2002, December 2002 and March 2003, respectively, in the Jefferson Circuit Court in Kentucky. The complaints in those lawsuits are nearly identical to the complaint in a putative class action lawsuit entitled Massachusetts State Carpenters Pension Fund v. Kindred Healthcare, Inc., et al, Civil Action No. 3:02CV-600-J, which was filed against the Company and certain of the Company’s current and former officers and directors on October 16, 2002 in the United States District Court for the Western District of Kentucky, Louisville Division (the “District Court”) and was dismissed with prejudice on January 12, 2004. Specifically, the derivative suits allege that from August 14, 2001 to October 10, 2002 the defendants violated Sections 10(b) and 20(a) of the Exchange Act by, among other things, issuing to the investing public a series of allegedly false and misleading statements that inaccurately indicated that the Company was successfully emerging from bankruptcy and implementing a growth plan. In particular, the complaint alleges that these statements were materially false and misleading because they failed to disclose that the 2001 Florida tort reform legislation had resulted in a marked increase in claims against the

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – LITIGATION (Continued)

Company in Florida, and also because the statements reflected a materially understated reserve for professional liability costs. The complaints further allege that as a result of the purportedly false and misleading statements, the price of the Company’s common stock was artificially inflated, the investing public was deceptively induced to purchase the stock at those inflated prices, and the defendants profited by selling shares at those prices. In May 2003, the Fedorka plaintiffs voluntarily dismissed their state court derivative lawsuit and refiled that lawsuit in the District Court, 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 District Court. On May 12, 2003, the Jefferson Circuit Court entered an order consolidating the Sommerfeld and Denchfield derivative actions and staying all proceedings in the consolidated derivative action pending the District Court’s ruling on the defendants’ motion to dismiss the consolidated putative class action. On July 24, 2003, the District Court entered a similar order concerning the Fedorka and Win federal derivative actions. After the District Court’s dismissal of the Massachusetts State Carpenters Pension Fund putative class action became final in February 2004, the plaintiffs in the consolidated Fedorka and Win federal derivative action voluntarily dismissed that consolidated derivative action, with prejudice. Subsequently, on October 4, 2004, the parties entered into an agreement to settle the Sommerfeld consolidated derivative action under which the Company agreed to pay $60,000 of the plaintiffs’ legal fees. Additional information concerning the terms of the settlement agreement is available on the website of the Sommerfeld plaintiffs’ counsel at www.brodsky-smith.com. In December 2004, the Jefferson Circuit Court will conduct a hearing to determine whether to approve the settlement agreement and dismiss the Sommerfeld consolidated derivative action.

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

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

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

RESULTS OF OPERATIONS

Cautionary Statement

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

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

•

the Company’s ability to operate pursuant to the terms of its debt obligations and its Master Lease Agreements with Ventas,

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

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

RESULTS OF OPERATIONS (Continued)

Cautionary Statement (Continued)

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

General

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

The Company is a healthcare services company that operates hospitals, nursing centers, institutional pharmacies and a contract rehabilitation services business. At September 30, 2004, the Company’s hospital division operated 74 hospitals (5,647 licensed beds) in 24 states. The Company’s health services division operated 249 nursing centers (31,973 licensed beds) in 29 states. The Company’s pharmacy division operated an institutional pharmacy business with 31 pharmacies in 20 states and a pharmacy management business servicing substantially all of the Company’s hospitals. 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.

On July 1, 2004, the Company completed the Hospital Services Reorganization.

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

In April 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.

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

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.

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.

The Company recorded income of approximately $2 million and $10 million for the third quarter of 2004 and 2003, respectively, and $8 million and $10 million for the nine months ended September 30, 2004 and 2003, respectively, related to settlements of prior year hospital Medicare cost reports. In addition, the Company recorded approximately $6 million of income in the second quarter of 2004 related to retroactive nursing center Medicaid rate increases in North Carolina that were approved in April 2004. See Note 4 of the accompanying Notes to Condensed Consolidated Financial Statements.

Collectibility of accounts receivable

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

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

The provision for doubtful accounts totaled $4 million and $5 million for the third quarter of 2004 and 2003, respectively, and totaled $17 million and $15 million for the nine months ended September 30, 2004 and 2003, respectively.

Allowances for insurance risks

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks recorded in the accompanying unaudited condensed consolidated balance sheet aggregated $294 million at September 30, 2004 and $296 million at December 31, 2003. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $311 million at both September 30, 2004 and December 31, 2003.

In recent years, the Company has recorded substantial cost increases related to professional liability risks. A portion of these costs were not funded into the limited purpose insurance subsidiary until the following fiscal year. Based upon actuarially determined estimates, the Company has funded approximately $12 million into its limited purpose insurance subsidiary through September 30, 2004 and intends to fund an additional $3 million 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 September 30, 2004 would impact the Company’s operating income by approximately $3 million. During the third quarter of 2004, the Company recorded a favorable change in estimate aggregating $11 million for professional liability reserves related to its former Florida and Texas nursing centers (included in discontinued operations).

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $18 million and $20 million for the third quarter of 2004 and 2003, respectively, and $61 million and $71 million for the nine months ended September 30, 2004 and 2003, respectively.

