Edgar Filing: KINDRED HEALTHCARE, INC

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2006

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

EXCHANGE ACT OF 1934

For the transition period from to .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

Delaware

61-1323993

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)


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

(502) 596-7300

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.


Large accelerated filer þ		Accelerated filer ¨		Non-accelerated filer ¨

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

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


Class of Common Stock		Outstanding at October 31, 2006
Common stock, $0.25 par value		39,874,429 shares

1 of 46

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX


		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements:
	Condensed Consolidated Statement of Operations — for the three months ended September 30, 2006 and 2005 and for the nine months ended September 30, 2006 and 2005	3

	Condensed Consolidated Balance Sheet — September 30, 2006 and December 31, 2005	4

	Condensed Consolidated Statement of Cash Flows — for the three months ended September 30, 2006 and 2005 and for the nine months ended September 30, 2006 and 2005	5

	Notes to Condensed Consolidated Financial Statements	6

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	42

Item 4.	Controls and Procedures	43

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	44

Item 6.	Exhibits	45

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Revenues	$	1,058,892		$	951,265		$	3,163,616		$	2,881,499

Salaries, wages and benefits		589,753			520,875			1,734,568			1,544,846
Supplies		170,815			144,914			502,007			415,519
Rent		81,252			66,457			225,466			197,553
Other operating expenses		176,546			159,417			524,245			475,238
Depreciation and amortization		32,046			25,916			89,720			73,852
Interest expense		4,667			1,931			10,850			6,370
Investment income		(3,530	)		(2,471	)		(10,665	)		(7,849	)

		1,051,549			917,039			3,076,191			2,705,529

Income from continuing operations before reorganization items and income taxes		7,343			34,226			87,425			175,970
Reorganization items		–			–			–			(1,371	)

Income from continuing operations before income taxes		7,343			34,226			87,425			177,341
Provision for income taxes		3,774			13,809			37,680			71,389

Income from continuing operations		3,569			20,417			49,745			105,952
Discontinued operations, net of income taxes:
Income (loss) from operations		(757	)		(916	)		6,850			13,859
Gain (loss) on divestiture of operations		126			(3,147	)		(25	)		(500	)

Net income	$	2,938		$	16,354		$	56,570		$	119,311

Earnings per common share:
Basic:
Income from continuing operations	$	0.09		$	0.54		$	1.27		$	2.84
Discontinued operations:
Income (loss) from operations		(0.02	)		(0.03	)		0.18			0.37
Gain (loss) on divestiture of operations		–			(0.08	)		–			(0.01	)

Net income	$	0.07		$	0.43		$	1.45		$	3.20

Diluted:
Income from continuing operations	$	0.09		$	0.45		$	1.20		$	2.32
Discontinued operations:
Income (loss) from operations		(0.02	)		(0.02	)		0.17			0.30
Gain (loss) on divestiture of operations		–			(0.07	)		–			(0.01	)

Net income	$	0.07		$	0.36		$	1.37		$	2.61

Shares used in computing earnings per common share:
Basic		39,014			38,013			39,104			37,279
Diluted		39,769			46,033			41,300			45,648

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	September 30, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	13,354		$	83,420
Cash – restricted		5,874			5,135
Insurance subsidiary investments		228,675			231,134
Accounts receivable less allowance for loss of $66,904 – September 30, 2006 and $62,078 – December 31, 2005		635,307			479,605
Inventories		50,477			43,731
Deferred tax assets		69,061			61,078
Assets held for sale		12,130			12,056
Other		29,906			28,805

		1,044,784			944,964

Property and equipment		979,038			891,009
Accumulated depreciation		(446,324	)		(369,393	)

		532,714			521,616

Goodwill		108,129			69,879
Intangible assets less accumulated amortization of $5,445 – September 30, 2006 and $1,763 – December 31, 2005		118,825			34,317
Insurance subsidiary investments		45,640			48,796
Deferred tax assets		89,917			73,750
Other		83,549			67,239

	$	2,023,558		$	1,760,561

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	129,957		$	134,547
Salaries, wages and other compensation		280,065			244,851
Due to third party payors		28,417			26,642
Professional liability risks		65,521			70,090
Other accrued liabilities		90,441			79,704
Income taxes		78,621			58,572
Long-term debt due within one year		71			6,221

		673,093			620,627

Long-term debt		174,208			26,323
Professional liability risks		191,096			182,113
Deferred credits and other liabilities		103,034			60,962

Commitments and contingencies

Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 39,889 shares – September 30, 2006 and 37,331 shares – December 31, 2005		9,972			9,333
Capital in excess of par value		702,186			673,358
Deferred compensation		–			(14,228	)
Accumulated other comprehensive income (loss)		683			(60	)
Retained earnings		169,286			202,133

		882,127			870,536

	$	2,023,558		$	1,760,561

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Cash flows from operating activities:
Net income	$	2,938		$	16,354		$	56,570		$	119,311
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		32,673			26,826			91,566			76,526
Amortization of stock-based deferred compensation costs		4,397			2,665			14,360			6,661
Provision for doubtful accounts		10,024			3,725			28,913			13,199
Deferred income taxes		657			–			(14,280	)		–
(Gain) loss on divestiture of discontinued operations		(126	)		3,147			25			500
Reorganization items		–			–			–			(1,371	)
Other		(2,868	)		(1,257	)		(4,317	)		(2,455	)
Change in operating assets and liabilities:
Accounts receivable		(56,219	)		(6,048	)		(182,053	)		(171,408	)
Inventories and other assets		(4,679	)		(1,380	)		(14,691	)		(6,899	)
Accounts payable		(60	)		(1,267	)		5,979			(1,004	)
Income taxes		(16,189	)		10,784			3,491			74,668
Due to third party payors		8,731			5,802			1,775			(10,077	)
Other accrued liabilities		43,500			(8,813	)		53,681			9,512

