Attached files

file filename
EX-12 - EX-12 - SELECT MEDICAL HOLDINGS CORPw77708exv12.htm
EX-23 - EX-23 - SELECT MEDICAL HOLDINGS CORPw77708exv23.htm
EX-21.1 - EX-21.1 - SELECT MEDICAL HOLDINGS CORPw77708exv21w1.htm
EX-31.1 - EX-31.1 - SELECT MEDICAL HOLDINGS CORPw77708exv31w1.htm
EX-32.1 - EX-32.1 - SELECT MEDICAL HOLDINGS CORPw77708exv32w1.htm
EX-31.2 - EX-31.2 - SELECT MEDICAL HOLDINGS CORPw77708exv31w2.htm
EX-10.119 - EX-10.119 - SELECT MEDICAL HOLDINGS CORPw77708exv10w119.htm
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
Form 10-K
 
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2009
OR
o
  TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission file numbers: 001-34465 and 001-31441
SELECT MEDICAL HOLDINGS CORPORATION
SELECT MEDICAL CORPORATION
(Exact name of Registrants as specified in their Charter)
 
     
Delaware
Delaware
  20-1764048
23-2872718
(State or Other Jurisdiction of Incorporation or Organization)   (I.R.S. Employer Identification Number)
 
     
4714 Gettysburg Road, P.O. Box 2034
Mechanicsburg, PA
(Address of Principal Executive Offices)
  17055
(Zip Code)
 
(717) 972-1100
(Registrants’ telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common Stock, $0.001 par value
  New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
NONE
 
Indicate by check mark if the registrants are well-known seasoned issuers, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
Indicate by check mark if the registrants are not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ
 
Indicate by check mark whether the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark whether the registrants have submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding twelve months (or for such shorter period that the registrants were required to submit and post such files).  Yes o     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants’ knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
Indicate by check mark whether the registrants are large accelerated filers, accelerated filers, non-accelerated filers, or smaller reporting companies. See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
             
Large Accelerated Filers o
       Accelerated Filers o   Non-Accelerated Filers þ   Smaller Reporting Companies o
    (Do not check if a smaller reporting companies)     
 
Indicate by check mark whether the registrants are shell companies (as defined in Rule 12b-2 of the Act).  Yes o     No þ
 
As of June 30, 2009 (the last business day of our most recently completed second fiscal quarter), Holdings’ common stock was not listed on any exchange or over-the counter market. Holdings’ common stock began trading on the New York Stock Exchange on September 25, 2009. As of December 31, 2009, the aggregate market value of Holdings’ voting stock held by non-affiliates was approximately $555,569,667 based on the number of shares held by non-affiliates as of December 31, 2009, and based on the reported last sale price of Holdings’ common stock on December 31, 2009.
 
The number of shares of Holdings’ Common Stock, $0.001 par value, outstanding as of March 1, 2010 was 160,005,236.
 
This Form 10-K is a combined annual report being filed separately by two Registrants: Select Medical Holdings Corporation and Select Medical Corporation. Unless the context indicates otherwise, any reference in this report to “Holdings” refers to Select Medical Holdings Corporation and any reference to “Select” refers to Select Medical Corporation, the wholly-owned operating subsidiary of Holdings. References to the “Company,” “we,” “us,” and “our” refer collectively to Select Medical Holdings Corporation and Select Medical Corporation.
 
Documents Incorporated by Reference
 
Listed hereunder are the documents, any portions of which are incorporated by reference and the Parts of this Form 10-K into which such portions are incorporated:
 
1. The registrant’s definitive proxy statement for use in connection with the 2010 Annual Meeting of Stockholders to be held on or about May 11, 2010 to be filed within 120 days after the registrant’s fiscal year ended December 31, 2009, portions of which are incorporated by reference into Part III of this Form 10-K. Such definitive proxy statement, except for the parts therein which have been specifically incorporated by reference, should not be deemed “filed” for the purposes of this form 10-K.
 


 

 
SELECT MEDICAL HOLDINGS CORPORATION
SELECT MEDICAL CORPORATION
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2009
TABLE OF CONTENTS
 
             
Item
      Page
 
    Forward-Looking Statements     1  
1.
  Business     2  
1A.
  Risk Factors     29  
1B.
  Unresolved Staff Comments     41  
2.
  Properties     41  
3.
  Legal Proceedings     43  
4.
  Reserved     44  
 
PART II
5.
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     44  
6.
  Selected Financial Data     46  
7.
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     50  
7A.
  Quantitative and Qualitative Disclosures About Market Risk     80  
8.
  Financial Statements and Supplementary Data     81  
9.
  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure     81  
  Controls and Procedures     81  
9B.
  Other Information     81  
 
PART III
10.
  Directors, Executive Officers and Corporate Governance     81  
11.
  Executive Compensation     82  
12.
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     82  
13.
  Certain Relationships, Related Transactions and Director Independence     82  
14.
  Principal Accountant Fees and Services     82  
 
PART IV
15.
  Exhibits and Financial Statement Schedules     83  
    93  
 EX-10.119
 EX-12
 EX-21.1
 EX-23
 EX-31.1
 EX-31.2
 EX-32.1


Table of Contents

 
PART I
 
Forward-Looking Statements
 
This annual report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. Forward-looking statements include statements preceded by, followed by or that include the words “may,” “could,” “would,” “should,” “believe,” “expect,” “anticipate,” “plan,” “target,” “estimate,” “project,” “intend” and similar expressions. These statements include, among others, statements regarding our expected business outlook, anticipated financial and operating results, our business strategy and means to implement our strategy, our objectives, the amount and timing of capital expenditures, the likelihood of our success in expanding our business, financing plans, budgets, working capital needs and sources of liquidity.
 
Forward-looking statements are only predictions and are not guarantees of performance. These statements are based on our management’s beliefs and assumptions, which in turn are based on currently available information. Important assumptions relating to the forward-looking statements include, among others, assumptions regarding our services, the expansion of our services, competitive conditions and general economic conditions. These assumptions could prove inaccurate. Forward-looking statements also involve known and unknown risks and uncertainties, which could cause actual results to differ materially from those contained in any forward-looking statement. Many of these factors are beyond our ability to control or predict. Such factors include, but are not limited to, the following:
 
  •  additional changes in government reimbursement for our services, including changes that will result from the expiration of the moratorium for long term acute care hospitals established by the SCHIP Extension Act of 2007 and the American Recovery and Reinvestment Act, may result in a reduction in net operating revenues, an increase in costs and a reduction in profitability;
 
  •  the failure of our specialty hospitals to maintain their Medicare certifications may cause our net operating revenues and profitability to decline;
 
  •  the failure of our facilities operated as “hospitals within hospitals” to qualify as hospitals separate from their host hospitals may cause our net operating revenues and profitability to decline;
 
  •  a government investigation or assertion that we have violated applicable regulations may result in sanctions or reputational harm and increased costs;
 
  •  future acquisitions or joint ventures may prove difficult or unsuccessful, use significant resources or expose us to unforeseen liabilities;
 
  •  private third-party payors for our services may undertake future cost containment initiatives that limit our future net operating revenues and profitability;
 
  •  the failure to maintain established relationships with the physicians in the areas we serve could reduce our net operating revenues and profitability;
 
  •  shortages in qualified nurses or therapists could increase our operating costs significantly;
 
  •  competition may limit our ability to grow and result in a decrease in our net operating revenues and profitability;
 
  •  the loss of key members of our management team could significantly disrupt our operations;
 
  •  the effect of claims asserted against us or lack of adequate available insurance could subject us to substantial uninsured liabilities;
 
  •  the ability to refinance our outstanding indebtedness before it comes due;
 
  •  the ability to obtain any necessary or desired waiver or amendment from our lenders may be difficult due to the current uncertainty in the credit markets;


1


Table of Contents

 
  •  the inability to draw funds under our senior secured credit facility because of lender defaults; and
 
  •  other factors discussed from time to time in our filings with the Securities and Exchange Commission (the “SEC”), including factors discussed under the heading “Risk Factors” of this annual report on Form 10-K.
 
Except as required by applicable law, including the securities laws of the United States and the rules and regulations of the SEC, we are under no obligation to publicly update or revise any forward-looking statements, whether as a result of any new information, future events or otherwise. You should not place undue reliance on our forward-looking statements. Although we believe that the expectations reflected in forward-looking statements are reasonable, we cannot guarantee future results or performance.
 
Investors should also be aware that while we do, from time to time, communicate with securities analysts, it is against our policy to disclose any material non-public information or other confidential commercial information. Accordingly, stockholders should not assume that we agree with any statement or report issued by any analyst irrespective of the content of the statement or report. Thus, to the extent that reports issued by securities analysts contain any projections, forecasts or opinions, such reports are not the responsibility of the Company.
 
Item 1.   Business.
 
Overview
 
We believe that we are one of the largest operators of both specialty hospitals and outpatient rehabilitation clinics in the United States based on number of facilities. As of December 31, 2009, we operated 89 long term acute care hospitals, or “LTCHs” and six inpatient rehabilitation facilities, or “IRFs” in 25 states, and 961 outpatient rehabilitation clinics in 37 states and the District of Columbia. We also provide medical rehabilitation services on a contract basis at nursing homes, hospitals, assisted living and senior care centers, schools and worksites. We began operations in 1997 under the leadership of our current management team.
 
We manage our company through two business segments, our specialty hospital segment and our outpatient rehabilitation segment. We had net operating revenues of $2,239.9 million for the year ended December 31, 2009. Of this total, we earned approximately 70% of our net operating revenues from our specialty hospital segment and approximately 30% from our outpatient rehabilitation segment. Our specialty hospital segment consists of hospitals designed to serve the needs of long term stay acute patients and hospitals designed to serve patients who require intensive inpatient medical rehabilitation care. Our outpatient rehabilitation segment consists of clinics and contract services that provide physical, occupational and speech rehabilitation services. See the financial statements beginning on page F-1 for financial information for each of our segments for the past three fiscal years.
 
Specialty Hospitals
 
We are a leading operator of specialty hospitals in the United States, with 95 facilities throughout 25 states, as of December 31, 2009. We operate 89 long term acute care hospitals, 88 of which are currently certified by the federal Medicare program as long term acute care hospitals and one which is in its demonstration period. We also operate six acute medical rehabilitation hospitals, all of which are currently certified by the federal Medicare program as inpatient rehabilitation facilities. For both the years ended December 31, 2008 and December 31, 2009, approximately 63% of the net operating revenues of our specialty hospital segment came from Medicare reimbursement. As of December 31, 2009, we operated a total of 4,233 available licensed beds and employed approximately 13,300 people in our specialty hospital segment, consisting primarily of registered or licensed nurses, respiratory therapists, physical therapists, occupational therapists and speech therapists.
 
Patients are typically admitted to our specialty hospitals from general acute care hospitals. These patients have specialized needs, and serious and often complex medical conditions such as respiratory failure, neuromuscular disorders, traumatic brain and spinal cord injuries, strokes, non-healing wounds, cardiac disorders, renal disorders and cancer. Given their complex medical needs, these patients generally require a longer length of stay than patients in a general acute care hospital and benefit from being treated in a specialty hospital that is designed to meet their unique medical needs. The average length of stay for patients in our specialty hospitals was 26 days in our long term acute care hospitals and 16 days in our inpatient rehabilitation facilities, for the year ended December 31, 2009.


2


Table of Contents

Below is a table that shows the distribution by medical condition (based on primary diagnosis) of patients in our hospitals for the year ended December 31, 2009:
 
         
    Distribution
Medical Condition
  of Patients
 
Respiratory disorders
    35 %
Neuromuscular disorders
    31  
Cardiac disorders
    9  
Wound care
    7  
Other
    18  
         
Total
    100 %
         
 
We believe that we provide our services on a more cost-effective basis than a typical general acute care hospital because we provide a much narrower range of services. We believe that our services are therefore attractive to healthcare payors who are seeking to provide the most cost-effective level of care to their enrollees. Additionally, we continually seek to increase our admissions by expanding and improving our relationships with the physicians and general acute care hospitals that refer patients to our facilities. We also maintain a strong focus on the provision of high-quality medical care within our facilities and believe that this operational focus is in part reflected by the accreditation of our specialty hospitals by The Joint Commission, previously known as the Joint Commission on Accreditation of Healthcare Organizations, and the Commission on Accreditation of Rehabilitation Facilities. As of December 31, 2009, The Joint Commission had fully accredited 91 of the 95 specialty hospitals we operated. The other four specialty hospitals are in the process of obtaining full accreditation. Three of our six inpatient rehabilitation facilities have also received accreditation from the Commission on Accreditation of Rehabilitation Facilities. The Joint Commission and the Commission on Accreditation of Rehabilitation Facilities are independent, not-for-profit organizations that establish standards related to the operation and management of healthcare facilities. Each of our accredited facilities must regularly demonstrate to a survey team conformance to the applicable standards. When a survey is completed, the facility receives a survey report that acknowledges best practices, contains suggestions for improving services, and makes recommendations for improvement based on conformance to the standards.
 
When a patient is referred to one of our hospitals by a physician, case manager, discharge planner, health maintenance organization or insurance company, a clinical liaison along with a case manager from our company makes an assessment to determine the care required. Based on the determinations reached in this clinical assessment, an admission decision is made by the attending physician.
 
Upon admission, an interdisciplinary team reviews a new patient’s condition. The interdisciplinary team is comprised of a number of clinicians and may include any or all of the following: an attending physician; a specialty nurse; a physical, occupational or speech therapist; a respiratory therapist; a dietician; a pharmacist; and a case manager. Upon completion of an initial evaluation by each member of the treatment team, an individualized treatment plan is established and implemented. The case manager coordinates all aspects of the patient’s hospital stay and serves as a liaison with the insurance carrier’s case management staff when appropriate. The case manager communicates progress, resource utilization, and treatment goals between the patient, the treatment team and the payor.
 
Each of our specialty hospitals has an interdisciplinary medical staff that is comprised of physicians that have completed the privileging and credentialing process required by that specialty hospital, and have been approved by the governing board of that specialty hospital. Physicians on the medical staff of our specialty hospitals are generally not directly employed by our specialty hospitals but instead have staff privileges at one or more hospitals. At each of our specialty hospitals, attending physicians conduct rounds on their patients on a daily basis and consulting physicians provide consulting services based on the medical needs of our patients. Our specialty hospitals also have on-call arrangements with physicians to ensure that a physician is available to care for our patients at all times. We staff our specialty hospitals with the number of physicians and other medical practitioners that we believe is appropriate to address the varying needs of our patients. When determining the appropriate composition of the medical staff of a specialty hospital, we consider (1) the size of the specialty hospital,


3


Table of Contents

(2) services provided by the specialty hospital, (3) if applicable, the size and capabilities of the medical staff of the acute care hospital that hosts an HIH and (4) if applicable, the proximity of an acute care hospital to a free-standing hospital. The medical staff of each of our specialty hospitals meets the applicable requirements set forth by Medicare, The Joint Commission and the state in which that specialty hospital is located.
 
Each of our specialty hospitals has an onsite management team consisting of a chief executive officer, a director of clinical services and a director of provider relations. These teams manage local strategy and day-to-day operations, including oversight of clinical care and treatment. They also assume primary responsibility for developing relationships with the general acute care providers and clinicians in the local areas we serve that refer patients to our specialty hospitals. We provide our hospitals with centralized accounting, payroll, legal, operational support, human resources, compliance, management information systems and billing and collection services. The centralization of these services improves efficiency and permits hospital staff to spend more time on patient care.
 
We operate the majority of our long term acute care hospitals as “hospitals within hospitals” or as “satellites,” which we collectively refer to as “HIHs.” A long term acute care hospital that operates as an HIH leases space from a general acute care “host” hospital and operates as a separately licensed hospital within the host hospital, or on the same campus as the host hospital. In contrast, a free-standing long term acute care hospital does not operate on a host hospital campus. We operated 89 long term acute care hospitals at December 31, 2009, of which 88 are owned and one is managed. Of the 88 long term acute care hospitals we owned, 65 were operated as HIHs and 23 were operated as free-standing hospitals.
 
All Medicare payments to our long term acute care hospitals are made in accordance with the prospective payment system specifically applicable to long term acute care hospitals, referred to as “LTCH-PPS.” Under LTCH-PPS, a long term acute care hospital is paid a pre-determined fixed amount depending upon the long term care diagnosis-related group, or “LTC-DRG,” to which each patient is assigned. LTCH-PPS includes special payment policies that adjust the payments for some patients based on a variety of factors. Some of these special payment policies have been the subject of recent regulatory developments. See “— Government Regulations” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Regulatory Changes.”
 
All Medicare payments to our acute medical rehabilitation hospitals are made in accordance with the prospective payment system specifically applicable to inpatient rehabilitation facilities, referred to as “IRF-PPS.” Under the IRF-PPS, each patient discharged from an inpatient rehabilitation facility is assigned to a case mix group or “IRF-CMG” containing patients with similar clinical conditions that are expected to require similar amounts of resources. An inpatient rehabilitation facility is generally paid a pre-determined fixed amount applicable to the assigned IRF-CMG. The IRF-PPS includes special payment policies that adjust the payments for some patients based on the patient’s length of stay, the facility’s costs, whether the patient was discharged and readmitted and other factors, some of which have been the subject of recent regulatory developments. See “— Government Regulations” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Regulatory Changes.”
 
Specialty Hospital Strategy
 
The key elements of our specialty hospital strategy are to:
 
Focus on Specialized Inpatient Services.  We serve highly acute patients and patients with debilitating injuries that cannot be adequately cared for in a less medically intensive environment, such as a skilled nursing facility. Generally, patients in our specialty hospitals require longer stays and higher levels of clinical care than patients treated in general acute care hospitals. Our patients’ average length of stay in our specialty hospitals was 24 days for the year ended December 31, 2009.
 
Provide High Quality Care and Service.  We believe that our specialty hospitals serve a critical role in comprehensive healthcare delivery. Through our specialized treatment programs and staffing models, we treat patients with acute, complex and specialized medical needs who are typically referred to us by general acute care hospitals. Our specialized treatment programs focus on specific patient needs and medical conditions such as


4


Table of Contents

ventilator weaning programs, wound care protocols and rehabilitation programs for brain trauma and spinal cord injuries. Our responsive staffing models ensure that patients have the appropriate clinical resources over the course of their stay. We believe that we are recognized for providing quality care and service, as evidenced by accreditation by The Joint Commission and the Commission on Accreditation of Rehabilitation Facilities. We also believe we develop brand loyalty in the local areas we serve allowing us to strengthen our relationships with physicians and other referral sources and drive additional patient volume to our hospitals.
 
Our treatment programs benefit patients because they give our clinicians access to the regimens that we have found to be most effective in treating various conditions such as respiratory failure, non-healing wounds, brain and spinal cord injuries, strokes and neuromuscular disorders. In addition, we combine or modify these programs to provide a treatment plan tailored to meet our patients’ unique needs.
 
The quality of the patient care we provide is continually monitored using several measures, including patient, payor and physician satisfaction surveys, as well as clinical outcomes analyses. Quality measures are collected monthly and reported quarterly and annually. In order to benchmark ourselves against other healthcare organizations, we have contracted with outside vendors to collect our clinical and patient satisfaction information and compare it to other healthcare organizations. The information collected is reported back to each hospital, to our corporate office, and directly to The Joint Commission. As of December 31, 2009, The Joint Commission had fully accredited 91 of the 95 specialty hospitals we operated. The other four specialty hospitals are in the process of obtaining full accreditation. Three of our six inpatient rehabilitation facilities have also received accreditation from the Commission on Accreditation of Rehabilitation Facilities. See “— Government Regulations — Licensure — Accreditation.”
 
Reduce Operating Costs.  We continually seek to improve operating efficiency and reduce costs at our hospitals by standardizing operations and centralizing key administrative functions. These initiatives include:
 
  •  centralizing administrative functions such as accounting, finance, payroll, legal, operational support, compliance, human resources and billing and collection;
 
  •  standardizing management information systems to aid in financial reporting as well as billing and collecting; and
 
  •  participating in group purchasing arrangements to receive discounted prices for pharmaceuticals and medical supplies.
 
Increase Higher Margin Commercial Volume.  With reimbursement rates from commercial insurers typically higher than the federal Medicare program, we have focused on continued expansion of our relationships with commercial insurers to increase our volume of patients with commercial insurance in our specialty hospitals. We believe that commercial payors seek to contract with our hospitals because we offer patients high quality, cost-effective care at more attractive rates than general acute care hospitals. We also offer commercial enrollees customized treatment programs not typically offered in general acute care hospitals.
 
Develop Inpatient Facilities.  As a result of the Medicare, Medicaid, and SCHIP Extension Act of 2007, or “SCHIP Extension Act,” which prohibits the establishment and classification of new LTCHs or satellites during the three calendar years commencing on December 29, 2007, we have stopped all LTCH development. However, we expect to continue evaluating opportunities to develop joint venture relationships with significant health systems.
 
By leveraging the experience of our senior management and dedicated development team, we believe that we are well positioned to capitalize on development opportunities. When we identify joint venture opportunities, our development team conducts an extensive review of the area’s referral patterns and commercial insurance to determine the general reimbursement trends and payor mix. Ultimately, we determine the needs of a joint venture, which could include working capital, the construction of new space or the leasing and renovation of existing space. During construction or renovation, the project is transitioned to our start-up team, which is experienced in preparing a specialty hospital for opening. The start-up team oversees equipment purchases, licensure procedures and the recruitment of a full-time management team. After the facility is opened, responsibility for its management is transitioned to this new management team and our corporate operations group. From time to time we may also develop new inpatient rehabilitation facilities.


5


Table of Contents

Pursue Opportunistic Acquisitions.  In addition to our development initiatives, we may grow our network of specialty hospitals through opportunistic acquisitions. When we acquire a hospital or a group of hospitals, a team of our professionals is responsible for formulating and executing an integration plan. We have generally been able to improve financial performance at acquired facilities by adding clinical programs that attract commercial payors, centralizing administrative functions and implementing our standardized resource management programs.
 
Outpatient Rehabilitation
 
We believe that we are the largest operator of outpatient rehabilitation clinics in the United States based on number of facilities, with 961 facilities throughout 37 states and the District of Columbia, as of December 31, 2009. Typically, each of our clinics is located in a medical complex or retail location. As of December 31, 2009, our outpatient rehabilitation segment employed approximately 8,600 people.
 
In our clinics and through our contractual relationships, we provide physical, occupational and speech rehabilitation programs and services. We also provide certain specialized programs such as hand therapy or sports performance enhancement that treat sports and work related injuries, musculoskeletal disorders, chronic or acute pain and orthopedic conditions. The typical patient in one of our clinics suffers from musculoskeletal impairments that restrict his or her ability to perform normal activities of daily living. These impairments are often associated with accidents, sports injuries, strokes, heart attacks and other medical conditions. Our rehabilitation programs and services are designed to help these patients minimize physical and cognitive impairments and maximize functional ability. We also provide services designed to prevent short term disabilities from becoming chronic conditions. Our rehabilitation services are provided by our professionals including licensed physical therapists, occupational therapists, speech-language pathologists and respiratory therapists.
 
Outpatient rehabilitation patients are generally referred or directed to our clinics by a physician, employer or health insurer who believes that a patient, employee or member can benefit from the level of therapy we provide in an outpatient setting. We believe that our services are attractive to healthcare payors who are seeking to provide the most cost-effective level of care to their enrollees.
 
In addition to providing therapy in our outpatient clinics, we provide medical rehabilitative services including physical and occupational therapies and speech pathology services, to residents and patients of nursing homes, hospitals, schools, assisted living and senior care centers and worksites. We provide rehabilitative services to approximately 310 contracted locations in 22 states, while our contract operations in New York provide pediatric contract care at approximately 150 locations.
 
In our outpatient rehabilitation segment, approximately 90% of our net operating revenues come from commercial payors, including healthcare insurers, managed care organizations and workers’ compensation programs, contract management services and private pay sources. The balance of our reimbursement is derived from Medicare and other government sponsored programs.
 
Outpatient Rehabilitation Strategy
 
The key elements of our outpatient rehabilitation strategy are to:
 
Provide High Quality Care and Service.  We are focused on providing a high level of service to our patients throughout their entire course of treatment. To measure satisfaction with our service we have developed surveys for both patients and physicians. Our clinics utilize the feedback from these surveys to continuously refine and improve service levels. We believe that by focusing on quality care and offering a high level of customer service we develop brand loyalty in the local areas we serve. This high quality of care and service allows us to strengthen our relationships with referring physicians, employers and health insurers and drive additional patient volume.
 
Increase Market Share.  We strive to establish a leading presence within the local areas we serve. To increase our presence, we seek to expand our services and programs and to continue to provide high quality care and strong customer service. This allows us to realize economies of scale, heightened brand loyalty, workforce continuity and increased leverage when negotiating payor contracts.


6


Table of Contents

Expand Rehabilitation Programs and Services.  Through our local clinical directors of operations and clinic managers within their service areas, we assess the healthcare needs of the areas we serve. Based on these assessments, we implement additional programs and services specifically targeted to meet demand in the local community. In designing these programs we benefit from the knowledge we gain through our national network of clinics. This knowledge is used to design programs that optimize treatment methods and measure changes in health status, clinical outcomes and patient satisfaction.
 
Optimize the Profitability of our Payor Contracts.  We rigorously review payor contracts up for renewal and potential new payor contracts to optimize our profitability. Before we enter into a new contract with a commercial payor, we evaluate it with the aid of our contract management system. We assess potential profitability by evaluating past and projected patient volume, clinic capacity, and expense trends. We create a retention strategy for the top performing contracts and a renegotiation strategy for contracts that do not meet our defined criteria. We believe that our size and our strong reputation enable us to negotiate favorable outpatient contracts with commercial insurers.
 
Maintain Strong Employee Relations.  We believe that the relationships between our employees and the referral sources in their communities are critical to our success. Our referral sources, such as physicians and healthcare case managers, send their patients to our clinics based on three factors: the quality of our care, the service we provide and their familiarity with our therapists. We seek to retain and motivate our therapists by implementing a performance-based bonus program, a defined career path with the ability to be promoted from within, timely communication on company developments and internal training programs. We also focus on empowering our employees by giving them a high degree of autonomy in determining local area strategy. This management approach reflects the unique nature of each local area in which we operate and the importance of encouraging our employees to assume responsibility for their clinic’s performance.
 
Pursue Opportunistic Acquisitions.  We may grow our network of outpatient rehabilitation facilities through opportunistic acquisitions. We significantly expanded our network with the 2007 acquisition of the outpatient rehabilitation division of HealthSouth Corporation, consisting of 569 clinics in 35 states and the District of Columbia, including 18 states in which we did not previously have outpatient rehabilitation facilities. We believe our size and centralized infrastructure allow us to take advantage of operational efficiencies and increase margins at acquired facilities.
 
Other Services
 
Other services (which accounted for less than 1% of our net operating revenues for the year ended December 31, 2009) include corporate services and certain non-healthcare services.
 
Our Competitive Strengths
 
We believe that the success of our business model is based on a number of competitive strengths, including our position as a leading operator in each of our business segments, proven financial performance and strong cash flow, significant scale, experience in completing and integrating acquisitions, ability to capitalize on consolidation opportunities and an experienced management team.
 
Leading Operator in Distinct but Complementary Lines of Business.  We believe that we are a leading operator in each of our principal business segments, based on number of facilities in the United States. Our leadership position and reputation as a high quality, cost-effective healthcare provider in each of our business segments allows us to attract patients and employees, aids us in our marketing efforts to payors and referral sources and helps us negotiate payor contracts. In our specialty hospital segment, we operated 89 long term acute care hospitals with 3,770 available licensed beds in 25 states and six inpatient rehabilitation facilities with 463 beds in four states and derived approximately 70% of net operating revenues from these operations, for the year ended December 31, 2009. In our outpatient rehabilitation segment, we operated 961 outpatient rehabilitation clinics in 37 states and the District of Columbia and derived approximately 30% of net operating revenues from these operations, for the year ended December 31, 2009. With these leading positions in the areas we serve, we believe that we are well-positioned to benefit from the rising demand for medical services due to an aging population in the United States, which will drive growth across our business lines.


7


Table of Contents

Proven Financial Performance and Strong Cash Flow.  We have established a track record of improving the financial performance of our facilities due to our disciplined approach to revenue growth, expense management and an intense focus on free cash flow generation. This includes regular review of specific financial metrics of our business to determine trends in our revenue generation, expenses, billing and cash collection. Based on the ongoing analysis of such trends, we make adjustments to our operations to optimize our financial performance and cash flow.
 
Significant Scale.  By building significant scale in each of our business segments, we have been able to leverage our operating costs by centralizing administrative functions at our corporate office. As a result, we have been able to minimize our general and administrative expense as a percentage of revenues.
 
Well-Positioned to Capitalize on Consolidation Opportunities.  We believe that we are well-positioned to capitalize on consolidation opportunities within each of our business segments and selectively augment our internal growth. We believe that each of our business segments is highly fragmented, with many of the nation’s long term acute care hospitals, inpatient rehabilitation facilities and outpatient rehabilitation facilities being operated by independent operators lacking national or broad regional scope. With our geographically diversified portfolio of facilities in the United States, we believe that our footprint provides us with a wide-ranging perspective on multiple potential acquisition opportunities.
 
Experience in Successfully Completing and Integrating Acquisitions.  From our inception in 1997 through 2009, we completed six significant acquisitions for approximately $894.8 million in aggregate consideration. We believe that we have improved the operating performance of these facilities over time by applying our standard operating practices and by realizing efficiencies from our centralized operations and management.
 
Experienced and Proven Management Team.  Prior to co-founding our company with our current Chief Executive Officer, our Executive Chairman founded and operated three other healthcare companies focused on inpatient and outpatient rehabilitation services. In addition, our four senior operations executives have an average of over 32 years of experience in the healthcare industry, including extensive experience working together for our company and for past companies focused on operating acute rehabilitation hospitals and outpatient rehabilitation facilities.
 
Sources of Net Operating Revenues
 
The following table presents the approximate percentages by source of net operating revenue received for healthcare services we provided for the periods indicated:
 
                         
    Year Ended December 31,
Net Operating Revenues by Payor Source
  2007   2008   2009
 
Medicare
    48.0 %     46.2 %     46.6 %
Commercial insurance(1)
    44.2 %     46.3 %     45.9 %
Private and other(2)
    5.5 %     5.4 %     5.1 %
Medicaid
    2.3 %     2.1 %     2.4 %
                         
Total
    100.0 %     100.0 %     100.0 %
                         
 
 
(1) Includes commercial healthcare insurance carriers, health maintenance organizations, preferred provider organizations, workers’ compensation and managed care programs.
 
(2) Includes self payors, contract management services and non-patient related payments. Self pay revenues represent less than 1% of total net operating revenues.
 
Government Sources
 
Medicare is a federal program that provides medical insurance benefits to persons age 65 and over, some disabled persons, and persons with end-stage renal disease. Medicaid is a federal-state funded program, administered by the states, which provides medical benefits to individuals who are unable to afford healthcare. We operate 95 specialty hospitals, all of which are currently certified as Medicare providers. Our outpatient rehabilitation


8


Table of Contents

clinics regularly receive Medicare payments for their services. Additionally, many of our specialty hospitals participate in state Medicaid programs. Amounts received under the Medicare and Medicaid programs are generally less than the customary charges for the services provided. In recent years there have been significant changes made to the Medicare and Medicaid programs. Since a significant portion of our revenues come from patients under the Medicare program, our ability to operate our business successfully in the future will depend in large measure on our ability to adapt to changes in the Medicare program. See “— Government Regulations — Overview of U.S. and State Government Reimbursements.”
 
Non-Government Sources
 
An increasing amount of our net operating revenues continue to come from commercial and private payor sources. These sources include insurance companies, workers’ compensation programs, health maintenance organizations, preferred provider organizations, other managed care companies and employers, as well as by patients directly. Patients are generally not responsible for any difference between customary charges for our services and amounts paid by Medicare and Medicaid programs, insurance companies, workers’ compensation companies, health maintenance organizations, preferred provider organizations and other managed care companies, but are responsible for services not covered by these programs or plans, as well as for deductibles and co-insurance obligations of their coverage. The amount of these deductibles and co-insurance obligations has increased in recent years. Collection of amounts due from individuals is typically more difficult than collection of amounts due from government or business payors.
 
Initial Public Offering of Common Stock
 
On September 30, 2009, Holdings completed an initial public offering of 30,000,000 shares of common stock at a price to the public of $10.00 per share, and on October 28, 2009, the underwriters exercised their over-allotment option to purchase an additional 3,602,700 shares at the same price. The total net proceeds to Holdings after deducting underwriting discounts and commissions and offering expenses was approximately $312.5 million. Holdings used the proceeds from the offering to repay $258.4 million of revolving and term loans outstanding under its senior secured credit facility and to make payments to executive officers under the Long Term Cash Incentive Plan of $18.0 million. The remaining proceeds were used for general corporate purposes.
 
The Merger Transactions
 
On February 24, 2005, EGL Acquisition Corp. was merged with and into Select, with Select continuing as the surviving corporation and a wholly owned subsidiary of Holdings. The merger was completed pursuant to an agreement and plan of merger, dated as of October 17, 2004, among EGL Acquisition Corp., Holdings and Select. Upon the consummation of the merger, all of the capital stock of Holdings was owned by an investor group that included Welsh, Carson, Anderson, & Stowe (“Welsh Carson”), Thoma Cressey Bravo (“Thoma Cressey”), and certain other “rollover” investors that participated in the merger. We refer to the merger and the related transactions collectively as the “Merger Transactions.”
 
As a result of the Merger Transactions, the majority of Select’s assets and liabilities were adjusted to their fair value as of February 25, 2005. The excess of the total purchase price over the fair value of Select’s tangible and identifiable intangible assets was allocated to goodwill, which is the subject of an annual impairment test. Additionally, a portion of the equity related to our continuing stockholders was recorded at the stockholder’s predecessor basis and a corresponding portion of the fair value of the acquired assets was reduced accordingly. By definition, our statements of financial position and results of operations subsequent to the Merger Transactions are not comparable to the same statements for the periods prior to the Merger Transactions due to the resulting change in basis.
 
Acquisition of HealthSouth Corporation’s Outpatient Rehabilitation Division
 
On May 1, 2007, we acquired HealthSouth Corporation’s outpatient rehabilitation division for approximately $245.0 million, reduced by approximately $7.0 million at closing for assumed indebtedness and other matters. We significantly expanded our network of outpatient rehabilitation clinics with the HealthSouth acquisition, consisting of 569 outpatient rehabilitation clinics in 35 states and the District of Columbia, including 18 states in which we did not previously have outpatient rehabilitation clinics.


9


Table of Contents

Employees
 
As of December 31, 2009, we employed approximately 22,500 people throughout the United States. Approximately 15,600 of our employees are full time and the remaining approximately 6,900 are part time employees. Outpatient, contract therapy and physical rehabilitation and occupational health employees totaled approximately 8,600 and specialty hospital employees totaled approximately 13,300. The remaining approximately 600 employees were in corporate management, administration and other services.
 
