Capella Healthcare, Inc. - FORM 10-Q

Capella Healthcare, Inc. - FORM 10-Q - August 14, 2015

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2015

¨	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: 333-175188

Capella Healthcare, Inc.

(Exact name of registrant as specified in its charter)

Delaware

20-2767829

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

501 Corporate Centre Drive, Suite 200

Franklin, Tennessee

37067

(Address of principal executive offices)

(Zip Code)

(615) 764-3000

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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

(Note: As a voluntary filer not subject to the filing requirements of Section 13 or 15(d) of the Exchange Act, the registrant has filed all reports pursuant to Section 13 or 15(d) of the Exchange Act during the preceding 12 months as if it were subject to such filing requirements.)

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

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

As of August 14, 2015, 100 shares of the registrant’s Common Stock were outstanding.

CAPELLA HEALTHCARE, INC.

TABLE OF CONTENTS


PART I – FINANCIAL INFORMATION

	Item 1.	Financial Statements	3

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	40

	Item 4.	Controls and Procedures	41

PART II – OTHER INFORMATION

	Item 1.	Legal Proceedings	41

	Item 1A.	Risk Factors	41

	Item 6.	Exhibits	42

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Capella Healthcare, Inc.

Condensed Consolidated Balance Sheets

(In millions, except share and per share data)


	December 31, 2014 (a)			June 30, 2015
				(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	28.7		$	53.9
Restricted cash		73.9			—
Accounts receivable, net of allowance for doubtful accounts of $84.4 and $84.4 at December 31, 2014 and June 30, 2015, respectively		120.9			115.9
Inventories		23.7			24.3
Prepaid expenses and other current assets		10.9			14.6
Deferred tax assets		2.4			1.8
Assets held for sale		33.7			64.1

Total current assets		294.2			274.6
Property and equipment, net		409.6			413.6
Goodwill		127.9			128.8
Intangible assets, net		10.9			11.7
Other assets, net		27.1			25.1

Total assets	$	869.7		$	853.8

Liabilities and stockholder’s deficit
Current liabilities:
Accounts payable	$	29.8		$	28.4
Salaries and benefits payable		27.5			22.3
Accrued interest		23.3			23.2
Other accrued liabilities		23.5			26.6
Current portion of long-term debt		6.0			6.6
Revolving facility		5.0			—
Liabilities held for sale		3.6			9.1

Total current liabilities		118.7			116.2
Long-term debt		607.8			606.0
Deferred income taxes		18.2			15.5
Other liabilities		31.0			31.9
Redeemable non-controlling interests		11.7			11.6
Due to Parent		213.7			213.6
Stockholder’s deficit:
Common stock, $0.01 par value per share; 1,000 shares authorized; 100 shares issued and outstanding at December 31, 2014 and June 30, 2015, respectively		—			—
Retained deficit		(131.4	)		(141.0	)

Total stockholder’s deficit		(131.4	)		(141.0	)

Total liabilities and stockholder’s deficit	$	869.7		$	853.8

(a)	Derived from audited consolidated financial statements

See accompanying notes

Capella Healthcare, Inc.

Condensed Consolidated Statements of Operations (Unaudited)

(In millions)


	Three Months Ended June 30,						Six Months Ended June 30,
	2014			2015			2014			2015
Revenues before provision for bad debts	$	193.2		$	232.4		$	384.2		$	459.2
Provision for bad debts		(14.5	)		(23.8	)		(36.2	)		(43.6	)

Revenues		178.7			208.6			348.0			415.6
Salaries and benefits		85.0			97.3			165.3			194.4
Supplies		29.8			34.5			58.4			69.7
Other operating expenses		45.6			50.7			87.8			102.3
Other income		(3.1	)		(2.3	)		(3.2	)		(4.3	)
Management fees		0.1			0.1			0.1			0.1
Interest, net		13.8			14.2			27.6			28.5
Depreciation and amortization		10.6			11.4			21.1			22.4
Impairment charges		—			10.9			—			10.9

Loss from continuing operations before income taxes		(3.1	)		(8.2	)		(9.1	)		(8.4	)
Income tax (benefit) expense		0.8			(2.7	)		1.6			(1.8	)

Loss from continuing operations		(3.9	)		(5.5	)		(10.7	)		(6.6	)
Loss from discontinued operations, net of tax		(0.9	)		(1.1	)		(3.0	)		(2.3	)

Net loss		(4.8	)		(6.6	)		(13.7	)		(8.9	)
Less: Net income attributable to non-controlling interests		0.6			0.4			0.7			0.7

Net loss attributable to Capella Healthcare, Inc.	$	(5.4	)	$	(7.0	)	$	(14.4	)	$	(9.6	)

See accompanying notes

Capella Healthcare, Inc.

Condensed Consolidated Statement of Stockholder’s Deficit

For the Six Months Ended June 30, 2015

(In millions, except share amounts)


					Total Retained Deficit
	Common Stock							Stockholder’s Deficit
	Shares		Amount					Stockholder’s Deficit
Balance at December 31, 2014(a)		100	$	—	$	(131.4	)	$	(131.4	)
Net loss attributable to Capella Healthcare, Inc. (unaudited)		—		—		(9.6	)		(9.6	)

Balance at June 30, 2015 (unaudited)		100	$	—	$	(141.0	)	$	(141.0	)

(a)	Derived from audited consolidated financial statements

See accompanying notes

Capella Healthcare, Inc.

Condensed Consolidated Statements of Cash Flows (Unaudited)

(In millions)


	Six Months Ended June 30,
	2014			2015
Operating activities:
Net loss	$	(13.7	)	$	(8.9	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Loss from discontinued operations		3.0			2.3
Depreciation and amortization		21.1			22.4
Amortization of loan costs and debt discount		2.0			2.0
Provision for bad debts		36.2			43.6
Deferred income taxes		1.6			(2.1	)
Stock-based compensation		3.3			0.7
Impairment charges		—			10.9
Changes in operating assets and liabilities, net of divestitures		(39.8	)		(46.7	)

Net cash provided by operating activities – continuing operations		13.7			24.2
Net cash used in operating activities – discontinued operations		(5.1	)		(4.2	)

Net cash provided by operating activities		8.6			20.0
Investing activities:
Purchases of property and equipment, net		(9.7	)		(11.4	)
Proceeds from disposition of healthcare business		11.2			27.8

Net cash provided by investing activities – continuing operations		1.5			16.4
Net cash used in investing activities – discontinued operations		(0.5	)		—

Net cash provided by investing activities		1.0			16.4
Financing activities:
Payments on capital leases and other obligations		(7.5	)		(8.1	)
Payments of financing costs and fees		(2.0	)		(1.0	)
Advances to Parent		(6.0	)		(7.5	)
Distributions to non-controlling interests		(0.5	)		(1.3	)
Sale of non-controlling interests		0.1			—

Net cash used in financing activities – continuing operations		(15.9	)		(17.9	)
Net cash provided by financing activities – discontinued operations		5.6			6.7

Net cash used in financing activities		(10.3	)		(11.2	)

Net (decrease) increase in cash and cash equivalents		(0.7	)		25.2
Cash and cash equivalents at beginning of period		26.4			28.7

Cash and cash equivalents at end of period	$	25.7		$	53.9

Supplemental disclosure of cash flow information:
Cash paid for interest	$	25.5		$	26.7

Cash paid for taxes	$	0.7		$	1.0

Supplemental disclosure of non-cash information:
Capital lease obligations recorded	$	—		$	2.5

See accompanying notes

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

1.	ORGANIZATION AND BASIS OF PRESENTATION

Organization

Capella Healthcare, Inc., a Delaware corporation (the “Company”), is a wholly owned subsidiary of Capella Holdings, Inc. (the “Parent”). The Company operates general acute care hospitals and ancillary healthcare facilities in non-urban communities in the United States. At June 30, 2015, as part of continuing operations, the Company operated ten general acute care hospitals and related ancillary healthcare facilities with a total of 1,425 licensed beds. Unless noted otherwise, discussions in these notes pertain to the Company’s continuing operations, which exclude the results of those facilities that have been previously disposed or are included in assets and liabilities held for sale.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, and disclosures considered necessary for a fair presentation have been included. The preparation of the accompanying condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and all subsidiaries and entities controlled by the Company through the Company’s direct or indirect ownership of a majority interest and exclusive rights granted to the Company as the sole general partner or managing member of such entities. All intercompany accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.

Recently Issued Accounting Pronouncement

In May 2014, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board issued a final, converged, principles-based standard on revenue recognition. Companies across all industries will use a five-step model to recognize revenue from customer contracts. The new standard, which replaces nearly all existing GAAP and International Financial Reporting Standards revenue recognition guidance, will require significant management judgment in addition to changing the way many companies recognize revenue in their financial statements. The standard was originally scheduled to become effective for public entities for annual and interim periods beginning after December 15, 2016. Early adoption was originally not to be permitted under GAAP. During April 2015, the FASB proposed a deferral of the effective date of the new revenue standard by one year, but would permit entities to adopt one year earlier if they choose (i.e., the original effective date). The FASB decided, based on its outreach to various stakeholders and forthcoming exposure drafts, which amend the new revenue standard, that a deferral may be necessary to provide adequate time to effectively implement the new standard. We are continuing to evaluate the effects the adoption of this standard will have on our financial statements and financial disclosures.

In February 2015, the FASB issued Accounting Standards Update 2015-02 Consolidation (“ASU 2015-2”). ASU 2015-02 includes amendments that are intended to improve targeted areas of consolidation for legal entities including reducing the number of consolidation models from four to two and simplifying the FASB Accounting Standards Codification. The provisions of ASU 2015-02 are effective for annual reporting periods beginning after December 15, 2015. The amendments may be applied retrospectively in previously issued financial statements for one or more years with a cumulative effect adjustment to retained earnings as of the beginning of the first year restated. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of ASU 2015-02 will have on the Company’s consolidated financial statements.

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

In April 2015, the FASB issued Accounting Standards Update 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”), which requires that debt issuance costs be presented in the balance sheet as a direct deduction from the carrying amount of the debt liability. The guidance in the new standard is limited to the presentation of debt issuance costs. ASU 2015-03 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2015. Early adoption is permitted, and the new guidance should be applied retrospectively. The Company does not expect the adoption of ASU 2015-03 will have an impact on its results of operations or cash flows.

2.	GENERAL AND ADMINISTRATIVE COSTS

The majority of the Company’s expenses are “cost of revenue” items. Costs that could be classified as “general and administrative” by the Company would include its corporate overhead costs, which were $16.1 million and $10.4 million for the six months ended June 30, 2014 and 2015, respectively. Stock-based compensation expense is included in salaries and benefits in the accompanying consolidated statements of operations and within the aforementioned general and administrative costs. During the six months ended June 30, 2014 and 2015, the Company incurred non-cash stock-based compensation expense of $3.3 million and $0.7 million, respectively. Business development and refinancing related costs, also included within the aforementioned general and administrative costs, included in other operating expenses on the condensed consolidated statements of operations, were $1.0 million and $0.9 million for the six months ended June 30, 2014 and 2015, respectively.

3.	FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company applies the provisions of FASB authoritative guidance regarding fair value measurements, which provide a single definition of fair value, establishes a framework for measuring fair value, and expands disclosures concerning fair value measurements. The Company applies these provisions to the valuation and disclosure of certain financial instruments. This authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: (i) Level 1, which is defined as quoted prices in active markets that can be accessed at the measurement date; (ii) Level 2, which is defined as inputs other than quoted prices in active markets that are observable, either directly or indirectly; and (iii) Level 3, which is defined as unobservable inputs resulting from the existence of little or no market data, therefore potentially requiring an entity to develop its own assumptions. The Company’s policy is to recognize transfers between levels as of the actual date of the event or change in circumstances that caused the transfer.

The carrying amounts of the Company’s short-term financial instruments, including cash, accounts receivable, inventories, prepaid expenses and other current assets, other receivables, accounts payable, salaries and benefits payable, accrued interest and accrued liabilities are reflected in the accompanying condensed consolidated financial statements at amounts that approximate fair value because of the short-term nature of these instruments. The fair value of the Company’s capital leases, term loan facility and other long-term financing obligations also approximate carrying value as they bear interest at current market rates. The carrying amount of the Company’s 9¹/₄% Senior Unsecured Notes due 2017 (the “9¹/₄% Notes”) was $500.0 million at June 30, 2015 as disclosed in Note 10. The estimated fair value of the 9¹/₄% Notes at June 30, 2015 was approximately $513.1 million based on the average bid and ask price as determined using published rates and is categorized as Level 2 within the fair value hierarchy.

4.	REVENUE RECOGNITION AND ACCOUNTS RECEIVABLE

The Company recognizes revenue before the provision for bad debts, including revenue from in-house patients and patients who have been discharged but not yet billed, in the period in which services are performed. Accounts receivable primarily consist of amounts due from third-party payors and patients. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. The Company has entered into agreements with third-party payors, including government programs and managed care health plans, under which the Company is paid based upon established charges, the cost of providing services, predetermined rates per diagnosis, fixed per diem rates or discounts from established charges. Amounts the Company receives for treatment of patients covered by governmental programs, such as Medicare and Medicaid, and other third-party payors, such as health maintenance organizations, preferred provider organizations and other private insurers, are generally less than the Company’s established billing rates. Accordingly, the revenues and accounts receivable reported in the accompanying unaudited condensed consolidated financial statements are recorded at the amount expected to be received.

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

The following table sets forth the percentages of revenues before the provision for bad debts by payor for the three and six months ended June 30, 2014 and 2015:


	Three months ended June 30,						Six months ended June 30,
	2014			2015			2014			2015
Medicare(1)		40.7	%		39.5	%		40.5	%		40.7	%
Medicaid(1)		18.9			16.9			17.8			16.8
Managed Care and other(2)		34.2			36.2			34.6			35.8
Self-Pay		6.2			7.4			7.1			6.7

Total		100.0	%		100.0	%		100.0	%		100.0	%

(1)	Includes revenues received under managed Medicare or managed Medicaid programs.

(2)	Includes the health insurance exchanges, beginning with the first quarter of 2014.

The Company derives a significant portion of its revenue before the provision for bad debts from Medicare, Medicaid and other payors that receive discounts from its standard charges. The Company must estimate the total amount of these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be calculated are complex and are subject to interpretation and adjustment. The Company estimates the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ from the Company’s estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual discounts affect revenues reported in the accompanying unaudited condensed consolidated statements of operations.

Settlements under reimbursement agreements with third-party payors are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. Final determination of amounts earned under the Medicare and Medicaid programs often occurs subsequent to the year in which services are rendered because of audits by the programs, rights of appeal and the application of numerous technical provisions. There is at least a reasonable possibility that such estimates will change by a material amount in the near term. The net estimated third-party payor settlements receivable by the Company as of December 31, 2014 totaled $0.1 million compared to $0.9 million as of June 30, 2015, and are included in prepaid expenses and other current assets in the accompanying condensed consolidated balance sheets. For the three and six months ended June 30, 2014, the net adjustments to estimated cost report settlements resulted in an increase to revenues of $1.2 million and $2.0 million, respectively. For the three and six months ended June 30, 2015, the net adjustments to estimated cost report settlements resulted in an decrease to revenues of $2.8 million and $1.9 million, respectively. The decrease is a result of the Company’s receipt of a Notice of Program Reimbursement on May 14, 2015 requesting a refund of $2.8 million as a result of a retroactive change by CMS in the method used to calculate Medicare disproportionate share payments for certain adolescent psychiatric services provided at the facility. The Company plans to appeal this determination. The Company cannot predict the outcome of such appeal. The Company’s management believes that adequate provisions have been made for adjustments that may result from final determination of amounts earned under these programs.

