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EX-3.1 - SUN HEALTHCARE GROUP INCex3-1.htm
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EX-10.2 - SUN HEALTHCARE GROUP INCex10-2.htm
EX-10.3 - SUN HEALTHCARE GROUP INCex10-3.htm
EX-32.1 - SUN HEALTHCARE GROUP INCex32-1.htm
EX-21.1 - SUN HEALTHCARE GROUP INCex21-1.htm
EX-10.5 - SUN HEALTHCARE GROUP INCex10-5.htm
EX-10.6 - SUN HEALTHCARE GROUP INCex10-6.htm
EX-23.1 - SUN HEALTHCARE GROUP INCex23-1.htm
EX-10.7 - SUN HEALTHCARE GROUP INCex10-7.htm
EX-32.2 - SUN HEALTHCARE GROUP INCex32-2.htm
EX-31.2 - SUN HEALTHCARE GROUP INCex31-2.htm
EX-10.4 - SUN HEALTHCARE GROUP INCex10-4.htm
EX-10.12 - SUN HEALTHCARE GROUP INCex10-12.htm
EX-31.1 - SUN HEALTHCARE GROUP INCex31-1.htm
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________
FORM 10-K
(Mark One)
x    Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2010
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 number 1-12040
 
SUN HEALTHCARE GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware
(State of Incorporation)
13-4230695
(I.R.S. Employer Identification No).
18831 Von Karman, Suite 400
Irvine, CA  92612
(949) 255-7100
(Address, including zip code, and telephone number of principal executive offices)

Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
Common Stock, par value $.01 per share
Name of Exchange on Which Registered
The NASDAQ Stock Market LLC (Nasdaq Global Select Market)
 
 
Securities registered pursuant to Section 12(g) of the Act:  None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. oYes     xNo
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. oYes     xNo
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. xYes     oNo
 
Indicate by check mark whether the registrant has submitted electronically and posted to its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   oYes     oNo
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filero     Accelerated filerx     Non-accelerated filero     Smaller reporting companyo
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). oYes     xNo
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, as reported on the NASDAQ Global Select Market, as of the last business day of the registrant's most recently completed second fiscal quarter was $348.4 million.
 
     On March 1, 2011, Sun Healthcare Group, Inc. had 24,979,551 outstanding shares of Common Stock.
 
Documents Incorporated by Reference:  Part III of this Form 10-K incorporates information by reference from the Registrant’s definitive proxy statement for the 2011 Annual Meeting to be filed prior to May 2, 2011.
 
 

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

INDEX
   
Page
PART I
   
     
Item 1.
Business
1
Item 1A.
Risk Factors
8
Item 1B.
Unresolved Staff Comments
16
Item 2.
Properties
17
Item 3.
Legal Proceedings
19
     
PART II
   
     
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer
 
 
Purchases of Equity Securities
19
Item 6.
Selected Financial Data
21
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
 
 
Operations
24
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
50
Item 8.
Financial Statements and Supplementary Data
50
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial
 
 
Disclosure
50
Item 9A.
Controls and Procedures
51
Item 9B.
Other Information
51
     
PART III
   
     
Item 10.
Directors, Executive Officers and Corporate Governance
52
Item 11.
Executive Compensation
52
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related
 
 
Stockholder Matters
52
Item 13.
Certain Relationships and Related Transactions and Director Independence
52
Item 14.
Principal Accountant Fees and Services
52
     
PART IV
   
     
Item 15.
Exhibits and Financial Statement Schedules
52
     
Signatures
 
56
___________________
     References throughout this document to the Company, “we,” “our,” “ours” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

    Sun Healthcare Group®, SunBridge®, SunDance®, CareerStaff Unlimited®, SolAmor®, Rehab Recovery Suites® and related names are trademarks of Sun Healthcare Group, Inc. and its subsidiaries.
__________________________________________

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information provided in this Annual Report on Form 10-K (“Annual Report”) contains “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”).  Any statements that do not relate to historical or current facts or matters are forward-looking statements.  Examples of forward-looking statements include all statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, business strategy, budgets, the impact of reductions in reimbursements and other changes in government reimbursement programs, the outcome and costs of litigation, projected expenses and capital expenditures, growth opportunities and potential acquisitions, competitive position, plans and objectives of management for future operations and compliance with and changes in governmental regulations.  You can identify some of the forward-looking statements by the use of forward-looking words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “may” and other similar expressions are forward-looking statements.  The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  We caution investors that any forward-looking statements made by us herein are not guarantees of future performance and that investors should not place undue reliance on any of such forward-looking statements, which speak only as of the date of this report.  Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements.  You should carefully consider the disclosures we make concerning risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements, including those described in this report under Part I, Item 1A – “Risk Factors” and any of those made in our other reports filed with the Securities and Exchange Commission. There may be additional risks of which we are presently unaware or that we currently deem immaterial.  We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.
 
 
 

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

PART I

Item 1.  Business

Overview

Sun Healthcare Group, Inc. (NASDAQ GS: SUNH) is a healthcare services company, serving principally the senior population, with consolidated annual revenues in excess of $1.9 billion and approximately 30,000 employees in 46 states. Sun’s services are provided through its subsidiaries: as of December 31, 2010, SunBridge Healthcare and its subsidiaries operates 164 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, ten assisted living centers, two independent living centers and eight mental health centers with an aggregate of 23,053 licensed beds in 25 states; SunDance Rehabilitation provides rehabilitation therapy services to affiliated and non-affiliated centers in 36 states; CareerStaff Unlimited provides medical staffing services in 39 states; and SolAmor Hospice provides hospice services in 10 states.

2010 Restructuring

On November 15, 2010, our former parent, Sun Healthcare Group, Inc. (“Old Sun”) completed a restructuring of its business by separating its real estate assets and its operating assets into two separate publicly traded companies.  The restructuring consisted of certain key transactions including the reorganization, through a series of internal corporate restructurings, such that (i) substantially all of Old Sun’s owned real property and related mortgage indebtedness owed to third parties were transferred to or assumed by Sabra Health Care REIT, Inc (“Sabra”), a Maryland corporation and a wholly owned subsidiary of Old Sun, or one or more subsidiaries of Sabra, and (ii) all of Old Sun’s operations and other assets and liabilities were transferred to or assumed by SHG Services, Inc., a Delaware corporation and a wholly owned subsidiary of Old Sun (“New Sun”), or one or more subsidiaries of New Sun.

On November 15, 2010, Old Sun distributed to its stockholders on a pro rata basis all of the outstanding shares of New Sun common stock (the “Separation”), together with a pro rata cash distribution to Old Sun’s stockholders aggregating approximately $10 million.  Old Sun then merged with and into Sabra, with Sabra surviving the merger and Old Sun’s stockholders receiving shares of Sabra common stock in exchange for their shares of Old Sun’s common stock (the “REIT Conversion Merger”).  Immediately following the Separation and REIT Conversion Merger, New Sun changed its name to Sun Healthcare Group, Inc.  Pursuant to master lease agreements that were entered into between subsidiaries of Sabra and of New Sun in connection with the Separation, subsidiaries of Sabra lease to subsidiaries of New Sun the properties that Sabra’s subsidiaries own following the REIT Conversion Merger.

In this Annual Report we discuss the business of both Old Sun and of New Sun because New Sun has continued the business of Old Sun and is the successor issuer to Old Sun for purposes of the Securities Exchange of 1934, as amended (the “Exchange Act”).   References to ‘we’, ‘us’ ‘our’ and the ‘Company’ refer to Old Sun and New Sun and their businesses.

Business Segments

During 2010, our subsidiaries engaged in the following three principal business segments:

 
Ø
inpatient services, primarily skilled nursing centers;
 
Ø
rehabilitation therapy services; and
 
Ø
medical staffing services.
 
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Inpatient services.    As of December 31, 2010, we operate 164 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, two independent living centers and eight mental health centers with an aggregate of 23,053 licensed beds in 25 states through SunBridge Healthcare Corporation (“SunBridge”) and other subsidiaries. Our skilled nursing centers provide services that include daily nursing, therapeutic rehabilitation, social services, housekeeping, nutrition and administrative services for individuals requiring certain assistance for activities in daily living. Rehab Recovery Suites (“RRS”), which specialize in Medicare and managed care patients, are located in 68 of our skilled nursing centers, and 47 of our skilled nursing centers contain wings dedicated to the care of residents afflicted with Alzheimer’s disease. Our assisted living centers provide services that include minimal nursing assistance, housekeeping, nutrition, laundry and administrative services for individuals requiring minimal assistance for activities in daily living. Our independent living centers provide services that include security, housekeeping, nutrition and limited laundry services for individuals requiring no assistance for activities in daily living. Our mental health centers provide a range of inpatient and outpatient behavioral health services for adults and children through specialized treatment programs. We also provide hospice services, including palliative care, social services, pain management and spiritual counseling, through our subsidiary SolAmor Hospice Corporation (“SolAmor”), in 11 states for individuals facing end of life issues. We generated 89.0%, 89.0% and 88.6% of our consolidated net revenues through inpatient services in 2010, 2009 and 2008, respectively.

Rehabilitation therapy services.  We provide rehabilitation therapy services through SunDance Rehabilitation Corporation (“SunDance”). SunDance provides a broad array of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy. As of December 31, 2010, SunDance provided rehabilitation therapy services to 508 centers in 36 states, 346 of which were operated by nonaffiliated parties and 162 of which were operated by affiliates.  We generated 6.3%, 5.6% and 4.9% of our consolidated net revenues through rehabilitation therapy services in 2010, 2009 and 2008, respectively.

Medical staffing services.  We provide temporary medical staffing in 39 states through CareerStaff Unlimited, Inc. (“CareerStaff”). For the year ended December 31, 2010, CareerStaff derived 50.6% of its revenues from hospitals and other providers, 26.8% from skilled nursing centers, 16.4% from schools and 6.2% from prisons. CareerStaff provides (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians, (iv) physicians and (v) related medical personnel. We generated 4.7%, 5.4% and 6.5% of our consolidated net revenues through medical staffing services in 2010, 2009 and 2008, respectively.

See Note 13 – “Segment Information” to our consolidated financial statements included in this Annual Report on Form 10-K for additional information regarding our segments.

Competition

Our businesses are competitive. The nature of competition within the inpatient services industry varies by location. We compete with other healthcare centers based on key factors such as the number of centers in the local market, the types of services available, quality of care, reputation, age and appearance of each center and the cost of care in each locality. Increased competition in the future could limit our ability to attract and retain residents or to expand our business.

We also compete with other companies in providing rehabilitation therapy services, medical staffing services and hospice services, and in employing and retaining qualified nurses, therapists and other medical personnel. The primary competitive factors for the ancillary services markets are quality of services, charges for services and responsiveness to customer needs.

 
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Competitive Strengths
 
We believe that the following strengths will allow us to improve our operations and profitability:
 
 
 
High Quality Portfolio. SunBridge operates inpatient services in all of its centers, which, as of December 31, 2010, consisted of 164 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, two independent living centers and eight mental health centers. Our subsidiaries also provide rehabilitation therapy services through SunDance, which, as of December 31, 2010, provided rehabilitation therapy services to 508 centers in 36 states and medical staffing services through CareerStaff, which, as of December 31, 2010, provided medical staffing services in 39 states. Our operations are geographically diversified and characterized by strong operating metrics. The quality of our operations enables SunBridge to manage patients with higher acuity levels (i.e., the condition of patients that determines the level of skilled nursing and rehabilitation therapy services required).  Higher acuity levels help drive operating margins. The size of our operations enables us to realize the benefits of economies of scale, purchasing power and increased operating efficiencies. Furthermore, our geographic diversity helps to mitigate the risk associated with adverse regulatory changes related to Medicaid reimbursement in any one state.
 
 
 
Core Inpatient Services Business. Our inpatient business has the ability to achieve consistent revenue and earnings growth by expanding services and increasing focus on integrated skilled nursing care and rehabilitation therapy services to attract high-acuity patients to all of our nursing and rehabilitation centers and through targeting specific centers with Rehab Recovery Suites that exclusively specialize in caring for high-acuity patients.
 
 
 
Quality of Care and Strong Brand Image. SunBridge’s centers maintain initiatives to provide high quality of care to their patients. These initiatives have resulted in third-party recognition for quality of care and clinical services. SunBridge has been able to, and expects to continue to, attract an increased number of high-acuity patients, maintain a high occupancy rate and develop an effective referral network of patients.
 
 
 
Ancillary Businesses Will Support Inpatient Services and Provide Diversification. SunDance, our rehabilitation therapy business, complements our core inpatient services business. Its services are particularly attractive to high-acuity patients who require more intensive and medically complex care. SunDance has demonstrated the ability to grow organically and partner with non-affiliated skilled and assisted living facilities in delivering efficient and effective rehabilitation services to customers in 36 states. Our SolAmor hospice business, which serves patients in certain of our nursing centers, in-home settings and non-affiliated centers, is an increasingly important contributor to our earnings growth and operating margin.  SolAmor now operates in 11 states and has demonstrated the ability to integrate efficiently the operations of three nonaffiliated hospice companies since 2008. CareerStaff, our medical staffing business, primarily services non-affiliated providers and derives a majority of its revenues from its placement of therapists. CareerStaff also places physicians, nurses and pharmacists. We expect to continue to leverage the core competencies of CareerStaff’s business to benefit the SunBridge and SunDance businesses. These ancillary businesses diversify our revenue base and  provide an opportunity to improve our payor mix.
 
 
 
Experienced Management Team with a Proven Track Record. We have a strong and committed management team with substantial industry knowledge. Our chief executive officer and chief financial officer together have over 45 years of healthcare experience, as well as a proven track record of operational success in the long-term care industry. Our management team has successfully acquired and integrated numerous businesses, assets and properties, and this experience should position us well to successfully implement our growth and integration strategies.

 
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Business Strategy

We intend to build on our current competitive strengths and to grow our businesses and strengthen our position as a nationwide provider of senior healthcare services by pursuing the following:

Focus on Inpatient Growth. SunBridge intends to increase its inpatient revenue and profitability by maintaining high occupancy rates and by continuing to focus on attracting more high-acuity and Medicare patients. SunBridge will implement this strategy by focusing on expanding its clinical and case management and by developing additional Rehab Recovery Suites that exclusively specialize in Medicare and managed care patients. SunBridge plans to take advantage of its marketing infrastructure, local community knowledge and brand image to attract new patients and to expand its referral and customer bases.

Grow Ancillary Businesses. SolAmor intends to grow its hospice operations through acquisitions and internal growth. SunDance will focus on its rehabilitation therapy business, which will be a key driver of our Medicare services and revenues, by improving its clinical product offering, labor productivity and operating profitability and increasing the number of third-party contracts. Our hospice and ancillary services businesses should provide us with diversified revenue sources, a favorable payor mix and growth opportunities.

Increase Operational Efficiency and Leverage Our Existing Platform. We will focus on improving operating efficiencies without compromising high quality of care. We plan to reduce costs and enhance efficiencies through various methods, including:
 
 
 
reducing labor and billing expenses through technological advances and operational improvements that enable management to more efficiently deploy resources;
 
 
 
reducing overhead through process improvement initiatives and frequent re-examination of costs;
 
 
 
improving therapist productivity in our rehabilitation services business;
 
 
 
controlling litigation expenses by focusing on risk management; and
 
 
 
monitoring and analyzing the operations and profitability of individual business units.
 
 
Employees and Labor Relations

As of December 31, 2010, we and our subsidiaries had 29,922 full-time, part-time and per diem employees. Of this total, there were 24,163 employees in our inpatient services operations (including 485 employees in our hospice operations), 3,564 employees in our rehabilitation therapy services operations, 1,895 employees in our medical staffing business and 300 employees at our corporate offices.

As of December 31, 2010, SunBridge operated 35 centers with union employees. Approximately 2,800 of our employees (9.4% of all of our employees) who worked in healthcare centers in Alabama, California, Connecticut, Georgia, Massachusetts, Maryland, Montana, New Jersey, Ohio, Rhode Island, Washington and West Virginia were covered by collective bargaining contracts. Collective bargaining agreements covering approximately 1,600 of these employees (5.3% of all our employees) either are currently in renegotiations or will shortly be in renegotiations due to the expiration of the collective bargaining agreements.

 
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Federal and State Regulatory Oversight

The healthcare industry is extensively regulated. In the ordinary course of business, our operations are continuously subject to federal, state and local regulatory scrutiny, supervision and control. This often includes inquiries, investigations, examinations, audits, site visits and surveys. As more fully described below, various laws, including anti-kickback, anti-fraud and abuse provisions codified under the Social Security Act, prohibit certain business practices and relationships that might affect the provision and cost of healthcare services reimbursable under Medicare and Medicaid. Sanctions for violating these anti-kickback, anti-fraud and abuse provisions include criminal penalties, civil sanctions, fines and possible exclusion from government programs such as Medicare and Medicaid. If a center is decertified as a Medicare or Medicaid provider by the Centers for Medicare and Medicaid Services (“CMS”) or a state, the center will not thereafter be reimbursed for caring for residents that are covered by Medicare and Medicaid, and the center would be forced to care for such residents without being reimbursed or to transfer such residents.

Our skilled nursing centers and mental health centers are currently licensed under applicable state law, and are certified or approved as providers under the Medicare and Medicaid programs. State and local agencies survey all skilled nursing centers on a regular basis to determine whether such centers are in compliance with governmental operating and health standards and conditions for participation in government sponsored third-party payor programs. From time to time, we receive notice of noncompliance with various requirements for Medicare/Medicaid participation or state licensure. We review such notices for factual correctness, and based on such reviews, either take appropriate corrective action or challenge the stated basis for the allegation of noncompliance. Where corrective action is required, we work with the reviewing agency to create mutually agreeable measures to be taken to bring the center or service provider into compliance. Under certain circumstances, the federal and state agencies have the authority to take adverse actions against a center or service provider, including the imposition of a monitor, the imposition of monetary penalties and the decertification of a center or provider from participation in the Medicare and/or Medicaid programs or licensure revocation. When appropriate, we vigorously contest such sanctions. Challenging and appealing notices or allegations of noncompliance can require significant legal expenses and management attention.

Various states in which we operate centers have established minimum staffing requirements or may establish minimum staffing requirements in the future. Our ability to satisfy such staffing requirements depends upon our ability to attract and retain qualified healthcare professionals, including nurses, certified nurse’s assistants and other staff. Failure to comply with such minimum staffing requirements may result in the imposition of fines or other sanctions.

Most states in which we operate have statutes which require that, prior to the addition or construction of new nursing home beds, the addition of new services or certain capital expenditures in excess of defined levels, we first must obtain a certificate of need (“CON”), which certifies that the state has made a determination that a need exists for such new or additional beds, new services or capital expenditures. The certification process is intended to promote quality healthcare at the lowest possible cost and to avoid the unnecessary duplication of services, equipment and centers.

We are subject to federal and state laws that govern financial and other arrangements between healthcare providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between healthcare providers that are designed to induce the referral of patients to, or the recommendation of, a particular provider for medical products and services. These laws include:
 
the “anti-kickback” provisions of the Medicare and Medicaid programs, which prohibit, among other things, knowingly and willfully soliciting, receiving, offering or paying any remuneration (including any kickback, bribe or rebate) directly or indirectly in return for or to induce the referral of an
 
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individual to a person for the furnishing or arranging for the furnishing of any item or service for which payment may be made in whole or in part under Medicare or Medicaid; and
   
the “Stark laws” which prohibit, with limited exceptions, the referral of patients by physicians for certain services, including physical therapy and occupational therapy, to an entity in which the physician has a financial interest.

False claims are prohibited pursuant to criminal and civil statutes. These provisions prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid or failing to refund overpayments or improper payments. Suits alleging false claims can be brought by individuals, including employees and competitors.  Newly adopted legislation has expanded the scope of the federal False Claims Act and eased some requirements for the filing of a lawsuit under the act.  We believe that our billing practices are compliant with the False Claims Act and similar state laws.  However, if our practices, policies and procedures are found not to comply with the provisions of those laws, we could be subject to civil sanctions.

Commencing January 1, 2010, recovery audit contractors, or RACs, operating under the Medicare Integrity Program, seek to identify alleged Medicare overpayments based on the medical necessity of services provided in nursing centers.  Similar audits are conducted by various state agencies under the Medicaid program.

As of December 31, 2010, we have approximately $4.6 million, or 0.2% of our revenues, of claims that are under various stages of review or appeal with the Medicare Administration Contractors/Fiscal Intermediaries.  We cannot assure you that future recoveries will not be material or that any appeal of a medical review or RAC audit that we are pursuing will be successful.
 
 
We are also subject to regulations under the privacy and security provisions of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). The privacy rules provide for, among other things, (i) giving consumers the right and control over the release of their medical information, (ii) the establishment of boundaries for the use of medical information and (iii) civil or criminal penalties for violation of an individual’s privacy rights.

These privacy regulations apply to “protected health information,” which is defined generally as individually identifiable health information transmitted or maintained in any form or medium, excluding certain education records and student medical records. The privacy regulations limit a provider’s use and disclosure of most paper, oral and electronic communications regarding a patient’s past, present or future physical or mental health or condition, or relating to the provision of healthcare to the patient or payment for that healthcare.

The security regulations require us to ensure the confidentiality, integrity, and availability of all electronic protected health information that we create, receive, maintain or transmit. We must protect against reasonably anticipated threats or hazards to the security of such information and the unauthorized use or disclosure of such information. 

Compliance Process

Our compliance program, referred to as the “Compliance Process,” was initiated in 1996. It has evolved as the requirements of federal and private healthcare programs have changed.  There are seven principal elements to the Compliance Process:

Written Policies, Procedures and Standards of Conduct.    Our business lines have extensive policies and procedures (“P&Ps”) modeled after applicable laws, regulations, government manuals and industry practices
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

and customs. The P&Ps govern the clinical, reimbursement, and operational aspects of each subsidiary. To emphasize adherence to our P&Ps, we publish and distribute a Code of Conduct and an employee handbook.   

Designated Compliance Officer and Compliance Committee.    We have a Chief Compliance Officer whose responsibilities include, among other things: (i) overseeing the Compliance Process; (ii) overseeing compliance with judicial and regulatory requirements, and functioning as the liaison with the state agencies and the federal government on matters related to the Compliance Process and such requirements; (iii) reporting to our board of directors, the Compliance Committee of our board of directors, and senior corporate managers on the status of the Compliance Process; and (iv) overseeing the coordination of a comprehensive training program which focuses on the elements of the Compliance Process and employee background screening process. Compliance matters are reported to the Compliance Committee of our board of directors on a regular basis. The Compliance Committee is comprised solely of independent directors.

Effective Training and Education.    Every employee, director and officer is trained on the Compliance Process and Code of Conduct. Training also occurs for appropriate employees in applicable provisions of the Medicare and Medicaid laws, fraud and abuse prevention, clinical standards, and practices, and claim submission and reimbursement P&Ps.

Effective Lines of Communication.    Employees are encouraged to report issues of concern without fear of retaliation using a Four Step Reporting Process, which includes the toll-free “Sun Quality Line.” The Four Step Reporting Process encourages employees to discuss clinical, ethical or financial concerns with supervisors and local management since these individuals will be most familiar with the laws, regulations, and policies that impact their concerns. The Sun Quality Line is an always-available option that may be used for anonymous reporting if the employee so chooses. Reported concerns are internally reviewed and proper follow-up is conducted.

Internal Monitoring and Auditing.    Our Compliance Process puts internal controls in place to meet the following objectives: (i) accuracy of claims, reimbursement submissions, cost reports and source documents; (ii) provision of patient care, services, and supplies as required by applicable standards and laws; (iii) accuracy of clinical assessment and treatment documentation; and (iv) implementation of judicial and regulatory requirements (e.g., background checks, licensing and training). Each business line monitors and audits compliance with P&Ps and other standards to ensure that the objectives listed above are met. Data from these internal monitoring and auditing systems are analyzed and acted upon through a quality improvement process. We have designated the subsidiary presidents and each member of the operations management team as Compliance Liaisons. Each Compliance Liaison is responsible for making certain that all requirements of the Compliance Process are completed at the operational level for which the Compliance Liaison is responsible.

Enforcement of Standards.    Our policies, the Code of Conduct and the employee handbook, as well as all associated training materials, clearly indicate that employees who violate our standards will be subjected to discipline. Sanctions range from oral warnings to suspensions and/or to termination of employment. We have also adopted a proactive approach to offset the need for punitive measures. First, we have implemented employee background review practices that surpass industry standards. Second, as noted above, we devote significant resources to employee training. Finally, we have adopted a performance management program intended to make certain that all employees are aware of what duties are expected of them and understand that compliance with policies, procedures, standards and laws related to job functions is required.

Responses to Detected Offenses and Development of Corrective Actions.    Correction of detected misconduct or a violation of our policies is the responsibility of every manager. As appropriate, a manager is expected to develop and implement corrective action plans and monitor whether such actions are likely to keep a similar violation from occurring in the future.

 
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Our Compliance Process incorporates the terms of a revised Permanent Injunction and Final Judgment entered on September 14, 2005 (“PIFJ”). The PIFJ, which resulted from investigations by the Bureau of Medi-Cal Fraud and Elder Abuse of the Office of the California Attorney General and applies to our California centers, required compliance with certain clinical practices that are substantially consistent with existing law and our current practices, and imposed staffing requirements and specific training obligations. All California administrators have been trained on the requirements of the PIFJ.  The PIFJ was terminated in January 2011.

General Information

New Sun was incorporated in Delaware in 2002, and continues the business of Old Sun, which was incorporated in Delaware in 1993.  Our principal executive offices are located at 18831 Von Karman, Suite 400, Irvine, CA 92612, and our telephone number is (949) 255-7100.  We maintain a website at www.sunh.com.  Through the “Financial Info” and “SEC Filings” links on our website, we make available free of charge, as soon as reasonably practicable after such information has been filed or furnished to the Securities and Exchange Commission, each of our filings with the SEC, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act .

Item 1A. Risk Factors

Our business is dependent on reimbursement rates under federal and state programs, and legislation or regulatory action may reduce or otherwise materially adversely affect the reimbursement rates.

Our revenues are heavily dependent on payments administered under the Medicare and Medicaid programs. The economic downturn has caused many states to institute freezes on or reductions in Medicaid reimbursements to address state budget concerns. Moreover, for the 2010 federal fiscal year (commencing October 1, 2009), the Centers for Medicare and Medicaid Services (“CMS”) effectively reduced our Medicare reimbursement rates (this reduction was not repeated for the 2011 federal fiscal year). In addition, the skilled nursing center exception to the statutory cap on Medicare reimbursements for therapy services is scheduled to expire on December 31, 2011. If the skilled nursing center exception is not extended, reimbursement for therapy services rendered to our residents and patients will be reduced.

In addition to these reductions, there have been numerous initiatives on the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services. Aspects of certain of these initiatives, such as further reductions in funding of the Medicare and Medicaid programs, additional changes in reimbursement regulations by CMS, enhanced pressure to contain healthcare costs by Medicare, Medicaid and other payors, and additional operational requirements, could materially adversely affect us.

Healthcare reform may affect our revenues and increase our costs and otherwise materially adversely affect our business.

In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 were signed into law. Together, these two measures make the most sweeping and fundamental changes to the U.S. health care system since the creation of Medicare and Medicaid. These new laws include a large number of health-related provisions that are scheduled to take effect over the next four years, including expanding Medicaid eligibility, requiring most individuals to have health insurance, establishing new regulations on health plans, establishing health insurance exchanges and modifying certain payment systems to encourage more cost-effective care and a reduction of inefficiencies and waste, including through new tools to address fraud and abuse. In addition, in 2011, federal legislation is being formulated to

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

repeal or amend provisions of these new statutes.  We cannot predict the exact effect these newly enacted laws or any future legislation or regulation will have on us, including future reimbursement rates and occupancy in our inpatient facilities.

Our revenue and collections have been adversely affected and may continue to be materially adversely affected by the economic downturn.

In addition to state and federal budgetary actions that have impacted the amount of reimbursements that we receive for services under state and federal programs, the recent economic downturn has resulted in reduced demand for our staffing services that we provide through or to other healthcare providers and has impacted our ability to collect receivables from nongovernmental sources. If economic conditions do not improve or if they worsen, this reduction in demand and impact on our receivables collection could continue. Adverse economic conditions could also result in continued reduced demand for our therapy and staffing services, which could have a material adverse effect on our business, financial position or results of operations.

Delays in collecting or the inability to collect our accounts receivable could materially adversely affect our cash flows and financial position.

Prompt billing and collection are important factors in our liquidity. Billing and collection of our accounts receivable are subject to the complex regulations that govern Medicare and Medicaid reimbursement and rules imposed by nongovernment payors. Our inability to bill and collect on a timely basis pursuant to these regulations and rules could subject us to payment delays that could negatively impact our cash flows and ultimately our financial position in a material manner. In addition, commercial payors and other customers, as well as individual patients, may be unable to make payments to us for which they are responsible. The recent economic downturn has resulted in a decrease in our ability to collect accounts receivable from some of our customers. A continuation or worsening of recent unfavorable economic conditions may result in a further decrease in our ability to collect accounts receivable from some of our customers, in which case we will have to make larger allowances for doubtful accounts or incur bad debt write-offs, each of which could have a material adverse effect on our business, financial position or results of operations.

Our business is subject to reviews, audits and investigations under federal and state programs and by private payors, which could have a material adverse effect on our business, financial position or results of operations.

We are subject to review, audit or investigation by federal and state governmental agencies to verify compliance with the requirements of the Medicare and Medicaid programs and other federal and state programs. Audits under the Medicare and Medicaid programs have intensified in recent years. Private payors also may have a contractual right to review or audit our files. Any review, audit or investigation could result in various actions, including our paying back amounts that we have been paid pursuant to these programs, our paying fines or penalties, the suspension of our ability to collect payment for new residents to a skilled nursing center, exclusion of a skilled nursing center from participation in one or more governmental programs, revocation of a license to operate a skilled nursing center, or loss of a contract with a private payor. Any of these events could have a material adverse effect on our business, financial position or results of operations.
 
Possible changes in the case mix of residents and patients as well as payor mix and payment methodologies could materially affect our revenue and profitability.

The sources and amount of our revenues are determined by a number of factors, including the licensed bed capacity and occupancy rates of our healthcare centers, the mix of residents and patients and the rates of reimbursement among payors. Likewise, services provided by our ancillary businesses vary based upon payor

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

and payment methodologies. Changes in the case mix of the residents and patients as well as payor mix among private pay, Medicare and Medicaid could materially affect our profitability. In particular, any significant decrease in our population of high-acuity residents and patients or any significant increase in our Medicaid population could have a material adverse effect on our business, financial position or results of operations, especially if states operating Medicaid programs continue to limit, or more aggressively seek limits on, reimbursement rates.