Provisions for loss for workers compensation risks retained by the limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $70 million at September 30, 2004 and $64 million at December 31, 2003. The provision for workers compensation risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $13 million and $11 million for the three months ended September 30, 2004 and 2003, respectively, and $38 million and $34 million for the nine months ended September 30, 2004 and 2003, respectively.

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

Accounting for income taxes

The provision for income taxes is based upon the Company’s estimate of taxable income or loss for each respective accounting period. The Company recognizes an asset or liability for the deferred tax consequences of

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Accounting for income taxes (Continued)

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, among other things, which could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized. A valuation allowance is provided for deferred tax assets to the extent the realizability of the deferred tax assets is uncertain. The Company recognized deferred tax assets totaling $198 million at September 30, 2004 and $182 million at 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 was treated as an increase to capital in excess of par value.

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

In November 2004, the Internal Revenue Service proposed certain adjustments to the Company’s 2000 and 2001 federal income tax returns which the Company intends to contest. Management believes that the ultimate resolution of these issues will not have a material adverse effect on the Company’s financial position, results of operations or liquidity.

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

Valuation of long-lived assets and goodwill

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

In assessing the carrying values of long-lived assets, the Company estimates future cash flows at the lowest level for which there are independent, identifiable cash flows. For this purpose, these cash flows are aggregated based upon the contractual agreements underlying the operation of the facility or group of facilities. Generally, an individual facility is considered the lowest level for which there are independent, identifiable cash flows. However, to the extent that groups of facilities are leased under a master lease agreement in which the operations

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

RESULTS OF OPERATIONS (Continued)

Critical Accounting Policies (Continued)

Valuation of long-lived assets and goodwill (Continued)

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.

Recent Developments

The Company has contracts with non-Kindred short-term acute care and other hospitals to operate long-term acute care hospitals within the host hospital. Under these arrangements, the Company leases space and purchases a limited amount of ancillary services from the host hospital and provides it with the option to discharge a portion of its clinically appropriate patients into the care of the Company’s hospital. These hospitals-in-hospitals (“HIHs”) also receive patients from general short-term acute care hospitals other than the host hospital. At September 30, 2004, the Company operated 60 free-standing hospitals (5,086 licensed beds) and 14 HIHs (561 licensed beds).

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

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

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

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

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

RESULTS OF OPERATIONS (Continued)

Recent Developments (Continued)

The Company is continuing to evaluate the impact of the final regulations on its operations and is awaiting additional payment instructions to be issued by CMS. At this time, the Company does not believe that the new rules will significantly impact its ongoing operations since only 10% of its existing hospital licensed beds would be subject to the new rules. For the third quarter of 2004, the Company’s HIHs generated revenues of approximately $25 million, operating income of approximately $6 million and pretax income of approximately $3 million. The Company also is considering the impact of the final regulations on its HIH development activities.

Results of Operations – Continuing Operations

Hospital Division

Revenues increased 4% to $356 million in the third quarter of 2004 from $341 million in the same period a year ago and 5% to $1.1 billion for the nine months ended September 30, 2004 from $1.0 billion in the same period last year. Revenue growth in both periods was a result of growth in admissions and new hospital development. Revenues for the third quarter and nine months ended September 30, 2004 included income of $2 million and $8 million, respectively, related to settlements of prior year Medicare cost reports. Revenues for the third quarter of 2003 included income of approximately $10 million related to settlements of prior year Medicare cost reports and approximately $4 million of favorable Medicare reimbursement adjustments that resulted from the conversion to LTAC PPS. On a same-store basis, revenues increased 5% in the third quarter of 2004 and 3% for the nine months ended September 30, 2004 compared to the same periods a year ago.

Admissions rose 12% in the third quarter of 2004 and 10% for the first nine months of 2004 compared to the respective prior year periods. On a same-store basis, admissions increased 5% in both the third quarter and nine months ended September 30, 2004 compared to the respective periods in 2003. Declines in patient days in both periods resulted primarily from reduced average length of stay.

Hospital operating income declined 9% to $80 million in the third quarter of 2004 from $87 million in the third quarter of 2003. For the nine months ended September 30, 2004, operating income rose 6% to $246 million from $233 million for the same period a year ago. Operating margins were 22.3% in the third quarter of 2004 compared to 25.5% in the third quarter of 2003. For the nine months ended September 30, 2004, operating margins were 23.2% compared to 23.0% in the same period last year.

As previously discussed, favorable Medicare reimbursement adjustments increased hospital operating income by approximately $2 million and $14 million in the third quarter of 2004 and 2003, respectively, and by approximately $8 million and $14 million for the nine months ended September 30, 2004 and 2003, respectively. Operating income in the third quarter of 2004 was reduced by approximately $4 million in connection with the Hospital Services Reorganization. Excluding these items, growth in hospital operating income in both periods was primarily attributable to growth in admissions and related operating efficiencies. Aggregate operating costs per admission (including costs associated with the Hospital Services Reorganization) declined 3% in the third quarter of 2004 and 5% for the first nine months of 2004 compared to the respective periods last year.