Net cash provided by operating activities		22,779			50,538			41,019			107,163

Cash flows from investing activities:
Purchase of property and equipment		(37,719	)		(33,552	)		(99,754	)		(80,113	)
Acquisitions		(11,086	)		(42	)		(134,667	)		(73,919	)
Sale of assets		205			92			10,510			11,196
Purchase of insurance subsidiary investments		(81,207	)		(61,620	)		(165,487	)		(266,816	)
Sale of insurance subsidiary investments		82,725			52,795			177,609			243,157
Net change in insurance subsidiary cash and cash equivalents		1,185			(3,445	)		(4,288	)		20,952
Net change in other investments		(1,101	)		(250	)		743			3,469
Other		(2,033	)		(713	)		927			1,794

Net cash used in investing activities		(49,031	)		(46,735	)		(214,407	)		(140,280	)

Cash flows from financing activities:
Net change in revolving credit borrowings		30,700			–			173,300			–
Repayment of long-term debt		(321	)		(1,363	)		(3,294	)		(3,881	)
Payment of deferred financing costs		(223	)		(168	)		(1,170	)		(371	)
Issuance of common stock		178			976			143,366			23,711
Repurchase of common stock		–			–			(194,310	)		–
Other		(5,763	)		1,493			(14,570	)		(17,360	)

Net cash provided by financing activities		24,571			938			103,322			2,099

Change in cash and cash equivalents		(1,681	)		4,741			(70,066	)		(31,018	)
Cash and cash equivalents at beginning of period		15,035			33,369			83,420			69,128

Cash and cash equivalents at end of period	$	13,354		$	38,110		$	13,354		$	38,110

Supplemental information:
Interest payments	$	2,340		$	2,513		$	7,467		$	5,024
Income tax payments		18,833			2,452			52,758			5,398

See accompanying notes.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. is a healthcare services company that through its subsidiaries operates hospitals, nursing centers, a contract rehabilitation services business and institutional pharmacies across the United States (collectively, “Kindred” or the “Company”). At September 30, 2006, the Company’s hospital division operated 80 long-term acute care (“LTAC”) hospitals in 24 states. The Company’s health services division operated 242 nursing centers in 28 states. The Company operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings. The Company’s pharmacy division operated an institutional pharmacy business with 45 pharmacies in 26 states and a pharmacy management business servicing substantially all of the Company’s hospitals.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals, nursing centers and other healthcare businesses to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains or losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at September 30, 2006 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 4 for a summary of discontinued operations.

Impact of recent accounting pronouncements

On September 29, 2006, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 158 (“SFAS 158”), “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position, and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. SFAS 158 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position and revises certain disclosure requirements. The benefit obligation is defined as the projected benefit obligation for pension plans and as the accumulated postretirement benefit obligation for any other postretirement benefit plan, such as a retiree health care plan. The Company is required to adopt SFAS 158 prospectively in the fourth quarter of 2006. The adoption of SFAS 158 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

On September 15, 2006, the FASB issued SFAS No. 157 (“SFAS 157”), “Fair Value Measurements,” which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

On September 13, 2006, the Securities and Exchange Commission (the “SEC”) staff issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 was issued to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of SAB 108 is not expected to affect the Company’s consolidated financial statements.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Impact of recent accounting pronouncements (Continued)

On July 13, 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” The interpretation clarifies the accounting for uncertain income tax issues recognized in an entity’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

Stock option accounting

In December 2004, the FASB issued SFAS No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment,” which requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. In connection with the adoption of SFAS 123R, the Company began to recognize compensation expense prospectively in its consolidated financial statements for non-vested stock options beginning January 1, 2006. See Note 14.

Prior to the adoption of SFAS 123R, the Company followed Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its employee stock options.

Pro forma information regarding net income and earnings per share determined as if the Company had accounted for its employee stock options granted under the fair value method of SFAS 123R as of January 1, 2005 follows (in thousands, except per share amounts):


	Three months ended September 30, 2005			Nine months ended September 30, 2005
Net income, as reported	$	16,354		$	119,311
Adjustments:
Stock-based employee compensation expense included in reported net income		1,639			4,117
Stock-based employee compensation expense determined under fair value based method		(3,668	)		(9,695	)

Pro forma net income	$	14,325		$	113,733

Earnings per common share:
As reported:
Basic	$	0.43		$	3.20
Diluted	$	0.36		$	2.61
Pro forma:
Basic	$	0.38		$	3.05
Diluted	$	0.31		$	2.46

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Comprehensive income

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


	Three months ended September 30,					Nine months ended September 30,
	2006		2005			2006		2005
Net income	$	2,938	$	16,354		$	56,570	$	119,311
Net unrealized investment gains (losses), net of income taxes		846		(236	)		743		(734	)

Comprehensive income	$	3,784	$	16,118		$	57,313	$	118,577

Other information

The accompanying unaudited condensed consolidated financial statements do not include all of the disclosures normally required by generally accepted accounting principles or those normally required in annual reports on Form 10-K. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2005 filed with the SEC on Form 10-K.