Unfavorable resolution of litigation matters and disputes could have a material adverse effect on our business, financial position or results of operations.

Skilled nursing center operators, including our inpatient services subsidiaries, are from time to time subject to lawsuits seeking to hold them liable for alleged negligent or other wrongful conduct of employees that allegedly result in injury or death to residents of the centers. We currently have numerous patient care lawsuits pending against us, as well as other types of lawsuits. Adverse determinations in legal proceedings, including potential punitive damages, and any adverse publicity arising therefrom could have a material adverse effect on our business, financial position or results of operations.

We rely primarily on self-funded insurance programs for general and professional liability and workers’ compensation claims against us, and any claims not covered by, or in excess of, our insurance coverage limits could have a material adverse effect upon our business, financial position or results of operations.

We self-insure for the majority of our insurable risks, including general and professional liabilities, workers’ compensation liabilities and employee health insurance liabilities, through the use of self-insurance or self-funded insurance policies, which vary by the states in which we operate. We rely upon self-funded insurance programs for general and professional liability claims up to $5.0 million per claim, which amounts we are responsible for funding. We maintain excess insurance for claims above this amount. There is a risk that the amounts funded to our programs of self-insurance and future cash flows may not be sufficient to respond to all claims asserted under those programs.

There is no assurance that a claim in excess of our insurance coverage limits will not arise. A claim against us that is not covered by, or is in excess of, the coverage limits provided by our excess insurance policies could have a material adverse effect upon our business, financial position or results of operations. Furthermore, there is no assurance that we will be able to obtain adequate excess liability insurance in the future or that, if such insurance is available, it will be available on acceptable terms.

Our operations are extensively regulated and adverse determinations against us could result in severe penalties, including loss of licensure and decertification.

In the ordinary course of business, we are subject to a wide variety of federal, state and local laws and regulations and to federal and state regulatory scrutiny and supervision in various areas, including referral of patients, false claims under Medicare and Medicaid, health and safety laws, environmental laws and the protection of health information. Such regulatory scrutiny often includes inquiries, civil and criminal investigations, examinations, audits, site visits and surveys, some of which are non-routine. If we are found to have engaged in improper practices, we could be subject to civil, administrative or criminal fines, penalties or restitutionary relief or corporate settlement agreements with federal, state or local authorities, and reimbursement authorities could also seek our suspension or exclusion from participation in their programs. The exclusion of centers from participating in Medicare or Medicaid could have a material adverse effect on our business, financial position or results of operations. We cannot predict the future course of any laws or regulations to which we are subject, including Medicare and Medicaid statutes and regulations, the intensity of federal and state enforcement actions or the extent and size of any potential sanctions, fines or

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

penalties. Changes in existing laws or regulations, or the enactment of new laws or regulations, could result in changes to our operations requiring significant capital expenditures or additional operating expenses. Evolving interpretations of existing, new or amended laws and regulations or heightened enforcement efforts could have a material adverse effect on our business, financial position or results of operations.

Our hospice business is subject to a cap on the amount paid by Medicare and other Medicare payment limitations, which limitations could materially adversely affect our hospice revenues and earnings.

Payments made by Medicare for hospice services are subject to a cap amount on a per hospice basis. Our ability to comply with this limitation depends on a number of factors, including the number of admissions, average length of stay, acuity level of our patients and patients that transfer into and out of our hospice programs. Our hospice revenue and profitability could be materially reduced if we are unable to comply with this and other Medicare payment limitations.

Our business is dependent on referral sources, which have no obligation to refer residents and patients to our skilled nursing centers, and our failure to maintain our existing referral sources, develop new relationships or achieve or maintain a reputation for providing high quality of care could materially adversely affect us.

We rely on referrals from physicians, hospitals and other healthcare providers to provide our skilled nursing centers with our patient population. These referral sources are not obligated to refer business to us and may refer business to other long-term care providers. If we fail to maintain our existing referral sources, fail to develop new relationships or fail to achieve or maintain a reputation for providing high quality of care, our patient population, payor mix, revenue and profitability could be materially adversely affected.

Providers of commercial insurance and other nongovernmental payors are increasingly seeking to control costs, which efforts could materially adversely impact our revenues.

Private insurers are seeking to control healthcare costs through direct contracts with healthcare providers, and reviews of the propriety of, and charges for, services provided. These private payors are increasingly demanding discounted fee structures. These cost control efforts could have a material adverse effect on our business, financial position or results of operations.

We face national, regional and local competition, which could materially limit our ability to attract and retain residents or to expand our business.

The healthcare industry is highly competitive and subject to continual changes in the methods by which services are provided and the types of companies providing services. Our nursing centers compete primarily on a local and regional basis with many long-term care providers, some of whom may own as few as a single nursing center. Our ability to compete successfully varies from location to location depending on a number of factors, including the number of competing centers in the local market, the types of services available, quality of care, reputation, age and appearance of each center and the cost of care in each locality.  Our rehabilitation, staffing and hospice businesses also face significant competition from local and regional providers.  Increased competition in the future could limit our ability to attract and retain residents or to expand our business.

State efforts to regulate the construction or expansion of healthcare providers could impair our ability to expand our operations or make acquisitions.

Some states require healthcare providers (including skilled nursing centers, hospices and assisted living centers) to obtain prior approval, in the form of a CON, for the purchase, construction or expansion of healthcare

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

centers; capital expenditures exceeding a prescribed amount; or changes in services or bed capacity. To the extent that we are unable to obtain any required CON or other similar approvals, our expansion could be materially adversely affected. We cannot make any assurances that we will be able to obtain a CON or other similar approval for any future projects requiring this approval.

We may be unable to reduce costs to offset completely any decreases in our revenues.

Reduced levels of occupancy in our healthcare centers or reductions in reimbursements from Medicare and Medicaid could materially adversely impact our cash flow and revenues. Fluctuations in occupancy levels may become more common as we increase our emphasis on patients with shorter stays but higher acuities. If we are unable to put in place corresponding adjustments in costs in response to declines in census or other revenue shortfalls, we will be unable to prevent future decreases in earnings. Our centers are able to reduce some of their costs as occupancy decreases, although the decrease in costs will in most cases be less than the decrease in revenues. However, our centers are not able to reduce their costs of providing care to offset a decrease in reimbursement revenues from federal and state programs.

We continue to be adversely affected by an industry-wide shortage of qualified center care-provider personnel and increasing labor costs.

We, like other providers in the long-term care industry, have had and continue to have difficulties in retaining qualified personnel to staff our healthcare centers, particularly nurses, and in such situations we may be required to use temporary employment agencies to provide additional personnel. The labor costs are generally higher for temporary employees than for full-time employees. In addition, many states in which we operate have increased minimum staffing standards. As minimum staffing standards are increased, we may be required to retain additional staffing. In addition, in recent years we have experienced increases in our labor costs primarily due to higher wages and greater benefits required to attract and retain qualified personnel and to increase staffing levels in our centers.

A similar situation exists in the rehabilitation therapy industry. We, like other providers in the long-term care industry, have had and continue to have difficulties in hiring a sufficient number of rehabilitation therapists. Under these circumstances, we, like others in this industry, have been required to offer higher compensation to attract and retain these personnel, and we have been forced to rely on independent contractors, at higher costs, to fulfill our contractual commitments with our customers. Existing contractual commitments, regulatory limitations and the market for these services have made it difficult for us to pass through these increased costs to our customers.

Our business may be adversely impacted by labor union activity.

As of December 31, 2010, we had 29,992 employees, of which 9.4% are represented by unions.  Collective bargaining agreements covering 5.3% of all our employees either are currently in renegotiations or will shortly be in renegotiations due to the expiration of the collective bargaining agreements.  At this time, we are unable to predict the outcome of the negotiations, but increases in salaries, wages and benefits could result from renegotiated agreements. No assurances can be made that we will not in the future experience these and other types of conflicts with labor unions or our employees generally.  We are unable to predict the outcome of future union organizing activities by labor unions and employees.  To the extent a greater portion of our employee base unionizes, our labor costs could increase materially.

If we are unable to meet minimum staffing standards, we may be subject to fines or other sanctions and increased costs, which could materially adversely affect our profitability.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Increased attention to the quality of care provided in skilled nursing centers has caused several states to mandate, and other states to consider mandating, minimum staffing laws that require minimum nursing hours of direct care per resident per day. These minimum staffing requirements further increase the gap between demand for and supply of qualified professionals, and lead to higher labor costs. Failure to comply with minimum staffing requirements can result in lawsuits seeking significant damages, fines and requirements that we provide a plan of correction.

Our ability to satisfy minimum staffing requirements depends upon our ability to attract and retain qualified healthcare professionals, including nurses, certified nurse’s assistants and other personnel. Attracting and retaining these personnel is difficult given existing shortages of these employees in the labor markets in which we operate. Furthermore, if states do not appropriate additional funds (through Medicaid program appropriations or otherwise) sufficient to pay for any additional operating costs resulting from minimum staffing requirements, our profitability could be materially adversely affected.

If we lose our key management personnel, we may not be able to successfully manage our business and achieve our objectives, which could have a material adverse effect on our business, financial position or results of operations.

Our future success depends in large part upon the leadership and performance of our executive management team and key employees at the operating level. If we lose the services of any of our executive officers or any of our key employees at the operating or regional level, we may not be able to replace them with similarly qualified personnel, which could have a material adverse effect on our business, financial position or results of operations.

We could be materially adversely affected by our level of indebtedness.

As of December 31, 2010, we had indebtedness of $156.0 million, a $60.0 million revolving credit facility ($30.0 million of which may be utilized for letters credit, but undrawn at December 31, 2010) and a $75.0 million letter of credit facility ($66.2 million outstanding at December 31, 2010) funded by proceeds of additional term loans. The level of our indebtedness could have adverse consequences to us, such as requiring us to dedicate a substantial portion of our cash flows from operations to payments on our debt, limiting our ability to fund, and potentially increasing the cost of funding, working capital, capital expenditures, acquisitions and other general corporate requirements and making us more vulnerable to general adverse economic and industry conditions. If we fail to comply with the payment requirements or financial covenants contained in our debt agreements, we would be required to seek waivers from our lenders. Seeking these waivers may be difficult or expensive to obtain and, if we fail to obtain any necessary waivers, the resulting default would allow the lenders to accelerate the maturity of the indebtedness, which could have a material adverse effect on our business, financial position or results of operations.

An increase in market interest rates could increase our interest costs on existing and future debt and could adversely affect our stock price.

If interest rates increase, so could our interest costs for any new debt. This increased cost could make the financing of any acquisition more costly. We may incur more variable interest rate indebtedness in the future. Rising interest rates could limit our ability to refinance existing debt when it matures, or cause us to pay higher interest rates upon refinancing and increased interest expense on refinanced indebtedness.

Covenants in our debt agreements may limit our operational flexibility, and a covenant breach could materially adversely affect our business, financial position or results of operations.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The agreements governing our indebtedness contain customary covenants that include restrictions on our ability to make acquisitions and other investments, pay dividends, incur additional indebtedness and make capital expenditures. These restrictions may limit our operational flexibility or require us to approach our lenders for consent to allow us to implement our business plans.  Such a consent could be difficult or expensive to obtain. Our failure to comply with such restrictions and other covenants could materially adversely affect our business, financial position or results of operations or our ability to incur additional indebtedness or refinance existing indebtedness.

We continue to seek acquisitions and other strategic opportunities, which may result in the use of a significant amount of management resources or significant costs and we may not be able to fully realize the potential benefit of such transactions.

We continue to seek acquisitions and other strategic opportunities. Accordingly, we are often engaged in evaluating potential transactions and other strategic alternatives. In addition, from time to time, we may engage in discussions that may result in one or more transactions. Although there is uncertainty that any of these discussions will result in definitive agreements or the completion of any transaction, we may devote a significant amount of our management resources to such a transaction, which could negatively impact our operations. In addition, we may incur significant costs in connection with seeking acquisitions or other strategic opportunities regardless of whether the transaction is completed and in combining our operations if such a transaction is completed. In the event that we consummate an acquisition or strategic alternative in the future, there is no assurance that we would fully realize the potential benefit of such a transaction.
 
We lease substantially all of our centers and could experience risks relating to lease termination, lease extensions, and special charges, which could have a material adverse effect on our business, financial position or results of operations.

We face risks because of the number of centers that we lease. We currently lease 195 of the 200 healthcare centers operated by our subsidiaries as of December 31, 2010. Each of our lease agreements provides that the lessor may terminate the lease for a number of reasons, including, subject to applicable cure periods, the default in any payment of rent, taxes or other payment obligations or the breach of any other covenant or agreement in the lease. Termination of any of our lease agreements could result in a default under our debt agreements and could have a material adverse effect on our business, financial position or results of operations. Although we believe that we will be able to renew our lease agreements that we wish to extend, there is no assurance that we will succeed in obtaining extensions in the future at rental rates and on other terms that we believe to be reasonable, or at all. Our high percentage of leased centers limits our ability to exit markets. As a result, if some centers should prove to be unprofitable, we could remain obligated for lease payments even if we decided to withdraw from those locations. We could incur special charges relating to the closing of such centers including lease termination costs, impairment charges and other special charges that would reduce our profits and could have a material adverse effect on our business, financial position or results of operations.

Natural disasters and other adverse events may harm our centers and residents.

Our centers and residents may suffer harm as a result of natural or other causes, such as storms, earthquakes, floods, fires and other conditions. Such events can disrupt our operations, negatively affect our revenues, and increase our costs or result in a future impairment charge. For example, nine of our healthcare centers are in Florida, which is prone to hurricanes, and 16 of our centers and our executive offices are in California, which is prone to earthquakes.

Environmental compliance costs and liabilities associated with our centers may have a material adverse effect on our business, financial position or results of operations.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

We are subject to various federal, state and local environmental and health and safety laws and regulations with respect to our centers. These laws and regulations address various matters, including asbestos, fuel oil management, wastewater discharges, air emissions, medical wastes and hazardous wastes. The costs of complying with these laws and regulations and the penalties for non-compliance can be substantial. For example, with respect to our owned and leased property, we may be held liable for costs relating to the investigation and clean up of any of our owned or leased properties from which there has been a release or threatened release of a regulated material as well as other properties affected by the release. In addition to these costs, which are typically not limited by law or regulation and could exceed the property’s value, we could be liable for certain other costs, including governmental fines and injuries to persons, property or natural resources. Further, some environmental laws create a lien on the contaminated site in favor of the government for damages and the costs it incurs in connection with the contamination. Such environmental compliance costs and liabilities may have a material adverse effect on our business, financial position or results of operations.

Our ability to use our net operating losses (“NOLs”) and other tax attributes to offset future taxable income could be limited by an ownership change and/or decisions by California and other states to suspend the use of NOLs.

We have significant NOLs, tax credits and amortizable goodwill available to offset our future U.S. federal and state taxable income. Our ability to utilize these NOLs and other tax attributes may be subject to significant limitations under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), and applicable state law if we undergo an ownership change. An ownership change occurs for purposes of Section 382 of the Code if certain events occur, including 5% stockholders (i.e., stockholders who own or have owned 5% or more of our stock (with certain groups of less-than-5% stockholders treated as single stockholders for this purpose)) increasing their aggregate percentage ownership of our stock by more than fifty percentage points above the lowest percentage of the stock owned by these stockholders at any time during the relevant testing period. An issuance of shares of our common stock in connection with acquisitions or for any other reason can contribute to or result in an ownership change under Section 382. Stock ownership for purposes of Section 382 of the Code is determined under a complex set of attribution rules, so that a person is treated as owning stock directly, indirectly (i.e., through certain entities) and constructively (through certain related persons and certain unrelated persons acting as a group). In the event of an ownership change, Section 382 imposes an annual limitation (based upon our value at the time of the ownership change, as determined under Section 382 of the Code) on the amount of taxable income and tax liabilities a corporation may offset with NOLs and other tax attributes, such as tax credit carryforwards. Any unused annual limitation may be carried over to later years until the applicable expiration date for the respective NOL and tax credit carryforwards. As a result, our inability to utilize these NOLs or credits as a result of any ownership changes could materially adversely impact our business, financial position or results of operations.

In addition, California and certain states have suspended use of NOLs for certain taxable years, and other states are considering similar measures. As a result, we may incur higher state income tax expense in the future. Depending on our future tax position, continued suspension of our ability to use NOLs in states in which we are subject to income tax could have a material adverse impact on our business, financial position or results of operations.

Failure to maintain effective internal control over financial reporting could have a material adverse effect on our ability to report our financial results on a timely and accurate basis.

We are required to maintain internal control over financial reporting pursuant to Rule 13a-15 under the Exchange Act. Failure to maintain such controls could result in misstatements in our financial statements and potentially subject us to sanctions or investigations by the SEC or other regulatory authorities or could cause us

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

to delay the filing of required reports with the SEC and our reporting of financial results. Any of these events could result in a decline in the price of shares of our common stock. Although we have taken steps to maintain our internal control structure as required, we cannot assure you that control deficiencies will not result in a misstatement in the future.

We do not expect to pay any dividends for the foreseeable future, which will affect the extent to which our investors realize any future gains on their investment.

We are currently prohibited by the terms of our senior credit facility from paying dividends to holders of our common stock. We do not anticipate paying any other dividends in the foreseeable future. Accordingly, investors must rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment.
 
Delaware law and provisions in our Restated Certificate of Incorporation, Amended and Restated Bylaws and our stockholder rights plan may delay or prevent takeover attempts by third parties and therefore inhibit our stockholders from realizing a premium on their stock.

We are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law (the “DGCL”). This section prevents any stockholder who owns 15% or more of our outstanding common stock from engaging in certain business combinations with us for a period of three years following the time that the stockholder acquired such stock ownership unless certain approvals were or are obtained from our board of directors or the holders of 66 2/3 % of our outstanding common stock (excluding the shares of our common stock owned by the 15% or more stockholder).

Our Restated Certificate of Incorporation and Amended and Restated Bylaws also contain several other provisions that may make it more difficult for a third party to acquire control of us without the approval of our board of directors. These provisions include (i) advance notice for raising business or making director nominations at meetings, (ii) an affirmative vote of the holders of 66 2/3 % of our outstanding common stock for stockholders to remove directors or amend our Amended and Restated Bylaws or certain provisions of our Restated Certificate of Incorporation and (iii) the ability to issue “blank check” preferred stock, which our board of directors, without stockholder approval, can designate and issue with such dividend, liquidation, conversion, voting or other rights, including the right to issue convertible securities. The issuance of blank check preferred stock may adversely affect the voting and other rights of the holders of our common stock as our board of directors may designate and issue preferred stock with terms that are senior to shares of our common stock.

Our board of directors can use these and other provisions to discourage, delay or prevent a change in the control of the Company or a change in our management.  Any delay or prevention of a change in control transaction or a change in our board of directors or management could deter potential acquirers or prevent the completion of a transaction in which our stockholders could receive a substantial premium over the current market price for their shares.  These provisions could also limit the price that investors might be willing to pay for our common stock.

Item 1B.  Unresolved Staff Comments

None.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Item 2.  Properties

Inpatient Services

As of December 31, 2010, we operate 164 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, ten assisted living centers, two independent living centers and eight mental health centers. The 200 centers are comprised of 195 properties that are leased and five properties that are owned. We hold options to acquire, at fair value or at a set purchase price, ownership of 21 of the centers that we currently lease, of which options on four centers are exercisable or will become exercisable by December 31, 2011. We generally consider our properties to be in good operating condition and suitable for the purposes for which they are being used. Our leased centers are subject to long-term operating leases or subleases which require us, among other things, to fund all applicable capital expenditures, taxes, insurance and maintenance costs. The annual rent payable under most of the leases generally increases based on a fixed percentage or increases in the U.S. Consumer Price Index. Many of the leases contain extension options.  Administrative office space was also leased for our inpatient segment in 19 locations in twelve states.

On July 1, 2010 we assumed operations of a skilled nursing center in Idaho that we owned but did not previously operate.  We also transferred operations of a leased skilled nursing center in Washington to an outside party effective October 1, 2010 and operations of two skilled nursing centers in Oklahoma to outside parties effective January 1, 2011.  During the third quarter of 2010 we disposed of our nurse practitioner services group of our Inpatient Services segment, whose results have been reclassified to discontinued operations for all periods presented in accordance with GAAP.  We continue to review our operations to identify centers and operations that do not perform at an appropriate level.

Our aggregate occupancy percentage for all of our nursing and rehabilitation, assisted living, independent living and mental health centers was 87.0% for the year ended December 31, 2010. Our occupancy was 88.5% and 88.9% for the years ended December 31, 2009 and 2008, respectively. The percentages were computed by dividing the average daily number of beds occupied by the total number of available beds for use during the periods indicated (beds of acquired centers are included in the computation following the date of acquisition only). However, we believe that occupancy percentages, either individually or in the aggregate, should not be relied upon alone to determine the performance of a center. Other factors that may impact the performance of a center include, among other things, the sources of payment, terms of reimbursement and the acuity level of the patients.

The following table sets forth certain information concerning the 200 centers in our continuing operations as of December 31, 2010, which consisted of 164 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, two independent living centers and eight mental health centers.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
       
Number of Licensed Beds/Units(1)
                     
   
Total
     
Assisted/
       
   
Number of
 
Skilled
 
Independent
 
Mental
   
State
 
Centers
 
Nursing
 
Living
 
Health
 
Total
Ohio
 
17
 
2,392
 
-
 
-
 
2,392
Massachusetts
 
18
 
1,803
 
57
 
-
 
1,860
Kentucky
 
20
 
1,598
 
235
 
-
 
1,833
New Hampshire
 
15
 
1,131
 
474
 
-
 
1,605
Connecticut
 
10
 
1,327
 
72
 
-
 
1,399
California
 
15
 
858
 
-
 
473
 
1,331
Colorado
 
9
 
1,203
 
97
 
-
 
1,300
Idaho
 
11
 
1,053
 
141
 
22
 
1,216
Oklahoma
 
7
 
1,003
 
83
 
60
 
1,146
Florida
 
9
 
1,120
 
-
 
-
 
1,120
New Mexico
 
9
 
890
 
180
 
-
 
1,070
Georgia
 
9
 
1,002
 
32
 
-
 
1,034
North Carolina
 
8
 
930
 
44
 
-
 
974
Alabama
 
7
 
757
 
26
 
-
 
783
West Virginia
 
7
 
739
 
-
 
-
 
739
Tennessee
 
8
 
693
 
22
 
-
 
715
Montana
 
5
 
538
 
112
 
-
 
650
Washington
 
5
 
444
 
36
 
-
 
480
Maryland
 
3
 
434
 
-
 
-
 
434
Rhode Island
 
2
 
261
 
-
 
-
 
261
Indiana
 
2
 
208
 
-
 
-
 
208
New Jersey
 
1
 
176
 
-
 
-
 
176
Arizona
 
1
 
161
 
-
 
-
 
161
Utah
 
1
 
120
 
-
 
-
 
120
Wyoming
 
1
 
46
 
-
 
-
 
46
  Total
 
200
 
20,887
 
1,611
 
555
 
23,053

(1)
“Licensed Beds” refers to the number of beds for which a license has been issued, which may vary in  some instances from licensed beds available for use, which is used in the computation of occupancy. Available beds for the 200 centers were 22,400.

Rehabilitation Therapy Services

As of December 31, 2010, we leased offices and patient care delivery sites in 32 locations in 11 states to operate our rehabilitation therapy businesses.

Medical Staffing Services

As of December 31, 2010, we leased offices in 25 locations in 17 states to operate our medical staffing business.

Hospice Services

As of December 31, 2010, we leased offices in 20 locations in 10 states to operate our hospice business.
 
 
18

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Corporate

We lease our executive offices in Irvine, California. We also own three corporate office buildings and lease office space in a fourth building in Albuquerque, New Mexico.

Item 3.  Legal Proceedings

For a description of our legal proceedings, see Note 12(a) – “Other Events – Litigation” of our consolidated financial statements included in this Annual Report on Form 10-K, which is incorporated by reference to this item.

PART II

Item 5.  Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

New Sun’s common stock began trading under the symbol “SUNHD” on The NASDAQ Global Select Market on November 16, 2010 and then began trading under the symbol “SUNH” on December 20, 2010.  The following table shows the high and low sale prices for the common stock as reported by The NASDAQ Global Select Market for the periods indicated.  Prior to November 16, 2010, Old Sun’s common stock was traded under the symbol “SUNH” on The NASDAQ Global Select Market.

         
   
High
 
Low
2010
       
Fourth Quarter (November 16 to December 31, 2010)
$
12.99
$
9.37

There were approximately 3,265 holders of record of our common stock as of March 1, 2011. Other than in connection with the Separation, we have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future. Our senior credit facility prohibits us from paying any dividends or making any distributions to our stockholders. Any future determination to pay dividends will be at the discretion of our board of directors and will be dependent upon our financial condition, results of operations, capital requirements and other factors as our board of directors deems relevant.

 
19

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
STOCK PRICE PERFORMANCE GRAPH

New Sun separated from Old Sun on November 15, 2010 and began trading on The NASDAQ Global Select Market on November 16, 2010.  The following graph and chart compare the cumulative total stockholder return for the period from November 16, 2010 through December 31, 2010 assuming $100 was invested on November 16, 2010 in (i) our common stock, (ii) the Russell 2000 Stock Index and (iii) the Morningstar Long-Term Care Facilities Index. Cumulative total stockholder return assumes the reinvestment of all dividends. Stock price performances shown in the graph are not necessarily indicative of future price performances.

COMPARISON OF CUMULATIVE TOTAL RETURN

ASSUMES $100 INVESTED ON NOV. 16, 2010
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING DEC. 31, 2010

   
11/16/10
   
11/22/10
   
11/29/10
   
12/6/10
   
12/13/10
   
12/20/10
   
12/27/10
   
12/31/10
 
Sun Healthcare Group, Inc.
  $ 100.00     $ 88.39     $ 83.82     $ 93.14     $ 105.63     $ 109.85     $ 110.29     $ 111.35  
Russell 2000 Index
  $ 100.00     $ 103.13     $ 103.81     $ 107.93     $ 109.56     $ 111.03     $ 112.47     $ 111.30  
Long-Term Care Facilities
  $ 100.00     $ 105.40     $ 102.51     $ 107.41     $ 114.49     $ 118.90     $ 120.24     $ 120.05  


The above performance graph shall not be deemed to be soliciting material or to be filed with the Securities and Exchange Commission under the Securities Act of 1933 or the Securities Exchange Act of 1934 or incorporated by reference in any document so filed.

 
20

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Item 6.  Selected Financial Data

The following selected consolidated financial data for the periods indicated have been derived from our consolidated financial statements.  The financial data set forth below should be read in connection with Item 7 – “Management's Discussion and Analysis of Financial Condition and Results of Operations” and with our consolidated financial statements and related notes thereto (in thousands, except per share data and percentages):
 
   
At or For the Year Ended December 31,
 
   
2010 (1)
   
2009 (2)
   
2008 (3)
   
2007 (4)
   
2006 (5)
 
                               
Total net revenues
  $ 1,906,861     $ 1,880,776     $ 1,822,766     $ 1,557,463     $ 982,658  
Income before income taxes
                                       
and discontinued operations
    248       72,696       67,161       43,367       11,259  
(Loss) income from continuing
                                       
operations
    (2,716 )     43,080       114,509       54,281       11,473  
(Loss) income from discontinued
                                       
operations
    (1,934 )     (4,409 )     (5,222 )     3,229       15,645  
Net (loss) income
  $ (4,650 )   $ 38,671     $ 109,287     $ 57,510     $ 27,118  
                                         
Basic earnings per common and common equivalent share:
                                 
(Loss) income from continuing
                                       
operations
  $ (0.14 )   $ 2.95     $ 7.93     $ 3.85     $ 1.09  
(Loss) income from discontinued
                                       
operations
    (0.10 )     (0.30 )     (0.36 )     0.23       1.48  
Net (loss) income
  $ (0.24 )   $ 2.65     $ 7.57     $ 4.07     $ 2.57  
                                         
Diluted earnings per common and common equivalent share:
                         
(Loss) income from continuing
                                       
operations
  $ (0.14 )   $ 2.93     $ 7.60     $ 3.58     $ 1.07  
(Loss) income from discontinued
                                       
operations
    (0.10 )     (0.30 )     (0.35 )     0.21       1.47  
Net (loss) income
  $ (0.24 )   $ 2.63     $ 7.25     $ 3.80     $ 2.54  
                                         
Weighted average number of common and common equivalent shares:
                 
Basic
    19,280       14,614       14,444       14,117       10,546  
Diluted
    19,280       14,714       15,075       15,142       10,696  
Working capital
  $ 172,592     $ 175,604     $ 172,145     $ 83,721     $ 96,245  
Total assets
  $ 1,081,758     $ 1,571,194     $ 1,543,334     $ 1,373,826     $ 621,423  
Long-term debt and capital lease
   obligations, including current portion
  $ 155,980     $ 700,548     $ 725,841     $ 729,268     $ 174,165  
Stockholders' equity
  $ 512,443     $ 449,064     $ 403,709     $ 246,257     $ 144,133  
Dividends per share   $ 0.1335     $ -     $ -     $ -     $ -  
Dividends
  $ 9,996     $ -     $ -     $ -     $ -  
                                         
Supplemental Financial Information:
                                       
EBITDA (6)
  $ 91,320     $ 167,476     $ 162,112     $ 118,930     $ 44,013  
EBITDA margin (6)
    4.8 %     8.9 %     8.9 %     7.6 %     4.5 %
                                         
Adjusted EBITDA (6)
  $ 121,388     $ 168,822     $ 161,135     $ 122,126     $ 45,161  
Adjusted EBITDA margin (6)
    6.4 %     9.0 %     8.8 %     7.8 %     4.6 %
                                         
Adjusted EBITDAR (6)
  $ 205,722     $ 241,950     $ 234,728     $ 192,536     $ 96,575  
Adjusted EBITDAR margin (6)
    10.8 %     12.9 %     12.9 %     12.4 %     9.8 %

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
(1)
Results for the year ended December 31, 2010 include $29.1 million in transaction costs and $29.2 million in loss on extinguishment of debt due to the Separation.  The results also reflect an increase of $13.1 million of reserves for prior period self-insurance and other general liabilities and $0.4 million of transaction costs related to a hospice acquisition.
   