Provision for Bad Debts and Allowance for Doubtful Accounts

To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty of such allowance lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

Additions to the allowance for doubtful accounts are made by means of the provision for bad debts. Accounts written off as uncollectible are deducted from the allowance for doubtful accounts and subsequent recoveries are added. The amount of the provision for bad debts is based upon management’s assessment of historical and expected net collections, business and economic conditions, trends in federal, state, and private employer healthcare coverage and other collection indicators. The provision for bad debts and the allowance for doubtful accounts relate primarily to “uninsured” amounts (including copayment and deductible amounts from patients who have healthcare coverage) due directly from patients. Accounts are written off when all reasonable internal and external collection efforts have been performed. The Company considers the return of an account from the primary external collection

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

agency to be the culmination of its reasonable collection efforts and the timing basis for writing off the account balance. Accounts written off are based upon specific identification and the write-off process requires a write-off adjustment entry to the patient accounting system. Management relies on the results of detailed reviews of historical write-offs and recoveries (the hindsight analysis) as one source of information to utilize in estimating the collectability of the Company’s accounts receivable.

The Company performs the hindsight analysis on a quarterly basis for all hospitals, generally utilizing rolling twelve-month accounts receivable collection, write-off, and recovery data. The Company supplements its hindsight analysis with other analytical tools, including, but not limited to, revenue days in accounts receivable, historical cash collections experience and revenue trends by payor classification. Adverse changes in general economic conditions, billing and collections operations, payor mix, or trends in federal or state governmental healthcare coverage could affect the Company’s collection of accounts receivable, cash flows and results of operations.

A summary of activity in the Company’s allowance for doubtful accounts is as follows (in millions):


	Beginning Balance at January 1, 2015		Additions Charged to provision for bad debts		Accounts Written Off, Net of Recoveries			Balance at End of Period
Six months ended June 30, 2015	$	84.4	$	43.6	$	(43.6	)	$	84.4

The allowance for doubtful accounts was $84.4 million and $84.4 million as of December 31, 2014 and June 30, 2015, respectively. These balances as a percentage of accounts receivable net of contractual adjustments were 41.1% and 42.6% as of December 31, 2014 and June 30, 2015, respectively.

5.	BUSINESS COMBINATIONS

Effective January 1, 2015, the Company acquired controlling ownership interest in Carolina Pines Regional Medical Center (“Carolina Pines”), a 116-bed acute care facility located in Hartsville, South Carolina, through the acquisition of all of the equity interests in Hartsville Medical Group, LLC and substantially all of the equity interests in Hartsville, LLC (formerly Hartsville HMA, LLC), each a South Carolina limited liability company. The cash purchase price, subject to final working capital adjustments, was $67.3 million plus $12.0 million for working capital and was funded by a $100 million, seven-year term loan facility (the “Term Loan Facility”). The transaction resulted in goodwill of approximately $11.0 million.

The fair values of assets acquired and liabilities assumed at the acquisition date are as follows (in millions):


Accounts receivable, net	$	13.1
Prepaids and other		0.4
Inventories		2.4
Property and equipment		57.6
Intangibles		1.2
Goodwill		11.0

Total assets acquired		85.7

Accounts payable		1.7
Salaries and benefits payable		2.4
Accrued expenses		1.1
Non-controlling interest		1.2

Total liabilities assumed		6.4

Net assets acquired	$	79.3

The preliminary values of the consideration transferred, assets acquired and liabilities assumed, including the related tax effects, are subject to receipt of a final valuation and final working capital adjustments.

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Pro-Forma Information

Net revenues of approximately $25.3 million and $49.6 million and income from continuing operations before income taxes of $1.8 million and $2.6 million for Carolina Pines are included in the Company’s consolidated statement of operations for the three and six months ended June 30, 2015. The following table provides certain pro-forma financial information for the Company as if this acquisition occurred as of January 1, 2014 (in millions):


	Three months ended June 30,					Six months ended June 30,
	2014		2015			2014			2015
Net Revenue	$	201.5	$	208.6		$	391.9		$	415.6

Income (loss) from continuing operations before income taxes	$	0.1	$	(8.2	)	$	(4.4	)	$	(8.4	)

6.	DIVESTITURES AND IMPAIRMENT CHARGES

At December 31, 2014, the Company committed to plans to sell certain of one of its facilities in Tennessee and one in Missouri. In connection with these planned divestures, the Company recognized an estimated loss on the planned sale totaling $15.9 million (including $5.8 million of goodwill) during the year ended December 31, 2014. The Company has presented the operating results, financial positions and cash flows as discontinued operations in the accompanying consolidated financial statements for all periods, and the related assets and liabilities are reflected as held for sale in the accompanying condensed consolidated financial statements.

On May 1, 2015, the Company completed the sale of Mineral Area Regional Medical Center, a 135 bed facility located in Farmington, Missouri. In connection with the planned divestiture, the Company recognized an estimated loss on the sale totaling $7.1 million during the year ended December 31, 2014, which was reduced for changes in net working capital of $1.7 million during the six months ended June 30, 2015. The Company has presented the operating results, financial positions and cash flows as discontinued operations in the accompanying condensed consolidated financial statements.

Revenues before the provision for bad debts and the loss reported in discontinued operations for the Company’s discontinued operations for the three and six months ended June 30, 2014 and 2015, are as follows (in millions):


	Three months ended June 30,						Six months ended June 30,
	2014			2015			2014			2015
Revenues before the provision for bad debts from discontinued operations	$	15.2		$	6.9		$	34.4		$	19.4

Loss from discontinued operations
Net loss from sale of healthcare business		—			(0.5	)		(1.6	)		(0.5	)
Gain from held for sale adjustment		—			0.5			—			1.5
Loss from operations		(0.9	)		(1.1	)		(1.4	)		(3.3	)

Loss from discontinued operations, net of tax	$	(0.9	)	$	(1.1	)	$	(3.0	)	$	(2.3	)

In July, 2015, the Company entered into a definitive agreement regarding the sale of Stones River Hospital and three additional hospitals consisting of DeKalb Community Hospital, Highlands Medical Center, and River Park Hospital (collectively, the “Tennessee Facilities”) all of which reside in the State of Tennessee. The sale closed effective August 1, 2015. Included in the accompanying unaudited condensed consolidated statement of operations is income before taxes attributable to DeKalb Community Hospital, Highlands Medical Center and River Park Hospital of $1.1 million and $1.2 million for the three months ended June 30, 2014 and, 2015, respectively, and $1.7 million and $1.5 million for the six months ended June 30 2014 and 2015, respectively. The assets and liabilities have been classified as held for sale in connection with the Tennessee Facilities of $61.9 million and $8.4 million, respectively.

In connection with the Company’s entry into a definitive agreement to sell the Tennessee Facilities, the Company recognized an impairment charge of $10.9 million, during the three and six months ended June 30, 2015 for DeKalb Community Hospital, Highlands Medical Center and River Park Hospital. The impairment charge included write-down of property, equipment, allocated goodwill and certain other assets to their estimated fair values. Stones River Hospital was recognized as a discontinued operation and is included in the discontinued operations noted above.

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

The Company estimated the fair value of its assets and liabilities held for sale at December 31, 2014 at approximately $33.7 million and $3.6 million, respectively. The Company estimated the fair value of its assets and liabilities held for sale at June 30, 2015 at approximately $64.1 million and $9.1 million, respectively. The estimated fair value is based on the amount outlined in the executed purchase agreement and is categorized as Level 3 within the fair value hierarchy in accordance with Accounting Standards Codification 820-10, “Fair Value Measurements and Disclosures”.

7.	GOODWILL AND INTANGIBLE ASSETS

Goodwill

The Company’s business comprises a single reporting unit for impairment test purposes. For the purposes of these analyses, the Company’s estimates of fair value are based on the income approach, which estimates the fair value of the Company based on its future discounted cash flows. In addition to the annual impairment reviews, impairment reviews are performed whenever circumstances indicate a possible impairment may exist. The Company performed its most recent goodwill impairment testing as of October 1, 2014 and did not incur an impairment charge. The Company’s goodwill balance was $127.9 million and $128.8 million at December 31, 2014 and June 30, 2015, respectively.

Deferred Loan Costs

The Company records deferred loan costs for expenditures related to acquiring or issuing new debt instruments. These expenditures include bank fees and premiums, as well as attorneys’ and filing fees. Net deferred loan costs totaled $9.8 million and $9.3 million, net of accumulated amortization of $12.2 million and $13.7 million at December 31, 2014 and June 30, 2015, respectively, and are included in other assets on the accompanying condensed consolidated balance sheets. The Company amortizes the deferred loan costs to interest expense over the life of the respective debt instrument.

Contract-Based Physician Minimum Revenue Guarantees

The Company committed to provide certain financial assistance pursuant to recruiting agreements, or “physician minimum revenue guarantees,” with various physicians practicing in the communities it serves. In consideration for a physician relocating to one of its communities and agreeing to engage in private practice for the benefit of the respective community, the Company may advance certain amounts of money to a physician to assist in establishing his or her practice.

The Company records a contract-based intangible asset and related guarantee liability for new physician minimum revenue guarantees. The contract-based intangible asset is amortized to other operating expenses over the period of the physician contract, which is typically four years. The Company’s physician income guarantee intangible assets were $12.1 million ($6.7 million, net) and $13.6 million ($7.2 million, net) at December 31, 2014 and June 30, 2015, respectively. The Company committed to advance a maximum amount of approximately $3.7 million at June 30, 2015. As of December 31, 2014 and June 30, 2015, the Company’s liability balance for contract-based physician minimum revenue guarantees was approximately $0.7 million and $1.4 million, respectively, which is included in other accrued liabilities in the accompanying condensed consolidated balance sheets.

8.	INCOME TAXES

The Company’s income tax benefit was $1.8 million on losses from continuing operations of $8.4 million, for an effective income tax rate of 21.7% during the six months ended June 30, 2015. The Company’s income tax expense was $1.6 million on losses from continuing operations of $9.1 million, for an effective income tax rate of 17.6% during the six months ended June 30, 2014. Due to the Company’s valuation allowance, the effective tax rate bears no relationship to pre-tax income.

9.	COMMITMENTS AND CONTINGENCIES

Employment Agreements

The Company has executed senior management agreements with six of its senior executive officers. The agreements provide for minimum salary levels, adjusted based upon individual and Company performance criteria, as well as for participation in bonus plans which are payable if specific management goals are met. The agreements also provide for severance benefits, if certain criteria are met, for a period of up to two years. The senior management agreements remain in place for each of the senior executive officers during their period of employment with the Company or any of its subsidiaries.

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Legal Proceedings and General Liability Claims

The Company is, from time to time, subject to claims and suits arising in the ordinary course of business, including claims for damages for personal injuries, medical malpractice, breach of management contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request punitive or other damages against the Company which may not be covered by insurance. The Company is currently not a party to any proceeding which, in management’s opinion, would have a material adverse effect on the Company’s business, financial condition or results of operations.

Acquisitions

The Company has historically acquired businesses with prior operating histories. Acquired businesses may have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations, medical and general professional liabilities, workers compensation liabilities, previous tax liabilities and unacceptable business practices. Although the Company institutes policies designed to conform practices to its standards following completion of acquisitions, there can be no assurance that the Company will not become liable for past activities of the acquired businesses that may later be asserted to be improper by private plaintiffs or government agencies. Although the Company generally seeks to obtain indemnification from prospective sellers covering such matters, there can be no assurance that any such matter will be covered by indemnification, or if covered, that such indemnification will be adequate to cover potential losses and fines.

10.

DEBT OBLIGATIONS

The following table presents a summary of the Company’s debt obligations at December 31, 2014 and June 30, 2015 (in millions):


	December 31, 2014			June 30, 2015
9¹/₄% Notes	$	500.0		$	500.0
Unamortized discount on 9¹/₄% Notes		(2.2	)		(1.8	)

Total 9¹/₄% Notes	$	497.8		$	498.2
Term Loan Facility	$	100.0		$	99.5
Unamortized discount on Term Loan Facility		(1.0	)		(0.9	)

Total Term Loan Facility	$	99.0		$	98.6
Capital lease obligations		17.0			15.8

Total debt obligations	$	613.8		$	612.6
Less current maturities		6.0			6.6

Total long-term debt	$	607.8		$	606.0

9¹/₄% Senior Unsecured Notes

In June 2010, the Company completed a comprehensive refinancing plan (the “Refinancing”). Under the Refinancing, the Company issued $500 million of 9¹/₄% Notes due 2017 and entered into a new senior secured asset-based loan (“ABL”), consisting of a $100 million revolving credit facility maturing in December 2014 (the “2010 Revolving Facility”). The proceeds from the 9¹/₄% Notes were used to repay the outstanding principal and interest related to the Company’s 2008 bank credit agreement and to pay fees and expenses relating to the Refinancing of approximately $21.7 million.

Interest on the 9¹/₄% Notes is payable semi-annually on July 1 and January 1 of each year. The 9¹/₄% Notes are unsecured general obligations of the Company and rank equal in right of payment to all existing and future senior unsecured indebtedness of the Company. All payments on the 9¹/₄% Notes are guaranteed jointly and severally on a senior unsecured basis by the Company and its subsidiaries, other than those subsidiaries that do not guarantee the obligations of the borrowers under the Company’s prior senior credit facilities.

The Company may redeem all or a part of the 9¹/₄% Notes at any time, plus accrued and unpaid interest, if any, to the date of redemption plus a redemption price equal to a percentage of the principal amount of the notes redeemed based on the following redemption schedule:


July 1, 2014 to June 30, 2015	104.625	%
July 1, 2015 to June 30, 2016	102.313	%
July 1, 2016 and thereafter	100.000	%

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

If the Company experiences a change of control under certain circumstances, the Company must offer to repurchase all of the 9¹/₄% Notes at a price equal to 101.000% of their principal amount, plus accrued and unpaid interest, if any, to the repurchase date.

The 9¹/₄% Notes contain customary affirmative and negative covenants, which among other things, limit the Company’s ability to incur additional debt, create liens, pay dividends, effect transactions with its affiliates, sell assets, pay subordinated debt, merge, consolidate, enter into acquisitions and effect sale leaseback transactions.

Upon and subject to the closing of the merger described in Note 13 below, the indebtedness of the Parent and its subsidiaries, including the outstanding 9 ¹/₄% Notes, will be repaid or otherwise discharged, with the indenture underlying the 9 ¹/₄% Notes to be terminated upon such repayment or other discharge, provided that the redemption of the 9 ¹/₄% Notes may occur after the effective time of the merger in accordance with a valid redemption notice delivered prior to or substantially concurrently with the effective time of the merger.

ABL and 2010 Revolving Facility

On December 31, 2014, the Company entered into an Amended and Restated Loan Agreement (the “ABL Agreement”), by and among the Company, the borrowing subsidiaries signatory thereto, the guarantying subsidiaries signatory thereto, the lenders party thereto, and Bank of America, N.A., as agent for the lenders (“ABL Agent”). The ABL Agreement amends, restates, and replaces in its entirety the Loan and Security Agreement, dated as of June 28, 2010 (as previously amended, the “Prior ABL Agreement”), by and among the Company and certain borrowing subsidiaries as borrowers, certain guarantying subsidiaries as guarantors, certain financial institutions party thereto from time to time as lenders, and ABL Agent as agent for the lenders.

The ABL Agreement amends and restates the Prior ABL Agreement to, among other things, change the maturity date of the 2010 Revolving Facility from December 29, 2014 to the earlier to occur of (a) June 3, 2019, (b) November 16, 2016, if, as of such date, (i) the 9¹/₄% Notes have not been repaid in full or refinanced on terms reasonably satisfactory to ABL Agent (including a maturity date no earlier than December 3, 2019) and (ii) the Term Loan Facility has not been repaid in full or the maturity date has not been extended to a date that is no earlier than September 3, 2019, and (c) April 1, 2017 if, as of such date, the Company’s 9¹/₄% Notes have not been repaid in full or refinanced on terms reasonably satisfactory to ABL Agent (including a maturity date no earlier than December 3, 2019).