Competition
 
We compete on the basis of pricing, the quality of the patient services we provide and the results that we achieve for our patients. The primary competitive factors in the long term acute care and inpatient rehabilitation businesses include quality of services, charges for services and responsiveness to the needs of patients, families, payors and physicians. Other companies operate long term acute care hospitals and inpatient rehabilitation facilities that compete with our hospitals, including large operators of similar facilities, such as Kindred Healthcare Inc., HealthSouth Corporation and RehabCare Group, Inc. The competitive position of any hospital is also affected by the ability of its management to negotiate contracts with purchasers of group healthcare services, including private employers, managed care companies, preferred provider organizations and health maintenance organizations. Such organizations attempt to obtain discounts from established hospital charges. The importance of obtaining contracts with preferred provider organizations, health maintenance organizations and other organizations which finance healthcare, and its effect on a hospital’s competitive position, vary from area to area, depending on the number and strength of such organizations.
 
Our outpatient rehabilitation clinics face competition principally from locally owned and managed outpatient rehabilitation clinics in the communities they serve and from selected national providers such as Physiotherapy Associates and U.S. Physical Therapy in selected local areas. Many of these clinics have longer operating histories and greater name recognition in these communities than our clinics, and they may have stronger relations with physicians in these communities on whom we rely for patient referrals.
 
Government Regulations
 
General
 
The healthcare industry is required to comply with many laws and regulations at the federal, state and local government levels. These laws and regulations require that hospitals and outpatient rehabilitation clinics meet various requirements, including those relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, safeguarding protected health information, compliance with building codes and environmental protection and healthcare fraud and abuse. These laws and regulations are extremely complex and, in many instances, the industry does not have the benefit of significant regulatory or judicial interpretation. If we fail to comply with applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate and our ability to participate in the Medicare, Medicaid and other federal and state healthcare programs.
 
Licensure
 
Facility Licensure.  Our healthcare facilities are subject to state and local licensing regulations ranging from the adequacy of medical care to compliance with building codes and environmental protection laws. In order to assure continued compliance with these various regulations, governmental and other authorities periodically inspect our facilities, not only at scheduled intervals but also in response to complaints from patients and others. While our facilities intend to comply with existing licensing and Medicare certification requirements and accreditation standards, there can be no assurance that regulatory authorities will determine that all applicable requirements are fully met at any given time. A determination by an applicable regulatory authority that a facility is not in compliance with these requirements could lead to the imposition of corrective action, assessment of fines and penalties, or loss of licensure, Medicare certification or accreditation. These consequences could have an adverse effect on our company.
 
Some states still require us to get approval under certificate of need regulations when we create, acquire or expand our facilities or services, or alter the ownership of such facilities, whether directly or indirectly. The


10


Table of Contents

certificate of need regulations vary from state to state, and are subject to change and new interpretation. If we fail to show public need and obtain approval in these states for our new facilities or changes to the ownership structure of existing facilities, we may be subject to civil or even criminal penalties, lose our facility license or become ineligible for reimbursement.
 
Professional licensure and corporate practice.  Healthcare professionals at our hospitals and outpatient rehabilitation clinics are required to be individually licensed or certified under applicable state law. We take steps to ensure that our employees and agents possess all necessary licenses and certifications. Some states prohibit the “corporate practice of therapy” so that business corporations such as ours are restricted from practicing therapy through the direct employment of therapists. The laws relating to corporate practice vary from state to state and are not fully developed in each state in which we have clinics. We believe that each of our outpatient therapy clinics complies with any current corporate practice prohibition of the state in which it is located. For example, in those states that apply the corporate practice prohibition, we either contract to obtain therapy services from an entity permitted to employ therapists or we manage the physical therapy practice owned by licensed therapists through which the therapy services are provided. However, future interpretations of the corporate practice prohibition, enactment of new legislation or adoption of new regulations could cause us to have to restructure our business operations or close our clinics in a particular state. If new legislation, regulations or interpretations establish that our clinics do not comply with state corporate practice prohibition, we could be subject to civil, and perhaps criminal, penalties. Any such restructuring or penalties could have a material adverse effect on our business.
 
Certification.  In order to participate in the Medicare program and receive Medicare reimbursement, each facility must comply with the applicable regulations of the United States Department of Health and Human Services relating to, among other things, the type of facility, its equipment, its personnel and its standards of medical care, as well as compliance with all applicable state and local laws and regulations. Of the 95 specialty hospitals we operate, all are currently certified as Medicare providers. In addition, we provide the majority of our outpatient rehabilitation services through clinics certified by Medicare as rehabilitation agencies or “rehab agencies.”
 
Accreditation.  Our specialty hospitals receive accreditation from The Joint Commission. As of December 31, 2009, The Joint Commission had fully accredited 91 of the 95 specialty hospitals we operated. The other four specialty hospitals are in the process of obtaining full accreditation. Three of our six inpatient rehabilitation facilities have also received accreditation from the Commission on Accreditation of Rehabilitation Facilities, an independent, not-for-profit organization which reviews and grants accreditation for rehabilitation facilities that meet established standards for service and quality.
 
Overview of U.S. and State Government Reimbursements
 
Medicare.  The Medicare program reimburses healthcare providers for services furnished to Medicare beneficiaries, which are generally persons age 65 and older, those who are chronically disabled, and those suffering from end stage renal disease. The program is governed by the Social Security Act of 1965 and is administered primarily by the Department of Health and Human Services and CMS. Net operating revenues generated directly from the Medicare program represented approximately 48% of our consolidated net operating revenues for the year ended December 31, 2007, 46% for the year ended December 31, 2008, and 47% for the year ended December 31, 2009.
 
The Medicare program reimburses various types of providers, including long term acute care hospitals, inpatient rehabilitation facilities and outpatient rehabilitation providers, using different payment methodologies. The Medicare reimbursement systems for long term acute care hospitals, inpatient rehabilitation facilities and outpatient rehabilitation providers, as described below, are different than the system applicable to general acute care hospitals. For general acute care hospitals, Medicare payments are made under an inpatient prospective payment system, or “IPPS,” under which a hospital receives a fixed payment amount per discharge (adjusted for area wage differences) using diagnosis-related groups, or “DRGs.” The general acute care hospital DRG payment rate is based upon the national average cost of treating a Medicare patient’s condition in that type of facility. Although the average length of stay varies for each DRG, the average stay of all Medicare patients in a general acute care hospital is approximately six days. Thus, the prospective payment system for general acute care hospitals creates an economic incentive for those hospitals to discharge medically complex Medicare patients as soon as clinically possible. Effective October 1, 2005, CMS expanded its post-acute care transfer policy under which general acute


11


Table of Contents

care hospitals are paid on a per diem basis rather than the full DRG rate if a patient is discharged early to certain post-acute care settings, including LTCHs and IRFs. When a patient is discharged from selected DRGs to, among other providers, an LTCH, the general acute care hospital is reimbursed below the full DRG payment if the patient’s length of stay is less than the geometric mean length of stay for the DRG. This policy originally applied to ten DRGs beginning in fiscal year 1999 and was expanded to additional DRGs in FY 2004 and to a total of 182 DRGs effective October 1, 2005. The expansion of this policy to patients in a greater number of DRGs could cause general acute care hospitals to delay discharging those patients to our long term acute care hospitals and inpatient rehabilitation facilities.
 
Long Term Acute Care Hospital Medicare Reimbursement.  The Medicare payment system for long term acute care hospitals is based on a prospective payment system specifically applicable to LTCH. The long-term care hospital prospective payment system, or “LTCH-PPS” was established by CMS final regulations published on August 30, 2002, and applies to long term acute care hospitals for their cost reporting periods beginning on or after October 1, 2002. Under LTCH-PPS, each patient discharged from a long term acute care hospital is assigned to a distinct LTC-DRG and a long term acute care hospital will generally be paid a pre-determined fixed amount applicable to the assigned LTC-DRG (adjusted for area wage differences). The payment amount for each LTC-DRG is intended to reflect the average cost of treating a Medicare patient assigned to that LTC-DRG in a long term acute care hospital. Cases with unusually high costs, referred to as “high cost outliers,” receive a payment adjustment to reflect the additional resources utilized. Conversely, cases with a stay that is 5/6th or less than the geometric mean length of stay for each specific LTC-DRG, a “short-stay outlier,” receive a reduction in payment. LTCH-PPS also includes special payment policies that adjust the payments for some patients based on the patient’s length of stay, the facility’s costs, whether the patient was discharged and readmitted and other factors. Congress required that the LTC-DRG payment rates maintain budget neutrality during the first years of the prospective payment system with total expenditures that would have been made under the previous reasonable cost-based payment system. The LTCH-PPS regulations permit CMS to make a one-time adjustment between December 29, 2010 and October 1, 2012 to correct any significant error CMS made in estimating the federal rate in the first year of LTCH-PPS.
 
The LTCH-PPS regulations also refined the criteria that must be met in order for a hospital to be certified as a long term acute care hospital. For cost reporting periods beginning on or after October 1, 2002, a long term acute care hospital must have an average inpatient length of stay for Medicare patients (including both Medicare covered and non-covered days) of greater than 25 days. Previously, average lengths of stay were measured with respect to all patients. LTCHs that fail to exceed an average length of stay of greater than 25 days during any cost reporting period will be paid under the general acute care hospital DRG-based reimbursement.
 
Prior to qualifying under the payment system applicable to long term acute care hospitals, a new long term acute care hospital initially receives payments under the general acute care hospital DRG-based reimbursement system. The long term acute care hospital must continue to be paid under this system for a minimum of six months while meeting certain Medicare long term acute care hospital requirements, the most significant requirement being an average Medicare length of stay of more than 25 days.
 
August 2004 Final Rule.   On August 11, 2004, CMS published final regulations applicable to LTCHs that are operated as HIHs. Effective for hospital cost reporting periods beginning on or after October 1, 2004, subject to certain exceptions, the final regulations provide lower rates of reimbursement to HIHs for those Medicare patients admitted from their host hospitals that are in excess of a specified percentage threshold. For HIHs opened after October 1, 2004, the Medicare admissions threshold has been established at 25% except for HIHs located in rural areas or co-located with an MSA dominant hospital or single urban hospital where the percentage is no more than 50%, nor less than 25%.
 
For HIHs that meet specified criteria and were in existence as of October 1, 2004, including all but two of our then existing HIHs, the Medicare admissions thresholds were phased in over a four year period starting with hospital cost reporting periods that began on or after October 1, 2004. For discharges during the cost reporting period that began on or after October 1, 2005 and before October 1, 2006, the Medicare admissions threshold was the lesser of the Fiscal 2004 Percentage of Medicare discharges admitted from the host hospital or 75%. For discharges during the cost reporting period beginning on or after October 1, 2006 and before October 1, 2007, the Medicare admissions threshold was the lesser of the Fiscal 2004 Percentage of Medicare discharges admitted from the host


12


Table of Contents

hospital or 50%. For discharges during cost reporting periods beginning on or after October 1, 2007, the Medicare admissions threshold is 25%. However, the SCHIP Extension Act (as amended by the American Recovery and Reinvestment Act, or “ARRA”) has limited the application of the Medicare admission threshold on HIHs in existence on October 1, 2004 and subject to the four year phase in described above. For these HIHs, the admission threshold is no lower than 50% for a three year period to commence on an LTCH’s first cost reporting period to begin on or after October 1, 2007, except for HIHs located in rural areas and those which receive referrals from MSA dominant hospitals or single urban hospitals (as defined by current regulations), in which cases the percentage threshold is no more than 75% during the same three cost reporting years. As used above, “Fiscal 2004 Percentage” means, with respect to any HIH, the percentage of all Medicare patients discharged by such HIH during its cost reporting period beginning on or after October 1, 2003 and before October 1, 2004 who were admitted to such HIH from its host hospital, but in no event is the Fiscal 2004 Percentage less than 25%. The HIH regulations also established exceptions to the Medicare admissions thresholds with respect to patients who reach “outlier” status at the host hospital, HIHs located in MSA dominant hospitals or HIHs located in rural areas.
 
In the 2008 rate year final rule, CMS applied the Medicare admissions threshold to admissions to grandfathered HIHs and grandfathered satellites from co-located hospitals. The SCHIP Extension Act delays application of the admissions threshold on grandfathered HIHs for a three year period commencing on the first cost reporting period beginning on or after July 1, 2007. The ARRA limits application of the admission threshold to no more than 50% of Medicare admissions to grandfathered satellites from a co-located hospital for a three year period commencing on the first cost reporting period beginning on or after July 1, 2007.
 
August 2005 Final Rule.   On August 12, 2005, CMS published the final rules for the general acute care hospital IPPS, for fiscal year 2006, which included an update of the LTC-DRG relative weights. CMS estimated the changes to the relative weights would reduce LTCH Medicare payments-per-discharge by approximately 4.2% in fiscal year 2006 (the period from October 1, 2005 through September 30, 2006).
 
May 2006 Final Rule.   On May 12, 2006, CMS published its final annual payment rate updates for the 2007 LTCH-PPS rate year (affecting discharges and cost reporting periods beginning on or after July 1, 2006 and before July 1, 2007), or “RY 2007.” The May 2006 final rule revised the payment adjustment formula for short stay outlier, or “SSO,” patients. For discharges occurring on or after July 1, 2006, the rule changed the payment methodology for Medicare patients with a length of stay less than or equal to five-sixths of the geometric average length of stay for each SSO case. Payment for these patients had been based on the lesser of (1) 120% of the cost of the case; (2) 120% of the LTC-DRG specific per diem amount multiplied by the patient’s length of stay; or (3) the full LTC-DRG payment. The May 2006 final rule modified the limitation in clause (1) above to reduce payment for SSO cases to 100% (rather than 120%) of the cost of the case. The final rule also added a fourth limitation, capping payment for SSO cases at a per diem rate derived from blending 120% of the LTC-DRG specific per diem amount with a per diem rate based on the general acute care hospital IPPS. Under this methodology, as a patient’s length of stay increases, the percentage of the per diem amount based upon the IPPS component will decrease and the percentage based on the LTC-DRG component will increase.
 
In addition, for discharges occurring on or after July 1, 2006, the May 2006 final rule provided for (1) a zero-percent update to the LTCH-PPS standard federal rate used as a basis for LTCH-PPS payments for the 2007 LTCH-PPS rate year; (2) the elimination of the surgical case exception to the three day or less interruption of stay policy (under the surgical exception, Medicare reimburses a general acute care hospital directly for surgical services furnished to a long term acute care hospital patient during a brief interruption of stay from the long term acute care hospital, rather than requiring the long term acute care hospital to bear responsibility for such surgical services); and (3) increasing the costs that a long term acute care hospital must bear before Medicare will make additional payments for a case under its high-cost outlier policy for RY 2007.
 
CMS estimated that the changes in the May 2006 final rule would result in an approximately 3.7% decrease in LTCH Medicare payments-per-discharge compared to the 2006 rate year, largely attributable to the revised SSO payment methodology. We estimated that the May 2006 final rule reduced Medicare revenues associated with SSO cases and high-cost outlier cases to our long term acute care hospitals by approximately $29.3 million for RY 2007.
 
Additionally, had CMS updated the LTCH-PPS standard federal rate by the 2007 estimated market basket index of 3.4% rather than applying the zero-percent update, we estimated that we would have received


13


Table of Contents

approximately $31.0 million in additional annual Medicare revenues based on our historical Medicare patient volumes and revenues (such revenues would have been paid to our hospitals for discharges beginning on or after July 1, 2006).
 
August 2006 Final Rule.   On August 18, 2006, CMS published the IPPS final rule for fiscal year 2007, which is the period from October 1, 2006 through September 30, 2007, that included an update of the LTC-DRG relative weights for fiscal year 2007. CMS estimated the changes to the relative weights would reduce LTCH Medicare payments-per-discharge by approximately 1.3% in fiscal year 2007. The August 2006 final rule also included changes to the DRGs in IPPS that apply to LTCHs, as the LTC-DRGs are based on the IPPS DRGs. CMS created 20 new DRGs and modified 32 others, including LTC-DRGs. Prior to the August 2006 final rule, certain HIHs that were in existence on or before September 30, 1995, and certain satellite facilities that were in existence on or before September 30, 1999, referred to as grandfathered HIHs or satellites, were not subject to certain HIH “separateness and control” requirements as long as the “grandfathered” HIHs or satellites continued to operate under the same terms and conditions, including the number of beds and square footage, in effect on September 30, 2003 (for grandfathered HIHs) or September 30, 1999 (for grandfathered satellites). These grandfathered HIHs were also not subject to the payment adjustments for discharged Medicare patients admitted from their host hospitals in excess of the specified percentage threshold, as discussed in the August final 2004 rule above. The August 2006 final rule revised the regulations to provide grandfathered HIHs more flexibility in adjusting square footage upward or downward, or decreasing the number of beds without being subject to the “separateness and control” requirements and payment adjustment provisions. As of December 31, 2009, we operated two grandfathered HIHs.
 
May 2007 Final Rule.   On May 1, 2007, CMS published its annual payment rate update for the 2008 LTCH-PPS rate year, or “RY 2008” (affecting discharges and cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008). The May 2007 final rule made several changes to LTCH-PPS payment methodologies and amounts during RY 2008 although, as described below, many of these changes have been postponed for a three year period by the SCHIP Extension Act.
 
For cost reporting periods beginning on or after July 1, 2007, the May 2007 final rule expanded the current Medicare admissions threshold to apply to Medicare patients admitted from any individual hospital. Previously, the admissions threshold was applicable only to Medicare admissions from hospitals co-located with an LTCH or satellite of an LTCH. Under the May 2007 final rule, free-standing LTCHs and grandfathered HIHs are subject to the Medicare admission thresholds, as well as HIHs that admit Medicare patients from non-co-located hospitals. To the extent that any LTCH’s or LTCH satellite facility’s discharges that are admitted from an individual hospital (regardless of whether the referring hospital is co-located with the LTCH or LTCH satellite) exceed the applicable percentage threshold during a particular cost reporting period, the payment rate for those discharges would be subject to a downward payment adjustment. Cases admitted in excess of the applicable threshold are reimbursed at a rate comparable to that under general acute care IPPS, which is generally lower than LTCH-PPS rates. Cases that reach outlier status in the discharging hospital do not count toward the limit and are paid under LTCH-PPS. CMS estimated the impact of the expansion of the Medicare admission thresholds would result in a reduction of 2.2% of the aggregate payments to all LTCHs in RY 2008.
 
The applicable percentage threshold is generally 25% after the completion of the phase-in period described below. The percentage threshold for LTCH discharges from a referring hospital that is an MSA dominant hospital or a single urban hospital is the percentage of total Medicare discharges in the MSA that are from the referring hospital, but no less than 25% nor more than 50%. For Medicare discharges from LTCHs or LTCH satellites located in rural areas, as defined by the Office of Management and Budget, the percentage threshold is 50% from any individual referring hospital. The expanded 25% rule was phased in over a three year period. The three year transition period started with cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008, when the threshold was the lesser of 75% or the percentage of the LTCH’s or LTCH satellite’s admissions discharged from the referring hospital during its cost reporting period beginning on or after July 1, 2004 and before July 1, 2005, or “RY 2005.” For cost reporting periods beginning on or after July 1, 2008 and before July 1, 2009, the threshold was the lesser of 50% or the percentage of the LTCH’s or LTCH satellite’s admissions from the referring hospital, during its RY 2005 cost reporting period. For cost reporting periods beginning on or after July 1, 2009, all LTCHs were subject to the 25% threshold (or applicable threshold for rural, urban-single, or MSA dominant hospitals). The SCHIP Extension Act, as amended by the ARRA, postponed the application of the percentage threshold to all free-


14


Table of Contents

standing and grandfathered HIHs for a three year period commencing on an LTCH’s first cost reporting period on or after July 1, 2007. However, the SCHIP Extension Act did not postpone the application of the percentage threshold, or the transition period stated above, to those Medicare patients discharged from an LTCH HIH or satellite that were admitted from a non-co-located hospital.
 
The May 2007 final rule further revised the payment adjustment formula for SSO cases. Beginning with discharges on or after July 1, 2007, for cases with a length of stay that is less than the average length of stay plus one standard deviation for the same DRG under IPPS, referred to as the so-called “IPPS comparable threshold,” the rule effectively lowers the LTCH payment to a rate based on the general acute care hospital IPPS. SSO cases with covered lengths of stay that exceed the IPPS comparable threshold would continue to be paid under the SSO payment policy described above under the May 2006 final rule. Cases with a covered length of stay less than or equal to the IPPS comparable threshold and less than five-sixths of the geometric average length of stay for that LTC-DRG are paid at an amount comparable to the IPPS per diem. The SCHIP Extension Act also postpones, for the three year period beginning on December 29, 2007, the SSO policy changes made in the May 2007 final rule.
 
The May 2007 final rule increased the standard federal rate by 0.71% for RY 2008. As a result, the federal rate for RY 2008 increased to $38,356.45 from $38,086.04 for RY 2007. Subsequently, the SCHIP Extension Act eliminated the update to the standard federal rate that occurred for RY 2008 effective April 1, 2008. This adjustment to the standard federal rate was applied prospectively on April 1, 2008 and reduced the federal rate back to $38,086.04. In a technical correction to the May 2007 final rule, CMS increased the fixed-loss amount for high cost outlier in RY 2008 to $20,738 from $14,887 in RY 2007. CMS projected an estimated 0.4% decrease in LTCH payments in RY 2008 due to this change in the fixed-loss amount and the overall impact of the May 2007 final rule to be a 1.2% decrease in total estimated LTCH-PPS payments for RY 2008.
 
The May 2007 final rule provided that beginning with the annual payment rate updates to the LTC-DRG classifications and relative weights for the fiscal year 2008, or “FY 2008” (affecting discharges beginning on or after October 1, 2007 and before September 30, 2008), annual updates to the LTC-DRG classification and relative weights are to have a budget neutral impact. Under the May 2007 final rule, future LTC-DRG reclassification and recalibrations, by themselves, should neither increase nor decrease the estimated aggregated LTCH-PPS payments.
 
August 2007 Final Rule.   On August 22, 2007, CMS published the IPPS final rule for FY 2008, which created a new patient classification system with categories referred to as MS-DRGs and MS-LTC-DRGs, respectively, for hospitals reimbursed under IPPS and LTCH-PPS. Beginning with discharges on or after October 1, 2007, the new classification categories take into account the severity of the patient’s condition. CMS assigned proposed relative weights to each MS-DRG and MS-LTC-DRG to reflect their relative use of medical care resources.
 
The August 2007 final rule published a budget neutral update to the MS-LTC-DRG classification and relative weights. In the preamble to the IPPS final rule for FY 2008 CMS restated that it intends to continue to update the LTC-DRG weights annually in the IPPS rulemaking and those weights would be modified by a budget neutrality adjustment factor to ensure that estimated aggregate LTCH payments after reweighting are equal to estimated aggregate LTCH payments before reweighting.
 
Medicare, Medicaid and SCHIP Extension Act of 2007.   On December 29, 2007, President Bush signed into law the SCHIP Extension Act. Among other changes in the federal healthcare programs, the SCHIP Extension Act made significant changes to Medicare policy for LTCHs including a new statutory definition of an LTCH, a report to Congress on new LTCH patient criteria, relief from certain LTCH-PPS payment policies for three years, a three year moratorium on the establishment and classification of new LTCHs and LTCH beds, elimination of the payment update for the last quarter of RY 2008 and new medical necessity reviews by Medicare contractors through at least October 1, 2010.
 
Previously, the statutory definition of an LTCH focused on the facility having an average length of stay of greater than 25 days. The SCHIP Extension Act adds to the statutory requirements by defining an LTCH as a hospital primarily engaged in providing inpatient services to Medicare beneficiaries with medically complex conditions that require a long hospital stay. In addition, by definition, LTCHs must meet certain facility criteria, including (1) instituting a review process that screens patients for appropriateness of an admission and validates the patient criteria within 48 hours of each patient’s subsequent admission, evaluates regularly their patients for


15


Table of Contents

continuation of care and assesses the available discharge options; (2) having active physician involvement with patient care that includes a physician available on-site daily and additional consulting physicians on call; and (3) having an interdisciplinary team of healthcare professionals “to prepare and carry out an individualized treatment plan for each patient.” We do not expect that these changes will have any impact on the designation of our hospitals as LTCHs.
 
The SCHIP Extension Act requires the Secretary of the Department of Health and Human Services to conduct a study on the establishment of national LTCH facility and patient criteria for the purpose of determining medical necessity, appropriateness of admissions and continued stay at, and discharge from, LTCHs. The Secretary must submit a report on the results of this study to Congress. Both the study and the report are required to consider recommendations on LTCH-specific facility and patient criteria contained in a June 2004 report to Congress by the Medicare Payment Advisory Commission.
 
As described above, the SCHIP Extension Act precludes the Secretary from implementing, during the three year moratorium period, the provisions added by the May 2007 final rule that extended the 25% rule to free-standing LTCHs and grandfathered HIHs. The SCHIP Extension Act also modifies, during the moratorium, the effect of the 25% threshold for admissions from co-located hospitals that was established in the August 2004 final rule. For non-grandfathered HIHs and satellites opened on or before October 1, 2004, the applicable percentage threshold is set at 50%, except for those HIHs and satellites located in rural areas and those which receive referrals from MSA dominant hospitals or single urban hospitals, in which cases the percentage threshold is set at no more than 75%. The ARRA, as discussed below, further revised the SCHIP Extension Act to modify the delay in the percentage limitations to the three cost reporting periods beginning on or after July 1, 2007 for freestanding LTCHs, grandfathered HIHs, and grandfathered satellites and on or after October 1, 2007 for non-grandfathered LTCH HIHs and non-grandfathered satellites.
 
The SCHIP Extension Act also precludes the Secretary from implementing, for the three year period beginning on December 29, 2007, a one-time adjustment to the LTCH standard federal rate. This rule, established in the original LTCH-PPS regulations, permits CMS to restate the standard federal rate to reflect the effect of changes in coding since the LTCH-PPS base year. In the preamble to the May 2007 final rule, CMS discussed making a one-time prospective adjustment to the LTCH-PPS rates for the 2009 rate year. In addition, the SCHIP Extension Act reduced the Medicare payment update for the portion of RY 2008 from April 1, 2008 to June 30, 2008 to the same base rate applied to LTCH discharges during RY 2007.
 
For the three calendar years following December 29, 2007, the Secretary must impose a moratorium on the establishment and classification of new LTCHs, LTCH satellite facilities, and LTCH beds in existing LTCH or satellite facilities. This moratorium does not apply to LTCHs that, before the date of enactment, (1) began the qualifying period for payment under the LTCH-PPS, (2) have a written agreement with an unrelated party for the construction, renovation, lease or demolition for a LTCH and have expended at least 10% of the estimated cost of the project or $2,500,000, or (3) have obtained an approved certificate of need. Additionally, an LTCH located in a state with only two LTCHs, may request an increase in licensed beds following the closure or decrease in the number of licensed beds at the other LTCH located within the state. As a result of the SCHIP Extension Act’s three calendar year moratorium on the development of new LTCHs, we have stopped all LTCH development.
 
Beginning with LTCH discharges on or after October 1, 2007 and through September 30, 2010 (unless extended by the Secretary), the SCHIP Extension Act also requires the Secretary to significantly expand medical necessity review for patients admitted to LTCHs by instituting a review of the medical necessity of continued stays of patients admitted to LTCHs. The medical necessity reviews must include a representative sample that results in a 95% confidence interval and guarantees that at least 75% of overpayments received by LTCHs for medically unnecessary admissions and continued stays are recovered and not counted toward an LTCH’s Medicare average length of stay. The Secretary may use up to 40% of the recouped overpayments to compensate the fiscal intermediaries and Medicare administrative contractors for the costs of conducting medical necessity reviews.
 
May 6, 2008 Interim Final Rule.   On May 6, 2008, CMS published an interim final rule with comment period, which implemented portions of the SCHIP Extension Act. The May 6, 2008 interim final rule addressed: (1) the payment adjustment for very short-stay outliers, (2) the standard federal rate for the last three months of


16


Table of Contents

RY 2008, (3) adjustment of the high cost outlier fixed-loss amount for the last three months of RY 2008, and (4) made reference to the SCHIP Extension Act in the discussion of the basis and scope of the LTCH-PPS rules.
 
As provided in the SCHIP Extension Act, for discharges beginning on or after December 29, 2007 and before December 29, 2010, the RY 2008 short-stay outlier rule based on the IPPS comparable threshold does not apply. The RY 2008 rule required that cases with a covered length of stay less than or equal to the IPPS comparable threshold and less than five-sixths of the geometric average length of stay for that DRG were paid at an amount comparable to the IPPS per diem. IPPS comparable threshold is defined as cases with a length of stay that is less than the average length of stay plus one standard deviation for the same DRG under IPPS. For discharges occurring on or after April 1, 2008 through June 30, 2008, the revised RY 2008 standard federal rate is $38,086.04, which is the same as the RY 2007 federal rate. In the only interpretation of the SCHIP Extension Act in the interim rule, CMS stated that it is interpreting the term “base rate” to be the standard federal rate “because we believe Congress meant to eliminate the 0.71% update from the RY 2008 standard federal rate.” Finally, the revised high cost outlier fixed-loss amount for discharges occurring on or after April 1, 2008 through June 30, 2008 was $20,707, a decrease of $31 per discharge from the $20,738 fixed-loss amount established by CMS in its technical correction to the May 2007 final rule. CMS indicated that the other issues addressed in the SCHIP Extension Act will be discussed in a forthcoming regulation, including instructions concerning (1) the moratorium on the certification of new LTCHs and satellites and the expansion of beds in existing facilities and (2) implementing changes to the 25% admission threshold adjustment for LTCH patients admitted from certain referring hospitals for a three year period.
 
May 9, 2008 Final Rule.   On May 9, 2008, CMS published its annual payment rate update for the 2009 LTCH-PPS rate year, or “RY 2009” (affecting discharges and cost reporting periods beginning on or after July 1, 2008). The final rule adopted a 15-month rate update, from July 1, 2008 through September 30, 2009 and moved LTCH-PPS from a July-June update cycle to the same update cycle as the general acute care hospital inpatient rule (October — September). For RY 2009, the rule established a 2.7% update to the standard federal rate. The rule increased the fixed-loss amount for high cost outlier cases to $22,960, which is $2,222 higher than the 2008 LTCH-PPS rate year. The final rule provided that CMS may make a one-time reduction in the LTCH-PPS rates to reflect a budget neutrality adjustment no earlier than December 29, 2010 and no later than October 1, 2012. CMS estimated this reduction will be approximately 3.75%.
 
May 22, 2008 Interim Final Rule.   On May 22, 2008, CMS published an interim final rule with comment period, which implemented portions of the SCHIP Extension Act not addressed in the May 6, 2008 interim final rule. Among other things, the May 22, 2008 interim final rule established a definition for “free-standing” LTCHs as a hospital that: (1) has a Medicare provider agreement, (2) has an average length of stay of greater than 25 days, (3) does not occupy space in a building used by another hospital, (4) does not occupy space in one or more separate or entire buildings located on the same campus as buildings used by another hospital; and (5) is not part of a hospital that provides inpatient services in a building also used by another hospital. As required by the SCHIP Extension Act, CMS made certain changes to the payment adjustment policy in the May 22, 2008 interim final rule. Effective for cost reporting periods beginning on or after December 29, 2007 and before December 29, 2010, CMS delayed the extension of the 25% threshold payment adjustment to grandfathered HIHs and free-standing LTCHs. Furthermore, CMS increased the patient percentage thresholds from 25% to 50% for certain LTCH HIH and satellite discharges admitted from a co-located hospital, and from 50% to 75% for certain LTCH HIH and satellite discharges at rural HIHs or admitted from a co-located MSA dominant or urban single hospital. For purposes of LTCH HIH and satellite discharges admitted from a co-located MSA dominant or urban single hospital, the percentage threshold continued to be limited by the percentage of total Medicare discharges in the MSA in which the hospital is located that are from the co-located hospital.
 
The May 22, 2008 interim final rule, effective December 29, 2007, continued to apply the percentage threshold to grandfathered satellites for patients admitted from any individual hospital with which they are not co-located. In addition, LTCH HIHs and LTCH satellites that are not grandfathered remained subject to the percentage threshold for patients admitted from non-co-located hospitals. Neither the SCHIP Extension Act nor the ARRA delayed or excluded these facilities from the percentage threshold applicable for cost reporting periods beginning on or after July 1, 2007. For LTCHs subject to the expanded percentage threshold a three year transition period starts with cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008, when the threshold is the lesser of 75% or the percentage of the LTCH’s or LTCH satellite’s admissions discharged from the referring hospital during its


17


Table of Contents

cost reporting period beginning on or after July 1, 2004 and before July 1, 2005 (“RY 2005”). For cost reporting periods beginning on or after July 1, 2008 and before July 1, 2009, the threshold will be the lesser of 50% or the percentage of the LTCH’s or LTCH satellite’s admissions from the referring hospital, during its RY 2005 cost reporting period. For cost reporting periods beginning on or after July 1, 2009, LTCHs subject to the expanded percentage threshold will be subject to the 25% threshold (or applicable threshold for rural, urban-single, or MSA dominant hospitals).
 
In accordance with the SCHIP Extension Act, the May 22, 2008 interim final rule provided an exception for new LTCHs that, on or before December 29, 2007, (1) began the qualifying period for payment under the LTCH-PPS, (2) have a binding written agreement with an unrelated party for the construction, renovation, lease or demolition for a LTCH and have expended at least 10% of the estimated cost of the project or $2,500,000, or (3) have obtained an approved certificate of need. The May 22, 2008 interim final rule implemented a moratorium on any increase of LTCH beds in existing LTCHs or LTCH satellites beginning on December 29, 2007 and continuing through December 28, 2010. The May 22, 2008 interim final rule also implemented a narrow exception for new beds. LTCHs located in a state with only two LTCHs may request an increase in beds following the closure or decrease in the number of beds at the other LTCH located within the state. CMS noted that the exception for an increase in beds does not apply to the limit on the number of beds in grandfathered LTCH HIHs or grandfathered LTCH satellites. A grandfathered facility would not be allowed to maintain its grandfathered status if it increases its number of beds under the exception.
 
August 2008 Final Rule.   On August 19, 2008, CMS published the IPPS final rule for FY 2009 (affecting discharges and cost reports beginning on or after October 1, 2008 and before October 1, 2009), which made limited revisions to the classifications of cases in MS-LTC-DRGs. The final rule also included a number of hospital ownership and physician referral provisions, including expansion of a hospital’s disclosure obligations by requiring physician-owned hospitals to disclose ownership or investment interests held by immediate family members of a referring physician. The final rule requires physician-owned hospitals to furnish to patients, on request, a list of physicians or immediate family members who own or invest in the hospital. Moreover, a physician-owned hospital must require all physician owners or investors who are also active members of the hospital’s medical staff to disclose in writing their ownership or investment interests in the hospital to all patients they refer to the hospital. CMS can terminate the Medicare provider agreement of a physician-owned hospital if it fails to comply with these disclosure provisions or with the requirement that a hospital disclose in writing to all patients whether there is a physician on-site at the hospital 24 hours per day, seven days per week.
 