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

Reclassifications

Certain prior period amounts have been reclassified to conform with the current period presentation. These changes did not have any impact on the Company’s financial position, results of operations or liquidity.

NOTE 2 – PROPOSED SPIN-OFF TRANSACTION

On October 25, 2006, the Company signed a definitive agreement with AmerisourceBergen Corporation (“AmerisourceBergen”) to combine their respective institutional pharmacy businesses, Kindred Pharmacy Services (“KPS”) and PharMerica Long-Term Care (“PharMerica LTC”), into a new, independent, publicly traded company. The transaction is intended to be tax-free to shareholders of both Kindred and AmerisourceBergen and is expected to be completed in the first quarter of 2007.

Under the terms of the agreement, both KPS and PharMerica LTC will each borrow up to $150 million and use such proceeds to fund a one-time cash distribution, intended to be tax-free, to their respective parent companies. Following the cash distribution, each institutional pharmacy business is expected to be spun off to the shareholders of their respective parent companies. Immediately thereafter, a stock-for-stock merger will be effected that would result in Kindred and AmerisourceBergen shareholders each owning 50% of the new publicly traded company. The proposed transaction is subject to certain conditions, including the completion of the registration statement to be filed with the SEC and a favorable determination by the Internal Revenue Service (the “IRS”). The closing of the proposed transaction also will require the receipt of required regulatory approvals and the satisfaction of certain other conditions.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – PROPOSED SPIN-OFF TRANSACTION (Continued)

For accounting purposes, the historical operating results of the Company’s pharmacy segment will be reclassified as discontinued operations upon the consummation of the proposed transaction.

NOTE 3 – VENTAS RENT RESET

At September 30, 2006, the Company leased from Ventas, Inc. and its affiliates (“Ventas”) 39 LTAC hospitals and 186 nursing centers under four master leases (the “Master Leases”).

On October 12, 2006, Ventas exercised a one-time right to reset rent under each of the four Master Leases. These new aggregate annual rents of approximately $239 million became effective retroactively to July 19, 2006 and were determined as fair market rentals by the final independent appraisers engaged in connection with the rent reset process under the four Master Leases. Aggregate annual Ventas rents prior to the rent reset approximated $206 million. As required, Ventas paid the Company a reset fee of approximately $4.6 million which will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases. In connection with the exercise of the rent reset, the new annual rents were allocated among the facilities subject to the Master Leases in accordance with the determinations made by the final appraisers during the rent reset process. The new contingent annual rent escalator will be 2.7% for Master Leases 1, 3 and 4. The escalator for Master Lease 2 is based upon the Consumer Price Index (the “CPI”) with a floor of 2.25% and a ceiling of 4%. Prior to the rent reset, the contingent annual Ventas rent escalator under each Master Lease was 3.5%.

In 2003, the Company had agreed to pay Ventas additional rents in varying amounts generally over seven years in consideration for the divestiture of the Company’s former Florida and Texas nursing centers. For accounting purposes, these additional rent payments were classified as long-term debt. As a result of the rent reset, the remaining obligations under the 2003 agreement were extinguished. For accounting purposes, the Company’s remaining debt obligation to Ventas of $28.3 million as of July 18, 2006 has been reclassified as a deferred credit in the accompanying unaudited condensed consolidated balance sheet and will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases.

NOTE 4 – DISCONTINUED OPERATIONS

Nursing center dispositions

On August 8, 2006, the Company entered into definitive agreements with Health Care Property Investors, Inc. (“HCP”) to acquire the real estate related to 11 unprofitable leased nursing centers operated by the Company for resale in exchange for three hospitals currently owned by the Company. As part of the transaction, the Company will continue to operate the hospitals under a long-term lease arrangement with HCP. In addition, the Company will pay HCP a one-time cash payment of approximately $36 million. The Company also will amend its existing master lease with HCP to (1) terminate the current annual rent of approximately $9.9 million on the 11 nursing centers, (2) add the three hospitals to the master lease with a current annual rent of approximately $6.3 million and (3) extend the initial expiration date of the master lease until September 30, 2016.

On November 7, 2006, the Company entered into a definitive agreement to sell the real estate and related operations of these 11 nursing centers for $78 million (the “Sale Transaction”). The Sale Transaction is subject to the receipt of required approvals and the satisfaction of several conditions to closing, including without limitation, the successful closing of the HCP transaction.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – DISCONTINUED OPERATIONS (Continued)

Nursing center dispositions (Continued)

The 11 nursing centers, which contain 1,754 licensed beds, generated pretax losses of approximately $4.0 million for the year ended December 31, 2005 and $2.5 million for the nine months ended September 30, 2006. The HCP transaction and the Sale Transaction are subject to various regulatory approvals and the satisfaction of several conditions to closing. Upon completion of the HCP transaction, the Company expects to record a pretax loss ranging from $7 million to $10 million.

For accounting purposes, the operating results of the 11 nursing centers have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented.

Discontinued operations summary

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” divestitures over the past several years have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the gains or losses related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. At September 30, 2006, the Company held for sale 11 nursing centers and one closed hospital.