(2)
Results for the year ended December 31, 2009 include an increase of $8.2 million of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, $1.3 million of restructuring costs and $0.5 million of transaction costs related to a hospice acquisition.
   
(3)
Results for the year ended December 31, 2008 include a full year of revenues and expenses of Harborside Healthcare Corporation (“Harborside”), which was acquired on April 1, 2007, a release of $70.5 million of deferred tax valuation allowance, an increase of $0.9 million of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, and a gain of $0.9 million related to the sale of non-core business assets.
   
(4)
Results for the year ended December 31, 2007 include the revenues and expenses of the Harborside centers since April 1, 2007, a release of $28.8 million of deferred tax valuation allowance, a reduction of $8.6 million of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, and a charge of $3.2 million related to the early extinguishment of debt.
   
(5)
Results for the year ended December 31, 2006 include an $11.7 million release of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, a $2.5 million non-cash charge to account for certain lease rate escalation clauses, a net loss on sale of assets of $0.2 million and a $1.0 million charge for the termination of a management contract associated with the acquisition of hospice operations.
   
(6)
We define EBITDA as net income before loss (gain) on discontinued operations, interest expense (net of interest income), income tax expense (benefit), depreciation and amortization.  EBITDA margin is EBITDA as a percentage of revenue.  Adjusted EBITDA is EBITDA adjusted for the following:
· gain (loss) on sale of asset, net
· restructuring costs
· loss on extinguishment of debt, net
· loss on contract termination
 
Adjusted EBITDA margin is Adjusted EBITDA as a percentage of revenue.  Adjusted EBITDAR is Adjusted EBITDA before center rent expense.  Adjusted EBITDAR margin is Adjusted EBITDAR as a percentage of revenue. We believe that the presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides useful information regarding our operational performance because they enhance the overall understanding of the financial performance and prospects for the future of our core business activities.
 
Specifically, we believe that a presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods.  EBITDA, Adjusted EBITDA and Adjusted EBITDAR are three of the primary indicators we use for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of U.S. generally accepted accounting principles (“GAAP”), expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.
 
In addition to other financial measures, including net segment income, we use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated, segment and a center-by-center level.  EBITDA, Adjusted EBITDA and Adjusted EBITDAR are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes, depreciation and amortization expense and special charges, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a center is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business unit operates. These types of charges are dependent on factors unrelated to our underlying business. As a result, we believe that the use of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying business between periods by eliminating certain items required by GAAP which have little or no significance in our day-to-day operations.
 
We also make capital allocations to each of our centers based on expected EBITDA returns and establish compensation programs and
 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
bonuses for our center-level employees that are based upon the achievement of pre-established EBITDA and Adjusted EBITDA targets.
 
Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and facility level basis, EBITDA, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by GAAP.  As the items excluded from EBITDA, Adjusted EBITDA and Adjusted EBITDAR are significant components in understanding and assessing our financial performance, EBITDA, Adjusted EBITDA and Adjusted EBITDAR should not be considered in isolation or as alternatives to net income, cash flows generated by or used in operating, investing or financing activities or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity.  Therefore, our EBITDA, Adjusted EBITDA and Adjusted EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP.  Some of these limitations are:
 
· they do not reflect our cash expenditures, or future requirements for capital expenditures, or
   contractual commitments;
· they do not reflect changes in, or cash requirements for, our working capital needs;
· they do not reflect the interest expense, or the cash requirements necessary to service interest or
   principal payments, on our debt;
· they do not reflect any income tax payments we may be required to make;
· although depreciation and amortization are non-cash charges, the assets being depreciated and
   amortized will often have to be replaced in the future, and EBITDA, Adjusted EBITDA and
   Adjusted EBITDAR do not reflect any cash requirements for such replacements;
· they are not adjusted for all non-cash income or expense items that are reflected in our consolidated
   statements of cash flows;
· they do not reflect the impact on earnings of charges resulting from certain matters we consider
   not to be indicative of our ongoing operations; and
· other companies in our industry may calculate these measures differently than we do, which may limit
   their usefulness as comparative measures.
 
We compensate for these limitations by using EBITDA, Adjusted EBITDA and Adjusted EBITDAR only to supplement net income on a basis prepared in conformance with GAAP in order to provide a more complete understanding of the factors and trends affecting our business. We strongly encourage investors to consider net income determined under GAAP as compared to EBITDA, Adjusted EBITDA and Adjusted EBITDAR, and to perform their own analysis, as appropriate.
 
The following table provides a reconciliation of our net (loss) income, which is the most directly comparable financial measure presented in accordance with GAAP for the periods indicated, to EBITDA, Adjusted EBITDA and Adjusted EBITDAR (in thousands):

   
For the Years Ended December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
                               
Net (loss) income
$
(4,650
)
$
38,671
 
$
109,287
 
$
57,510
 
$
27,118
 
                               
Plus:
                             
Loss (income) from discontinued
     operations
 
1,934
   
4,409
   
5,222
   
(3,229
)
 
(15,646
)
Interest expense, net of interest
     income
 
43,064
   
49,327
   
54,603
   
44,347
   
18,179
 
Income tax expense (benefit)
 
2,964
   
29,616
   
(47,348
)
 
(10,914
)
 
(214
)
Depreciation and amortization
 
48,008
   
45,453
   
40,348
   
31,216
   
14,576
 
EBITDA
$
91,320
 
$
167,476
 
$
162,112
 
$
118,930
 
$
44,013
 
                               
Plus:
                             
Loss (gain) on sale of assets, net
 
847
   
42
   
(977
)
 
23
   
173
 
Restructuring costs
 
-
   
1,304
   
-
   
-
   
-
 
Loss on extinguishment of debt
 
29,221
   
-
   
-
   
3,173
   
-
 
Loss on contract termination
 
-
   
-
   
-
   
-
   
975
 
Adjusted EBITDA
$
121,388
 
$
168,822
 
$
161,135
 
$
122,126
 
$
45,161
 
                               
Plus:
                             
Center rent expense
 
84,334
   
73,128
   
73,593
   
70,410
   
51,414
 
Adjusted EBITDAR
$
205,722
 
$
241,950
 
$
234,728
 
$
192,536
 
$
96,575
 
                               
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes, which appear elsewhere in this Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report. See Item 1A – “Risk Factors.”

Overview

Our subsidiaries provide long-term, subacute and related specialty healthcare services primarily to the senior population in the United States. We were engaged in the following three principal business segments during 2010:
 
Ø
 inpatient services, primarily skilled nursing centers;
 Ø  rehabilitation therapy services; and
 Ø  medical staffing services.
 
Commencing in 2005, we implemented a business strategy to leverage our existing platform, and in December 2005, we acquired an operator of 56 skilled nursing centers and independent and assisted living residences and a small hospice operation.  In 2006, we continued this strategy by purchasing a hospice company now known as SolAmor.  In April 2007, we acquired Harborside, an operator of 73 skilled nursing centers, one assisted living center and one independent living center with approximately 9,000 licensed beds in ten states.

We continually review our operations and portfolio of facilities to determine if any of these operations or assets no longer fit with our business strategies.  This review has resulted in dispositions of certain assets and operations.

During 2008, we reclassified six skilled nursing centers into discontinued operations because they were divested, sold or qualified as assets held for sale. In 2008, we sold two hospitals that were classified as held for sale since 2007; exercised an option to purchase a skilled nursing center that was classified as held for sale since 2007 and simultaneously sold the asset; exercised options to purchase two skilled nursing centers that were classified as held for sale and sold those centers and a third center; transferred operations of two leased skilled nursing centers, and sold a regional provider of adolescent rehabilitation and special education services.

During 2009, we reclassified an assisted living facility into discontinued operations.  We elected not to renew the lease of the assisted living facility and allowed operations to transfer to another operator.  We also closed a leased skilled nursing center and transferred the remaining residents to other centers.

During 2010, we updated our historical financial statements to reflect the reclassification of our nurse practitioner services group of our Inpatient Services segment to discontinued operations during the year ended December 31, 2010.  U.S. generally accepted accounting principles (“GAAP”) require that these operations be reclassified as discontinued operations on a retroactive basis. The financial information in this Annual Report reflects that reclassification for all periods since January 1, 2006.

2010 Restructuring

As discussed in Item 1. Business, in 2010 Old Sun completed a restructuring of its business by separating its real estate assets and its operating assets into two separate publicly traded companies, Sabra and New Sun.  New Sun changed its name to Sun Healthcare Group, Inc. following the merger of Old Sun into Sabra.  Pursuant to master lease agreements that were entered into between subsidiaries of Sabra and of New Sun in connection

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

with the Separation, subsidiaries of Sabra lease to subsidiaries of New Sun the properties that Sabra’s subsidiaries own following the REIT Conversion Merger.

The Separation was accounted for as a reverse spinoff where New Sun was designated as the “accounting” spinnor and Sabra was designated as the “accounting” spinnee.  Accordingly, the assets and liabilities distributed were recorded based on their historical carrying values.

The historical carrying values of assets and liabilities distributed to Sabra in the Separation are as follows (in thousands):

Cash
$$
66,862
 
Restricted cash
 
5,527
 
Property and equipment, net of accumulated depreciation and
     
amortization of $91,878
 
484,801
 
Intangible and other assets, net
 
16,116
 
Long-term debt and mortgage notes payable
 
(386,678
)
Accrued interest on mortgage notes payable
 
(1,425
)
Other accrued liabilities
 
(2,326
)
Deferred tax liabilities
 
(21,821
)
Due to Sun Healthcare Group, Inc.
 
(5,307
)
Net distribution
$$
155,749
 

For accounting purposes, the historical consolidated financial statements of Old Sun became the historical consolidated financial statements of New Sun after the distribution on November 15, 2010.

Revenues from Medicare, Medicaid and Other Sources

We receive revenues from Medicare, Medicaid, commercial insurance, self-pay residents, other third party payors and healthcare centers that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our centers, the acuity level of patients and the rates of reimbursement among payors. Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid, and pressures on state budgets resulting from the recent adverse economic conditions in the United States may intensify these efforts. This focus has not been limited to skilled nursing centers, but includes specialty services provided by us, such as skilled therapy services, to third parties. We cannot at this time predict the extent to which proposals limiting federal or state expenditures will be adopted or, if adopted and implemented, what effect, if any, such proposals will have on us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.

In addition, due to recent adverse economic conditions, we have experienced reduced demand for the specialty services that we provide to third parties.  If economic conditions do not improve or worsen, we may experience additional reductions in demand for the specialty services we provide.  We are unable at this time to predict the impact or extent of such reduced demand.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     The following table sets forth the total nonaffiliated revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the periods indicated (data includes revenues for acquired centers following the date of acquisition only):

   
For the Years Ended
 
Sources of Revenues
 
December 31, 2010
   
December 31, 2009
   
December 31, 2008
 
   
(dollars in thousands)
 
Consolidated:
                                   
  Medicaid
  $ 771,128       40.5 %   $ 753,393       40.0 %   $ 729,014       40.0 %
  Medicare
    566,874       29.7       554,570       29.5       521,819       28.7  
  Private pay and other
    472,706       24.8       471,218       25.1       480,242       26.3  
  Managed care and
                                               
   commercial insurance
    96,153       5.0       101,595       5.4       91,691       5.0  
Total
  $ 1,906,861       100.0 %   $ 1,880,776       100.0 %   $ 1,822,766       100.0 %
                                                 
Inpatient Only:
                                               
  Medicaid
  $ 770,978       45.4 %   $ 753,260       45.0 %   $ 728,882       45.1 %
  Medicare
    548,216       32.3       538,316       32.1       509,276       31.6  
  Private pay and other
    283,271       16.7       282,300       16.9       286,025       17.7  
  Managed care and
                                               
   commercial insurance
    94,979       5.6       100,876       6.0       91,139       5.6  
Total
  $ 1,697,444       100.0 %   $ 1,674,752       100.0 %   $ 1,615,322       100.0 %

Medicare

Medicare is available to nearly every United States citizen 65 years of age and older. It is a broad program of health insurance designed to help the nation’s elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled or those having end-stage renal disease. Medicare is comprised of four related health insurance programs.  Medicare Part A provides for inpatient services including hospital, skilled long-term care, hospice and home healthcare.  Medicare Part B provides for outpatient services including physicians’ services, diagnostic service, durable medical equipment, skilled therapy services and medical supplies.  Medicare Part C is a managed care option (“Medicare Advantage”) for beneficiaries who are entitled to Part A and enrolled in Part B.  Medicare Part D is a benefit that provides prescription drug benefits for both Medicare and Medicare/Medicaid dually eligible patients.

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequent revisions, the most recent of which was effective October 1, 2010.   PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. The amount to be paid is determined by classifying each patient into one of 53 Resource Utilization Group (“RUG”) categories prior to October 1, 2010 and 66 RUGs categories after October 1, 2010.  Each RUG level represents the level of services required to treat the patient’s condition or level of acuity.

The new 66 RUG categorization is the result of research performed by CMS that created the Resource Utilization Group version IV (“RUG IV”).   RUG IV is part of CMS’s continuing effort to increase the correlation of the cost of services to the condition of individual patients.  CMS created the system to be budget neutral, but actual results are expected to vary by provider.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Under the RUG III system, CMS considered some services that were delivered in the hospital when determining the payment category, referred to as the “lookback”.  Under the RUG IV system CMS eliminated this consideration.   The RUG III system also reimbursed for therapy service delivered concurrently, in a group or individually at the same rate.  The RUG IV system changes maintain the same reimbursement methodology for group and individual therapy, but will only consider concurrent therapy if it is delivered to two patients and divides the services between the two patients that receive the services.

Changes were also made in the qualifications required to qualify for each RUG level and additional levels were added to provider further refinement.

In order to implement the RUG IV system, it was necessary for CMS to change the way some payment related data was collected and collect additional data.  CMS implemented the Minimum Data Set version 3.0 to accomplish this as well at to gather additional data that will be used to improve the quality of care of patients.

The following table sets forth the average amounts of inpatient Medicare Part A revenues per patient, per day, recorded by our healthcare centers for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2010
 
2009
 
2008
$
476.59
$
455.02
$
424.23

Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services.  An automatic exception was in place for patients residing in skilled nursing centers.  That exception will continue through December 31, 2011.

Effective January 1, 2011, changes were made in the payment methodology for Medicare Part B services received by patients in a skilled nursing facility setting.   As part of the Physician Fee Schedule, CMS applied a Multi Procedure Payment Reduction (“MPPR”).  CMS previously applied an MPPR to diagnostic services and is now expanding it to include other Part B services.  A portion of the payment for Part B services is related to activities that CMS contends are only delivered one time when multiple units of the same or related services are delivered.  CMS reduced the portion of the rate that contains these services by 25% which equates to a 7.2% reduction in Part B therapy services for us.

The adjustment will impact our rehabilitation therapy services segment by reducing the amount that we are able to charge to external customers.  We estimate the impact to be $6.5 million annually.
 
We receive Medicare reimbursements for hospice care at daily or hourly rates based on the level of care furnished to the patient.  Our ability to receive Medicare reimbursement for our hospice services is subject to two limitations:
 
 
·
If inpatient days of care provided to all patients at a hospice exceed 20% of the total days of hospice care provided by that hospice for an annual period, then payment for days in excess of this limit are paid for at the routine home care rate.  None of our hospice programs exceeded the payment limits on inpatient services for 2010 or 2009.
 
 
·
Overall payments made by Medicare on a per hospice program basis are subject to a cap amount at the end of an annual period.  The cap amount is calculated by multiplying the number of first time Medicare hospice beneficiaries during the year by the Medicare per beneficiary cap amount, resulting in that hospice’s aggregate cap, which is the allowable amount of total Medicare payments that hospice can receive for that cap year.  If a hospice program exceeds its aggregate cap, then the hospice must repay
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
the excess.  As of December 31, 2010, we had accrued $2.1 million for the repayment of Medicare payments received in excess of the cap limits.

On July 14, 2010, CMS also issued its final rule for hospice services for the 2011 federal fiscal year.  The rule includes a market basket increase of 2.6% and a 0.8% decrease resulting from a phase out of the wage index budget neutrality factor.  We estimate that the net impact on our hospice service operations of these two adjustments will be an increase of 2.2% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.3 million per quarter.

Medicaid

Medicaid is a state-administered program financed by state funds and federal matching funds. The program provides for medical assistance to the indigent and certain other eligible persons. Although administered under broad federal regulations, states are given flexibility to construct programs and payment methods. Each state in which we operate nursing and rehabilitation centers has its own unique Medicaid reimbursement system.

Medicaid outlays are a significant component of state budgets, and there have been cost containment pressures on Medicaid outlays for nursing homes.  The recent economic downturn has caused many states to institute freezes on or reductions in Medicaid spending to address state budget concerns.

Twenty-one of the states in which we operate impose a provider tax on nursing homes as a method of increasing federal matching funds paid to those states for Medicaid.  Those states that have imposed the provider tax have used some or all of the matching funds to fund Medicaid reimbursement to nursing homes.

The following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (excluding any impact of individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2010
 
2009
 
2008
$
173.62
$
171.55
$
166.62

For comparison purposes, the following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day, (including the impact from individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2010
 
2009
 
2008
$
159.79
$
159.51
$
157.08

Managed Care and Insurance

During the year ended December 31, 2010, we received 5.0% of our revenues from managed care and insurance, of which the Medicare Advantage program is the primary component.  As discussed above, Medicare Advantage is the managed care option for Medicare beneficiaries.  Medicare Advantage is administered by contracted third party payors.  The managed care and insurance payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers and increased utilization review.  These payors are increasingly demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2010
 
2009
 
2008
$
374.02
$
372.93
$
351.93

Private Payors, Veterans and Other

During the year ended December 31, 2010, we received 24.8% of our revenues from private payors, veterans’ coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors. These private and other payors are continuing their efforts to control healthcare costs.  Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2010
 
2009
 
2008
$
188.05
$
179.05
$
172.50

Other Reimbursement Matters

Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Results of Operations

The following table sets forth our historical consolidated income statements and certain percentage relationships for the years ended December 31 (dollars in thousands):

                     
As a Percentage of Net Revenues
 
   
2010
   
2009
   
2008
   
2010
   
2009
   
2008
 
                                     
Total net revenues
  $ 1,906,861     $ 1,880,776     $ 1,822,766       100.0 %     100.0 %     100.0 %
Costs and expenses:
                                               
Operating salaries and benefits
    1,077,859       1,056,265       1,027,872       56.5       56.2       56.4  
Self-insurance for workers’ compensation
                                           
and general and professional liabilities
70,806       63,740       59,689       3.7       3.4       3.3  
General and administrative expenses
    60,842       62,068       62,302       3.2       3.3       3.4  
Other operating costs (1)
    441,951       435,579       424,143       23.2       23.2       23.3  
Center rent expense
    84,334       73,128       73,593       4.4       3.9       4.0  
Depreciation and amortization
    48,008       45,453       40,348       2.5       2.4       2.2  
Provision for losses on accounts receivable
20,568       21,174       14,032       1.1       1.1       0.8  
Interest, net
    43,064       49,327       54,603       2.3       2.6       3.0  
Other expenses (income) (2)
    59,181       1,346       (977 )     3.1       -       (0.1 )
Income before income taxes and
                                               
discontinued operations
    248       72,696       67,161       -       3.9       3.7  
Income tax expense (benefit)
    2,964       29,616       (47,348 )     0.1       1.6       (2.6 )
(Loss) income from continuing operations
(2,716 )     43,080       114,509       (0.1 )     2.3       6.3  
Loss from discontinued operations
    (1,934 )     (4,409 )     (5,222 )     (0.1 )     (0.2 )     (0.3 )
Net (loss) income
  $ (4,650 )   $ 38,671     $ 109,287       (0.2 )%     2.1 %     6.0 %
                                                 
Supplemental Financial Information:
                                               
EBITDA (3)
  $ 91,320     $ 167,476     $ 162,112       4.8 %     8.9 %     8.9 %
Adjusted EBITDA (3)
  $ 121,388     $ 168,822     $ 161,135       6.4 %     9.0 %     8.8 %
Adjusted EBITDAR (3)
  $ 205,722     $ 241,950     $ 234,728       10.8 %     12.9 %     12.9 %
 
(1) Operating administrative expenses are included in “other operating costs” above.
 
(2)  Other expenses include transaction costs, loss (gain) on sale of assets, loss on extinguishment of debt and restructuring costs.
 
(3) We define EBITDA as net income before loss (gain) on discontinued operations, interest expense (net of interest income), income tax expense  (benefit), depreciation and amortization.  Adjusted EBITDA is EBITDA adjusted for gain (loss) on sale of assets, net, restructuring costs, loss on extinguishment of debt, net, loss on contract termination and loss on asset impairment. Adjusted EBITDAR is Adjusted EBITDA before center rent expense. See footnote 6 to Item 6 – “Selected Financial Data” of this report for an explanation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR, including a description of our uses of, and the limitations associated with, EBITDA, Adjusted EBITDA and Adjusted EBITDAR, and a reconciliation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR to net income, the most directly comparable GAAP financial measure.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

       The following discussion of the “Year Ended December 31, 2010 Compared to Year Ended December 31, 2009” and “Year Ended December 31, 2009 Compared to Year Ended December 31, 2008” is based on the financial information presented in Note 13 – “Segment Information” of our consolidated financial statements included in this Annual Report on Form 10-K.

Year Ended December 31, 2010 Compared to Year Ended December 31, 2009

Total net revenue increased $26.1 million, or 1.4%, to $1,906.9 million for the year ended December 31, 2010 from $1,880.8 million for the year ended December 31, 2009.  Of this increase in revenue, $22.6 million was contributed by our Inpatient Services segment and $14.3 million by our Rehabilitation Therapy segment.  These increases were offset by a $10.8 million decrease in revenue from our Medical Staffing segment.

Operating salaries and benefits expense increased $21.6 million, or 2.0%, to $1,077.9 million (56.5% of net revenues) for the year ended December 31, 2010 from $1,056.3 million (56.2% of net revenues) for the year ended December 31, 2009.  The increase is primarily the result of wage rate increases.

Self insurance for workers’ compensation and general and professional liability insurance increased $7.1 million, or 11.1%, to $70.8 million (3.7% of net revenues) for the year ended December 31, 2010 from $63.7 million (3.4% of net revenues) for the year ended December 31, 2009.  The increase was attributable to increased general and professional liability insurance costs driven by adverse developments in claims incurred in prior years.

General and administrative expenses decreased $1.3 million, or 2.1%, to $60.8 million (3.2% of net revenues) for the year ended December 31, 2010 from $62.1 million (3.3% of net revenues) for the year ended December 31, 2009.  The decrease was due to decreased salaries and bonus costs driven by continued efforts to control costs.

Other operating costs increased $6.4 million, or 1.5%, to $442.0 million (23.2% of net revenues) for the year ended December 31, 2010 from $435.6 million (23.2% of net revenues) for the year ended December 31, 2009.  The increase in other operating costs was principally comprised of cost increases due to increased provider taxes, coupled with increases in service contracts for software maintenance.

Center rent expense increased $11.2 million, or 15.3%, to $84.3 million (4.4% of net revenues) for the year ended December 31, 2010 from $73.1 million (3.9% of net revenues) for the year ended December 31, 2009.  The increase was primarily due to increased rent paid to Sabra after the Separation.

Depreciation and amortization increased $2.5 million, or 5.5%, to $48.0 million (2.5% of net revenues) for the year ended December 31, 2010 from $45.5 million (2.4% of net revenues) for the year ended December 31, 2009.  The increase was primarily attributable to additional capital expenditures incurred for information systems improvements in 2010, partially offset by a decrease in depreciation related to buildings as a result of the transfer of substantially all of our real estate to Sabra in the Separation.

The provision for losses on accounts receivable decreased $0.6 million, or 2.8%, to $20.6 million (1.1% of net revenues) for the year ended December 31, 2010 from $21.2 million (1.1% of net revenues) for the year ended December 31, 2009.  The decrease was principally driven by improved cash collections.

Net interest expense decreased $6.2 million, or 12.6%, to $43.1 million (2.3% of net revenues) for the year ended December 31, 2010 from $49.3 million (2.6% of net revenues) for the year ended December 31, 2009, principally due to lower interest rates on variable rate indebtedness coupled with reduced debt balances following the Separation.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

        Income tax expense decreased $26.6 million, or 90.0%, to $3.0 million (0.1% of net revenues) for the year ended December 31, 2010 from $29.6 million (1.6% of net revenues) for the year ended December 31, 2009, principally due to a decrease in income before income taxes and discontinued operations.  Offsetting the decrease is a partial increase because we anticipate that certain of the transaction costs for the Separation will not be deductible for tax purposes, which increases our income tax expense.

Other expenses (income) are comprised of transaction costs, loss (gain) on sale of assets, loss on extinguishment of debt and restructuring costs.  Other expenses increased $57.9 million to $59.2 million for the year ended December 31, 2010 from $1.3 million for the year ended December 31, 2009.  The increase is driven by $29.1 million of transaction costs and $29.2 million of loss on extinguishment of debt, both of which are due to the Separation and REIT Conversion Merger.

Our Adjusted EBITDA decreased $47.4 million, or 28.1%, to $121.4 million (6.4% of net revenues) for the year ended December 31, 2010 from $168.8 million (9.0% of net revenues) for the year ended December 31, 2009.  The decrease was primarily attributable to transaction costs incurred for the Separation ($29.1 million), operating salaries and benefits ($21.6 million), self-insurance for workers’ compensation and general and professional liability insurance ($7.1 million), and other operating costs ($6.4 million), offset by additional revenues of $26.1 million, all discussed above.  For an explanation of Adjusted EBITDA, including a description of our uses of, and the limitations associated with, Adjusted EBITDA, and a reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see footnote 6 to Item 6 – “Selected Financial Data” of this Annual Report on Form 10-K.

Segment information

Our reportable segments are strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.

The following table sets forth the amount and percentage of certain elements of total net revenues for the years ended December 31 (dollars in thousands):

   
2010
   
2009
   
2008
 
Inpatient Services
  $ 1,697,444       89.0 %   $ 1,674,752       89.0 %   $ 1,615,322       88.6 %
Rehabilitation Therapy Services
206,088       10.8       179,532       9.5       150,475       8.3  
Medical Staffing Services
    91,801       4.8       102,554       5.5       120,410       6.6  
Corporate
    40       0.0       34       0.0       37       0.0  
Intersegment eliminations
    (88,512 )     (4.6 )     (76,096 )     (4.0 )     (63,478 )     (3.5 )
Total net revenues
  $ 1,906,861       100.0 %   $ 1,880,776       100.0 %   $ 1,822,766       100.0 %

Inpatient services revenues for long-term care, subacute care and assisted living services include revenues billed to patients or third party payors for therapy and medical staffing services provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the years ended December 31 (in thousands):

   
2010
   
2009
   
2008
 
Rehabilitation Therapy Services
  $ 86,476     $ 74,166     $ 60,856  
Medical Staffing Services
    2,036       1,930       2,622  
Total affiliated revenues
  $ 88,512     $ 76,096     $ 63,478  
 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income.  Net segment income is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, transaction costs, income tax benefit and discontinued operations. Net segment income for the year ended December 31, 2010 for (1) our inpatient services segment decreased $6.0 million, or 3.8%, to $150.7 million, (2) our rehabilitation therapy services segment increased $3.0 million, or 27.0%, to $14.1 million and (3) our medical staffing services segment decreased $3.0 million, or 34.9%, to $5.6 million due to the factors discussed below for each segment. We use the measure of net segment income to help identify opportunities for improvement and assist in allocating resources to each segment.  The following table sets forth the amount of net segment income for the years ended December 31 (in thousands):

   
2010
   
2009
   
2008
 
Inpatient Services
  $ 150,744     $ 156,685     $ 154,866  
Rehabilitation Therapy Services
    14,073       11,112       8,462  
Medical Staffing Services
    5,595       8,610       9,690  
Net segment income before Corporate
    170,412       176,407       173,018  
Corporate
    (110,983 )   $ (102,365 )   $ (106,834 )
Net segment income
  $ 59,429       74,042       66,184  

Inpatient Services.  Net revenues increased $22.7 million, or 1.4%, to $1,697.4 million for the year ended December 31, 2010 from $1,674.7 million for the year ended December 31, 2009.  The increase in net revenues was primarily the result of:

-
an increase of $19.3 million in Medicaid revenues, driven by increases in customer base and rates, which drove $10.5 million and $8.8 million of the increase, respectively;
   
-
an increase of $14.6 million in hospice revenues due to an acquisition and internal growth; and
   
-
an increase of $2.5 million in other revenues including veterans and other various inpatient services;
   
 
offset by
   
-
a $6.2 million decrease in managed care and commercial insurance revenues due to a lower customer base;
   
-
a $4.9 million decrease in private revenues also due to a lower customer base; and
   
-
a $2.6 million decrease in Medicare revenues due to a lower customer base, which was mitigated by  increases in Medicare Part A rates and Medicare Part B revenues, which resulted in increased revenues of $21.1 million and $0.9 million, respectively.

Operating salaries and benefits expenses, excluding workers' compensation insurance costs, increased $4.6 million, or 0.6%, to $838.3 million for the year ended December 31, 2010 from $833.7 million for the year ended December 31, 2009.  The increase was primarily due to:

-
increases in compensation and related benefits and taxes of $7.2 million to remain competitive in local markets;
   
 
offset by
 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

   
-
a decrease of $2.6 million in overtime expenses.
 
        Self-insurance for workers’ compensation and general and professional liability insurance decreased $5.4 million, or 9.0%, to $54.4 million for the year ended December 31, 2010 as compared to $59.8 million for the year ended December 31, 2009.  The decrease was attributable to a $4.2 million decrease in general and professional liability insurance costs and a $1.2 million decrease in workers’ compensation costs.

Other operating costs increased $20.3 million, or 4.8%, to $457.7 million for the year ended December 31, 2010, from $437.4 million for the year ended December 31, 2009.  The increase was primarily due to:

-
a $9.4 million increase in therapy, pharmacy and medical supplies attributable to patient mix as well an increase in the number of new Rehab Recovery Suites coming on line;
   
-
a $6.7 million increase in taxes (primarily provider taxes and real estate taxes);
   
-
a $4.4 million increase in purchased services of which a majority of the increase was in service contracts, software maintenance and collection agency expense;
   
-
a $1.0 million increase in utility costs;
   
-
a $0.8 million increase in legal fees;
   
-
a $0.7 million increase in other supplies costs, principally food costs;
   
-
a $0.7 million increase in rebates and vendor discounts; and
   
-
a $0.5 million increase in contract nursing labor;
   
 
offset by
   
-
a $1.4 million decrease in equipment rental;
   
-
a $1.2 million decrease in training and recruitment costs;
   
-
a $1.0 million decrease in nursing and ancillary services consultant costs; and
   
-
a $0.3 million decrease in office lease costs.