The American Recovery and Reinvestment Act of 2009.   On February 17, 2009, President Obama signed into law the ARRA. The ARRA made several technical corrections to the SCHIP Extension Act, including a clarification that, during the moratorium period established by the SCHIP Extension Act, the percentage threshold for grandfathered satellites is set at 50% and not phased in to the 25% level for admissions from a co-located hospital. In addition, the ARRA clarified that the application of the percentage threshold is postponed for a LTCH HIH or satellite that was co-located with a provider-based, off-campus location of an IPPS hospital that did not deliver services payable under IPPS. The ARRA also modified certain delays in the application of the percentage thresholds as originally established in the SCHIP Extension Act. The effective date of the delay in application of the full 25% patient threshold payment adjustment policy is changed from cost reporting periods beginning on or after December 29, 2007 to cost reporting periods beginning on or after July 1, 2007 for freestanding LTCHs and grandfathered HIHs and satellites, and cost reporting periods beginning on or after October 1, 2007 for non-grandfathered LTCH HIHs and satellites.
 
June 3, 2009 Interim Final Rule.   On June 3, 2009, CMS published an interim final rule in which CMS adopted a new table of MS-LTC-DRG relative weights that will apply from June 3, 2009 to the remainder of fiscal year 2009 (through September 30, 2009). This interim final rule revised the MS-LTC-DRG relative weights for payment under the LTCH-PPS for fiscal year 2009 due to CMS’s misapplication of its established methodology in the calculation of the budget neutrality factor. CMS stated that the calculation of the budget neutrality factor of 1.04186 was determined using the unadjusted recalibrated relative weights rather than using the normalized relative weights. The revised fiscal year 2009 budget neutrality factor is 1.0030401. This error resulted in relative weights that were higher, by approximately 3.9% for all of fiscal year 2009 (October 1, 2008 through September 30, 2009).


18


Table of Contents

However, CMS is only applying the corrected weights to the remainder of fiscal year 2009 (that is, from June 3, 2009 through September 30, 2009).
 
July 31, 2009 Final Rule.   On July 31, 2009, CMS released its annual payment rate update for the 2010 LTCH-PPS rate year, or “RY 2010” (affecting discharges and cost reporting periods beginning on or after October 1, 2009 and before September 30, 2010). The increase in the standard federal rate uses a 2.0% update factor based on the market basket update of 2.5% less an adjustment of 0.5% to account for changes in documentation and coding practices. As a result, the standard federal rate for RY 2010 is set at $39,896.65, an increase from $39,114.36 in RY 2009. The fixed loss amount for high cost outlier cases is set at $18,425. This is a decrease from the fixed loss amount in the 2009 rate year of $22,960.
 
The July 31, 2009 annual payment rate update also included an interim final rule with comment period implementing provisions of the ARRA discussed above, including amendments to provisions of the SCHIP Extension Act relating to payments to LTCHs and LTCH satellite facilities and increases in beds in existing LTCHs and LTCH satellite facilities under the LTCH-PPS.
 
On July 31, 2009, CMS finalized three interim final rules with comment period that it previously published but had yet to respond to public comment. First, CMS finalized the June 3, 2009 interim final rule that adopted a new table of MS-LTC-DRG relative weights for the period between June 3, 2009 and September 30, 2009. Second, CMS finalized the May 6, 2008 interim final rule that implemented changes to LTCH-PPS mandated by the SCHIP Extension Act addressing: (1) payment adjustments for certain short-stay outliers , (2) the federal standard rate for the last three months of rate year 2008, and (3) adjustment of the high cost outlier fixed-loss amount. Finally, CMS finalized the May 22, 2008 interim final rule that implemented changes to LTCH-PPS mandated by the SCHIP Extension Act modifying the percentage threshold policy for certain LTCHs and addressing the three-year moratorium on the establishment of new LTCHs and bed increases at existing LTCHs and LTCH satellites.
 
The SCHIP Extension Act, as amended by the ARRA, among other things, limited the application of the Medicare admission threshold on HIHs in existence on October 1, 2004 to no lower than 50% (subject to exceptions for rural and MSA dominant hospitals) for a three year period to commence on an LTCH’s first cost reporting period to begin on or after October 1, 2007, postponed for the three year period beginning on December 29, 2007 the SSO policy changes made in the May 2007 final rule and postponed the application of the percentage threshold to all free-standing and grandfathered HIHs for a three year period commencing on an LTCH’s first cost reporting period on or after July 1, 2007. The ARRA further limited application of the admissions threshold to no more than 50% of Medicare admissions to grandfathered satellites from a co-located hospital for a three year period commencing on the first cost reporting period beginning on or after July 1, 2007. If the May 2004 final rules and May 2007 final rules become effective as currently written after the expiration of the applicable provisions of the SCHIP Extension Act and the ARRA, these regulatory changes will collectively cause an adverse effect on our operating revenues and profitability in 2011 and beyond, which adverse effect could be partially mitigated if we are able to implement certain operational changes. However, the effect of these changes in 2010 will not be significant.
 
Medicare Reimbursement of Inpatient Rehabilitation Facility Services.  Inpatient rehabilitation facilities are paid under a prospective payment system specifically applicable to this provider type, which is referred to as “IRF-PPS.” Under the IRF-PPS, each patient discharged from an inpatient rehabilitation facility is assigned to a case mix group or “IRF-CMG” containing patients with similar clinical conditions that are expected to require similar amounts of resources. An inpatient rehabilitation facility is generally paid a pre-determined fixed amount applicable to the assigned IRF-CMG (subject to applicable case adjustments related to length of stay and facility level adjustments for location and low income patients). The payment amount for each IRF-CMG is intended to reflect the average cost of treating a Medicare patient’s condition in an inpatient rehabilitation facility relative to patients with conditions described by other IRF-CMGs. The IRF-PPS also includes special payment policies that adjust the payments for some patients based on the patient’s length of stay, the facility’s costs, whether the patient was discharged and readmitted and other factors. As required by Congress, IRF-CMG payments rates have been set to maintain budget neutrality with total expenditures that would have been made under the previous reasonable cost based system. The IRF-PPS was phased in over a transition period in 2002. For cost reporting periods beginning on or after October 1, 2002, inpatient rehabilitation facilities are paid solely on the basis of the IRF-PPS payment rate.


19


Table of Contents

Although the initial IRF-PPS regulations did not change the criteria that must be met in order for a hospital to be certified as an inpatient rehabilitation facility, CMS adopted a separate final rule on May 7, 2004 that made significant changes to those criteria. The new inpatient rehabilitation facility certification criteria became effective for cost reporting periods beginning on or after July 1, 2004. Under the historic IRF certification criteria that had been in effect since 1983, in order to qualify as an IRF, a hospital was required to satisfy certain operational criteria as well as demonstrate that, during its most recent 12-month cost reporting period, it served an inpatient population of whom at least 75% required intensive rehabilitation services for one or more of ten conditions specified in the regulation. We refer to such 75% requirement as the “75% rule.”
 
CMS adopted four major changes to the 75% rule in its May 7, 2004 final rule. First, CMS temporarily lowered the 75% compliance threshold, as follows: (1) 50% for cost reporting periods beginning on or after July 1, 2004 and before July 1, 2005; (2) 60% for cost reporting periods beginning on or after July 1, 2005 and before July 1, 2006; (3) 65% for cost reporting periods beginning on or after July 1, 2006 and before July 1, 2007; and (4) 75% for cost reporting periods beginning on or after July 1, 2007. Second, CMS modified and expanded from ten to 13 the medical conditions used to determine whether a hospital qualifies as an inpatient rehabilitation facility. Third, the agency finalized the conditions under which comorbidities can be used to verify compliance with the 75% rule. Fourth, CMS changed the timeframe used to determine compliance with the 75% rule from “the most recent 12-month cost reporting period” to “the most recent, consecutive, and appropriate 12-month period,” with the result that a determination of non-compliance with the applicable compliance threshold will affect the facility’s certification for its cost reporting period that begins immediately after the 12-month review period.
 
Under the Deficit Reduction Act of 2005, enacted on February 8, 2006, Congress extended the phase-in period for the 75% rule by maintaining the compliance threshold at 60% (rather than increasing it to 65%) during the 12-month period beginning on July 1, 2006. The compliance threshold was then to increase to 65% for cost reporting periods beginning on or after July 1, 2007 and again to 75% for cost reporting periods beginning on or after July 1, 2008.
 
August 2006 Final Rule.   In the August 2006 final rule updating IRF-PPS for discharges occurring on or after October 1, 2006 and on or before September 30, 2007, CMS reduced the standard payment amount by 2.6% and increased the outlier threshold for fiscal year 2007 to $5,534 from $5,129 for fiscal year 2006. CMS stated that the reduction in standard payment was to account for coding changes that did not reflect real changes in case mix.
 
August 2007 Final Rule.   In the August 2007 final rule updating IRF-PPS for discharges occurring on or after October 1, 2007 and on or before September 30, 2008, CMS increased the standard payment amount by 3.2% and increased the outlier threshold for fiscal year 2008 to $7,362 from $5,534 for fiscal year 2007.
 
Medicare Medicaid and SCHIP Extension Act of 2007.   The SCHIP Extension Act included a permanent freeze in the 75% rule patient classification criteria compliance threshold at 60% (with comorbidities counting toward this threshold) and a payment freeze from April 1, 2008 through September 30, 2009. In order to comply with Medicare inpatient rehabilitation facility certification criteria, it may be necessary for our IRFs to implement restrictive admissions policies and not admit patients whose diagnoses fall outside the 13 specified conditions. Such policies may result in reduced patient volumes, which could have a negative effect on financial performance.
 
In addition to meeting the compliance threshold, a hospital must meet other facility criteria to be classified as an IRF, including: (1) a provider agreement to participate as a hospital in Medicare; (2) a preadmission screening procedure; (3) ensuring that patients receive close medical supervision and furnish, through the use of qualified personnel, rehabilitation nursing, physical therapy, and occupational therapy, plus, as needed, speech therapy, social or psychological services, and orthotic and prosthetic services; (4) a full-time, qualified director of rehabilitation; (5) a plan of treatment for each inpatient that is established, reviewed, and revised as needed by a physician in consultation with other professional personnel who provide services to the patient; (6) a coordinated multidisciplinary team approach in the rehabilitation of each inpatient, as documented by periodic clinical entries made in the patient’s medical record to note the patient’s status in relationship to goal attainment, and that team conferences are held at least every two weeks to determine the appropriateness of treatment. Failure to comply with any of the classification criteria, including the compliance threshold, may cause a hospital to lose its exclusion from the prospective payment system that applies to general acute care hospitals and, as a result, no longer be eligible for payment at a higher rate.


20


Table of Contents

The SCHIP Extension Act requires the Secretary, in consultation with providers, trade organizations and the Medicare Payment Advisory Commission, to prepare an analysis of the compliance threshold for the Committee on Ways and Means of the House of Representatives and the Committee on Finance of the Senate. Among other things, the analysis must include the potential effect of the 75% rule on access to care, alternatives to the 75% rule policy for certifying inpatient rehabilitation hospitals, and the appropriate setting of care for conditions of patients commonly admitted to IRFs that are not one of the 13 specified conditions. In requiring the Secretary to produce a recommendation for classifying IRFs, Congress used the term “75% rule” for the first time to describe the compliance threshold requirement, while at the same time freezing the threshold at 60%. The results of this analysis may impact future policies, regulations and statutes governing IRF-PPS.
 
August 2008 Final Rule.   On August 8, 2008, CMS published the final rule for IRF-PPS for FY 2009. The final rule includes changes to the IRF-PPS regulations designed to implement portions of the SCHIP Extension Act. In particular, the patient classification criteria compliance threshold is established at 60% (with comorbidities counting toward this threshold). In addition to updating the various values that compose the IRF-PPS, the final rule increased the outlier threshold amount to $10,250 from $7,362 for fiscal year 2007. CMS also updated the CMG relative weights and average length of stay values.
 
July 31, 2009 Final Rule.   On July 31, 2009, CMS released its final rule establishing the annual payment rate update for the IRF-PPS for FY 2010 (affecting discharges and cost reporting periods beginning on October 1, 2009 through September 30, 2010). The standard federal rate is established at $13,661 for FY 2010, an increase from $12,958 in FY 2009. The proposed outlier threshold amount is set at $10,652, an increase from $10,250 in FY 2009.
 
In the same final rule, CMS adopted new coverage criteria, including requirements for preadmission screening, post-admission evaluations, and individualized treatment planning that emphasize the role of physicians in ordering and overseeing beneficiaries’ IRF care. Among other things, the rule requires IRF services to be ordered by a rehabilitation physician with specialized training and experience in rehabilitation services and be coordinated by an interdisciplinary team meeting the rule’s specifications. The interdisciplinary team must meet weekly to review the patient’s progress and make any needed adjustments to the individualized plan of care. IRFs must use qualified personnel to provide required rehabilitation nursing, physical therapy, occupational therapy, speech-language pathology, social services, psychological services, and prosthetic and orthotic services (CMS notes that it also is considering adopting specific standards on the use of group therapies at a future date). The rule also includes new documentation requirements, including a requirement that IRFs submit patient assessment data on Medicare Advantage patients. While the final rule’s payment rate updates are effective for IRF discharges on or after October 1, 2009, CMS has adopted a January 1, 2010 effective date for the new coverage requirements to provide facilities more time to comply with the new framework. If we fail to implement the new coverage criteria, claims for our services may be denied in whole or in part.
 
Specialty Hospital Medicaid Reimbursement.  The Medicaid program is designed to provide medical assistance to individuals unable to afford care. The program is governed by the Social Security Act of 1965 and administered and funded jointly by each individual state government and CMS. Medicaid payments are made under a number of different systems, which include cost based reimbursement, prospective payment systems or programs that negotiate payment levels with individual hospitals. In addition, Medicaid programs are subject to statutory and regulatory changes, administrative rulings, interpretations of policy by the state agencies and certain government funding limitations, all of which may increase or decrease the level of program payments to our hospitals. Net operating revenues generated directly from the Medicaid program represented approximately 3.3% of our specialty hospital net operating revenues for the year ended December 31, 2009.
 
Medicare Reimbursement of Outpatient Rehabilitation Services.  Beginning on January 1, 1999, the Balanced Budget Act of 1997 subjected certain outpatient therapy providers reimbursed under the Medicare physician fee schedule to annual limits for therapy expenses. Effective January 1, 2010, the annual limit on outpatient therapy services is $1,860 for combined physical and speech language pathology services and $1,860 for occupational therapy services. The per beneficiary caps were $1,840 for calendar year 2009. In the Deficit Reduction Act of 2005, Congress implemented an exception process to the annual limit for therapy expenses. Under this process, a Medicare enrollee (or person acting on behalf of the Medicare enrollee) is able to request an exception from the therapy caps if the provision of therapy services was deemed to be medically necessary. Therapy cap exceptions


21


Table of Contents

were available automatically for certain conditions and on a case-by-case basis upon submission of documentation of medical necessity. The exception process has been extended by Congress several times. Most recently, the Temporary Extension Act of 2010 extended the exception process through March 31, 2010. The exception process will expire on April 1, 2010 unless further extended by Congress. There can be no assurance that Congress will extend it further. Failure to extend the exception process may reduce our future net operating revenues and profitability.
 
The Medicare program reimburses outpatient rehabilitation providers based on the Medicare physician fee schedule. The Medicare physician fee schedule rates are automatically updated annually based on a formula, called the sustainable growth rate (“SGR”) formula, contained in legislation. The SGR formula has resulted in automatic reductions in rates in every year since 2002; however, for each year through 2009 CMS or Congress has taken action to prevent the SGR formula reductions. On December 19, 2009, President Obama signed the Department of Defense Appropriations Act, 2010 into law, which delayed until March 1, 2010 the payment reductions for 2010 required by the SGR formula. The Temporary Extension Act of 2010 further delayed the scheduled reduction in Medicare payment until March 31, 2010. Congress is now considering several proposals to delay the payment cut further or to replace the SGR formula with another methodology for setting Medicare physician payment rates. We cannot predict what actions, if any, Congress or CMS may take with respect to the Medicare physician fee schedule update. If no further legislation is passed by Congress and signed by the President, the SGR formula will reduce our Medicare outpatient rehabilitation payment rates by approximately 21.2% beginning April 1, 2010. For the year ended December 31, 2009, we received approximately 9.7% of our outpatient rehabilitation net operating revenues from Medicare.
 
Historically, outpatient rehabilitation services have been subject to scrutiny by the Medicare program for, among other things, medical necessity for services, appropriate documentation for services, supervision of therapy aides and students and billing for group therapy. CMS has issued guidance to clarify that services performed by a student are not reimbursed even if provided under “line of sight” supervision of the therapist. Likewise, CMS has reiterated that Medicare does not pay for services provided by aides regardless of the level of supervision. CMS also has issued instructions that outpatient physical and occupational therapy services provided simultaneously to two or more individuals by a practitioner should be billed as group therapy services.
 
Workers’ Compensation.  Net operating revenues generated directly from Workers’ compensation programs represented approximately 18.9% of our net operating revenue from outpatient rehabilitation services for the year ended December 31, 2009. Workers’ compensation is a state mandated, comprehensive insurance program that requires employers to fund or insure medical expenses, lost wages and other costs resulting from work related injuries and illnesses. Workers’ compensation benefits and arrangements vary on a state-by-state basis and are often highly complex. In some states, payment for services covered by workers’ compensation programs are subject to cost containment features, such as requirements that all workers’ compensation injuries be treated through a managed care program, or the imposition of payment caps. In addition, these workers’ compensation programs may impose requirements that affect the operations of our outpatient rehabilitation services.
 
Federal Healthcare Reform Proposals
 
Healthcare is one of the largest industries in the United States and continues to attract much legislative interest and public attention. Comprehensive national healthcare reform is currently a focus at the federal level. In the final months of 2009, both houses of the U.S. Congress passed different versions of comprehensive healthcare reform legislation. Both versions of the legislation would require most individuals to have health insurance coverage, and would aim to promote quality and cost efficiency in healthcare delivery and budgetary savings in the Medicare program. On March 3, 2010, President Obama announced that he would seek passage of healthcare reform legislation with certain changes. While no comprehensive healthcare reform legislation has yet become law, we anticipate that Congress will continue to consider legislative changes, either as part of comprehensive healthcare reform or separately, that could affect our business.
 
Legislative changes that have been discussed as part of healthcare reform have included, among other things, calls for bundled payments to hospitals that would cover not just the hospitalization, but care from certain post-acute providers for the 30 days after the hospitalization. A significant portion of the services furnished by our specialty


22


Table of Contents

hospitals and outpatient rehabilitation clinics are to patients discharged from acute care hospitals. Therefore, the proposal to bundle payments to hospitals could have a material impact on volume of referrals to our facilities from acute care hospitals and the payment rates that we receive for our services. Other proposed legislative changes have included negative adjustments to the annual market basket updates for the Medicare long term care hospital and inpatient rehabilitation payment systems, penalties for hospital readmissions, value-based purchasing and enhanced efforts to curb fraud and abuse, including by implementing additional prepayment reviews. There has also been discussion of establishing an Independent Medicare Advisory Board charged with presenting proposals to Congress to reduce Medicare expenditures when such expenditures exceed specified levels.
 
Healthcare reform legislation passed by the U.S. Senate in 2009 contained a temporary extension of policies adopted in the SCHIP Extension Act, including extending relief from certain LTCH-PPS payment policies and extending the moratorium on the establishment and classification of new LTCHs and LTCH beds. The healthcare reform legislation passed by the U.S. House of Representatives in 2009 did not contain a similar extension. It is uncertain whether both houses of Congress will enact healthcare reform legislation or other legislation that includes an extension of the policies adopted in the SCHIP Extension Act.
 
At this time we are unable to predict what action Congress or the President might take with respect to comprehensive healthcare reform or other legislation affecting healthcare, or the impact of any such legislation on our revenues, operating costs, results of operations or cash flows.
 
Other Healthcare Regulations
 
Medicare Recovery Audit Contractors.  The Tax Relief and Health Care Act of 2006 instructed CMS to contract with third-party organizations, known as recovery audit contractors, or “RACs,” to identify Medicare underpayments and overpayments, and to authorize RACs to recoup any overpayments. The compensation paid to each RAC is based on a percentage of overpayment recoveries identified by the RAC. CMS has selected and entered into contracts with four RACs, each of which has begun their audit activities in specific jurisdictions. RAC audits of our Medicare reimbursement may lead to assertions that we have been overpaid, require us to incur additional costs to respond to requests for records and pursue the reversal of payment denials, and ultimately require us to refund any amounts determined to have been overpaid. We cannot predict the impact of future RAC reviews on our results of operations or cash flows.
 
Fraud and Abuse Enforcement.  Various federal and state laws prohibit the submission of false or fraudulent claims, including claims to obtain payment under Medicare, Medicaid and other government healthcare programs. Penalties for violation of these laws include civil and criminal fines, imprisonment and exclusion from participation in federal and state healthcare programs. In recent years, federal and state government agencies have increased the level of enforcement resources and activities targeted at the healthcare industry. In addition, the federal False Claims Act and similar state statutes allow individuals to bring lawsuits on behalf of the government, in what are known as qui tam or “whistleblower” actions, alleging false or fraudulent Medicare or Medicaid claims or other violations of the statute. The use of these private enforcement actions against healthcare providers has increased dramatically in recent years, in part because the individual filing the initial complaint is entitled to share in a portion of any settlement or judgment. Revisions to the False Claims Act enacted in 2009 expanded significantly the scope of liability, provided for new investigative tools, and made it easier for whistleblowers to bring and maintain False Claims Act suits on behalf of the government. See “— Legal Proceedings.”
 
From time to time, various federal and state agencies, such as the Office of the Inspector General of the Department of Health and Human Services, issue a variety of pronouncements, including fraud alerts, the Office of Inspector General’s Annual Work Plan and other reports, identifying practices that may be subject to heightened scrutiny. These pronouncements can identify issues relating to long term acute care hospitals, inpatient rehabilitation facilities or outpatient rehabilitation services or providers. For example, the Office of Inspector General’s 2005 Work Plan describes plans to study whether patients in long term acute care hospitals are receiving acute-level services or could be cared for in skilled nursing facilities. The 2006 and 2007 Work Plans describe plans: (1) to study the accuracy of Medicare payment for inpatient rehabilitation stays when patient assessments are entered later than the required deadlines, (2) to study both inpatient rehabilitation facility and long term acute care hospital payments in order to determine whether they were made in accordance with applicable regulations, including


23


Table of Contents

policies on outlier payments and interrupted stays, and (3) to study physical and occupational therapy claims in order to determine whether the services were medically necessary, adequately documented and certified. The 2007 Work Plan describes plans to study the extent to which long term acute care hospitals admit patients from a sole general acute care hospital and whether hospitals currently reimbursed under LTCH-PPS are in compliance with the average length of stay criteria. The 2008 Work Plan announced plans to review whether payments to long term acute care hospitals were appropriate for: (1) interrupted stays, (2) short stay outliers, (3) cases involving the readmission of patients transferred to a co-located general acute care hospital, and (4) cases exceeding the applicable patient threshold payment adjustment policy. In the 2009 Work Plan, the Office of Inspector General indicated an interest in reviewing Medicare claims involving cases transferred from inpatient rehabilitation facilities to other inpatient rehabilitation facilities, long term acute care hospitals, acute inpatient hospitals, or nursing homes that accept payments under the Medicare or Medicaid programs. The 2009 Work Plan also announced an interest in reviewing Medicare bad debts claimed by inpatient rehabilitation facilities and long term acute care hospitals in order to determine whether such claims were reimbursable. The 2010 Work Plan identified as an area of concern whether the patient assessments instruments prepared by inpatient rehabilitation facilities were submitted in accordance with Medicare regulations. We monitor government publications applicable to us to supplement and enhance our compliance efforts.
 
We endeavor to conduct our operations in compliance with applicable laws, including healthcare fraud and abuse laws. If we identify any practices as being potentially contrary to applicable law, we will take appropriate action to address the matter, including, where appropriate, disclosure to the proper authorities, which may result in a voluntary refund of monies to Medicare, Medicaid or other governmental healthcare programs.
 
Remuneration and Fraud Measures.  The federal “anti-kickback” statute prohibits some business practices and relationships under Medicare, Medicaid and other federal healthcare programs. These practices include the payment, receipt, offer or solicitation of remuneration in connection with, to induce, or to arrange for, the referral of patients covered by a federal or state healthcare program. Violations of the anti-kickback law may be punished by a criminal fine of up to $50,000 or imprisonment for each violation, or both, civil monetary penalties of $50,000 and damages of up to three times the total amount of remuneration, and exclusion from participation in federal or state healthcare programs.
 
Section 1877 of the Social Security Act, commonly known as the “Stark Law,” prohibits referrals for designated health services by physicians under the Medicare and Medicaid programs to other healthcare providers in which the physicians have an ownership or compensation arrangement unless an exception applies. Sanctions for violating the Stark Law include civil monetary penalties of up to $15,000 per prohibited service provided, assessments equal to three times the dollar value of each such service provided and exclusion from the Medicare and Medicaid programs and other federal and state healthcare programs. The statute also provides a penalty of up to $100,000 for a circumvention scheme. In addition, many states have adopted or may adopt similar anti-kickback or anti-self-referral statutes. Some of these statutes prohibit the payment or receipt of remuneration for the referral of patients, regardless of the source of the payment for the care. While we do not believe our arrangements are in violation of these prohibitions, we cannot assure you that governmental officials charged with the responsibility for enforcing the provisions of these prohibitions will not assert that one or more of our arrangements are in violation of the provisions of such laws and regulations.
 
Provider-Based Status.  The designation “provider-based” refers to circumstances in which a subordinate facility (e.g., a separately certified Medicare provider, a department of a provider or a satellite facility) is treated as part of a provider for Medicare payment purposes. In these cases, the services of the subordinate facility are included on the “main” provider’s cost report and overhead costs of the main provider can be allocated to the subordinate facility, to the extent that they are shared. We operate 12 specialty hospitals that are treated as provider-based satellites of certain of our other facilities, certain of our outpatient rehabilitation services are operated as departments of our inpatient rehabilitation facilities, and we provide rehabilitation management and staffing services to hospital rehabilitation departments that may be treated as provider-based. These facilities are required to satisfy certain operational standards in order to retain their provider-based status.
 
Health Information Practices.  The Health Insurance Portability and Accountability Act of 1996 or “HIPAA” mandates the adoption of standards for the exchange of electronic health information in an effort to encourage


24


Table of Contents

overall administrative simplification and enhance the effectiveness and efficiency of the healthcare industry, while maintaining the privacy and security of health information. Among the standards that the Department of Health and Human Services has adopted or will adopt pursuant to the Health Insurance Portability and Accountability Act of 1996 are standards for electronic transactions and code sets, unique identifiers for providers (referred to as National Provider Identifier), employers, health plans and individuals, security and electronic signatures, privacy and enforcement. If we fail to comply with the HIPAA requirements, we could be subject to criminal penalties and civil sanctions. The privacy, security and enforcement provisions of HIPAA were enhanced by the Health Information Technology for Economic and Clinical Health Act, or “HITECH,” which was included in the ARRA. Among other things, HITECH establishes security breach notification requirements, allows enforcement of HIPAA by state attorneys general, and increases penalties for HIPAA violations.
 
The Department of Health and Human Services has adopted standards in three areas that most affect our operations.
 
Standards relating to the privacy of individually identifiable health information govern our use and disclosure of protected health information and require us to impose those rules, by contract, on any business associate to whom such information is disclosed. We were required to comply with these standards by April 14, 2003.
 
Standards relating to electronic transactions and code sets require the use of uniform standards for common healthcare transactions, including healthcare claims information, plan eligibility, referral certification and authorization, claims status, plan enrollment and disenrollment, payment and remittance advice, plan premium payments and coordination of benefits. We were required to comply with these requirements by October 16, 2003.
 
Standards for the security of electronic health information require us to implement various administrative, physical and technical safeguards to ensure the integrity and confidentiality of electronic protected health information. We were required to comply with these security standards by April 20, 2005.
 
We maintain a HIPAA committee that is charged with evaluating and monitoring our compliance with the Health Insurance Portability and Accountability Act of 1996. The HIPAA committee monitors regulations promulgated under HIPPA as they have been adopted to date and as additional standards and modifications are adopted. Although health information standards have had a significant effect on the manner in which we handle health data and communicate with payors, the cost of our compliance has not had a material adverse effect on our business, financial condition or results of operations. We cannot estimate the cost of compliance with standards that have not been issued or finalized by the Department of Health and Human Services.
 
In addition to HIPAA, there are numerous federal and state laws and regulations addressing patient and consumer privacy concerns, including unauthorized access or theft of personal information. State statutes and regulations vary from state to state. The Federal Trade Commission issued so-called “Red Flag” regulations aimed at preventing and detecting identity theft, which are expected to become effective soon. Lawsuits, including class actions and action by state attorneys general, directed at companies that have experienced a privacy or security breach are becoming more common. Although our policies and procedures are aimed at complying with privacy and security requirements and minimizing the risks of any breach of privacy or security, there can be no assurance that a breach of privacy or security will not occur. If there is a breach, we may be subject to various penalties and damages and may be required to incur costs to mitigate the impact of the breach on affected individuals.
 
Compliance Program
 
Our Compliance Program
 
In late 1998, we voluntarily adopted our code of conduct. The code is reviewed and amended as necessary and is the basis for our company-wide compliance program. Our written code of conduct provides guidelines for principles and regulatory rules that are applicable to our patient care and business activities. These guidelines are implemented by a compliance officer, a compliance committee, and employee education and training. We also have established a reporting system, auditing and monitoring programs, and a disciplinary system as a means for enforcing the code’s policies.


25


Table of Contents

Operating Our Compliance Program
 
We focus on integrating compliance responsibilities with operational functions. We recognize that our compliance with applicable laws and regulations depends upon individual employee actions as well as company operations. As a result, we have adopted an operations team approach to compliance. Our corporate executives, with the assistance of corporate experts, designed the programs of the compliance committee. We utilize facility leaders for employee-level implementation of our code of conduct. This approach is intended to reinforce our company-wide commitment to operate in accordance with the laws and regulations that govern our business.
 
Compliance Committee
 
Our compliance committee is made up of members of our senior management and in-house counsel. The compliance committee meets on a quarterly basis and reviews the activities, reports and operation of our compliance program. In addition, the HIPAA committee meets on a regular basis to review compliance with regulations promulgated under HIPPA, including amendments made by the Health Information Technology for Economic and Clinical Health Act or HITECH, and provides reports to the compliance committee. The vice president of compliance and audit services meets with the audit committee on a quarterly basis to provide an overview of the activities and operation of our compliance program.
 
Compliance Issue Reporting
 
In order to facilitate our employees’ ability to report known, suspected or potential violations of our code of conduct, we have developed a system of anonymous reporting. This anonymous reporting may be accomplished through our toll free compliance hotline, compliance e-mail address or our compliance post office box. The compliance officer and the compliance committee are responsible for reviewing and investigating each compliance incident in accordance with the compliance department’s investigation policy.
 
Compliance Monitoring and Auditing / Comprehensive Training and Education
 
Monitoring reports and the results of compliance for each of our business segments are reported to the compliance committee on a quarterly basis. We train and educate our employees regarding the code of conduct, as well as the legal and regulatory requirements relevant to each employee’s work environment. New and current employees are required to acknowledge and certify that the employee has read, understood and has agreed to abide by the code of conduct. Additionally, all employees are required to re-certify compliance with the code on an annual basis.
 
Policies and Procedures Reflecting Compliance Focus Areas
 
We review our policies and procedures for our compliance program from time to time in order to improve operations and to ensure compliance with requirements of standards, laws and regulations and to reflect the ongoing compliance focus areas which have been identified by the compliance committee.
 
Internal Audit
 
In addition to and in support of the efforts of our compliance department, during 2001 we established an internal audit function. The vice president of compliance and audit services manages the combined Compliance and Audit Department and meets with the audit committee of the board of directors on a quarterly basis to discuss audit results.
 
Available Information
 
We are subject to the information and periodic reporting requirements of the Securities Exchange Act of 1934 and, in accordance therewith, file periodic reports, proxy statements and other information with the SEC. Such periodic reports, proxy statements and other information is available for inspection and copying at the SEC’s Public Reference Room at 100 F Street, NE., Washington, DC 20549, or may be obtained by calling the SEC at 1 — 800 —


26


Table of Contents

SEC — 0330. In addition, the SEC maintains a website at http://www.sec.gov that contains reports, proxy statements and other information regarding issuers that file electronically with the SEC.
 
Our website address is http://www.selectmedicalcorp.com and can be used to access free of charge, through the investor relations section, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC. The information on our website is not incorporated as a part of this annual report.
 
Executive Officers
 
The following table sets forth the names, ages and titles, as well as a brief account of the business experience, of each person who was an executive officer of the Company as of December 31, 2009:
 
             
Name
 
Age
 
Position
 
Rocco A. Ortenzio
    77     Executive Chairman
Robert A. Ortenzio
    52     Chief Executive Officer
Patricia A. Rice
    63     President and Chief Operating Officer
David W. Cross
    63     Executive Vice President and Chief Development Officer
S. Frank Fritsch
    58     Executive Vice President and Chief Human Resources Officer
Martin F. Jackson
    55     Executive Vice President and Chief Financial Officer
James J. Talalai
    48     Executive Vice President and Chief Information Officer
Michael E. Tarvin
    49     Executive Vice President, General Counsel and Secretary
Scott A. Romberger
    49     Senior Vice President, Controller and Chief Accounting Officer
Robert G. Breighner, Jr. 
    41     Vice President, Compliance and Audit Services and Corporate Compliance Officer
 
Rocco A. Ortenzio co-founded our company and he served as Chairman and Chief Executive Officer from February 1997 until September 2001. Mr. Ortenzio has served as Executive Chairman since September 2001. He became a director of Holdings upon the consummation of the Merger Transactions. In 1986, he co-founded Continental Medical Systems, Inc., and served as its Chairman and Chief Executive Officer until July 1995. In 1979, Mr. Ortenzio founded Rehab Hospital Services Corporation, and served as its Chairman and Chief Executive Officer until June 1986. In 1969, Mr. Ortenzio founded Rehab Corporation and served as its Chairman and Chief Executive Officer until 1974. Mr. Ortenzio is the father of Robert A. Ortenzio, our Chief Executive Officer.
 
Robert A. Ortenzio co-founded our company and has served as a director of Select since February 1997. He became a director of Holdings upon the consummation of the Merger Transactions. Mr. Ortenzio has served as our Chief Executive Officer since January 1, 2005 and as our President and Chief Executive Officer from September 2001 to January 1, 2005. Mr. Ortenzio also served as our President and Chief Operating Officer from February 1997 to September 2001. He was an Executive Vice President and a director of Horizon/CMS Healthcare Corporation from July 1995 until July 1996. In 1986, Mr. Ortenzio co-founded Continental Medical Systems, Inc., and served in a number of different capacities, including as a Senior Vice President from February 1986 until April 1988, as Chief Operating Officer from April 1988 until July 1995, as President from May 1989 until August 1996 and as Chief Executive Officer from July 1995 until August 1996. Before co-founding Continental Medical Systems, Inc., he was a Vice President of Rehab Hospital Services Corporation. He currently serves on the board of directors of Odyssey Healthcare, Inc., a hospice healthcare company, and U.S. Oncology, Inc. Mr. Ortenzio is the son of Rocco A. Ortenzio, our Executive Chairman.
 