Discontinued operations included favorable pretax adjustments of $0.4 million and $4.1 million for the third quarter of 2006 and 2005, respectively, and $17.3 million and $36.7 million for the nine months ended September 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas.

A summary of discontinued operations follows (in thousands):


	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Revenues	$	22,237		$	31,517		$	68,259		$	103,860

Salaries, wages and benefits		10,885			17,383			34,958			57,051
Supplies		1,209			2,333			4,259			7,589
Rent		2,485			3,162			7,488			10,068
Other operating expenses		8,262			9,275			8,574			4,332
Depreciation		627			910			1,846			2,674
Interest expense		–			–			–			–
Investment income		(1	)		(57	)		(5	)		(390	)

		23,467			33,006			57,120			81,324

Income (loss) from operations before income taxes		(1,230	)		(1,489	)		11,139			22,536
Income tax provision (benefit)		(473	)		(573	)		4,289			8,677

Income (loss) from operations		(757	)		(916	)		6,850			13,859
Gain (loss) on divestiture of operations, net of income taxes		126			(3,147	)		(25	)		(500	)

	$	(631	)	$	(4,063	)	$	6,825		$	13,359

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – DISCONTINUED OPERATIONS (Continued)

Discontinued operations summary (Continued)

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


	Three months ended September 30,					Nine months ended September 30,
	2006		2005			2006		2005
Revenues:
Hospital division:
Hospitals	$	753	$	1,402		$	3,055	$	10,126
Ancillary services		1		–			2		11

		754		1,402			3,057		10,137
Health services division		21,483		30,115			65,202		93,723
Pharmacy division		–		–			–		–

	$	22,237	$	31,517		$	68,259	$	103,860

Operating income (loss):
Hospital division:
Hospitals	$	461	$	(469	)	$	106	$	(312	)
Ancillary services		1		9			1		20

		462		(460	)		107		(292	)
Health services division		1,419		2,986			20,361		35,170
Pharmacy division		–		–			–		10

	$	1,881	$	2,526		$	20,468	$	34,888

Rent:
Hospital division:
Hospitals	$	–	$	33		$	38	$	114
Ancillary services		–		2			–		2

		–		35			38		116
Health services division		2,485		3,127			7,450		9,952
Pharmacy division		–		–			–		–

	$	2,485	$	3,162		$	7,488	$	10,068

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

		–		–			–		–
Health services division		627		910			1,846		2,674
Pharmacy division		–		–			–		–

	$	627	$	910		$	1,846	$	2,674

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – DISCONTINUED OPERATIONS (Continued)

Discontinued operations summary (Continued)

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


	September 30, 2006			December 31, 2005
Current assets:
Property and equipment, net	$	11,780		$	11,587
Other		350			469

		12,130			12,056
Current liabilities (included in other accrued liabilities)		(1,346	)		(266	)

	$	10,784		$	11,790

NOTE 5 – SIGNIFICANT QUARTERLY ADJUSTMENTS

Operating results for the third quarter of 2006 included pretax income of $1.3 million related to an insurance recovery and a favorable adjustment of a prior year tax dispute, and a pretax charge of $3.5 million for costs incurred in connection with the planned spin-off of the Company’s institutional pharmacy business and professional fees incurred in connection with the Ventas rent reset issue. Third quarter 2006 results also included a charge of $0.6 million related to a change in estimate of the Company’s annual effective income tax rate.

Operating results for the nine months ended September 30, 2006 also included a $1.3 million pretax gain from an institutional pharmacy joint venture transaction, a pretax charge of $2.7 million related primarily to revisions to prior estimates for accrued contract labor costs in the Company’s rehabilitation division, a $3.0 million pretax charge in connection with the settlement of a prior year tax dispute, and a pretax charge of $4.3 million for costs related to investment banking services and professional fees incurred in connection with the Ventas rent reset issue.

Operating results included income related to the favorable settlement of prior year hospital Medicare cost reports that aggregated $5.9 million for the third quarter of 2005, and $6.2 million and $63.4 million for the nine months ended September 30, 2006 and 2005, respectively.

Operating results for the third quarter of 2005 included costs associated with Hurricane Katrina and Hurricane Rita which reduced hospital pretax income by $2.1 million.

Operating results for the nine months ended September 30, 2005 included pretax charges of $13.7 million (including a $0.7 million favorable adjustment recorded in the third quarter of 2005) related to a special recognition payment to non-executive caregivers and employees and $5.0 million related to a charitable donation. The allocation of these costs by segment follows (in thousands):


	Recognition payment		Charitable donation
Hospital division	$	3,703	$	–
Health services division		8,038		–
Rehabilitation division		1,024		–
Pharmacy division		697		–
Corporate		216		5,000

	$	13,678	$	5,000

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – SIGNIFICANT QUARTERLY ADJUSTMENTS (Continued)

Operating results for the nine months ended September 30, 2005 included pretax income of $15.8 million ($31.2 million of revenues less $15.4 million of provider taxes classified as operating expenses) related to retroactive nursing center Medicaid rate increases in the state of Indiana, of which approximately $2.1 million related to the first quarter of 2005 and approximately $13.7 million related to prior years.

NOTE 6 – REORGANIZATION ITEMS

Transactions related to the Company’s emergence from bankruptcy have been classified separately in the accompanying unaudited condensed consolidated statement of operations. Operating results for the nine months ended September 30, 2005 included income of $1.4 million resulting from changes in estimates for accrued professional and administrative costs related to the Company’s emergence from bankruptcy.