Operating administrative expenses were consistent with the prior year at $41.2 million for the years ended December 31, 2010 and 2009.

The provision for losses on accounts receivable decreased $1.2 million, or 5.8%, to $19.4 million for the year ended December 31, 2010, from $20.6 million for the year ended December 31, 2009.  The decrease is due to improved cash collections.

Center rent expense for the year ended December 31, 2010 increased $11.3 million, or 15.8%, to $83.0 million, compared to $71.7 million for the year ended December 31, 2009. The increase was attributable to the new lease agreements signed in conjunction with the Separation and negotiated rent increases.

Depreciation and amortization increased $2.0 million, or 4.8%, to $43.3 million for the year ended
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

December 31, 2010, from $41.3 million for the year ended December 31, 2009. Increases in depreciation and amortization related to computer hardware and software, respectively, were partially offset by a decrease in depreciation related to buildings transferred to Sabra in the Separation.

Net interest expense for the year ended December 31, 2010 was $9.5 million as compared to $12.2 million for the year ended December 31, 2009.  The decrease of $2.7 million was a result of lower borrowing costs and lower aggregate borrowings.

Rehabilitation Therapy Services.  Total revenues increased $26.6 million, or 14.8%, to $206.1 million for the year ended December 31, 2010, from $179.5 million for the year ended December 31, 2009.  Of the $26.6 million increase in total revenues, affiliated contract revenues increased $12.3 million; nonaffiliated contract revenues increased $13.2 million and other revenue increased $1.1 million. The addition of 35 affiliated contracts, combined with a rate increase and service volume growth drove the affiliated contract revenue increase. The increase in nonaffiliated contract revenues was due primarily to new contracts (net positive change in contract count), rate increases in existing business and growth in dysphagia and management services business lines.  Affiliated and non-affiliated volume growth was offset by the negative effects of the changes in reimbursement for therapy occasioned by the implementation of RUG IV in October 2010.

Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, increased $21.7 million, or 14.4%, to $172.0 million for the year ended December 31, 2010 from $150.3 million for the year ended December 31, 2009. The increase was primarily due to service volume growth and an average increase of 1.66% in therapy wage rates.

Other operating costs, including contract labor expenses, increased $0.4 million, or 5.3%, to $8.0 million for the year ended December 31, 2010 from $7.6 million for the year ended December 31, 2009. The increase was primarily due to increased contract labor, supplies, administrative and business tax expenses resulting from the increased business volume.

Medical Staffing Services.  Total revenues from Medical Staffing Services decreased $10.8 million, or 10.5%, to $91.8 million for the year ended December 31, 2010 from $102.6 million for the year ended December 31, 2009. The decrease in revenues was primarily the result of:

-
a $8.1 million decrease in staffing other medical professionals due to a decline of 82,600 hours;
   
-
a decrease in locum tenens (physician placement) business of $3.3 million; and
   
-
a $0.1 million decrease due to nursing offices permanently closed in 2009;
   
 
offset by
   
-
a $0.7 million increase in the nurse staffing business.

Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, decreased $4.7 million, or 6.5%, to $67.6 million for the year ended December 31, 2010 from $72.3 million for the year ended December 31, 2009. The $4.7 million decrease was primarily driven by the decline in business volume.

Other operating costs decreased $2.9 million, or 18.5%, to $12.8 million for the year ended December 31, 2010 from $15.7 million for the year ended December 31, 2009. The decrease was primarily attributable to a decline in hours associated with the decline in revenues.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Corporate.  General and administrative costs not directly attributed to operating segments decreased $1.3 million, or 2.1%, to $60.8 million for the year ended December 31, 2010 from $62.1 million for the year ended December 31, 2009. The decrease was due to decreased salaries and bonus costs driven by continued efforts to control costs.

Interest expense

Net interest expense not directly attributed to operating segments decreased $3.5 million, or 9.4%, to $33.6 million for the year ended December 31, 2010 from $37.1 million for the year ended December 31, 2009. The decrease was principally due to lower interest rates on variable rate indebtedness coupled with reduced debt balances.

Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

Total net revenue increased $58.0 million, or 3.2%, to $1,880.8 million for the year ended December 31, 2009 from $1,822.8 million for the year ended December 31, 2008.  Of this increase in revenue $59.4 million was contributed by our Inpatient Services segment and $15.8 million by our Rehabilitation Therapy segment.  These increases were offset by a $17.2 million decrease in revenue from our Medical Staffing segment.

Operating salaries and benefits expense increased $28.4 million, or 2.8%, to $1,056.3 million (56.2% of net revenues) for the year ended December 31, 2009 from $1,027.9 million (56.4% of net revenues) for the year ended December 31, 2008.  The increase is primarily the result of wage rate increases.

Self insurance for workers’ compensation and general and professional liability insurance increased $4.0 million, or 6.7%, to $63.7 million (3.4% of net revenues) for the year ended December 31, 2009 from $59.7 million (3.3% of net revenues) for the year ended December 31, 2008.  The increase was attributable to a $5.7 million increase in general and professional liability insurance costs driven by an increased claims costs related to prior years, partially offset by a $1.7 million decrease in workers’ compensation costs resulting from costs recorded in 2008 related to earlier years.

General and administrative expenses decreased $0.2 million, or 0.3%, to $62.1 million (3.3% of net revenues) for the year ended December 31, 2009 from $62.3 million (3.4% of net revenues) for the year ended December 31, 2008.  The decrease was due to cost reductions in professional and consultant fees and benefits expenses.

Other operating costs increased $11.5 million, or 2.7%, to $435.6 million (23.2% of net revenues) for the year ended December 31, 2009 from $424.1 million (23.3% of net revenues) for the year ended December 31, 2008.  The increase in other operating costs was principally comprised of cost increases relating to pharmaceutical, therapy and other ancillary services, which in turn were driven by increased patient needs, coupled with increases in utilities and provider and real estate taxes.

Center rent expense decreased $0.5 million, or 0.7%, to $73.1 million (3.9% of net revenues) for the year ended December 31, 2009 from $73.6 million (4.0% of net revenues) for the year ended December 31, 2008.  The decrease was due to reduced rent for a previously leased center that was purchased in the first quarter of 2009.

Depreciation and amortization increased $5.2 million, or 12.9%, to $45.5 million (2.4% of net revenues) for the year ended December 31, 2009 from $40.3 million (2.2% of net revenues) for the year ended December 31, 2008.  The increase was primarily attributable to the purchase of previously leased centers and additional capital expenditures incurred for center and information systems improvements in 2009.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The provision for losses on accounts receivable increased $7.2 million, or 51.4%, to $21.2 million (1.1% of net revenues) for the year ended December 31, 2009 from $14.0 million (0.8% of net revenues) for the year ended December 31, 2008. The increase was principally driven by lower recoveries of inpatient services bad debt and continued deterioration in the aging of uncollected accounts, which are primarily private payor accounts.

Net interest expense decreased $5.3 million, or 9.7%, to $49.3 million (2.6% of net revenues) for the year ended December 31, 2009 from $54.6 million (3.0% of net revenues) for the year ended December 31, 2008, principally due to lower interest rates on variable rate indebtedness coupled with reduced debt balances.

There is a provision for income taxes of $29.6 million for the year ended December 31, 2009, compared to an income tax benefit of $47.3 million for the year ended December 31, 2008.  The 2008 benefit amount included a $70.5 million benefit from the reversal of a portion of the valuation allowance on our net deferred tax assets offset by a provision from operations and other adjustments totaling $23.2 million.  Our valuation allowance on our net deferred tax assets decreased $6.7 million during the year ended December 31, 2009 due to the write-off of deferred tax assets for certain state net operating loss carryforwards that were fully reserved.  No portion of the $6.7 million reduction in our valuation allowance in 2009 affected our provision for income taxes.

Our Adjusted EBITDA increased $7.7 million, or 4.8%, to $168.8 million (9.0% of net revenues) for the year ended December 31, 2009 from $161.1 million (8.8% of net revenues) for the year ended December 31, 2008.  The increase was primarily attributable to additional revenues of $58.0 million, offset by additional expenses, primarily operating salaries and benefits ($28.4 million), other operating costs ($11.5 million), provision for losses on accounts receivable ($7.2 million) and self-insurance for workers’ compensation and general and professional liability insurance ($4.0 million), all discussed above.  For an explanation of Adjusted EBITDA, including a description of our uses of, and the limitations associated with, Adjusted EBITDA, and a reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see footnote 6 to Item 6 – “Selected Financial Data” of this Annual Report on Form 10-K.

Segment information

Net segment income is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, transaction costs, income tax benefit and discontinued operations. Net segment income for the year ended December 31, 2009 for (1) our inpatient services segment increased $1.8 million, or 1.2%, to $156.7 million, (2) our rehabilitation therapy services segment increased $2.6 million, or 30.6%, to $11.1 million and (3) our medical staffing services segment decreased $1.1 million, or 11.3%, to $8.6 million due to the factors discussed below for each segment.

Inpatient Services.  Net revenues increased $59.5 million, or 3.7%, to $1,674.8 million for the year ended December 31, 2009 from $1,615.3 million for the year ended December 31, 2008.  The increase in net revenues was primarily the result of:
 
-
an increase of $35.6 million in Medicare revenues driven by increases in Medicare Part A rates and Medicare Part B revenues, which drove $31.6 million and $4.0 million of the increase, respectively;
   
-
an increase of $24.3 million in Medicaid revenues, driven by increases in rates and customer base, which drove $21.0 million and $3.3 million of the increase, respectively;
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

-
an increase of $15.2 million in hospice revenues due to an acquisition and internal growth; and
   
-
a $9.5 million increase in managed and commercial insurance revenues driven by a higher customer base and higher rates, which caused $4.2 million and $5.3 million of the increase, respectively;
   
-
an $8.9 million increase in revenues from private sources due to higher rates;
   
-
an increase of $0.3 million in other revenue including veterans and other various inpatient services;
   
 
offset by
   
-
a $20.2 million decrease in Medicare revenues due to a lower customer base; and
   
-
a $14.1 million decrease in private revenues also due to a lower customer base.

Operating salaries and benefits expenses, excluding workers' compensation insurance costs, increased $17.0 million, or 2.0%, to $833.7 million for the year ended December 31, 2009 from $816.7 million for the year ended December 31, 2008.  The increase was primarily due to:

-
increases in compensation and related benefits and taxes of $24.8 million to remain competitive in local markets;
   
 
offset by
   
-
a decrease of $7.8 million in overtime expenses.

Self-insurance for workers’ compensation and general and professional liability insurance increased $4.3 million, or 7.7%, to $59.8 million for the year ended December 31, 2009 as compared to $55.5 million for the year ended December 31, 2008.  The increase was attributable to a $6.1 million increase in general and professional liability insurance costs, offset by a $1.8 million decrease in workers’ compensation costs. The increase in general and professional liability costs was a result of increased claims costs related to prior years. The decrease in workers’ compensation costs resulted from costs recorded in 2008 from changes in estimates related to earlier years.

Other operating costs increased $25.6 million, or 6.2%, to $437.4 million for the year ended December 31, 2009, from $411.8 million for the year ended December 31, 2008.  The increase was primarily due to:
 
-
a $15.1 million increase in therapy, pharmacy and medical supplies attributable to patient mix as well an increase in the number of new Rehab Recovery Suites coming on line;
   
-
a $12.0 million increase in taxes (primarily provider taxes and real estate taxes);
   
-
a $4.3 million increase in purchased services of which a majority of the increase was in service contracts and software maintenance;
   
-
a $1.0 million increase in legal fees; and
   
-
a $0.5 million increase in acquisition transaction costs related to an acquisition of a hospice
 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
 
company;
   
 
Offset by
   
-
a $2.5 million decrease in contract nursing labor;
   
-
a $1.2 million decrease in equipment rental;
   
-
a $1.2 million increase in vendor discounts and rebates;
   
-
a $1.2 million decrease in help wanted;
   
-
a $1.1 million decrease in civil monetary penalties; and
   
-
a $0.1 million decrease in travel and vehicle expenses.

Operating administrative expenses decreased $0.2 million, or 0.5%, to $41.2 million for the year ended December 31, 2009 from $41.4 million for the year ended December 31, 2008.

The provision for losses on accounts receivable increased $7.3 million, or 54.9%, to $20.6 million for the year ended December 31, 2009, from $13.3 million for the year ended December 31, 2008.  The increase is due to increased credit risk associated with slower cash collections.

Center rent expense for the year ended December 31, 2009 decreased $0.5 million, or 0.7%, to $71.7 million, compared to $72.2 million for the year ended December 31, 2008. The decrease was attributable to the purchase of previously leased centers.

Depreciation and amortization increased $5.3 million, or 14.7%, to $41.3 million for the year ended December 31, 2009, from $36.0 million for the year ended December 31, 2008. The increase was attributable to additional depreciation expense due to the purchase of previously leased centers and for property and equipment acquired during the period.

Net interest expense for the year ended December 31, 2009 was $12.2 million as compared to $13.7 million for the year ended December 31, 2008.  The decrease of $1.5 million was a result of lower borrowing costs and lower aggregate borrowings.

Rehabilitation Therapy Services.  Total revenues increased $29.0 million, or 19.3%, to $179.5 million for the year ended December 31, 2009, from $150.5 million for the year ended December 31, 2008.  Of the $29.0 million increase in total revenues, affiliated revenues increased $13.3 million; nonaffiliated revenues increased $14.8 million and other revenue increased $0.9 million. The addition of nine affiliated contracts, coupled by a rate increase and service volume growth in our affiliated book of business, drove the affiliated revenue increase. The increase in nonaffiliated revenues was due primarily to new contracts (net positive change in contract count), rate increases in existing business and growth in dysphagia and management services business lines.

Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, increased $25.5 million, or 20.4%, to $150.3 million for the year ended December 31, 2009 from $124.8 million for the year ended December 31, 2008. The increase was primarily due to service volume growth and an average increase of 4.18% in therapy wage rates. These increases were compounded by an increase in health insurance costs of $1.5 million.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Other operating costs, including contract labor expenses, increased $0.5 million, or 7.0%, to $7.6 million for the year ended December 31, 2009 from $7.1 million for the year ended December 31, 2008. The increase was primarily due to increased administrative expenses and other direct contract expenses resulting from the increased business volume.

Provision for losses on accounts receivable increased $0.3 million to $0.5 million for the year ended December 31, 2009 from $0.2 million for the year ended December 31, 2008.  The increase was due to the aging of uncollected accounts and a higher reserve percentage for our oldest rehab agency accounts.

Medical Staffing Services.  Total revenues from Medical Staffing Services decreased $17.8 million, or 14.8%, to $102.6 million for the year ended December 31, 2009 from $120.4 million for the year ended December 31, 2008.  The decrease in revenues was primarily the result of:

-
a $11.2 million decrease in the nurse staffing business;
   
-
a $5.4 million decrease in staffing other medical professionals due to a decline in hours; and
   
-
a $2.4 million decrease due to nursing offices permanently closed in 2008;
   
 
offset by
   
-
an increase in locum tenens (physician placement) business of $1.2 million.

Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, decreased $14.0 million, or 16.2%, to $72.3 million for the year ended December 31, 2009 from $86.3 million for the year ended December 31, 2008. The $14.0 million decrease was primarily driven by the decline in revenue.

Other operating costs decreased $1.9 million, or 10.8%, to $15.7 million for the year ended December 31, 2009 from $17.6 million for the year ended December 31, 2008. The decrease was primarily attributable to a decline in hours associated with the decline in revenue.

Provision for losses on accounts receivable decreased $0.5 million, or 83.3%, to $0.1 million for the year ended December 31, 2009 from $0.6 million for the year ended December 31, 2008 due primarily to the recovery of large accounts that were reserved in prior year and strong ongoing collections efforts.

Corporate.  General and administrative costs not directly attributed to operating segments decreased $0.2 million, or 0.3%, to $62.1 million for the year ended December 31, 2009 from $62.3 million for the year ended December 31, 2008.

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the year ended December 31, 2009, we incurred $1.3 million of restructuring costs.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff.

Interest expense

Net interest expense not directly attributed to operating segments decreased $3.9 million, or 9.5%, to $37.1 million for the year ended December 31, 2009 from $41.0 million for the year ended December 31, 2008. The decrease was principally due to lower interest rates on variable rate indebtedness coupled with reduced debt balances.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Liquidity and Capital Resources

For the year ended and as of December 31, 2010, our net loss was $4.7 million and our working capital was $172.6 million. As of December 31, 2010, we had cash and cash equivalents of $81.2 million, $60.0 million available on our revolving credit facility and $156.0 million in borrowings.  As of December 31, 2010, we were in compliance with the covenants contained in the credit agreement governing the revolving credit facility.

Based on current levels of operations, we believe that our operating cash flows (which were $79.9 million for the year ended December 31, 2010), existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary) as discussed under “Capital Expenditures”, scheduled debt service payments and our other commitments described in the table under “Obligations and Commitments” at least through the next twelve months. We believe our long term liquidity needs will be satisfied by these same sources, as well as borrowings as required to refinance indebtedness. Although our credit agreement, which is described under “Loan Agreements”, contains restrictions on our ability to incur indebtedness, we currently believe that we will be able to refinance existing indebtedness or incur additional indebtedness, if needed. However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing debt or equity securities, on terms that are acceptable to us or at all.

Since April 2007 we have relied on our cash flows to provide for operational needs and capital expenditures, and have not relied on revolving credit borrowings. However, there can be no assurance that our operations will continue to provide sufficient cash flow or that refinancing sources will be available in the future, particularly given current economic conditions. We anticipate that we will be able to utilize our revolving credit facility if needed, as we expect to remain in compliance with the covenants contained in our credit agreement for at least the next twelve months. While we do not anticipate that any of our lenders will be unable to lend under our revolving credit facility if we determine to borrow funds, no assurance can be given that one or more of our lenders will be able to fulfill their commitments.  We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.

Cash flows

During the year ended December 31, 2010, net cash provided by operating activities decreased by $29.0 million as compared to the prior year.  This decrease was the result of (i) a year-over-year decrease in net income of $43.3 million, which is primarily driven by the transaction costs and loss on extinguishment of debt resulting from the Separation and REIT Conversion Merger, (ii) a year-over-year increase in working capital changes of $25.6 million due to timing differences and (iii) a $11.3 million decrease in non-cash adjustments to net income, principally related to deferred taxes offset by the loss on extinguishment of debt, depreciation and amortization expenses and the provision for losses on accounts receivable.

Net cash used for investing activities of $67.4 million for the year ended December 31, 2010 is comprised of (i) $53.5 million used for capital expenditures and (ii) $13.9 million used for acquisitions net of cash acquired.

Net cash used for financing activities of $35.8 million for the year ended December 31, 2010 is comprised of (i) $590.9 million in principal repayments of long-term debt and capital lease obligations, (ii) $66.9 million distributed to Sabra in connection with the Separation, (iii) $26.8 million in deferred financing costs, (iv) a $10.0 million dividend to stockholders in connection with the Separation, and (v) $2.1 million in payments to a non-controlling interest, offset by (vi) $435.5 million provided by long-term borrowings and (vii) $225.4 million provided by the issuance of common stock.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

        During the year ended December 31, 2009, net cash provided by operating activities increased by $20.7 million as compared to the prior year.  This increase was the result of (i) a year-over-year decrease in net income of $70.6 million, (ii) a year-over-year increase in working capital changes of $5.2 million due to timing differences and (iii) a $86.2 million increase in non-cash adjustments to net income, principally related to depreciation and amortization expenses, the provision for losses on accounts receivable and recognition of deferred taxes.

Loan Agreements

Prior to the completion of financings related to the Separation, Old Sun had issued, and there remained outstanding, $200.0 million aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”), and a senior secured credit facility with a syndicate of financial institutions (the “Old Sun Credit Agreement”).    The Old Sun Credit Agreement, following an amendment entered into in June 2010, provided for $365.0 million of term loans, a $45.0 million letter of credit facility and a $50.0 million revolving credit facility.   Interest on the outstanding unpaid principal amount of loans under the Old Sun Credit Agreement equaled an applicable percentage plus, at Old Sun’s option, either (a) an alternative base rate determined by reference to the higher of (i) the prime rate announced by Credit Suisse and (ii) the federal funds rate plus one-half of 1.0%, or (b) the London Interbank Offered Rate (“LIBOR”), adjusted for statutory reserves.  The applicable percentage for term loans and revolving loans at September 30, 2010 was 2.0% for alternative base rate loans and 3.0% for LIBOR loans.

In October 2010, in connection with the Separation, subsidiaries of Sabra issued $225 million principal amount of senior notes due 2018, the proceeds of which were used, together with cash from Old Sun, to redeem the Notes in December 2010, including accrued interest and a redemption premium.

In October 2010, in connection with the Separation, New Sun entered into a $285.0 million senior secured credit facility (the “Credit Agreement”) with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent.  The Credit Agreement provides for $150.0 million in term loans ($147.5 million was outstanding at December 31, 2010), a $60.0 million revolving credit facility ($30.0 million of which may be utilized for letters of credit) and a $75.0 million letter of credit facility funded by proceeds of additional term loans ($66.2 million was utilized at December 31, 2010).  The revolving credit facility was undrawn on December 31, 2010. In addition to funding the letter of credit facility, the proceeds of the term loans were used to repay outstanding term loans under the Old Sun Credit Agreement, which was concurrently terminated, to pay related fees and expenses and to provide funds for general corporate purposes.  The letter of credit facility replaced the letter of credit facility under the Old Sun Credit Agreement.  The final maturity date of the term loans and the letter of credit facility is October 18, 2016 and the revolving credit facility terminates on October 18, 2015.

Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test and a leverage covenant.  The Credit Agreement contains customary events of default, such as a failure by New Sun to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting certain actions, including incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments.  The obligations of New Sun under the Credit Agreement are guaranteed by most of New Sun’s subsidiaries and are collateralized by the assets of New Sun and most of New Sun’s subsidiaries.

Amounts borrowed under the term loan facility are due in quarterly installments of $2.5 million, with the remaining principal amount due on the maturity date of the term loans.  Accrued interest is payable at the end of an interest period, but no less frequently than every three months.  Borrowings under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at New Sun’s option, either (a) the greater of 1.75% or LIBOR, adjusted for statutory reserves or (b) an alternative base
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

rate determined by reference to the highest of (i) the prime rate announced by Credit Suisse, (ii) the federal funds rate plus one-half of 1.0%, and (iii) the greater of 1.75% or one-month LIBOR adjusted for statutory reserves plus 1%.  The applicable percentage for term loans and revolving loans is 4.75% for alternative base rate loans and 5.75% for LIBOR loans.  Each year, commencing in 2012, within 90 days of the prior fiscal year end, New Sun is required to prepay a portion of the term loans in an amount based on the prior year’s excess cash flows, if any, as defined in the Credit Agreement. In addition to paying interest on outstanding loans under the Credit Agreement, New Sun is required to pay a facility fee of 0.50% per annum to the lenders under the revolving credit facility in respect of the unused revolving commitments.

In August 2010, we refinanced mortgage indebtedness collateralized by four of our health care centers.  The new mortgage indebtedness of $20.5 million bears interest at LIBOR plus 4.5% (with a LIBOR floor of 1.0%).  In October 2010, we refinanced mortgage indebtedness collateralized by nine of our health care centers.  The new mortgage indebtedness of $30.0 million bears interest at LIBOR plus 4.5% (with a LIBOR floor of 1.0%), and was collateralized by seven of our health care centers.  Both mortgage loans were assumed by Sabra in the Separation.

Acquisitions

In December 2010, we completed the purchase of a hospice company that operates in Alabama and Georgia for $13.9 million.  The purchase price included allocations of $6.7 million for intangible assets, $9.7 million for goodwill, and $0.3 million for net working capital and other assets.

In October 2009, we completed the purchase of a hospice company, which operates four hospice programs in three states in the New England area, for $16.1 million.  The purchase price included allocations of $6.3 million for intangible assets, $11.3 million for goodwill, and $1.5 million for net working capital and other assets.

Assets held for sale

We had no assets held for sale as of December 31, 2010 or 2009.

During 2010 we disposed of our nurse practitioner services group of our Inpatient Services segment, whose results have been reclassified to discontinued operations for all periods presented in accordance with GAAP.  During October 2009, we transferred operations of an assisted living center in Utah to an outside party.  This center has been classified as a discontinued operation.

Capital expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, of $53.5 million, $54.3 million, and $42.5 million for the years ended December 31, 2010, 2009, and 2008, respectively, which included capital expenditures for discontinued operations of $0.1 million for the year ended December 31, 2008.  We did not incur any capital expenditures related to discontinued operations in 2010 or 2009.  During the year ended December 31, 2010, we incurred $32.1 million of capital expenditures for ongoing normal operational needs of our centers, plus we expended $16.4 million for major renovations of our centers, including $7.4 million spent on construction of our Rehab Recovery Suites.  Our development and rollout of a new billing platform and labor management system resulted in $2.1 million of expenditures during 2010.  We also incurred capital expenditures of $2.9 million in our Corporate segment for information systems and other needs.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

We had construction commitments as of December 31, 2010 under various contracts of $9.4 million related to improvements at centers.  These commitments, and other expenditures in response to emergency situations at our centers, the amount of which we cannot predict, represent our non-discretionary capital expenditures.  The remaining amount of our 2010 planned capital expenditures is discretionary.  We expect to incur approximately $55 million to $60 million in capital expenditures during 2011, related primarily to improvements at existing centers and information system upgrades.

Obligations and Commitments

The following table provides information about our contractual obligations and commitments in future years as of December 31, 2010 (in thousands):

   
Payments Due by Period
 
                                       
After
 
   
Total
   
2011
   
2012
   
2013
   
2014
   
2015
   
2015
 
Contractual Obligations:
                                         
Debt, including interest
                                         
payments (1)
  $ 249,081     $ 28,035     $ 27,288     $ 26,541     $ 25,323     $ 24,084     $ 117,810  
Capital leases (2)
    587       336       194       51       6       -       -  
Construction commitments
    9,387       9,387       -       -       -       -       -  
Purchase obligations (3)
    373,080       101,880       101,880       79,080       56,280       33,960       -  
Operating leases (4)
    1,199,645       147,256       143,121       139,600       110,483       108,637       550,548  
Other liabilities (5)
    6,173       -       6,173       -       -       -       -  
                                                         
Total
  $ 1,837,953     $ 286,894     $ 278,656     $ 245,272     $ 192,092     $ 166,681     $ 668,358  

   
Amount of Commitment Expiration Per Period
 
   
Total
                                     
   
Amounts
                                 
After
 
   
Committed
   
2011
   
2012
   
2013
   
2014
   
2015
   
2015
 
Other Commercial Commitments:
                           
Letters of credit (6)
  $ 66,169     $ 66,169     $ -     $ -     $ -     $ -     $ -  
                                                         
Total
  $ 66,169     $ 66,169     $ -     $ -     $ -     $ -     $ -  

(1)
Debt includes principal payments and interest payments through the maturity dates. Total interest on debt, based on contractual rates, is $93.6 million, of which $88.9 million is attributable to variable interest rates determined using the weighted average method.
(2)
Includes interest of $0.1 million.
(3)
Represents our estimated level of purchasing from our main suppliers assuming that we continue to operate the same number of centers in future periods.
(4)
Some of our operating leases also have contingent rentals.
(5)
$6.2 million of liability due to the previous shareholders of Harborside when certain tax benefits associated with that acquisition are realized.  Excludes liabilities for uncertain tax positions that are included in other liabilities at December 31, 2010 for which we are unable to make a reasonably reliable estimate as to when, if at all, cash settlements with taxing authorities will occur.
(6)
Letters of credit expire annually but may be reissued pursuant to a $75.0 million letter of credit facility that terminates in October 2016.

Critical Accounting Estimates

Our discussion and analysis of the financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of assets and liabilities, the disclosure of contingent assets and
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ materially from these estimates. We believe the following are the most significant judgments and estimates affecting the accounting policies we use in the preparation of the consolidated financial statements.

Net revenues.  Net revenues consist of long-term and subacute care revenues, rehabilitation therapy revenues, and medical staffing services revenues. Net revenues are recognized as services are provided and billed. Revenues are recorded net of provisions for discount arrangements with commercial payors and contractual allowances with third-party payors, primarily Medicare and Medicaid. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment. Estimated third-party payor settlements are recorded in the period the related services are rendered. The methods of making such estimates are reviewed periodically, and differences between the net amounts accrued and subsequent settlements or estimates of expected settlements are reflected in current results of operations, when determined.

Accounts receivable and related allowance.  Our accounts receivable relate to services provided by our various operating divisions to a variety of payors and customers. The primary payors for services provided in healthcare centers that we operate are the Medicare program and the various state Medicaid programs. The rehabilitation therapy service operations provide services to patients in nonaffiliated healthcare centers. The billings for those services are submitted to the nonaffiliated centers. Many of the nonaffiliated healthcare centers receive a large majority of their revenues from the Medicare program and the state Medicaid programs.

Estimated provisions for losses on accounts receivable are recorded each period as an expense in the income statement.  In evaluating the collectability of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the financial condition of our customers, the composition of patient accounts by payor type, the status of ongoing disputes with third-party payors and general industry conditions.  Any changes in these factors or in the actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of change.  In addition, a retrospective collection analysis is performed within each operating company to test the adequacy of the reserve on a semi-annual basis.

The allowance for doubtful accounts related to centers that we have divested was based on management’s expectation of collectability at the time of divestiture and was recorded in gain or loss on disposal of discontinued operations, net. As collections are recognized or new information becomes available, the allowance is adjusted as appropriate. As of December 31, 2010, accounts receivable for divested operations were significantly reserved.

Insurance.  We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs.  Insurance reserves represent estimates of future claims payments. This liability includes an estimate of the development of reported losses and losses incurred but not reported. Provisions for changes in insurance reserves are made in the period of the related coverage.  An independent actuarial analysis is prepared twice a year to assist management in determining the adequacy of the self-insurance obligations booked as liabilities in our financial statements. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments resulting there from are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform detailed actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  Reported loss methods focus on development of case reserves for incurred losses through claims closure. Paid loss methods focus on development of claims actually paid to date. Expected loss methods are based upon an anticipated loss per unit of measure. The Bornhuetter-Ferguson method is a combination of loss development methods and expected loss methods.