Professional liability costs were $5 million in the third quarter of 2004 and $16 million for the nine months ended September 30, 2004, compared to $6 million and $18 million for the respective periods in 2003.

Health Services Division

Revenues increased 6% to $450 million in the third quarter of 2004 compared to $423 million in the same period a year ago and increased 8% to $1.3 billion for the nine months ended September 30, 2004 compared to $1.2 billion in the same period last year. The increase in revenues in both periods was primarily attributable to

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)

increases in rates, including a 6% increase in Medicare reimbursement that became effective on October 1, 2003. Overall occupancy rates declined approximately 1% in both the third quarter and nine months ended September 30, 2004 compared to the same periods in 2003.

Medicare patient days declined 3% in the third quarter of 2004 and increased 3% during the first nine months of 2004. Management believes that the decline in Medicare census in the third quarter of 2004 resulted generally from weaker Medicare census levels in short-term acute care hospitals from which most of the these patients are referred.

Nursing center operating income increased 5% to $58 million in the third quarter of 2004 compared to $56 million in the third quarter of 2003 and increased 8% to $170 million compared to $158 million for the same period last year. Operating margins of 12.9% in the third quarter of 2004 were relatively unchanged from 13.1% in the third quarter of 2003. For the nine months ended September 30, 2004, operating margins of 12.7% were relatively unchanged compared to 12.8% for the same period a year ago. The improvement in nursing center operating income for the third quarter of 2004 and nine months ended September 30, 2004 was primarily attributable to favorable reimbursement rates. Growth in overall operating expenses per patient day in both the third quarter of 2004 and the nine months ended September 30, 2004 compared to the same periods last year were approximately the same as the rates of growth in revenues per patient day.

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 5% to $242 million in the third quarter of 2004 compared to $256 million for the same period a year ago. Average hourly wage rates were relatively unchanged in the third quarter and first nine months of 2004 compared to the same periods a year ago, while employee benefit costs declined 6% and 4%, respectively, for the same periods. Intercompany charges for rehabilitation services provided by the rehabilitation division to the Company’s nursing centers in the third quarter and nine months ended September 30, 2004 totaled $36 million and $109 million, respectively.

Professional liability costs totaled $13 million for the third quarter of 2004 compared to $14 million for the same period a year ago. For the nine months ended September 30, 2004, professional liability costs totaled $45 million compared to $53 million for the same period a year ago.

Rehabilitation Division

Revenues increased to $61 million in the third quarter of 2004 from $13 million for the same period a year ago, while operating income totaled $8 million in the third quarter of 2004 compared to breakeven results in the third quarter of 2003. For the nine months ended September 30, 2004, revenues increased to $166 million from $30 million for the same period a year ago, while operating income totaled $24 million compared to an operating loss of $2 million for the same period a year ago. The increase in revenues and operating income in the third quarter and first nine months of 2004 was primarily attributable to the Rehabilitation Services Reorganization. Intercompany revenues for services provided to the Company’s nursing centers totaled $36 million and $109 million in the third quarter and first nine months of 2004, respectively. Intercompany revenues and operating income associated with the Hospital Services Reorganization aggregated $10 million and $1 million, respectively, in the third quarter of 2004.

Pharmacy Division

Revenues increased 44% to $97 million in the third quarter of 2004 compared to $67 million for the third quarter a year ago. For the nine months ended September 30, 2004, revenues increased 32% to $261 million

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

RESULTS OF OPERATIONS (Continued)

Results of Operations – Continuing Operations (Continued)

Pharmacy Division (Continued)

compared to $198 million for the same period a year ago. Revenues associated with the Hospital Services Reorganization aggregated $10 million in the third quarter of 2004. Revenue increases in both the third quarter of 2004 and the nine months ended September 30, 2004 also resulted from growth in the number of non-affiliated customers, price increases and increased demand for higher priced drugs. At September 30, 2004, the Company provided pharmacy services to nursing centers containing 65,100 licensed beds, including 28,500 licensed beds that it operates. At September 30, 2003, the Company provided pharmacy services to nursing facilities containing 57,400 licensed beds, including 27,900 licensed beds that it operates.

Pharmacy operating income totaled $11 million in the third quarter of 2004 compared to $6 million in the same period a year ago. For the nine months ended September 30, 2004, operating income totaled $26 million compared to $19 million in the same period a year ago. Operating income associated with the Hospital Services Reorganization aggregated $2 million in the third quarter of 2004. Operating margins were 11.2% in the third quarter of 2004 compared to 9.2% for the same period a year ago. For the nine months ended September 30, 2004, operating margins were 10.0% compared to 9.6% for the same period a year ago. The cost of goods sold as a percentage of institutional pharmacy revenues rose to 65.3% in the third quarter of 2004 compared to 64.3% for the same period a year ago. For the nine months ended September 30, 2004, the cost of goods sold as a percentage of institutional pharmacy revenues rose to 65.2% compared to 63.2% for the same period a year ago. The increase in the cost of goods sold ratio was primarily attributable to Medicaid reimbursement reductions in certain states and competitive customer pricing. Despite the deterioration in the cost of goods sold ratio, aggregate pharmacy operating margins improved in both periods compared to last year primarily due to administrative cost efficiencies associated with volume growth and the favorable impact of the Hospital Services Reorganization.