NOTE 7 – ACQUISITIONS

The following is a summary of the Company’s significant acquisition activities. The operating results of these acquired businesses have been included in the accompanying unaudited condensed consolidated financial statements of the Company since the respective acquisition dates. The purchase price of these acquired businesses resulted from negotiations with each of the sellers that were based upon both the historical and expected future cash flows of the respective businesses.

Commonwealth acquisition

On February 28, 2006, the Company acquired the operations of the LTAC hospitals, skilled nursing facilities and assisted living facilities operated by Commonwealth Communities Holdings LLC and certain of its affiliates (the “Commonwealth Acquisition”). The transaction was financed primarily through the use of the Company’s revolving credit facility. Goodwill recorded in connection with the Commonwealth Acquisition aggregated $32.9 million. The purchase price also included identifiable intangible assets of $75.9 million related to the value of acquired certificates of need with indefinite lives and other intangible assets of $5.2 million which will be amortized over approximately three years. Additional adjustments to the purchase price of approximately $7 million may occur through February 2008 as a result of contingent consideration in accordance with the acquisition agreement.

A preliminary summary of the Commonwealth Acquisition follows (in thousands):


Fair value of assets acquired, including goodwill and other intangible assets	$	130,645
Fair value of liabilities assumed		(6,991	)

Net cash paid	$	123,654

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – ACQUISITIONS (Continued)

Commonwealth acquisition (Continued)

The pro forma effect of the Commonwealth Acquisition assuming the transaction occurred on January 1, 2006 or January 1, 2005 follows (in thousands, except per share amounts):


	Three months ended September 30, 2005		Nine months ended September 30,
	Three months ended September 30, 2005		2006		2005
Revenues	$	1,010,769	$	3,203,407	$	3,055,480
Income from continuing operations		22,033		49,771		110,594
Net income		17,970		56,596		123,953

Earnings per common share:
Basic:
Income from continuing operations	$	0.58	$	1.27	$	2.97
Net income	$	0.47	$	1.45	$	3.33
Diluted:
Income from continuing operations	$	0.48	$	1.20	$	2.42
Net income	$	0.39	$	1.37	$	2.71

Pro forma financial data have been derived by combining the historical financial results of the Company and the operations acquired in the Commonwealth Acquisition for all periods presented.

Pharmacy acquisitions

On March 2, 2005, the Company acquired the assets of Pharmacy Partners, Inc., an operator of two institutional pharmacies in Pennsylvania (the “PPI Acquisition”). The transaction was financed through the use of existing cash. Goodwill recorded in connection with the PPI Acquisition aggregated $11.6 million. The purchase price also included acquired identifiable intangible assets totaling $11.3 million that will be amortized over approximately 12 years.

On April 1, 2005, the Company acquired the assets of Skilled Care Pharmacy, an operator of two institutional pharmacies in California (the “SCP Acquisition”). The transaction was financed through the use of existing cash and the Company’s revolving credit facility. Goodwill recorded in connection with the SCP Acquisition aggregated $16.5 million. The purchase price also included acquired identifiable intangible assets totaling $10.4 million that will be amortized over approximately 13 years.

A summary of both the PPI Acquisition and the SCP Acquisition follows (in thousands):


	PPI Acquisition			SCP Acquisition
Fair value of assets acquired, including goodwill and other intangible assets	$	31,085		$	37,480
Fair value of liabilities assumed		(213	)		(732	)

Net cash paid through September 30, 2005		30,872			36,748
Additional payment of transaction costs		1			–

Total cash paid through September 30, 2006	$	30,873		$	36,748

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – ACQUISITIONS (Continued)

Pharmacy acquisitions (Continued)

During the third quarter of 2006, the Company acquired three institutional pharmacies for an aggregate cost of $14.5 million. Goodwill recorded in connection with these acquisitions aggregated $3.9 million. The purchase price also included acquired identifiable intangible assets totaling $7.1 million that will be amortized over approximately 10 years. Additional adjustments to the purchase price of approximately $2 million may occur through July 2008 as a result of contingent consideration in accordance with the acquisition agreements.

NOTE 8 – REVENUES

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

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


	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Medicare	$	476,442		$	400,126		$	1,475,528		$	1,264,689
Medicaid		288,435			307,445			835,790			899,747
Private and other		387,564			324,860			1,127,028			953,060

		1,152,441			1,032,431			3,438,346			3,117,496
Eliminations:
Rehabilitation		(57,019	)		(49,779	)		(168,065	)		(144,916	)
Pharmacy		(36,530	)		(31,387	)		(106,665	)		(91,081	)

		(93,549	)		(81,166	)		(274,730	)		(235,997	)

	$	1,058,892		$	951,265		$	3,163,616		$	2,881,499

NOTE 9 – EARNINGS PER SHARE

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9 – EARNINGS PER SHARE (Continued)

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


	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Earnings:
Income from continuing operations	$	3,569		$	20,417		$	49,745		$	105,952
Discontinued operations, net of income taxes:
Income (loss) from operations		(757	)		(916	)		6,850			13,859
Gain (loss) on divestiture of operations		126			(3,147	)		(25	)		(500	)