The foundation for most of these methods is our actual historical reported and/or paid loss data, over which we have effective internal controls. We utilize third-party administrators (“TPAs”) to process claims and to provide us with the data utilized in our semi-annual actuarial analyses. The TPAs are under the oversight of our in-house risk management and legal functions. These functions ensure that the claims are properly administered so that the historical data is reliable for estimation purposes. Case reserves, which are approved by our legal and risk management departments, are determined based on our estimate of the ultimate settlement of individual claims. In cases where our historical data are not statistically credible, stable, or mature, we supplement our experience with nursing home industry benchmark reporting and payment patterns.

The use of multiple methods tends to eliminate any biases that one particular method might have. Management’s judgment based upon each method’s inherent limitations is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which includes the case reserves plus an estimate for future development of these reserves based on past trends, and an estimate for losses incurred but not reported.   These results are compared by accident year and an estimated unpaid loss and allocated loss adjustment expense are determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.

Regarding our estimates for workers’ compensation reserves, there were no large or unusual settlements during the 2010 period.  As of December 31, 2010, the discounting of the policy periods resulted in a reduction to our reserves of $13.4 million.

During 2010 we determined that the previous estimates for general and professional liabilities reserves for matters related to years prior to 2010 were understated by $13.1 million due to adverse developments with respect to a number of claims that arose in prior periods. Accordingly we have recorded a charge in the fourth quarter of 2010 to increase our general and professional liabilities reserves.  Professional liability claims have a reporting tail that exceeds one year.  A significant component of our reserves is estimates for incidents that have been incurred but not reported.

Impairment of assets.

Goodwill and Accounting for Business Combinations

Goodwill represents the excess of the purchase price over the fair value of the net assets of acquired companies.  Our goodwill included in our consolidated balance sheets as of December 31, 2010 and 2009 was $348.0 and $338.3 million, respectively.  The increase in our goodwill during 2010 was primarily the result of a hospice acquisition in our Inpatient Services segment.

Under GAAP, goodwill and intangible assets with indefinite lives are not amortized; however, they are subject to annual impairment tests. Intangible assets with definite lives continue to be amortized over their estimated useful lives.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


The purchase price of acquisitions is allocated to the assets acquired and liabilities assumed based upon their respective fair values.  We may engage independent third-party valuation firms to assist us in determining the fair values of assets acquired and liabilities assumed for significant acquisitions.  Such valuations require us to make significant estimates and assumptions, including projections of future events and operating performance.

We perform our annual goodwill impairment analysis for our reporting units during the fourth quarter of each year, which timing for 2010 also coincided with the Separation.  A reporting unit is a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment and are reviewed at the division level.  For our Rehabilitation Therapy Services and Medical Staffing Services segments, the reporting unit for our annual goodwill impairment analysis was determined to be at the segment level.  For our Inpatient Services segment, the reporting unit for our annual goodwill impairment analysis was determined to be at one level below our segment level.  Our goodwill balances by reporting unit as of December 31, 2010 are (in thousands):

Inpatient Services – Healthcare facilities reporting unit
  $ 314,729  
Inpatient Services – Hospice services reporting unit
    28,710  
Rehabilitation Therapy Services segment
    75  
Medical Staffing Services segment
    4,533  
Total goodwill
  $ 348,047  

We determined potential impairment by comparing the net assets of each reporting unit to their respective fair values, which GAAP describes as Step 1 of goodwill impairment testing. We determined the estimated fair value of each reporting unit using a discounted cash flow analysis and other appropriate valuation methodologies. In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit, which is referred to in GAAP as Step 2 of the impairment analysis. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill.  An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value.

The discounted cash flow model utilizes five years of projected cash flows for each reporting unit. The projected financial results are created from critical assumptions and estimates based upon management’s business plan and historical trends while giving consideration to the overall economic environment. Determining fair value requires the exercise of significant judgments about appropriate discount rates, business growth rates, the amount and timing of expected future cash flows and market information relevant to our overall company value. In addition, to validate the reasonableness of our assumptions, we utilized our discounted cash flow model on a consolidated basis and compared the estimated fair value to our market capitalization as of December 31, 2010.  Key assumptions in the discounted cash flow model are as follows:

Business Growth Assumptions – In determining our projected Inpatient Services revenue growth rates for our discounted cash flow model, we focus on the two primary drivers: average daily census (“ADC”) and reimbursement rates. Key revenue inputs include historical ADC adjusted for known trends and current Medicare and Medicaid rates adjusted for anticipated changes. ADC trends have been reasonably constant within a narrow range and may be influenced over the long run by a number of factors, including demographic changes in the population we serve and our ability to deliver quality service in an attractive environment. Generally long term care reimbursement rates are set annually by the payor. To estimate these rates, we evaluate the current reimbursement climate and adjust historical trends where appropriate. Significant adverse rate changes in any one year would cause us to reevaluate our projected rates.  In recent years we have generated historical revenue growth of 1.4% to 6.2% annually.  Expenses generally vary with ADC and have historically grown by approximately 2.9% to
 
47

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

5.6% annually.  Labor is the largest component of our expenses.  We consider labor market trends and staffing needs for the projected ADC levels in determining labor growth rates to be used in our projections. The projected growth rates used in our discounted cash flow model took into account the potential adverse effects of the current economic downturn on our projected revenue and expenses.

Terminal Value EBITDAR Multiple – Consistent with commonly accepted valuation techniques, a terminal multiple for the final year’s projected results is applied to estimate our value in the final year of the analysis. That multiple is applied to the final year’s projected EBITDAR from continuing operations.

Discount Rate – Market conditions indicated that a discount rate of 13% was appropriate at December 31, 2010.  This discount rate is consistent with our overall market capitalization comparison. We consistently apply the same discount rate to the evaluation of each reporting unit.

The goodwill impairment analysis is subject to impact from uncertainties arising from such events as changes in economic or competitive conditions, the current general economic environment, material changes in Medicare and Medicaid reimbursement that could positively or negatively impact anticipated future operating conditions and cash flows, and the impact of strategic decisions such as the Separation. The Step 1 results of our fourth quarter 2010 goodwill impairment analysis showed that none of our reporting units exhibited any indications of potential goodwill impairment. Based on the analysis performed, we determined there was no goodwill impairment for the years ended December 31, 2010, 2009 or 2008.

In accordance with the authoritative guidance for goodwill and other intangible assets, we are required to perform an impairment test for goodwill and indefinite lived intangible assets at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. During 2010 and 2009, the market value of our common stock was below our book equity value. Management believes that the difference between our market equity value and our book equity during 2010 was generally attributable to uncertainty in equity markets related to certain Medicare regulatory changes that went into effect October 1, 2010 for our Inpatient Services and Rehabilitation Services segments and uncertainty related to the enactment of healthcare reform legislation during 2010. Management believes that the difference between our market equity value and our book equity value during 2009 was generally attributable to uncertainty in the equity markets related to proposed federal healthcare reform legislation and certain Medicare revenue reductions announced by CMS during the year. The difference between the book equity value and the market value of our common stock during 2010 and 2009 was a potential indication that the carrying value of our goodwill may have been impaired but was not viewed as a triggering event.

Although we have determined that there was no goodwill or other indefinite lived intangible asset impairments as of December 31, 2010, adverse changes in the operating environment and related key assumptions used to determine the fair value of our reporting units and indefinite lived intangible assets or declines in the value of our common stock may result in future impairment charges for a portion or all of these assets. Specifically, if the rate of growth of government and commercial revenues earned by our reporting units were to be less than projected or if healthcare reforms were to negatively impact our business, an impairment charge for a portion or all of the assets may be required. An impairment charge could have a material adverse effect on our financial position and results of operations, but would not be expected to have an impact on our cash flows or liquidity.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
Indefinite Lived Intangibles

Our indefinite lived intangibles primarily consist of values assigned to CONs and regulatory licenses obtained through various acquisitions.

We evaluate the recoverability of our indefinite lived intangibles by comparing the asset's respective carrying value to estimates of fair value. We determine the estimated fair value of these intangible assets through an estimate of incremental cash flows with the intangible assets versus cash flows without the intangible assets in place. We determined there was no impairment charge to our indefinite lived intangibles for the years ended December 31, 2010, 2009 or 2008.

Finite Lived Intangibles

Our finite lived intangibles include tradenames, favorable lease intangibles and customer contracts.

We evaluate the recoverability of our finite lived intangibles if an impairment indicator is present.  As there were no such indicators, we determined there was no impairment of our finite lived intangibles for the years ended December 31, 2010, 2009 or 2008.

Long-Lived Assets

GAAP requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets' carrying amounts at each center. The impairment loss is measured by comparing the estimated fair value of the asset, usually based on discounted cash flows, to its carrying amount.  We assess the need for an impairment write-down when such indicators of impairment are present.  We determined there was no impairment to our long-lived assets used in continuing operations for the years ended December 31, 2010, 2009, and 2008.

Income Taxes.  Pursuant to GAAP, an asset or liability is recognized for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements.  These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled.  Deferred tax assets are also recognized for the future tax benefits from net operating loss, capital loss and tax credit carryforwards.  A valuation allowance is to be provided for the net deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

In evaluating the need to record or continue to reflect a valuation allowance, all items of positive evidence (e.g., future sources of taxable income and tax planning strategies) and negative evidence (e.g., history of taxable losses) are considered.  In determining future sources of taxable income, we use management-approved budgets and projections of future operating results for an appropriate number of future periods, taking into consideration our history of operating results, taxable income and losses, etc.  This future taxable income is then used, along with all other items of positive and negative evidence, to determine the amount of valuation allowance that is needed, and whether any amount of such allowance should be reversed.

We are subject to income taxes in the U.S. and numerous state and local jurisdictions.  Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.  Effective January 1, 2007, we adopted the GAAP guidance for accounting for uncertainty in income tax positions, which contains a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

processes, if any.  The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement.  We reserve for our uncertain tax positions, and we adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the expiration of the statute of limitations.

Recent Accounting Pronouncements

Discussion of recent accounting pronouncements can be found in the “Recent Accounting Pronouncements” portion of Note 2 – “Summary of Significant Accounting Policies” to our consolidated financial statements included in this Annual Report on Form 10-K, which is incorporated by reference in response to this item.

Impact of Inflation

CMS implemented market basket increases of 2.3%, 2.2%, and 3.4% to the Medicare reimbursement rates for Federal fiscal years 2011, 2010, and 2009, respectively, which increases were primarily intended to keep track with inflation. The final rule for Federal fiscal year 2010 also had a 0.6% reduction for a forecast error/parity adjustment.  We estimate that the net result of the two 2011 adjustments, based on our current acuity mix, will be an increase of 1.7% in our reimbursement rates, which we estimate will increase our net revenues by approximately $1.9 million per quarter.

Off-Balance Sheet Arrangements

None.

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk because we hold debt that is sensitive to changes in interest rates.  We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates for debt.

   
Expected Maturity Dates
         
Fair Value
   
Fair Value
 
                                             
December 31,
    December 31,
   
2011
   
2012
   
2013
   
2014
   
2015
   
Thereafter
   
Total
   
2010 (1)
   
2009 (1)
 
   
(Dollars in thousands)
 
Long-term Debt:
                                                     
Fixed rate debt
$
1,050
 
$
1,002
 
$
949
 
$
517
 
$
65
 
$
4,897
 
$
8,480
 
$
8,584
 
$
488,393
 
Rate
 
7.5
%
 
7.3
%
 
7.0
%
 
6.8
%
 
6.7
%
 
6.7
%
                 
Variable rate debt
$
10,000
 
$
10,000
 
$
10,000
 
$
10,000
 
$
10,000
 
$
97,500
 
$
147,500
 
$
147,500
 
$
202,557
 
Rate
 
7.5
%
 
7.5
%
 
7.5
%
 
7.5
%
 
7.5
%
 
7.5
%
                 
                                                       
 
(1)    
The fair value of fixed and variable rate debt was determined based on the current rates offered for debt with similar risks and maturities.
 

Item 8.  Financial Statements and Supplementary Data

Information with respect to Item 8 is contained in our consolidated financial statements and financial statement schedules and is set forth herein beginning on Page F-1 which information is incorporated by reference into this Item 8.

Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Item 9A.  Controls and Procedures

Management's Report on Disclosure Controls and Procedures

We maintain disclosure controls and procedures defined in Rule 13a-15(e) under the Exchange Act, as controls and other procedures that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer (“CEO”), William A. Mathies, and Chief Financial Officer (“CFO”), L. Bryan Shaul, as appropriate to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of management, including the CEO and CFO, of the effectiveness of the Company’s disclosure controls and procedures.  Based on that evaluation, our CEO and CFO concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2010.

Management's Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act).  Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation and presentation. Therefore, even those systems determined to be effective may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of internal control over financial reporting as of December 31, 2010, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control – Integrated Framework.  Based on this assessment, our management concluded that our internal control over financial reporting was effective as of December 31, 2010.

The effectiveness of the Company’s internal control over financial reporting as of December 31, 2010 has been audited by PricewaterhouseCoopers LLP (“PwC”), an independent registered public accounting firm, as stated in their report which appears herein.

Changes to Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2010 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Item 9B.  Other Information

Not applicable.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

PART III

Item 10.  Directors, Executive Officers and Corporate Governance

The information required under Item 10 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to May 2, 2011.

Code of Ethics

     We have adopted a Code of Ethics that applies to our Chief Executive Officer, Chief Financial Officer, and Corporate Controller, and other financial personnel.  The Code of Ethics is designed to deter wrongdoing and to promote, among other things, (i) honest and ethical conduct, (ii) full, fair, accurate, timely and understandable disclosures, and (iii) compliance with applicable governmental laws, rules and regulations.  The Code of Ethics is available on our web site at www.sunh.com by clicking on “Governance” and then “Compliance.”   If we make any substantive amendments to the Code of Ethics or grant any waiver, including any implicit waiver, from a provision of the Code to our Chief Executive Officer, Chief Financial Officer or Corporate Controller, we will disclose the nature of such amendment or waiver on our website.

Item 11.  Executive Compensation

The information required under Item 11 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to May 2, 2011.

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required under Item 12 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to May 2, 2011.

Item 13.  Certain Relationships and Related Transactions and Director Independence

The information required under Item 13 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to May 2, 2011.

Item 14.  Principal Accountant Fees and Services

The information required under Item 14 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to May 2, 2011.

PART IV

Item 15.  Exhibits, Financial Statements and Schedules
 
(a)
(1)
The following consolidated financial statements of Sun Healthcare Group, Inc. and subsidiaries are filed as part of this report under Item 8 – “Financial Statements and Supplementary Data”:
     
   
Report of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
   
   
Consolidated Balance Sheets as of December 31, 2010 and 2009
     
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
   
   
Consolidated Income Statements for the years ended December 31, 2010, 2009 and 2008
     
   
Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the years ended December 31, 2010, 2009 and 2008
     
   
Consolidated Statements of Cash Flows for the years ended December 31, 2010, 2009 and 2008
     
   
Notes to Consolidated Financial Statements
     
 
(2)
Financial schedules required to be filed by Item 8 of this form, and by Item 15(a)(2) below:
     
   
Schedule II Valuation and Qualifying Accounts for the years ended December 31, 2010, 2009 and 2008
     
   
All other financial schedules are not required under the related instructions or are inapplicable and therefore have been omitted.
     
 
(3)
Exhibits
 
Exhibit
 
Number
Description of Exhibits
   
2.1(1)
Agreement and Plan of Merger dated October 19, 2006 by and among Sun Healthcare Group, Inc., Horizon Merger, Inc. and Harborside Healthcare Corporation
   
2.2(8)±
Distribution Agreement, dated November 4, 2010, by and among Sun Healthcare Group, Inc. (Old Sun), Sabra Health Care REIT, Inc. and Sun Healthcare Group, Inc. (formerly SHG Services, Inc.)
   
3.1*
Amended and Restated Certificate of Incorporation of Sun Healthcare Group, Inc., as amended
   
3.2*
Amended and Restated Bylaws of Sun Healthcare Group, Inc.
   
10.1(2)
Credit Agreement, dated as of October 18, 2010, among Sun Healthcare Group, Inc., the Lenders named therein and Credit Suisse, as Administrative Agent and Collateral Agent for the Lenders
   
10.2*+
Sun Healthcare Group, Inc. 2004 Equity Incentive Plan
   
10.3*+
Sun Healthcare Group, Inc. 2009 Performance Incentive Plan
   
10.4*+
Form of Stock Option Agreement
   
10.5*+
Form of Stock Unit Agreement for employees
   
10.6*+
Form of Stock Unit Agreement for non-employee directors
 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
10.7*+
Non-employee Directors Stock-for-Fees Program and Payment Election Form
   
10.8(3)+
Amended and Restated Employment Agreement by and between Sun Healthcare Group, Inc. and L. Bryan Shaul dated as of December 17, 2008
   
10.9(4)+
Employment Agreement by and between Sun Healthcare Group, Inc. and William A.  Mathies dated as of November 18, 2010
   
10.10(3)+
Amended and Restated Employment Agreement by and between Sun Healthcare Group, Inc. and Michael Newman dated as of December 17, 2008
   
10.11(3)+
Amended and Restated Employment Agreement by and between Sun Healthcare Group, Inc. and Chauncey J. Hunker dated as of December 17, 2008
   
10.12*+
Non-Employee Director Compensation Policy of Sun Healthcare Group, Inc.
   
10.13(9)
Tax Allocation Agreement, dated as of September 23, 2010, by and among Sun Healthcare Group, Inc. (Old Sun), Sabra Health Care REIT, Inc. and Sun Healthcare Group, Inc. (formerly SHG Services, Inc.)
   
10.14(5)
Third Amended and Restated Master Lease Agreement among Sun Healthcare Group, Inc. and certain of its subsidiaries (as Lessees) and Omega Healthcare Investors, Inc. and certain of its subsidiaries (as Lessors) dated November 4, 2010
   
10.14.1(5)
Guaranty dated November 4, 2010 by Sun Healthcare Group, Inc. in favor of Lessors under the Third Amended and Restated Master Lease Agreement dated November 4, 2010 among Sun Healthcare Group, Inc. and certain of its subsidiaries (as Lessees) and Omega Healthcare Investors, Inc. and certain of its subsidiaries (as Lessors)
   
10.15(5)
Form of Indemnification Agreement entered into with each of the directors and officers of Sun Healthcare Group, Inc. and certain of its subsidiaries
   
10.16(10)+
Sun Healthcare Group, Inc. Deferred Compensation Plan
   
10.17(6)+
Amended and Restated Severance Benefits Agreement dated as of December 17, 2008 by and between Richard L. Peranton and CareerStaff Unlimited, Inc.
   
10.18(7)+
Amended and Restated Severance Benefits Agreement dated as of December 17, 2008 by and between Sue Gwyn and SunDance Rehabilitation Corporation
   
10.19(8)
Transition Services Agreement, dated November 4, 2010, by and between Sun Healthcare Group, Inc. (formerly SHG Services, Inc.) and Sabra Health Care REIT, Inc.
   
10.20(8)
Form of Master Lease Agreement entered into between subsidiaries of Sun Healthcare Group, Inc. (formerly SHG Services, Inc.) and subsidiaries of Sabra Health Care REIT, Inc.
   
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

10.20.1(8)
Form of Guaranty entered into by Sun Healthcare Group, Inc. (formerly SHG Services, Inc.) in favor of subsidiaries of Sabra Health Care REIT, Inc., as landlords under the Master Lease Agreements.
   
21.1*
Subsidiaries of Sun Healthcare Group, Inc.
   
23.1*
Consent of PricewaterhouseCoopers LLP
   
31.1*
Section 302 Sarbanes-Oxley Certifications by Principal Executive Officer
   
31.2*
Section 302 Sarbanes-Oxley Certifications by Principal Financial and Accounting Officer
   
32.1*
Section 906 Sarbanes-Oxley Certifications by Principal Executive Officer
   
32.2*
Section 906 Sarbanes-Oxley Certifications by Principal Financial and Accounting Officer
_______________

*      Filed herewith.
+      Designates a management compensation plan, contract or arrangement
±
Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The registrant hereby agrees to furnish supplementally copies of any of the omitted schedules and exhibits upon request by the Securities and Exchange Commission.


(1)
Incorporated by reference from exhibits to our Form 8-K filed on October 25, 2006
(2)
Incorporated by reference from exhibits to our Form 8-K filed on October 22, 2010
(3)
Incorporated by reference from exhibits to our Form 10-K filed on March 4, 2009
(4)
Incorporated by reference from exhibits to our Form 8-K filed on November 23, 2010
(5)
Incorporated by reference from exhibits to our Form 8-K filed on November 16, 2010
(6)
Incorporated by reference from exhibits to our Form 10-Q filed on August 7, 2009
(7)
Incorporated by reference from exhibits to our Form 10-K filed on March 5, 2010
(8)
Incorporated by reference from exhibits to our Form 8-K filed on November 5, 2010
(9)
Incorporated by reference from exhibits to our Form 8-K filed on September 29, 2010
(10)
Incorporated by reference from exhibits to our Form 10-Q filed on April 29, 2009



 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
SUN HEALTHCARE GROUP, INC.
   
   
   
 
By:    /s/ L. Bryan Shaul                            
 
       L. Bryan Shaul
 
       Chief Financial Officer

February 28, 2011


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant as of dates and in the capacities indicated.
 
Signatures
 
Title
Date
       
   
Chairman of the Board and Chief
Executive Officer
 
  /s/ William A. Mathies                    
 
(Principal Executive Officer)
February 28, 2011
   William A. Mathies
     
       
   
Executive Vice President and Chief
Financial Officer (Principal
 
  /s/ L. Bryan Shaul                            
 
Financial and Accounting Officer)
February 28, 2011
   L. Bryan Shaul
     
       
       
  /s/ Gregory S. Anderson                  
 
Director
March 2, 2011
   Gregory S. Anderson
     
       
       
  /s/ Tony M. Astorga                         
 
Director
February 25, 2011
   Tony M. Astorga
     
       
       
  /s/ Christian K. Bement                   
 
Director
February 25, 2011
   Christian K. Bement
     
       
       
  /s/ Michael J. Foster                        
 
Director
March 2, 2011
   Michael J. Foster
     
       
       
  /s/ Barbara B. Kennelly                   
 
Director
February 25, 2011
   Barbara B. Kennelly
     
       
       
  /s/ Milton J. Walters                       
 
Director
March 2, 2011
   Milton J. Walters
     
       
       
 
57

 
 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


Index to Consolidated Financial Statements

December 31, 2010


 
Page
   
Report of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
F-2
   
Consolidated Balance Sheets
F-3– F-4
As of December 31, 2010 and 2009
 
   
Consolidated Statements of Operations
F-5
For the years ended December 31, 2010, 2009 and 2008
 
   
Consolidated Statements of Stockholders’ Equity and Comprehensive (Loss)
F-6
Income for the years ended December 31, 2010, 2009 and 2008
 
   
Consolidated Statements of Cash Flows
F-7 – F-8
For the years ended December 31, 2010, 2009 and 2008
 
   
Notes to Consolidated Financial Statements
F-9 – F-45
   
Supplementary Data (Unaudited) - Quarterly Financial Data
1 – 3
   
Schedule II – Valuation and Qualifying Accounts
4


 
F-1

 

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of
Sun Healthcare Group, Inc.

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Sun Healthcare Group, Inc and its subsidiaries at December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America.  In addition, in our opinion the financial statement schedule listed in the accompanying index on page F-1 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.  Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP
Irvine, California
March 3, 2011


 
F-2

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS
(in thousands)

   
December 31, 2010
   
December 31, 2009
 
             
Current assets:
           
Cash and cash equivalents
  $ 81,163     $ 104,483  
Restricted cash
    15,329       24,034  
Accounts receivable, net of allowance for doubtful accounts of $66,607
   
and $55,402 at December 31, 2010 and 2009, respectively
    218,040       220,319  
Prepaid expenses and other assets
    16,859       21,757  
Deferred tax assets
    69,800       68,415  
                 
Total current assets
    401,191       439,008  
                 
Property and equipment, net of accumulated depreciation and amortization
     
of $102,897 and $153,854 at December 31, 2010 and 2009, respectively
139,860       622,682  
Intangible assets, net of accumulated amortization of $12,506 and $9,760 at
     
December 31, 2010 and 2009, respectively
    41,967       38,628  
Goodwill
    348,047       338,296  
Restricted cash, non-current
    350       3,317  
Deferred tax assets
    126,540       108,999  
Other assets
    23,803       20,264  
Total assets
  $ 1,081,758     $ 1,571,194  

 
F-3

 


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (Continued)

LIABILITIES AND STOCKHOLDERS' EQUITY
(in thousands, except share data)

   
December 31, 2010
   
December 31, 2009
 
Current liabilities:
           
Accounts payable
  $ 49,993     $ 57,109  
Accrued compensation and benefits
    61,518       58,953  
Accrued self-insurance obligations, current portion
    52,093       45,661  
Other accrued liabilities
    53,945       55,265  
Current portion of long-term debt and capital lease obligations
    11,050       46,416  
                 
Total current liabilities
    228,599       263,404  
                 
Accrued self-insurance obligations, net of current portion
    133,405       121,948  
Long-term debt and capital lease obligations, net of current portion
    144,930       654,132  
Unfavorable lease obligations, net of accumulated amortization of
               
$19,298 and $16,450 at December 31, 2010 and 2009, respectively
    9,815       12,663  
Other long-term liabilities
    52,566       69,983  
                 
Total liabilities
    569,315       1,122,130  
                 
Commitments and contingencies (Note 8)
               
                 
Stockholders' equity:
               
Preferred stock of $.01 par value, authorized 3,333,333
               
shares, zero shares issued and outstanding as of December 31, 2010
   
and authorized 10,000,000 shares, zero shares issued and
outstanding as of December 31, 2009
    -       -  
Common stock of $.01 par value, authorized 41,666,667 shares,
               
24,973,693 shares issued and outstanding as of December 31, 2010
   
and authorized 125,000,000 shares, 43,764,240 shares issued and
               
outstanding as of December 31, 2009
    250       438  
Additional paid-in capital
    720,854       655,666  
Accumulated deficit
    (208,661 )     (204,011 )
Accumulated other comprehensive loss, net
    -       (3,029 )
Total stockholders' equity
    512,443       449,064  
Total liabilities and stockholders' equity
  $ 1,081,758     $ 1,571,194  

See accompanying notes.

 
F-4

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

   
For the Years Ended December 31,
 
   
2010
   
2009
   
2008
 
                   
Total net revenues
  $ 1,906,861     $ 1,880,776     $ 1,822,766  
Costs and expenses:
                       
Operating salaries and benefits
    1,077,859       1,056,265       1,027,872  
Self-insurance for workers' compensation and general
                       
and professional liability insurance
    70,806       63,740       59,689  
Operating administrative expenses
    51,943       50,924       51,171  
Other operating costs
    390,008       384,655       372,972  
Center rent expense
    84,334       73,128       73,593  
General and administrative expenses
    60,842       62,068       62,302  
Depreciation and amortization
    48,008       45,453       40,348  
Provision for losses on accounts receivable
    20,568       21,174       14,032  
Interest, net of interest income of $315, $383, and $1,781, respectively
    43,064       49,327       54,603  
Loss on extinguishment of debt
    29,221       -       -  
Transaction costs
    29,113       -       -  
Loss (gain) on sale of assets, net
    847       42       (977 )
Restructuring costs
    -       1,304       -  
Total costs and expenses
    1,906,613       1,808,080       1,755,605  
                         
Income before income taxes and discontinued operations
    248       72,696       67,161  
Income tax expense (benefit)
    2,964       29,616       (47,348 )
(Loss) income from continuing operations
    (2,716 )     43,080       114,509  
                         
Discontinued operations:
                       
Loss from discontinued operations, net of related taxes
    (1,934 )     (4,076 )     (2,221 )
Loss on disposal of discontinued operations, net of related taxes
    -       (333 )     (3,001 )
Loss from discontinued operations
    (1,934 )     (4,409 )     (5,222 )
                         
Net (loss) income
  $ (4,650 )   $ 38,671     $ 109,287  
                         
Basic earnings per common and common equivalent share:
                       
(Loss) income from continuing operations
  $ (0.14 )   $ 2.95     $ 7.93  
Loss from discontinued operations, net
    (0.10 )     (0.30 )     (0.36 )
Net (loss) income
  $ (0.24 )   $ 2.65     $ 7.57  
                         
Diluted earnings per common and common equivalent share:
                       
(Loss) income from continuing operations
  $ (0.14 )   $ 2.93     $ 7.60  
Loss from discontinued operations, net
    (0.10 )     (0.30 )     (0.35 )
Net (loss) income
  $ (0.24 )   $ 2.63     $ 7.25  
                         
Weighted average number of common and common equivalent
                       
shares outstanding:
                       
Basic
    19,280       14,614       14,444  
Diluted
    19,280       14,714       15,075  

See accompanying notes.

 
F-5

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
COMPREHENSIVE (LOSS) INCOME
(in thousands)

   
For the Years Ended December 31,
 
   
2010
   
2009
   
2008
 
   
Shares
   
Amount
   
Shares
   
Amount
   
Shares
   
Amount
 
Common stock:
                                   
Issued and outstanding at beginning of period
    43,764     $ 438       43,545     $ 435       43,016     $ 430  
Issuance of common stock
    306       3       219       3       529       5  
Issuance of common stock in the equity offering
30,763       307       -       -       -       -  
Exchange of shares in the Separation (Note 1)
    (49,859 )     (498 )     -       -       -       -  
Common stock issued and outstanding at
                                               
end of period
    24,974       250       43,764       438       43,545       435  
                                                 
Additional paid-in capital:
                                               
Balance at beginning of period
            655,666               650,542               600,199  
Issuance of common stock in excess of par value
      494               101               2,488  
Stock based compensation expense
            6,300               5,810               5,270  
Issuance of common stock in excess of par value
   from the equity offering, net
    224,685               -               -  
Exchange of shares in the Separation (Note 1)
            498               -               -  
Realization of pre-emergence tax benefits
            -               -               43,093  
Dividend to stockholders (Note 1)
            (9,996 )             -               -  
Distribution to Sabra (Note 1)
            (155,749 )             -               -  
Other
            (1,044 )             (787 )             (508 )
Additional paid-in capital at end of period
            720,854               655,666               650,542  
                                                 
Accumulated deficit:
                                               
Balance at beginning of period
            (204,011 )             (242,682 )             (351,969 )
Net (loss) income
            (4,650 )             38,671               109,287  
Accumulated deficit at end of period
            (208,661 )             (204,011 )             (242,682 )
                                                 
Accumulated other comprehensive loss:
                                               
Balance at beginning of period
            (3,029 )             (4,586 )             (2,403 )
Other comprehensive income (loss) from cash
   flow hedge, net of related tax expense (benefit)
   of $2,105, $1,038, and ($3,058)
      3,029               1,557               (2,183 )
Accumulated other comprehensive loss at
                                               
end of period
            -               (3,029 )             (4,586 )
                                                 
Total stockholders' equity
          $ 512,443             $ 449,064             $ 403,709  
                                                 
Comprehensive (loss) income:
                                               
                                                 
Net (loss) income
          $ (4,650 )           $ 38,671             $ 109,287  
Other comprehensive income (loss) from cash flow
   hedge, net of related tax expense (benefit) of
   $2,019, $1,038, and ($3,058), respectively
    3,029               1,557               (2,183 )
Comprehensive (loss) income
          $ (1,621 )           $ 40,228             $ 107,104  
                                                 
 
 
See accompanying notes.
 