Patricia A. Rice has served as our President and Chief Operating Officer since January 1, 2005. Prior to this, she served as our Executive Vice President and Chief Operating Officer since January 2002 and as our Executive


27


Table of Contents

Vice President of Operations from November 1999 to January 2002. She served as Senior Vice President of Hospital Operations from December 1997 to November 1999. She was Executive Vice President of the Hospital Operations Division for Continental Medical Systems, Inc. from August 1996 until December 1997. Prior to that time, she served in various management positions at Continental Medical Systems, Inc. from 1987 to 1996.
 
David W. Cross has served as our Executive Vice President and Chief Development Officer since February 2007. He served as our Senior Vice President and Chief Development Officer from December 1998 to February 2007. Before joining us, he was President and Chief Executive Officer of Intensiva Healthcare Corporation from 1994 until we acquired it. Mr. Cross was a founder, the President and Chief Executive Officer, and a director of Advanced Rehabilitation Resources, Inc., and served in each of these capacities from 1990 to 1993. From 1987 to 1990, he was Senior Vice President of Business Development for RehabCare Group, Inc., a publicly traded rehabilitation care company, and in 1993 and 1994 served as Executive Vice President and Chief Development Officer of RehabCare Group, Inc. Mr. Cross currently serves on the board of directors of Odyssey Healthcare, Inc., a hospice healthcare company.
 
S. Frank Fritsch has served as our Executive Vice President and Chief Human Resources Officer since February 2007. He served as our Senior Vice President of Human Resources from November 1999 to February 2007. He served as our Vice President of Human Resources from June 1997 to November 1999. Prior to June 1997, he was Senior Vice President — Human Resources for Integrated Health Services from May 1996 until June 1997. Prior to that time, Mr. Fritsch was Senior Vice President — Human Resources for Continental Medical Systems, Inc. from August 1992 to April 1996. From 1980 to 1992, Mr. Fritsch held senior human resources positions with Mercy Health Systems, Rorer Pharmaceuticals, ARA Mark and American Hospital Supply Corporation.
 
Martin F. Jackson has served as our Executive Vice President and Chief Financial Officer since February 2007. He served as our Senior Vice President and Chief Financial Officer from May 1999 to February 2007. Mr. Jackson previously served as a Managing Director in the Health Care Investment Banking Group for CIBC Oppenheimer from January 1997 to May 1999. Prior to that time, he served as Senior Vice President, Health Care Finance with McDonald & Company Securities, Inc. from January 1994 to January 1997. Prior to 1994, Mr. Jackson held senior financial positions with Van Kampen Merritt, Touche Ross, Honeywell and L’Nard Associates. Mr. Jackson also serves as a director of several private companies.
 
James J. Talalai has served as our Executive Vice President and Chief Information Officer since February 2007. He served as our Senior Vice President and Chief Information Officer from August 2001 to February 2007. He joined our company in May 1997 and served in various leadership capacities within Information Services. Before joining us, Mr. Talalai was Director of Information Technology for Horizon/ CMS Healthcare Corporation from 1995 to 1997. He also served as Data Center Manager at Continental Medical Systems, Inc. in the mid-1990s. During his career, Mr. Talalai has held development positions with PHICO Insurance Company and with Harrisburg HealthCare.
 
Michael E. Tarvin has served as our Executive Vice President, General Counsel and Secretary since February 2007. He served as our Senior Vice President, General Counsel and Secretary from November 1999 to February 2007. He served as our Vice President, General Counsel and Secretary from February 1997 to November 1999. He was Vice President — Senior Counsel of Continental Medical Systems from February 1993 until February 1997. Prior to that time, he was Associate Counsel of Continental Medical Systems from March 1992. Mr. Tarvin was an associate at the Philadelphia law firm of Drinker Biddle & Reath, LLP from September 1985 until March 1992.
 
Scott A. Romberger has served as our Senior Vice President and Controller since February 2007. He served as our Vice President and Controller from February 1997 to February 2007. In addition, he has served as our Chief Accounting Officer since December 2000. Prior to February 1997, he was Vice President — Controller of Continental Medical Systems from January 1991 until January 1997. Prior to that time, he served as Acting Corporate Controller and Assistant Controller of Continental Medical Systems from June 1990 and December 1988, respectively. Mr. Romberger is a certified public accountant and was employed by a national accounting firm from April 1985 until December 1988.
 
Robert G. Breighner, Jr. has served as our Vice President, Compliance and Audit Services since August 2003. He served as our Director of Internal Audit from November 2001 to August 2003. Previously, Mr. Breighner was


28


Table of Contents

Director of Internal Audit for Susquehanna Pfaltzgraff Co. from June 1997 until November 2001. Mr. Breighner held other positions with Susquehanna Pfaltzgraff Co. from May 1991 until June 1997.
 
Item 1A.   Risk Factors.
 
In addition to the factors discussed elsewhere in this Form 10-K, the following are important factors which could cause actual results or events to differ materially from those contained in any forward-looking statements made by or on behalf of us.
 
If there are changes in the rates or methods of government reimbursements for our services, our net operating revenues and profitability could decline.
 
Approximately 46% and 47% of our net operating revenues for the year ended December 31, 2008 and the year ended December 31, 2009, respectively, came from the highly regulated federal Medicare program. In recent years, through legislative and regulatory actions, the federal government has made substantial changes to various payment systems under the Medicare program. President Obama has proposed comprehensive reforms to the healthcare system, including changes to the methods for, and amounts of, Medicare reimbursement. Reforms or other changes to these payment systems, including modifications to the conditions on qualification for payment, bundling payments to cover both acute and post-acute care or the imposition of enrollment limitations on new providers, may be proposed or could be adopted, either by the U.S. Congress or by the Centers for Medicare & Medicaid Services, or “CMS.” If revised regulations are adopted, the availability, methods and rates of Medicare reimbursements for services of the type furnished at our facilities could change. We cannot predict what form healthcare reform will take, or if significant healthcare reform in the near term will take place at all. Some of these changes and proposed changes could adversely affect our business strategy, operations and financial results. In addition, there can be no assurance that any increases in Medicare reimbursement rates established by CMS will fully reflect increases in our operating costs.
 
We conduct business in a heavily regulated industry, and changes in regulations, new interpretations of existing regulations or violations of regulations may result in increased costs or sanctions that reduce our net operating revenues and profitability.
 
The healthcare industry is subject to extensive federal, state and local laws and regulations relating to:
 
  •  facility and professional licensure, including certificates of need;
 
  •  conduct of operations, including financial relationships among healthcare providers, Medicare fraud and abuse and physician self-referral;
 
  •  addition of facilities and services and enrollment of newly developed facilities in the Medicare program;
 
  •  payment for services; and
 
  •  safeguarding protected health information.
 
Both federal and state regulatory agencies inspect, survey and audit our facilities to review our compliance with these laws and regulations. While our facilities intend to comply with existing licensing, Medicare certification requirements and accreditation standards, there can be no assurance that these regulatory authorities will determine that all applicable requirements are fully met at any given time. In recent years, some regulatory agencies inspecting our facilities have applied these requirements and standards more strictly. A determination by any of these regulatory authorities that a facility is not in compliance with these requirements could lead to the imposition of requirements that the facility takes corrective action, assessment of fines and penalties, or loss of licensure, Medicare certification or accreditation. These consequences could have an adverse effect on our company.
 
In addition, there have been heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry. The ongoing investigations relate to, among other things, various referral practices, cost reporting, billing practices, physician ownership and joint ventures involving hospitals. In the future, different interpretations or enforcement of these laws and regulations could subject us to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel,


29


Table of Contents

services and capital expenditure programs. These changes may increase our operating expenses and reduce our operating revenues. If we fail to comply with these extensive laws and government regulations, we could become ineligible to receive government program reimbursement, suffer civil or criminal penalties or be required to make significant changes to our operations. In addition, we could be forced to expend considerable resources responding to any related investigation or other enforcement action.
 
During July 2009, we received a subpoena from the Office of Inspector General of the U.S. Department of Health and Human Services seeking various documents concerning our financial relationships with certain physicians practicing at our hospitals in Columbus, Ohio. We do not know whether the subpoena has been issued in connection with a lawsuit under the qui tam provisions of the federal False Claims Act or in connection with possible civil, criminal or administrative proceedings by the government. We have produced documents in response to the subpoena and intend to fully cooperate with this investigation. At this time, we are unable to predict the timing and outcome of this matter. See “Legal Proceedings” and “Business — Government Regulations.”
 
Expiration of the moratorium imposed on certain federal regulations otherwise applicable to long term acute care hospitals operated as “hospitals within hospitals” or as “satellites” will have an adverse effect on our future net operating revenues and profitability.
 
On August 11, 2004, CMS published final regulations applicable to long term acute care hospitals that are operated as “hospitals within hospitals” or as “satellites.” We collectively refer to hospitals within hospitals and satellites as “HIHs,” and we refer to the CMS final regulations as the “final regulations.” HIHs are separate hospitals located in space leased from, and located in or on the same campus of, another hospital. We refer to such other hospitals as “host” hospitals.
 
Effective for hospital cost reporting periods beginning on or after October 1, 2004, the final regulations, subject to certain exceptions, provide lower rates of reimbursement to HIHs for those Medicare patients admitted from their host hospitals that are in excess of a specified percentage threshold. For HIHs opened after October 1, 2004, the Medicare admissions threshold has been established at 25% except for HIHs located in rural areas or co-located with an “MSA dominant” hospital or single urban hospital (as defined by the current regulations) in which cases the percentage is no more than 50%, nor less than 25%. Certain grandfathered HIHs were initially excluded from the Medicare admission threshold in the August 11, 2004 final regulations. Grandfathered HIHs refer to certain HIHs that were in existence on or before September 30, 1995, and grandfathered satellite facilities refer to satellites of grandfathered HIHs that were in existence on or before September 30, 1999.
 
For HIHs that meet specified criteria and were in existence as of October 1, 2004, including all but two of our then existing grandfathered HIHs, the Medicare admissions thresholds were phased in over a four year period starting with hospital cost reporting periods beginning on or after October 1, 2004, as follows: (1) for discharges during the cost reporting period beginning on or after October 1, 2004 and before October 1, 2005, the Medicare admissions threshold was the Fiscal 2004 Percentage (as defined below) of Medicare discharges admitted from the host hospital; (2) for discharges during the cost reporting period beginning on or after October 1, 2005 and before October 1, 2006, the Medicare admissions threshold was the lesser of the Fiscal 2004 Percentage of Medicare discharges admitted from the host hospital or 75%; (3) for discharges during the cost reporting period beginning on or after October 1, 2006 and before October 1, 2007, the Medicare admissions threshold was the lesser of the Fiscal 2004 Percentage of Medicare discharges admitted from the host hospital or 50%; and (4) for discharges during cost reporting periods beginning on or after October 1, 2007, the Medicare admissions threshold is 25%.
 
The Medicare, Medicaid, and SCHIP Extension Act of 2007, or the “SCHIP Extension Act,” (as amended by the American Recovery and Reinvestment Act, the “ARRA”) has limited the application of the Medicare admission threshold on HIHs in existence on October 1, 2004 and subject to the four year phase in described above. For these HIHs, the admission threshold is no lower than 50% for a three year period to commence on a long term acute care hospital’s, or “LTCH’s,” first cost reporting period to begin on or after October 1, 2007. Under the SCHIP Extension Act, for HIHs located in rural areas the percentage threshold is no more than 75% for the same three year period. For HIHs that are co-located with MSA dominant hospitals or single urban hospitals, the percentage threshold is no more than 75% during the same three year period or the percentage of total Medicare discharges in the MSA in which the hospital is located that are from the co-located hospital. In the 2008 rate year final rule, CMS applied the


30


Table of Contents

Medicare admissions threshold to admissions to grandfathered HIHs and grandfathered satellites from co-located hospitals. The SCHIP Extension Act delays application of the admissions threshold on grandfathered HIHs for a three year period commencing on the first cost reporting period beginning on or after July 1, 2007. The ARRA limits application of the admission threshold to no more than 50% of Medicare admissions to grandfathered satellites from a co-located hospital for a three year period commencing on the first cost reporting period beginning on or after July 1, 2007. As of December 31, 2009, we owned 65 LTCH HIHs; four of these HIHs were subject to a maximum 25% Medicare admission threshold, 19 of these HIHs were co-located with a MSA dominate hospital or single urban hospital and were subject to a Medicare admission threshold of no more than 75%, 38 of these HIHs were subject to a maximum 50% Medicare admissions threshold, two of these HIHs were located in a rural area and were subject to a maximum 75% Medicare admission threshold, and two of these HIHs were grandfathered HIHs and not subject to a Medicare admission threshold.
 
With respect to any HIH, “Fiscal 2004 Percentage” means the percentage of all Medicare patients discharged by such HIH during its cost reporting period beginning on or after October 1, 2003 and before October 1, 2004 who were admitted to such HIH from its host hospital. In no event, however, is the Fiscal 2004 Percentage less than 25%.
 
Because these rules are complex and are based on the volume of Medicare admissions from our host hospitals as a percent of our overall Medicare admissions, we cannot predict with any certainty the impact on our future net operating revenues of compliance with these regulations. However, after the expiration of the three year moratorium provided by the SCHIP Extension Act, we expect many of our HIHs will experience an adverse financial impact beginning for their cost reporting periods on or after October 1, 2010, when the Medicare admissions thresholds decline to 25%.
 
Expiration of the moratorium imposed on certain federal regulations otherwise applicable to long term acute care hospitals operated as free-standing or grandfathered “hospitals within hospitals” or grandfathered “satellites” will have an adverse effect on our future net operating revenues and profitability.
 
All Medicare payments to our long term acute care hospitals are made in accordance with a prospective payment system specifically applicable to long term acute care hospitals, referred to as “LTCH-PPS.” On May 1, 2007, CMS published its annual payment rate update for the 2008 LTCH-PPS rate year, or RY 2008. We refer to such rate update as the May 2007 final rule. The May 2007 final rule makes several changes to LTCH-PPS payment methodologies and amounts during RY 2008. As described below, however, many of these changes have been postponed for a three year period by the SCHIP Extension Act.
 
For cost reporting periods beginning on or after July 1, 2007, the May 2007 final rule expanded the current Medicare HIH admissions threshold to apply to Medicare patients admitted from any individual hospital. Previously, the admissions threshold was applicable only to Medicare HIH admissions from hospitals co-located with an LTCH or satellite of an LTCH. Under the May 2007 final rule, free-standing LTCHs and grandfathered LTCH HIHs are subject to the Medicare admission thresholds, as well as HIHs that admit Medicare patients from non-co-located hospitals. To the extent that any LTCH’s or LTCH satellite facility’s discharges that are admitted from an individual hospital (regardless of whether the referring hospital is co-located with the LTCH or LTCH satellite) exceed the applicable percentage threshold during a particular cost reporting period, the payment rate for those discharges is subject to a downward payment adjustment. Cases admitted in excess of the applicable threshold are reimbursed at a rate comparable to that under general acute care inpatient prospective payment system, or “IPPS.” IPPS rates are generally lower than LTCH-PPS rates. Cases that reach outlier status in the discharging hospital do not count toward the limit and are paid under LTCH-PPS.
 
The SCHIP Extension Act, as amended, postponed the application of the percentage threshold to free-standing LTCHs and grandfathered HIHs for a three year period commencing on an LTCH’s first cost reporting period on or after July 1, 2007. However, the SCHIP Extension Act did not postpone the application of the percentage threshold, or the transition period stated above, to Medicare patients discharged from an LTCH HIH or satellite that were admitted from a non-co-located hospital. In addition, the SCHIP Extension Act, as interpreted by CMS, did not provide relief from the application of the threshold for patients admitted from a co-located hospital to certain non-grandfathered HIHs.
 
Of the 88 long term acute care hospitals we owned as of December 31, 2009, 23 were operated as free-standing hospitals and two qualified as grandfathered LTCH HIHs. Because these rules are complex and are based on the


31


Table of Contents

volume of Medicare admissions from other referring hospitals as a percent of our overall Medicare admissions, we cannot predict with any certainty the impact on our future net operating revenues of compliance with these regulations. However, if the May 2007 rule is applied as currently written, there will be an adverse financial impact to the net operating revenues and profitability of many of these hospitals for cost reporting periods on or after July 1, 2010 when the Medicare admissions thresholds go into effect for free-standing hospitals.
 
The moratorium on the Medicare certification of new long term care hospitals and beds in existing long term care hospitals will limit our ability to increase long term acute care hospital bed capacity, expand into new areas or increase services in existing areas we serve.
 
The SCHIP Extension Act imposed a three year moratorium beginning on December 29, 2007 on the establishment and classification of new LTCHs, LTCH satellite facilities and LTCH beds in existing LTCH or satellite facilities. The moratorium does not apply to LTCHs that, before December 29, 2007, (1) began the qualifying period for payment under the LTCH-PPS, (2) had a written agreement with an unrelated party for the construction, renovation, lease or demolition for a LTCH and had expended at least 10% of the estimated cost of the project or $2,500,000 or (3) had obtained an approved certificate of need. The moratorium also does not apply to an increase in beds in an existing hospital or satellite facility if the LTCH is located in a state where there is only one other LTCH and the LTCH requests an increase in beds following the closure or the decrease in the number of beds of the other LTCH. Since we may still acquire LTCHs that were in existence prior to December 29, 2007, we do not expect this moratorium to materially impact our strategy to expand by acquiring additional LTCHs if such LTCHs can be acquired at attractive valuations. This moratorium, however, may still otherwise adversely affect our ability to increase long term acute care bed capacity, expand into new areas or increase bed capacity in existing areas we serve.
 
Government implementation of recent changes to Medicare’s method of reimbursing our long term acute care hospitals will reduce our future net operating revenues and profitability.
 
The May 2007 final rule changed the payment methodology for Medicare patients with a length of stay less than or equal to five-sixths of the geometric average length of stay for each long term care diagnosis-related group, or “LTC-DRG” (also referred to as “short-stay outlier” or “SSO” cases). Under this methodology, as a patient’s length of stay increases, the percentage of the per diem amount based upon the IPPS component decreases and the percentage based on the LTC-DRG component increases. For the three year period beginning on December 29, 2007, the SCHIP Extension Act delays the SSO policy changes made in the May 2007 final rule. In an interim final rule dated May 6, 2008, CMS revised the regulations to provide that the change in the SSO policy adopted in the RY 2008 annual payment update does not apply for a three year period beginning with discharges occurring on or after December 29, 2007 and before December 29, 2010. The implementation of the payment methodology for short-stay outliers discharged after December 29, 2010 will reduce our future net operating revenues and profitability.
 
A long term acute care hospital is paid a pre-determined fixed amount for Medicare patients under LTCH-PPS depending upon the LTC-DRG to which each patient is assigned. LTCH-PPS includes special payment policies that adjust the payments for some patients based on a variety of factors. On May 12, 2006, CMS published its final annual payment rate updates for the 2007 LTCH-PPS rate year. The May 2006 final rule made several changes to LTCH-PPS payment methodologies and amounts. For discharges occurring on or after July 1, 2006, the rule changed the payment methodology for SSO cases. Payment for these patients was previously based on the lesser of (1) 120% of the cost of the case, (2) 120% of the LTC-DRG specific per diem amount multiplied by the patient’s length of stay or (3) the full LTC-DRG payment. The May 2006 final rule modified the limitation in clause (1) above to reduce payment for SSO cases to 100% (rather than 120%) of the cost of the case. The final rule also added a fourth limitation, capping payment for SSO cases at a per diem rate derived from blending 120% of the LTC-DRG specific per diem amount with a per diem rate based on the general acute care hospital IPPS. Under this methodology, as a patient’s length of stay increases, the percentage of the per diem amount based upon the IPPS component decreases and the percentage based on the LTC-DRG component increases.
 
On May 1, 2007, CMS published its final annual payment rate updates for the 2008 LTCH-PPS rate year. The May 2007 final rule further revised the payment adjustment for SSO cases. Beginning with discharges on or after July 1, 2007, for cases with a length of stay that is less than the average length of stay plus one standard deviation for


32


Table of Contents

the same diagnosis-related group, or “DRG,” under IPPS, referred to as the so-called “IPPS comparable threshold,” the rule effectively lowered the LTCH payment to a rate based on the general acute care hospital IPPS. SSO cases with covered lengths of stay that exceed the IPPS comparable threshold would continue to be paid under the SSO payment policy described above under the May 2006 final rule. Cases with a covered length of stay less than or equal to the IPPS comparable threshold and less than five-sixths of the geometric average length of stay for that LTC-DRG are paid at an amount comparable to the IPPS per diem. As previously stated, the SCHIP Extension Act delays the SSO policy changes made in the May 2007 final rule for the three year period beginning on December 29, 2007.
 
If our long term acute care hospitals fail to maintain their certifications as long term acute care hospitals or if our facilities operated as HIHs fail to qualify as hospitals separate from their host hospitals, our net operating revenues and profitability may decline.
 
We operate 89 long term acute care hospitals, 88 of which are currently certified by Medicare as long term acute care hospitals and one which is in its demonstration period. Long term acute care hospitals must meet certain conditions of participation to enroll in, and seek payment from, the Medicare program as a long term acute care hospital, including, among other things, maintaining an average length of stay for Medicare patients in excess of 25 days. Similarly, our HIHs must meet conditions of participation in the Medicare program, which include additional criteria establishing separateness from the hospital with which the HIH shares space. If our long term acute care hospitals or HIHs fail to meet or maintain the standards for certification as long term acute care hospitals, they will receive payment under the general acute care hospitals IPPS which is generally lower than payment under the system applicable to long term acute care hospitals. Payments at rates applicable to general acute care hospitals would result in our long term acute care hospitals receiving significantly less Medicare reimbursement than they currently receive for their patient services.
 
Implementation of additional patient or facility criteria for LTCHs that limit the population of patients eligible for our hospitals’ services or change the basis on which we are paid could adversely affect our net operating revenue and profitability.
 
CMS and industry stakeholders have, for a number of years, explored the development of facility and patient certification criteria for LTCHs, potentially as an alternative to the current specific payment adjustment features of LTCH-PPS. In its June 2004 “Report to Congress,” the Medicare Payment Advisory Commission recommended the adoption by CMS of new facility staffing and services criteria and patient clinical characteristics and treatment requirements for LTCHs in order to ensure that only appropriate patients are admitted to these facilities. The Medicare Payment Advisory Commission is an independent federal body that advises Congress on issues affecting the Medicare program. After the Medicare Payment Advisory Commission’s recommendation, CMS awarded a contract to Research Triangle Institute International to examine such recommendation. However, while acknowledging that Research Triangle Institute International’s findings are expected to have a substantial impact on future Medicare policy for LTCHs, CMS stated in the May 2006 final rule that many of the specific payment adjustment features of LTCH-PPS then in place may still be necessary and appropriate even with the development of patient- and facility-level criteria for LTCHs. In the preamble to the RY 2009 LTCH-PPS proposed rule, CMS indicated that Research Triangle Institute International continues to work with the clinical community to make recommendations to CMS regarding payment and treatment of critically ill patients in LTCHs. The SCHIP Extension Act requires the Secretary of the Department of Health and Human Services to conduct a study and submit a report to Congress on the establishment of national LTCH facility and patient criteria and to consider the recommendations contained in the Medicare Payment Advisory Commission’s June 2004 report to Congress. Implementation of additional criteria that may limit the population of patients eligible for our hospitals’ services or change the basis on which we are paid could adversely affect our net operating revenues and profitability. See “Business — Government Regulations — Overview of U.S. and State Government Reimbursements — Long Term Acute Care Hospital Medicare Reimbursement.”


33


Table of Contents

Implementation of modifications to the admissions policies of our inpatient rehabilitation facilities as required in order to achieve compliance with Medicare regulations may result in a reduction of patient volume at these hospitals and, as a result, may reduce our future net operating revenues and profitability.
 
We operate six acute medical rehabilitation hospitals, all of which are currently certified by Medicare as inpatient rehabilitation facilities, or “IRFs.” In order for these facilities to be eligible for payment under the IRF prospective payment system (“IRF-PPS”) for services provided to Medicare patients, each IRF must establish that, during its most recent 12-month cost reporting period, it served an inpatient population requiring intensive rehabilitation services. In particular, for cost reporting periods beginning on or after July 1, 2005, at least 60% of an IRFs inpatient population must require intensive rehabilitation services for treatment of one or more of 13 specific conditions with specified comorbidities counting toward this threshold.
 
In order to comply with Medicare inpatient rehabilitation facility certification criteria, it may be necessary for us to implement more restrictive admissions policies at our inpatient rehabilitation facilities and not admit patients whose diagnoses fall outside the specified conditions. Such policies may result in a reduction of patient volume at these hospitals and, as a result, may reduce our future net operating revenues and profitability. See “Business — Government Regulations.”
 
Decreases in Medicare reimbursement rates received by our outpatient rehabilitation clinics or implementation of annual caps that limit the amount that can be paid for outpatient therapy services rendered to any Medicare beneficiary may reduce our future net operating revenues and profitability.
 
Our outpatient rehabilitation clinics receive payments from the Medicare program under a fee schedule. The Medicare physician fee schedule rates are automatically updated annually based on a formula, called the sustainable growth rate (“SGR”) formula, contained in legislation. If no further legislation is passed by Congress and signed by the President, the SGR formula will reduce our Medicare outpatient rehabilitation payment rates by approximately 21.2% beginning April 1, 2010.
 
Congress has established annual caps that limit the amount that can be paid (including deductible and coinsurance amounts) for outpatient therapy services rendered to any Medicare beneficiary. As directed by Congress in the Deficit Reduction Act of 2005, CMS implemented an exception process for therapy expenses incurred in 2006. Under this process, a Medicare enrollee (or person acting on behalf of the Medicare enrollee) was able to request an exception from the therapy caps if the provision of therapy services was deemed to be medically necessary. Therapy cap exceptions were available automatically for certain conditions and on a case-by-case basis upon submission of documentation of medical necessity. The exception process has been extended by Congress several times. Most recently, the Temporary Extension Act of 2010 extended the exception process through March 31, 2010. The exception process will expire on April 1, 2010 unless further extended by Congress. There can be no assurance that Congress will extend it further. To date, the implementation of the therapy caps has not had a material adverse effect on our business. However, if the exception process is not renewed, our future net operating revenues and profitability may decline. For the years ended December 31, 2008 and December 31, 2009, we received approximately 9.5% and 9.7%, respectively, of our outpatient rehabilitation net operating revenues from Medicare. See “Business — Government Regulations.”
 
Our facilities are subject to extensive federal and state laws and regulations relating to the privacy of individually identifiable information.
 
The Health Insurance Portability and Accountability Act of 1996 required the United States Department of Health and Human Services to adopt standards to protect the privacy and security of individually identifiable health-related information. The department released final regulations containing privacy standards in December 2000 and published revisions to the final regulations in August 2002. The privacy regulations extensively regulate the use and disclosure of individually identifiable health-related information. The regulations also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed. The security regulations require healthcare providers to implement administrative, physical and technical practices to protect the security of individually identifiable health information that is maintained or transmitted electronically. The Health Information Technology for Economic and Clinical Health Act, or “HITECH,” which was signed into


34


Table of Contents

law in February of 2009, enhanced the privacy, security and enforcement provisions of HIPAA by, among other things establishing security breach notification requirements, allowing enforcement of HIPAA by state attorneys general, and increasing penalties for HIPAA violations. Violations of the Health Insurance Portability and Accountability Act of 1996 or the Health Information Technology for Economic and Clinical Health Act could result in civil or criminal penalties.
 
In addition to HIPPA, there are numerous federal and state laws and regulations addressing patient and consumer privacy concerns, including unauthorized access or theft of personal information. State statutes and regulations vary from state to state. The Federal Trade Commission issued so-called “Red Flag” regulations aimed at preventing and detecting identity theft, which are expected to become effective soon. Lawsuits, including class actions and action by state attorneys general, directed at companies that have experienced a privacy or security breach are becoming more common.
 
We have developed a comprehensive set of policies and procedures in our efforts to comply with the Health Insurance Portability and Accountability Act of 1996 and other privacy laws. Our compliance officers and information security officers are responsible for implementing and monitoring compliance with our privacy and security policies and procedures at our facilities. We believe that the cost of our compliance with the Health Insurance Portability and Accountability Act of 1996 and other federal and state privacy laws will not have a material adverse effect on our business, financial condition, results of operations or cash flows. However, there can be no assurance that a breach of privacy or security will not occur. If there is a breach, we may be subject to various penalties and damages and may be required to incur costs to mitigate the impact of the breach on affected individuals.
 
As a result of increased post-payment reviews of claims we submit to Medicare for our services, we may incur additional costs and may be required to repay amounts already paid to us.
 
We are subject to regular post-payment inquiries, investigations and audits of the claims we submit to Medicare for payment for our services. These post-payment reviews are increasing as a result of new government cost-containment initiatives, including enhanced medical necessity reviews for Medicare patients admitted to LTCHs, and audits of Medicare claims under the Recovery Audit Contractor program. These additional post-payment reviews may require us to incur additional costs to respond to requests for records and to pursue the reversal of payment denials, and ultimately may require us to refund amounts paid to us by Medicare that are determined to have been overpaid.
 
We may be adversely affected by negative publicity which can result in increased governmental and regulatory scrutiny and possibly adverse regulatory changes.
 
Negative press coverage can result in increased governmental and regulatory scrutiny and possibly adverse regulatory changes. On February 10, 2010, the New York Times published an article focusing on our Company and the long term acute care hospital industry entitled “Long-Term Care Hospitals Face Little Scrutiny.” On March 8, 2010, we received a letter from the United States Senate Finance Committee in response to the New York Times article asking us to respond to a variety of questions regarding our long-term care hospitals. Adverse publicity such as articles in the New York Times and increased governmental scrutiny can have a negative impact on our reputation with referral sources and patients and on the morale and performance of our employees, both of which could adversely affect our businesses and results of operations.
 
Future acquisitions or joint ventures may use significant resources, may be unsuccessful and could expose us to unforeseen liabilities.
 
As part of our growth strategy, we may pursue acquisitions or joint ventures of specialty hospitals, outpatient rehabilitation clinics and other related healthcare facilities and services. These acquisitions or joint ventures may involve significant cash expenditures, debt incurrence, additional operating losses and expenses that could have a material adverse effect on our financial condition and results of operations. Acquisitions or joint ventures involve numerous risks, including:
 
  •  difficulty and expense of integrating acquired personnel into our business;


35


Table of Contents

 
  •  diversion of management’s time from existing operations;
 
  •  potential loss of key employees or customers of acquired companies; and
 
  •  assumption of the liabilities and exposure to unforeseen liabilities of acquired companies, including liabilities for failure to comply with healthcare regulations.
 
We cannot assure you that we will succeed in obtaining financing for acquisitions or joint ventures at a reasonable cost, or that such financing will not contain restrictive covenants that limit our operating flexibility. We also may be unable to operate acquired hospitals and outpatient rehabilitation clinics profitably or succeed in achieving improvements in their financial performance.
 
Future cost containment initiatives undertaken by private third-party payors may limit our future net operating revenues and profitability.
 
Initiatives undertaken by major insurers and managed care companies to contain healthcare costs affect the profitability of our specialty hospitals and outpatient rehabilitation clinics. These payors attempt to control healthcare costs by contracting with hospitals and other healthcare providers to obtain services on a discounted basis. We believe that this trend may continue and may limit reimbursements for healthcare services. If insurers or managed care companies from whom we receive substantial payments reduce the amounts they pay for services, our profit margins may decline, or we may lose patients if we choose not to renew our contracts with these insurers at lower rates.
 
If we fail to maintain established relationships with the physicians in the areas we serve, our net operating revenues may decrease.
 
Our success is partially dependent upon the admissions and referral practices of the physicians in the communities our hospitals and our outpatient rehabilitation clinics serve, and our ability to maintain good relations with these physicians. Physicians referring patients to our hospitals and clinics are generally not our employees and, in many of the local areas that we serve, most physicians have admitting privileges at other hospitals and are free to refer their patients to other providers. If we are unable to successfully cultivate and maintain strong relationships with these physicians, our hospitals’ admissions and clinics’ businesses may decrease, and our net operating revenues may decline.
 
Changes in federal or state law limiting or prohibiting certain physician referrals may preclude physicians from investing in our hospitals or referring to hospitals in which they already own an interest.
 
The federal self referral law, or “Stark Law,” 42 U.S.C. § 1395nn, prohibits a physician who has a financial relationship with an entity from referring his or her Medicare or Medicaid patients to that entity for certain designated health services, including inpatient and outpatient hospital services. Under current law, physicians who have a direct or indirect ownership interest in a hospital will not be prohibited from referring to the hospital because of the applicability of the “whole hospital exception” to the Stark Law. Various bills recently introduced in Congress have included provisions that further restrict physician ownership in hospitals to which the physician refers patients. These provisions would typically limit the Stark Law’s “whole hospital exception” to existing hospitals with physician ownership. Physicians with ownership in “new” hospitals would be prohibited from referring to that hospital. Certain requirements and limitations would also be placed on existing hospitals with physician ownership, such as limiting the expansion of any such hospital and limiting the amount and terms of physician investment. Furthermore, initiatives are underway in some states to restrict physician referrals to physician-owned hospitals. Currently, nine of our hospitals have physicians as minority owners. The aggregate revenue of these nine hospitals was $172.6 million for the year ended December 31, 2009, or approximately 7.7% of our revenues for the year ended December 31, 2009. The range of physician minority ownership of these nine hospitals was 2.1% to 49.0%, with the average physician minority ownership of 10.7% as of the year ended December 31, 2009. There can be no assurance that new legislation or regulation prohibiting or limiting physician referrals to physician-owned hospitals will not be successfully enacted in the future. If such federal or state laws are adopted, among other outcomes, physicians who have invested in, or considered investing in, our hospitals could be precluded from referring to, investing in or continuing to be physician owners of a hospital. In addition, expansion of our physician-owned


36


Table of Contents

hospitals may be limited, and the revenues, profitability and overall financial performance of our hospitals may be negatively affected.
 
Shortages in qualified nurses or therapists could increase our operating costs significantly.
 
Our specialty hospitals are highly dependent on nurses for patient care and our outpatient rehabilitation clinics are highly dependant on therapists for patient care. The availability of qualified nurses and therapists nationwide has declined in recent years, and the salaries for nurses and therapists have risen accordingly. We cannot assure you we will be able to attract and retain qualified nurses or therapists in the future. Additionally, the cost of attracting and retaining nurses and therapists may be higher than we anticipate, and as a result, our profitability could decline.
 
Competition may limit our ability to acquire hospitals and clinics and adversely affect our growth.
 