Upon the occurrence of certain events, the Company may request the 2010 Revolving Facility to be increased by an aggregate amount not to exceed $25.0 million. Availability under the 2010 Revolving Facility is subject to a borrowing base of 85% of eligible net accounts receivable. Borrowings under the ABL Agreement bear interest at a rate equal to, at the Company’s option, either (a) LIBOR plus an applicable margin or (b) Base Rate, as defined in the ABL Agreement, plus an applicable margin. Subsequent to the most recent amendment and restatement of the ABL Agreement, the applicable margin in effect for borrowings under the 2010 Revolving Facility was reduced from 2.00% to 0.50% with respect to base rate borrowings and from 3.00% to 1.50% with respect to LIBOR borrowings, or reduced from a maximum of 2.50% to 1.00% with respect to base rate borrowings and reduced from a maximum of 3.50% to 2.00% for LIBOR borrowings, subject to the Company’s fixed charge coverage ratio. In addition to paying interest on outstanding principal, the Company is required to pay a commitment fee to the lenders under the 2010 Revolving Facility in respect of the unutilized commitments thereunder. Subsequent to the most recent amendment and restatement of the ABL Agreement, based on the average facility usage for the most recently ended calendar month, the commitment fee was reduced from a range of 0.50% 0.75% to a range of 0.25% to 0.375% per annum. The Company must also pay customary letter of credit fees.

At June 30, 2015, the Company had no outstanding loans under the ABL Agreement. At June 30, 2015, the Company had a borrowing base of $82.2 million, net of outstanding letters of credit of $6.7 million, primarily used as the collateral under the Company’s workers’ compensation programs, immediately available for borrowing under the ABL Agreement.

Upon and subject to the closing of the merger described in Note 13 below, the indebtedness of the Parent and its subsidiaries, including any outstanding loans under the ABL Agreement, will be repaid or otherwise discharged, with the ABL Agreement to be terminated upon such repayment or other discharge.

Term Loan Facility

On December 31, 2014, the Company entered into a Credit Agreement (the “Term Loan Credit Agreement”) by and among the Company, as borrower, the Parent, as a guarantor, Credit Suisse AG, Cayman Islands Branch, as administrative agent, and certain other lenders from time to time party thereto.

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

The Term Loan Credit Agreement establishes the Term Loan Facility, a new senior secured term loan facility consisting of a $100.0 million seven-year term loan. The per annum interest rates applicable to borrowings under the Term Loan Facility are periodically determined at the Company’s election as either (a) the LIBO Rate (as defined in the Term Loan Credit Agreement) plus 4.25% or (b) the Base Rate (as defined in the Term Loan Credit Agreement) plus 3.25%. The interest rate as of June 30, 2015 was 5.25%.

The Term Loan Facility is to be repaid in equal quarterly principal payments of $250,000, with the balance to be paid at maturity. The maturity date applicable to borrowings under the Term Loan Facility is the earlier to occur of (a) December 31, 2021, and (b) February 16, 2017, if, as of such date, the 9¹/₄% Notes have not been refinanced in full with certain permitted debt. The Term Loan Facility is generally subject to mandatory prepayment in amounts equal to: (a) 100% of the net cash proceeds received from certain asset sales (including insurance recoveries and condemnation events), subject to reinvestment provisions and customary exceptions; (b) 100% of the net cash proceeds from the issuance of new debt (other than certain permitted debt); and (c) 50% of the Company’s Excess Cash Flow (as defined in the Term Loan Credit Agreement), with step-downs to (i) 25% and (ii) 0% based on the Secured Net Leverage Ratio (as defined in the Term Loan Credit Agreement).

The Company’s obligations under the Term Loan Facility are unconditionally guaranteed by all of the Company’s material domestic wholly-owned subsidiaries (other than captive insurance subsidiaries, unrestricted subsidiaries, and certain other subsidiaries identified as excluded subsidiaries in the Term Loan Credit Agreement), provided that a guarantor subsidiary may be released if certain conditions are met. The Company’s obligations under the Term Loan Facility are secured by a substantial portion of its assets as well as the assets of its subsidiaries. The Term Loan Credit Agreement contains other terms and conditions that are customary in agreements used in connection with similar transactions.

The proceeds of the Term Loan Facility primarily were used to finance the January 1, 2015 acquisition of a controlling ownership interest in Carolina Pines through the acquisition of all of the equity interests in Hartsville Medical Group, LLC and substantially all of the equity interests in Hartsville, LLC (formerly Hartsville HMA, LLC), each a South Carolina limited liability company.

Upon and subject to the closing of the merger described in Note 13 below, the indebtedness of the Parent and its subsidiaries, including the Term Loan Facility, will be repaid or otherwise discharged, with the Term Loan Credit Agreement to be terminated upon such repayment or other discharge.

Debt Covenants

The indenture governing the 9¹/₄% Notes and the Term Loan Facility contain a number of covenants that, among other things, restrict, subject to certain exceptions, the Company’s ability and the ability of the Company’s subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, pay dividends and distributions or repurchase our capital stock, create liens on assets, make investments, engage in mergers or consolidations, and engage in certain transactions with affiliates. At June 30, 2015, the Company was in compliance with the debt covenants for the 9¹/₄% Notes and the Term Loan Facility that were subject to testing at that date.

The ABL Agreement contains a number of covenants, including the requirement that the Company’s fixed charge coverage ratio (as defined) cannot be less than 1.10 to 1.00 at the end of any measurement period. At June 30, 2015, the Company was in compliance with the ABL Agreement debt covenants that were subject to testing at that date.

11.

STOCK-BASED COMPENSATION

The Parent issues stock-based awards to the Company’s employees from time to time, including stock options and other stock-based awards in accordance with the Parent’s various board-approved compensation plans. In April 2014, the Parent adopted the 2014 Stock Option Plan (the “2014 Plan”), which effectively replaced the 2006 Stock Option Plan. During the three and six months ended June 30, 2014, the Company incurred non-cash stock-based compensation expense of $3.2 million and $3.3 million, respectively. During the three and six months ended June 30, 2015, the Company incurred non-cash stock-based compensation expense of $0.3 million and $0.7 million, respectively. Stock-based compensation expense is included in salaries and benefits in the accompanying condensed consolidated statements of operations.

Restricted Shares

As of June 30, 2015, approximately 537,000 restricted share awards issued by the Parent remained unvested. The Company expects approximately 454,000 of the unvested restricted shares to vest. As of June 30, 2015, there was approximately $0.4 million of estimated unrecognized compensation cost related to these outstanding restricted share awards. These costs are expected to be recognized by the Company over approximately 2.7 years.

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Stock Options

The Company records stock-based employee compensation for options granted using a Black-Scholes-Merton model. The following table sets forth the range of assumptions the Company has utilized in the Black-Scholes-Merton model.


Risk-free interest rate			1.92% to 2.31%
Dividend yield			0%
Volatility (annual)			30.0% to 35.0%
Expected option life			6.5 years

For stock-based awards included in the Black-Scholes-Merton valuation model, the Company uses historical stock price information of certain peer group companies for a period of time equal to the expected award life period to determine estimated volatility. The Company determined the expected life of the stock awards by averaging the contractual life of the awards and the vesting period of the awards. The estimated fair value of awards are amortized to expense on a straight-line basis over the awards’ vesting period. Compensation cost related to stock-based awards will be adjusted for future changes in estimated forfeitures and actual results of performance measures.

The 2014 Plan permits the Parent’s board of directors to issue approximately 90.5 million stock options to the Company’s employees. During the six months ended June 30, 2015, the Parent issued to the Company’s employees 125,000 stock options under the 2014 Plan. As of June 30, 2015, approximately 266,000 options have been forfeited and the Parent has the ability to issue approximately 814,000 additional stock based awards under the 2014 Plan. The stock options vest over five years. The Parent’s options outstanding have an exercise price of $0.16 per option. The Black-Sholes-Merton valuation model indicated that the fair value of options granted during the six months ended June 30, 2015, at $0.06 per option. As of June 30, 2015, 17.1 million options were vested, and the Company expects approximately 74.5 million options to vest over the life of the awards. As of June 30, 2015, there was approximately $3.5 million of estimated unrecognized compensation cost related to outstanding stock options. These costs are expected to be recognized over approximately 3.9 years.

See Note 13 below for a discussion of the impact of the merger described therein on the restricted shares and stock options issued by the Parent.

12.

GUARANTOR AND NON-GUARANTOR SUPPLEMENTARY INFORMATION

The 9¹/₄% Notes are jointly and severally guaranteed on an unsecured senior basis by substantially all of the Company’s wholly-owned subsidiaries. The subsidiary guarantee release provisions under the indentures governing these notes are considered customary and include the sale, merger or transfer of the subsidiary’s assets under a qualifying transaction as set forth in the indentures; the full release or discharge of the indebtedness including a legal defeasance or a qualifying covenant defeasance; and the designation of the subsidiary as an unrestricted subsidiary as set forth in the indentures.

The following presents the condensed consolidating financial information for the Company (as parent issuer), guarantor subsidiaries, non-guarantor subsidiaries, certain eliminations and the Company as of December 31, 2014 and June 30, 2015 and for the three and six months ended June 30, 2014 and 2015:

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Balance Sheets

December 31, 2014

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations		Consolidated
Assets
Current assets:
Cash	$	36.7		$	(5.1	)	$	(2.9	)	$	—	$	28.7
Restricted cash		73.9			—			—			—		73.9
Accounts receivable, net		—			70.4			50.5			—		120.9
Inventories		—			13.5			10.2			—		23.7
Prepaid expenses and other current assets		1.5			6.0			3.4			—		10.9
Deferred tax assets		2.4			—			—			—		2.4
Assets held for sale		—			31.6			2.1			—		33.7

Total current assets		114.5			116.4			63.3			—		294.2
Property and equipment, net		1.7			265.9			142.0			—		409.6
Goodwill		127.9			—			—			—		127.9
Intangible assets, net		—			7.5			3.4			—		10.9
Investments in subsidiaries		(6.4	)		—			—			6.4		—
Other assets, net		26.3			0.7			0.1			—		27.1

Total assets	$	264.0		$	390.5		$	208.8		$	6.4	$	869.7

Liabilities and stockholder’s deficit
Current liabilities:
Accounts payable	$	0.9		$	16.2		$	12.7		$	—	$	29.8
Salaries and benefits payable		5.0			12.8			9.7			—		27.5
Accrued interest		23.3			—			—			—		23.3
Other accrued liabilities		8.9			6.7			7.9			—		23.5
Current portion of long-term debt		1.0			3.1			1.9			—		6.0
Revolving facility		5.0			—			—			—		5.0
Liabilities held for sale		—			3.0			0.6			—		3.6

Total current liabilities		44.1			41.8			32.8			—		118.7
Long-term debt		98.0			367.4			142.4			—		607.8
Deferred income taxes		18.2			—			—			—		18.2
Other liabilities		30.3			0.4			0.3			—		31.0
Redeemable non-controlling interests		—			—			11.7			—		11.7
Due to Parent		204.8			33.4			(24.5	)		—		213.7
Total stockholder’s deficit		(131.4	)		(52.5	)		46.1			6.4		(131.4	)

Total liabilities and stockholder’s deficit	$	264.0		$	390.5		$	208.8		$	6.4	$	869.7

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Balance Sheets

June 30, 2015

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations		Consolidated
Assets
Current assets:
Cash	$	59.4		$	(4.0	)	$	(1.5	)	$	—	$	53.9
Accounts receivable, net		—			68.6			47.3			—		115.9
Inventories		—			13.7			10.6			—		24.3
Prepaid expenses and other current assets		4.0			6.3			4.3			—		14.6
Deferred tax assets		1.8			—			—			—		1.8
Assets held for sale		—			—			64.1			—		64.1

Total current assets		65.2			84.6			124.8			—		274.6
Property and equipment, net		3.5			256.8			153.3			—		413.6
Goodwill		128.8			—			—			—		128.8
Intangible assets, net		—			8.2			3.5			—		11.7
Investments in subsidiaries		(4.8	)		—			—			4.8		—
Other assets, net		25.1			0.8			(0.8	)		—		25.1

Total assets	$	217.8		$	350.4		$	280.8		$	4.8	$	853.8

Liabilities and stockholder’s deficit
Current liabilities:
Accounts payable	$	2.1		$	12.0		$	14.3		$	—	$	28.4
Salaries and benefits payable		0.6			12.4			9.3			—		22.3
Accrued interest		23.2			—			—			—		23.2
Other accrued liabilities		12.8			8.0			5.8			—		26.6
Current portion of long-term debt		1.0			3.2			2.4			—		6.6
Liabilities held for sale		—			—			9.1			—		9.1

Total current liabilities		39.7			35.6			40.9			—		116.2
Long-term debt		97.6			366.1			142.3			—		606.0
Deferred income taxes		15.5			—			—			—		15.5
Other liabilities		30.6			0.5			0.8			—		31.9
Redeemable non-controlling interests		—			—			11.6			—		11.6
Due to Parent		175.4			6.0			32.2			—		213.6
Total stockholder’s deficit		(141.0	)		(57.8	)		53.0			4.8		(141.0	)

Total liabilities and stockholder’s deficit	$	217.8		$	350.4		$	280.8		$	4.8	$	853.8

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Statements of Operations

For Three Months Ended June 30, 2014

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations			Consolidated
Revenues before provision for bad debts	$	—		$	112.4		$	80.8		$	—		$	193.2
Provision for bad debts		—			(7.7	)		(6.8	)		—			(14.5	)

Revenues		—			104.7			74.0			—			178.7
Salaries and benefits		9.0			46.1			29.9			—			85.0
Supplies		—			15.5			14.3			—			29.8
Other operating expenses		1.8			24.8			19.0			—			45.6
Other income		—			(0.2	)		(2.9	)		—			(3.1	)
Equity in (earnings) losses of affiliates		(3.8	)		—			—			3.8			—
Management fees		(4.4	)		2.9			1.6			—			0.1
Interest, net		2.0			8.7			3.1			—			13.8
Depreciation and amortization		0.1			6.8			3.7			—			10.6

Loss from continuing operations before income taxes		(4.7	)		0.1			5.3			(3.8	)		(3.1	)
Income tax (benefit) expense		0.7			0.1			—			—			0.8

Loss from continuing operations		(5.4	)		—			5.3			(3.8	)		(3.9	)
Loss from discontinued operations, net of tax		—			(0.5	)		(0.4	)		—			(0.9	)

Net loss		(5.4	)		(0.5	)		4.9			(3.8	)		(4.8	)
Less: Net loss attributable to non-controlling interests		—			—			0.6			—			0.6

Net loss attributable to Capella Healthcare, Inc.	$	(5.4	)	$	(0.5	)	$	4.3		$	(3.8	)	$	(5.4	)

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Statements of Operations

For Three Months Ended June 30, 2015

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations			Consolidated
Revenues before provision for bad debts	$	—		$	114.3		$	118.1		$	—		$	232.4
Provision for bad debts		—			(10.1	)		(13.7	)		—			(23.8	)

Revenues		—			104.2			104.4			—			208.6
Salaries and benefits		2.4			48.9			46.0			—			97.3
Supplies		—			16.1			18.4			—			34.5
Other operating expenses		1.6			24.9			24.2			—			50.7
Other income		—			—			(2.3	)		—			(2.3	)
Equity in (earnings) losses of affiliates		(0.6	)		—			—			0.6			—
Management fees		(5.5	)		2.7			2.9			—			0.1
Interest, net		1.8			8.1			4.3			—			14.2
Depreciation and amortization		0.1			6.4			4.9			—			11.4
Impairment charges		9.9			—			1.0			—			10.9

Loss from continuing operations before income taxes		(9.7	)		(2.9	)		5.0			(0.6	)		(8.2	)
Income tax (benefit) expense		(2.8	)		0.2			(0.1	)		—			(2.7	)

Loss from continuing operations		(6.9	)		(3.1	)		5.1			(0.6	)		(5.5	)
Loss from discontinued operations, net of tax		(0.1	)		(1.6	)		0.6			—			(1.1	)

Net loss		(7.0	)		(4.7	)		5.7			(0.6	)		(6.6	)
Less: Net loss attributable to non-controlling interests		—			—			0.4			—			0.4