F-6

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

   
For the Years Ended December 31,
 
   
2010
   
2009
   
2008
 
Cash flows from operating activities:
                 
Net (loss) income
  $ (4,650 )   $ 38,671     $ 109,287  
Adjustments to reconcile net (loss) income to net cash provided by
                       
operating activities, including discontinued operations:
                       
Loss on extinguishment of debt
    14,126       -       -  
Depreciation and amortization
    48,023       45,465       40,614  
Amortization of favorable and unfavorable lease intangibles
    (1,945 )     (1,824 )     (1,879 )
Provision for losses on accounts receivable
    21,175       21,196       15,283  
Loss on sale of assets, including discontinued operations, net
    847       605       2,151  
Impairment charge for discontinued operation
    -       -       1,800  
Stock-based compensation expense
    6,300       5,810       5,270  
Deferred taxes
    (1,590 )     27,003       (51,128 )
Other
    -       -       (10 )
Changes in operating assets and liabilities, net of acquisitions:
                       
Accounts receivable
    (18,945 )     (33,547 )     (35,136 )
Restricted cash
    3,176       10,628       3,215  
Prepaid expenses and other assets
    5,671       2,940       (4,213 )
Accounts payable
    (1,842 )     (8,390 )     4,032  
Accrued compensation and benefits
    2,519       (2,989 )     (2,367 )
Accrued self-insurance obligations
    17,890       7,759       4,773  
Income taxes payable
    -       -       (1,806 )
Other accrued liabilities
    (9,919 )     (3,196 )     (8,719 )
Other long-term liabilities
    (928 )     (1,223 )     7,020  
Net cash provided by operating activities
    79,908       108,908       88,187  
                         
Cash flows from investing activities:
                       
Capital expenditures
    (53,528 )     (54,312 )     (42,543 )
Purchase of leased real estate
    -       (3,275 )     (8,956 )
Proceeds from sale of assets held for sale
    -       2,174       18,354  
Acquisitions, net of cash acquired
    (13,894 )     (14,936 )     (11,734 )
Insurance proceeds received
    -       -       628  
Net cash used for investing activities
    (67,422 )     (70,349 )     (44,251 )
                         
Cash flows from financing activities:
                       
Borrowings of long-term debt
    435,500       20,822       20,290  
Principal repayments of long-term debt and capital lease obligations
    (590,939 )     (46,292 )     (29,627 )
Payment to non-controlling interest
    (2,025 )     (311 )     (418 )
Distribution to non-controlling interest
    (105 )     (549 )     (353 )
Distribution to Sabra Health Care REIT, Inc.
    (66,862 )     -       -  
    Dividend to stockholders
    (9,996 )     -       -  
Proceeds from issuance of common stock
    225,393       101       2,493  
Deferred financing costs
    (26,772 )     -       -  
Net cash (used for) provided by financing activities
    (35,806 )     (26,229 )     (7,615 )
                         
Net (decrease) increase in cash and cash equivalents
    (23,320 )     12,330       36,321  
Cash and cash equivalents at beginning of period
    104,483       92,153       55,832  
Cash and cash equivalents at end of period
  $ 81,163     $ 104,483     $ 92,153  
Supplemental disclosure of cash flow information:
                       
Interest payments
  $ 47,160     $ 48,781     $ 52,208  
Capitalized interest
  $ 614     $ 523     $ 447  
Income taxes paid, net
  $ 103     $ 3,484     $ 2,231  

 
F-7

 
 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(in thousands)

Supplemental Disclosures of Non-Cash Investing and Financing Activities


For the year ended December 31, 2010, additional paid-in capital decreased due to the distribution of net non-cash assets to Sabra in the amount of $88.9 million (see Note 1 – “Nature of Business”).

For the year ended December 31, 2009, capital lease obligations of $79 were incurred in 2009 when we entered into new equipment and vehicle leases.

For the year ended December 31, 2008, stockholders’ equity increased by $43,093 due to a change in the valuation allowance for deferred tax assets and income tax payable attributable to fresh-start accounting and business combinations (see Note 9 – “Income Taxes”).  Capital lease obligations of $575 were incurred in 2008 when we entered into new equipment and vehicle leases.

































See accompanying notes


 
F-8

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2010

(1)  Nature of Business

References throughout this document to the Company include Sun Healthcare Group, Inc. and our consolidated subsidiaries. In accordance with the Securities and Exchange Commission's “Plain English” guidelines, this Annual Report has been written in the first person. In this document, the words “we,” “our,” “ours” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

Business

Our subsidiaries provide long-term, subacute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  We operated 200 healthcare facilities in 25 states as of December 31, 2010.

Equity Offering

In August 2010, we completed a public offering of 30,762,500 shares of our common stock. The shares were issued at a public offering price of $7.75 per share, resulting in proceeds of $224.8 million, net of the underwriter’s discount and other professional fees. The net proceeds and other cash on hand were used to repay $225.0 million of our term loans (see Note 3 – “Long-Term Debt, Capital Lease Obligations and Hedging Arrangements”).

2010 Restructuring

On November 15, 2010, our former parent, Sun Healthcare Group, Inc. ("Old Sun"), completed a restructuring of its business by separating its real estate assets and its operating assets into two separate publicly traded companies.  The restructuring consisted of certain key transactions including the reorganization, through a series of internal corporate restructurings, such that (i) substantially all of Old Sun's owned real property and related mortgage indebtedness owed to third parties were transferred to or assumed by Sabra Health Care REIT, Inc (“Sabra”), a Maryland corporation and a wholly owned subsidiary of Old Sun, or one or more subsidiaries of Sabra, and (ii) all of Old Sun’s operations and other assets and liabilities were transferred to or assumed by SHG Services, Inc., a Delaware corporation and a wholly owned subsidiary of Old Sun (“New Sun”), or one or more subsidiaries of New Sun.

On November 15, 2010, Old Sun distributed to its stockholders on a pro rata basis all of the outstanding shares of New Sun common stock (the “Separation”), together with a pro rata cash distribution to Old Sun’s stockholders aggregating approximately $10 million.  Old Sun then merged with and into Sabra, with Sabra surviving the merger and Old Sun’s stockholders receiving shares of Sabra common stock in exchange for their shares of Old Sun’s common stock (the “REIT Conversion Merger”).  Immediately following the Separation and REIT Conversion Merger, New Sun changed its name to Sun Healthcare Group, Inc.  Pursuant to master lease agreements that were entered into between subsidiaries of Sabra and of New Sun in connection with the Separation, subsidiaries of Sabra lease to subsidiaries of New Sun the properties that Sabra’s subsidiaries own following the REIT Conversion Merger.

The Separation was accounted for as a reverse spinoff where New Sun was designated as the “accounting” spinnor and Sabra was designated as the “accounting” spinnee.  Accordingly, the assets and liabilities distributed were recorded based on their historical carrying values.

 
F-9

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

    The historical carrying values of assets and liabilities distributed to Sabra in the Separation are as follows (in thousands):

Cash
  $ 66,862  
Restricted cash
    5,527  
Property and equipment, net of accumulated depreciation and
amortization of $91,878
    484,801  
Intangible and other assets, net
    16,116  
Long-term debt and mortgage notes payable
    (386,678 )
Accrued interest on mortgage notes payable
    (1,425 )
Other accrued liabilities
    (2,326 )
Deferred tax liabilities
    (21,821 )
Due to Sun Healthcare Group, Inc.
    (5,307 )
Net distribution
  $ 155,749  
 
For accounting purposes, the historical consolidated financial statements of Old Sun became the historical consolidated financial statements of New Sun after the distribution on November 15, 2010.

Exchange of Shares in the Separation

In connection with the Separation on November 15, 2010, stockholders of Old Sun received one share of New Sun in exchange for every three shares of Old Sun.  All prior period share amounts have been adjusted to give retroactive effect to the exchange of shares in the Separation.

Transaction Costs

Our results of operations for 2010 include $29.1 million of transaction costs related to the Separation and REIT Conversion Merger, which consist primarily of fees for professional services such as investment banker, legal and accounting fees.

Restructuring Costs

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the year ended December 31, 2009, we incurred $1.3 million of restructuring costs, of which $1.0 million was paid during 2009 and the remainder paid in 2010.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff and costs related to closure of a center in Massachusetts.

Comparability of Financial Information

Generally accepted accounting principles in the U.S. (“GAAP”) requires reclassification of the results of operations of subsequent divestitures that qualify as discontinued operations for all periods presented.

 
F-10

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(2)  Summary of Significant Accounting Policies

(a)  Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of net revenues, allowances for doubtful accounts, self-insurance obligations, goodwill and other intangible assets (including impairments), and allowances for deferred tax assets.  Actual results could differ from those estimates.

(b)  Principles of Consolidation

Our consolidated financial statements include the accounts of our subsidiaries in which we own more than 50% of the voting interest. Investments of companies in which we own between 20% - 50% of the voting interests and have significant influence were accounted for using the equity method, which records as income an ownership percentage of the reported income of the subsidiary.  Investments in companies in which we own less than 20% of the voting interests and do not have significant influence are carried at lower of cost or fair value. All significant intersegment accounts and transactions have been eliminated in consolidation.

(c)  Cash and Cash Equivalents

We consider all highly liquid, unrestricted investments with original maturities of three months or less when purchased to be cash equivalents. Cash equivalents are stated at fair value.

(d)  Restricted Cash

Certain of our cash balances are restricted for specific purposes such as funding of self-insurance reserves, mortgage escrow requirements and capital expenditures on HUD-insured buildings (see Note 8 – “Commitments and Contingencies”).  These balances are presented separately from cash and cash equivalents on our consolidated balance sheets and are classified as a current asset when expected to be utilized within the next year.  Restricted cash balances are stated at cost, which approximates fair value.

(e)  Net Revenues

Net revenues consist of long-term and subacute care revenues, rehabilitation therapy services revenues, temporary medical staffing services revenues and other ancillary services revenues. Net revenues are recognized as services are provided and billed. Revenues are recorded net of provisions for discount arrangements with commercial payors and contractual allowances with third-party payors, primarily Medicare and Medicaid. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment. Estimated third-party payor settlements are recorded in the period the related services are rendered. The methods of making such estimates are reviewed periodically, and differences between the net amounts accrued and subsequent settlements or estimates of expected settlements are reflected in the current period results of operations. Laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation.

 
F-11

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

       Revenues from Medicaid accounted for 40.5%, 40.0%, and 40.0% of our net revenue for the years ended December 31, 2010, 2009 and 2008, respectively.  Revenues from Medicare comprised 29.7%, 29.5%, and 28.7% of our net revenues for the years ended December 31, 2010, 2009 and 2008, respectively.

(f)  Accounts Receivable

Our accounts receivable relate to services provided by our various operating divisions to a variety of payors and customers. The primary payors for services provided in healthcare centers that we operate are the Medicare program and the various state Medicaid programs. Our rehabilitation therapy service operations provide services to patients in unaffiliated healthcare centers. The billings for those services are submitted to the unaffiliated centers. Many of the unaffiliated healthcare centers receive a large majority of their revenues from the Medicare program and the state Medicaid programs.

Estimated provisions for losses on accounts receivable are recorded each period as an expense in the income statement.  In evaluating the collectability of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the financial condition of our customers, the composition of patient accounts by payor type, the status of ongoing disputes with third-party payors and general industry and economic conditions.  Any changes in these factors or in the actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of change.  In addition, a retrospective collection analysis is performed within each operating company to test the adequacy of the reserve.

The allowance for doubtful accounts related to centers that we have divested was based on management’s expectation of collectability at the time of divestiture and is recorded with the gain or loss on disposal of discontinued operations.  As collections are realized or if new information becomes available, the allowance is adjusted as appropriate.  As of December 31, 2010 and 2009, accounts receivable for divested operations were significantly reserved.

(g)  Property and Equipment

Property and equipment are stated at historical cost. Property and equipment held under capital lease are stated at the net present value of future minimum lease payments and their amortization is included in depreciation expense.  Major renewals or improvements are capitalized whereas ordinary maintenance and repairs are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows: buildings and improvements – five to forty years; leasehold improvements - the shorter of the estimated useful lives of the assets or the life of the lease; and equipment - three to twenty years.  We subject our long-lived assets to an impairment test if an indicator of potential impairment is present. (See Note 6 – “Goodwill, Intangible Assets and Long-Lived Assets.”)

(h)  Intangible Assets

Consistent with GAAP, we do not amortize goodwill and intangible assets with indefinite lives. Consequently, we subject them at a minimum to annual impairment tests. Intangible assets with definite lives are amortized over their estimated useful lives. (See Note 6 – “Goodwill, Intangible Assets and Long-Lived Assets.”)

 
F-12

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(i) Insurance

We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities, through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Provisions for estimated reserves, including incurred but not reported losses, are provided in the period of the related loss and then updated through the coverage period. These provisions are based on actuarial analyses, internal evaluations of the merits of individual claims, and industry loss development factors or lag analyses. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any resulting adjustments are reflected in current earnings. Claims are paid over varying periods, and future payments may differ materially than the estimated reserves.  (See Note 8 – “Commitments and Contingencies.”)

(j)  Stock-Based Compensation

We follow the fair value recognition provisions of GAAP, which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values.  (See Note 11 – “Capital Stock.”)

(k)  Income Taxes

Pursuant to GAAP, an asset or liability is recognized for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements.  These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled.  Deferred tax assets are also recognized for the future tax benefits from net operating loss, capital loss and tax credit carryforwards.  A valuation allowance is to be provided for the net deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

In evaluating the need to record or continue to reflect a valuation allowance, all items of positive evidence (e.g., future sources of taxable income and tax planning strategies) and negative evidence (e.g., history of taxable losses) are considered.  In determining future sources of taxable income, we use management-approved budgets and projections of future operating results for an appropriate number of future periods, taking into consideration our history of operating results, taxable income and losses, etc.  This future taxable income is then used, along with all other items of positive and negative evidence, to determine the amount of valuation allowance that is needed, and whether any amount of such allowance should be reversed.

We are subject to income taxes in the U.S. and numerous state and local jurisdictions.  Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.  GAAP guidance for accounting for uncertainty in income tax positions contains a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any.  The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement.  We reserve for our uncertain tax positions, and we adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate.  (See Note 9 – “Income Taxes.”)

 
F-13

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(l)  Net (Loss) Income Per Share

Basic net (loss) income per share is based upon the weighted average number of common shares outstanding during the period.  The weighted average number of common shares for the years ended December 31, 2010, 2009 and 2008 includes all the common shares that are presently outstanding and the common shares issued as common stock awards and exclude non-vested restricted stock.  (See Note 11 – “Capital Stock.”)

The diluted calculation of income per common share includes the dilutive effect of warrants, stock options and non-vested restricted stock, using the treasury stock method (see Note 11 – “Capital Stock”). However, in periods of losses from continuing operations, diluted net income per common share is based upon the weighted average number of basic shares outstanding.

(m)  Discontinued Operations and Assets Held for Sale

GAAP requires that long-lived assets to be disposed of be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations.  GAAP also requires the reporting of discontinued operations which includes all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. Depreciation is discontinued once an asset is classified as held for sale.  (See Note 7 – “Sale of Assets, Discontinued Operations and Assets and Liabilities Held for Sale.”)

(n)  Reclassifications

Certain reclassifications have been made to the prior period financial statements to conform to the 2010 financial statement presentation.  Specifically, we have reclassified the results of operations of material divestitures subsequent to December 31, 2009 (see Note 7 – “Sale of Assets, Discontinued Operations and Assets and Liabilities Held for Sale”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.

(o)  Interest Rate Swap Agreements

We manage interest expense using a mix of fixed and variable rate debt, and to help manage borrowing costs, we have entered into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount. We use interest rate swaps to manage interest rate risk related to borrowings.  Our intent is to only enter such arrangements that qualify for hedge accounting treatment.  Accordingly, we designate all such arrangements as cash-flow hedges and perform initial and quarterly effectiveness testing using the hypothetical derivative method.  To the extent that such arrangements are effective hedges, changes in fair value are recognized through other comprehensive income.  Ineffectiveness, if any, would be recognized in earnings.  (See Note 3 – “Long-Term Debt, Capital Lease Obligations and Hedging Arrangements.”)

(p)  Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (the “FASB”) issued revised guidance for disclosures of fair value measurements.  The guidance requires additional disclosures regarding transfers between defined categories of quality and reliability and prescribes a rollforward of activity in the lowest category (i.e.


 
F-14

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

Level 3).  Disclosures regarding transfers are required beginning January 1, 2010 and the Level 3 rollforward is to be disclosed in reporting periods beginning after December 15, 2010.  Since we had no transfers between categories, the additional disclosures are not applicable to us for the periods presented.

The Emerging Issues Task Force of the FASB issued an Accounting Standards Update in August 2010 regarding the balance sheet presentation of medical malpractice claims and related insurance recoveries.  Currently there is diversity in practice for health care entities related to the presentation of medical malpractice liability net of insurance recoveries.  The updated guidance requires the insurance recovery receivable to be presented as a gross asset instead of netting it against the medical malpractice liability.  The updated presentation is effective for us beginning with interim filings in 2011.  We are in the process of determining the impact that the adoption of this new guidance will have on our financial position.

(3)  Long-Term Debt, Capital Lease Obligations and Hedging Arrangements

Prior to the completion of financings related to the Separation, Old Sun had issued, and there remained outstanding, $200.0 million aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”), and a senior secured credit facility with a syndicate of financial institutions (the “Old Sun Credit Agreement”).  The Old Sun Credit Agreement, following an amendment entered into in June 2010, provided for $365.0 million of term loans, a $45.0 million letter of credit facility and a $50.0 million revolving credit facility.   Interest on the outstanding unpaid principal amount of loans under the Old Sun Credit Agreement equaled an applicable percentage plus, at Old Sun’s option, either (a) an alternative base rate determined by reference to the higher of (i) the prime rate announced by Credit Suisse and (ii) the federal funds rate plus one-half of 1.0%, or (b) the London Interbank Offered Rate (“LIBOR”), adjusted for statutory reserves.  The applicable percentage for term loans and revolving loans at September 30, 2010 was 2.0% for alternative base rate loans and 3.0% for LIBOR loans.

In October 2010, in connection with the Separation, subsidiaries of Sabra issued $225 million principal amount of senior notes due 2018, the proceeds of which were used, together with cash from Old Sun, to redeem the Notes in December 2010, including accrued interest and a redemption premium.

In October 2010, in connection with the Separation, New Sun entered into a $285.0 million senior secured credit facility (the “Credit Agreement”) with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent.  The Credit Agreement provides for $150.0 million in term loans ($147.5 million was outstanding at December 31, 2010), a $60.0 million revolving credit facility ($30.0 million of which may be utilized for letters of credit) and a $75.0 million letter of credit facility funded by proceeds of additional term loans ($66.2 million was utilized at December 31, 2010).  The revolving credit facility was undrawn on December 31, 2010. In addition to funding the letter of credit facility, the proceeds of the term loans were used to repay outstanding term loans under the Old Sun Credit Agreement, which was concurrently terminated, to pay related fees and expenses and to provide funds for general corporate purposes.  The letter of credit facility replaced the letter of credit facility under the Old Sun Credit Agreement.  The final maturity date of the term loans and the letter of credit facility is October 18, 2016 and the revolving credit facility terminates on October 18, 2015.

Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test and a leverage covenant. As of December 31, 2010, we were in compliance with the covenants contained in the Credit Agreement governing the revolving credit facility. The Credit Agreement also contains customary events of default, such as a failure by us to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit

 
F-15

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

Agreement). The Credit Agreement also contains customary covenants restricting certain actions, including incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments.  The obligations of New Sun under the Credit Agreement are guaranteed by most of New Sun’s subsidiaries and are collateralized by the assets of New Sun and most of New Sun’s subsidiaries.

Amounts borrowed under the term loan facility are due in quarterly installments of $2.5 million, with the remaining principal amount due on the maturity date of the term loans.  Accrued interest is payable at the end of an interest period, but no less frequently than every three months.  Borrowings under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at New Sun’s option, either (a) the greater of 1.75% or LIBOR, adjusted for statutory reserves or (b) an alternative base rate determined by reference to the highest of (i) the prime rate announced by Credit Suisse, (ii) the federal funds rate plus one-half of 1.0%, and (iii) the greater of 1.75% or one-month LIBOR adjusted for statutory reserves plus 1%.  The applicable percentage for term loans and revolving loans is 4.75% for alternative base rate loans and 5.75% for LIBOR loans.  Each year, commencing in 2012, within 90 days of the prior fiscal year end, New Sun is required to prepay a portion of the term loans in an amount based on the prior year’s excess cash flows, if any, as defined in the Credit Agreement. In addition to paying interest on outstanding loans under the Credit Agreement, New Sun is required to pay a facility fee of 0.50% per annum to the lenders under the revolving credit facility in respect of the unused revolving commitments.

In August 2010, we refinanced mortgage indebtedness collateralized by four of our health care centers.  The new mortgage indebtedness of $20.5 million bears interest at LIBOR plus 4.5% (with a LIBOR floor of 1.0%).  In October 2010, we refinanced mortgage indebtedness collateralized by nine of our health care centers.  The new mortgage indebtedness of $30.0 million bears interest at LIBOR plus 4.5% (with a LIBOR floor of 1.0%), and was collateralized by seven of our health care centers.  Both mortgage loans were assumed by Sabra in the Separation.

Our long-term debt and capital lease obligations consisted of the following as of December 31 (in thousands):

   
2010
   
2009
 
Revolving loans
  $ -     $ -  
Mortgage notes payable due at various dates through 2042, interest at
               
rates from 6.7% to 8.5%, collateralized by the carrying values of
               
various centers totaling approximately $6.7 million
    7,979       170,608  
Term loans
    147,492       329,107  
Senior subordinated notes
    -       200,000  
Capital leases
    509       833  
Total long-term obligations
    155,980       700,548  
Less amounts due within one year
    (11,050 )     (46,416 )
Long-term obligations, net of current portion
  $ 144,930     $ 654,132  


 
F-16

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

        The scheduled or expected maturities of long-term obligations as of December 31, 2010 were as follows (in thousands):
 
2011
  $ 11,050  
2012
    11,002  
2013
    10,949  
2014
    10,517  
2015
    10,065  
Thereafter
    102,397  
    $ 155,980  

We manage interest expense using a mix of fixed and variable rate debt, and to help manage borrowing costs, we may enter into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount. We use interest rate swaps to manage interest rate risk related to borrowings.  Our intent is to only enter such arrangements that qualify for hedge accounting treatment in accordance with GAAP.  Accordingly, we designate all such arrangements as cash-flow hedges and perform initial and quarterly effectiveness testing using the hypothetical derivative method.  To the extent that such arrangements are effective hedges, changes in fair value are recognized through other comprehensive loss.  Ineffectiveness, if any, would be recognized in earnings.

We entered into interest rate swap agreements in July 2008 and July 2007 for interest rate risk management purposes, both of which expired in July 2010.  The interest rate swap agreements effectively modified our exposure to interest rate risk by converting a portion of our floating rate debt to a fixed rate.  The interest rate swap agreements qualified for hedge accounting treatment and were designated as cash flow hedges.  None of our 2010 other comprehensive loss was reclassified into earnings as the agreements expired in July 2010 without any cash settlement.

The fair values of our interest rate swap agreements as presented in the consolidated balance sheets at December 31 are as follows (in thousands):
 
   
Liability Derivatives
   
2010
 
2009
   
Balance Sheet
       
Balance Sheet
       
   
Location
   
Fair Value
 
Location
   
Fair Value
 
Derivatives designated as
                     
hedging instruments:
                     
Interest rate swap
           
Other Long-Term
       
agreements
 
N/A
 
$
N/A
 
Liabilities
 
$
5,048
 



 
F-17

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010


The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the year ended December 31 is as follows (in thousands):

         
Gain Reclassified from
 
   
Amount of Income/(Loss)
   
Accumulated Other Comprehensive
 
   
In Other Comprehensive
   
Loss to Net Income
 
   
Income/(Loss)
   
(ineffective portion)
 
   
2010
   
2009
   
2008
   
2010
   
2009
   
2008
 
Derivatives designated as cash
                                   
flow hedges:
                                   
Interest rate swap agreements
$
3,029
 
$
1,557
 
$
(2,183
)
$
-
 
$
-
 
$
-
 

The Credit Agreement requires that 50% of our term loans be subject to at least a 3-year hedging arrangement.  We executed two hedging instruments on January 18, 2011 to satisfy this requirement.  A two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012.  The cap is effective when LIBOR rises above 1.75%, effectively fixing $82.5 million of the debt at 7.5% for two years.  The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement.  A two-year “forward starting” interest rate swap effectively converts $82.5 million of debt to fixed rate from January 1, 2013 through December 31, 2014.  LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 8.935%.  There was no fee for this swap agreement.

Both arrangements qualify for hedge accounting treatment and necessary disclosures will be made in our interim financial statements beginning with the first quarter 2011.

(4)  Property and Equipment

Property and equipment consisted of the following as of December 31 (in thousands):

   
2010
   
2009
 
Land
  $ 2,936     $ 78,848  
Buildings and improvements
    21,235       464,136  
Equipment
    116,468       128,939  
Leasehold improvements
    93,680       83,751  
Construction in process(1)
    8,438       20,862  
Total
    242,757       776,536  
Less accumulated depreciation and amortization
    (102,897 )     (153,854 )
Property and equipment, net
  $ 139,860     $ 622,682  

(1)
Capitalized interest associated with construction in process is $0.6 million and $0.4 million at December 31, 2010 and 2009, respectively.

(5)  Acquisitions

On December 29, 2010 we completed the purchase of a hospice company that operates in Alabama and Georgia for $13.9 million.  The purchase price excludes $0.5 million of transaction costs, which consisted primarily of investment banker success fees that were expensed in the accompanying statements of operations in accordance with GAAP.  The hospice company's results of operations will be included in our consolidated financial statements beginning January 1, 2011.  Pro forma information related to this acquisition is not provided because the impact on


 
F-18

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

our consolidated financial position and results of operations is not significant.  The purchase price was funded through cash on-hand at the time of the acquisition and allocated to the following fair values of assets acquired and liabilities assumed at the date of acquisition (in thousands):

Net working capital
  $ 67  
Property and equipment
    177  
Licensing intangible asset
    6,652  
Goodwill(1)
    9,683  
Other long-term assets
    47  
Total assets acquired
    16,626  
         
Liabilities assumed
    (2,732 )
         
Net assets acquired
  $ 13,894  

(1)
Tax-deductible goodwill has not yet been determined.

On October 1, 2009 we acquired a hospice company that provides services to patients in Maine, Massachusetts and New Hampshire, for $16.1 million in cash, excluding transaction costs.  The purchase price excludes $0.5 million of transaction costs, which consisted primarily of investment banker success fees that were expensed in the accompanying income statement in accordance with GAAP.  The hospice company's results of operations have been included in our consolidated financial statements since October 1, 2009.  Pro forma information related to this acquisition is not provided because the impact on our consolidated financial position and results of operations is not significant.  The purchase price was funded through cash on-hand at the time of the acquisition and allocated to the following fair values of assets acquired and liabilities assumed at the date of acquisition (in thousands):

Net working capital
  $ 564  
Property and equipment
    264  
Licensing intangible asset
    6,271  
Goodwill(1)
    11,344  
Other long-term assets
    24  
Total assets acquired
    18,467  
         
Liabilities assumed
    (2,322 )
         
Net assets acquired
  $ 16,145  

(1)
Tax-deductible goodwill is $3.6 million.

We paid a premium (i.e., goodwill) over the fair value of the net tangible and identified intangible assets acquired because we believed the acquisitions of the hospice companies would create the following benefits:  (1) increase the scale of our operations, thus leveraging our corporate and regional infrastructure and (2) expand our hospice operations into a state in which we did not previously have a presence due to limitations with regulatory licensing.

 
F-19

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(6)  Goodwill, Intangible Assets and Long-Lived Assets

(a)  Goodwill

The following table provides information regarding our goodwill, which is included in the accompanying consolidated balance sheets at December 31 (in thousands):

         
Rehabilitation
   
Medical
       
   
Inpatient
   
Therapy
   
Staffing
       
   
Services
   
Services
   
Services
   
Consolidated
 
                         
Balance as of January 1, 2009
  $ 322,200     $ 75     $ 4,533     $ 326,808  
                                 
Goodwill acquired
    11,276       -       -       11,276  
Purchase price adjustments for prior
                               
year acquisition
    212       -       -       212  
                                 
Balance as of December 31, 2009
  $ 333,688     $ 75     $ 4,533     $ 338,296  
                                 
Goodwill acquired
    9,683       -       -       9,683  
Purchase price adjustments for prior
                               
year acquisition
    68       -       -       68  
                                 
Balance as of December 31, 2010
  $ 343,439     $ 75     $ 4,533     $ 348,047  

(b)  Intangible Assets

The following table provides information regarding our intangible assets, which are included in the accompanying consolidated balance sheets at December 31 (in thousands):

   
Gross
             
   
Carrying
   
Accumulated
   
Net
 
   
Amount
   
Amortization
   
Total
 
Finite-lived Intangibles:
                 
Favorable lease intangibles:
                 
2010
  $ 10,100     $ 3,831     $ 6,269  
2009
    10,311       3,140       7,171  
Management and customer contracts:
                       
2010
  $ 3,334     $ 2,500     $ 834  
2009
    3,334       2,024       1,310  
Tradenames:
                       
2010
  $ 13,109     $ 6,175     $ 6,934  
2009
    13,121       4,535       8,586  
Other intangible assets:
                       
2010
  $ -     $ -     $ -  
2009
    189       61       189  
                         
Indefinite-lived Intangibles:
                       
Certificates of need/licenses:
                       
2010
  $ 27,930     $ -     $ 27,930  
2009
    21,433       -       21,433  
                         
 
 
F-20

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

 
Total Intangible Assets:
                       
2010
  $ 54,473     $ 12,506     $ 41,967  
2009
    48,388       9,760       38,628  
                         
Unfavorable Lease Obligations:
                       
2010
  $ 29,113     $ 19,298     $ 9,815  
2009
    29,113       16,450       12,663  
 
A net credit to rent expense was a result of the amortization of favorable and unfavorable lease intangibles, recognized as adjustments in rent expense in connection with fair market valuations performed on our center lease agreements associated with fresh-start accounting and our acquisitions.