We have historically faced limited competition in acquiring specialty hospitals and outpatient rehabilitation clinics, but we may face heightened competition in the future. Our competitors may acquire or seek to acquire many of the hospitals and clinics that would be suitable acquisition candidates for us. This increased competition could hamper our ability to acquire companies, or such increased competition may cause us to pay a higher price than we would otherwise pay in a less competitive environment. Increased competition from both strategic and financial buyers could limit our ability to grow by acquisitions or make our cost of acquisitions higher and therefore decrease our profitability.
 
If we fail to compete effectively with other hospitals, clinics and healthcare providers in our local areas, our net operating revenues and profitability may decline.
 
The healthcare business is highly competitive, and we compete with other hospitals, rehabilitation clinics and other healthcare providers for patients. If we are unable to compete effectively in the specialty hospital and outpatient rehabilitation businesses, our net operating revenues and profitability may decline. Many of our specialty hospitals operate in geographic areas where we compete with at least one other hospital that provides similar services. Our outpatient rehabilitation clinics face competition from a variety of local and national outpatient rehabilitation providers. Other outpatient rehabilitation clinics in local areas we serve may have greater name recognition and longer operating histories than our clinics. The managers of these clinics may also have stronger relationships with physicians in their communities, which could give them a competitive advantage for patient referrals.
 
Our business operations could be significantly disrupted if we lose key members of our management team.
 
Our success depends to a significant degree upon the continued contributions of our senior officers and key employees, both individually and as a group. Our future performance will be substantially dependent in particular on our ability to retain and motivate four key employees, Rocco A. Ortenzio, our Executive Chairman, Robert A. Ortenzio, our Chief Executive Officer, Patricia A. Rice, our President and Chief Operating Officer, and Martin F. Jackson, our Executive Vice President and Chief Financial Officer. We currently have an employment agreement in place with each of Messrs. Rocco and Robert Ortenzio and Ms. Rice and a change in control agreement with Mr. Jackson. Each of these individuals also has a significant equity ownership in our company. We have no reason to believe that we will lose the services of any of these individuals in the foreseeable future; however, we currently have no effective replacement for any of these individuals due to their experience, reputation in the industry and special role in our operations. We also do not maintain any key life insurance policies for any of our employees. The loss of the services of any of these individuals would disrupt significant aspects of our business, could prevent us from successfully executing our business strategy and could have a material adverse affect on our results of operations.


37


Table of Contents

Significant legal actions as well as the cost and possible lack of available insurance could subject us to substantial uninsured liabilities.
 
Physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large claims and significant defense costs. We are also subject to lawsuits under federal and state whistleblower statutes designed to combat fraud and abuse in the healthcare industry. These whistleblower lawsuits are not covered by insurance and can involve significant monetary damages and award bounties to private plaintiffs who successfully bring the suits.
 
We currently maintain professional malpractice liability insurance and general liability insurance coverages under a combination of policies with a total annual aggregate limit of $30.0 million. Our insurance for the professional liability coverage is written on a “claims-made” basis and our commercial general liability coverage is maintained on an “occurrence” basis. These coverages are generally subject to a self-insured retention of $2.0 million per medical incident for professional liability claims and $2.0 million per occurrence for general liability claims. We review our insurance program annually and may make adjustments to the amount of insurance coverage and self-insured retentions in future years. In recent years, many insurance underwriters have become more selective in the insurance limits and types of coverage they will provide as a result of rising settlement costs. Insurance underwriters, in some instances, will no longer underwrite risk in certain states that have a history of high medical malpractice awards. There can be no assurance that malpractice insurance will be available in certain states in the future nor that we will be able to obtain insurance coverage at a reasonable price. Since our professional liability insurance is on a claims-made basis, any failure to obtain malpractice insurance in any state in the future would increase our exposure not only to claims arising in such state in the future but also to claims arising from injuries that may have already occurred but which had not been reported during the period in which we previously had insurance coverage in that state. In addition, our insurance coverage does not cover punitive damages and may not cover all claims against us. See “Business — Government Regulations — Other Healthcare Regulations.”
 
Concentration of ownership among our existing executives, directors and principal stockholders may prevent new investors from influencing significant corporate decisions.
 
Welsh Carson and Thoma Cressey beneficially own approximately 42.4% and 8.0%, respectively, of our outstanding common stock as of March 1, 2010. Our executives, directors and principal stockholders, including Welsh Carson and Thoma Cressey, beneficially own, in the aggregate, approximately 67.3% of our outstanding common stock as of March 1, 2010. As a result, these stockholders have significant control over our management and policies and are able to exercise influence over all matters requiring stockholder approval, including the election of directors, amendment of our certificate of incorporation and approval of significant corporate transactions. The directors elected by these stockholders are able to make decisions affecting our capital structure, including decisions to issue additional capital stock, implement stock repurchase programs and incur indebtedness. This influence may have the effect of deterring hostile takeovers, delaying or preventing changes in control or changes in management, or limiting the ability of our other stockholders to approve transactions that they may deem to be in their best interest.
 
We are a holding company and therefore depend on our subsidiaries to service our obligations under our indebtedness and for any funds to pay dividends to our stockholders. Our ability to repay our indebtedness or pay dividends to our stockholders depends entirely upon the performance of our subsidiaries and their ability to make distributions.
 
We have no operations of our own and derive all of our revenues and cash flow from our subsidiaries. Our subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due under our 10% senior subordinated notes and senior floating rate notes, or to make any funds available therefor, whether by dividend, distribution, loan or other payments. In addition, any of our rights in the assets of any of our subsidiaries upon any liquidation or reorganization of any subsidiary will be subject to the prior claims of that subsidiary’s creditors, including lenders under our senior secured credit facility and holders of Select’s 75/8% senior subordinated notes. Holdings’ total consolidated balance sheet liabilities as of December 31, 2009 were $1,832.7 million, of which $1,405.6 million constituted indebtedness, including $483.1 million of indebtedness (excluding $30.7 million of letters of credit) under our senior secured credit facility, $611.5 million of Select’s


38


Table of Contents

75/8% senior subordinated notes, $137.3 million of our 10% senior subordinated notes and $167.3 million of our senior floating rate notes. As of such date, we would have been able to borrow up to an additional $269.3 million under our senior secured credit facility. We and our restricted subsidiaries may incur additional debt in the future, including borrowings under our senior secured credit facility.
 
We depend on our subsidiaries, which conduct the operations of the business, for dividends and other payments to generate the funds necessary to meet our financial obligations, including payments of principal and interest on our indebtedness. We would also depend on our subsidiaries for any funds to pay dividends to our stockholders. In the event our subsidiaries are unable to pay dividends to us, we may not be able to service debt, pay obligations or pay dividends on common stock. The terms of our senior secured credit facility and the terms of the indentures governing Select’s 75/8% senior subordinated notes restrict Select and its subsidiaries from, in each case, paying dividends or otherwise transferring its assets to us. Such restrictions include, among others, financial covenants, prohibition of dividends in the event of a default and limitations on the total amount of dividends. In addition, legal and contractual restrictions in agreements governing other current and future indebtedness, as well as financial condition and operating requirements of our subsidiaries, currently limit and may, in the future, limit our ability to obtain cash from our subsidiaries. The earnings from other available assets of our subsidiaries may not be sufficient to pay dividends or make distributions or loans to enable us to make payments in respect of our indebtedness when such payments are due. In addition, even if such earnings were sufficient, we cannot assure you that the agreements governing the current and future indebtedness of our subsidiaries will permit such subsidiaries to provide us with sufficient dividends, distributions or loans to fund interest and principal payments on our indebtedness when due. If our subsidiaries are unable to make dividends or otherwise distribute funds to us, we may not be able to satisfy the terms of our indebtedness, there will not be sufficient funds remaining to make distributions to our stockholders and the value of your investment in our common stock will be materially decreased.
 
Our substantial indebtedness may limit the amount of cash flow available to invest in the ongoing needs of our business.
 
We have a substantial amount of indebtedness. As of December 31, 2009, we had approximately $1,405.6 million of total indebtedness. For the years ended December 31, 2008 and December 31, 2009, we paid cash interest of $135.8 million and $126.7 million, respectively on our indebtedness.
 
Our indebtedness could have important consequences to you. For example, it:
 
  •  requires us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, reducing the availability of our cash flow to fund working capital, capital expenditures, development activity, acquisitions and other general corporate purposes;
 
  •  increases our vulnerability to adverse general economic or industry conditions;
 
  •  limits our flexibility in planning for, or reacting to, changes in our business or the industries in which we operate;
 
  •  makes us more vulnerable to increases in interest rates, as borrowings under our senior secured credit facility and the senior floating rate notes are at variable rates;
 
  •  limits our ability to obtain additional financing in the future for working capital or other purposes, such as raising the funds necessary to repurchase all notes tendered to us upon the occurrence of specified changes of control in our ownership; and
 
  •  places us at a competitive disadvantage compared to our competitors that have less indebtedness.
 
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”


39


Table of Contents

Our senior secured credit facility requires Select to comply with certain financial covenants, the default of which may result in the acceleration of certain of our indebtedness.
 
Our senior secured credit facility requires Select to maintain certain interest expense coverage ratios and leverage ratios which become more restrictive over time. For the four consecutive fiscal quarters ended December 31, 2009, Select was required to maintain an interest expense coverage ratio (its ratio of consolidated EBITDA to cash interest expense) for the prior four consecutive quarters of at least 2.00 to 1.00. As of December 31, 2009, Select was required to maintain its leverage ratio (its ratio of total indebtedness to consolidated EBITDA for the prior four consecutive fiscal quarters) at less than 5.00 to 1.00. For the four quarters ended December 31, 2009, Select’s interest expense coverage ratio was 2.58 to 1.00 and Select’s leverage ratio was 3.11 to 1.00.
 
While Select has never defaulted on compliance with any of these financial covenants, its ability to comply with these ratios in the future may be affected by events beyond its control. Inability to comply with the required financial ratios could result in a default under our senior secured credit facility. In the event of any default under our senior secured credit facility, the lenders under our senior secured credit facility could elect to terminate borrowing commitments and declare all borrowings outstanding, together with accrued and unpaid interest and other fees, to be immediately due and payable. Any default under our senior secured credit facility that results in the acceleration of the outstanding indebtedness under our senior secured credit facility would also constitute an event of default under Select’s 75/8% senior subordinated notes and the senior floating rate notes, and the trustee or holders of each such notes could elect to declare such notes to be immediately due and payable.
 
Despite our substantial level of indebtedness, we and our subsidiaries may be able to incur additional indebtedness. This could further exacerbate the risks described above.
 
We and our subsidiaries may be able to incur additional indebtedness in the future. Although our senior secured credit facility, the indentures governing each of Select’s 75/8% senior subordinated notes and the senior floating rate notes each contain or will contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of qualifications and exceptions, and the indebtedness incurred in compliance with these restrictions could be substantial. Also, these restrictions do not prevent us or our subsidiaries from incurring obligations that do not constitute indebtedness. As of December 31, 2009, we had $269.3 million of revolving loan availability under our senior secured credit facility (after giving effect to $30.7 million of outstanding letters of credit). In addition, to the extent new debt is added to our and our subsidiaries’ current debt levels, the substantial leverage risks described above would increase.
 
Our inability to access external sources of financing when our senior secured credit facility terminates could have a material adverse effect on our business, operating results and financial condition.
 
Our Tranche B term loans mature on February 24, 2012 and Tranche B-1 term loans mature on August 22, 2014. Our revolving credit facility will terminate on February 24, 2011.
 
We anticipate refinancing at least a portion of the indebtedness under our senior secured credit facility within the next twelve months, which includes entering into a new revolving credit facility on or before the termination of our current revolving credit facility on February 24, 2011. There can be no assurance that we will be successful in our effort to enter into a new revolving credit facility and/or refinance indebtedness under our senior secured credit facility in the future. Many lenders have been adversely impacted by recent events in the United States and international financial markets and, as a result, have ceased or reduced the amount of lending they have made available to borrowers. While we expect there to be alternatives available to us to enter into a new revolving credit facility and/or refinance our indebtedness under our senior secured credit facility, we cannot assure you that any of these alternatives will be successfully implemented.
 
We depend on our revolving credit facility to meet our cash requirements to operate our business. If we repay our revolving credit facility upon its termination and are unable to enter into a new revolving credit facility on terms acceptable to us, or at all, we may be forced to reduce our operations and may not be able to respond to changing business conditions or competitive pressures. As a result, our business, operating results and financial condition could be adversely affected.


40


Table of Contents

Our inability to refinance our revolving credit facility, Tranche B term loans and Tranche B-1 term loans prior to their scheduled termination or maturity could cause an event of default under our senior secured credit facility because we may not otherwise have cash available to make final repayments of principal under our revolving credit facility, Tranche B term loans and Tranche B-1 term loans. We cannot assure you that we will be able to refinance indebtedness under our senior secured credit facility on terms acceptable to us, if at all. If an event of default were to occur under our senior secured credit facility due to our failure to make repayments of principal upon the termination or maturity of our revolving credit facility, Tranche B term loans or Tranche B-1 term loans, then an event of default would also occur under Select’s 75/8% senior subordinated notes, our senior floating rate notes and our 10% senior subordinated notes. Upon an event of default under our senior secured credit facility, Select’s 75/8% senior subordinated notes, our senior floating rate notes and our 10% senior subordinated notes, our lenders will be entitled to take various actions, including all actions permitted to be taken by a secured creditor, and our business, operating results and financial condition could be adversely affected.
 
We are exposed to the credit risk of our payors which in the future may cause us to make larger allowances for doubtful accounts or incur bad debt write-offs.
 
In the future, due to deteriorating economic conditions or other factors commercial payors may default on their payments to us, and individual patients may default on co-payments and deductibles for which they are responsible under the terms of either commercial insurance programs or Medicare. Although we review the credit risk of our commercial payors regularly, such risks will nevertheless arise from events or circumstances that are difficult to anticipate or control, such as a general economic downturn. As a result of the credit risk exposure of our payors defaulting on their payments to us in the future, we may have to make larger allowances for doubtful accounts or incur bad debt write-offs, both of which may have an adverse impact on our profitability.
 
Adverse economic conditions could materially adversely affect our net operating revenues in our outpatient rehabilitation segment from commercial payors.
 
Our net operating revenues may be materially adversely affected by adverse conditions in the general economy that could reduce the frequency of visits by patients of our outpatient rehabilitation clinics. While we believe that patient demand for the services provided by our outpatient rehabilitation clinics will not generally be impacted by the current state of the general economy, adverse economic conditions may result in some patients with commercial insurance electing to defer treatment or decrease the frequency of visits to our outpatient rehabilitation clinics in order to minimize their copay obligations. This could have a material adverse effect on the amount of our net operating revenues in our outpatient rehabilitation segment from commercial payors.
 
Item 1B.   Unresolved Staff Comments.
 
None.
 
Item 2.   Properties.
 
We currently lease most of our facilities, including clinics, offices, specialty hospitals and our corporate headquarters. We own three of our inpatient rehabilitation facilities and 12 of our long term acute care hospitals.
 
We lease all but four of our outpatient rehabilitation clinics and related offices, which, as of December 31, included 879 leased outpatient rehabilitation clinics throughout the United States. The outpatient rehabilitation clinics generally have a five year lease term and include options to renew. We also lease the majority of our long term acute care hospital facilities except for the facilities described above. As of December 31, 2009, in our LTCHs we had 65 hospital within hospital leases and 11 free-standing building leases.
 
We generally seek a five year lease for our long term acute care hospitals operated as HIHs, with an additional five year renewal at our option. We lease our corporate headquarters from companies owned by a related party affiliated with us through common ownership or management. Our corporate headquarters is approximately 132,138 square feet and is located in Mechanicsburg, Pennsylvania. We lease several other administrative spaces related to administrative and operational support functions. As of December 31, 2009, this was comprised of 10 locations throughout the United States with approximately 82,018 square feet in total.


41


Table of Contents

The following is a list of our hospitals and the number of beds at each hospital as of December 31, 2009.
 
                 
Hospital Name
 
City
  State   Beds
 
Select Specialty Hospital — Birmingham
  Birmingham   AL     38  
Select Specialty Hospital — Fort Smith
  Fort Smith   AR     32  
Select Specialty Hospital — Little Rock
  Little Rock   AR     43  
Select Specialty Hospital — Arizona (Phoenix Downtown Campus)
  Phoenix   AZ     33  
Select Specialty Hospital — Phoenix
  Phoenix   AZ     48  
Select Specialty Hospital — Arizona (Scottsdale Campus)
  Scottsdale   AZ     29  
Select Specialty Hospital — Colorado Springs
  Colorado Springs   CO     30  
Select Specialty Hospital — Denver
  Denver   CO     37  
Select Specialty Hospital — Denver (South Campus)
  Denver   CO     28  
Select Specialty Hospital — Wilmington
  Wilmington   DE     35  
Select Specialty Hospital — Orlando (South Campus)
  Edgewood   FL     40  
Select Specialty Hospital — Gainesville
  Gainesville   FL     44  
Select Specialty Hospital — Palm Beach
  Lake Worth   FL     60  
Select Specialty Hospital — Miami
  Miami   FL     47  
Select Specialty Hospital — Orlando (North Campus)
  Orlando   FL     35  
Select Specialty Hospital — Panama City
  Panama City   FL     30  
Select Specialty Hospital — Pensacola
  Pensacola   FL     54  
Select Specialty Hospital — Tallahassee
  Tallahassee   FL     29  
Select Specialty Hospital — Atlanta
  Atlanta   GA     27  
Select Specialty Hospital — Augusta
  Augusta   GA     80  
Select Specialty Hospital — Savannah
  Savannah   GA     36  
Select Specialty Hospital — Quad Cities
  Davenport   IA     50  
Select Specialty Hospital — Beech Grove
  Beech Grove   IN     40  
Select Specialty Hospital — Evansville
  Evansville   IN     60  
Select Specialty Hospital — Fort Wayne
  Fort Wayne   IN     32  
Select Specialty Hospital — Northwest Indiana
  Hammond   IN     70  
Select Specialty Hospital — Kansas City
  Overland Park   KS     40  
Select Specialty Hospital — Topeka
  Topeka   KS     34  
Select Specialty Hospital — Wichita
  Wichita   KS     60  
Select Specialty Hospital — Lexington
  Lexington   KY     41  
Select Specialty Hospital — Northwest Detroit
  Detroit   MI     36  
Select Specialty Hospital — Flint
  Flint   MI     26  
Select Specialty Hospital — Grosse Pointe
  Grosse Pointe Farms   MI     30  
Select Specialty Hospital — Kalamazoo
  Kalamazoo   MI     25  
Select Specialty Hospital — Macomb County
  Mount Clemens   MI     36  
Great Lakes Specialty Hospital — Hackley, LLC
  Muskegon   MI     31  
Great Lakes Specialty Hospital — Oak, LLC
  Muskegon   MI     20  
Select Specialty Hospital — Pontiac
  Pontiac   MI     30  
Select Specialty Hospital — Saginaw
  Saginaw   MI     32  
Select Specialty Hospital — Downriver
  Taylor   MI     40  
Select Specialty Hospital — Ann Arbor
  Ypsilanti   MI     36  
Select Specialty Hospital — Western Missouri
  Kansas   MO     34  
Select Specialty Hospital — Springfield
  Springfield   MO     44  
Select Specialty Hospital — St. Louis
  St. Louis   MO     33  
SSM Select Rehab St. Louis, LLC
  St. Louis   MO     60  
Select Specialty Hospital — Gulfport
  Gulfport   MS     61  
Select Specialty Hospital — Jackson
  Jackson   MS     53  
Select Specialty Hospital — Durham
  Durham   NC     30  
Select Specialty Hospital — Greensboro
  Greensboro   NC     30  
Select Specialty Hospital — Winston-Salem
  Winston-Salem   NC     42  


42


Table of Contents

                 
Hospital Name
 
City
  State   Beds
 
Select Specialty Hospital — Omaha (Central Campus)
  Omaha   NE     52  
Kessler Institute for Rehabilitation (Welkind Campus)
  Chester   NJ     72  
Select Specialty Hospital — Northeast New Jersey
  Rochelle Park   NJ     59  
Kessler Institute for Rehabilitation (North Campus)
  Saddle Brook   NJ     112  
Kessler Institute for Rehabilitation (West Campus)
  West Orange   NJ     143  
Select Specialty Hospital — Akron
  Akron   OH     60  
Select Specialty Hospital — Northeast Ohio (Canton Campus)
  Canton   OH     30  
Select Specialty Hospital — Cincinnati
  Cincinnati   OH     35  
Select Specialty Hospital — Columbus
  Columbus   OH     152  
Select Specialty Hospital — Columbus (Mt. Carmel Campus)
  Columbus   OH     24  
Select Specialty Hospital — Youngstown
  Youngstown   OH     31  
Select Specialty Hospital — Youngstown (Boardman Campus)
  Youngstown   OH     20  
Select Specialty Hospital — Zanesville
  Zanesville   OH     35  
Select Specialty Hospital — Oklahoma City
  Oklahoma City   OK     72  
Select Specialty Hospital — Tulsa/Midtown
  Tulsa   OK     56  
Select Specialty Hospital — Central Pennsylvania (Camp Hill Campus)
  Camp Hill   PA     31  
Select Specialty Hospital — Danville
  Danville   PA     30  
Select Specialty Hospital — Erie
  Erie   PA     50  
Penn State Hershey Rehabilitation
  Harrisburg   PA     32  
Select Specialty Hospital — Central Pennsylvania (Harrisburg Campus)
  Harrisburg   PA     38  
Select Specialty Hospital — Johnstown
  Johnstown   PA     39  
Select Specialty Hospital — Laurel Highlands
  Latrobe   PA     40  
Select Specialty Hospital — McKeesport
  McKeesport   PA     30  
Select Specialty Hospital — Pittsburgh
  Pittsburgh   PA     32  
Select Specialty Hospital — Central Pennsylvania (York Campus)
  York   PA     23  
Select Specialty Hospital — Sioux Falls
  Sioux Falls   SD     21  
Select Specialty Hospital — Tri-Cities
  Bristol   TN     33  
Select Specialty Hospital — Knoxville
  Knoxville   TN     35  
Select Specialty Hospital — North Knoxville
  Knoxville   TN     33  
Select Specialty Hospital — Memphis
  Memphis   TN     38  
Select Specialty Hospital — Nashville
  Nashville   TN     47  
Select Specialty Hospital — Dallas/Ft Worth
  Carrolton   TX     60  
Rehabilitation Institute of Denton, LLC
  Denton   TX     44  
Select Specialty Hospital — South Dallas
  DeSoto   TX     100  
Select Specialty Hospital — Houston (Houston Heights)
  Houston   TX     135  
Select Specialty Hospital — Houston (Houston Medical Center)
  Houston   TX     86  
Select Specialty Hospital — Houston (Houston West)
  Houston   TX     56  
Select Specialty Hospital — Longview
  Longview   TX     30  
Select Specialty Hospital — Midland
  Midland   TX     29  
Select Specialty Hospital — San Antonio
  San Antonio   TX     44  
Select Specialty Hospital — Madison
  Madison   WI     58  
Select Specialty Hospital — Milwaukee
  Milwaukee   WI     34  
Select Specialty Hospital — Milwaukee (St Luke’s Campus)
  Milwaukee   WI     29  
Select Specialty Hospital — Charleston
  Charleston   WV     32  
                 
Total Beds:
            4,233  
                 
 
Item 3.   Legal Proceedings.
 
To cover claims arising out of the operations of the Company’s specialty hospitals and outpatient rehabilitation facilities, the Company maintains professional malpractice liability insurance and general liability insurance. The Company also maintains umbrella liability insurance covering claims which, due to their nature or amount, are not covered by or not fully covered by the Company’s other insurance policies. These insurance policies also do not generally cover punitive damages and are subject to various deductibles and policy limits. Significant legal actions as well as the cost and possible lack of available insurance could subject the Company to substantial uninsured liabilities.

43


Table of Contents

The Company is subject to legal proceedings and claims that arise in the ordinary course of business, which include malpractice claims covered under insurance policies, subject to self-insured retention of $2.0 million per medical incident for professional liability claims and $2.0 million per occurrence for general liability claims. In the Company’s opinion, the outcome of these actions will not have a material adverse effect on its financial position or results of operations.
 
Healthcare providers are subject to lawsuits under the qui tam provisions of the federal False Claims Act. Qui tam lawsuits typically remain under seal (hence, usually unknown to the defendant) for some time while the government decides whether or not to intervene on behalf of a private qui tam plaintiff (known as a relator) and take the lead in the litigation. These lawsuits can involve significant monetary damages and penalties and award bounties to private plaintiffs who successfully bring the suits. The Company has been a defendant in these cases in the past, and may be named as a defendant in similar cases from time to time in the future.
 
During July 2009, the Company received a subpoena from the Office of Inspector General of the U.S. Department of Health and Human Services seeking various documents concerning the Company’s financial relationships with certain physicians practicing at its hospitals in Columbus, Ohio. The Company does not know whether the subpoena has been issued in connection with a qui tam lawsuit or in connection with possible civil, criminal or administrative proceedings by the government. The Company has produced documents in response to the subpoena and intends to fully cooperate with this investigation. At this time, the Company is unable to predict the timing and outcome of this matter.
 
Item 4.   Reserved.
 
PART II
 
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
Market Information
 
Our common stock has been quoted on the New York Stock Exchange under the symbol “SEM” since our initial public offering on September 25, 2009. Prior to that date there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low sales prices of our common stock, reported by the New York Stock Exchange.
 
                 
    Market Prices
Fiscal Year Ended December 31, 2009
  High   Low
 
Third Quarter (beginning September 25, 2009)
  $ 10.55     $ 9.35  
Fourth Quarter
  $ 10.88     $ 8.61  
 
Holders
 
At the close of business on March 1, 2010, we had 160,005,236 shares of common stock issued and outstanding. As of that date, there were 143 registered holders of record. This does not reflect beneficial stockholders who hold their stock in nominee or “street” name through brokerage firms.
 
Dividend Policy
 
We have not paid or declared any dividends on our common stock and do not anticipate paying any dividends on our common stock in the foreseeable future. We intend to retain future earnings to finance the ongoing operations and growth of our business. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on conditions at that time, including our financial condition, results of operations, contractual restrictions, capital requirements, business prospects and other factors our board of directors may deem relevant.


44


Table of Contents

Securities Authorized For Issuance Under Equity Compensation Plans
 
For information regarding securities authorized for issuance under equity compensation plans, see Part III “Item 12 — Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
 
Stock Performance Graph
 
The graph below compares the cumulative total stockholder return on $100 invested at the opening of the market on September 25, 2009, the date the Company’s initial public offering was priced for initial sale, through and including the market close on December 31, 2009, with the cumulative total return of the same time period on the same amount invested in the Standard & Poor’s 500 Index (“S&P 500”), and the Morgan Stanley Healthcare Provider Index (“RXH”), an equal-dollar weighted index of 16 companies involved in the business of hospital management and medical/nursing services. The chart below the graph sets forth the actual numbers depicted on the graph.
 
(PERFORMANCE GRAPH)
 
                                                   
      9/25/2009     9/30/2009     10/30/2009     11/30/2009     12/31/2009
Select Medical Holdings Corporation (SEM)
    $ 100.00       $ 100.70       $ 97.00       $ 90.50       $ 106.20  
Morgan Stanley Healthcare Provider Index (RXH)
      100.00         102.31         97.41         93.78         102.32  
S&P 500
      100.00         100.72         98.73         104.40         106.25  
                                                   
 
Recent Sales of Unregistered Securities
 
The following is a summary of our transactions during the year ended December 31, 2009, involving sales of our securities that were not registered under the Securities Act of 1933, as amended:
 
On March 3, 2009, we granted to an employee options to purchase an aggregate of 15,000 shares of our common stock under the Select Medical Holdings Corporation 2005 Equity Incentive Plan, as amended and restated (“2005 Equity Incentive Plan”), at an exercise price of $10.00 per share. The stock options described above were made under written compensatory plans or agreements in reliance on the exemption from registration pursuant to Rule 701 under the Securities Act or pursuant to Section 4(2) of the Securities Act.
 
From March 16, 2009 through June 24, 2009, we sold and issued to our employees an aggregate of 2,880 shares of our common stock pursuant to option exercises under our 2005 Equity Incentive Plan at a price of $8.33 per share for an aggregate purchase price of $24,000. The issuance of common stock described above was made under written compensatory plans or agreements in reliance on the exemption from registration pursuant to Rule 701 under the Securities Act or pursuant to Section 4(2) of the Securities Act.


45


Table of Contents

On August 12, 2009, we granted to our non-employee directors options to purchase an aggregate of 12,000 shares of our common stock under the Select Medical Holdings Corporation 2005 Equity Incentive Plan for Non-Employee Directors, as amended and restated, at an exercise price of $10.00 per share. The stock options described above were made under written compensatory plans or agreements in reliance on the exemption from registration pursuant to Rule 701 under the Securities Act or pursuant to Section 4(2) of the Securities Act.
 
On August 12, 2009, we awarded to certain of our employees an aggregate of 363,608 shares of our restricted common stock under our 2005 Equity Incentive Plan. These shares vested upon the consummation of our initial public offering. The awards of restricted common stock described above were made under written compensatory plans or agreements in reliance on the exemption from registration pursuant to Rule 701 under the Securities Act or pursuant to Section 4(2) of the Securities Act.
 
Use of Proceeds from Sales of Registered Securities
 
On September 24, 2009, our registration statement on Form S-1 originally filed on July 24, 2008 (File No. 333-152514) was declared effective, pursuant to which Holdings issued and sold (1) 30,000,000 shares of common stock for aggregate gross offering proceeds of $300.0 million at a price to the public of $10.00 per share, which closed on September 30, 2009, and (2) an additional 3,602,700 shares of common stock to the underwriters pursuant to their over-allotment option for aggregate gross offering proceeds of approximately $36.0 million at a price to the public of $10.00 per share, which closed on October 28, 2009. The managing underwriters were Goldman, Sachs & Co., Morgan Stanley & Co. Incorporated, Merrill Lynch, Pierce, Fenner & Smith Incorporated and J.P. Morgan Securities Inc.
 
We paid to the underwriters underwriting discounts and commissions totaling approximately $20.2 million in connection with the offering. In addition, we incurred additional costs of approximately $3.3 million in connection with the offering which, when added to the underwriting discounts and commissions paid by Holdings, resulted in total expenses of approximately $23.5 million related to the offering. Accordingly, the net proceeds to Holdings from the offering, after deducting underwriting discounts and commissions and offering expenses, were approximately $312.5 million. Except for the payments to executive officers under our Long Term Cash Incentive Plan described below, no amounts, including offering expenses, were paid directly or indirectly to any of our directors or officers (or their associates) or persons owning ten percent or more of any class of Holdings’ equity securities or to any other affiliates from the proceeds of the offering.
 
Holdings used the net proceeds from the offering to repay indebtedness, to make payments to its executive officers under our Long Term Cash Incentive Plan and for general corporate purposes. There was no material change in the planned use of proceeds from our initial public offering from that described in the Prospectus filed on September 25, 2009 with the SEC pursuant to Rule 424(b) of the Securities Act of 1933, as amended.
 
Item 6.   Selected Financial Data.
 
You should read the following selected historical consolidated financial data in conjunction with our consolidated financial statements and the accompanying notes. You should also read “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is contained elsewhere herein. The historical financial data as of December 31, 2005, 2006, 2007, 2008 and 2009 and for the period from January 1 through February 24, 2005 (Predecessor Period), for the period from February 25 through December 31, 2005 and for the years ended December 31, 2006, 2007, 2008 and 2009 (Successor Period) have been derived from consolidated financial statements audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The selected historical consolidated financial data as of December 31, 2008 and 2009, and for the years ended December 31, 2007, 2008 and 2009 have been derived from our consolidated financial information included elsewhere herein. The selected historical consolidated financial data as of December 31, 2005, 2006 and 2007 and for the period from January 1 through February 24, 2005 (Predecessor Period), and for the period from February 25 through December 31, 2005 and for the year ended December 31, 2006 (Successor Period) have been derived from our audited consolidated financial information not included elsewhere herein.