Corporate Overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $33 million in the third quarter of 2004 compared to $29 million in the third quarter of 2003. For the third quarter of 2004, corporate overhead included a pretax charge of $3 million related to a terminated pension plan. For the nine months ended September 30, 2004, corporate overhead aggregated $90 million compared to $84 million for the same period a year ago. As a percentage of consolidated revenues, corporate overhead totaled 3.7% in the third quarter of 2004 compared to 3.5% in the third quarter of 2003 and 3.4% for both respective nine-month periods.

Corporate expenses included the operating losses of the Company’s limited purpose insurance subsidiary of $2 million in the third quarter of 2004 compared to $4 million in the third quarter of 2003, and $5 million and $10 million for the nine months ended September 30, 2004 and 2003, respectively.

Capital Costs

Rent expense increased 4% to $67 million in the third quarter of 2004 compared to $64 million for the same period a year ago. For the nine months ended September 30, 2004, rent expense increased 3% to $196 million compared to $190 million for the same period a year ago. A substantial portion of the increase in both periods resulted from contractual inflation increases, including those associated with the Master Lease Agreements.

Depreciation expense increased 16% to $24 million in the third quarter of 2004 compared to $20 million for the same period a year ago. For the nine months ended September 30, 2004, depreciation expense increased 15% to $68 million compared to $59 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 $3 million in the third quarter of 2004 compared to $1 million for the same period a year ago. Interest expense for the third quarter of 2003 included approximately $2 million of gains in connection with the prepayment of long-term debt. For the nine months ended September 30, 2004, interest expense aggregated $11 million compared to $7 million for the same period a year ago. Interest expense for the nine months ended September 30, 2004 included a pretax charge of approximately $1 million resulting from the refinancing of the Company’s credit agreements. For accounting purposes, the $44 million present value rent obligation to Ventas incurred in connection with the Florida and Texas Divestiture bears interest at a rate of 11%. See Note 2 of the accompanying Notes to Condensed Consolidated Financial Statements.

Investment income, related primarily to the Company’s excess cash balances and insurance subsidiary investments, approximated $2 million in the third quarter of 2004 compared to $1 million in the third quarter of 2003, and $5 million for both the nine months ended September 30, 2004 and 2003.

Consolidated Results

The Company reported income from continuing operations before income taxes of $30 million for the third quarter of 2004 compared to $32 million for the third quarter of 2003. For the nine months ended September 30, 2004, income from continuing operations before income taxes aggregated $101 million compared to $63 million for the same period a year ago. Income from continuing operations in the third quarter of 2004 aggregated $19 million compared to $20 million in the third quarter of 2003. For the nine months ended September 30, 2004, income from continuing operations aggregated $60 million compared to $37 million for the same period a year ago.

Discontinued Operations

Net income from discontinued operations aggregated $4 million in the third quarter of 2004 compared to operating losses of $7 million in the third quarter of 2003. For the nine months ended September 30, 2004, net operating results for discontinued operations were approximately breakeven compared to a loss of $45 million for the same period a year ago. Net income from discontinued operations in the third quarter of 2004 included a favorable pretax adjustment of approximately $11 million ($7 million net of income taxes) resulting from a change in estimate for professional liability reserves related to the Company’s former nursing centers in Florida and Texas. See Notes 3 and 8 of the accompanying Notes to Condensed Consolidated Financial Statements.

Net losses associated with the divestiture of discontinued operations totaled approximately $8 million in the third quarter of 2004 and $1 million in the third quarter of 2003, and $9 million and $37 million for the respective nine-month periods.

Liquidity

Cash flows provided by operations (including discontinued operations) aggregated $174 million for the nine months ended September 30, 2004 compared to $111 million for the same period a year ago. During both periods, the Company maintained sufficient liquidity from operations to fund its ongoing capital expenditure program and finance acquisitions.

Cash and cash equivalents totaled $30 million at September 30, 2004 compared to $67 million at December 31, 2003. Based upon existing cash levels, expected operating cash flows and capital spending, and the availability of borrowings under the Credit Facility, management believes that the Company has the necessary financial resources to satisfy expected short-term and long-term liquidity needs. During the third quarter of 2004, the Company repaid all $80 million of outstanding borrowings under the Credit Facility.

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

RESULTS OF OPERATIONS (Continued)

Liquidity (Continued)

As previously discussed, the Company has funded approximately $12 million into its limited purpose insurance subsidiary through September 30, 2004 and intends to fund an additional $3 million by December 31, 2004 to satisfy fiscal 2003 funding requirements. In March 2003, the Company funded approximately $63 million into its limited purpose insurance subsidiary to satisfy fiscal 2002 funding requirements.