The net amount recorded to amortization was as follows for the years ended December 31 (in thousands):

   
2010
   
2009
   
2008
 
                   
Amortization expense
  $ 7,558 )   $ 7,359     $ 7,410  
Amortization of unfavorable
                       
and favorable lease intangibles, net
                       
included in rent expense
    (1,945 )     (1,824 )     (1,878 )
    $ 5,613     $ 5,535     $ 5,532  

Total estimated amortization expense (credit) for our intangible assets for the next five years is as follows (in thousands):
   
Expense
   
Credit
   
Net
 
                   
2011
  $ 2,838     $ (2,705 )   $ 133  
2012
    2,718       (2,436 )     282  
2013
    2,346       (2,115 )     231  
2014
    2,201       (904 )     1,297  
2015
    2,195       (898 )     1,297  

The weighted-average amortization period for lease intangibles is approximately six years at December 31, 2010.

(c)  Impairment of Intangible Assets

Goodwill

We perform our annual goodwill impairment analysis for our reporting units during the fourth quarter of each year, which timing for 2010 also coincided with the Separation.  A reporting unit is a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment and are reviewed at the division level.  For our Rehabilitation Therapy Services and Medical Staffing Services segments, the reporting unit for our annual goodwill impairment analysis was determined to be at the segment level.  For our Inpatient Services segment, the reporting unit for our annual goodwill impairment analysis was determined to be at one level below our segment level.

 
F-21

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

        We determined potential impairment by comparing the net assets of each reporting unit to their respective fair values, which GAAP describes as Step 1 of goodwill impairment testing. We determined the estimated fair value of each reporting unit using a discounted cash flow analysis and other appropriate valuation methodologies. In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit, which is referred to in GAAP as Step 2 of the impairment analysis. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill.  An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value.

The goodwill impairment analysis is subject to impact from uncertainties arising from such events as changes in economic or competitive conditions, the current general economic environment, material changes in Medicare and Medicaid reimbursement that could positively or negatively impact anticipated future operating conditions and cash flows, and the impact of strategic decisions such as the Separation. The Step 1 results of our fourth quarter 2010 goodwill impairment analysis showed that none of our reporting units exhibited any indications of potential goodwill impairment.  Based on the analysis performed, we determined there was no goodwill impairment for the years ended December 31, 2010, 2009 or 2008.

Indefinite Lived Intangibles

Our indefinite lived intangibles consist primarily of values assigned to CONs and regulatory licenses obtained through our acquisitions.

We evaluate the recoverability of our indefinite lived intangibles by comparing the asset's respective carrying value to estimates of fair value. We determine the estimated fair value of these intangible assets through an estimate of incremental cash flows with the intangible assets versus cash flows without the intangible assets in place. We determined there was no impairment of our indefinite lived intangibles for the years ended December 31, 2010, 2009 or 2008.

Finite Lived Intangibles

Our finite lived intangibles include tradenames, favorable lease intangibles and customer contracts.

We evaluate the recoverability of our finite lived intangibles if an impairment indicator is present.  As there were no such indicators, we determined there was no impairment of our finite lived intangibles for the years ended December 31, 2010, 2009 or 2008.

(d)  Impairment of Long-Lived Assets

GAAP requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets' carrying amounts. In estimating the undiscounted cash flows for our impairment assessment, we primarily use our internally prepared budgets and forecast information including adjustments for the following items: Medicare and Medicaid funding; overhead costs; capital expenditures; and patient care liability costs.  We assess the need for an impairment write-down when such indicators of impairment are present.  We determined there was no impairment of long-lived assets used in continuing operations for the years ended December 31, 2010, 2009 or 2008.

 
F-22

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(e)  Long Lived Assets to be Disposed Of

GAAP requires that long-lived assets to be disposed of be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations.  GAAP defines the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. Depreciation is discontinued once an asset is classified as held for sale.


(7)  Sale of Assets, Discontinued Operations and Assets and Liabilities Held for Sale

(a)  Gain (Loss) on Disposal of Discontinued Operations, net of related taxes

We did not incur a gain or loss on disposal of discontinued operations in 2010.  We reported a $0.3 million net loss and a $3.0 million net loss for the years ended December 31, 2009 and 2008, respectively, primarily related to the disposals of assets associated with discontinued operations.

(b)  Discontinued Operations

In accordance with GAAP, the results of operations of assets to be disposed of, disposed assets and the gains (losses) related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated income statements as their operations and cash flows have been (or will be) eliminated from our ongoing operations and we will not have any significant continuing involvement in their operations after their disposal.

Inpatient Services: During 2010 we disposed of our nurse practitioner services group of our Inpatient Services segment, whose results have been reclassified to discontinued operations for all periods presented in accordance with GAAP.

During 2009, we reclassified one assisted living center into discontinued operations as we elected to not renew that center’s lease and allowed operations to transfer to another operator.

(c)  Assets and Liabilities Held for Sale

We had no assets held for sale as of December 31, 2010 or 2009.

Other discontinued operations are principally comprised of the operations of a regional provider of adolescent rehabilitation and special education services.

 
F-23

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

    A summary of the discontinued operations for the years ended December 31 is as follows (in thousands):

   
2010
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
  $ 855     $ -     $ 855  
                         
Loss from discontinued operations, net (1)
  $ (1,861 )   $ (73 )   $ (1,934 )
Loss on disposal of discontinued operations, net (2)
    -       -       -  
Loss from discontinued operations, net
  $ (1,861 )   $ (73 )   $ (1,934 )

(1)  Net of related tax benefit of $1,031
(2)  Net of related tax expense of $0

   
2009
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
  $ 1,544     $ -     $ 1,544  
                         
Loss from discontinued operations, net (1)
  $ (4,043 )   $ (33 )   $ (4,076 )
Loss on disposal of discontinued operations, net (2)
    (317 )     (16 )     (333 )
Loss from discontinued operations, net
  $ (4,360 )   $ (49 )   $ (4,409 )

(1)  Net of related tax benefit of $2,416
(2)  Net of related tax benefit of $231

   
2008
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
  $ 43,024     $ 17,888     $ 60,912  
                         
Loss from discontinued operations, net (1)
  $ (2,008 )   $ (213 )   $ (2,221 )
Loss on disposal of discontinued operations, net (2)
    (2,246 )     (755 )     (3,001 )
Loss from discontinued operations, net
  $ (4,254 )   $ (968 )   $ (5,222 )

(1)  Net of related tax benefit of $1,125
(2)  Net of related tax benefit of $1,949




 
F-24

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010


(8)  Commitments and Contingencies

(a)  Lease Commitments

We lease real estate and equipment under cancelable and noncancelable agreements. Most of our operating leases have original terms from seven to twelve years and contain at least one renewal option (which could extend the terms of the leases by five to ten years), escalation clauses (primarily related to inflation) and provisions for payments by us of real estate taxes, insurance and maintenance costs. Leases with a fixed escalation are accounted for on a straight-line basis. Future minimum operating lease payments as of December 31, 2010 under real estate leases are as follows (in thousands):
 
2011
  $ 147,256  
2012
    143,121  
2013
    139,600  
2014
    110,483  
2015
    108,637  
Thereafter
    550,548  
Total minimum lease payments
  $ 1,199,645  

Center rent expense for continuing operations totaled $84.3 million, $73.1 million, and $73.6 million for the years ended December 31, 2010, 2009, and 2008, respectively. Center rent expense for discontinued operations for the years ended December 31, 2010, 2009 and 2008 was $0.1 million, $0.2 million, and $3.6 million, respectively.  The increase in future center lease payments is primarily due to the leases our subsidiaries entered into with subsidiaries of Sabra.

(b)  Purchase Commitments

We have an agreement establishing Medline Industries, Inc. (“Medline”) as the primary medical supply vendor through December 31, 2014 for all of the healthcare centers that we operate.  The agreement provides that the long-term care division of the Inpatient Services segment shall purchase at least 90% of its medical supply products from Medline.

We have an agreement establishing SYSCO Corporation (“SYSCO”) as our primary foodservice supply vendor through June 30, 2015 for all of our healthcare centers.  The agreement provides that the long-term care division of the Inpatient Services segment shall purchase at least 80% of its foodservice supply products from SYSCO.

We have an agreement establishing Omnicare Pharmacy Services as the primary pharmacy services vendor through July 15, 2013 for substantially all of the healthcare centers that we currently operate.

(c)  Insurance

We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs.  Insurance reserves represent estimates of future claims payments. This liability includes an estimate of the development of reported losses and losses incurred but not reported. Provisions for changes in insurance reserves

 
F-25

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

are made in the period of the related coverage.  An independent actuarial analysis is prepared twice a year to assist management in determining the adequacy of the self-insurance obligations booked as liabilities in our financial statements. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments resulting there from are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform detailed actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  Reported loss methods focus on development of case reserves for incurred losses through claims closure. Paid loss methods focus on development of claims actually paid to date. Expected loss methods are based upon an anticipated loss per unit of measure. The Bornhuetter-Ferguson method is a combination of loss development methods and expected loss methods.

The foundation for most of these methods is our actual historical reported and/or paid loss data, over which we have effective internal controls. We utilize third-party administrators (“TPAs”) to process claims and to provide us with the data utilized in our semi-annual actuarial analyses. The TPAs are under the oversight of our in-house risk management and legal functions. These functions ensure that the claims are properly administered so that the historical data is reliable for estimation purposes. Case reserves, which are approved by our legal and risk management departments, are determined based on our estimate of the ultimate settlement of individual claims. In cases where our historical data are not statistically credible, stable, or mature, we supplement our experience with nursing home industry benchmark reporting and payment patterns.

The use of multiple methods tends to eliminate any biases that one particular method might have. Management’s judgment based upon each method’s inherent limitations is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which includes the case reserves plus an estimate for future development of these reserves based on past trends, and an estimate for losses incurred but not reported.   These results are compared by accident year and an estimated unpaid loss and allocated loss adjustment expense are determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.

Regarding our estimates for workers’ compensation reserves, there were no large or unusual settlements during the 2010 period.  As of December 31, 2010, the discounting of the policy periods resulted in a reduction to our reserves of $13.4 million.

During 2010 we determined that the previous estimates for general and professional liabilities reserves for matters related to years prior to 2010 were understated by $13.1 million due to adverse developments with respect to a number of claims that arose in prior periods. Accordingly we have recorded a charge in the fourth quarter of 2010 to increase our general and professional liabilities reserves. Professional liability claims have a reporting tail that exceeds one year.  A significant component of our reserves is estimates for incidents that have been incurred but not reported.

 
F-26

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

        Activity in our insurance reserves as of and for the years ended December 31, 2010, 2009 and 2008 is as follows (in thousands):

   
Professional
Liability
   
Workers’
Compensation
   
Total
 
                   
Balance as of January 1, 2008
  $ 86,291     $ 61,439     $ 147,730  
                         
Current year provision, continuing operations
    29,454       29,335       58,789  
Current year provision, discontinued operations
    790       852       1,642  
Prior year reserve adjustments, continuing operations
    (1,700 )     2,600       900  
Prior year reserve adjustments, discontinued operations
    (20 )     400       380  
Claims paid, continuing operations
    (20,343 )     (18,499 )     (38,842 )
Claims paid, discontinued operations
    (3,755 )     (3,674 )     (7,429 )
Amounts paid for administrative services and other
    (3,435 )     (5,865 )     (9,300 )
                         
Balance as of December 31, 2008
  $ 87,282     $ 66,588     $ 153,870  
                         
Current year provision, continuing operations
    27,152       28,368       55,520  
Current year provision, discontinued operations
    1,512       644       2,156  
Prior year reserve adjustments, continuing operations
    6,500       1,720       8,220  
Prior year reserve adjustments, discontinued operations
    890       230       1,120  
Claims paid, continuing operations
    (20,394 )     (20,165 )     (40,559 )
Claims paid, discontinued operations
    (3,699 )     (2,530 )     (6,229 )
Amounts paid for administrative services and other
    (4,313 )     (7,349 )     (11,662 )
                         
Balance as of December 31, 2009
  $ 94,930     $ 67,506     $ 162,436  
                         
Current year provision, continuing operations
    29,620       28,086       57,706  
Current year provision, discontinued operations
    10       21       31  
Prior year reserve adjustments, continuing operations
    13,100       -       13,100  
Claims paid, continuing operations
    (19,636 )     (18,948 )     (38,584 )
Claims paid, discontinued operations
    (3,422 )     (2,059 )     (5,481 )
Amounts paid for administrative services and other
    (2,731 )     (6,121 )     (8,852 )
                         
Balance as of December 31, 2010
  $ 111,871     $ 68,485     $ 180,356  


 
F-27

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

    A summary of the assets and liabilities related to insurance risks at December 31 is as indicated below (in thousands):

   
2010
|
 
2009
   
Professional
   
Workers'
     
|
 
Professional
   
Workers'
     
   
Liability
   
Compensation
   
Total
|
 
Liability
   
Compensation
   
Total
Assets (1):
               
|
               
Restricted cash
               
|
               
Current
$
3,659
 
$
10,864
 
$
14,523
|
$
3,406
 
$
12,013
 
$
15,419
Non-current
 
-
   
-
   
-
|
 
-
   
-
   
-
Total
$
3,659
 
$
10,864
 
$
14,523
|
$
3,406
 
$
12,013
 
$
15,419
                 
|
               
Liabilities (2)(3):
               
|
               
Self-insurance
               
|
               
liabilities
               
|
               
Current
$
25,942
 
$
21,009
 
$
46,951
|
$
20,369
 
$
20,119
 
$
40,488
Non-current
 
85,929
   
47,476
   
133,405
|
 
74,561
   
47,387
   
121,948
Total
$
111,871
 
$
68,485
 
$
180,356
|
$
94,930
 
$
67,506
 
$
162,436

(1)
Total restricted cash includes cash collateral deposits posted and other cash deposits held by third parties.  Total restricted cash excluded $1,156 and $11,932 at December 31, 2010 and 2009, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD-insured buildings.
   
(2)
Total self-insurance liabilities excluded $5,142 and $5,173 at December 31, 2010 and 2009, respectively, related to our health insurance liabilities.
   
(3)
Total self-insurance liabilities are collateralized, in addition to the restricted cash, by letters of credit of $59,066 for workers' compensation as of December 31, 2010 and $250 and $53,191 for general and professional liability insurance and workers' compensation, respectively, as of December 31, 2009.

(d)  Construction Commitments

As of December 31, 2010, we had construction commitments under various contracts of approximately $9.4 million. These items consisted primarily of contractual commitments to improve existing centers.

(e)  Labor Relations

As of December 31, 2010, SunBridge operated 35 centers with union employees. Approximately 2,800 of our employees (9.4% of all of our employees) who worked in healthcare centers in Alabama, California, Connecticut, Georgia, Massachusetts, Maryland, Montana, New Jersey, Ohio, Rhode Island, Washington and West Virginia were covered by collective bargaining contracts. Collective bargaining agreements covering approximately 1,600 of these employees (5.3% of all our employees) either are currently in renegotiations or will shortly be in renegotiations due to the expiration of the collective bargaining agreements.

 
F-28

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(9)  Income Taxes

The provision for income taxes was based upon management's estimate of taxable income or loss for each respective accounting period.  We recognized an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements.  These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled.  We also recognized as deferred tax assets the future tax benefits from net operating loss, capital loss, and tax credit carryforwards.  A valuation allowance was provided for certain deferred tax assets, since it is more likely than not that a portion of the net deferred tax assets will not be realized.

Income tax expense (benefit) on income attributable to continuing operations consisted of the following for the years ended December 31 (in thousands):

   
2010
   
2009
   
2008
 
Current:
                 
Federal
  $ -     $ -     $ 941  
State
    1,772       2,300       1,417  
      1,772       2,300       2,358  
Deferred:
                       
Federal
    963       24,829       (40,150 )
State
    229       2,487       (9,556 )
      1,192       27,316       (49,706 )
Total
  $ 2,964     $ 29,616     $ (47,348 )

Actual tax expense (benefit) differed from the expected tax expense, which was computed by applying the U.S. Federal corporate income tax rate of 35% to our profit before income taxes for the years ended December 31 as follows (in thousands):

   
2010
   
2009
   
2008
 
                   
                   
Computed expected tax expense
  $ 87     $ 25,234     $ 23,302  
Adjustments in income taxes resulting from:
                       
Change in valuation allowance
    (111 )     -       (70,465 )
State income tax expense, net of Federal
                       
income tax effect
    694       3,814       3,568  
Reduction in unrecognized tax benefits
    (264 )     (56 )     (2,202 )
Nondeductible transaction costs
    3,771       -       -  
Tax credits
    (1,612 )     (1,339 )     (1,114 )
Nondeductible compensation
    31       53       137  
Other nondeductible expenses
    439       728       964  
Other
    (71 )     1,182       (1,538 )
Total
  $ 2,964     $ 29,616     $ (47,348 )
 

 
F-29

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

        Deferred tax assets (liabilities) at December 31 consisted of the following (in thousands):

   
2010
   
2009
 
             
Deferred tax assets:
           
Accounts and notes receivable
  $ 26,945     $ 22,722  
Accrued liabilities
    89,865       82,018  
Intangible assets
    9,936       19,555  
Property and equipment
    5,400       -  
Write-down of assets held for sale
    888       1,016  
Partnership investments
    2,165       4,274  
Minimum tax and other credit carryforwards
    6,457       8,794  
State net operating loss carryforwards
    16,120       25,035  
Federal net operating loss carryforwards
    56,690       79,122  
Other
    -       37  
      214,466       242,573  
                 
Less valuation allowance
    (18,126 )     (27,572 )
Total deferred tax assets
    196,340       215,001  
                 
Deferred tax liabilities:
               
Property and equipment
    -       (37,587 )
Deferred tax assets, net
  $ 196,340     $ 177,414  

In connection with the Separation, certain deferred tax assets (e.g., net operating loss carryforwards and tax credit carryforwards) and certain deferred tax liabilities (primarily related to property and equipment) were transferred to or assumed by Sabra.  In the case of net operating loss (“NOL”) carryforwards, regulations under the Internal Revenue Code and similar state rules require the NOLs to be allocated to the two companies based on their relative contributions (including the contributions of their subsidiaries) to the NOLs for each tax period.  Similar rules are applied for the allocation of tax credits.  In the case of other deferred balances (e.g., property and equipment), the deferred tax asset (liability) transferred was based upon the difference between the net book basis and net tax basis transferred to Sabra.  The net amount of deferred tax assets (liabilities) assumed by Sabra was approximately $21.8 million.

The $9.4 million total decrease in the valuation allowance resulted from the expiration or loss of certain state NOL carryforwards which were fully reserved ($0.9 million), the amount of valuation allowance related to deferred tax assets transferred to Sabra ($8.4 million), and an adjustment to our tax provision ($0.1 million).  The deferred tax asset for the expired state NOLs and the corresponding valuation allowance were reduced accordingly.  In evaluating the need to maintain a valuation allowance on our net deferred tax assets, all items of positive evidence (e.g., future sources of taxable income and tax planning strategies) and negative evidence (e.g., history of taxable losses) were considered.  This assessment required significant judgment.  Based upon our estimates of future taxable income, we believe that we will more likely than not realize a significant portion of our net deferred tax assets.  If any future reversals of the remaining valuation allowance of $18.1 million as of December 31, 2010, should occur, then such reversal would reduce the provision for income taxes.

 
F-30

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

        Internal Revenue Code Section 382 imposes a limitation on the use of a company’s NOL carryforwards and other losses when the company has an ownership change.  In general, an ownership change occurs when shareholders owning 5% or more of a “loss corporation” (a corporation entitled to use NOL or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any 3-year testing period beginning on the first day following the change date for an earlier ownership change.  The annual base Section 382 limitation is calculated by multiplying the loss corporation's value at the time of the ownership change times the greater of the long-term tax-exempt rate determined by the IRS in the month of the ownership change or the two preceding months.

The issuance of our common stock in connection with an acquisition in 2005 resulted in an ownership change under Section 382.  The annual base Section 382 limitation to be applied to our tax attribute carryforwards as a result of this ownership change is approximately $10.3 million.  Accordingly, our NOL, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  In addition, a separate annual base Section 382 limitation of approximately $14.6 million is to be applied to the tax attribute carryforwards of Harborside as a result of the Harborside acquisition.  Per the Tax Allocation Agreement between New Sun and Sabra (see Note 14 – “Transactions with Sabra”), New Sun and Sabra have agreed to allocate all Section 382 limitations to New Sun unless New Sun decides that a portion of the Section 382 limitation should be allocated to Sabra.

After considering the reduction in tax attributes resulting from the allocation to Sabra and the Section 382 limitation discussed above, we have Federal NOL carryforwards of approximately $162.0 million with expiration dates from 2019 through 2027.  Various subsidiaries have state NOL carryforwards totaling approximately $322.7 million with expiration dates beginning in 2011 through the year 2029.  Our application of the rules under Section 382 is subject to challenge upon IRS review.  A successful challenge could significantly impact our ability to utilize tax attribute carryforwards from periods prior to the ownership change dates.

We are subject to income taxes in the U.S. and numerous state and local jurisdictions.  Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.  Effective January 1, 2007, we adopted the guidance for accounting for uncertain tax positions, which contains a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any.  The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement.

Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different.  We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the expiration of the statute of limitations.  To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.  The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.

 
F-31

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

        A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands):

   
2010
   
2009
   
2008
 
                   
Balance at the beginning of the period
  $ 26,316     $ 25,654     $ 5,417  
                         
Additions for tax positions of prior years
    248       730       -  
Reductions for tax positions of prior years
    -       -       (1,501 )
Additions based on tax positions related to the current year
-       -       23,497  
Lapsing of statutes of limitations
    (318 )     (68 )     (1,759 )
                         
Balance at the end of the period
  $ 26,246     $ 26,316     $ 25,654  

All of the gross unrecognized tax benefits would affect the effective tax rate if recognized.  Unrecognized tax benefits are adjusted in the period in which new information about a tax position becomes available or the final outcome differs from the amount recorded.  Unrecognized tax benefits are not expected to change significantly over the next twelve months.

We recognize potential accrued interest related to unrecognized tax benefits in income tax expense.  Penalties, if incurred, would also be recognized as a component of income tax expense.  The amount of accrued interest related to unrecognized tax benefits as of December 31, 2010, 2009, and 2008 was $0.3 million, $0.2 million, and $0.1 million, respectively.

We file numerous consolidated and separate state and local income tax returns in addition to our consolidated U.S. federal income tax return.  With few exceptions, we are no longer subject to U.S. federal, state or local income tax examinations for years before 2007.  These jurisdictions can, however, adjust NOL carryforwards from earlier years.

(10)  Fair Value of Financial Instruments

The estimated fair values of our financial instruments as of December 31 were as follows (in thousands):

   
2010
   
2009
 
   
Carrying
         
Carrying
       
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
                         
Cash and cash equivalents
  $ 81,163     $ 81,163     $ 104,483     $ 104,483  
Restricted cash
  $ 15,679     $ 15,679     $ 27,351     $ 27,351  
Long-term debt and capital lease obligations,
                               
including current portion
  $ 155,980     $ 156,084     $ 700,548     $ 690,950  
Interest rate swap agreements
  $ -     $ -     $ 5,048     $ 5,048  

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At December 31, 2010 and 2009, the fair value of our long-term debt, including current maturities, and our interest rate swap agreement was based on estimates using present value techniques that are significantly affected by the assumptions used concerning the amount and timing of estimated future cash flows and discount rates that reflect varying degrees of risk.

 
F-32

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

 
The FASB accounting guidance establishes a hierarchy for ranking the quality and reliability of the information used to determine fair values.  This guidance requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1:
Unadjusted quoted market prices in active markets for identical assets or liabilities.
   
Level 2:
Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
   
Level 3:
Unobservable inputs for the asset or liability.

We endeavor to utilize the best available information in measuring fair value.  The following table summarizes the valuation of our financial instruments by the above pricing levels as of December 31 (in thousands):

   
December 31, 2010
       
Unadjusted Quoted
 
Significant Other
       
Market Prices
 
Observable Inputs
   
Total
 
(Level 1)
 
(Level 2)
                 
Restricted cash – money market funds
$
1,465
$
1,465
 
$
-
 


   
December 31, 2009
       
Unadjusted Quoted
 
Significant Other
       
Market Prices
 
Observable Inputs
   
Total
 
(Level 1)
 
(Level 2)
Cash equivalents – money market
           
funds/certificate of deposit
$
36,480
$
31,429
 
$
5,051
 
Restricted cash – money market funds
$
1,275
$
1,275
 
$
-
 
Interest rate swap agreement – liability
$
5,048
$
-
 
$
5,048
 

We currently have no other financial instruments subject to fair value measurement on a recurring basis.


(11)  Capital Stock

(a)  Basic and Diluted Shares

Basic net income per common share is calculated by dividing net income applicable to common stock by the weighted average number of common shares outstanding during the period. The calculation of diluted net income per common share is similar to that of basic net income per common share, except the denominator is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares, principally those issuable upon the exercise of stock options and warrants and the vesting of stock units, were issued during the period.

 
F-33

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

The following table summarizes the calculation of basic and diluted net income per common share for each period (in thousands except per share data):

   
2010
   
2009
   
2008
 
Numerator:
                 
Net (loss) income
$
(4,650
)
$
38,671
 
$
109,287
 
Denominator:
                 
Weighted average shares for basic net
                 
income per common share
 
19,280
   
14,614
   
   14,444
 
Add dilutive effect of assumed exercise of
                 
stock options and warrants and vesting
                 
of restricted stock units using the
                 
treasury stock method
 
-
   
100
   
524
 
Weighted average shares for diluted net
                 
income per common share
 
19,280
   
14,714
   
14,968
 
                   
Basic net income per common share
$
(0.24
)
$
2.65
 
$
7.57
 
Diluted net income per common share
$
(0.24
)
$
2.63
 
$
7.30
 

(b)  Equity Incentive Plans

Pursuant to our 2004 Equity Incentive Plan (the “2004 Plan”), as of December 31, 2010 our employees and directors held options to purchase 913,530 shares of common stock and 176,867 unvested restricted stock units. No additional awards can be made under the 2004 Plan.

As of December 31, 2010, our directors held options to purchase 16,604 shares under our 2002 Non-employee Director Equity Incentive Plan (the “Director Plan”). No additional awards can be made under the Director Plan.

Our 2009 Performance Incentive Plan (the “2009 Plan”) allows for the issuance of shares of common stock equal to the sum of:  (i) 4.0 million shares, plus (ii) the number of any shares subject to stock options granted under the 2004 Plan or the Director Plan  which expire, or for any reason are canceled or terminated, without being exercised, plus (3) the number of any shares subject to restricted stock units under the 2004 Plan which are forfeited, terminated or cancelled without having become vested.  As of December 31, 2010 our employees and directors held options to purchase 628,981 shares of common stock and 656,121 unvested restricted stock units.

Option awards are granted with an exercise price equal to the market price of our stock at the date of grant; those option awards generally vest based on four years of continuous service and have seven-year contractual terms.  Share awards generally vest over four years and no dividends are paid on unexercised options or unvested share awards.  Certain option and share awards provide for accelerated vesting if there is a change in control (as defined in the applicable plan).

During the year ended December 31, 2010, we issued 306,602 shares of common stock upon the vesting of restricted stock shares and restricted stock units and the exercise of stock options.

In connection with the Separation on November 15, 2010, vested and unvested option awards and unvested restricted stock unit awards of Old Sun were converted into awards with respect to shares of New Sun common

 
F-34

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

stock.  The number of shares subject to and the exercise price of each converted option, and the number of shares subject to each unvested or vested and deferred restricted stock unit, were adjusted to preserve the same intrinsic value of the awards that existed immediately prior to the Separation and REIT Conversion Merger.  Awards held by our former Chief Executive Officer were assumed by Sabra upon Separation and converted to awards with respect to Sabra common stock in a manner similar to the conversion of Old Sun to New Sun shares.

A summary of option activity under the 2004 Plan, the 2009 Plan and the Director Plan during the year ended December 31, 2010 is presented below:
               
Weighted-
       
               
Average
   
Aggregate
 
         
Weighted-
   
Remaining
   
Intrinsic
 
Options
 
Shares
   
Average
   
Contractual
   
Value
 
(Prior to the Separation)
 
(in thousands)
   
Exercise Price
   
Term (in years)
   
(in thousands)
 
                         
Outstanding at January 1, 2010
 
2,310
 
$
10.05
             
Granted
 
496
   
9.81
             
Exercised
 
(185
)
 
7.10
             
Assumed by Sabra
 
(788
)
 
10.08
             
Forfeited
 
(53
)
 
11.99
             
Outstanding at November 15, 2010
 
1,780
 
$
10.22
   
4
 
$
-
 
                         

               
Weighted-
       
               
Average
   
Aggregate
 
         
Weighted-
   
Remaining
   
Intrinsic
 
Options
 
Shares
   
Average
   
Contractual
   
Value
 
(Subsequent to the Separation)
 
(in thousands)
   
Exercise Price
   
Term (in years)
   
(in thousands)
 
                         
Outstanding at November 16, 2010
 
1,478
 
$
12.30
             
Granted
 
88
   
10.55
             
Forfeited
 
(7
)
 
10.89
             
Outstanding at December 31, 2010
 
1,559
 
$
10.52
   
4
 
$
526
 
                         
Exercisable at December 31, 2010
 
794
 
$
11.99
   
4
 
$
529
 

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following table.  Expected volatility is based on the historical volatility of our stock.  The expected term of options granted is derived using a temporary “shortcut approach” of our “plain vanilla” employee stock options as we do not have sufficient data to develop a more precise estimate. Under this approach, the expected term would be presumed to be the mid-point between the vesting date and the end of the contractual term.  The risk-free rate for the period within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The weighted-average grant-date fair value of stock options granted during the year ended December 31, 2010, 2009 and 2008 was $9.92, $9.86 and $5.78, respectively.