Net loss attributable to Capella Healthcare, Inc.	$	(7.0	)	$	(4.7	)	$	5.3		$	(0.6	)	$	(7.0	)

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Statements of Operations

For Six Months Ended June 30, 2014

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations			Consolidated
Revenues before provision for bad debts	$	—		$	224.7		$	159.5		$	—		$	384.2
Provision for bad debts		—			(19.5	)		(16.7	)		—			(36.2	)

Revenues		—			205.2			142.8			—			348.0
Salaries and benefits		12.7			92.1			60.5			—			165.3
Supplies		—			30.4			28.0			—			58.4
Other operating expenses		3.4			48.8			35.6			—			87.8
Other income		—			(0.2	)		(3.0	)		—			(3.2	)
Equity in (earnings) losses of affiliates		2.3			—			—			(2.3	)		—
Management fees		(9.0	)		5.8			3.3			—			0.1
Interest, net		3.6			17.6			6.4			—			27.6
Depreciation and amortization		0.1			13.5			7.5			—			21.1

Loss from continuing operations before income taxes		(13.1	)		(2.8	)		4.5			2.3			(9.1	)
Income tax expense		1.3			0.1			0.2			—			1.6

Loss from continuing operations		(14.4	)		(2.9	)		4.3			2.3			(10.7	)
Loss from discontinued operations, net of tax		—			(2.1	)		(0.9	)		—			(3.0	)

Net loss		(14.4	)		(5.0	)		3.4			2.3			(13.7	)
Less: Net loss attributable to non-controlling interests		—			—			0.7			—			0.7

Net loss attributable to Capella Healthcare, Inc.	$	(14.4	)	$	(5.0	)	$	2.7		$	2.3		$	(14.4	)

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Statements of Operations

For Six Months Ended June 30, 2015

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations			Consolidated
Revenues before provision for bad debts	$	—		$	228.1		$	231.1		$	—		$	459.2
Provision for bad debts		—			(18.4	)		(25.2	)		—			(43.6	)

Revenues		—			209.7			205.9			—			415.6
Salaries and benefits		7.0			97.1			90.3			—			194.4
Supplies		—			32.4			37.3			—			69.7
Other operating expenses		3.4			50.3			48.6			—			102.3
Other income		—			(1.9	)		(2.4	)		—			(4.3	)
Equity in (earnings) losses of affiliates		(1.6	)		—			—			1.6			—
Management fees		(10.9	)		5.6			5.4			—			0.1
Interest, net		3.5			16.4			8.6			—			28.5
Depreciation and amortization		0.2			12.6			9.6			—			22.4
Impairment charges		9.9			—			1.0			—			10.9

Loss from continuing operations before income taxes		(11.5	)		(2.8	)		7.5			(1.6	)		(8.4	)
Income taxes		(2.0	)		—			0.2			—			(1.8	)

Loss from continuing operations		(9.5	)		(2.8	)		7.3			(1.6	)		(6.6	)
Loss from discontinued operations, net of tax		(0.1	)		(2.5	)		0.3			—			(2.3	)

Net loss		(9.6	)		(5.3	)		7.6			(1.6	)		(8.9	)
Less: Net loss attributable to non-controlling interests		—			—			0.7			—			0.7

Net loss attributable to Capella Healthcare, Inc.	$	(9.6	)	$	(5.3	)	$	6.9		$	(1.6	)	$	(9.6	)

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Statements of Cash Flows

For The Six Months Ended June 30, 2014

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations			Consolidated
Operating activities:
Net loss	$	(14.4	)	$	(5.0	)	$	3.4		$	2.3		$	(13.7	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Equity in earnings of affiliates		2.3			—			—			(2.3	)		—
Loss from discontinued operations		—			2.1			0.9			—			3.0
Depreciation and amortization		0.1			13.5			7.5			—			21.1
Amortization of loan costs and debt discount		1.6			0.2			0.2			—			2.0
Provision for bad debts		—			19.5			16.7			—			36.2
Deferred income taxes		1.7			(0.1	)		—			—			1.6
Stock-based compensation		3.3			—			—			—			3.3
Changes in operating assets and liabilities, net of divestitures		6.5			(25.8	)		(20.5	)		—			(39.8	)

Net cash provided by operating activities – continuing operations		1.1			4.4			8.2			—			13.7
Net cash used in operating activities – discontinued operations		—			(4.6	)		(0.5	)		—			(5.1	)

Net cash provided by (used in) operating activities		1.1			(0.2	)		7.7			—			8.6
Investing activities:
Purchase of property and equipment, net		—			(6.9	)		(2.8	)		—			(9.7	)
Proceeds from disposition of healthcare business		—			11.2			—			—			11.2

Net cash provided by (used in) investing activities – continuing operations		—			4.3			(2.8	)		—			1.5
Net cash used in investing activities – discontinued operations		—			(0.3	)		(0.2	)		—			(0.5	)

Net cash provided by (used in) investing activities		—			4.0			(3.0	)		—			1.0
Financing activities:
Payments on capital leases and other obligations		—			(6.8	)		(0.7	)		—			(7.5	)
Payments of financing costs and fees		(2.0	)		—			—			—			(2.0	)
Advances from (to) Parent		(1.7	)		0.7			(5.0	)		—			(6.0	)
Distributions to non-controlling interests		—			—			(0.5	)		—			(0.5	)
Sale (repurchase) of non-controlling interests		—			—			0.1			—			0.1

Net cash used in financing activities – continuing operations		(3.7	)		(6.1	)		(6.1	)		—			(15.9	)
Net cash provided by financing activities – discontinued operations		—			3.8			1.8			—			5.6

Net cash used in financing activities		(3.7	)		(2.3	)		(4.3	)		—			(10.3	)

Change in cash and cash equivalents		(2.6	)		1.5			0.4			—			(0.7	)
Cash and cash equivalents at beginning of period		31.9			(3.6	)		(1.9	)		—			26.4

Cash and cash equivalents at end of period	$	29.3		$	(2.1	)	$	(1.5	)	$	—		$	25.7

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

Capella Healthcare, Inc.

Condensed Consolidating Statements of Cash Flows

For The Six Months Ended June 30, 2015

(In Millions)


	Parent Issuer			Guarantors			Non-Guarantors			Eliminations			Consolidated
Operating activities:
Net loss	$	(9.6	)	$	(5.3	)	$	7.6		$	(1.6	)	$	(8.9	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Equity in earnings of affiliates		(1.6	)		—			—			1.6			—
Loss from discontinued operations		0.1			2.5			(0.3	)		—			2.3
Depreciation and amortization		0.2			12.6			9.6			—			22.4
Amortization of loan costs and debt discount		2.0			—			—			—			2.0
Provision for bad debts		—			18.4			25.2			—			43.6
Deferred income taxes		(2.1	)		—			—			—			(2.1	)
Stock-based compensation		0.7			—			—			—			0.7
Impairment charges		9.9			—			1.0			—			10.9
Changes in operating assets and liabilities, net of divestitures		(1.0	)		(18.9	)		(26.8	)		—			(46.7	)

Net cash provided by operating activities – continuing operations		(1.4	)		9.3			16.3			—			24.2
Net cash used in operating activities – discontinued operations		—			(3.8	)		(0.4	)		—			(4.2	)

Net cash provided by operating activities		(1.4	)		5.5			15.9			—			20.0
Investing activities:
Purchase of property and equipment, net		—			(4.4	)		(7.0	)		—			(11.4	)
Proceeds from disposition of healthcare businesses		—			27.8			—			—			27.8

Net cash provided by investing activities		—			23.4			(7.0	)		—			16.4
Financing activities:
Payments on capital leases and other obligations		(7.7	)		(0.4	)		—			—			(8.1	)
Payment of financing costs and fees		(1.0	)		—			—			—			(1.0	)
Advances from (to) Parent		32.8			(30.7	)		(9.6	)		—			(7.5	)
Distributions to non-controlling interests		—			—			(1.3	)		—			(1.3	)

Net cash used in financing activities – continuing operations		24.1			(31.1	)		(10.9	)		—			(17.9	)
Net cash used in financing activities – discontinued operations		—			3.3			3.4			—			6.7

Net cash used in financing activities		24.1			(27.8	)		(7.5	)		—			(11.2	)

Change in cash and cash equivalents		22.7			1.1			1.4			—			25.2
Cash and cash equivalents at beginning of period		36.7			(5.1	)		(2.9	)		—			28.7

Cash and cash equivalents at end of period	$	59.4		$	(4.0	)	$	(1.5	)	$	—		$	53.9

Capella Healthcare, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2015

13.

SUBSEQUENT EVENTS

Sale of Tennessee Facilities

On July 21, 2015, the Company entered into a definitive agreement to sell the Tennessee Facilities as described previously in Note 6. The sale closed effective August 1, 2015.

Capella Holdings, Inc. Merger

On July 21, 2015, the Parent entered into an Agreement and Plan of Merger, dated as of July 21, 2015 (the “Merger Agreement”), with Capella Health Holdings, LLC (“Purchaser”), Capella Holdings Acquisition Sub, Inc., a wholly-owned subsidiary of Purchaser (“Merger Sub”), and GTCR Fund VIII, L.P., solely in its capacity as representative of the stockholders and option holders of the Parent (the “Representative”). Purchaser is a joint venture limited liability company between an indirect wholly-owned subsidiary of Medical Properties Trust, Inc. (“MPT Sub”) and an entity affiliated with the current senior management of the Company (“ManageCo”). Pursuant to the Merger Agreement, and subject to the satisfaction or waiver of the closing conditions set forth therein, Merger Sub will merge with and into the Parent, after which the separate existence of Merger Sub will cease, and the Parent will be the surviving corporation and a wholly-owned subsidiary of Purchaser (collectively, the “Merger”).

At the effective time of the Merger, each share of common stock of the Parent, other than (i) those shares held by the Parent, its subsidiaries, Purchaser or Merger Sub (other than those shares described in clause (iii) below), (ii) those shares with respect to which appraisal rights are properly exercised in accordance with the General Corporation Law of the State of Delaware and (iii) those shares contributed to Purchaser or its designee pursuant to an equity rollover mechanism facilitating the formation of ManageCo, will be converted into the right to receive a cash payment per share equal to (x) $900,000,000, subject to certain adjustments for the Parent’s cash, indebtedness, transaction expenses, working capital and other adjustment items at closing, plus the aggregate exercise price of all outstanding options, minus certain escrow and holdback amounts relating to post-closing purchase price adjustments and the costs, fees and expenses of the Representative, divided by (y) the number of shares outstanding on a fully-diluted basis assuming full exercise of all outstanding options (the “Closing Per Share Merger Consideration”). At the effective time of the Merger, each outstanding option to purchase shares of the Parent’s common stock will be converted into the right to receive a cash payment equal to the excess, if any, of (x) the Closing Per Share Merger Consideration multiplied by the number of shares of the Parent’s common stock issuable upon exercise of such option over (y) the aggregate exercise price of such option, and will automatically be cancelled. The Merger Agreement further provides that each share of common stock of the Parent (excluding those shares described in clauses (i) and (ii) above, but including those shares described in clause (iii) above) and each outstanding option to purchase shares of the Parent’s common stock will entitle the holder thereof to receive its pro rata portion of certain additional consideration, if any, resulting from certain post-closing adjustments, releases of escrow and holdback amounts and permitted dispositions of certain hospitals.

In addition to providing for the repayment of all other indebtedness of the Parent and its subsidiaries upon consummation of the Merger, the Merger Agreement provides that, subject to the consummation of the Merger, Purchaser will repay, or cause to be repaid, on behalf of the Parent and its subsidiaries, the outstanding 9 ¹/₄% Notes. The redemption of the 9 ¹/₄% Notes may occur after the effective time of the Merger in accordance with a valid redemption notice delivered prior to or substantially concurrently with the effective time of the Merger.

Following the consummation of the Merger, the Company and its operating subsidiaries will be managed and operated by ManageCo, or one or more of ManageCo’s affiliates, pursuant to the terms of a management agreement, which terms shall include a base management fee payable to ManageCo and incentive payments tied to mutually agreed benchmarks. Under the limited liability company agreement of Purchaser, ManageCo will manage Purchaser and MPT Sub will have no management authority or control except for certain protective rights consistent with a passive ownership interest, such as a limited right to approve annual budgets and the right to approve extraordinary transactions, other than in the case of certain extraordinary events.

Consummation of the Merger, which the parties anticipate will occur in the second half of 2015, is subject to the satisfaction or waiver of customary conditions to closing, including, among others, the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended.

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

The following discussion and analysis of financial condition and results of operations should be read in conjunction with (i) our condensed consolidated financial statements and accompanying notes included elsewhere in this report and (ii) our consolidated financial statements and accompanying notes and discussion and analysis of our financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2014 (the “2014 Annual Report on Form 10-K”). We intend for this discussion to provide you with information that will assist you in understanding our financial statements, the changes in certain key items in those financial statements from period to period, and the primary factors that accounted for those changes. The discussion consists of the following sections:

•

Forward Looking Statements;

•

Executive Overview;

•

Critical Accounting Policies;

•

Results of Operations Summary; and

•

Liquidity and Capital Resources.

Unless the context requires otherwise, Capella Healthcare, Inc. and its subsidiaries are referred to in this section as “Capella,” the “Company,” “we,” “us” and “our.”

FORWARD LOOKING STATEMENTS

This report and other materials the Company has filed or may file with the Securities and Exchange Commission, as well as information included in oral statements or other written statements made, or to be made, by executive management of the Company, contain, or will contain, disclosures that are “forward-looking statements,” which are intended to be covered by the safe harbors created by federal securities laws. Forward-looking statements are those statements that are based upon management’s current plans and expectations as opposed to historical and current facts and are often identified in this discussion by use of words, including but not limited to, “may,” “believe,” “will,” “should,” “expect,” “estimate,” “anticipate,” “intend,” and “plan.” These statements are based upon estimates and assumptions made by Capella’s management that, although believed to be reasonable, are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected. Except as required by law, we undertake no obligation to update publicly or to revise any forward-looking statements, whether as a result of new information, future events or otherwise.

In this report, for example, we make forward-looking statements, including statements discussing our expectations about: the ability of the parties to the merger described below to satisfy the conditions for the closing of such merger; our business strategy and operating philosophy, including efforts to provide high quality patient care and service excellence, investments in technology, recruitment and retention of physicians and nurses, expansion of service lines, and growth strategies for existing markets and for potential acquisitions; future financial performance and condition; industry and general economic trends, changes to reimbursement, patient volumes and related revenues; provisions for potential adjustments to reimbursement amounts; our compliance with new and existing laws and regulations, as well as costs and benefits associated with compliance; effects of competition and consolidation on our hospitals’ markets; costs of providing care to our patients; the provision for bad debts and the impact of bad debt expenses; compliance with and anticipated revenues from Medicare and Medicaid electronic health records (“EHR”) incentive payments; future liquidity and capital resources; and existing and future debt.

There are several factors, some beyond our control that could cause results to differ significantly from our expectations. Any factor described in this report and the 2014 Annual Report on Form 10-K could by itself, or together with one or more factors, adversely affect our business, results of operations and/or financial condition. There may be factors not described in this report or the 2014 Annual Report on Form 10-K that could also cause results to differ from our expectations. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our business or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied by any forward-looking statements.

EXECUTIVE OVERVIEW

We are a provider of general and specialized acute care, outpatient and other medically necessary services in primarily non-urban communities. We provide these services through a portfolio of acute care hospitals and complementary outpatient facilities and clinics in seven states. As of June 30, 2015, as part of continuing operations, we operated 10 general acute care hospitals and related ancillary healthcare facilities with a total of 1,425 licensed beds. We are focused on enabling our facilities to maximize their potential to deliver high quality care in a patient-friendly environment. We invest our financial and operational resources to establish and support services that meet the needs of our communities. We seek to achieve our objectives by providing exceptional quality care to our patients, establishing strong local management teams, physician leadership groups and hospital boards, developing deep physician and employee relationships and working closely with our communities.