Net income	$	2,938		$	16,354		$	56,570		$	119,311

Shares used in the computation:
Weighted average shares outstanding – basic computation		39,014			38,013			39,104			37,279
Dilutive effect of certain securities:
Warrants		–			6,752			1,497			6,875
Employee stock options		514			931			435			1,022
Non-vested restricted stock		241			337			264			472

Adjusted weighted average shares outstanding – diluted computation		39,769			46,033			41,300			45,648

Earnings per common share:
Basic:
Income from continuing operations	$	0.09		$	0.54		$	1.27		$	2.84
Discontinued operations:
Income (loss) from operations		(0.02	)		(0.03	)		0.18			0.37
Gain (loss) on divestiture of operations		–			(0.08	)		–			(0.01	)

Net income	$	0.07		$	0.43		$	1.45		$	3.20

Diluted:
Income from continuing operations	$	0.09		$	0.45		$	1.20		$	2.32
Discontinued operations:
Income (loss) from operations		(0.02	)		(0.02	)		0.17			0.30
Gain (loss) on divestiture of operations		–			(0.07	)		–			(0.01	)

Net income	$	0.07		$	0.36		$	1.37		$	2.61

NOTE 10 – STOCKHOLDERS’ EQUITY

The Company’s Series A warrants and Series B warrants expired on April 20, 2006. In connection with the exercise of these warrants, the Company issued approximately 10.1 million shares of common stock and received net proceeds of approximately $142.3 million. These proceeds were used to repurchase approximately 5.8 million shares of the Company’s common stock in the open market during the second quarter of 2006.

The Company also repurchased approximately two million shares of its common stock in the open market during the second quarter of 2006 at an aggregate cost of approximately $52 million, thereby completing a $100 million share repurchase program authorized by the Company’s Board of Directors in August 2005.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – BUSINESS SEGMENT DATA

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

The Company identifies its segments in accordance with the aggregation provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This information is consistent with information used by the Company in managing its businesses and aggregates businesses with similar economic characteristics.

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


	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Revenues:
Hospital division	$	406,923		$	389,776		$	1,277,045		$	1,217,378
Health services division		499,072			441,937			1,452,177			1,329,282
Rehabilitation division		76,003			65,553			221,541			195,865
Pharmacy division		170,443			135,165			487,583			374,971

		1,152,441			1,032,431			3,438,346			3,117,496
Eliminations:
Rehabilitation		(57,019	)		(49,779	)		(168,065	)		(144,916	)
Pharmacy		(36,530	)		(31,387	)		(106,665	)		(91,081	)

		(93,549	)		(81,166	)		(274,730	)		(235,997	)

	$	1,058,892		$	951,265		$	3,163,616		$	2,881,499

Income from continuing operations:
Operating income (loss):
Hospital division	$	74,793		$	90,728		$	284,164		$	326,792
Health services division		61,293			48,286			172,515			162,744
Rehabilitation division		8,857			7,913			21,549			24,613
Pharmacy division		16,152			14,455			48,020			39,207
Corporate:
Overhead		(37,683	)		(32,631	)		(118,274	)		(99,798	)
Insurance subsidiary		(1,634	)		(2,692	)		(5,178	)		(7,662	)

		(39,317	)		(35,323	)		(123,452	)		(107,460	)

		121,778			126,059			402,796			445,896
Reorganization items		–			–			–			1,371

Operating income		121,778			126,059			402,796			447,267
Rent		(81,252	)		(66,457	)		(225,466	)		(197,553	)
Depreciation and amortization		(32,046	)		(25,916	)		(89,720	)		(73,852	)
Interest, net		(1,137	)		540			(185	)		1,479

Income from continuing operations before income taxes		7,343			34,226			87,425			177,341
Provision for income taxes		3,774			13,809			37,680			71,389

	$	3,569		$	20,417		$	49,745		$	105,952

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – BUSINESS SEGMENT DATA (Continued)


	Three months ended September 30,				Nine months ended September 30,
	2006		2005		2006		2005
Rent:
Hospital division	$	32,245	$	25,366	$	88,452	$	75,327
Health services division		46,552		38,969		130,047		116,201
Rehabilitation division		932		817		2,698		2,434
Pharmacy division		1,448		1,226		4,044		3,321
Corporate		75		79		225		270

	$	81,252	$	66,457	$	225,466	$	197,553

Depreciation and amortization:
Hospital division	$	12,363	$	10,579	$	35,128	$	29,969
Health services division		10,966		7,721		30,513		22,066
Rehabilitation division		127		57		322		167
Pharmacy division		2,594		1,525		6,248		3,972
Corporate		5,996		6,034		17,509		17,678

	$	32,046	$	25,916	$	89,720	$	73,852

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	16,535	$	11,634	$	46,005	$	31,158
Health services division		12,849		14,488		29,225		32,431
Rehabilitation division		146		17		295		115
Pharmacy division		2,581		1,562		6,857		4,143
Corporate:
Information systems		5,376		5,580		16,848		11,213
Other		232		271		524		1,053

	$	37,719	$	33,552	$	99,754	$	80,113


	September 30, 2006		December 31, 2005
Assets at end of period:
Hospital division	$	750,211	$	560,767
Health services division		468,278		385,864
Rehabilitation division		10,723		7,124
Pharmacy division		227,057		188,914
Corporate		567,289		617,892

	$	2,023,558	$	1,760,561

Goodwill:
Hospital division	$	62,783	$	29,862
Pharmacy division		45,346		40,017

	$	108,129	$	69,879

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – INSURANCE RISKS

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

The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of or less than the amounts recorded. To the extent that subsequent expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited. See Note 4.