46


Table of Contents

                                                   
   
            Select Medical Holdings Corporation  
    Predecessor
         
    Period       Successor Period  
    Period from
      Period from
       
    January 1
      February 25
       
    through
      through
       
    February 24,       December 31,     Year Ended December 31,  
    2005(1)       2005(1)(2)     2006(1)(2)     2007(1)(2)     2008(1)(2)     2009  
    (In thousands,
            (In thousands, except per share data)  
    except
               
    per share data)                
Statement of Operations Data:
                                                 
Net operating revenues
  $ 277,736       $ 1,580,706     $ 1,851,498     $ 1,991,666     $ 2,153,362     $ 2,239,871  
Operating expenses(3)(4)
    373,418         1,322,068       1,546,956       1,740,484       1,885,168       1,933,052  
Depreciation and amortization
    5,933         37,922       46,668       57,297       71,786       70,981  
                                                   
Income (loss) from operations
    (101,615 )       220,716       257,874       193,885       196,408       235,838  
Gain (loss) on early retirement of debt(5)
    (42,736 )                         912       13,575  
Merger related charges(6)
    (12,025 )                                
Other income (expense)
    267         1,092             (167 )           (632 )
Interest expense, net(7)
    (4,128 )       (101,441 )     (130,538 )     (138,052 )     (145,423 )     (132,377 )
                                                   
Income (loss) from continuing operations before income taxes
    (160,237 )       120,367       127,336       55,666       51,897       116,404  
Income tax expense (benefit)
    (59,794 )       49,336       43,521       18,699       26,063       37,516  
                                                   
Income (loss) from continuing operations
    (100,443 )       71,031       83,815       36,967       25,834       78,888  
Income from discontinued operations, net of tax
    522         3,072       12,818                    
                                                   
Net income (loss)
    (99,921 )       74,103       96,633       36,967       25,834       78,888  
Less: Net income attributable to non-controlling interests(8)
    330         1,776       1,754       1,537       3,393       3,606  
                                                   
Net income (loss) attributable to Select Medical Holdings Corporation
    (100,251 )       72,327       94,879       35,430       22,441       75,282  
Less: Preferred dividends
            23,519       22,663       23,807       24,972       19,537  
                                                   
Net income (loss) available to common stockholders and participating securities
  $ (100,251 )     $ 48,808     $ 72,216     $ 11,623     $ (2,531 )   $ 55,745  
                                                   
Income (loss) per common share:
                                                 
Basic:
                                                 
Income (loss) from continuing operations
  $ (0.99 )     $ 0.70     $ 0.88     $ 0.17     $ (0.04 )   $ 0.61  
Income from discontinued operations, net of tax
    0.01         0.05       0.18                    
                                                   
Net income (loss)
  $ (0.98 )     $ 0.75     $ 1.06     $ 0.17     $ (0.04 )   $ 0.61  
                                                   
Diluted:
                                                 
Income (loss) from continuing operations
  $ (0.99 )     $ 0.70     $ 0.88     $ 0.17     $ (0.04 )   $ 0.61  
Income from discontinued operations, net of tax
    0.01         0.05       0.18                    
                                                   
Net income (loss)
  $ (0.98 )     $ 0.75     $ 1.06     $ 0.17     $ (0.04 )   $ 0.61  
                                                   
Weighted average common shares outstanding:
                                                 
Basic
    102,026         51,399       54,055       57,086       59,566       85,587  
Diluted
    102,026         51,399       54,055       57,086       59,566       86,045  
Balance Sheet Data (at end of period):
                                                 
Cash and cash equivalents
            $ 35,861     $ 81,600     $ 4,529     $ 64,260     $ 83,680  
Working capital
              77,556       59,468       14,730       118,370       170,772  
Total assets
              2,168,385       2,182,524       2,495,046       2,579,469       2,602,233  
Total debt
              1,628,889       1,538,503       1,755,635       1,779,925       1,405,571  
Total Select Medical Holdings Corporation stockholders’ equity
              (244,658 )     (169,139 )     (165,889 )     (174,204 )     738,988  
 


47


Table of Contents

                                                   
   
            Select Medical Corporation  
    Predecessor
         
    Period       Successor Period  
    Period from
      Period from
       
    January 1
      February 25
       
    through
      through
       
    February 24,       December 31,     Year Ended December 31,  
    2005(1)       2005(1)     2006(1)     2007(1)     2008(1)     2009  
    (In thousands)       (In thousands)  
Statement of Operations Data:
                                                 
Net operating revenues
  $ 277,736       $ 1,580,706     $ 1,851,498     $ 1,991,666     $ 2,153,362     $ 2,239,871  
Operating expenses(3)(4)
    373,418         1,322,068       1,546,956       1,740,484       1,885,168       1,933,052  
Depreciation and amortization
    5,933         37,922       46,668       57,297       71,786       70,981  
                                                   
Income (loss) from operations
    (101,615 )       220,716       257,874       193,885       196,408       235,838  
Gain (loss) on early retirement of debt(5)
    (42,736 )                         912       12,446  
Merger related charges(6)
    (12,025 )                                
Other income (expense)
    267         3,018       1,366       (4,494 )     (2,802 )     3,204  
Interest expense, net(7)
    (4,128 )       (82,985 )     (95,995 )     (103,394 )     (110,418 )     (99,451 )
                                                   
Income (loss) from continuing operations before income taxes
    (160,237 )       140,749       163,245       85,997       84,100       152,037  
Income tax expense (benefit)
    (59,794 )       56,470       56,089       29,315       37,334       49,987  
                                                   
Income (loss) from continuing operations
    (100,443 )       84,279       107,156       56,682       46,766       102,050  
Income from discontinued operations, net of tax
    522         3,072       12,818                    
                                                   
Net income (loss)
    (99,921 )       87,351       119,974       56,682       46,766       102,050  
Less: Net income attributable to non-controlling interests(8)
    330         1,776       1,754       1,537       3,393       3,606  
                                                   
Net income (loss) attributable to Select Medical Holdings Corporation
  $ (100,251 )     $ 85,575     $ 118,220     $ 55,145     $ 43,373     $ 98,444  
                                                   
Balance Sheet Data (at end of period):
                                                 
Cash and cash equivalents
            $ 35,861     $ 81,600     $ 4,529     $ 64,260     $ 83,680  
Working capital
              88,354       70,957       9,169       100,127       167,318  
Total assets
              2,163,369       2,177,642       2,490,777       2,562,425       2,599,179  
Total debt
              1,322,280       1,230,718       1,446,525       1,469,322       1,100,987  
Total Select Medical Corporation stockholders’ equity
              506,165       614,002       624,171       630,315       1,037,064  
 
 
(1) Adjusted for the adoption of an amendment issued by the FASB in December 2007 to ASC Topic 810, “Consolidation.” See Note 1, Organization and Significant Accounting Policies — Non-controlling Interests, in our audited consolidated financial statements.
(2) Adjusted for the clarification by the FASB that stated share based payment awards that have not vested meet the definition of a participating security provided the right to receive the dividend is non-forfeitable and non-contingent. See Note 14 in our audited consolidated financial statements for additional information.
(3) Operating expenses include cost of services, general and administrative expenses, and bad debt expenses.
(4) Includes stock compensation expense related to the repurchase of outstanding stock options in the Predecessor Period from January 1 through February 24, 2005, compensation expense related to restricted stock, stock options and long term incentive compensation in the Successor Periods from February 25 through December 31, 2005, and for the years ended December 31, 2006, 2007, 2008 and 2009.
(5) The loss in the Predecessor Period of January 1 through February 24, 2005 consists of the tender premium cost of $34.8 million and the remaining write-off of unamortized deferred financing costs of $7.9 million related to the tender offers for all of Select’s 91/2% senior subordinated notes due 2009 and all of Select’s 71/2% senior subordinated notes due 2013 completed in connection with the Merger. In the year ended December 31, 2008, we paid approximately $1.0 million to repurchase and retire a portion of Select’s 75/8% senior subordinated notes. These notes had a carrying value of $2.0 million.

48


Table of Contents

The gain on early retirement of debt recognized was net of the write-off of unamortized deferred financing costs related to the debt. During the year ended December 31, 2009, we paid approximately $30.1 million to repurchase and retire a portion of Select’s 75/8% senior subordinated notes. These notes had a carrying value of $46.5 million. The gain on early retirement of debt recognized was net of the write-off of unamortized deferred financing costs related to the debt. These gains were offset by the write-off of deferred financing costs of $2.9 million that occurred due to our early prepayment on the term loan portion of our credit facility. In addition, Holdings paid $6.5 million to repurchase and retire a portion of Holdings’ senior floating rate notes. These Notes had a carrying value of $7.7 million. The gain on early retirement of debt recognized was net of the write-off of unamortized deferred financing costs related to the debt.
(6) As a result of the Merger, Select incurred costs in the Predecessor Period of January 1 through February 24, 2005 directly related to the Merger. This included the cost of the investment advisor hired by the special committee of Select’s board of directors to evaluate the Merger, legal and accounting fees, costs associated with the Hart-Scott-Rodino filing relating to the Merger, the cost associated with purchasing a six year extended reporting period under our directors and officers liability insurance policy and other associated expenses.
(7) Interest expense, net equals interest expense minus interest income.
(8) Reflects interests held by other parties in subsidiaries, limited liability companies and limited partnerships owned and controlled by us.


49


Table of Contents

Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
You should read this discussion together with the “Selected Financial Data” and our consolidated financial statements and the accompanying notes included elsewhere herein.
 
Overview
 
We believe that we are one of the largest operators of both specialty hospitals and outpatient rehabilitation clinics in the United States based on number of facilities. As of December 31, 2009, we operated 89 long term acute care hospitals and six acute medical rehabilitation hospitals in 25 states, and 961 outpatient rehabilitation clinics in 37 states and the District of Columbia. We also provide medical rehabilitation services on a contracted basis to nursing homes, hospitals, assisted living and senior care centers, schools and work sites. We began operations in 1997 under the leadership of our current management team.
 
We manage our Company through two business segments, our specialty hospital segment and our outpatient rehabilitation segment. We had net operating revenues of $2,239.9 million for the year ended December 31, 2009. Of this total, we earned approximately 70% of our net operating revenues from our specialty hospitals and approximately 30% from our outpatient rehabilitation business for the year ended December 31, 2009. Our specialty hospital segment consists of hospitals designed to serve the needs of long term stay acute patients and hospitals designed to serve patients that require intensive medical rehabilitation care. Patients are typically admitted to our long term acute care hospitals from general acute care hospitals. These patients have specialized needs, and serious and often complex medical conditions such as respiratory failure, neuromuscular disorders, traumatic brain and spinal cord injuries, strokes, non-healing wounds, cardiac disorders, renal disorders and cancer. Our outpatient rehabilitation segment consists of clinics and contract services that provide physical, occupational and speech rehabilitation services. Our outpatient rehabilitation patients are typically diagnosed with musculoskeletal impairments that restrict their ability to perform normal activities of daily living.
 
Recent Trends and Events
 
Initial Public Offering of Common Stock
 
On September 30, 2009, we completed an initial public offering of 30,000,000 shares at a price to the public of $10.00 per share, and on October 28, 2009, the underwriters exercised their over-allotment option to purchase an additional 3,602,700 shares at a price to the public of $10.00 per share. The total net proceed to us after deducting underwriting discounts and commissions and offering expenses was approximately $312.5 million. We used the proceeds from the offering to repay $258.4 million of revolving and term loans outstanding under our senior secured credit facility and make payments to executive officers under the Long Term Cash Incentive Plan of $18.0 million. The remaining proceeds were used for general corporate purposes.
 
Summary Financial Results
 
Year Ended December 31, 2009
 
For the year ended December 31, 2009, our net operating revenues increased 4.0% to $2,239.9 million compared to $2,153.4 million for the year ended December 31, 2008. This increase in net operating revenues resulted from a 4.7% increase in our specialty hospital net operating revenue and a 2.6% increase in our outpatient rehabilitation net operating revenue from the prior year. The increase in our specialty hospital revenue was principally due to the hospitals we opened in 2008. The increase in our outpatient rehabilitation revenue was principally due to an increase in contract services based revenue. We had income from operations for the year ended December 31, 2009 of $235.8 million compared to $196.4 million for the year ended December 31, 2008. The increase in income from operations was principally related to an increase in profitability of our specialty hospitals opened as of January 1, 2008 and operated throughout both periods, an improvement in the operating results of the hospitals opened in 2008 and the growth in our contract services business, offset by the compensation costs of $22.0 million we incurred in connection with our initial public offering of common stock. Holdings’ interest expense for the year ended December 31, 2009 was $132.5 million compared to $145.9 million for the year ended December 31, 2008. Select’s interest expense for the year ended December 31, 2009 was $99.5 million compared to $110.9 million for the year ended December 31, 2008. The decrease in interest expense for both Holdings and Select was attributable to a reduction in outstanding debt balances during the year ended December 31, 2009.


50


Table of Contents

Cash flow from operations provided $165.6 million of cash for the year ended December 31, 2009 for Holdings and $198.5 million of cash for the year ended December 31, 2009 for Select. The difference primarily relates to interest payments on Holdings’ senior subordinated notes and senior floating rate notes.
 
Year Ended December 31, 2008
 
For the year ended December 31, 2008, our net operating revenues increased 8.1% to $2,153.4 million compared to $1,991.7 million for the year ended December 31, 2007. This increase in net operating revenues resulted from a 7.4% increase in our specialty hospital net operating revenue and a 10.2% increase in our outpatient rehabilitation net operating revenue. The increase in our specialty hospital revenue was due to increases in our discharge payment rates for Medicare and an increase in our non-Medicare patient volume. The increase in our outpatient rehabilitation net operating revenue was primarily attributable to the net operating revenues generated by clinics acquired from HealthSouth Corporation on May 1, 2007. We had income from operations for the year ended December 31, 2008 of $196.4 million compared to $193.9 million for the year ended December 31, 2007. Holdings’ interest expense for the year ended December 31, 2008 was $145.9 million compared to $140.2 million for the year ended December 31, 2007. Select’s interest expense for the year ended December 31, 2008 was $110.9 million compared to $105.5 million for the year ended December 31, 2007. The increase in interest expense for both Holdings and Select resulted from higher average debt levels existing for the year ended December 31, 2008 resulting primarily from borrowings to finance the HealthSouth transaction, offset by the effect of declining interest rates in 2008.
 
Cash flow from operations provided $107.4 million of cash for the year ended December 31, 2008 for Holdings and $140.2 million of cash for the year ended December 31, 2008 for Select. The difference primarily related to interest payments on Holdings’ senior subordinated notes and senior floating rate notes.
 
Regulatory Changes
 
Medicare Reimbursement of Long Term Acute Care Hospital Services
 
In the last few years, there have been significant regulatory changes affecting LTCHs that have affected our net operating revenues and, in some cases, caused us to change our operating models and strategies. The effective date of certain regulatory changes that would otherwise have an adverse effect on us has been suspended under a moratorium set to expire for cost reporting periods beginning over the next year. The following is a summary of some of the more significant healthcare regulatory changes that have affected our financial performance in the past or are likely to affect our financial performance in the future.
 
We have been subject to regulatory changes that occur through the rulemaking procedures of the Centers for Medicare & Medicaid Services, or “CMS.” Historically, rule updates occurred twice each year. All Medicare payments to our long term acute care hospitals are made in accordance with a prospective payment system specifically applicable to long term acute care hospitals, referred to as “LTCH-PPS.” Proposed rules specifically related to LTCHs were generally published in January, finalized in May and effective on July 1st of each year. Additionally, LTCHs are subject to annual updates to the rules related to the inpatient prospective payment system, or “IPPS,” that are typically proposed in May, finalized in August and effective on October 1st of each year. In the annual payment rate update for the 2009 fiscal year, CMS consolidated the two historical annual updates into one annual update. The final rule adopted a 15-month rate update for fiscal year 2009 and moves the LTCH-PPS from a July-June update cycle to an October-September cycle. Beginning fiscal year 2010 the LTCH rate year will begin October 1, coinciding with the start of the federal fiscal year.
 
August 2004 Final Rule.  On August 11, 2004, CMS published final regulations applicable to LTCHs that are operated as “hospital within hospitals” or as “satellites.” We collectively refer to hospital within hospitals and satellites as “HIHs,” and we refer to the CMS final regulations as the “final regulations.” HIHs are separate hospitals located in space leased from, and located in or on the same campus of, another hospital. We refer to such other hospitals as “host” hospitals. Effective for hospital cost reporting periods beginning on or after October 1, 2004, subject to certain exceptions, the final regulations provide lower rates of reimbursement to HIHs for those Medicare patients admitted from their host hospitals that are in excess of a specified percentage threshold. For HIHs opened after October 1, 2004, the Medicare admissions threshold has been established at 25% except for HIHs located in rural hospitals, metropolitan statistical areas, or “MSA dominant” hospitals or single urban hospitals where the


51


Table of Contents

percentage is no more than 50%, nor less than 25%. For HIHs that met specified criteria and were in existence as of October 1, 2004, including all but two of our then existing HIHs, the Medicare admissions thresholds were to have been phased in over a four year period starting with hospital cost reporting periods that began on or after October 1, 2004. However, as described below, many of these changes have been postponed for a three year period by the Medicare, Medicaid, and SCHIP Extension Act of 2007, or “SCHIP Extension Act,” and further clarified in the American Recovery and Reinvestment Act of 2009, or “ARRA.”
 
August 2005 Final Rule.  On August 12, 2005, CMS published the final rule for general acute care hospitals IPPS, for fiscal year 2006, which included an update of the relative weights for the long term care diagnosis-related group, or “LTC-DRG.” CMS estimated the changes to the relative weights would reduce LTCH Medicare payments-per-discharge by approximately 4.2% in fiscal year 2006 (the period from October 1, 2005 through September 30, 2006).
 
May 2006 Final Rule.  On May 12, 2006, CMS published its final annual payment rate updates for the 2007 LTCH-PPS rate year (affecting discharges and cost reporting periods beginning on or after July 1, 2006 and before July 1, 2007), or “RY 2007.” The May 2006 final rule revised the payment adjustment formula for short stay outlier, or “SSO,” patients. For discharges occurring on or after July 1, 2006, the rule changed the payment methodology for Medicare patients with a length of stay less than or equal to five-sixths of the geometric average length of stay for each SSO case. In addition, for discharges occurring on or after July 1, 2006, the May 2006 final rule provided for (1) a zero-percent update to the LTCH-PPS standard federal rate used as a basis for LTCH-PPS payments for RY 2007; (2) the elimination of the surgical case exception to the three day or less interruption of stay policy, under which surgical exception Medicare reimburses a general acute care hospital directly for surgical services furnished to a long term acute care hospital patient during a brief interruption of stay from the long term acute care hospital, rather than requiring the long term acute care hospital to bear responsibility for such surgical services; and (3) increasing the costs that a long term acute care hospital must bear before Medicare will make additional payments for a case under its high-cost outlier policy for RY 2007. CMS estimated that the changes in the May 2006 final rule would result in an approximately 3.7% decrease in LTCH Medicare payments-per-discharge compared to the 2006 rate year, largely attributable to the revised SSO payment methodology.
 
August 2006 Final Rule.  On August 18, 2006, CMS published the IPPS final rule for fiscal year 2007, which is the period from October 1, 2006 through September 30, 2007, that included an update of the LTC-DRG relative weights for fiscal year 2007. CMS estimated the changes to the relative weights would reduce LTCH Medicare payments-per-discharge by approximately 1.3% in fiscal year 2007. The August 2006 final rule also included changes to the diagnosis-related groups, or “DRGs,” in IPPS that apply to LTCHs, as the LTC-DRGs were based on the IPPS DRGs.
 
May 2007 Final Rule.  On May 1, 2007, CMS published its annual payment rate update for the 2008 LTCH-PPS rate year, or “RY 2008” (affecting discharges and cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008). The May 2007 final rule made several changes to LTCH-PPS payment methodologies and amounts during RY 2008 although, as described below, many of these changes have been postponed for a three year period by the SCHIP Extension Act.
 
For cost reporting periods beginning on or after July 1, 2007, the May 2007 final rule expanded the Medicare HIH admissions threshold to apply to Medicare patients admitted from any individual hospital. Previously, the admissions threshold was applicable only to Medicare HIH admissions from hospitals co-located with an LTCH or satellite of an LTCH. Under the May 2007 final rule, free-standing LTCHs and grandfathered HIHs are subject to the Medicare admission thresholds, as well as HIHs and satellites that admit Medicare patients from non-co-located hospitals. To the extent that any LTCH’s or LTCH satellite facility’s discharges that are admitted from an individual hospital (regardless of whether the referring hospital is co-located with the LTCH or LTCH satellite) exceed the applicable percentage threshold during a particular cost reporting period, the payment rate for those discharges are subject to a downward payment adjustment. Cases admitted in excess of the applicable threshold are reimbursed at a rate comparable to that under general acute care IPPS, which is generally lower than LTCH-PPS rates. Cases that reach outlier status in the discharging hospital do not count toward the limit and are paid under LTCH-PPS. CMS estimated the impact of the expansion of the Medicare admission thresholds would result in a reduction of 2.2% of the aggregate payments to all LTCHs in RY 2008.


52


Table of Contents

The applicable percentage threshold is generally 25% after the completion of the phase-in period described below. The percentage threshold for LTCH discharges from a referring hospital that is an MSA dominant hospital or a single urban hospital is the percentage of total Medicare discharges in the MSA that are from the referring hospital, but no less than 25% nor more than 50%. For Medicare discharges from LTCHs or LTCH satellites located in rural areas, as defined by the Office of Management and Budget, the percentage threshold is 50% from any individual referring hospital. The expanded 25% rule was phased in over a three year period. The three year transition period started with cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008, when the threshold was the lesser of 75% or the percentage of the LTCH’s or LTCH satellite’s admissions discharged from the referring hospital during its cost reporting period beginning on or after July 1, 2004 and before July 1, 2005, or “RY 2005.” For cost reporting periods beginning on or after July 1, 2008 and before July 1, 2009, the threshold was the lesser of 50% or the percentage of the LTCH’s or LTCH satellite’s admissions from the referring hospital, during its RY 2005 cost reporting period. For cost reporting periods beginning on or after July 1, 2009, all LTCHs were subject to the 25% threshold (or applicable threshold for rural, urban-single, or MSA dominant hospitals). The SCHIP Extension Act, as revised by the ARRA, postponed the application of the percentage threshold to all free-standing and grandfathered HIHs for a three year period commencing on an LTCH’s first cost reporting period on or after July 1, 2007. However, the SCHIP Extension Act did not postpone the application of the percentage threshold, or the transition period stated above, to those Medicare patients discharged from an LTCH HIH or HIH satellite that were admitted from a non-co-located hospital.
 
The May 2007 final rule further revised the payment adjustment for SSO cases. Beginning with discharges on or after July 1, 2007, for cases with a length of stay that is less than the average length of stay plus one standard deviation for the same DRG under IPPS, referred to as the so-called “IPPS comparable threshold,” the rule effectively lowers the LTCH payment to a rate based on the general acute care hospital IPPS. SSO cases with covered lengths of stay that exceed the IPPS comparable threshold would continue to be paid under the SSO payment policy described above under the May 2006 final rule. Cases with a covered length of stay less than or equal to the IPPS comparable threshold and less than five-sixths of the geometric average length of stay for that LTC-DRG are paid at an amount comparable to the IPPS per diem. The SCHIP Extension Act also postponed, for the three year period beginning on December 29, 2007, the SSO policy changes made in the May 2007 final rule.
 
The May 2007 final rule updated the standard federal rate by 0.71% for RY 2008. As a result, the federal rate for RY 2008 is equal to $38,356.45, compared to $38,086.04 for RY 2007. Subsequently, the SCHIP Extension Act eliminated the update to the standard federal rate that occurred for RY 2008 effective April 1, 2008. This adjustment to the standard federal rate was applied prospectively on April 1, 2008 and reduced the federal rate back to $38,086.04. In a technical correction to the May 2007 final rule, CMS increased the fixed-loss amount for high cost outlier in RY 2008 to $20,738, compared to $14,887 in RY 2007. CMS projected an estimated 0.4% decrease in LTCH payments in RY 2008 due to this change in the fixed-loss amount and the overall impact of the May 2007 final rule to be a 1.2% decrease in total estimated LTCH-PPS payments for RY 2008.
 
The May 2007 final rule provided that beginning with the annual payment rate updates to the LTC-DRG classifications and relative weights for the fiscal year 2008, or “FY 2008” (affecting discharges beginning on or after October 1, 2007 and before September 30, 2008), annual updates to the LTC-DRG classification and relative weights are to have a budget neutral impact. Under the May 2007 final rule, future LTC-DRG reclassification and recalibrations, by themselves, should neither increase nor decrease the estimated aggregated LTCH-PPS payments.
 
August 2007 Final Rule.  On August 1, 2007, CMS published the IPPS final rule for FY 2008, which created a new patient classification system with categories referred to as MS-DRGs and MS-LTC-DRGs, respectively, for hospitals reimbursed under IPPS and LTCH-PPS. Beginning with discharges on or after October 1, 2007, the new classification categories take into account the severity of the patient’s condition. CMS assigned relative weights to each MS-DRG and MS-LTC-DRG to reflect their relative use of medical care resources.
 
The August 2007 final rule published a budget neutral update to the MS-LTC-DRG classification and relative weights. In the preamble to the IPPS final rule for FY 2008 CMS restated that it intends to continue to update the LTC-DRG weights annually in the IPPS rulemaking and those weights would be modified by a budget neutrality adjustment factor to ensure that estimated aggregate LTCH payments after reweighting are equal to estimated aggregate LTCH payments before reweighting.


53


Table of Contents

Medicare, Medicaid, and SCHIP Extension Act of 2007.  On December 29, 2007, President Bush signed into law the SCHIP Extension Act. Among other changes in the federal healthcare programs, the SCHIP Extension Act makes significant changes to Medicare policy for LTCHs including a new statutory definition of an LTCH, a report to Congress on new LTCH patient criteria, relief from certain LTCH-PPS payment policies for three years, a three year moratorium on the development of new LTCHs and LTCH beds, elimination of the payment update for the last quarter of RY 2008 and new medical necessity reviews by Medicare contractors through at least October 1, 2010.
 
The SCHIP Extension Act precludes the Secretary from implementing, during the three year moratorium period, the provisions added by the May 2007 final rule that extended the 25% rule to free-standing LTCHs and grandfathered HIHs. The SCHIP Extension Act also modifies, during the moratorium, the effect of the 25% threshold for admissions from co-located hospitals that was established in the August 2004 final rule. For non-grandfathered HIHs and satellites opened on or before October 1, 2004, the applicable percentage threshold is set at 50%, except for those HIHs and satellites located in rural areas and those which receive referrals from MSA dominant hospitals or single urban hospitals in which cases the percentage threshold is set at no more than 75%. The ARRA, as discussed below, further revised the SCHIP Extension Act to modify the delay in the percentage limitations to the three cost reporting periods beginning on or after July 1, 2007 for freestanding LTCHs, grandfathered HIHs, and grandfathered satellites and on or after October 1, 2007 for non-grandfathered LTCH HIHs and non-grandfathered satellites.
 
The SCHIP Extension Act also precludes the Secretary from implementing, for the three year period beginning on December 29, 2007, a one-time adjustment to the LTCH standard federal rate. This rule, established in the original LTCH-PPS regulations, permits CMS to restate the standard federal rate to correct any significant error CMS made in estimating the standard federal rate in the first year of LTCH-PPS. In the preamble to the May 2007 final rule, CMS discussed making a one-time prospective adjustment to the LTCH-PPS rates for the 2009 rate year. In addition, the SCHIP Extension Act reduced the Medicare payment update for the portion of RY 2008 from April 1, 2008 to June 30, 2008 to the same base rate applied to LTCH discharges during RY 2007.
 
For the three years following December 29, 2007, the Secretary is required to impose a moratorium on the establishment and classification of new LTCHs, LTCH satellite facilities, and LTCH beds in existing LTCH or satellite facilities. This moratorium does not apply to LTCHs that, before the date of enactment, (1) began the qualifying period for payment under the LTCH-PPS, (2) have a written agreement with an unrelated party for the construction, renovation, lease or demolition for a LTCH and have expended at least 10% of the estimated cost of the project or $2,500,000, or (3) have obtained an approved certificate of need. As a result of the SCHIP Extension Act’s three year moratorium on the development of new LTCHs, we have stopped all LTCH development.
 
May 6, 2008 Interim Final Rule.  On May 6, 2008, CMS published an interim final rule with comment period, which implemented portions of the SCHIP Extension Act. The May 6, 2008 interim final rule addressed: (1) the payment adjustment for very short-stay outliers, (2) the standard federal rate for the last three months of RY 2008, (3) adjustment of the high cost outlier fixed-loss amount for the last three months of RY 2008, and (4) made references to the SCHIP Extension Act in the discussion of the basis and scope of the LTCH-PPS rules.
 
May 9, 2008 Final Rule.  On May 9, 2008, CMS published its annual payment rate update for the 2009 LTCH-PPS rate year, or “RY 2009” (affecting discharges and cost reporting periods beginning on or after July 1, 2008). The final rule adopted a 15-month rate update, from July 1, 2008 through September 30, 2009 and moved LTCH-PPS from a July-June update cycle to the same update cycle as the general acute care hospital inpatient rule (October — September). For RY 2009, the rule established a 2.7% update to the standard federal rate. The rule increased the fixed-loss amount for high cost outlier cases to $22,960, which was $2,222 higher than the 2008 LTCH-PPS rate year. The final rule provided that CMS may make a one-time reduction in the LTCH-PPS rates to reflect a budget neutrality adjustment no earlier than December 29, 2010 and no later than October 1, 2012. CMS estimated this reduction will be approximately 3.75%.
 
May 22, 2008 Interim Final Rule.  On May 22, 2008, CMS published an interim final rule with comment period, which implemented portions of the SCHIP Extension Act not addressed in the May 6, 2008 interim final rule. Among other things, the May 22, 2008 interim final rule established a definition for “free-standing” LTCHs as a hospital that: (1) has a Medicare provider agreement, (2) has an average length of stay of greater than 25 days, (3) does not occupy space in a building used by another hospital, (4) does not occupy space in one or more separate


54


Table of Contents

or entire buildings located on the same campus as buildings used by another hospital and (5) is not part of a hospital that provides inpatient services in a building also used by another hospital.
 
August 2008 Final Rule.  On August 19, 2008, CMS published the IPPS final rule for FY 2009 (affecting discharges and cost reports beginning on or after October 1, 2008 and before October 1, 2009), which made limited revisions to the classifications of cases in MS-LTC-DRGs. The final rule also included a number of hospital ownership and physician referral provisions, including expansion of a hospital’s disclosure obligations by requiring physician-owned hospitals to disclose ownership or investment interests held by immediate family members of a referring physician. The final rule requires physician-owned hospitals to furnish to patients, on request, a list of physicians or immediate family members who own or invest in the hospital. Moreover, a physician-owned hospital must require all physician owners or investors who are also active members of the hospital’s medical staff to disclose in writing their ownership or investment interests in the hospital to all patients they refer to the hospital. CMS can terminate the Medicare provider agreement of a physician-owned hospital if it fails to comply with these disclosure provisions or with the requirement that a hospital disclose in writing to all patients whether there is a physician on-site at the hospital 24 hours per day, 7 days per week.
 
The American Recovery and Reinvestment Act of 2009.  On February 17, 2009, the President signed into law the ARRA. The ARRA makes several technical corrections to the SCHIP Extension Act, including a clarification that, during the moratorium period established by the SCHIP Extension Act, the percentage threshold for grandfathered satellites is set at 50% and not phased in to the 25% level for admissions from a co-located hospital. In addition, the ARRA clarifies that the application of the percentage threshold is postponed for LTCH HIHs and satellites that are co-located with provider-based off-campus locations of IPPS hospitals. The ARRA also modified certain delays in the application of the percentage thresholds as originally established in the SCHIP Extension Act. The effective date of the delay in application of the full 25% patient threshold payment adjustment policy is changed from cost reporting periods beginning on or after December 29, 2007 to cost reporting periods beginning on or after July 1, 2007 for freestanding LTCHs and grandfathered HIHs and satellites, and cost reporting periods beginning on or after October 1, 2007 for non-grandfathered LTCH HIHs and satellites.
 
June 3, 2009 Interim Final Rule.  On June 3, 2009, CMS published an interim final rule in which CMS adopted a new table of MS-LTC-DRG relative weights that applied to the remainder of fiscal year 2009 (through September 30, 2009). This interim final rule revised the MS-LTC-DRG relative weights for payment under the LTCH-PPS for FY 2009 due to CMS’s misapplication of its established methodology in the calculation of the budget neutrality factor. This error resulted in relative weights that are higher, by approximately 3.9% for all of FY 2009 (October 1, 2008 through September 30, 2009) which has the effect of reducing reimbursement by approximately 3.9%. However, CMS only applied the corrected weights to the remainder of fiscal year 2009 (that is, from June 3, 2009 through September 30, 2009).
 
July 31, 2009 Final Rule.  On July 31, 2009, CMS released its annual payment rate update for the LTCH-PPS for “FY 2010” (affecting discharges and cost reporting periods beginning on or after October 1, 2009 and before September 30, 2010). For FY 2010 CMS adopted a 2.5% increase in payments under the LTCH-PPS. As a result, the standard federal rate for FY 2010 is set at $39,896.65, an increase from $39,114.36 in FY 2009. The increase in the standard federal rate uses a 2.0% update factor based on the market basket update of 2.5% less an adjustment of 0.5% to account for changes in documentation and coding practices. The fixed loss amount for high cost outlier cases is set at $18,425. This is a decrease from the fixed loss amount in the 2009 rate year of $22,960.
 
The July 31, 2009 annual payment rate update also included an interim final rule with comment period implementing provisions of the ARRA discussed above, including amendments to provisions of the SCHIP Extension Act relating to payments to LTCHs and LTCH satellite facilities and increases in beds in existing LTCHs and LTCH satellite facilities under the LTCH-PPS.
 
In the same federal register, CMS finalized three interim final rules with comment period that it previously published but had yet to respond to public comment. First, CMS finalized the June 3, 2009 interim final rule that adopted a new table of MS-LTC-DRG relative weights for the period between June 3, 2009 and September 30, 2009. Second, CMS finalized the May 6, 2008 interim final rule that implemented changes to LTCH-PPS mandated by the SCHIP Extension Act addressing: (1) payment adjustments for certain short-stay outliers, (2) the federal standard rate for the last three months of rate year 2008, and (3) adjustment of the high cost outlier fixed-loss amount. Finally,


55


Table of Contents

CMS finalized the May 22, 2008 interim final rule that implemented changes to LTCH-PPS mandated by the SCHIP Extension Act modifying the percentage threshold policy for certain LTCHs and addressing the three-year moratorium on the establishment of new LTCHs and bed increases at existing LTCHs and LTCH satellites.
 
The SCHIP Extension Act, as amended by the ARRA, among other things, limited the application of the Medicare admission threshold on HIHs in existence on October 1, 2004 to no lower than 50% (subject to exceptions for rural and MSA dominant hospitals) for a three year period to commence on an LTCH’s first cost reporting period to begin on or after October 1, 2007, postponed for the three year period beginning on December 29, 2007 the SSO policy changes made in the May 2007 final rule and postponed the application of the percentage threshold to all free-standing and grandfathered HIHs for a three year period commencing on an LTCH’s first cost reporting period on or after July 1, 2007. The ARRA further limited application of the admissions threshold to no more than 50% of Medicare admissions to grandfathered satellites from a co-located hospital for a three year period commencing on the first cost reporting period beginning on or after July 1, 2007. If the May 2004 final rules and May 2007 final rules become effective as currently written after the expiration of the applicable provisions of the SCHIP Extension Act and the ARRA, these regulatory changes will collectively cause an adverse effect on our operating revenues and profitability in 2011 and beyond, which adverse effect could be partially mitigated if we are able to implement certain operational changes. However, the effect of these changes in 2010 will not be significant.
 
Medicare Reimbursement of Inpatient Rehabilitation Facility Services
 
The following is a summary of significant changes to the Medicare prospective payment system for inpatient rehabilitation facilities or “IRF-PPS” during 2008 and 2009.
 
August 2008 Final Rule.  On August 8, 2008, CMS published the final rule for the inpatient rehabilitation facility prospective payment system (“IRF-PPS”) for FY 2009. The final rule included changes to the IRF-PPS regulations designed to implement portions of the SCHIP Extension Act. In particular, the patient classification criteria compliance threshold was established at 60% (with comorbidities counting toward this threshold). In addition to updating the various values that compose the IRF-PPS, the final rule updated the outlier threshold amount to $10,250 from $7,362 for fiscal year 2008.
 
July 31, 2009 Final Rule.  On July 31, 2009, CMS released its final rule establishing the annual payment rate update for the IRF-PPS for FY 2010 (affecting discharges and cost reporting periods beginning on October 1, 2009 through September 30, 2010). The standard federal rate is established at $13,661 for FY 2010, an increase from $12,958 in FY 2009. The proposed outlier threshold amount is set at $10,652, an increase from $10,250 in FY 2009.
 
In the same final rule, CMS adopted new coverage criteria, including requirements for preadmission screening, post-admission evaluations, and individualized treatment planning that emphasize the role of physicians in ordering and overseeing beneficiaries’ IRF care. Among other things, the rule requires IRF services to be ordered by a rehabilitation physician with specialized training and experience in rehabilitation services and be coordinated by an interdisciplinary team meeting the rule’s specifications. The interdisciplinary team must meet weekly to review the patient’s progress and make any needed adjustments to the individualized plan of care. IRFs must use qualified personnel to provide required rehabilitation nursing, physical therapy, occupational therapy, speech-language pathology, social services, psychological services, and prosthetic and orthotic services (CMS notes that it also is considering adopting specific standards on the use of group therapies at a future date). The rule also includes new documentation requirements, including a requirement that IRFs submit patient assessment data on Medicare Advantage patients.
 