In June 2004, the Company entered into the Credit Facility to refinance its existing credit agreements. In connection with the refinancing, the Company prepaid in full the outstanding balance of its senior secured notes with borrowings under the Credit Facility. Amounts borrowed under the Credit Facility bear interest, at the Company’s option, at (a) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (b) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based on the Company’s adjusted leverage ratio as defined in the Credit Facility. During the third quarter of 2004, the interest rate under the Credit Facility was 4.4%. The Credit Facility is collateralized by substantially all of the Company’s assets including certain owned real property and is guaranteed by substantially all of the Company’s subsidiaries. The Credit Facility constitutes a working capital facility for general corporate purposes and permits acquisitions and investments in healthcare facilities and companies up to an aggregate of $150 million. The Credit Facility also allows the Company, to a limited extent, to pay cash dividends and to repurchase its common stock. There were no outstanding borrowings under the Credit Facility at September 30, 2004. The Company was in compliance with the terms of its Credit Facility at September 30, 2004.

During the third quarter of 2004, the Company purchased for resale three leased nursing centers in exchange for total cash consideration of $12 million. Two of the three nursing centers were sold in the third quarter for $7 million in cash.

In December 2003, the Company completed the acquisition of the Ventas II Facilities for $85 million in cash. Aggregate cash proceeds from the sale of five of the Ventas II Facilities through September 30, 2004 approximated $15 million. The Company intends to dispose of the remaining properties as soon as practicable.

Capital Resources

Capital expenditures totaled $58 million for the nine months ended September 30, 2004 compared to $49 million for the nine months ended September 30, 2003. Capital expenditures (excluding acquisitions) could approximate $100 million in 2004. Management believes that its capital expenditure program is adequate to improve and equip existing facilities.

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

The Company’s capital expenditure program is financed generally through the use of operating cash flows. At September 30, 2004, the estimated cost to complete and equip construction in progress approximated $38 million.

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

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

RESULTS OF OPERATIONS (Continued)

Other Information

Effects of Inflation and Changing Prices

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

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

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

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

Litigation

The Company is a party to certain material litigation. See Note 12 of the accompanying Notes to Condensed Consolidated Financial Statements.

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

RESULTS OF OPERATIONS (Continued)

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)


	2003 Quarters												2004 Quarters
	First			Second			Third			Fourth			First			Second			Third
Revenues	$	794,494		$	806,104		$	828,831		$	822,535		$	863,314		$	891,034		$	889,435

Salaries, wages and benefits		454,892			456,297			463,027			467,244			487,048			489,519			499,436
Supplies		103,676			103,860			107,152			112,708			116,248			120,117			122,151
Rent		62,554			63,693			64,248			63,699			63,975			65,482			66,805
Other operating expenses		144,529			139,111			142,381			129,556			143,490			148,500			146,452
Depreciation		18,944			19,607			20,065			20,997			21,768			22,457			23,176
Interest expense		2,888			2,992			1,054			3,388			3,656			4,714			2,535
Investment income		(1,635	)		(1,676	)		(1,333	)		(1,491	)		(1,218	)		(1,826	)		(1,605	)

		785,848			783,884			796,594			796,101			834,967			848,963			858,950

Income from continuing operations before reorganization items and income taxes		8,646			22,220			32,237			26,434			28,347			42,071			30,485
Reorganization items		–			–			–			(1,010	)		–			(304	)		–

Income from continuing operations before income taxes		8,646			22,220			32,237			27,444			28,347			42,375			30,485
Provision for income taxes		5,036			8,236			13,127			11,349			11,926			17,452			12,063

Income from continuing operations		3,610			13,984			19,110			16,095			16,421			24,923			18,422
Discontinued operations, net of income taxes:
Income (loss) from operations		(16,734	)		(21,395	)		(6,576	)		(4,017	)		(2,581	)		(2,091	)		4,703
Loss on divestiture of operations		–			(36,019	)		(827	)		(42,567	)		–			(1,063	)		(7,557	)

Net income (loss)	$	(13,124	)	$	(43,430	)	$	11,707		$	(30,489	)	$	13,840		$	21,769		$	15,568

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.10		$	0.40		$	0.55		$	0.46		$	0.46		$	0.70		$	0.51
Discontinued operations:
Income (loss) from operations		(0.48	)		(0.61	)		(0.19	)		(0.12	)		(0.07	)		(0.06	)		0.13
Loss on divestiture of operations		–			(1.04	)		(0.02	)		(1.21	)		–			(0.03	)		(0.21	)

Net income (loss)	$	(0.38	)	$	(1.25	)	$	0.34		$	(0.87	)	$	0.39		$	0.61		$	0.43

Diluted:
Income from continuing operations	$	0.10			0.40		$	0.54		$	0.40		$	0.38		$	0.60		$	0.44
Discontinued operations:
Income (loss) from operations		(0.48	)		(0.61	)		(0.19	)		(0.10	)		(0.06	)		(0.05	)		0.11
Loss on divestiture of operations		–			(1.04	)		(0.02	)		(1.05	)		–			(0.03	)		(0.18	)

Net income (loss)	$	(0.38	)	$	(1.25	)	$	0.33		$	(0.75	)	$	0.32		$	0.52		$	0.37

Shares used in computing earnings (loss) per common share:
Basic		34,755			34,813			34,885			35,062			35,414			35,536			35,939
Diluted		34,767			34,828			35,143			40,685			42,721			41,913			42,293

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

RESULTS OF OPERATIONS (Continued)