Effective January 1, 2015, we acquired controlling interest in Carolina Pines Regional Medical Center (“Carolina Pines”), a 116-bed acute care facility located in Hartsville, South Carolina through the acquisition of all the equity interests in Hartsville Medical Group, LLC and substantially all the equity interests in Hartsville, LLC (formerly Hartsville HMA, LLC), each a South Carolina limited liability company. The cash purchase price, subject to final working capital adjustments, was $67.3 million plus $12.0 million for working capital and was funded by a senior secured term loan facility consisting of a $100 million seven-year term loan (the “Term Loan Facility”).

On May 1, 2015, the Company completed the sale of Mineral Area Regional Medical Center (“Mineral Area”), a 135 bed facility located in Farmington, Missouri. In connection with the planned divestiture, the Company recognized an estimated loss on the sale totaling $7.1 million during the year ended December 31, 2014, which was reduced for changes in net working capital of $1.7 million during the six months ended June 30, 2015. The Company has presented the operating results, financial positions and cash flows with respect to Mineral Area as discontinued operations in the accompanying condensed consolidated financial statements.

On July 21, 2015, the Company entered into a definitive agreement regarding the sale of Stones River Hospital and three additional hospitals consisting of DeKalb Community Hospital, Highlands Medical Center, and River Park Hospital (collectively, the “Tennessee Facilities”). The sale closed effective August 1, 2015. Included in the accompanying unaudited condensed consolidated statement of operations is income before taxes attributable to DeKalb Community Hospital, Highlands Medical Center and River Park Hospital of $1.1 million and $1.2 million for the three months ended June 30, 2014 and, 2015, respectively, and $1.7 million and $1.5 million for the six months ended June 30 2014 and 2015, respectively. The assets and liabilities have been classified as held for sale in connection with the Tennessee Facilities of $61.9 million and $8.4 million, respectively. In connection with the Company’s entry into a definitive agreement to sell the Tennessee Facilities, the Company recognized an impairment charge of $10.9 million, during the three and six months ended June 30, 2015 for DeKalb Community Hospital, Highlands Medical Center and River Park Hospital. The impairment charge included write-down of property, equipment, allocated goodwill and certain other assets to their estimated fair values. Stones River Hospital was recognized as a discontinued operation and is included in the discontinued operations in the accompanying condensed consolidated financial statements.

On July 21, 2015, Capella Holdings, Inc. (the “Parent”), the sole stockholder and parent company of the Company, entered into an Agreement and Plan of Merger, dated as of July 21, 2015 (the “Merger Agreement”), by and among the Parent, Capella Health Holdings, LLC (“Purchaser”), Capella Holdings Acquisition Sub, Inc., a wholly-owned subsidiary of Purchaser (“Merger Sub”), and GTCR Fund VIII, L.P., solely in its capacity as representative of the stockholders and option holders of the Parent. Pursuant to the Merger Agreement, and subject to the satisfaction or waiver of the closing conditions set forth therein, Merger Sub will merge with and into the Parent, after which the separate existence of Merger Sub will cease, and the Parent will be the surviving corporation and a wholly-owned subsidiary of Purchaser (collectively, the “Merger”).

In addition to providing for the repayment of all other indebtedness of the Parent and its subsidiaries upon consummation of the Merger, the Merger Agreement provides that, subject to the consummation of the Merger, Purchaser will repay, or cause to be repaid, on behalf of the Parent and its subsidiaries, the outstanding 9 ¹/₄% Senior Notes due 2017 issued by the Company (the “9 ¹/₄% Notes”). The redemption of the 9 ¹/₄% Notes may occur after the effective time of the Merger in accordance with a valid redemption notice delivered prior to or substantially concurrently with the effective time of the Merger.

Purchaser is a joint venture limited liability company between an indirect wholly-owned subsidiary of Medical Properties Trust, Inc. (“MPT Sub”) and an entity affiliated with the current senior management of the Company (“ManageCo”). Following the consummation of the Merger, the Company and its operating subsidiaries will be managed and operated by ManageCo, or one or more of ManageCo’s affiliates, pursuant to the terms of a management agreement, which terms shall include a base management fee payable to ManageCo and incentive payments tied to mutually agreed benchmarks. Under the limited liability company agreement of Purchaser, ManageCo will manage Purchaser and MPT Sub will have no management authority or control except for certain protective rights consistent with a passive ownership interest, such as a limited right to approve annual budgets and the right to approve extraordinary transactions, other than in the case of certain extraordinary events.

The results of operations and statistical data discussed throughout the remainder of this section pertain to the Company’s continuing operations, which include the results of Carolina Pines for the three and six months ended June 30, 2015 and exclude the results of those facilities that have been previously disposed or classified as part of discontinued operations. Discussions of same-hospital information pertain to the Company’s continuing operations, but exclude the impact of Carolina Pines.

Trends and Developments

The following sections discuss trends and developments that we believe impact our current and/or future operating results and cash flows. Certain of these trends and developments apply to the entire hospital industry, while others may apply to us more specifically. These trends and developments could be short-term in nature or could require long-term attention and resources. While these trends and developments may involve certain factors that are outside of our control, the extent to which they affect our hospitals and our ability to manage the impact of these trends and developments play vital roles in our current and future success. In many cases, we are unable to predict what impact, if any, these trends and developments will have on us.

Impact of Healthcare Reform

The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the “Affordable Care Act”) dramatically altered the United States healthcare system and is intended to decrease the number of uninsured Americans and reduce the overall cost of healthcare. The Affordable Care Act attempts to achieve these goals by, among other things, requiring most Americans to obtain health insurance, expanding Medicare and Medicaid eligibility, reducing Medicare disproportionate share (“DSH”) payments and Medicaid payments to providers, expanding the Medicare program’s use of value-based purchasing programs, tying hospital payments to the satisfaction of certain quality criteria, bundling payments to hospitals and other providers, and instituting certain private health insurance reforms. Although some of the measures contained in the Affordable Care Act did not take effect until 2014, certain of the reductions in Medicare spending, such as negative adjustments to the Medicare hospital inpatient and outpatient prospective payment system market basket updates and the incorporation of productivity adjustments to the Medicare program’s annual inflation updates, became effective in prior years. A number of provisions of the Affordable Care Act that were supposed to become effective in 2014, such as the employer mandate, the Small Business Health Options Program, and the state run exchange verification of income and Medicaid agency electronic notification of eligibility for tax credit and subsidy requirements, have been delayed until 2015, and additional delays could be imposed in the future.

On June 28, 2012, the United States Supreme Court upheld the “individual mandate” provision of the Affordable Care Act that generally requires all individuals to obtain healthcare insurance or pay a penalty. The Supreme Court also held, however, that the provision of the Affordable Care Act that authorized the Secretary of the Department of Health and Human Services (“HHS”) to penalize states that choose not to participate in the expansion of the Medicaid program by removing all existing Medicaid funding was unconstitutional. In response to the ruling, a number of states have already indicated that they will not expand their Medicaid programs. Doing so would result in the Affordable Care Act not providing coverage to some low-income persons in those states.

Additionally, several bills have been and will likely continue to be introduced in Congress to repeal or amend all or significant provisions of the Affordable Care Act. It is difficult to predict the full impact of the Affordable Care Act because of its complexity, lack of implementing regulations and interpretive guidance, state decisions to decline Medicaid expansion, gradual and potentially delayed implementation, future potential legal challenges, and possible repeal and/or amendment, as well as the inability to foresee how individuals and businesses will respond to the choices afforded to them by the Affordable Care Act. As a result, it is difficult to predict the full impact that the Affordable Care Act will have on our revenue and results of operations.

Adoption of Electronic Health Records

The Health Information Technology for Economic and Clinical Health Act (the “HITECH Act”), which was enacted into law on February 17, 2009 as part of the American Recovery and Reinvestment Act of 2009, includes provisions designed to increase the use of EHR by both physicians and hospitals. We intend to comply with the EHR meaningful use requirements of the HITECH Act in time to qualify for the maximum available Medicare and Medicaid incentive payments. We will recognize income related to the Medicare or Medicaid incentive payments as we are able to satisfy all appropriate contingencies, which includes completing attestations as to our eligible hospitals adopting, implementing or demonstrating meaningful use of certified EHR technology, and additionally for Medicare incentive payments, deferring income until the related Medicare fiscal year has passed and cost report information used to determine the final amount of reimbursement is known. Our compliance has resulted in significant costs including professional services focused on successfully designing and implementing our EHR solutions along with costs associated with the hardware and software components of the project. During the three and six months ended June 30, 2014 we recognized $3.1 million and $3.2 million, respectively of other income related to estimated EHR incentive payments. During the three and six months ended June 30, 2015 we recognized $2.3 million and $2.2 million, respectively of other income related to estimated EHR incentive payments. We currently estimate that, at a minimum, the total costs incurred to comply will be recovered through this initiative.

Medicare and Medicaid Reimbursement

Medicare payment methodologies have been, and are expected to be, significantly revised based on cost containment and policy considerations. The Centers for Medicare and Medicaid Services (“CMS”) already began implementing some of the Medicare reimbursement reductions required by the Affordable Care Act. These revisions will likely be more frequent and significant as more of the Affordable Care Act’s changes and cost-saving measures become effective. Additionally, the Middle Class Tax Relief and Job Creation Act of 2012 and the American Taxpayer Relief Act of 2012 (“ATRA”) require further reductions in Medicare payments, and the Budget Control Act of 2011 imposed a 2% reduction in Medicare spending effective as of April 1, 2013.

On February 2, 2015, the Office of Management and Budget released President Obama’s proposed budget for federal fiscal year (“FFY”) 2016 (the “Proposed Budget”). Among other things, the Proposed Budget would end sequestration but would also reduce Medicare spending by approximately $400 billion over the next 10 years. The Proposed Budget would achieve these reductions by, among other things, reducing Medicare coverage of bad debt, reducing payments to hospitals for graduate medical education programs, reducing payments to critical access hospitals, reducing payments to hospitals for services that are provided at off-campus hospital outpatient departments, and increasing financial liabilities for certain Medicare beneficiaries. On May 5, 2015, Congress adopted a budget resolution for FFY 2016. Among other things, the resolution contains non-binding language supporting the repeal of the Affordable Care Act (including its reductions in Medicare spending) and requiring approximately $430 billion in Medicare savings over the next 10 years. We cannot predict whether the Proposed Budget or the Congressional budget resolution for FFY 2016 will be implemented in whole or in part or whether Congress will take other legislative action to reduce spending on the Medicare and Medicaid programs. Additionally, future efforts to reduce the federal deficit may result in additional revisions to and payment reductions for the amounts we receive for our services.

On July 31, 2015, CMS issued the hospital inpatient prospective payment system (“IPPS”) final rule for FFY 2016, which will be effective as of October 1, 2015. Under the final rule, the operating payment rates for inpatient stays in general acute care hospitals paid under the IPPS that successfully participate in the Hospital Inpatient Quality Reporting (“IQR”) Program and are meaningful EHR users will be increased by 0.9%. This increase reflects the hospital market basket update of 2.4%, adjusted by -0.5 percentage points for multi-factor productivity and an additional -0.2 percentage points in accordance with the Affordable Care Act. Additionally, the rate is further decreased by 0.8% for a documentation and coding recoupment adjustment required by ATRA, as discussed below. Those hospitals that do not successfully participate in the Hospital IQR Program and do not submit the required quality data will be subject to a one-fourth reduction of the market basket update. In addition, any hospital that is not a meaningful EHR user will be reduced by one-half of the market basket update in FFY 2016. CMS projects that the rate increase, together with other changes to IPPS payment policies, will increase IPPS operating payments by approximately 0.4%.

With respect to the documentation and coding recoupment adjustment required by ATRA, the rate is subject to an additional -0.8% adjustment. Such adjustment is being made in order to recoup the entire $11 billion that CMS is required to recover by ATRA to offset the additional increase in aggregate payments to hospitals that Congress believes occurred from FFY 2008 through FFY 2013 as a result of the transition to the Medicare severity-adjusted diagnosis-related group system that do not reflect real changes in case-mix, and that was not recaptured by the adjustments that were mandated by the Transitional Medical Assistance, Abstinence Education, and Qualifying Individuals Programs Extension Act of 2007.

Among other things, in the IPPS final rule for FFY 2016, CMS established the amount to be distributed as uncompensated care payments to DSH-eligible hospitals in FFY 2016 at an estimated $6.4 billion, a decrease of $1.2 billion from the estimated FFY 2015 amount; included requirements for eligible hospitals and critical access hospitals participating in electronic reporting of clinical quality measures for the EHR Incentive Programs and the Hospital IQR Program; updated measures used in the Hospital IQR Program; finalized updates to the Hospital Value-Based Purchasing Program and expanded the number of measures; and finalized certain portions of the Hospital-Acquired Conditions Reduction Program.

On July 8, 2015, CMS published its hospital outpatient prospective payment system (“OPPS”) proposed rule for calendar year (“CY”) 2016, which begins on January 1, 2016. Among other things, the proposed rule provides for a payment rate decrease of 0.1% for hospitals that meet the reporting requirements of the Medicare Hospital Outpatient Quality Reporting (“OQR”) Program and a payment rate decrease of 2.1% for hospitals that do not. The proposed rate decrease is based on a proposed hospital market basket increase of 2.7%, which is reduced by a multi-factor productivity adjustment of 0.6% and an additional 0.2% reduction required by the Affordable Care Act. There is an additional 2.0% reduction to redress inflation in the OPPS payment rates resulting from excess packaged payments for laboratory tests that were expected to be packaged into OPPS payment rates that continued to be paid separately outside of the OPPS. The proposed rule also makes several other changes to the Medicare program’s OPPS, including the implementation of a new conditional packaging status indicator for laboratory tests that would assist hospitals in receiving separate payment for laboratory tests that are provided without other OPPS payments, the restructuring of the OPPS Ambulatory Payment Classifications (“APCs”) that would result in fewer APCs overall for nine clinical APC families, the creation of a Comprehensive Ambulatory Payment Classification for comprehensive observation services, and the addition of two new reporting measures to the OQR Program. Overall, CMS estimates that under the proposed rule, OPPS payments to providers would decrease by 0.2% or $43 million in FFY 2016.

Lastly, many states in which we operate are facing budgetary challenges and have adopted, or may be considering, legislation that is intended to control or reduce Medicaid expenditures, enroll Medicaid recipients in managed care programs, and/or impose additional taxes on hospitals to help finance or expand their Medicaid programs. Budget cuts, federal or state legislation, or other changes in the administration or interpretation of government health programs by government agencies or contracted managed care organizations could have a material adverse effect on our financial position and results of operations.

“Two Midnight Rule”

In the Medicare program’s hospital IPPS final rule for FFY 2014, CMS issued the “two midnight rule,” which modified CMS’s policy on how Medicare contractors will review inpatient hospital services for payment purposes. Under the two midnight rule, in addition to services designated by CMS as inpatient-only services, surgical procedures, diagnostic tests, and other treatments will generally be considered to be appropriate for inpatient admission and inpatient hospital payment under Medicare Part A when the treating physician expects the beneficiary to require a stay that crosses at least two midnights and admits the beneficiary to the hospital based on that expectation. CMS is prohibited from allowing recovery auditors to conduct inpatient hospital status reviews on claims with dates of admission October 1, 2013 through September 30, 2015, but, in the future, reviews could be conducted on claims with dates of admission after that time.

While the IPPS final rule for FFY 2014 became effective on October 1, 2013, CMS initially indicated on November 5, 2013 that it would not permit recovery auditors to review inpatient admissions of one midnight or less that began between October 1, 2013 and December 31, 2013. CMS subsequently extended that delay to inpatient admissions that occur on or prior to September 30, 2014. CMS did, however, instruct Medicare Administrative Contractors to review, on a pre-payment basis, a small sample of inpatient hospital claims relating to admissions that occur between March 31, 2014 and September 30, 2014 and that span less than two midnights after admission in order to determine each hospital’s compliance with the new inpatient admission and medical review criteria.