While the final rule’s payment rate updates are effective for IRF discharges on or after October 1, 2009, CMS has adopted a January 1, 2010 effective date for the new coverage requirements to provide facilities more time to comply with the new framework. If we fail to implement the new coverage criteria, claims for our services may be denied in whole or part.


56


Table of Contents

Medicare Reimbursement of Outpatient Rehabilitation Services
 
CMS released the final rule for the 2010 Medicare physician fee schedule on November 25, 2009. The final rule increased the annual per beneficiary cap on outpatient therapy services for 2010 to $1,860 for combined physical therapy and speech language pathology services and $1,860 for occupational therapy services. On March 2, 2010, President Obama signed the Temporary Extension Act of 2010, which extended the exception process through March 31, 2010. The exception process will expire on April 1, 2010 unless further extended by Congress. There can be no assurance that Congress will extend it further. Failure to extend the exception process may reduce our future net operating revenues and profitability.
 
The Medicare program reimburses outpatient rehabilitation providers based on the Medicare physician fee schedule. The Medicare physician fee schedule rates are automatically updated annually based on a formula, called the sustainable growth rate (“SGR”) formula, contained in legislation. The SGR formula has resulted in automatic reductions in rates in every year since 2002; however, for each year through 2009 CMS or Congress has taken action to prevent the SGR formula reductions. On December 19, 2009, President Obama signed the Department of Defense Appropriations Act, 2010 into law, which delayed until March 1, 2010 the payment reductions for 2010 required by the SGR formula. The Temporary Extension Act of 2010 further delayed the scheduled reduction in Medicare payment until March 31, 2010. Congress is now considering several proposals to delay the payment cut further or to replace the SGR formula with another methodology for setting Medicare physician payment rates. We cannot predict what actions, if any, Congress or CMS may take with respect to the Medicare physician fee schedule update. If no further legislation is passed by Congress and signed by the President, the SGR formula will reduce our Medicare outpatient rehabilitation payment rates by approximately 21.2% beginning April 1, 2010. For the year ended December 31, 2009, we received approximately 9.7% of our outpatient rehabilitation net operating revenues from Medicare.
 
Professional Licensure and Corporate Practice
 
Healthcare professionals at our hospitals and outpatient rehabilitation clinics are required to be individually licensed or certified under applicable state law. We take steps to ensure that our employees and agents possess all necessary licenses and certifications.
 
Some states prohibit the “corporate practice of therapy” so that business corporations such as ours are restricted from practicing therapy through the direct employment of therapists. The laws relating to corporate practice vary from state to state, and are not fully developed in each state in which we have clinics. We believe that each of our outpatient therapy clinics complies with any current corporate practice prohibition of the state in which it is located. For example, in those states that apply the corporate practice prohibition, we either contract to obtain therapy services from an entity permitted to employ therapists or we manage the physical therapy practice owned by licensed therapists through which the therapy services are provided. However, in those states where we furnish our services through business corporations, future interpretations of the corporate practice prohibition, enactment of new legislation or adoption of new regulations could have a material adverse effect on the business and operations of our outpatient therapy clinics. If new legislation, regulations or interpretations establish that our clinics do not comply with state corporate practice prohibition, we could be subject to civil, and perhaps criminal, penalties, and may be required to restructure our business operations or close our clinics in any such state.
 
Facility Licensure, Certification and Accreditation
 
Our hospitals and outpatient rehabilitation clinics are subject to extensive and changing federal, state and local regulations and private accreditation standards. Hospitals are required to comply with state hospital standards setting requirements related to patient rights, composition and responsibilities of the hospital governing body, medical staff, quality improvement, infection control, nursing services, food and nutrition, medical records, drug distribution, diagnostic and treatment services, surgical services, emergency services and social work. Our hospitals are also required to meet conditions of participation under Medicare programs in order to qualify to receive reimbursement under these programs. In addition, many of our hospitals and outpatient rehabilitation clinics are accredited by The Joint Commission by voluntarily complying with a specific set of accreditation standards.


57


Table of Contents

Our hospitals and outpatient rehabilitation clinics are subject to inspections, surveys and other reviews by governmental and private regulatory authorities, not only at scheduled intervals but also in response to complaints from patients and others. While our hospitals and outpatient rehabilitation clinics intend to comply with existing licensing, Medicare certification requirements and accreditation standards, there can be no assurance that regulatory authorities will determine that all applicable requirements are fully met at any given time. A determination by an applicable regulatory authority that a facility is not in compliance with these requirements could lead to the imposition of requirements that the facility takes corrective action, assessment of fines and penalties or loss of licensure, Medicare certification or accreditation. These consequences could have a material adverse effect on the Company.
 
Federal Healthcare Reform Proposals
 
Healthcare is one of the largest industries in the United States and continues to attract much legislative interest and public attention. Comprehensive national healthcare reform is currently a focus at the federal level. In the final months of 2009, both houses of the U.S. Congress passed different versions of comprehensive healthcare reform legislation. Both versions of the legislation would require most individuals to have health insurance coverage, and would aim to promote quality and cost efficiency in healthcare delivery and budgetary savings in the Medicare program. On March 3, 2010, President Obama announced that he would seek passage of healthcare reform legislation with certain changes. While no comprehensive healthcare reform legislation has yet become law, we anticipate that Congress will continue to consider legislative changes, either as part of comprehensive healthcare reform or separately, that could affect our business.
 
Legislative changes that have been discussed as part of healthcare reform have included, among other things, calls for bundled payments to hospitals that would cover not just the hospitalization, but care from certain post-acute providers for the 30 days after the hospitalization. A significant portion of the services furnished by our specialty hospitals and outpatient rehabilitation clinics are to patients discharged from acute care hospitals. Therefore, the proposal to bundle payments to hospitals could have a material impact on volume of referrals to our facilities by acute care hospitals and the payment rates that we receive for our services. Other proposed legislative changes have included negative adjustments to the annual market basket updates for the Medicare long term care hospital and inpatient rehabilitation payment systems, penalties for hospital readmissions, value-based purchasing and enhanced efforts to curb fraud and abuse, including by implementing additional prepayment reviews. There has also been discussion of establishing an Independent Medicare Advisory Board charged with presenting proposals to Congress to reduce Medicare expenditures when such expenditures exceed specified levels.
 
Healthcare reform legislation passed by the U.S. Senate in 2009 contained a temporary extension of policies adopted in the SCHIP Extension Act, including extending relief from certain LTCH-PPS payment policies and extending the moratorium on the establishment and classification of new LTCHs and LTCH beds. The healthcare reform legislation passed by the U.S. House of Representatives in 2009 did not contain a similar extension. It is uncertain whether both houses of Congress will enact healthcare reform legislation or other legislation that includes an extension of the policies adopted in the SCHIP Extension Act.
 
At this time we are unable to predict what action Congress or the President might take with respect to comprehensive healthcare reform or other legislation affecting healthcare, or the impact of any such legislation on our revenues, operating costs, results of operations or cash flows.
 
Development of New Specialty Hospitals and Clinics
 
In addition to the growth of our business through the acquisition and integration of other businesses, we have also grown our business through specialty hospital and outpatient rehabilitation facility development opportunities. Since our inception in 1997 through December 31, 2009, we have internally developed 62 specialty hospitals and 276 outpatient rehabilitation facilities. As a result of the SCHIP Extension Act however, which has a three year moratorium on the development of new LTCHs, we have stopped all new LTCH development. In addition, we will continue to evaluate opportunities to develop new joint venture relationships with significant health systems, and from time to time we may also develop new inpatient rehabilitation hospitals. The moratorium will not, however, apply to LTCHs acquired by us in the future so long as those LTCHs were in existence prior to December 29, 2007.


58


Table of Contents

We also intend to open new outpatient rehabilitation clinics in the local areas that we currently serve where we can benefit from existing referral relationships and brand awareness to produce incremental growth.
 
Critical Accounting Matters
 
Sources of Revenue
 
Our net operating revenues are derived from a number of sources, including commercial, managed care, private and governmental payors. Our net operating revenues include amounts estimated by management to be reimbursable from each of the applicable payors and the federal Medicare program. Amounts we receive for treatment of patients are generally less than the standard billing rates. We account for the differences between the estimated reimbursement rates and the standard billing rates as contractual adjustments, which we deduct from gross revenues to arrive at net operating revenues.
 
Net operating revenues generated directly from the Medicare program from all segments represented approximately 47%, 46% and 48% of net operating revenues for the years ended December 31, 2009, 2008 and 2007, respectively. Approximately 63%, 63% and 65% of our specialty hospital revenues for the years ended December 31, 2009, 2008 and 2007, respectively, were received for services provided to Medicare patients.
 
Most of our specialty hospitals receive bi-weekly periodic interim payments from Medicare instead of being paid on an individual claim basis. Under a periodic interim payment methodology, Medicare estimates a hospital’s claim volume based on historical trends and makes bi-weekly interim payments to us based on these estimates. Twice a year per hospital, Medicare reconciles the differences between the actual claim data and the estimated payments. To the extent our actual hospital’s experience is different from the historical trends used by Medicare to develop the estimate, the periodic interim payment will result in our being either temporarily over-paid or under-paid for our Medicare claims. At each balance sheet date, we record any aggregate under-payment as an account receivable or any aggregate over-payment as a payable to third-party payors on our balance sheet. The timing of receipt of bi-weekly periodic interim payments can have an impact on our accounts receivable balance and our days sales outstanding as of the end of any reporting period.
 
Contractual Adjustments
 
Net operating revenues include amounts estimated by us to be reimbursable by Medicare and Medicaid under prospective payment systems and provisions of cost-reimbursement and other payment methods. In addition, we are reimbursed by non-governmental payors using a variety of payment methodologies. Amounts we receive for treatment of patients covered by these programs are generally less than the standard billing rates. Contractual allowances are calculated and recorded through our internally developed systems. In our specialty hospital segment our billing system automatically calculates estimated Medicare reimbursement and associated contractual allowances. For non-governmental payors in our specialty hospital segment, we manually calculate the contractual allowance for each patient based upon the contractual provisions associated with the specific payor. In our outpatient segment, we perform provision testing, using internally developed systems, whereby we monitor a payors’ historical paid claims data and compare it against the associated gross charges. This difference is determined as a percentage of gross charges and is applied against gross billing revenue to determine the contractual allowances for the period. Additionally, these contractual percentages are applied against the gross receivables on the balance sheet to determine that adequate contractual reserves are maintained for the gross accounts receivables reported on the balance sheet. We account for any difference as additional contractual adjustments deducted from gross revenues to arrive at net operating revenues in the period that the difference is determined. We believe the processes described above and used in recording our contractual adjustments have resulted in reasonable estimates determined on a consistent basis.
 
Allowance for Doubtful Accounts
 
Substantially all of our accounts receivable are related to providing healthcare services to patients. Collection of these accounts receivable is our primary source of cash and is critical to our operating performance. Our primary collection risks relate to non-governmental payors who insure these patients, and deductibles, co-payments and self-insured amounts owed by the patient. Deductibles, co-payments and self-insured amounts are an immaterial


59


Table of Contents

portion of our net accounts receivable balance. At December 31, 2009, deductibles, co-payments and self-insured amounts owed by the patient accounted for approximately 0.5% of our net accounts receivable balance before doubtful accounts. Our general policy is to verify insurance coverage prior to the date of admission for a patient admitted to our hospitals or in the case of our outpatient rehabilitation clinics, we verify insurance coverage prior to their first therapy visit. Our estimate for the allowance for doubtful accounts is calculated by providing a reserve allowance based upon the age of an account balance. Generally we reserve as uncollectible all governmental accounts over 365 days and non-governmental accounts over 180 days from discharge. This method is monitored based on our historical cash collections experience. Collections are impacted by the effectiveness of our collection efforts with non-governmental payors and regulatory or administrative disruptions with the fiscal intermediaries that pay our governmental receivables.
 
We estimate bad debts for total accounts receivable within each of our operating units. We believe our policies have resulted in reasonable estimates determined on a consistent basis. We believe that we collect substantially all of our third-party insured receivables (net of contractual allowances) which include receivables from governmental agencies. To date, we believe there has not been a material difference between our bad debt allowances and the ultimate historical collection rates on accounts receivable. We review our overall reserve adequacy by monitoring historical cash collections as a percentage of net revenue less the provision for bad debts. Uncollected accounts are written off the balance sheet when they are turned over to an outside collection agency, or when management determines that the balance is uncollectible, whichever occurs first.
 
The following table is an aging of our net (after allowances for contractual adjustments but before doubtful accounts) accounts receivable (in thousands):
 
                                   
    Balance as of December 31,  
    2008       2009  
          Over 90
            Over 90
 
    0-90 Days     Days       0-90 Days     Days  
Medicare and Medicaid
  $ 101,687     $ 12,780       $ 117,991     $ 8,307  
Commercial insurance, and other
    186,200       68,803         176,195       47,943  
                                   
Total net accounts receivable
  $ 287,887     $ 81,583       $ 294,186     $ 56,250  
                                   
 
The approximate percentage of total net accounts receivable (after allowance for contractual adjustments but before doubtful accounts) summarized by aging categories is as follows:
 
                   
    As of December 31,
    2008     2009
0 to 90 days
    77.9 %       83.9 %
91 to 180 days
    8.8 %       6.6 %
181 to 365 days
    6.7 %       4.7 %
Over 365 days
    6.6 %       4.8 %
                   
Total
    100.0 %       100.0 %
                   
 
The approximate percentage of total net accounts receivable (after allowance for contractual adjustments but before doubtful accounts) summarized by insured status is as follows:
 
                   
    As of December 31,
    2008     2009
Government payors and insured receivables
    99.7 %       99.5 %
Self-pay receivables (including deductible and co-payments)
    0.3 %       0.5 %
                   
Total
    100.0 %       100.0 %
                   


60


Table of Contents

Insurance
 
Under a number of our insurance programs, which include our employee health insurance program and certain components under our property and casualty insurance program, we are liable for a portion of our losses. In these cases we accrue for our losses under an occurrence based principle whereby we estimate the losses that will be incurred by us in a given accounting period and accrue that estimated liability. Where we have substantial exposure, we utilize actuarial methods in estimating the losses. In cases where we have minimal exposure, we will estimate our losses by analyzing historical trends. We monitor these programs quarterly and revise our estimates as necessary to take into account additional information. At December 31, 2009 and December 31, 2008, we have recorded a liability of $60.8 million and $62.9 million, respectively, for our estimated losses under these insurance programs.
 
Related Party Transactions
 
We are party to various rental and other agreements with companies affiliated with us through common ownership. Our payments to these related parties amounted to $4.0 million and $3.3 million for the years ended December 31, 2009 and 2008, respectively. Our future commitments are related to commercial office space we lease for our corporate headquarters in Mechanicsburg, Pennsylvania. These future commitments as of December 31, 2009 amount to $45.6 million through 2023. These transactions and commitments are described more fully in the notes to our consolidated financial statements included herein. The Company’s practice is that any such transaction must receive the prior approval of both the audit and compliance committee and a majority of non-interested members of the Board of Directors. In addition, it is the Company’s practice that, prior to any related party transaction for the lease of office space, that an independent third-party appraisal is obtained that supports the amount of rent that the Company is obligated to pay for such leased space.
 
Goodwill and Other Intangible Assets
 
Goodwill and certain other indefinite-lived intangible assets are subject to periodic impairment evaluations. Our most recent impairment assessment was completed during the fourth quarter of 2009, which indicated that there was no impairment with respect to goodwill or other recorded intangible assets. The majority of our goodwill resides in our specialty hospital reporting unit. In performing periodic impairment tests, the fair value of the reporting unit is compared to the carrying value, including goodwill and other intangible assets. If the carrying value exceeds the fair value, an impairment condition exists, which results in an impairment loss equal to the excess carrying value. Impairment tests are required to be conducted at least annually, or when events or conditions occur that might suggest a possible impairment. These events or conditions include, but are not limited to, a significant adverse change in the business environment, regulatory environment or legal factors; a current period operating or cash flow loss combined with a history of such losses or a projection of continuing losses; or a sale or disposition of a significant portion of a reporting unit. The occurrence of one of these events or conditions could significantly impact an impairment assessment, necessitating an impairment charge and adversely affecting our results of operations. For purposes of goodwill impairment assessment, we have defined our reporting units as specialty hospitals, outpatient rehabilitation clinics and contract therapy with goodwill having been allocated among reporting units based on the relative fair value of those divisions when the Merger occurred in 2005 and based on subsequent acquisitions.
 
To determine the fair value of our reporting units, we use a discounted cash flow approach. Included in the discounted cash flow are assumptions regarding revenue growth rates, internal development of specialty hospitals and rehabilitation clinics, future EBITDA margin estimates, future selling, general and administrative expense rates and the weighted average cost of capital for our industry. We also must estimate residual values at the end of the forecast period and future capital expenditure requirements. Each of these assumptions requires us to use our knowledge of (1) our industry, (2) our recent transactions, and (3) reasonable performance expectations for our operations. If any one of the above assumptions changes or fails to materialize, the resulting decline in our estimated fair value could result in a material impairment charge to the goodwill associated with any one of the reporting units.


61


Table of Contents

Realization of Deferred Tax Assets
 
Deferred tax assets and liabilities are required to be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Deferred tax assets are also required to be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. As part of the process of preparing our consolidated financial statements, we estimate our income taxes based on our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. We also recognize as deferred tax assets the future tax benefits from net operating loss carry forwards. We evaluate the realizability of these deferred tax assets by assessing their valuation allowances and by adjusting the amount of such allowances, if necessary. Among the factors used to assess the likelihood of realization are our projections of future taxable income streams, the expected timing of the reversals of existing temporary differences, and the impact of tax planning strategies that could be implemented to avoid the potential loss of future tax benefits. However, changes in tax codes, statutory tax rates or future taxable income levels could materially impact our valuation of tax accruals and assets and could cause our provision for income taxes to vary significantly from period to period.
 
At December 31, 2009, we had deferred tax assets in excess of deferred tax liabilities of approximately $18.2 million for both Holdings and Select. This amount is net of approximately $22.4 million of valuation reserves related primarily to state and federal tax net operating losses that may not be realized at December 31, 2009.
 
Uncertain Tax Positions
 
We record and review quarterly our uncertain tax positions. Reserves for uncertain tax positions are established for exposure items related to various federal and state tax matters. Income tax reserves are recorded when an exposure is identified and when, in the opinion of management, it is more likely than not that a tax position will not be sustained and the amount of the liability can be estimated. While we believe that our reserves for uncertain tax positions are adequate, the settlement of any such exposures at amounts that differ from current reserves may require us to materially increase or decrease our reserves for uncertain tax positions.
 
Stock Based Compensation
 
Determining the fair value of our stock requires making complex and subjective judgments. Our approach to valuation is based on a discounted future cash flow approach that uses our estimates of revenue and estimated costs as well as discount rates determined by analyzing comparable companies and industry capital structures. These estimates are consistent with the plans and estimates that we use to manage the business. The fair value of the common stock has generally been determined contemporaneously with the grants. There is inherent uncertainty in making these estimates.


62


Table of Contents

Operating Statistics
 
The following tables set forth operating statistics for our specialty hospitals and our outpatient rehabilitation clinics for each of the periods presented. The data in the tables reflect the changes in the number of specialty hospitals and outpatient rehabilitation clinics we operate that resulted from acquisitions, start-up activities, closures, sales and consolidations. The operating statistics reflect data for the period of time these operations were managed by us.
 
                         
    Year Ended
    Year Ended
    Year Ended
 
    December 31,
    December 31,
    December 31,
 
    2007     2008     2009  
 
Specialty hospital data(1):
                       
Number of hospitals — start of period
    96       87       93  
Number of hospital start-ups
    3       7       1  
Number of hospitals acquired
          2       2  
Number of hospitals closed/sold
    (8 )     (1 )     (2 )
Number of hospitals consolidated
    (4 )     (2 )      
                         
Number of hospitals owned — end of period
    87       93       94  
Number of hospitals managed — end of period
                1  
                         
Total hospitals (all) — end of period
    87       93       95  
                         
Available licensed beds
    3,819       4,222       4,233  
Admissions
    40,008       41,177       42,674  
Patient days
    987,624       1,005,719       1,015,500  
Average length of stay (days)
    25       24       24  
Net revenue per patient day(2)
  $ 1,378     $ 1,453     $ 1,507  
Occupancy rate
    69 %     67 %     67 %
Percent patient days — Medicare
    69 %     65 %     64 %
Outpatient rehabilitation data:
                       
Number of clinics owned — start of period
    477       918       880  
Number of clinics acquired
    570       4       24  
Number of clinic start-ups
    15       17       13  
Number of clinics closed/sold(3)
    (144 )     (59 )     (34 )
                         
Number of clinics owned — end of period
    918       880       883  
Number of clinics managed — end of period
    81       76       78  
                         
Total number of clinics (all) — end of period
    999       956       961  
                         
Number of visits
    4,032,197       4,533,727       4,502,049  
Net revenue per visit(4)
  $ 100     $ 102     $ 102  
 
 
(1) Specialty hospitals consist of long term acute care hospitals and inpatient rehabilitation facilities.
(2) Net revenue per patient day is calculated by dividing specialty hospital patient service revenues by the total number of patient days.
(3) The number of clinics closed/sold for the year ended December 31, 2007 relate primarily to clinics closed in connection with the restructuring plan for integrating the acquisition of HealthSouth Corporation’s outpatient rehabilitation division.
(4) Net revenue per visit is calculated by dividing outpatient rehabilitation clinic revenue by the total number of visits. For purposes of this computation, outpatient rehabilitation clinic revenue does not include contract services revenue.


63


Table of Contents

 
Results of Operations
 
The following table outlines, for the periods indicated, selected operating data as a percentage of net operating revenues:
 
                         
    Select Medical Holdings Corporation
    Year
  Year
  Year
    Ended
  Ended
  Ended
    December 31,
  December 31,
  December 31,
    2007   2008   2009
 
Net operating revenues
    100.0 %     100.0 %     100.0 %
Cost of services(1)
    83.3       83.2       81.3  
General and administrative
    2.2       2.2       3.2  
Bad debt expense
    1.9       2.2       1.8  
Depreciation and amortization
    2.9       3.3       3.2  
                         
Income from operations
    9.7       9.1       10.5  
Gain on early retirement of debt
          0.0       0.6  
Other expense
    0.0             (0.0 )
Interest expense, net
    (6.9 )     (6.7 )     (5.9 )
                         
Income from continuing operations before income taxes
    2.8       2.4       5.2  
Income tax expense
    0.9       1.2       1.7  
                         
Net income
    1.9       1.2       3.5  
Net income attributable to non-controlling interests
    0.1       0.2       0.2  
                         
Net income attributable to the Holdings
    1.8 %     1.0 %     3.3 %
                         
 
                         
    Select Medical Corporation
    Year
  Year
  Year
    Ended
  Ended
  Ended
    December 31,
  December 31,
  December 31,
    2007   2008   2009
 
Net operating revenues
    100.0 %     100.0 %     100.0 %
Cost of services(1)
    83.3       83.2       81.3  
General and administrative
    2.2       2.2       3.2  
Bad debt expense
    1.9       2.2       1.8  
Depreciation and amortization
    2.9       3.3       3.2  
                         
Income from operations
    9.7       9.1       10.5  
Gain on early retirement of debt
          0.0       0.6  
Other income (expense)
    (0.2 )     (0.1 )     0.1  
Interest expense, net
    (5.2 )     (5.1 )     (4.4 )
                         
Income from continuing operations before income taxes
    4.3       3.9       6.8  
Income tax expense
    1.4       1.7       2.2  
                         
Net income
    2.9       2.2       4.6  
Net income attributable to non-controlling interests
    0.1       0.2       0.2  
                         
Net income attributable to Select
    2.8 %     2.0 %     4.4 %
                         


64


Table of Contents

The following tables summarize selected financial data by business segment, for the periods indicated:
 
                                         
    Select Medical Holdings Corporation  
                      %
    %
 
    Year Ended
    Year Ended
    Year Ended
    Change
    Change
 
    December 31,
    December 31,
    December 31,
    2007-
    2008-
 
    2007     2008     2009     2008     2009  
    (In thousands)  
 
Net operating revenues:
                                       
Specialty hospitals
  $ 1,386,410     $ 1,488,412     $ 1,557,821       7.4 %     4.7 %
Outpatient rehabilitation
    603,413       664,760       681,892       10.2       2.6  
Other(3)
    1,843       190       158       (89.7 )     (16.8 )
                                         
Total company
  $ 1,991,666     $ 2,153,362     $ 2,239,871       8.1 %     4.0 %
                                         
Income (loss) from operations:
                                       
Specialty hospitals
  $ 180,090     $ 192,450     $ 247,891       6.9 %     28.8 %
Outpatient rehabilitation
    57,979       52,964       64,109       (8.6 )     21.0  
Other(3)
    (44,184 )     (49,006 )     (76,162 )     (10.9 )     (55.4 )
                                         
Total company
  $ 193,885     $ 196,408     $ 235,838       1.3 %     20.1 %
                                         
Adjusted EBITDA:(2)
                                       
Specialty hospitals
  $ 217,175     $ 236,388     $ 290,370       8.8 %     22.8 %
Outpatient rehabilitation
    75,437       77,279       89,072       2.4       15.3  
Other(3)
    (37,684 )     (43,380 )     (49,215 )     (15.1 )     (13.5 )
Adjusted EBITDA margins:(2)
                                       
Specialty hospitals
    15.7 %     15.9 %     18.6 %     1.3 %     17.0 %
Outpatient rehabilitation
    12.5       11.6       13.1       (7.2 )     12.9  
Other(3):
    N/M       N/M       N/M       N/M       N/M  
Total assets:
                                       
Specialty hospitals
  $ 1,882,476     $ 1,910,402     $ 1,944,677                  
Outpatient rehabilitation
    513,397       504,869       499,603                  
Other(3)
    99,173       164,198       157,953                  
                                         
Total company
  $ 2,495,046     $ 2,579,469     $ 2,602,233                  
                                         
Purchases of property and equipment, net:
                                       
Specialty hospitals
  $ 146,901     $ 40,069     $ 46,452                  
Outpatient rehabilitation
    14,737       13,271       9,940                  
Other(3)
    4,436       3,164       1,485                  
                                         
Total company
  $ 166,074     $ 56,504     $ 57,877                  
                                         
 


65


Table of Contents

                                         
    Select Medical Corporation  
                      %
    %
 
    Year Ended
    Year Ended
    Year Ended
    Change
    Change
 
    December 31,
    December 31,
    December 31,
    2007-
    2008-
 
    2007     2008     2009     2008     2009  
    (In thousands)  
 
Net operating revenues:
                                       
Specialty hospitals
  $ 1,386,410     $ 1,488,412     $ 1,557,821       7.4 %     4.7 %
Outpatient rehabilitation
    603,413       664,760       681,892       10.2       2.6  
Other(3)
    1,843       190       158       (89.7 )     (16.8 )
                                         
Total company
  $ 1,991,666     $ 2,153,362     $ 2,239,871       8.1 %     4.0 %
                                         
Income (loss) from operations:
                                       
Specialty hospitals
  $ 180,090     $ 192,450     $ 247,891       6.9 %     28.8 %
Outpatient rehabilitation
    57,979       52,964       64,109       (8.6 )     21.0  
Other(3)
    (44,184 )     (49,006 )     (76,162 )     (10.9 )     (55.4 )
                                         
Total company
  $ 193,885     $ 196,408     $ 235,838       1.3 %     20.1 %
                                         
Adjusted EBITDA:(2)
                                       
Specialty hospitals
  $ 217,175     $ 236,388     $ 290,370       8.8 %     22.8 %
Outpatient rehabilitation
    75,437       77,279       89,072       2.4       15.3  
Other(3)
    (37,684 )     (43,380 )     (49,215 )     (15.1 )     (13.5 )
Adjusted EBITDA margins:(2)
                                       
Specialty hospitals
    15.7 %     15.9 %     18.6 %     1.3 %     17.0 %
Outpatient rehabilitation
    12.5       11.6       13.1       (7.2 )     12.9  
Other(3):
    N/M       N/M       N/M       N/M       N/M  
Total assets:
                                       
Specialty hospitals
  $ 1,882,476     $ 1,910,402     $ 1,944,677                  
Outpatient rehabilitation
    513,397       504,869       499,603                  
Other(3)
    94,904       147,154       154,899                  
                                         
Total company
  $ 2,490,777     $ 2,562,425     $ 2,599,179                  
                                         
Purchases of property and equipment, net:
                                       
Specialty hospitals
  $ 146,901     $ 40,069     $ 46,452                  
Outpatient rehabilitation
    14,737       13,271       9,940                  
Other(3)
    4,436       3,164       1,485                  
                                         
Total company
  $ 166,074     $ 56,504     $ 57,877                  
                                         

66


Table of Contents

The following tables reconcile same hospitals information:
 
                 
    Year Ended
 
    December 31,  
    2007     2008  
    (In thousands)  
 
Net operating revenue
               
Specialty hospitals net operating revenue
  $ 1,386,410     $ 1,488,412  
Less: Specialty hospitals in development, opened or closed after 1/1/07
    79,500       85,709  
                 
Specialty hospitals same store net operating revenue
  $ 1,306,910     $ 1,402,703  
                 
Adjusted EBITDA(2)
               
Specialty hospitals Adjusted EBITDA(2)
  $ 217,175     $ 236,388  
Less: Specialty hospitals in development, opened or closed after 1/1/07
    (10,928 )     (21,339 )
                 
Specialty hospitals same store Adjusted EBITDA(2)
  $ 228,103     $ 257,727  
                 
All specialty hospitals Adjusted EBITDA margin(2)
    15.7 %     15.9 %
Specialty hospitals same store Adjusted EBITDA margin(2)
    17.5 %     18.4 %
 
                 
    Year Ended
 
    December 31,  
    2008     2009  
    (In thousands)  
 
Net operating revenue
               
Specialty hospitals net operating revenue
  $ 1,488,412     $ 1,557,821  
Less: Specialty hospitals in development, opened or closed after 1/1/08
    56,363       108,806  
                 
Specialty hospitals same store net operating revenue
  $ 1,432,049     $ 1,449,015  
                 
Adjusted EBITDA(2)
               
Specialty hospitals Adjusted EBITDA(2)
  $ 236,388     $ 290,370  
Less: Specialty hospitals in development, opened or closed after 1/1/08
    (24,305 )     (1,452 )
                 
Specialty hospitals same store Adjusted EBITDA(2)
  $ 260,691     $ 291,822  
                 
All specialty hospitals Adjusted EBITDA margin(2)
    15.9 %     18.6 %
Specialty hospitals same store Adjusted EBITDA margin(2)
    18.2 %     20.1 %
 
N/M — Not Meaningful.
 
(1) Cost of services includes salaries, wages and benefits, operating supplies, lease and rent expense and other operating costs.
(2) We define Adjusted EBITDA as net income before interest, income taxes, depreciation and amortization, gain (loss) on early retirement of debt, stock compensation expense, other income (expense), long term incentive compensation and non-controlling interest. We believe that the presentation of Adjusted EBITDA is important to investors because Adjusted EBITDA is commonly used as an analytical indicator of performance by investors within the healthcare industry. Adjusted EBITDA is used by management to evaluate financial performance and determine resource allocation for each of our operating units. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles. Items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows


67


Table of Contents

generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Because Adjusted EBITDA is not a measurement determined in accordance with generally accepted accounting principles and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. See Note 13 to our audited consolidated financial statements for a reconciliation of net income to Adjusted EBITDA as utilized by us in reporting our segment performance.
(3) Other includes our general and administrative services and non-healthcare services.
 
Year Ended December 31, 2009 Compared to Year Ended December 31, 2008
 
In the following discussion, we address the results of operations of Select and Holdings. With the exception of incremental interest expense, gain on early retirement of debt and income taxes, the results of operations of Holdings are identical to those of Select. Therefore, discussion related to net operating revenue, operating expenses, Adjusted EBITDA, income from operations and non-controlling interest is identical for Holdings and Select.
 
Net Operating Revenues
 
Our net operating revenues increased by 4.0% to $2,239.9 million for the year ended December 31, 2009 compared to $2,153.4 million for the year ended December 31, 2008.
 
Specialty Hospitals.  Our specialty hospital net operating revenues increased by 4.7% to $1,557.8 million for the year ended December 31, 2009 compared to $1,488.4 million for the year ended December 31, 2008. For the year ended December 31, 2009, the hospitals opened in 2008 and 2009 increased net operating revenues by $58.8 million from the prior year and the hospitals acquired in 2008 and 2009 increased net operating revenues by $14.0 million from the prior year. These increases were offset partially by the loss of revenues from hospitals that closed during 2008 and 2009, which accounted for $20.4 million of the difference in net operating revenues between the year ended December 31, 2008 and December 31, 2009. Net operating revenues for the specialty hospitals opened as of January 1, 2008 and operated by us throughout both periods increased by $17.0 million to $1,449.0 million for the year ended December 31, 2009, compared to $1,432.1 million for the year ended December 31, 2008. Our patient days for these same store hospitals decreased 2.1%, which was attributable to a decline in our Medicare patient days. The occupancy percentage in our same store hospitals decreased to 69% for the year ended December 31, 2009 from 70% for the year ended December 31, 2008. The effect on net operating revenues from the decrease in patient days was offset by an increase in our average net revenue per patient day. Our average net revenue per patient day in our same store hospitals increased 3.2% to $1,506 for the year ended December 31, 2009 from $1,459 for the year ended December 31, 2008. This increase in net revenue per patient day was primarily the result of an increase in the Medicare base rate used to determine our discharge based payments and an increase in the case mix index of our patients which adjusts the base rate to compensate us for differences in the severity of the cases we treat.
 
Outpatient Rehabilitation.  Our outpatient rehabilitation net operating revenues increased 2.6% to $681.9 million for the year ended December 31, 2009 compared to $664.8 million for the year ended December 31, 2008. The increase in our outpatient rehabilitation net operating revenues is due to an increase in contracted services based revenue resulting from new business, offset by a reduction in the net operating revenues generated by our outpatient rehabilitation clinics. The number of patient visits in our outpatient rehabilitation clinics decreased 0.7% for the year ended December 31, 2009 to 4,502,049 visits compared to 4,533,727 visits for the year ended December 31, 2008. The decline in visits, which principally occurred during the first quarter of 2009, was the result of various factors in numerous locations where we operate, including staffing shortages and increased competition. Net revenue per visit in our clinics was $102 for both the year ended December 31, 2009 and 2008.
 