Operating Data

(Unaudited)

(In thousands)


	2003 Quarters												2004 Quarters
	First			Second			Third			Fourth			First			Second			Third
Revenues:
Hospital division	$	331,862		$	338,360		$	341,368		$	325,619		$	348,648		$	355,312		$	356,260
Health services division (a)		402,917			408,768			423,481			424,790			435,998			452,820			449,674
Rehabilitation division (a)		8,502			8,795			12,065			14,121			52,699			52,588			61,157	(b)
Pharmacy division		66,126			64,850			67,075			74,382			79,746			84,346			96,591	(b)

		809,407			820,773			843,989			838,912			917,091			945,066			963,682
Eliminations:
Rehabilitation (a)		–			–			–			–			(36,023	)		(36,579	)		(46,779	)(b)
Pharmacy		(14,913	)		(14,669	)		(15,158	)		(16,377	)		(17,754	)		(17,453	)		(27,468	)(b)

		(14,913	)		(14,669	)		(15,158	)		(16,377	)		(53,777	)		(54,032	)		(74,247	)

	$	794,494		$	806,104		$	828,831		$	822,535		$	863,314		$	891,034		$	889,435

Income from continuing operations:
Operating income (loss):
Hospital division	$	70,538		$	75,455		$	87,171		$	73,702		$	80,066		$	86,483		$	79,616	(b)
Health services division (a)		44,436			57,759			55,361			64,565			48,945			63,001			57,978
Rehabilitation division (a)		(959	)		(750	)		261			(315	)		8,519			7,265			7,737	(b)
Pharmacy division		6,702			6,133			6,150			7,508			7,609			7,729			10,853	(b)
Corporate:
Overhead		(26,713	)		(28,354	)		(28,670	)		(28,898	)		(26,834	)		(30,356	)		(33,028	)
Insurance subsidiary		(2,607	)		(3,407	)		(4,002	)		(3,535	)		(1,777	)		(1,224	)		(1,760	)

		(29,320	)		(31,761	)		(32,672	)		(32,433	)		(28,611	)		(31,580	)		(34,788	)

		91,397			106,836			116,271			113,027			116,528			132,898			121,396
Reorganization items		–			–			–			1,010			–			304			–

Operating income		91,397			106,836			116,271			114,037			116,528			133,202			121,396
Rent		(62,554	)		(63,693	)		(64,248	)		(63,699	)		(63,975	)		(65,482	)		(66,805	)
Depreciation		(18,944	)		(19,607	)		(20,065	)		(20,997	)		(21,768	)		(22,457	)		(23,176	)
Interest, net		(1,253	)		(1,316	)		279			(1,897	)		(2,438	)		(2,888	)		(930	)

Income from continuing operations before income taxes		8,646			22,220			32,237			27,444			28,347			42,375			30,485
Provision for income taxes		5,036			8,236			13,127			11,349			11,926			17,452			12,063

	$	3,610		$	13,984		$	19,110		$	16,095		$	16,421		$	24,923		$	18,422

(a)

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

(b)

Effective July 1, 2004, the Company completed the Hospital Services Reorganization. Revenues in the third quarter of 2004 associated with this new arrangement aggregated $10.3 million in the rehabilitation division and $9.4 million in the pharmacy division. This new arrangement reduced hospital division operating income by approximately $4.3 million while increasing rehabilitation division operating income by approximately $1.4 million and pharmacy division operating income by approximately $2.1 million.

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)

(In thousands)


	2003 Quarters								2004 Quarters
	First		Second		Third		Fourth		First		Second		Third
Rent:
Hospital division	$	23,284	$	23,706	$	23,441	$	22,753	$	22,844	$	23,529	$	24,262
Health services division (a)		38,507		39,286		39,924		39,999		39,799		40,398		40,923
Rehabilitation division (a)		69		95		123		185		611		708		747
Pharmacy division		630		547		698		703		662		790		812
Corporate		64		59		62		59		59		57		61

	$	62,554	$	63,693	$	64,248	$	63,699	$	63,975	$	65,482	$	66,805

Depreciation:
Hospital division	$	7,054	$	7,450	$	7,684	$	8,257	$	8,464	$	8,712	$	9,139
Health services division (a)		6,122		6,249		6,346		6,409		6,615		6,796		6,901
Rehabilitation division (a)		16		20		22		25		33		37		38
Pharmacy division		517		539		561		560		530		583		603
Corporate		5,235		5,349		5,452		5,746		6,126		6,329		6,495

	$	18,944	$	19,607	$	20,065	$	20,997	$	21,768	$	22,457	$	23,176

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	2,822	$	4,133	$	5,773	$	13,388	$	5,406	$	5,177	$	8,867
Health services division (a)		3,222		6,375		9,768		9,804		8,450		6,487		7,074
Rehabilitation division (a)		51		47		35		11		47		56		19
Pharmacy division		616		522		815		2,254		773		1,075		1,004
Corporate:
Information systems		3,207		5,992		4,071		8,223		2,651		4,033		4,251
Other		647		408		361		1,551		554		829		1,175

	$	10,565	$	17,477	$	20,823	$	35,231	$	17,881	$	17,657	$	22,390

(a)