On April 1, 2014, President Obama signed the Protecting Access to Medicare Act of 2014 (the “PAM Act”) into law. Among other things, the PAM Act extended the delay of the enforcement of the two midnight rule by recovery auditors and other Medicare review contractors through March 31, 2015. The PAM Act also authorized CMS to continue to allow Medicare Administrative Contractors to review, on a pre-payment basis only, a small sample of inpatient hospital claims relating to admissions that span less than two midnights and that occur between March 31, 2014 and March 31, 2015 in order to determine hospital compliance with the new inpatient admission and medical review criteria. The Medicare Access and CHIP Reauthorization Act of 2015 (“MACRA”), which was signed into law by President Obama on April 16, 2015 and is also commonly known as the “doc fix,” extends the prohibition on recovery auditor inpatient hospital patient status reviews through September 30, 2015, and allows Medicare Administrative Contractors to continue to conduct their pre-payment reviews until that same date. Post-payment reviews are not allowed unless there is evidence of systematic gaming, fraud, abuse, or delays.

On May 15, 2014, in the IPPS proposed rule for FFY 2015, CMS solicited comments regarding the development of an alternative payment methodology under the Medicare program for short inpatient hospital stays. In the IPPS proposed rule for FFY 2016, CMS indicated it would consider feedback from hospitals and physicians regarding concerns about the two midnight rule, as well as recent Medicare Payment Advisory Commission recommendations. CMS noted that it expects to include a further discussion of the broader set of issues related to short inpatient hospital stays, long outpatient stays with observation services, and the related -0.2% IPPS payment adjustment in the CY 2016 hospital outpatient prospective payment system proposed rule.

On July 8, 2015, as part of the OPPS proposed rule for CY 2016, CMS proposed modifications to the two midnight rule. Under the proposed rule, for stays that are expected to last less than two midnights, an inpatient admission would be payable under Medicare Part A on a case-by-case basis based on the judgment of the admitting physician if the documentation in the medical record supports the admitting physician’s determination that an inpatient admission was necessary. The admitting physician’s determination would be subject to medical review. CMS has indicated that despite the proposed modifications, its expectation would continue to be that inpatient stays under 24 hours would rarely qualify for an exception to the two-midnight benchmark. The proposed rule does not change the standard for stays that are expected to be two midnights or longer, and, as a result, those stays would still generally be considered appropriate for Medicare Part A payment.

In addition to proposing modifications to the Medicare Part A payment standard for stays that are expected to last less than two midnights, the OPPS proposed rule for CY 2016 also makes changes to how CMS will educate providers about and enforce the two midnight rule. The proposed rule states that effective as of October 1, 2015, CMS will use Quality Improvement Organization (“QIO”) contractors, and not Medicare administrative contractors, to perform “probe and educate” audits and other reviews of short inpatient stays. Under the new review strategy, recovery auditor reviews of short inpatient stays would be limited to hospitals that have consistently high denial rates based on QIO patient status reviews or fail to improve their performance after QIO educational intervention and that are referred to the recovery auditor by the QIO.

We cannot predict whether Congress or CMS will further delay the review of inpatient admissions of one midnight or less by recovery auditors or other Medicare review contractors or the impact that any such reviews will have on our business and results of operations when they are allowed by CMS. In addition, legislation has been introduced in Congress that, among other things, would generally prohibit Medicare review contractors from denying claims due to the length of a patient’s stay or a determination that services

could have been provided in an outpatient setting and require CMS to develop a new payment methodology for services that are provided during short inpatient hospital stays. Federal lawsuits have also been filed challenging the two midnight rule primarily on the grounds that the implementation of the rule itself, and the payment reduction associated with the rule, violate the Administrative Procedure Act. We cannot predict whether the legislation that has been introduced in Congress will be adopted or, if adopted, the amount of reimbursement that would be paid under any alternative payment methodology that is developed by CMS. We also cannot predict whether the federal court challenges to the two midnight rule will be successful.

Value-Based Reimbursement

The trend in the healthcare industry continues towards value-based purchasing of healthcare services. These value-based purchasing programs include both public reporting and financial incentives tied to the quality and efficiency of care provided by facilities. The Affordable Care Act expands the use of value based purchasing initiatives in federal healthcare programs. We expect programs of this type to become more common in the healthcare industry.

Medicare requires providers to report certain quality measures in order to receive full reimbursement increases for inpatient and outpatient procedures that previously were awarded automatically. Historically, CMS has expanded, through a series of rulemakings, the number of patient care indicators that hospitals must report. Additionally, we anticipate that CMS will continue to expand the number of inpatient and outpatient quality measures. We have invested significant capital and resources in the implementation of our advanced clinical system that assists us in monitoring and reporting these quality measures. CMS makes the data submitted by hospitals, including our hospitals, public on its website.

The Affordable Care Act requires HHS to implement a value-based purchasing program for inpatient hospital services. Beginning in FFY 2013, HHS reduced inpatient hospital payments for all discharges by a percentage specified by statute and pooled the total amount collected from these reductions to fund payments to reward hospitals that meet or exceed certain quality performance standards established by HHS. CMS evaluates hospitals’ performance during a performance period, and hospitals receive points on each of a number of pre-determined measures based on the higher of (i) their level of achievement relative to an established standard or (ii) their improvement in performance from their performance during a prior baseline period. Each hospital’s combined scores on all the measures will be translated into value-based incentive payments beginning with inpatient discharges occurring on or after October 1, 2012. In addition, the Affordable Care Act contains a number of other provisions that further tie reimbursement to quality and efficiency. Under the IPPS proposed rule for FFY 2016 discussed above, CMS proposed to continue updates to the hospital value-based purchasing program and to expand the number of measures. CMS also proposed removing two measures, effective with the FFY 2018 program year, and signaled its intent to make future policy changes that will affect certain National Health Safety Network measures beginning with the FFY 2019 program year. Also beginning in FFY 2013, hospitals that have “excess readmissions” for specified conditions receive reduced reimbursement. Each hospital’s performance is publicly reported, and HHS has the discretion to determine terms and conditions of the program such as what “excessive readmissions” means. Medicare also no longer pays hospitals additional amounts for the treatment of certain hospital-acquired conditions, also known as HACs, unless the conditions were present at admission. Further, beginning in FFY 2015, hospitals that rank in the worst 25% of all hospitals nationally for HACs in the previous year will receive reduced Medicare reimbursements. The FFY 2014 IPPS final rule finalized the scoring methodology and quality measures that will be used to determine the quartile, as well as the processes, hospitals will use to review and correct their data. Under the IPPS final rule for FFY 2016, CMS issued certain changes to existing program policies and noted that hospitals in the lowest quartile will have their Medicare pay reduced by 1%. In the IPPS final rule for FFY 2016, CMS also adopted an extraordinary circumstance exception policy that would allow hospitals that experience an extraordinary circumstance (e.g., a hurricane or flood) to request a waiver for use of data from the affected time period. The Affordable Care Act also prohibits the use of federal funds under the Medicaid program to reimburse providers for treating certain provider-preventable conditions.

Physician Services

Physician services are reimbursed under the Medicare physician fee schedule, or PFS, system, under which CMS has assigned a national relative value unit (“RVU”) to most medical procedures and services that reflects the various resources required by a physician to provide the services relative to all other services. Each RVU is calculated based on a combination of work required in terms of time and intensity of effort for the service, practice expense (overhead) attributable to the service and malpractice insurance expense attributable to the service. These three elements are each modified by a geographic adjustment factor to account for local practice costs then aggregated. The aggregated amount is multiplied by a conversion factor that accounts for inflation and targeted growth in Medicare expenditures (as calculated by the sustainable growth rate (“SGR”)) to arrive at the payment amount for each service.

The PFS rates are adjusted each year, and reductions in both current and future payments are anticipated. The SGR formula has resulted in payment decreases to physicians every year since 2002. However, all but one of those payment decreases has been averted by Congressional action. For CY 2014, CMS issued a final rule that would have applied the SGR and resulted in an aggregate reduction of 20.1% to all physician payments under the PFS for CY 2014. The Pathway for SGR Reform Act of 2013 (the “Pathway Act”) delayed application of the SGR and provided for a 0.5% increase in PFS payment rates through March 31, 2014. The PAM Act extended the 0.5% increase in PFS payment rates established by the Pathway Act through December 31, 2014, and also provided that there will be no increase to the CY 2015 PFS from January 1, 2015, through March 31, 2015. For the remainder of CY 2015, CMS issued a final rule that would have applied the SGR and resulted in a 21.2% reduction in PFS rates.

On April 16, 2015, President Obama signed MACRA into law. Among other things, MACRA replaces the SGR formula with new systems for establishing the annual updates to payments made under the PFS. Under MACRA, PFS payment rates would remain at their current levels through June 30, 2015, and would then be increased by 0.5% for the remainder of CY 2015. PFS payment rates would be increased by 0.5% a year from CY 2016 through CY 2019 and would then remain at their CY 2019 levels through CY 2025. Beginning in CY 2019, amounts paid to individual physicians would be subject to adjustment through either the Merit-Based Incentive Payment System (“MIPS”) or the Alternative Payment Model (“APM”) program. Physicians who participate in the MIPS program, which would essentially consolidate the existing Physician Quality Reporting System, the Value-Based Modifier, and the Meaningful Use of EHR incentive programs, would be subject to positive, zero, or negative performance adjustments depending on how the physician’s performance compared to a performance threshold. In addition, from CY 2019 through CY 2024, MACRA provides an additional $500 million per year for an additional performance adjustment for physicians who participate in MIPS and achieve exceptional performance. Physicians who participate in an APM program and receive a substantial amount of their revenue from an alternative payment model would receive, from CY 2019 through CY 2024, a lump-sum payment equal to 5% of their Medicare payments in the prior year for services paid under the PFS. Beginning in CY 2026, PFS payment rates for physicians participating in an APM program would be increased by 0.75% a year. Payments for other providers would be increased by 0.25% per year.

On July 15, 2015, CMS published the PFS proposed rule for CY 2016. Among other things, the proposed rule implements the 0.5% increase in PFS payment rates for CY 2016 that is specified by MACRA. In addition, the proposed rule also makes modifications to the Physician Quality Reporting System, establishes separate payment and a payment rate for two advance care planning services provided to Medicare beneficiaries provided by physicians and other practitioners, and makes a number of updates to the regulations that implement the requirements of the federal physician self-referral law (the “Stark Law”). The proposed changes to the regulations that implement the Stark Law are intended to accommodate delivery and payment system reform and to reduce the burden on and facilitate compliance by hospitals and other healthcare providers and include, among other things, a new exception that would permit payments to physicians for the employment of certain non-physician practitioners and clarifying changes to existing exceptions that could reduce perceived or actual technical non-compliance with the Stark Law in areas that do not present a risk of abuse.

Medicare Access and CHIP Reauthorization Act of 2015

As previously noted, on April 16, 2015, MACRA was signed into law. In addition to delaying the enforcement of the two midnight rule and repealing the SGR, MACRA made changes to a number of payment and other provisions of the Medicare and Medicaid programs. Among other things, MACRA:

•

Extends the Medicare dependent hospital program, which provides enhanced payment support for rural hospitals that have no more than 100 beds and at least 60% of their inpatient days or discharges covered by the Medicare program, until October 1, 2017;

•

Extends the Medicare low volume hospital program, which provides additional Medicare reimbursement for general acute care hospitals that are located 15 road miles from another general acute care hospital and have less than 1,600 Medicare discharges each fiscal year, until October 1, 2017;

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Extends the therapy cap exception process until January 1, 2018;

•

Extends the 3% add-on to payments made for home health services provided to patients in rural areas through January 1, 2018;

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Extends funding for the Children’s Health Insurance Program through FFY 2017;

•

Permanently extends the Transitional Medicare Assistance Program, which provides Medicaid insurance coverage for families transitioning from welfare to work; and

•

Delays until October 1, 2018, the Medicaid state DSH allotment reductions required by the Affordable Care Act that were scheduled to become effective October 1, 2017, and extends those reductions through FFY 2025.

The costs associated with the repeal of the SGR and the extension of the Medicare and Medicaid programs noted above would be partly covered by increased premiums for Medicare beneficiaries with relatively high income, reducing the updates to the Medicare program’s payment rates for certain providers of post-acute-care and long-term care services to 1% in 2018, and phasing the one-time 3.2 percentage point increase in IPPS payment rates that hospitals are scheduled to receive in FFY 2018 when the recoupments required by ATRA have been completed in at 0.5 percentage points per year over six years beginning in FFY 2018.

In addition, MACRA also contains provisions that are intended to protect the integrity of the Medicare program, including, among other things, provisions that prohibit the inclusion of Social Security numbers on Medicare cards, require the establishment of policies to prevent wrongful Medicare payments for services provided to incarcerated individuals, individuals who are not lawfully present in the United States, and deceased individuals, require Medicare administrative contractors to establish improper payment outreach and education programs, require valid prescriber National Provider Identifiers on pharmacy claims, and eliminate civil monetary penalties for inducements to physicians to limit services that are not medically necessary.

Physician Alignment

Our ability to attract skilled physicians to our hospitals is critical to our success. Coordination of care and alignment of care strategies between hospitals and physicians will become more critical as reimbursement becomes more episode-based. We have physician recruitment goals with primary emphasis on recruiting physicians specializing in family practice, internal medicine, general surgery, oncology, obstetrics and gynecology, cardiology, neurology, orthopedics, urology, otolaryngology and inpatient hospital care (hospitalists). To provide our patients access to the appropriate physician resources, we actively recruit physicians to the communities served by our hospitals through employment agreements, relocation agreements or physician practice acquisitions. We invest in the infrastructure necessary to coordinate our physician alignment strategies and manage our physician operations. The costs associated with recruiting, integrating and managing a large number of new physicians will have a negative impact on our operating results and cash flows in the near term. However, we expect to realize improved clinical quality and service expansion capabilities from this initiative that will impact our operating results positively over the long term.

HIPAA

We are subject to the privacy and security requirements of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) and the HITECH Act, which are designed to protect the confidentiality, availability and integrity of health information. The HIPAA privacy and security regulations apply to health plans, health care clearinghouses, and healthcare providers that transmit health information in an electronic form in connection with HIPAA standard transactions. The HIPAA security standards require us to establish and maintain reasonable and appropriate administrative, technical and physical safeguards to ensure the integrity, confidentiality and the availability of electronic health and related financial information.

In January 2014, the Federal Trade Commission (the “FTC”) ruled that Section 5 of the Federal Trade Commission Act gives the FTC the authority to regulate as unfair business practices companies’ inadequate data security programs that may expose consumers to fraud, identify theft and privacy intrusions. On February 24, 2014, HHS announced its plan to survey 1,200 organizations (both covered entities and business associates) as a first step in selecting organizations for the next round of HIPAA audits. HHS has advised that the survey will gather information to enable the Office of Civil Rights (OCR) “to assess the size, complexity, and fitness of a respondent for an audit.” HHS has advised that the information to be collected will include, among other things, “recent data about the number of patient visits or insured lives, use of electronic information, revenue, and business locations.” We cannot predict whether our hospitals will be selected in the future for an audit or the results of such an audit. In addition, our facilities will continue to remain subject to any state laws that are more restrictive than the privacy regulations issued under HIPAA.

On January 17, 2013, HHS issued a final rule which, among other things, made final modifications to the HIPAA Privacy, Security, and Enforcement Rules mandated by the HITECH Act; adopted changes to the HIPAA Enforcement Rule to incorporate the increased and tiered civil money penalty structure provided by the HITECH Act; adopted a final rule on Breach Notification for Unsecured Protected Health Information which replaces the breach notification rule’s prior “harm” threshold with a more objective standard; and modified the HIPAA Privacy Rule as required by the Genetic Information Nondiscrimination Act (GINA). The new rules are effective as of March 26, 2013. Our facilities were required to comply with the applicable requirements of the Final HIPAA Rule by September 23, 2013, except that existing business associate agreements qualified for an extended compliance date of September 23, 2014.