Operating Expenses
 
Our operating expenses increased by $47.9 million to $1,933.1 million for the year ended December 31, 2009 compared to $1,885.2 million for the year ended December 31, 2008. The principal component of this increase were compensation costs of $22.0 million that we incurred in connection with our initial public offering of common stock. Our operating expenses include our cost of services, general and administrative expense and bad debt


68


Table of Contents

expense. As a percentage of our net operating revenues, our operating expenses were 86.3% for the year ended December 31, 2009 compared to 87.6% for the year ended December 31, 2008. Our cost of services, a major component of which is labor expense, were $1,819.8 million for the year ended December 31, 2009 compared to $1,791.8 million for the year ended December 31, 2008. This increase in cost of services was principally the result of an increase in costs in our specialty hospital segment. The increase in cost of services we experienced in the specialty hospital segment was due to an increase in patient volume in the hospitals we opened or acquired in 2008 and 2009. Another component of cost of services is facility rent expense, which was $117.1 million for the year ended December 31, 2009 compared to $110.2 million for the year ended December 31, 2008. General and administrative expenses were $72.4 million for the year ended December 31, 2009 compared to $45.5 million for the year ended December 31, 2008. The increase of $26.9 million in general and administrative expense is primarily due to an increase in compensation costs primarily the result of an $18.3 million payment under our Long Term Cash Incentive Plan paid in connection with our initial public offering and $3.7 million in stock compensation expense related to the grant of restricted stock that vested in connection with our initial public offering of common stock. Our bad debt expense as a percentage of net operating revenues declined to 1.8% for the year ended December 31, 2009 compared to 2.2% for the year ended December 31, 2008. The reduction resulted from improved collection activity.
 
Adjusted EBITDA
 
Specialty Hospitals.  Adjusted EBITDA increased by 22.8% to $290.4 million for the year ended December 31, 2009 compared to $236.4 million for the year ended December 31, 2008. Our Adjusted EBITDA margins increased to 18.6% for the year ended December 31, 2009 from 15.9% for the year ended December 31, 2008. The hospitals opened as of January 1, 2008 and operated by us throughout both periods had Adjusted EBITDA of $291.8 million for the year ended December 31, 2009, an increase of $31.1 million or 11.9% over the Adjusted EBITDA of $260.7 million for these hospitals for the year ended December 31, 2008. Our Adjusted EBITDA margin in these same store hospitals increased to 20.1% for the year ended December 31, 2009 from 18.2% for the year ended December 31, 2008. The principal reason for the growth in our Adjusted EBITDA and Adjusted EBITDA margin for these same store hospitals was an increase in our net revenue per patient day due to an increase in the payment rates for our Medicare cases while we controlled our costs related to these cases. We were also able to reduce the bad debt expense in these hospitals, which had the effect of increasing our Adjusted EBITDA and Adjusted EBITDA margin. We also reduced the Adjusted EBITDA losses in our recently opened hospitals. Our hospitals opened during 2008 incurred Adjusted EBITDA losses of $2.0 million for the year ended December 31, 2009 compared to Adjusted EBITDA losses of $22.7 million incurred for the year ended December 31, 2008. We only opened one new hospital in 2009.
 
Outpatient Rehabilitation.  Adjusted EBITDA increased by 15.3% to $89.1 million for the year ended December 31, 2009 compared to $77.3 million for the year ended December 31, 2008. Our Adjusted EBITDA margins increased to 13.1% for the year ended December 31, 2009 from 11.6% for the year ended December 31, 2008. The increase in Adjusted EBITDA was primarily the result of the growth in our contract services business. We also had improvement in our clinic based business, which was the result of improvements in the performance of the outpatient clinics acquired from HealthSouth Corporation.
 
Other.  The Adjusted EBITDA loss was $49.2 million for the year ended December 31, 2009 compared to an Adjusted EBITDA loss of $43.4 million for the year ended December 31, 2008 and is primarily related to our general and administrative expenses. The increase of $5.8 million is principally related to increases in salary related costs.
 
Income from Operations
 
For the year ended December 31, 2009 we experienced income from operations of $235.8 million compared to $196.4 million for the year ended December 31, 2008. The increase in income from operations resulted primarily from the significantly reduced losses at our hospitals opened in 2008 and the improved operating performance at our specialty hospitals opened as of January 1, 2008 and operated by us throughout both periods. This was offset by the compensation costs of $22.0 million we incurred in connection with our initial public offering of common stock.


69


Table of Contents

Gain on Early Retirement of Debt
 
Select Medical Corporation.  For the year ended December 31, 2009, we paid approximately $30.1 million to repurchase and retire a portion of our 75/8% senior subordinated notes. These notes had a carrying value of $46.5 million. A gain on early retirement of debt in the amount of $15.3 million was recognized on the transactions which was net of the write-off of unamortized deferred financing costs related to the repurchased debt. These gains were offset by the write-off of deferred financing costs of $2.9 million related to our prepayments of term loans under our credit facility with proceeds from our initial public offering of common stock.
 
Select Medical Holdings Corporation.  For the year ended December 31, 2009, we paid approximately $30.1 million to repurchase and retire a portion of our 75/8% senior subordinated notes. These notes had a carrying value of $46.5 million. A gain on early retirement of debt in the amount of $15.3 million was recognized on the transactions which was net of the write-off of unamortized deferred financing costs related to the debt. In addition, for the year ended December 31, 2009, we paid approximately $6.5 million to repurchase and retire a portion of Holdings’ senior floating rate notes. These notes have a carrying value of $7.7 million. A gain on early retirement of debt in the amount of $1.1 million was recognized on the transaction which was net of the write-off of unamortized deferred financing costs related to the repurchased debt. These gains were offset by the write-off of deferred financing costs of $2.9 million related to our prepayments of term loans under our credit facility with proceeds from our initial public offering of common stock.
 
Interest Expense
 
Select Medical Corporation.  Interest expense was $99.5 million for the year ended December 31, 2009 compared to $110.9 million for the year ended December 31, 2008. The decrease in interest expense is related to a reduction in outstanding debt balances in 2009.
 
Select Medical Holdings Corporation.  Interest expense was $132.5 million for the year ended December 31, 2009 compared to $145.9 million for the year ended December 31, 2008. The decrease in interest expense is related to a reduction in outstanding debt balances in 2009.
 
Income Taxes
 
Select Medical Corporation.  We recorded income tax expense of $50.0 million for the year ended December 31, 2009. The expense represented an effective tax rate of 32.9%. We recorded income tax expense of $37.3 million for the year ended December 31, 2008. The expense represented an effective tax rate of 44.4%. The lower effective tax rate we experienced for the year ended December 31, 2009 is principally due to tax refunds and associated interest we received related to the resolution of federal tax returns that occurred before the Merger. Our effective tax rate for 2008 was higher than our expected blended federal and state tax rate as a result of an increase in valuation reserves due to our inability to use state net operating losses of the entities acquired from HealthSouth Corporation and excess federal capital losses that can only be offset by future capital gains.
 
Select Medical Holdings Corporation.  We recorded income tax expense of $37.5 million for the year ended December 31, 2009. The expense represented an effective tax rate of 32.2%. We recorded income tax expense of $26.1 million for the year ended December 31, 2008. The expense represented an effective tax rate of 50.2%. The lower effective tax rate we experienced for the year ended December 31, 2009 is principally due to tax refunds and associated interest we received related to the resolution of federal tax returns that occurred before the Merger. Our effective tax rate for 2008 was higher than our expected blended federal and state tax rate as a result of an increase in valuation reserves due to our inability to use state net operating losses of the entities acquired from HealthSouth Corporation and excess federal capital losses that can only be offset by future capital gains.
 
Non-Controlling Interests
 
Non-controlling interests in consolidated earnings were $3.6 million for the year ended December 31, 2009 and $3.4 million for the year ended December 31, 2008.


70


Table of Contents

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
 
Net Operating Revenues
 
Our net operating revenues increased by 8.1% to $2,153.4 million for the year ended December 31, 2008 compared to $1,991.7 million for the year ended December 31, 2007.
 
Specialty Hospitals.  Our specialty hospital net operating revenues increased 7.4% to $1,488.4 million for the year ended December 31, 2008 compared to $1,386.4 million for the year ended December 31, 2007. Net operating revenues for the specialty hospitals opened as of January 1, 2007 and operated by us throughout both periods increased 7.3% to $1,402.7 million for the year ended December 31, 2008 from $1,306.9 million for the year ended December 31, 2007. This increase was partially offset by the loss of revenues from closed hospitals, which accounted for $52.2 million of the difference in net operating revenues between 2007 and 2008. Hospitals opened in 2007 and 2008 increased net operating revenues by $58.4 million for the year ended December 31, 2008. The increase in same store hospitals’ net operating revenues resulted from increases in our patient days and our average net revenue per patient day. Our patient days for these same store hospitals increased 2.1% and was attributable to an increase in our non-Medicare patient days. Our average net revenue per patient day in our same store hospitals increased 5.0% to $1,458 for the year ended December 31, 2008 from $1,388 for the year ended December 31, 2007. This increase in net revenue per patient day resulted from increased Medicare revenues and was primarily the result of an increase in the Medicare case mix index of our patients which adjusts our Medicare base rate used to determine our discharge payments to compensate us for differences in the severity of the cases we treat.
 
Outpatient Rehabilitation.  Our outpatient rehabilitation net operating revenues increased 10.2% to $664.8 million for the year ended December 31, 2008 compared to $603.4 million for the year ended December 31, 2007. The increase in outpatient rehabilitation net operating revenues was primarily attributable to an increase in patient visits. The number of patient visits in our outpatient rehabilitation clinics increased 12.4% for the year ended December 31, 2008 to 4,533,727 visits compared to 4,032,197 visits for the year ended December 31, 2007. Substantially all of the increase in net operating revenues and patient visits was related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation in May 2007. Net revenue per visit in our clinics was $102 for the year ended December 31, 2008 compared to $100 for the year ended December 31, 2007.
 
Other.  Our other revenues were $0.2 million for the year ended December 31, 2008 compared to $1.8 million for the year ended December 31, 2007. These revenues relate to revenue from other non-healthcare services.
 
Operating Expenses
 
Our operating expenses increased by 8.3% to $1,885.2 million for the year ended December 31, 2008 compared to $1,740.5 million for the year ended December 31, 2007. Our operating expenses include our cost of services, general and administrative expense and bad debt expense. The increase in operating expenses occurred in both of our operating segments. In our specialty hospital segment, the cause of the increase in costs was equally divided between costs related to the increase in patient volume and an increase in the cost to treat patients. In our outpatient rehabilitation segment the cause of the increase in costs was principally related to the increased patient volumes resulting from the acquisition of the outpatient division of HealthSouth Corporation. As a percentage of our net operating revenues, our operating expenses were 87.6% for the year ended December 31, 2008 compared to 87.4% for the year ended December 31, 2007. The increase in the relative percentage of our operating expenses compared to net operating revenue was principally related to our bad debt costs. Cost of services as a percentage of operating revenues was 83.2% for the year ended December 31, 2008 compared to 83.3% for the year ended December 31, 2007. These costs primarily reflect our labor expenses. Another component of cost of services was facility rent expense, which was $110.2 million for the year ended December 31, 2008 compared to $98.5 million for the year ended December 31, 2007. The increase in rent expense was principally related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation and recently opened specialty hospitals that are leased. General and administrative expenses were 2.2% of net operating revenues for both the years ended December 31, 2008 and 2007. Our bad debt expense as a percentage of net operating revenues was 2.2% for the year ended December 31, 2008 compared to 1.9% for the year ended December 31, 2007. The increase in our bad debt expense occurred principally in our specialty hospitals. In our specialty hospitals we experienced an aging of our accounts receivable which caused us to increase our reserves for doubtful accounts for the year ended December 31,


71


Table of Contents

2008. Additionally, we experienced an increase in the write-off of uncollectible Medicare co-payments and deductibles where state Medicaid programs are the secondary payor which has the effect of increasing our bad debt expense.
 
Adjusted EBITDA
 
Specialty Hospitals.  Adjusted EBITDA increased by 8.8% to $236.4 million for the year ended December 31, 2008 compared to $217.2 million for the year ended December 31, 2007. Our Adjusted EBITDA margins increased to 15.9% for the year ended December 31, 2008 from 15.7% for the year ended December 31, 2007. The hospitals opened before January 1, 2007 and operated throughout both years had Adjusted EBITDA of $257.7 million, an increase of $29.6 million or 13.0% over the Adjusted EBITDA of these hospitals for the year ended December 31, 2007. Our Adjusted EBITDA margin in these same store hospitals increased to 18.4% for the year ended December 31, 2008 from 17.5% for the year ended December 31, 2007. The principal reason for the growth in our Adjusted EBITDA and Adjusted EBITDA margin for these same store hospitals was the result of increased patient volume and the increase in our net revenue per patient day. Our hospitals opened during 2007 and 2008 incurred Adjusted EBITDA losses of $22.4 million and $11.3 million for the year ended December 31, 2008 and 2007, respectively.
 
Outpatient Rehabilitation.  Adjusted EBITDA increased by 2.4% to $77.3 million for the year ended December 31, 2008 compared to $75.4 million for the year ended December 31, 2007. Our Adjusted EBITDA margins decreased to 11.6% for the year ended December 31, 2008 from 12.5% for the year ended December 31, 2007. Our Adjusted EBITDA margins decreased for the year ended December 31, 2008 compared to the year ended December 31, 2007 due to lower margins generated by the outpatient rehabilitation clinics acquired from HealthSouth Corporation. The principal cause of the lower margins was a reduction in patient volume at these clinics. Due to the small size of these clinics, it was difficult for us to reduce our cost structures to offset patient volume declines.
 
Other.  The Adjusted EBITDA loss was $43.4 million for the year ended December 31, 2008 compared to a loss of $37.7 million for the year ended December 31, 2007 and was primarily related to our general and administrative expenses.
 
Income from Operations
 
For the year ended December 31, 2008, we had income from operations of $196.4 million compared to income from operations of $193.9 million for the year ended December 31, 2007. The decrease in income from operations resulted from an increase in depreciation and amortization expense offset by the Adjusted EBITDA changes described above. The increase in depreciation and amortization expense resulted primarily from increased depreciation expense associated with free-standing hospitals that were placed in service and an increase in depreciation and amortization expense related to the outpatient rehabilitation clinics acquired from HealthSouth Corporation.
 
Interest Expense
 
Select Medical Corporation.  Interest expense was $110.9 million for the year ended December 31, 2008 compared to $105.5 million for the year ended December 31, 2007. The increase in interest expense was related to higher average outstanding debt balances under our senior secured credit facility existing during the year ended December 31, 2008. The increase in outstanding debt was principally related to the borrowings on our senior secured credit facility used to fund the acquisition of the outpatient rehabilitation division of HealthSouth Corporation, offset by the effect of declining interest rates in 2008.
 
Select Medical Holdings Corporation.  Interest expense was $145.9 million for the year ended December 31, 2008 compared to $140.2 million for the year ended December 31, 2007. The increase in interest expense was related to higher average outstanding debt balances under our senior secured credit facility existing during the year ended December 31, 2008. The increase in outstanding debt was principally related to the borrowings on our senior secured credit facility used to fund the acquisition of the outpatient rehabilitation division of HealthSouth Corporation, offset by the effect of declining interest rates in 2008.


72


Table of Contents

Gain on Early Retirement of Debt
 
In the year ended December 31, 2008, we paid approximately $1.0 million to repurchase and retire a portion of our 75/8% senior subordinated notes. These notes had a carrying value of $2.0 million. A gain on early retirement of debt in the amount of $0.9 million was recognized on the transaction which included the write-off of the unamortized deferred financing costs related to the debt.
 
Income Taxes
 
Select Medical Corporation.  We recorded income tax expense of $37.3 million, representing an effective tax rate of 44.4%, for the year ended December 31, 2008. For the year ended December 31, 2007, we recorded income tax expense of $29.3 million, representing an effective tax rate of 34.1%. In the year ended December 31, 2008 we experienced an effective tax rate that was higher than our expected blended federal and state tax rate as a result of an increase in valuation reserves due to our inability to use state net operating losses arising in tax entities acquired from HealthSouth Corporation and excess federal capital losses that can only be offset by future capital gains. For the year ended December 31, 2007 we recognized a lower effective tax rate as a result of greater than expected tax benefits generated on the sale of equipment and subsidiaries.
 
Select Medical Holdings Corporation.  We recorded income tax expense of $26.1 million for the year ended December 31, 2008. This expense represented an effective tax rate of 50.2%. For the year ended December 31, 2007, we recorded income tax expense of $18.7 million. This expense represented an effective tax rate of 33.6%. In the year ended December 31, 2008 we experienced an effective tax rate that was higher than our expected blended federal and state tax rate as a result of an increase in valuation reserves due to our inability to use state net operating losses arising in the tax entities acquired from HealthSouth Corporation and excess federal capital losses that can only be offset by future capital gains. For the year ended December 31, 2007 we recognized a lower effective tax rate as a result of greater than expected tax benefits generated on the sale of equipment and subsidiaries.
 
Non-Controlling Interests
 
Non-Controlling interests in consolidated earnings were $3.4 million for the year ended December 31, 2008 compared to $1.5 million for the year ended December 31, 2007. This increase in non-controlling interest was due to an increase in the non-controlling ownership in three of our specialty hospitals.
 
Liquidity and Capital Resources
 
Year Ended December 31, 2009, Year Ended December 31, 2008 and the Year Ended December 31, 2007
 
                                                 
    Select Medical Holdings Corporation     Select Medical Corporation  
    Year Ended December 31,     Year Ended December 31,  
    2007     2008     2009     2007     2008     2009  
    (In thousands)     (In thousands)  
 
Cash flows provided by operating activities
  $ 86,013     $ 107,438     $ 165,639     $ 118,786     $ 140,245     $ 198,478  
Cash flows used in investing activities
    (382,676 )     (60,438 )     (77,917 )     (382,676 )     (60,438 )     (77,917 )
Cash flows provided by (used in) financing activities
    219,592       12,731       (68,302 )     186,819       (20,076 )     (101,141 )
                                                 
Net increase (decrease) in cash and cash equivalents
    (77,071 )     59,731       19,420       (77,071 )     59,731       19,420  
Cash and cash equivalents at beginning of period
    81,600       4,529       64,260       81,600       4,529       64,260  
                                                 
Cash and cash equivalents at end of period
  $ 4,529     $ 64,260     $ 83,680     $ 4,529     $ 64,260     $ 83,680  
                                                 
 
Operating activities for Select provided $198.5 million for the year ended December 31, 2009. The increase in cash flow provided by operating activities in comparison to our operating cash flow provided by operating activities


73


Table of Contents

for the year ended December 21, 2008 is principally related to the increase in our net income and a decline in our accounts receivable during the year ended December 31, 2009. Our days sales outstanding were 49 days at December 31, 2009 compared to 53 days at December 31, 2008. The reduction in days sales outstanding between December 31, 2008 and December 31, 2009 is primarily related to a reduction in our non-governmental accounts receivable that resulted from improved collections activities in our business offices.
 
Operating activities for Select generated $140.2 million in cash during the year ended December 31, 2008. The increase in cash flow provided by operating activities in comparison to our operating cash flow provided by operating activities for the year ended December 31, 2007 is principally related to a reduction in the cash taxes we paid during 2008. Our days sales outstanding were 53 days at December 31, 2008 compared to 48 days at December 31, 2007. The increase in days sales outstanding between December 31, 2007 and December 31, 2008 is primarily related to the timing of the periodic interim payments we received from Medicare for the services provided at our specialty hospitals.
 
Operating activities for Select generated $118.8 million in cash during the year ended December 31, 2007. Our days sales outstanding were 48 days at December 31, 2007 compared to 41 days at December 31, 2006. In comparison to our operating cash flow generated for the year ended December 31, 2006, our operating cash flow was negatively affected by a reduction in our operating earnings, an increase in interest expense and an increase in our accounts receivable.
 
The operating cash flow of Select exceeds the operating cash flow of Holdings by $32.8 million for the years ended December 31, 2009, 2008 and 2007. The difference relates to interest payments on Holdings’ senior subordinated notes and senior floating rate notes.
 
Investing activities used $77.9 million, $60.4 million and $382.7 million of cash flow for the years ended December 31, 2009, 2008, and 2007, respectively. Of this amount, we incurred acquisition related payments of $21.4 million, $7.6 million and $237.0 million, respectively in 2009, 2008 and 2007. In 2007, the acquisition of the outpatient division of HealthSouth Corporation accounted for the $236.9 million in acquisition payments. The remaining acquisition payments relate primarily to small acquisitions of outpatient businesses and specialty hospitals. Investing activities also used cash for the purchases of property and equipment of $57.9 million, $56.5 million and $166.1 million in 2009, 2008, and 2007, respectively. In 2009 and 2008 our purchases of property and equipment were principally related to routine capital expenditures. In 2007 our purchases of property and equipment were related principally to construction of new hospitals and relocation of existing hospitals. Additionally during 2007 we made major improvements and expanded our rehabilitation hospital in West Orange, New Jersey. We sold business units and real property which generated $1.3 million, $3.4 million and $16.0 million in cash during the years ended December 31, 2009, 2008 and 2007, respectively.
 
Financing activities for Select used $101.1 million of cash flow for the year ended December 31, 2009. The primary usage of cash related to net payments on our senior secured credit facility of $323.4 million, the repurchase of a portion of Select’s 75/8% senior subordinated notes for $30.1 million, repayment of bank overdrafts of $21.1 million, dividends paid to Holdings to fund interest payments of $39.4 million and $2.8 million in distributions related to non-controlling interests, offset by an additional investment in Select by Holdings of $316.0 million which primarily related to the net proceeds from Holdings’ initial public offering of common stock.
 
Financing activities for Select used $20.1 million of cash for the year ended December 31, 2008. The cash usage resulted primarily from dividends paid to Holdings to fund interest payments of $33.4 million, payments on seller and other debt of $5.6 million, distributions to non-controlling interests of $2.0 million, payment of initial public offering costs of $1.3 million and repurchase of Select’s 75/8% senior subordinated notes of $1.0 million, offset by borrowings on our senior secured credit facility of $23.2 million.
 
Financing activities for Select provided $186.8 million of cash for the year ended December 31, 2007. The cash resulted primarily from borrowings, net of repayments on our senior secured credit facility of $213.5 million and proceeds from bank overdrafts of $8.9 million, offset by dividends paid to Holdings to fund interest payments of $32.8 million, distributions to non-controlling interests of $1.7 million and payments on seller and other debt of $1.3 million. Approximately $203.0 million of the borrowings from our senior secured credit facility were used to


74


Table of Contents

fund the acquisition of the outpatient division of HealthSouth Corporation. The remaining borrowings were used to fund our normal operations including our hospital construction activities.
 
The difference in cash flows provided by (used in) financing activities of Holdings compared to Select of $32.8 million for each of the years ended December 31, 2009, 2008 and 2007 relates to dividends paid by Select to Holdings to service Holdings’ interest obligations related to its senior subordinated notes and its senior floating rate notes and to fund repurchases of common and preferred stock.
 
Capital Resources
 
Select Medical Corporation.  Select had net working capital of $167.3 million at December 31, 2009 compared to net working capital of $100.1 million at December 31, 2008. The increase in net working capital is primarily due to our improved cash position that has resulted from our recently completed initial public offering of common stock and a reduction in our accrued liabilities.
 
Select Medical Holdings Corporation.  Holdings had net working capital of $170.8 million at December 31, 2009 compared to net working capital of $118.4 million at December 31, 2008. The increase in net working capital is primarily due to our improved cash position that has resulted from our recently completed initial public offering of common stock and a reduction in our accrued liabilities.
 
After giving effect to Amendment No. 3 to our senior secured credit facility (as described below) on August 5, 2009, our senior secured credit facility provided for senior secured financing consisting of:
 
  •  a $300.0 million revolving loan facility that will terminate on February 24, 2011, including both a letter of credit sub-facility and a swingline loan sub-facility, and
 
  •  $268.6 million in term loans that mature on February 24, 2012 (the “Tranche B Term Loans”), and
 
  •  $384.5 million in term loans that mature on August 22, 2014 (the “Tranche B-1 Term Loans”).
 
The interest rates per annum applicable to loans, other than swingline loans and Tranche B-1 Term Loans, under our senior secured credit facility are, at our option, equal to either an alternate base rate or an adjusted LIBOR rate for a one, two, three or six month interest period, or a nine or twelve month period if available, in each case, plus an applicable margin percentage. The interest rates per annum applicable to the Tranche B-1 Term Loans under our senior credit facility are, at our option, equal to either an alternate base rate or an adjusted LIBOR rate for a three or six month interest period, or a nine or twelve month period if available, in each case, plus an applicable margin percentage. The alternate base rate is the greater of (1) JPMorgan Chase Bank, N.A.’s prime rate and (2) one-half of 1% over the weighted average of rates on overnight Federal funds as published by the Federal Reserve Bank of New York. The adjusted LIBOR rate is determined by reference to settlement rates established for deposits in dollars in the London interbank market for a period equal to the interest period of the loan and the maximum reserve percentages established by the Board of Governors of the United States Federal Reserve to which our lenders are subject. The applicable margin percentage for borrowings under our revolving loans is subject to change based upon the ratio of Select’s total indebtedness to consolidated EBITDA (as defined in the credit agreement). The applicable margin percentage for revolving loans will decrease from (1) 1.00% to 0.75% for alternate base rate loans and (2) 2.00% to 1.75% for adjusted LIBOR loans upon the delivery of Select’s Annual Report on Form 10-K to JPMorgan Chase Bank, N.A., as administrative agent to Select’s senior secured credit facility. The applicable margin percentages for the Tranche B Term Loans are (1) 1.00% for alternate base rate loans and (2) 2.00% for adjusted LIBOR loans. The applicable margin percentages for the Tranche B-1 Term Loans are (1) 2.75% for alternate base rate loans and (2) 3.75% for adjusted LIBOR loans.
 
Our senior secured credit facility requires Select to maintain certain interest expense coverage ratios and leverage ratios which become more restrictive over time. For the four consecutive fiscal quarters ended December 31, 2009, Select was required to maintain an interest expense coverage ratio (its ratio of consolidated EBITDA (as defined in our senior secured credit facility) to cash interest expense) for the prior four consecutive fiscal quarters of at least 2.00 to 1.00. Select’s interest expense coverage ratio was 2.58 to 1.00 for such period. As of December 31, 2009, Select was required to maintain its leverage ratio (its ratio of total indebtedness to consolidated


75


Table of Contents

EBITDA for the prior four consecutive fiscal quarters) at less than 5.00 to 1.00. Select’s leverage ratio was 3.11 to 1.00 as of December 31, 2009.
 
Also, as of December 31, 2009, we had $191.8 million outstanding in Tranche B term loans and $291.3 million outstanding in Tranche B-1 term loans. We also had $269.3 million of availability under our revolving loan facility (after giving effect to $30.7 million of outstanding letters of credit).
 
Our initial public offering of common stock triggered the mandatory prepayment obligation under our senior secured credit facility in the amount of 50% of the net proceeds we received in the offering. On October 5, 2009 we repaid to the lenders under the senior secured credit facility $139.4 million, of which $57.3 million was applied to Tranche B term loans and $82.1 million was applied to Tranche B-1 term loans. On October 16, 2009, we made an additional $12.1 million voluntary prepayment of Tranche B Term Loans with a portion of the initial public offering proceeds. On November 3, 2009 we repaid $16.9 million of debt under our senior secured credit facility, of which $6.7 million was applied to Tranche B term loans and $10.2 million was applied to Tranche B-1 term loans.
 
On June 13, 2005, Select entered into two five year interest rate swap transactions with an effective date of August 22, 2005. On March 8, 2007 and November 23, 2007, Select entered into two additional interest rate swap transactions for three years with effective dates of May 22, 2007 and November 23, 2007, respectively. The swaps are designated as a cash flow hedge of forecasted LIBOR-based variable rate interest payments. The underlying variable rate debt is $500.0 million.
 
On August 5, 2009 we entered into Amendment No. 3 to our senior secured credit facility with a group of holders of Tranche B term loans and JPMorgan Chase Bank, N.A., as administrative agent. Amendment No. 3 extended the maturity of $384.5 million principal amount of Tranche B term loans from February 24, 2012 to August 22, 2014, and made related technical changes to our senior secured credit facility. Holders of Tranche B term loans that extended the maturity of their Tranche B term loans now hold Tranche B-1 term loans that mature on August 22, 2014, and holders of Tranche B term loans that did not extend the maturity of their Tranche B term loans continue to hold Tranche B term loans that mature on February 24, 2012. The applicable margin percentage for the Tranche B-1 term loans under our senior secured credit facility is 3.75% for adjusted LIBOR loans and 2.75% for alternate base rate loans. Under the terms of Amendment No. 3, if, prior to August 5, 2011, our senior secured credit facility is amended to reduce the applicable margin percentage for the Tranche B-1 term loans, then we will be required to pay a fee in an amount equal to 1% of the outstanding Tranche B-1 term loans held by those holders of Tranche B-1 term loans that agree to amend our senior secured credit facility to reduce the applicable margin percentage. In addition, if, prior to August 5, 2011, we make any prepayment of Tranche B-1 term loans with proceeds of any term loan indebtedness, we will be required to pay a fee to holders of Tranche B-1 term loans in an amount equal to 1% of the outstanding Tranche B-1 term loans that are being prepaid.
 
On February 24, 2005, EGL Acquisition Corp. issued and sold $660.0 million in aggregate principal amount of 75/8% senior subordinated notes due 2015, which Select assumed in connection with the Merger. The net proceeds of the offering were used to finance a portion of the funds needed to consummate the Merger with EGL Acquisition Corp. The notes were issued under an indenture between EGL Acquisition Corp. and U.S. Bank Trust National Association, as trustee. Interest on the notes is payable semi-annually in arrears on February 1 and August 1 of each year. The notes are guaranteed by all of Select’s wholly-owned subsidiaries, subject to certain exceptions. On or after February 1, 2010, the notes may be redeemed at Select’s option, in whole or in part, at redemption prices that decline annually to 100% on and after February 1, 2013, plus accrued and unpaid interest. Upon a change of control of Holdings, each holder of notes may require us to repurchase all or any portion of the holder’s notes at a purchase price equal to 101% of the principal amount plus accrued and unpaid interest to the date of purchase.
 
During 2009, we paid approximately $30.1 million to repurchase and retire additional 75/8% senior subordinated notes. These notes had a carrying value of $46.5 million. A gain on early retirement of debt in the amount of $15.3 million was recognized, which was net of the write-off of unamortized deferred financing costs related to the debt.
 
On September 29, 2005, Holdings sold $175.0 million of senior floating rate notes due 2015, which bear interest at a rate per annum, reset semi-annually, equal to the 6-month LIBOR plus 5.75%. Interest is payable semi-annually in arrears on March 15 and September 15 of each year, with the principal due in full on September 15,


76


Table of Contents

2015. The senior floating rate notes are general unsecured obligations of Holdings and are not guaranteed by Select or any of its subsidiaries. The net proceeds of the issuance of the senior floating rate notes, together with cash was used to reduce the amount of our preferred stock, to make a payment to participants in our long-term incentive plan and to pay related fees and expenses.
 
During 2009, we paid approximately $6.5 million to repurchase and retire a portion of Holdings senior floating rate notes. These notes had a carrying value of $7.7 million. A gain on early retirement of debt in the amount of $1.1 million was recognized, which was net of the write-off of unamortized deferred financing costs related to the debt.
 
We may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, may be funded from operating cash flows or other sources and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material.
 
We believe our internally generated cash flows and borrowing capacity under our senior secured credit facility will be sufficient to finance normal operations in the over the next twelve months. Our lenders, including the lenders participating in our senior secured credit facility, may have suffered losses related to their lending and other financial relationships, especially because of the general weakening of the national economy, increased financial instability of many borrowers and the declining value of their assets. As a result, lenders may become insolvent or tighten their lending standards, which could make it more difficult for us to borrow under our revolving credit facility. Our access to funds under the senior secured credit facility is dependent upon the ability of our lenders to meet their funding commitments. Our financial condition and results of operations would be adversely affected if we were unable to draw funds under our senior secured credit facility because of a lender default or to obtain other cost-effective financing.
 
Our Tranche B term loans mature on February 24, 2012 and Tranche B-1 term loans mature on August 22, 2014. Our revolving credit facility will terminate on February 24, 2011. We anticipate refinancing at least a portion of the indebtedness under our senior secured credit facility within the next twelve months, which includes entering into a new revolving credit facility on or before the termination of our current revolving credit facility on February 24, 2011. There can be no assurance that we will be successful in our effort to enter into a new revolving credit facility and/or refinance indebtedness under our senior secured credit facility in the future. While we expect there to be alternatives available to us to enter into a new revolving credit facility and/or refinance our indebtedness under our senior secured credit facility, we cannot assure you that any of these alternatives will be successfully implemented. We depend on our revolving credit facility to meet our cash requirements to operate our business. If we repay our revolving credit facility upon its termination and are unable to enter into a new revolving credit facility on terms acceptable to us, or at all, we may be forced to reduce our operations and may not be able to respond to changing business conditions or competitive pressures. As a result, our business, operating results and financial condition could be adversely affected.
 
Longer term disruptions in the capital and credit markets as a result of uncertainty, changing or increased regulation, reduced alternatives or failures of significant financial institutions could adversely affect our access to liquidity needed for our business. Any disruption could require us to take measures to conserve cash until the markets stabilize or until alternative credit arrangements or other funding for our business can be arranged. Such measures could include deferring capital expenditures and reducing or eliminating other discretionary uses of cash.
 
As a result of the SCHIP Extension Act, which prohibits the establishment and classification of new LTCHs or satellites during the three calendar years commencing on December 29, 2007, we have stopped all new LTCH development. However, we continue to evaluate opportunities to develop new joint venture relationships with significant health systems, and from time to time we may also develop new inpatient rehabilitation hospitals. We also intend to open new outpatient rehabilitation clinics in local areas that we currently serve where we can benefit from existing referral relationships and brand awareness to produce incremental growth.


77


Table of Contents

Commitments and Contingencies
 
The following tables summarize contractual obligations at December 31, 2009, and the effect such obligations are expected to have on liquidity and cash flow in future periods. Reserves for uncertain tax positions of $25.0 million have been excluded from the tables below as we cannot reasonably estimate the amounts or periods in which these liabilities will be paid.
 
Select Medical Holdings Corporation:
 
                                         
    Payments Due by Year  
Contractual Obligations
  Total     2010     2011-2013     2014-2015     After 2015  
    (In thousands)  
 
75/8% senior subordinated notes
  $ 611,500     $     $     $ 611,500     $  
Senior secured credit facility
    483,067       1,223       200,119       281,725        
10% senior subordinated notes(1)
    137,284                   137,284        
Senior floating rate notes
    167,300                   167,300        
Seller notes
    971       487       484              
Capital lease obligations
    1,347       304       1,043              
Other debt obligations
    4,102       2,131       1,971              
                                         
Total debt
    1,405,571       4,145       203,617       1,197,809        
Interest(2)
    461,784       100,475       254,750       106,559        
Letters of credit outstanding
    30,654             30,654              
Purchase obligations
    3,376       1,699       1,677              
Construction contracts
    11,148       11,148                    
Naming, promotional and sponsorship agreement
    51,202       2,679       8,417       5,942       34,164  
Operating leases
    626,738       115,352       200,759       63,677       246,950  
Related party operating leases
    45,556       3,068       9,525       6,580       26,383  
                                         
Total contractual cash obligations
  $ 2,636,029     $ 238,566     $ 709,399     $ 1,380,567     $ 307,497  
                                         
 
Select Medical Corporation:
 
                                         
    Payments Due by Year  
Contractual Obligations
  Total