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

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)


	2003 Quarters								2004 Quarters
	First		Second		Third		Fourth		First		Second		Third
Hospital data:
End of period data:
Number of hospitals		63		63		64		66		68		70		74
Number of licensed beds		5,076		5,098		5,129		5,219		5,323		5,474		5,647

Revenue mix % (a):
Medicare		60		59		62		63		66		64		63
Medicaid		8		8		7		8		7		8		8
Private and other		32		33		31		29		27		28		29

Admissions:
Medicare		6,612		6,346		6,053		6,681		6,900		6,816		6,675
Medicaid		648		604		670		661		715		820		796
Private and other		1,281		1,322		1,333		1,359		1,460		1,588		1,580

		8,541		8,272		8,056		8,701		9,075		9,224		9,051

Admissions mix %:
Medicare		77		77		75		77		76		74		74
Medicaid		8		7		8		7		8		9		9
Private and other		15		16		17		16		16		17		17

Patient days:
Medicare		216,266		214,116		193,069		191,904		207,052		201,580		191,383
Medicaid		31,764		32,470		31,362		29,488		27,754		29,293		30,504
Private and other		56,225		59,339		54,080		52,725		52,391		53,031		54,073

		304,255		305,925		278,511		274,117		287,197		283,904		275,960

Average length of stay:
Medicare		32.7		33.7		31.9		28.7		30.0		29.6		28.7
Medicaid		49.0		53.8		46.8		44.6		38.8		35.7		38.3
Private and other		43.9		44.9		40.6		38.8		35.9		33.4		34.2
Weighted average		35.6		37.0		34.6		31.5		31.6		30.8		30.5

Revenues per admission (a):
Medicare	$	30,050	$	31,594	$	35,157	$	30,987	$	33,321	$	33,397	$	33,538
Medicaid		40,547		44,766		36,974		37,825		33,228		32,952		34,594
Private and other		83,449		83,830		77,860		68,870		65,054		63,384		66,366
Weighted average		38,855		40,904		42,374		37,423		38,419		38,520		39,361

Revenues per patient day (a):
Medicare	$	919	$	936	$	1,102	$	1,079	$	1,110	$	1,129	$	1,170
Medicaid		827		833		790		848		856		922		903
Private and other		1,901		1,868		1,919		1,775		1,813		1,898		1,939
Weighted average		1,091		1,106		1,226		1,188		1,214		1,252		1,291

Medicare case mix index (discharged patients only)		N/A		N/A		N/A		1.20		1.26		1.25		1.21

Average daily census		3,381		3,362		3,027		2,980		3,156		3,120		3,000
Occupancy %		69.8		69.0		61.9		59.9		62.4		60.1		56.5

(a)

Includes income of $13.8 million in the third quarter of 2003, $2.2 million in the first quarter of 2004, $3.9 million in the second quarter of 2004 and $1.6 million in the third quarter of 2004 related to certain Medicare reimbursement issues.

N/A

– not available.

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

RESULTS OF OPERATIONS (Continued)

Operating Data (Continued)

(Unaudited)


	2003 Quarters								2004 Quarters
	First		Second		Third		Fourth		First		Second			Third
Nursing center data:
End of period data:
Number of nursing centers:
Owned or leased		242		242		242		242		242		242			242
Managed		7		7		7		7		7		7			7

		249		249		249		249		249		249			249

Number of licensed beds:
Owned or leased		31,361		31,192		31,187		31,193		31,193		31,189			31,170
Managed		803		803		803		803		803		803			803

		32,164		31,995		31,990		31,996		31,996		31,992			31,973

Revenue mix %:
Medicare		33		33		32		33		36		33			32
Medicaid		48		48		50		48		46		49	(a)		50
Private and other		19		19		18		19		18		18			18
Patient days (excludes managed facilities):
Medicare		391,660		391,920		387,342		388,940		423,649		400,487			377,563
Medicaid		1,662,372		1,668,785		1,718,954		1,701,819		1,642,585		1,657,812			1,701,837
Private and other		400,130		408,909		411,864		413,876		396,408		399,321			404,823

		2,454,162		2,469,614		2,518,160		2,504,635		2,462,642		2,457,620			2,484,223

Patient day mix %:
Medicare		16		16		16		16		17		16			15
Medicaid		68		68		68		68		67		68			69
Private and other		16		16		16		16		16		16			16

Revenues per patient day:
Medicare	$	338	$	342	$	344	$	364	$	373	$	376		$	386
Medicaid		117		118		123		120		121		134	(a)		132
Private and other		189		190		190		191		198		200			197
Weighted average		164		165		168		170		177		184			181

Average daily census		27,268		27,139		27,371		27,224		27,062		27,007			27,002
Occupancy %		86.6		86.2		87.4		86.9		86.4		86.3			86.2

Rehabilitation data:
Revenue mix %:
Company-operated		N/A		N/A		N/A		N/A		70		71			76
Non-affiliated		N/A		N/A		N/A		N/A		30		29			24

Pharmacy data:
Number of institutional customer licensed beds at end of period:
Company-operated		29,804		27,566		27,886		28,280		28,188		28,164			28,476
Non-affiliated		28,365		28,848		29,507		33,127		35,102		36,385			36,671

		58,169		56,414		57,393		61,407		63,290		64,549			65,147

(a)

Includes income of $8.7 million related to prior period North Carolina provider tax program revenues. Prior period provider tax expense of $2.8 million related to this program was recorded in other operating expenses.