In addition to HIPAA’s privacy and security requirements, we are also subject to the administrative simplification provisions of HIPAA, which require the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. In January 2009, CMS published its 10th revision of International Statistical Classification of Diseases (“ICD-10”), which establishes an updated code set to be used for classifying health care diagnoses and procedures. Entities covered under HIPAA will be required to use the ICD-10, which contains significantly more diagnostic and procedural codes than the existing ICD-9 coding system. Because of the greater number of codes, the coding for the services provided in our facilities will require much greater specificity. Implementation of ICD-10 will require a significant investment in technology and training. We may experience delays in reimbursement while our facilities and the payors from which we seek reimbursement make the transition to ICD-10. While providers were previously required to begin using the ICD-10 coding system on October 1, 2014, the PAM Act delayed the effective date of the ICD-10 transition to October 1, 2015. If any of our facilities fail to implement the new coding system by the deadline, the affected facility will not be paid for services. We are not able to predict the timeframe or the overall financial impact of the transition to ICD-10.

Cost Pressures

In order to demonstrate a highly reliable environment of care, we must hire and retain nurses who share our ideals and beliefs with respect to delivering high quality patient care and who have access to the training necessary to implement our clinical quality initiatives. While the national nursing shortage has abated somewhat over the last several years, the nursing workforce remains volatile. As a result, we expect continuing pressures on nursing salaries and benefits. These pressures include base wage increases, demands for flexible working hours and other increased benefits as well as higher nurse-to-patient ratios. In addition, inflationary pressures and technological advancements and increased acuity continue to drive supply costs higher. We implemented multiple supply chain initiatives, including consolidation of low-priced vendors, established value analysis teams and coordinated quality of care efforts to encourage group purchasing contract compliance.

Uncompensated Care

For the three months ended June 30, 2015, our uncompensated care as a percentage of revenue, which is comprised of discounts to the uninsured, bad debts and charity care, was 18.1%, compared to 14.2% during the same prior year period. During the three months ended June 30, 2014 our uncompensated care as a percentage of revenue decreased as a result of self-pay patients being eligible for Medicaid during the three months ended June 30, 2014 that were previously identified as self pay during the three months ended March 31, 2014. For the six months ended June 30, 2015, our uncompensated care as a percentage of revenues was 17.9%, compared to 17.8% during the same prior year period. During the six months ended June 30, 2015, our uncompensated care as a percentage of revenues decreased primarily as a result of healthcare reform and the expansion of Medicaid coverage in certain of the states in which we operate, which has resulted in lower self-pay volume and revenue for the six months ended June 30, 2015 compared to the same prior year period.

Similar to others in the hospital industry, we have a significant amount of self-pay receivables (including co-payments and deductibles from insured patients), and collecting these receivables may become more difficult if economic conditions worsen. The following table provides a summary of our accounts receivable from continuing operations by payor class mix as of December 31, 2014 and June 30, 2015:


December 31, 2014	0-90 Days			91-180 Days			Over 180 Days			Total
Medicare(1)		28.3	%		0.9	%		1.4	%		30.6	%
Medicaid(1)		7.1			0.9			1.3			9.3
Managed Care and Other		21.0			2.3			1.8			25.1
Self-Pay(2)		8.1			7.5			19.4			35.0

Total		64.5	%		11.6	%		23.9	%		100.0	%


June 30, 2015	0-90 Days			91-180 Days			Over 180 Days			Total
Medicare(1)		29.9	%		0.6	%		0.8	%		31.3	%
Medicaid(1)		8.2			1.2			1.1			10.5
Managed Care and Other		19.8			2.4			2.0			24.2
Self-Pay(2)		9.1			8.1			16.8			34.0

Total		67.0	%		12.3	%		20.7	%		100.0	%

(1)	Includes receivables under managed Medicare or managed Medicaid programs.

(2)	Includes both uninsured as well as estimated co-payment and deductible amounts from insured patients.

The volume of self-pay accounts receivable remains sensitive to a combination of factors, including price increases, acuity of services, higher levels of insured patient co-payments and deductibles, economic factors and the increased difficulties of uninsured patients who do not qualify for charity care programs to pay for escalating healthcare costs. We have implemented a number of practices to mitigate bad debt expense and increase collections, including increased focus on upfront cash collections, incentive plans for our hospitals’ financial counselors and registration personnel, and increased focus on payment plans with non-emergent patients, among other efforts. Despite these practices, we believe bad debts will remain a significant risk for us and the rest of the hospital industry.

Revenues and Volume Trends

Our revenues depend upon inpatient occupancy levels, outpatient procedures, ancillary services and therapy programs as well as our ability to negotiate appropriate payment rates for services with third-party payors and our ability to achieve quality metrics to maximize payment from our payors.

The primary sources of our revenue before the provision for bad debts include managed care payors, including managed Medicare and managed Medicaid programs, the traditional Medicare program, state Medicaid programs, commercial health plans and patients themselves. We are typically paid less than our gross charges, regardless of the payor source, and report revenue before the provision for bad debts to reflect contractual adjustments and other allowances required by managed care providers and federal and state agencies.

Revenues from continuing operations for the three months ended June 30, 2015, increased $29.9 million to $208.6 million, compared to $178.7 million in the same prior year period. Revenues for the six months ended June 30, 2015, increased $67.6 million to $415.6 million, compared to $348.0 million in the same prior year period. Revenues for the three and six months ended June 30, 2015 was impacted by approximately $25.3 and $49.6 million, respectively related to the purchase of controlling interest in Carolina Pines. Beyond Carolina Pines, the increase was impacted primarily by same-hospital increases in admissions, adjusted admissions, ER visits and outpatient surgeries as a result of strategic initiatives.

Admissions and adjusted admissions increased 12.7% and 20.4%, respectively, for the three months ended June 30, 2015, compared to the same prior year period. Inpatient surgeries and outpatient surgeries increased 12.1% and 13.1%, respectively, for the three months ended June 30, 2015 compared to the same prior year period. In general, our reported hospital volumes are being impacted by the purchase of Carolina Pines, effective January 1, 2015. Same-hospital admissions, ER visits and outpatient surgeries increased 0.9%, 2.9% and 2.8%, respectively, for the three months ended June 30, 2015 compared to the same prior year period. In general, we believe our hospital volumes are reflective of our physician recruitment success augmented by the development of our specialty service lines.

The following table sets forth the percentages of revenues from continuing operations, before the provision for bad debts by payor for the three months ended June 30, 2014 and 2015:


	Three months ended June 30,						Six months ended June 30,
	2014			2015			2014			2015
Medicare(1)		40.7	%		39.5	%		40.5	%		40.7	%
Medicaid(1)		18.9			16.9			17.8			16.8
Managed Care and other(2)		34.2			36.2			34.6			35.8
Self-Pay		6.2			7.4			7.1			6.7

Total		100.0	%		100.0	%		100.0	%		100.0	%

(1)	Includes revenues received under managed Medicare or managed Medicaid programs.

(2)	Includes the health insurance exchanges, beginning with the first quarter of 2014.

Revenue per adjusted admission decreased 3.2% and 2.1% for the three and six months ended June 30, 2015, respectively, compared to the same prior year periods. The decrease in revenue per adjusted admission for the three and six month period ended June 30, 2015 was driven by the change in the mix of inpatient to outpatient services as a result of the increase in outpatient service utilization when compared to the prior period, the overall reduction in our Medicare case mix index of 1.2%, the impact of prior period cost report settlements which decreased from revenue of $1.9 million for the six month period ended June 30, 2014 to contractuals of $1.9 million for the six month period ended June 30, 2015.

See “Item 1 — Business — Sources of Revenue” and “Item 1 — Business — Government Regulation and Other Factors”, included in the 2014 Annual Report on Form 10-K, for a description of the types of payments we receive for services provided to patients enrolled in the traditional Medicare plan, managed Medicare plans, Medicaid plans, managed Medicaid plans and managed care plans. In those sections, we also discuss the unique reimbursement features of the traditional Medicare plan, including the annual Medicare regulatory updates published by CMS that impact reimbursement rates for services provided under the plan. The future potential impact to reimbursement for certain of these payors under the Affordable Care Act is also addressed in the 2014 Annual Report on Form 10-K.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts and related disclosures. We consider an accounting estimate to be critical if:

•

it requires assumptions to be made that were uncertain at the time the estimate was made; and

•

changes in the estimate or different estimates that could have been made could have a material impact on our consolidated results of operations or financial condition.

Our critical accounting estimates are more fully described in the 2014 Annual Report on Form 10-K. There have been no significant changes in the nature of our critical accounting policies or the application of those policies since December 31, 2014.

RESULTS OF OPERATIONS

The following table presents summaries of results from continuing operations for the three and six months ended June 30, 2014 and 2015, respectively. Dollar amounts below are in millions.


	Three Months Ended June 30, 2014						Three Months Ended June 30, 2015						Six Months Ended June 30, 2014						Six Months Ended June 30, 2015
	Amount			Percentage			Amount			Percentage			Amount			Percentage			Amount			Percentage
Revenues before provision for bad debts	$	193.2			108.1	%	$	232.4			111.5	%	$	384.2			110.4	%	$	459.2			110.5	%
Provision for bad debts		(14.5	)		(8.1	)		(23.8	)		(11.5	)		(36.2	)		(10.4	)		(43.6	)		(10.5	)

Revenues		178.7			100.0			208.6			100.0			348.0			100.0			415.6			100.0
Salaries and benefits		85.0			47.6			97.3			46.7			165.3			47.5			194.4			46.8
Supplies		29.8			16.7			34.5			16.6			58.4			16.8			69.7			16.8
Other operating expenses		45.6			25.5			50.7			24.3			87.8			25.2			102.3			24.6
Other income		(3.1	)		(1.7	)		(2.3	)		(1.1	)		(3.2	)		(0.9	)		(4.3	)		(1.0	)
Management fees		0.1			—			0.1			—			0.1			—			0.1			—
Interest, net		13.8			7.7			14.2			6.8			27.6			7.9			28.5			6.9
Depreciation and amortization		10.6			5.9			11.4			5.4			21.1			6.1			22.4			5.4
Impairment charges		—			—			10.9			5.2			—			—			10.9			2.6

Loss from continuing operations before income taxes		(3.1	)		(1.7	)		(8.2	)		(4.0	)		(9.1	)		(2.6	)		(8.4	)		(2.0	)
Income tax (benefit) expense		0.8			0.4			(2.7	)		(1.3	)		1.6			0.5			(1.8	)		(0.4	)

Loss from continuing operations		(3.9	)		(2.2	)		(5.5	)		(2.6	)		(10.7	)		(3.1	)		(6.6	)		(1.6	)
Loss from discontinued operations, net of taxes		(0.9	)		(0.5	)		(1.1	)		(0.6	)		(3.0	)		(0.9	)		(2.3	)		(0.6	)

Net loss	$	(4.8	)		(2.7	)	$	(6.6	)		(3.2	)	$	(13.7	)		(3.9	)	$	(8.9	)		(2.1	)

Less: Net income (loss) attributable to non-controlling interests		0.6			0.3			0.4			0.2			0.7			0.2			0.7			0.2

Net loss attributable to Capella Healthcare, Inc.	$	(5.4	)		(3.0	)%	$	(7.0	)		(3.4	)%	$	(14.4	)		(4.1	)%	$	(9.6	)		(2.3	)%

Selected Operating Data

The following table sets forth certain unaudited operating data and excludes all discontinued operations for each of the periods presented.


	Three Months Ended June 30,				Six Months Ended June 30,
	2014		2015		2014		2015
Continuing operations:
Admissions(1)		9,451		10,648		18,813		21,614
Adjusted admissions(2)		20,620		24,829		40,160		48,988
Revenue per adjusted admission	$	8,673	$	8,396	$	8,668	$	8,481
Inpatient surgeries		2,153		2,414		4,265		4.934
Outpatient surgeries(3)		5,382		6,088		10,274		11,643
Emergency room visits(4)		51,028		61,461		98,683		122,251
Same-hospital:
Admissions(1)		9,451		9,534		18,813		19,266
Adjusted admissions(2)		20,620		22,407		40,160		43,969
Revenue per adjusted admission	$	8,673	$	8,174	$	8,668	$	8,322
Inpatient surgeries		2,153		2,090		4,265		4,223
Outpatient surgeries(3)		5,382		5,533		10,274		10,589
Emergency room visits(4)		51,028		52,544		98,683		104,482

(1)	Represents the total number of patients admitted to our hospitals and used by management and investors as a general measure of inpatient volume.

(2)	Adjusted admissions are used as a general measure of combined inpatient and outpatient volume. We compute adjusted admissions by multiplying admissions by the outpatient factor (the sum of gross inpatient revenue and gross outpatient revenue and then dividing the result by gross inpatient revenue).

(3)	Outpatient surgeries are surgeries that do not require admission to our hospitals.

(4)	Represents the total number of hospital-based emergency room visits.

Three Months Ended June 30, 2015 Compared to June 30, 2014

The following discussion is for continuing operations only and excludes all operations included in discontinued operations.

Revenues. Revenues for the three months ended June 30, 2015 was $208.6 million, an increase of $29.9 million, or 16.7%, over the prior year period. The increase in revenue was primarily due to the purchase of Carolina Pines, effective January 1, 2015, which impacted the overall increase by approximately $25.3 million. The remaining increase of $4.6 million was impacted by the overall increase in same-hospital adjusted admissions of 8.7% as well as higher contracted rates from HMOs, PPOs and other private insurers.

Our provision for bad debts increased $9.3 million, or 64%, compared to the prior year period. Same-hospital self-pay admissions were 4.2% of total admissions, compared to 3.2% in the prior year period and self pay gross revenues as a percentage of total gross revenue was 3.3% compared to 2.9% in the prior year period. Our provision for bad debts was impacted by Carolina Pines, which increased our provision for bad debts by $6.0 million for the three months ended June 30, 2015. Same-hospital provision for bad debts increased by $3.3 million for the three months ended June 30, 2015. Our provision for doubtful accounts increased as a result of higher self-pay revenues during the three months ended June 30, 2015.The provision for doubtful accounts relates principally to self-pay amounts due from patients.

Salaries and benefits. Salaries and benefits for the three months ended June 30, 2015 was $97.3 million, or 46.7% of revenues, compared to $85.0 million, or 47.6% of revenues, in the prior year period. The increase of $12.3 million was primarily a result of our recent acquisition of Carolina Pines and the impact of an increasing number of employed physicians and related support staff.

Supplies. Supplies expense increased to $34.5 million, or 15.7%, as compared to $29.8 million for the same period last year primarily as a result of our recent acquisition of Carolina Pines. In addition, the increase was a result of increased medical device costs related to higher intensity surgical cases.

Other operating expenses. Other operating expenses include, among other things, contract services, professional fees, repairs and maintenance, rents and leases, utilities, insurance, non-income taxes and physician income guarantee amortization. Our other operating expenses increased $5.1 million during the three months ended June 30, 2015, compared to the prior year period. This increase was due to $6.6 million of other operating expenses related to the acquisition of controlling interest in Carolina Pines.

Other income. Other income includes EHR incentive payments, which represent those incentives under the HITECH Act for which the recognition criteria have been met. For the three months ended June 30, 2015, EHR incentive income decreased by $0.8 million.

Income taxes. Our effective tax rate from continuing operations was approximately 33.8% for the three months ended June 30, 2015, compared to 25.8% for the same prior year period. The change in the effective tax rate is driven by changes in the level of pretax income combined with our net deferred tax liability position and related limitations with respect to indefinite life deferred tax liabilities.

Six Months Ended June 30, 2015 Compared to June 30, 2014

The following discussion is for continuing operations only and excludes all operations included in discontinued operations.