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


	Three months ended September 30,					Nine months ended September 30,
	2006		2005			2006			2005
Professional liability:
Continuing operations	$	13,539	$	17,166		$	51,820		$	53,985
Discontinued operations		2,866		(1,035	)		(8,761	)		(27,066	)

Workers compensation:
Continuing operations	$	8,918	$	11,652		$	32,845		$	36,217
Discontinued operations		327		712			1,215			2,201

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


	September 30, 2006						December 31, 2005
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	145,477	$	83,198	$	228,675	$	142,654	$	88,480	$	231,134
Reinsurance recoverables		1,908		–		1,908		2,404		–		2,404

		147,385		83,198		230,583		145,058		88,480		233,538
Non-current:
Insurance subsidiary investments		45,640		–		45,640		48,796		–		48,796
Reinsurance recoverables		8,770		–		8,770		8,186		–		8,186
Deposits		7,250		1,502		8,752		7,250		1,720		8,970
Other		–		204		204		3		102		105

		61,660		1,706		63,366		64,235		1,822		66,057

	$	209,045	$	84,904	$	293,949	$	209,293	$	90,302	$	299,595

Liabilities:
Allowance for insurance risks:
Current	$	65,521	$	25,131	$	90,652	$	70,090	$	24,707	$	94,797
Non-current		191,096		60,091		251,187		182,113		53,421		235,534

	$	256,617	$	85,222	$	341,839	$	252,203	$	78,128	$	330,331

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – INSURANCE RISKS (Continued)

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $269 million at September 30, 2006 and $266 million at December 31, 2005.

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

NOTE 13 – LEASES

The Company leases real estate and equipment under cancelable and non-cancelable arrangements. The following table sets forth rent expense by business segment (in thousands):


	Three months ended September 30,				Nine months ended September 30,
	2006		2005		2006		2005
Hospital division:
Buildings:
Ventas	$	19,522	$	15,851	$	51,933	$	47,206
Other landlords		6,486		3,628		17,904		10,881
Equipment		6,237		5,887		18,615		17,240

		32,245		25,366		88,452		75,327
Health services division:
Buildings:
Ventas		35,922		31,565		100,455		94,009
Other landlords		9,862		6,707		27,305		20,039
Equipment		768		697		2,287		2,153

		46,552		38,969		130,047		116,201
Rehabilitation division:
Buildings		19		18		57		53
Equipment		913		799		2,641		2,381

		932		817		2,698		2,434
Pharmacy division:
Buildings		1,270		1,025		3,422		2,801
Equipment		178		201		622		520

		1,448		1,226		4,044		3,321
Corporate:
Buildings		70		74		204		241
Equipment		5		5		21		29

		75		79		225		270

	$	81,252	$	66,457	$	225,466	$	197,553

Rent expense for the third quarter of 2006 included increased rents, net of deferred credit amortization, associated with the Ventas rent reset of $3.1 million in the hospital division and $3.3 million in the health services division.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 14 – STOCK-BASED COMPENSATION

The Company maintains plans under which up to ten million restricted stock awards and options to purchase common stock may be granted to officers, directors and key employees. Exercise provisions vary, but most stock options are exercisable in whole or in part beginning one to four years after grant and ending seven to ten years after grant. Shares of common stock available for future grants were 2,049,617 at September 30, 2006.

Stock options

As discussed in Note 1, the Company adopted SFAS 123R as of January 1, 2006. The fair value of each stock option is estimated at the date of grant using a Black-Scholes option valuation model with the following weighted average assumptions for the nine months ended September 30, 2006: risk-free interest rate of 4.61%; no dividend yield; expected term of five years; and volatility factors based upon the historical price of the Company’s common stock of 0.51. The expected term represents the period of time that stock options granted are expected to be outstanding. As required by SFAS 123R, an estimate of expected forfeitures was determined and compensation expense was recognized only for those stock options expected to vest. The weighted average fair value of stock options granted during the nine months ended September 30, 2006 under a Black-Scholes valuation model was $10.95.

At September 30, 2006, unearned compensation costs related to non-vested stock options aggregated $7.5 million. These costs will be expensed over the remaining weighted average vesting period of approximately two years. Compensation expense related to stock options approximated $1.9 million ($1.6 million net of income taxes or $0.04 per diluted share) for the third quarter of 2006 and $5.5 million ($4.6 million net of income taxes or $0.11 per diluted share) for the nine months ended September 30, 2006.

Activity in the various plans is summarized below:


	Shares under option		Option price per share		Weighted average exercise price
Balances, December 31, 2005	3,087,197		$	6.39 to $37.17	$	21.97
Granted	515,443			21.99 to 28.89		22.44
Exercised	(71,819	)		6.39 to 24.53		14.66
Canceled	(108,869	)		6.39 to 29.72		19.02

Balances, September 30, 2006	3,421,952		$	6.39 to $37.17	$	22.29

The intrinsic value of the stock options exercised during the nine months ended September 30, 2006 approximated $0.8 million.