N/A

– not available.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

Interest Rate Sensitivity

Principal (Notional) Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)


	Expected maturities																				Fair value 9/30/04
	2004			2005			2006			2007			2008			Thereafter			Total		Fair value 9/30/04

Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate:
Ventas debt obligation:
Principal	$	1,189		$	5,311		$	6,264		$	7,338		$	5,660		$	12,880		$	38,642	$	38,642
Interest		1,031			3,778			3,143			2,399			1,646			2,376			14,373		–

		2,220			9,089			9,407			9,737			7,306			15,256			53,015		38,642
Other		16			63			67			71			76			820			1,113		1,046

	$	2,236		$	9,152		$	9,474		$	9,808		$	7,382		$	16,076		$	54,128	$	39,688

Average interest rate		10.9	%		10.9	%		10.9	%		11.0	%		10.9	%		10.7	%
Variable rate (a)	$	–		$	–		$	–		$	–		$	–		$	–		$	–	$	–

(a)

The Company has no outstanding variable rate long-term debt at September 30, 2004. Interest on borrowings under the Credit Facility is payable, at the Company’s option, at (a) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (b) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based on the Company’s adjusted leverage ratio as defined in the Credit Facility.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

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

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

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Summary descriptions of various significant legal and regulatory activities follow.

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 issued an order on July 29, 2004, vacating the previous judge’s denial of the defendants’ motion to dismiss. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

Three shareholder derivative suits entitled Elizabeth Sommerfeld v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 08476; Ilse Denchfield v. Kindred Healthcare, Inc., et al., Civil Action No. 02 CI 09475; and Fedorka v. Edward L. Kuntz, et al., Civil Action No. 03 CI 02015, were filed in November 2002, December 2002 and March 2003, respectively, in the Jefferson Circuit Court in Kentucky. The complaints in those lawsuits are nearly identical to the complaint in a putative class action lawsuit entitled Massachusetts State Carpenters Pension Fund v. Kindred Healthcare, Inc., et al, Civil Action No. 3:02CV-600-J, which was filed against the Company and certain of the Company’s current and former officers and directors on October 16, 2002 in the District Court and was dismissed with prejudice on January 12, 2004. Specifically, the derivative suits allege that from August 14, 2001 to October 10, 2002 the defendants violated Sections 10(b) and 20(a) of the Exchange Act by, among other things, issuing to the investing public a series of allegedly false and misleading statements that inaccurately indicated that the Company was successfully emerging from bankruptcy and implementing a growth plan. In particular, the complaint alleges that these statements were materially false and misleading because they failed to disclose that the 2001 Florida tort reform legislation had resulted in a marked increase in claims against the Company in Florida, and also because the statements reflected a materially understated reserve for professional liability costs. The complaints further allege that as a result of the purportedly false and misleading

PART II. OTHER INFORMATION (Continued)

Item 1. Legal Proceedings (Continued)

statements, the price of the Company’s common stock was artificially inflated, the investing public was deceptively induced to purchase the stock at those inflated prices, and the defendants profited by selling shares at those prices. In May 2003, the Fedorka plaintiffs voluntarily dismissed their state court derivative lawsuit and refiled that lawsuit in the District Court, 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 District Court. On May 12, 2003, the Jefferson Circuit Court entered an order consolidating the Sommerfeld and Denchfield derivative actions and staying all proceedings in the consolidated derivative action pending the District Court’s ruling on the defendants’ motion to dismiss the consolidated putative class action. On July 24, 2003, the District Court entered a similar order concerning the Fedorka and Win federal derivative actions. After the District Court’s dismissal of the Massachusetts State Carpenters Pension Fund putative class action became final in February 2004, the plaintiffs in the consolidated Fedorka and Win federal derivative action voluntarily dismissed that consolidated derivative action, with prejudice. Subsequently, on October 4, 2004, the parties entered into an agreement to settle the Sommerfeld consolidated derivative action under which the Company agreed to pay $60,000 of the plaintiffs’ legal fees. Additional information concerning the terms of the settlement agreement is available on the website of the Sommerfeld plaintiffs’ counsel at www.brodsky-smith.com. In December 2004, the Jefferson Circuit Court will conduct a hearing to determine whether to approve the settlement agreement and dismiss the Sommerfeld consolidated derivative action.

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



		10.1		Amendment No. 1 to the Kindred 401(k) Plan dated July 1, 2004.

		10.2		Amendment No. 1 to the Kindred & Affiliates 401(k) Plan dated July 1, 2004.

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

		32		Section 1350 Certifications.

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: November 5, 2004						/s/ PAUL J. DIAZ
						Paul J. Diaz President and Chief Executive Officer

Date: November 5, 2004						/s/ RICHARD A. LECHLEITER
						Richard A. Lechleiter Senior Vice President and Chief Financial Officer