Revenues. Revenues for the six months ended June 30, 2015 was $415.6 million, an increase of $67.6 million, or 19.4%, over the prior year period. The increase in revenue was primarily due to the purchase of Carolina Pines, effective January 1, 2015, which impacted the overall increase by approximately $49.6 million. The remaining increase of $18.0 million was due an increase in adjusted admissions of 9.5% offset but a decline in revenue per adjusted admission of 3.2%.

Our provision for bad debts increased $7.4 million, or 20.4%, compared to the prior year period. Our provision for bad debts was impacted by Carolina Pines, which increased our provision for bad debts by $10.3 million for the six months ended June 30, 2015. Same-hospital provision for bad debts decreased by $2.9 million for the six months ended June 30, 2015. Self-pay ER visits were 13.0% of total ER visits, compared to 15.6% in the prior year period. Our provision for doubtful accounts decreased as a result of lower self-pay revenues during the six months ended June 30, 2015. Self-pay revenues before the provision for bad debts decreased over the same period last year as a result of a shift from self-pay to Medicaid and HMOs, PPOs and other private insurers for a portion of our patient population, which primarily was a result of healthcare reform and the expansion of Medicaid coverage in certain of the states in which we operate. The provision for doubtful accounts relates principally to self-pay amounts due from patients.

Salaries and benefits. Salaries and benefits for the six months ended June 30, 2015 was $194.4 million, or 46.8% of revenues, compared to $165.3 million, or 47.5% of revenues, in the prior year period. The decrease in salaries and benefits as a percentage of revenues is due to decreased stock-based compensation expense. Non-cash stock-based compensation expense was $0.7 million and $3.3 million, for the six months ended June 30, 2015 and 2014, respectively. After adjusting for the current period expense related to the equity awards issued by our Parent in connection with its equity restructuring, salaries and benefits were approximately 46.6% of revenues, compared to 46.6% of revenues in the prior year period.

Supplies. Supplies expense increased to $69.7 million, or 19.3%, as compared to $58.4 million for the same period last year primarily as a result of our recent acquisition of Carolina Pines. In addition, the increase was a result of increased medical device costs related to higher intensity surgical cases.

Other operating expenses. Other operating expenses include, among other things, contract services, professional fees, repairs and maintenance, rents and leases, utilities, insurance, non-income taxes and physician income guarantee amortization. Our other operating expenses increased $14.5 million during the six months ended June 30, 2015, compared to the prior year period. This increase was due to $13.4 million of other operating expenses related to the acquisition of controlling interest in Carolina Pines, increased service lines and increased revenue cycle fees resulting from improved collections.

Other income. Other income includes EHR incentive payments, which represent those incentives under the HITECH Act for which the recognition criteria have been met. For the six months ended June 30, 2015, we recognized $2.2 million of incentive reimbursements income, or an decrease of $1.0 million over the comparable six months ended June 30, 2014. Other income also includes income from the Oregon Health Authority Hospital Transformation Performance Program (HTTP), which represents payments primarily based on quality measurements for which the recognition criteria have been met. For the six months ended June 30, 2015, we recognized $2.1 million of income related to this program.

Income taxes. Our effective tax rate from continuing operations was approximately 21.7% for the six months ended June 30, 2015 compared to 17.6% for the same prior year period. The change in the effective tax rate is driven by changes in the level of pretax income combined with our net deferred tax liability position and related limitations with respect to indefinite life deferred tax liabilities.

LIQUIDITY AND CAPITAL RESOURCES

The following table shows a summary of our cash flows for the six months ended June 30, 2014 and 2015, are as follows (in millions).


	Six Months Ended June 30,
	2014			2015
Cash provided by operating activities	$	8.6		$	20.0
Cash (used in) provided by investing activities		1.0			16.4
Cash used in financing activities		(10.3	)		(11.2	)

Operating Activities

Cash provided by operating activities increased by $11.4 million for the six months ended June 30, 2015, compared to the six months ended June 30, 2014. Net changes in operating assets and liabilities, excluding the impact of divestitures, negatively impacted operating cash flows by $46.7 million during the six months ended June 30, 2014 compared to a negative impact of $39.8 million during the six months ended June 30, 2015. Cash flows from operating activities were impacted by the interest payments of $25.5 million and $26.7 million for the six month periods ended June 30, 2014 and 2015, respectively.

At June 30, 2015, we had working capital excluding assets and liabilities held for sale and the current portion of long-term debt of $110.0 million, including cash and cash equivalents of $53.9 million. At December 31, 2014, our working capital excluding assets and liabilities held for sale and the current portion of long-term debt was $77.5 million, including cash and cash equivalents of $28.7 million.

Investing Activities

Cash provided by investing activities was $1.0 million for the six months ended June 30, 2014 compared to cash provided by investing activities of $16.4 million for the six months ended June 30, 2015. During the six months ended June 30, 2014, we received $11.2 million in proceeds from the sale of one of our hospitals. During the six months ended June 30, 2015, we received $27.8 million in proceeds from the sale of Mineral Area. We continue to make significant, targeted investments at our hospitals to modernize facilities and expand the services available. Two facilities have been approved for projects totaling $41.0 million that are expected to renovate and expand existing facilities primarily related to our cardiac, emergency services and general surgical service lines. Both projects are long-term projects with expected cash outflows in years 2014 to 2017 and are expected to be completed by the end of 2017.

Financing Activities

Cash used in financing activities was $10.3 million for the six months ended June 30, 2014, compared to $11.2 million for the six months ended June 30, 2015. Cash used in financing activities includes approximately $8.1 million of payments made on our capital lease obligations along with approximately $1.3 million of distributions made to our non-controlling interests during the six months ended June 30, 2015.

As of June 30, 2015, our outstanding debt was $612.6 million, and we had $82.2 million of borrowing capacity under the our senior secured asset-based loan consisting of a $100.0 million revolving credit facility (the “2010 Revolving Facility”), net of outstanding letters of credit.

Upon and subject to the closing of the Merger, the indebtedness of the Parent and its subsidiaries, including any outstanding loans under the 2010 Revolving Facility, will be repaid or otherwise discharged, with the agreement establishing the 2010 Revolving Facility to be terminated upon such repayment or other discharge.

Capital Resources

We rely on available cash, cash flows generated by operations and available borrowing capacity under the 2010 Revolving Facility to fund our operations and capital expenditures. We had $28.7 million and $53.9 million of cash and cash equivalents as of December 31, 2014 and June 30, 2015, respectively. We invest our cash in accounts in high-quality financial institutions. We continually explore various options to increase the return on our invested cash while preserving our principal cash balances. However, the significant majority of our cash and cash equivalents are held in accounts that are not federally-insured and could be at risk in the event of a collapse of the financial institutions at which those accounts are held.

In addition to available cash, our liquidity and ability to fund our capital requirements are dependent on our future financial performance, which is subject to general economic, financial and other factors that are beyond our control. If the Merger is not consummated, and if the forgoing factors significantly change or other unexpected factors adversely affect us, our business may not generate sufficient cash flows from operations or we may not be able to obtain future financings to meet our liquidity needs.

We anticipate that, to the extent additional liquidity is necessary to fund our operations or capital expenditures if the merger is not consummated, it would be funded through borrowings under our 2010 Revolving Facility, the incurrence of other indebtedness, additional note issuances or a combination of these potential sources of liquidity. We may not be able to obtain this additional liquidity when needed on terms acceptable to us.

Debt Covenants

The indenture governing the 9¹/₄% Notes and the Term Loan Facility contain a number of covenants that among other things, restrict, subject to certain exceptions, our ability and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, pay dividends and distributions or repurchase our capital stock, create liens on assets, make investments, engage in mergers or consolidations, and engage in certain transactions with affiliates. Additionally, with respect to the 2010 Revolving Facility, the Amended and Restated Loan Agreement, dated December 31, 2014, by and among the Company, the borrowing subsidiaries signatory thereto, the guarantying subsidiaries signatory thereto, the lenders party thereto, and Bank of America, N.A., as agent for the lenders (the “ABL Agreement”), contains a number of covenants, including the requirement that the Company’s fixed charge coverage ratio cannot be less than 1.10 to 1.00 at the end of any measurement period. At December 31, 2014 and June 30, 2015, we were in compliance with all debt covenants that were subject to testing at such dates.

Upon and subject to the closing of the Merger, the indebtedness of the Parent and its subsidiaries, including the outstanding 9 ¹/₄% Notes and the Term Loan Facility, will be repaid, with the indenture underlying the 9 ¹/₄% Notes and the agreement establishing the Term Loan Facility to be terminated upon such repayment or other discharge, provided that the redemption of the 9 ¹/₄% Notes may occur after the effective time of the merger in accordance with a valid redemption notice delivered prior to or substantially concurrently with the effective time of the Merger.

Obligations and Commitments

Except as disclosed under “Investing Activities” above, during the six months ended June 30, 2015, there were no material changes in our contractual obligations as presented in our 2014 Annual Report on Form 10-K.

Guarantees and Off-Balance Sheet Arrangements

We are a party to certain master lease agreements and other similar arrangements with non-affiliated entities.

We enter into physician income guarantees and other guarantee arrangements, including parent-subsidiary guarantees, in the ordinary course of business. We do not believe we have engaged in any transaction or arrangement with an unconsolidated entity that is reasonably likely to affect liquidity materially.

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Effects of Inflation and Changing Prices

Various federal, state and local laws have been enacted that, in certain cases, limit our ability to increase prices. Revenue for acute hospital services rendered to Medicare patients is established under the federal government’s prospective payment system. We believe that hospital industry operating margins have been, and may continue to be, under significant pressure because of changes in payor mix and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. In addition, as a result of increasing regulatory and competitive pressures, our ability to maintain operating margins through price increases to non-Medicare patients is limited.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are subject to market risk from exposure to changes in interest rates based on our financing, investing and cash management activities. As of June 30, 2015, our Term Loan Facility bears interest based on floating rates. A 1% change in interest rates on our Term Loan Facility would have resulted in interest expense fluctuating approximately $0.3 million and $0.5 million for the three and six months ended June 30, 2015, respectively. Although changes in the alternate base rate or the LIBOR rate would affect the cost of funds borrowed under the ABL Agreement in the future, we believe the effect, if any, of reasonably possible near-term changes in interest rates would not be material to our results of operations or cash flows.

Item 4. Controls and Procedures

We carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 15d-15 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us (including our consolidated subsidiaries) in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported on a timely basis.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the three months ended June 30, 2015 that have affected materially, or are reasonably likely to affect materially, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

We operate in a highly regulated and litigious industry. As a result, we are, from time to time, subject to claims and suits arising in the ordinary course of business, including claims for damages for personal injuries, medical malpractice, breach of contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request payment for damages, including punitive damages that may not be covered by insurance. We are currently not a party to any pending or threatened proceeding, which, in management’s opinion, would have a material adverse effect on our business, financial condition or results of operations.

Item 1A. Risk Factors

There have not been any material changes to the risk factors previously disclosed in our 2014 Annual Report on Form 10-K except for the addition of the risk factors set forth below:

The parties to the Merger Agreement may be unable to satisfy the conditions to the closing of the Merger in the anticipated timeframe or at all.

Consummation of the Merger is subject to the satisfaction or waiver of customary conditions to closing, including, among others, the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. This and the other conditions to the closing of the Merger may fail to be satisfied. In addition, the satisfaction of the closing conditions and the consummation of the Merger may take longer than expected, cost more than expected, or both.

Failure to consummate the Merger could adversely affect our business or financial position.

If the Merger is not consummated for any reason, we would still remain liable for significant transaction costs and the focus of our management would have been diverted from seeking other potential strategic opportunities, in each case, without realizing any benefits of the Merger. For these and other reasons, the failure of the Merger could adversely affect our business, operating results or financial condition.

While the Merger is pending, we are subject to business uncertainties and contractual restrictions that could adversely affect our business or results of operations.

Our employees, patients, customers and suppliers may have uncertainties about the effects of the Merger. Although we have taken actions designed to reduce any adverse effects of these uncertainties, these uncertainties may impair our ability to attract, retain and motivate key employees and could cause customers, suppliers and others that deal with us to try to change our existing business relationships. The pursuit of the Merger and preparations for post-Merger integration with Purchaser have placed, and will continue to place, a significant burden on many of our employees and internal resources. If, despite our efforts, key employees depart because of these uncertainties and burdens, or because they do not wish to be employed by the post-Merger company, our business or operating results could be adversely affected. In addition, the Merger Agreement restricts our ability to take certain actions with respect to our business and financial affairs without the consent of Purchaser, and these restrictions could be in place for an extended period of time if the Merger is delayed. For these and other reasons, the pendency of the Merger could adversely affect our business, operating results or financial condition.

Item 6. Exhibits


Exhibit Number		Description

2.1		Agreement and Plan of Merger, dated as of July 21, 2015, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., Capella Health Holdings, LLC and Capella Holdings Acquisition Sub, Inc. (incorporated by reference from exhibits to the Current Report on Form 8-K filed by Capella Healthcare, Inc. on July 27, 2015)

2.2		Amendment to Agreement and Plan of Merger, dated as of July 27, 2015, by and among Capella Holdings, Inc., Capella Health Holdings, LLC and Capella Holdings Acquisition Sub, Inc.

3.1		Certificate of Incorporation of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

3.2		By-Laws of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

4.1		Indenture, dated as of June 28, 2010, among Capella Healthcare, Inc., the Guarantors named therein and U.S. Bank National Association, as Trustee (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

4.2		Form of 9¹/₄% Senior Notes due 2017 (included in Exhibit 4.1) (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

4.3		Form of Supplemental Indenture to add a Guaranty Subsidiary (incorporated by reference from exhibits to Capella Healthcare Inc.’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012)

31.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS		XBRL Instance Document

101.SCH		XBRL Taxonomy Extension Schema Document

101.CAL		XBRL Taxonomy Calculation Linkbase Document

101.DEF		XBRL Taxonomy Definition Linkbase Document

101.LAB		XBRL Taxonomy Label Linkbase Document

101.PRE		XBRL Taxonomy Presentation Linkbase Document

SIGNATURES

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


Capella Healthcare, Inc.

By:		/s/ Denise W. Warren
		Denise W. Warren
		Executive Vice President, Chief Financial Officer and Treasurer
		(principal financial officer and principal accounting officer)

Date: August 14, 2015

EXHIBIT INDEX


Exhibit Number		Description

2.1		Agreement and Plan of Merger, dated as of July 21, 2015, by and among Capella Holdings, Inc., GTCR Fund VIII, L.P., Capella Health Holdings, LLC and Capella Holdings Acquisition Sub, Inc. (incorporated by reference from exhibits to the Current Report on Form 8-K filed by Capella Healthcare, Inc. on July 27, 2015)

2.2		Amendment to Agreement and Plan of Merger, dated as of July 27, 2015, by and among Capella Holdings, Inc., Capella Health Holdings, LLC and Capella Holdings Acquisition Sub, Inc.

3.1		Certificate of Incorporation of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

3.2		By-Laws of Capella Healthcare, Inc. (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

4.1		Indenture, dated as of June 28, 2010, among Capella Healthcare, Inc., the Guarantors named therein and U.S. Bank National Association, as Trustee (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

4.2		Form of 9¹/₄% Senior Notes due 2017 (included in Exhibit 4.1) (incorporated by reference from exhibits to the Registration Statement on Form S-4 filed by Capella Healthcare, Inc. on June 28, 2011, File No. 333-175188)

4.3		Form of Supplemental Indenture to add a Guaranty Subsidiary (incorporated by reference from exhibits to Capella Healthcare Inc.’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012)

31.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of the Chief Executive Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of the Chief Financial Officer of Capella Healthcare, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS		XBRL Instance Document

101.SCH		XBRL Taxonomy Extension Schema Document

101.CAL		XBRL Taxonomy Calculation Linkbase Document

101.DEF		XBRL Taxonomy Definition Linkbase Document

101.LAB		XBRL Taxonomy Label Linkbase Document

101.PRE		XBRL Taxonomy Presentation Linkbase Document

Large accelerated filer

Accelerated filer

Non-accelerated filer

x (Do not check if a smaller reporting company)

Smaller reporting company