 
F-35

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

    The significant assumptions in the valuation model for the years ended December 31 are as follows:

 
2010
 
2009
 
2008
Expected volatility
49.6 %- 51.9%
 
51.2% - 51.9%
 
50.7% - 80.6%
Weighted-average volatility
60.4%
 
51.6%
 
61.3%
Expected term (in years)
4.75
 
4.75
 
4.75
Risk-free rate
1.3% - 2.5%
 
1.8% - 2.6%
 
1.6% - 5.0%

In connection with the restricted stock units granted to employees we recognized the full fair value of the shares of nonvested restricted stock awards.  A summary of restricted stock activity with our share-based compensation plans during the year ended December 31, 2010 is as follows:

         
Weighted-
         
Average
Nonvested Shares
 
Shares
   
Grant-Date
(Prior to the Separation)
 
(in thousands)
   
Fair Value
           
Nonvested at January 1, 2010
 
999
 
$
10.93
Granted
 
623
   
9.75
Vested
 
(457
)
 
10.65
Assumed by Sabra
 
(130
)
 
10.52
Forfeited
 
(35
)
 
11.61
Nonvested at November 15, 2010
 
1,000
   
10.33
           

         
Weighted-
         
Average
Nonvested Shares
 
Shares
   
Grant-Date
(Subsequent to the Separation)
 
(in thousands)
   
Fair Value
           
Nonvested at November 16, 2010
 
831
 
$
10.69
Granted
 
19
   
10.59
Vested
 
(6
)
 
8.82
Forfeited
 
(7
)
 
10.99
Nonvested at December 31, 2010
 
837
   
10.72

The total fair value of restricted shares vested was $4.9 million for the year ended December 31, 2010 and $4.0 million for the year ended December 31, 2009.

We recognized stock compensation expense of $6.3 million, $5.8 million and $5.3 million for the years ended December 31, 2010, 2009 and 2008 respectively.

 
F-36

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(12)  Other Events

(a)  Litigation

We are a party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our centers and claims relating to employment and commercial matters. Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations, financial condition and cash flows.  In certain states in which we have operations, insurance coverage for the risk of punitive damages arising from general and professional liability litigation may not be available due to state law public policy prohibitions.  There can be no assurance that we will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available.

We operate in an industry that is extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found by a court of competent jurisdiction to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief; and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

In September 2010, a lawsuit was filed by a former employee of a subsidiary of our medical staffing company, alleging violation of various wage and hour provisions of the California Labor Code.  We deny all of the allegations in the employee’s complaint.  The lawsuit, which was filed as a purported class action on behalf of the former employee and all those similarly situated, has been settled. The terms of the settlement are confidential pending court approval.   We believe our reserves are adequate for this matter.

In November 2010, a jury verdict was rendered in a Kentucky state court against us for $2.75 million in compensatory damages and $40 million in punitive damages. On February 25, 2011, the trial court judge reduced the punitive damage award to $24.75 million.  The case involves claims for professional negligence resulting in wrongful death.  We disagree with the jury’s verdict and believe that it is not supported by the facts of the case or applicable law.  We are in the process of preparing our appeal of this judgment.  We believe our reserves are adequate for this matter.

(b)  Other Inquiries

From time to time, fiscal intermediaries and Medicaid agencies examine cost reports filed by predecessor operators of our skilled nursing centers. If, as a result of any such examination, it is concluded that overpayments to a predecessor operator were made, we, as the current operator of such centers, may be held financially responsible for such overpayments. At this time we are unable to predict the outcome of any existing or future examinations.
 
 
F-37

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

(c)  Legislation, Regulations and Market Conditions

We are subject to extensive federal, state and local government regulation relating to licensure, conduct of operations, ownership of centers, expansion of centers and services and reimbursement for services. As such, in the ordinary course of business, our operations are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which may be non-routine. We believe that we are in substantial compliance with the applicable laws and regulations. However, if we are ever found to have engaged in improper practices, we could be subjected to civil, administrative or criminal fines, penalties or restitutionary relief, which may have a material adverse impact on our financial position, results of operations and cash flows.

(13)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of nursing, rehabilitative, and related ancillary care services to nursing home patients.

The following summarizes the services provided by our reportable and other segments:

Inpatient Services:  This segment provides, among other services, inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these centers by registered nurses, licensed practical nurses and certified nursing aids.  At December 31, 2010, we operated 200 healthcare centers (consisting of 164 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, two independent living centers and eight mental health centers with an aggregate of 23,053 licensed beds) as compared with 205 healthcare centers (consisting of 183 skilled nursing centers, 14 assisted living and independent living centers and eight mental health centers) with 23,205 licensed beds at December 31, 2009.

Rehabilitation Therapy Services:  This segment provides, among other services, physical, occupational, speech and respiratory therapy supplies and services to affiliated and nonaffiliated skilled nursing centers. At December 31, 2010, this segment provided services in 36 states via 508 contracts, 346 nonaffiliated and 162 affiliated, as compared to 464 contracts at December 31, 2009, of which 337 were nonaffiliated and 127 were affiliated.

Medical Staffing Services:  For the year ended December 31, 2010, this segment provided services in 39 states and derived 50.6% of its revenues from hospitals and other providers, 26.8% from skilled nursing centers, 16.4% from schools and 6.2% from prisons. We provide (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians, (iv) physicians, and (v) related medical personnel.  As of December 31, 2010, this segment had 25 branch offices, which provided temporary therapy, nursing, pharmacy and physician staffing services in major metropolitan areas and one office servicing locum tenens.  As of December 31, 2008, this segment had 30 branch offices, which provided temporary therapy, nursing, pharmacy and physician staffing services in major metropolitan areas and one division office, which specializes in the placement of temporary traveling therapists, and one office servicing locum tenens.

Corporate assets primarily consist of cash and cash equivalents, receivables from subsidiary segments, notes receivable, property and equipment and unallocated intangible assets. Although corporate assets include unallocated intangible assets, the amortization, if applicable, is reflected in the results of operations of the associated segment.

 
 
F-38

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

        The accounting policies of the segments are the same as those described in Note 2 – “Summary of Significant Accounting Policies.” We primarily evaluate segment performance based on profit or loss from operations before reorganization and restructuring items, income taxes and extraordinary items. Gains or losses on sales of assets and certain items including impairment of assets recorded in connection with annual impairment testing and restructuring costs are not considered in the evaluation of segment performance. Interest expense is recorded in the segment carrying the obligation to which the interest relates.

Our reportable segments are strategic business units that provide different products and services.  They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income.  Net segment income is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, income tax benefit and discontinued operations. Net segment income for the year ended December 31, 2010 for (1) our inpatient services segment decreased $6.0 million, or 3.8%, to $150.7 million, (2) our rehabilitation therapy services segment increased $3.0 million, or 27.0%, to $14.1 million and (3) our medical staffing services segment decreased $5.2 million, or 34.9%, to $5.6 million. We use the measure of net segment income to help identify opportunities for improvement and assist in allocating resources to each segment. 


 
 
F-39

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010



As of and for the
                                   
Year Ended
                                   
December 31, 2010
       
Segment Information (in thousands):
 
                                     
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,697,444
 
$
119,612
 
$
89,765
 
$
40
 
$
-
 
$
1,906,861
 
                                     
Intersegment revenues
 
-
   
86,476
   
2,036
   
-
   
(88,512
)
 
-
 
                                     
Total revenues
 
1,697,444
   
206,088
   
91,801
   
40
   
(88,512
)
 
1,906,861
 
                                     
Operating salaries and benefits
 
838,251
   
171,970
   
67,638
   
-
   
-
   
1,077,859
 
                                     
Self insurance for workers'
                                   
  compensation and general and
                                   
  professional liability insurance
 
54,379
   
1,774
   
1,309
   
13,344
   
-
   
70,806
 
                                     
Other operating costs
 
457,693
   
8,008
   
12,819
   
-
   
(88,512
)
 
390,008
 
                                     
General and administrative expenses
 
41,195
   
8,160
   
2,588
   
60,842
   
-
   
112,785
 
                                     
Provision for losses on
                                   
  accounts receivable
 
19,362
   
929
   
277
   
-
   
-
   
20,568
 
                                     
Segment operating income (loss)
$
286,564
 
$
15,247
 
$
7,170
 
$
(74,146
)
$
-
 
$
234,835
 
                                     
Center rent expense
 
82,994
   
496
   
844
   
-
   
-
   
84,334
 
                                     
Depreciation and amortization
 
43,333
   
678
   
732
   
3,265
   
-
   
48,008
 
                                     
Interest, net
 
9,493
   
-
   
(1
)
 
33,572
   
-
   
43,064
 
                                     
Net segment income (loss)
$
150,744
 
$
14,073
 
$
5,595
 
$
(110,983
)
$
-
 
$
59,429
 
                                     
Identifiable segment assets
$
708,227
 
$
16,492
 
$
20,933
 
$
313,536
 
$
20,879
 
$
1,080,067
 
                                     
Goodwill
$
343,439
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
348,047
 
                                     
Segment capital expenditures
$
49,003
 
$
1,061
 
$
203
 
$
3,261
 
$
-
 
$
53,528
 
 
_____________________________________
General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net, loss (gain) on sale of assets, net, restructuring costs, transaction costs, loss on extinguishment of debt, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, transaction costs, income tax expense and discontinued operations.


 
F-40

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010



As of and for the
                                   
Year Ended
                                   
December 31, 2009
       
Segment Information (in thousands):
 
                                     
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,674,752
 
$
105,366
 
$
100,624
 
$
34
 
$
-
 
$
1,880,776
 
                                     
Intersegment revenues
 
-
   
74,166
   
1,930
   
-
   
(76,096
)
 
-
 
                                     
Total revenues
 
1,674,752
   
179,532
   
102,554
   
34
   
(76,096
)
 
1,880,776
 
                                     
Operating salaries and benefits
 
833,658
   
150,271
   
72,336
   
-
   
-
   
1,056,265
 
                                     
Self insurance for workers'
                                   
  compensation and general and
                                   
  professional liability insurance
 
59,830
   
2,161
   
1,331
   
418
   
-
   
63,740
 
                                     
Other operating costs
 
437,418
   
7,620
   
15,713
   
-
   
(76,096
)
 
384,655
 
                                     
General and administrative expenses
 
41,245
   
6,868
   
2,811
   
62,068
   
-
   
112,992
 
                                     
Provision for losses on
                                   
  accounts receivable
 
20,637
   
482
   
55
   
-
   
-
   
21,174
 
                                     
Segment operating income (loss)
$
281,964
 
$
12,130
 
$
10,308
 
$
(62,452
)
$
-
 
$
241,950
 
                                     
Center rent expense
 
71,728
   
480
   
920
   
-
   
-
   
73,128
 
                                     
Depreciation and amortization
 
41,325
   
540
   
780
   
2,808
   
-
   
45,453
 
                                     
Interest, net
 
12,226
   
(2
)
 
(2
)
 
37,105
   
-
   
49,327
 
                                     
Net segment income (loss)
$
156,685
 
$
11,112
 
$
8,610
 
$
(102,365
)
$
-
 
$
74,042
 
                                     
Identifiable segment assets
$
1,190,638
 
$
16,011
 
$
25,143
 
$
863,505
 
$
(528,456
)
$
1,566,841
 
                                     
Goodwill
$
333,688
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
338,296
 
                                     
Segment capital expenditures
$
50,418
 
$
650
 
$
74
 
$
3,170
 
$
-
 
$
54,312
 
 
_____________________________________
General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net, loss (gain) on sale of assets, net, restructuring costs, transaction costs, loss on extinguishment of debt, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, transaction costs, income tax expense and discontinued operations.


 
F-41

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010



As of and for the
                                   
Year Ended
                                   
December 31, 2008
       
Segment Information (in thousands):
 
                                     
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,615,322
 
$
89,619
 
$
117,788
 
$
37
 
$
-
 
$
1,822,766
 
                                     
Intersegment revenues
 
-
   
60,856
   
2,622
   
-
   
(63,478
)
 
-
 
                                     
Total revenues
 
1,615,322
   
150,475
   
120,410
   
37
   
(63,478
)
 
1,822,766
 
                                     
Operating salaries and benefits
 
816,710
   
124,817
   
86,345
   
-
   
-
   
1,027,872
 
                                     
Self insurance for workers'
                                   
  compensation and general and
                                   
  professional liability insurance
 
55,480
   
2,138
   
1,514
   
557
   
-
   
59,689
 
                                     
Other operating costs
 
411,784
   
7,113
   
17,553
   
-
   
(63,478
)
 
372,972
 
                                     
General and administrative expenses
 
41,382
   
6,806
   
2,983
   
62,302
   
-
   
113,473
 
                                     
Provision for losses on
                                   
  accounts receivable
 
13,256
   
213
   
563
   
-
   
-
   
14,032
 
                                     
Segment operating income (loss)
$
276,710
 
$
9,388
 
$
11,452
 
$
(62,822
)
$
-
 
$
234,728
 
                                     
Center rent expense
 
72,223
   
394
   
976
   
-
   
-
   
73,593
 
                                     
Depreciation and amortization
 
35,951
   
533
   
806
   
3,058
   
-
   
40,348
 
                                     
Interest, net
 
13,670
   
(1
)
 
(20
)
 
40,954
   
-
   
54,603
 
                                     
Net segment income (loss)
$
154,866
 
$
8,462
 
$
9,690
 
$
(106,834
)
$
-
 
$
66,184
 
                                     
Identifiable segment assets
$
1,145,106
 
$
12,489
 
$
28,262
 
$
880,428
 
$
(528,449
)
$
1,537,836
 
                                     
Goodwill
$
322,200
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
326,808
 
                                     
Segment capital expenditures
$
39,976
 
$
286
 
$
188
 
$
1,962
 
$
-
 
$
42,412
 
 
_____________________________________
General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net, loss (gain) on sale of assets, net, restructuring costs, loss on extinguishment of debt, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, transaction costs, income tax expense and discontinued operations.

 
F-42

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

 
Measurement of Segment Income or Loss

The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies (See Note 2 – “Summary of Significant Accounting Policies”).  We evaluate financial performance and allocate resources primarily based on income or loss from operations before income taxes, excluding any unusual items.

The following table reconciles net segment income to consolidated income before income taxes and discontinued operations for the years ended December 31 (in thousands):

   
2010
   
2009
   
2008
 
                   
Net segment income
$
59,429
 
$
74,042
 
$
66,184
 
Transaction costs
 
(29,113
)
 
-
   
-
 
Restructuring costs, net
 
-
   
(1,304
)
 
-
 
Loss on extinguishment of debt
 
(29,221
)
 
-
   
-
 
(Loss) gain on sale of assets, net
 
(847
)
 
(42
)
 
977
 
Income before income taxes and
                 
discontinued operations
$
248
 
$
72,696
 
$
67,161
 

(14)  Transactions with Sabra

For the purpose of governing certain of the ongoing relationships between us and Sabra after the Separation and to provide mechanisms for an orderly transition, we and Sabra entered into various agreements. The most significant agreements are as follows:
 
 
Distribution Agreement

The Distribution Agreement provides for the various actions taken in connection with the Separation, the conditions to the Separation and the relationship between the parties subsequent to the Separation. Pursuant to the Distribution Agreement, any liability arising from or relating to legal proceedings involving Old Sun’s healthcare business prior to the Separation will be assumed by New Sun, and New Sun will indemnify Sabra against any losses arising from or relating to such legal proceedings. The Distribution Agreement provides that any liability arising from or relating to legal proceedings involving Old Sun’s real property assets now owned by Sabra are assumed by Sabra. Any liability arising from or relating to legal proceedings prior to the Separation, other than those arising from or relating to legal proceedings involving Old Sun’s healthcare business or such real property assets, are assumed by New Sun.

In addition, the Distribution Agreement provides for cross-indemnities that require (i) Sabra to indemnify New Sun (and its subsidiaries, directors, officers, employees and agents and certain other related parties) against all losses arising from or relating to the liabilities being assumed by Sabra or the breach of the Distribution Agreement by Sabra and (ii) New Sun to indemnify Sabra (and its subsidiaries, directors, officers, employees and agents and certain other related parties) against all losses arising from or relating to the liabilities being assumed or retained by New Sun or the breach of the Distribution Agreement by New Sun.

New Sun and Sabra have agreed in the Distribution Agreement that New Sun will pay all costs associated with the Separation and REIT Conversion Merger that are incurred prior to the Separation. All costs relating to

 
F-43

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

the Separation or REIT Conversion Merger incurred after the Separation will be borne by the party incurring such costs.

Master Lease Agreements
 
Sabra received substantially all of Old Sun’s owned real property in the Separation and leases such real property to New Sun under eighteen master lease agreements which set forth the terms governing each of the leased properties (the "Lease Agreements").
 
Subsidiaries of New Sun (each a “Tenant”) entered into the Lease Agreements with subsidiaries of Sabra (each a “Lessor”) pursuant to which the Tenants lease the 86 healthcare properties owned by subsidiaries of Sabra following the Separation (consisting of 67 skilled nursing facilities, ten combined skilled nursing, assisted and independent living facilities, five assisted living facilities, two mental health facilities, one independent living facility and one continuing care retirement community). The obligations of the Tenants under the Lease Agreements are guaranteed by New Sun.

The Lease Agreements provide for the lease of land, buildings, structures and other improvements on the land, easements and similar appurtenances to the land and improvements, and equipment relating to the operation of the leased properties. There are multiple bundles of leased properties under each Lease Agreement with each bundle containing one to fourteen leased properties. The Lease Agreements provide for an initial term of between 10 and 15 years and no purchase options. At the option of the Tenant, the Lease Agreements may be extended for up to two five-year renewal terms beyond the initial term at the then currently in place rental rate plus an annual rent escalator equal to the lesser of the percentage change in the Consumer Price Index or 2.50% (but not less than zero). If the Tenant elects to renew the term of one or more expiring Lease Agreements, the renewal will be effective as to all, but not less than all, of the leased property then subject to the applicable Lease Agreements.
 
The Lease Agreements are commonly known as triple-net leases. Accordingly, in addition to rent, the Tenant will be required to pay the following: (1) all facility maintenance, (2) all insurance required in connection with the leased properties and the business conducted on the leased properties, (3) taxes levied on or with respect to the leased properties (other than taxes on the income of the Lessor) and (4) all utilities and other services necessary or appropriate for the leased properties and the business conducted on the leased properties.

Under the Lease Agreements, the initial annual aggregate base rent payable by subsidiaries of New Sun is $70.2 million. The Lease Agreements provide for an annual rent escalator equal to the lesser of the percentage change in the Consumer Price Index or 2.50% (but not less than zero).

Tax Allocation Agreement
 
Under the Tax Allocation Agreement, New Sun is responsible for and will indemnify Sabra against (i) all federal income taxes, including any taxes resulting from the restructuring of Old Sun’s business and the distribution of shares of New Sun common stock to Old Sun’s stockholders, that are reportable on any tax return for periods prior to and including the Separation that includes Sabra or one of its subsidiaries, on the one hand, and New Sun or one of its subsidiaries, on the other hand, (ii) all state and local income taxes in jurisdictions in which it is expected that net operating losses or other tax attributes will be sufficient to offset tax liability for such returns in such periods, and (iii) all transfer taxes resulting from the restructuring of Old Sun’s business and the distribution of shares of New Sun common stock to Old Sun’s stockholders. With respect to non-income

 
F-44

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2010

taxes (other than transfer taxes) and income taxes in state and local jurisdictions in which it is not expected that net operating losses or other tax attributes will be sufficient to offset tax liability, tax liability will be allocated between New Sun and Sabra using a closing of the books method on the date of Separation.

After the 2010 tax year, Sabra and New Sun have agreed, to the extent allowable by applicable law, to allocate all limitations to utilize net operating loss carryforwards to New Sun. New Sun will prepare, at its own cost, all tax returns and elections for periods prior to and including the date of the Separation. In addition, New Sun will generally have the right to control the conduct and disposition of any audits or other proceeding with regard to such periods. In addition, from and after the distribution date of the Separation, New Sun will be entitled to any refund or credit for such periods.

New Sun included in the cash allocation made to Sabra pursuant to the Distribution Agreement, an amount equal to an estimate of such unpaid taxes described above for the 2010 taxable year. New Sun will only indemnify Sabra against such taxes if, and to the extent, such taxes exceed such estimate. With respect to any period in which Sabra has made or will make an election to be taxed as a real estate investment trust (“REIT”), New Sun will not make any indemnity payments to Sabra in an amount that could cause Sabra to fail to qualify as a REIT. The unpaid amount, if any, of such indemnity will be placed in escrow and will be paid to Sabra only upon the satisfaction of certain conditions related to the REIT income requirements under the Code. Any such amount held in escrow after five years will be released back to New Sun.

The Tax Allocation Agreement is not binding on the IRS or any other governmental entity and does not affect the liability of each of New Sun, Sabra, and their respective subsidiaries and affiliates, to the IRS or any other governmental authority for all U.S. federal, state or local or non-U.S. taxes of the Old Sun consolidated group relating to periods through the distribution date for the Separation. Accordingly, although the Tax Allocation Agreement will allocate tax liabilities between New Sun and Sabra, either Sabra and its subsidiaries or New Sun and its subsidiaries could be liable for tax liabilities not allocated to them under the Tax Allocation Agreement in the event that any tax liability is not discharged by the other party.

Transition Services Agreement

To the extent requested by Sabra, New Sun will provide Sabra with administrative and support services on a transitional basis pursuant to the Transition Services Agreement, including finance and accounting, human resources, legal support, and information systems support (the “Transition Services”) for a period of up to one year, subject to any permitted extensions contained therein.  The Transition Services Agreement provides for Sabra to pay New Sun a rate per labor hour of actual services rendered. The Transition Services Agreement provides that Sabra has the right to terminate a Transition Service after an agreed notice period. The Transition Services Agreement also contains provisions whereby Sabra  generally agrees to indemnify New Sun for all claims, losses, damages, liabilities and other costs incurred by New Sun to a third party which arise in connection with the provision of a Transition Service, other than those costs resulting from New Sun’s gross negligence or willful misconduct.
 
F-45

 



SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

SUPPLEMENTARY DATA (UNAUDITED)
QUARTERLY FINANCIAL DATA

The following tables reflect unaudited quarterly financial data for fiscal years 2010 and 2009 (in thousands, except per share data):
   
For the Year Ended
 
   
December 31, 2010
 
   
Fourth
   
Third
   
Second
   
First
       
   
Quarter (a)
   
Quarter
   
Quarter
   
Quarter
   
Total
 
                               
Total net revenues
  $ 483,418     $ 475,997     $ 474,394     $ 473,052     $ 1,906,861  
                                         
(Loss) income from continuing operations
  $ (31,930 )   $ 7,998     $ 10,499     $ 10,717     $ (2,716 )
Loss from discontinued operations
  $ (446 )   $ (442 )   $ (526 )   $ (520 )   $ (1,934 )
                                         
Net (loss) income
  $ (32,376 )   $ 7,556     $ 9,973     $ 10,197     $ (4,650 )
                                         
Basic earnings per common and
                                       
common equivalent share:
                                       
(Loss) income from continuing operations
  $ (1.24 )   $ 0.40     $ 0.71     $ 0.73     $ (0.14 )
Loss from discontinued operations
    (0.02 )     (0.02 )     (0.03 )     (0.04 )     (0.10 )
Net (loss) income
  $ (1.26 )   $ 0.38     $ 0.68     $ 0.69     $ (0.24 )
                                         
Diluted earnings per common and
                                       
common equivalent share:
                                       
(Loss) income from continuing operations
  $ (1.24 )   $ 0.40     $ 0.71     $ 0.72     $ (0.14 )
Loss from discontinued operations
    (0.02 )     (0.02 )     (0.04 )     (0.03 )     (0.10 )
Net (loss) income
  $ (1.26 )   $ 0.38     $ 0.67     $ 0.69     $ (0.24 )
                                         
Weighted average number of
                                       
common and common equivalent
                                       
shares outstanding:
                                       
Basic
    25,791       19,839       14,744       14,677       19,280  
Diluted
    25,791       19,857       14,843       14,802       19,280  
                                         

 
 (a)  Includes certain pretax amounts related to year-end charges due to the Separation, consisting primarily of $29.1 million of transaction costs and $29.2 million of loss on extinguishment of debt.
 

 
1

 


   
For the Year Ended
 
   
December 31, 2009 (1)
 
   
Fourth
   
Third
   
Second
   
First
       
   
Quarter
   
Quarter
   
Quarter
   
Quarter
   
Total
 
                               
Total net revenues
  $ 473,827     $ 470,644     $ 468,444     $ 467,861     $ 1,880,776  
                                         
Income from continuing  operations
  $ 9,810     $ 10,539     $ 10,974     $ 11,757     $ 43,080  
(Loss) income from discontinued operations
  $ (1,135 )   $ (881 )   $ (878 )   $ (1,515 )   $ (4,409 )
                                         
Net income
  $ 8,675     $ 9,658     $ 10,096     $ 10,242     $ 38,671  
                                         
Basic earnings per common and
                                       
common equivalent share:
                                       
Income from continuing operations
  $ 0.67     $ 0.72     $ 0.75     $ 0.81     $ 2.95  
(Loss) income from discontinued operations
    (0.08 )     (0.06 )     (0.06 )     (0.11 )     (0.30 )
Net income
  $ 0.59     $ 0.66     $ 0.69     $ 0.70     $ 2.65  
                                         
Diluted earnings per common and
                                       
common equivalent share:
                                       
Income from continuing operations
  $ 0.67     $ 0.72     $ 0.75     $ 0.80     $ 2.93  
(Loss) income from discontinued operations
    (0.08 )     (0.06 )     (0.06 )     (0.11 )     (0.30 )
Net income
  $ 0.59     $ 0.66     $ 0.69     $ 0.69     $ 2.63  
                                         
Weighted average number of
                                       
common and common equivalent
                                       
shares outstanding:
                                       
Basic
    14,648       14,641       14,617       14,548       14,614  
Diluted
    14,746       14,717       14,707       14,738       14,714  

(1)
We have reclassified all activity related to entities whose operations were divested or identified for disposal for the years ended December 31, 2010 and 2009 to discontinued operations.  Therefore, the quarterly financial data presented above including revenues, income (loss) before income taxes and discontinued operations and income (loss) on discontinued operations will not reflect the amounts reported previously in our Quarterly Reports on Form 10-Q filed with the SEC.  However, net income remains the same.

 

 
2

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

SUPPLEMENTARY DATA (UNAUDITED)


INSURANCE RESERVES

Activity in our insurance reserves as of and for the three months ending December 31, 2010 and 2009 is as follows (in thousands):
 
   
Professional
Liability
   
Workers’
Compensation
   
Total
 
                   
Balance as of September 30, 2009
  $ 90,007     $ 65,554     $ 155,561  
Current year provision, continuing operations
    6,942       7,260       14,202  
Current year provision, discontinued operations
    434       161       595  
Prior year reserve adjustments, continuing operations
    2,200       1,720       3,920  
Prior year reserve adjustments, discontinued operations
    300       230       530  
Claims paid, continuing operations
    (4,045 )     (4,901 )     (8,946 )
Claims paid, discontinued operations
    (635 )     (680 )     (1,315 )
Amounts paid for administrative services and other
    (273 )     (1,838 )     (2,111 )
Balance as of December 31, 2009
  $ 94,930     $ 67,506     $ 162,436  
                         
                         
Balance as of September 30, 2010
  $ 98,953     $ 68,794     $ 167,747  
Current year provision, continuing operations
    7,690       6,314       14,004  
Current year provision, discontinued operations
    3       5       8  
Prior year reserve adjustments, continuing operations
    13,100       -       13,100  
Claims paid, continuing operations
    (6,278 )     (4,990 )     (11,268 )
Claims paid, discontinued operations
    (930 )     (417 )     (1,347 )
Amounts paid for administrative services and other
    (667 )     (1,221 )     (1,888 )
Balance as of December 31, 2010
  $ 111,871     $ 68,485     $ 180,356  


 
3

 

SCHEDULE II

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS
(in thousands)


   
Column A
   
Column B
   
Column C
   
Column D
   
Column E
 
   
Balance at
   
Charged to
   
Additions
         
Balance at
 
   
Beginning
   
Costs and
   
Charged to
   
Deductions
   
End of
 
Description
 
of Period
   
Expenses(1)
   
Other Accounts(2)
   
Other(3)
   
Period
 
Year ended December 31, 2010
                             
  Allowance for doubtful accounts
$
55,402
 
$
21,175
 
$
-
 
$
(9,970
)
$
66,607
 
  Other receivables reserve (4)
$
1,182
 
$
168
 
$
-
 
$
-
 
$
1,350
 
  Allowance for deferred tax assets
$
27,572
 
$
-
 
$
-
 
$
(9,446
)
$
18,126
 
                               
Year ended December 31, 2009
                             
  Allowance for doubtful accounts
$
44,830
 
$
21,196
 
$
214
 
$
(10,838
)
$
55,402
 
  Other receivables reserve (4)
$
1,077
 
$
105
 
$
-
 
$
-
 
$
1,182
 
  Allowance for deferred tax assets
$
34,321
 
$
-
 
$
-
 
$
(6,749
)
$
27,572
 
                               
Year ended December 31, 2008
                             
  Allowance for doubtful accounts
$
42,144
 
$
15,283
 
$
180
 
$
(12,777
)
$
44,830
 
  Other receivables reserve (4)
$
1,587
 
$
-
 
$
-
 
$
(510
)
$
1,077
 
  Allowance for deferred tax assets
$
132,905
 
$
-
 
$
13,945
 
$
(112,529
)
$
34,321
 

(1)
Charges included in (adjustment) provision for losses on accounts receivable of $606, $(1), and $1,176 for the years ended December 31, 2010, 2009, and 2008, respectively, related to discontinued operations.
   
(2)
Column C primarily represents increases that resulted from acquisition activity (see Note 5 – “Acquisitions”).
   
(3)
Column D primarily represents write offs and recoveries of receivables that have been fully reserved or valuation allowance on deferred tax assets transferred to Sabra (see Note 9 – “Income Taxes”).
   
(4)
The other receivables reserve is classified in prepaid and other assets on our consolidated balance sheets.  Other receivables, net of reserves, were $2,424, $4,943, and $5,599 as of December 31, 2010, 2009 and 2008, respectively.



 
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