A summary of stock options outstanding at September 30, 2006 follows:


	Options outstanding				Options exercisable
Range of exercise prices	Number outstanding at September 30, 2006	Weighted average remaining contractual life	Weighted average exercise price		Number exercisable at September 30, 2006	Weighted average exercise price
$ 6.39 to $11.04	560,551	7 years	$	10.55	516,501	$	10.69
$15.91 to $20.00	718,023	6 years		17.66	662,023		17.48
$21.99 to $29.72	1,312,170	7 years		24.22	533,482		25.57
$30.42 to $37.17	831,208	6 years		31.18	831,208		31.18

	3,421,952	6 years	$	22.29	2,543,214	$	22.27

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 14 – STOCK-BASED COMPENSATION (Continued)

Stock options (Continued)

The intrinsic value of the stock options outstanding and stock options that are exercisable as of September 30, 2006 approximated $26.7 million and $20.2 million, respectively.

Restricted stock

At September 30, 2006, unearned compensation costs related to non-vested restricted stock aggregated $11.4 million. These costs will be expensed over the remaining weighted average vesting period of approximately three years. Compensation expense related to these awards approximated $2.5 million ($1.5 million net of income taxes or $0.04 per diluted share) for the third quarter of 2006 and $8.9 million ($5.4 million net of income taxes or $0.13 per diluted share) for the nine months ended September 30, 2006 and $2.7 million ($1.6 million net of income taxes or $0.04 per diluted share) for the third quarter of 2005 and $6.6 million ($4.0 million net of income taxes or $0.09 per diluted share) for the nine months ended September 30, 2005.

A summary of non-vested restricted shares follows:


	Non-vested restricted shares		Weighted average fair value at date of grant
Balances, December 31, 2005	890,216		$	26.05
Granted	274,650			21.99
Vested	(356,880	)		21.79

Balances, September 30, 2006	807,986		$	26.55

NOTE 15 – CONTINGENCIES

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

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

Principal contingencies are described below:

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

Professional liability risks – The Company has provided for loss for professional liability risks based upon actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Notes 4 and 12.

Income taxes – The IRS has proposed certain adjustments to the Company’s 2000 and 2001 federal income tax returns which the Company is contesting. The principal proposed adjustment relates to the manner of reduction of the Company’s tax attributes, primarily its net operating loss carryforwards (“NOLs”), in connection with the Company’s emergence from bankruptcy in 2001. These proposed adjustments could have the effect of substantially eliminating the Company’s NOLs.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 15 – CONTINGENCIES (Continued)

Litigation – The Company is a party to certain material litigation as well as various suits and claims arising in the ordinary course of business. See Note 16.

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

NOTE 16 – LITIGATION

A summary description of significant litigation follows.

A shareholder derivative suit entitled Thomas G. White on behalf of Vencor, Inc. and Ventas, Inc. v. W. Bruce Lunsford, et al., Case No. 98CI03669, was filed on July 2, 1998 in the Jefferson County, Kentucky, Circuit Court. The suit was brought on behalf of the Company and Ventas against certain former executive officers and directors of the Company and Ventas. The complaint alleges that the defendants damaged the Company and Ventas by engaging in violations of the securities laws, engaging in insider trading, fraud and securities fraud and damaging the reputation of the Company and Ventas. The plaintiff asserts that such actions were taken deliberately, in bad faith and constitute breaches of the defendants’ duties of loyalty and due care. The suit seeks unspecified damages, interest, punitive damages, reasonable attorneys’ fees, expert witness fees and other costs, and any extraordinary equitable and/or injunctive relief permitted by law or equity to assure that the Company and Ventas have an effective remedy. In October 2002, the defendants filed a motion to dismiss for failure to prosecute the case. The court granted the motion to dismiss but the plaintiff subsequently moved the court to vacate the dismissal. The defendants filed an opposition to the plaintiff’s motion to vacate the dismissal, but in August 2003 the court reinstated the lawsuit. In September 2003, the Company filed a renewed motion to dismiss, as to all defendants, based upon the plaintiff’s failure to make a demand for remedy upon the appropriate board of directors. On July 26, 2005, the court granted defendants’ motion to dismiss based upon the plaintiff’s failure to make a statutorily required demand for remedy upon the appropriate board of directors. On August 25, 2005, the plaintiff filed an appeal with the Court of Appeals of Kentucky. By a decision dated September 24, 2006, the Kentucky Court of Appeals ordered the dismissal of this case with prejudice. This decision is final since the appeal period has expired.

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

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

Cautionary Statement

This Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements regarding the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities, plans and objectives of management and statements containing the words such as “anticipate,” “approximate,” “believe,” “plan,” “estimate,” “expect,” “project,” “could,” “should,” “will,” “intend,” “may” and other similar expressions, are forward-looking statements.

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

•

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

•

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

•

the Company’s and AmerisourceBergen’s ability to complete the proposed merger of their respective institutional pharmacy operations, including the receipt of all required regulatory approvals and the satisfaction of other closing conditions to the proposed transaction,

•

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

•

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

•

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

•

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

•

changes in the reimbursement rates or methods of payment from third party payors, including the Medicare and Medicaid programs, changes arising from and related to the Medicare prospective payment system for LTAC hospitals (“LTAC PPS”), including the final Medicare payment rules issued in May 2006, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“Medicare Part D”), and changes in Medicare and Medicaid reimbursements for the Company’s nursing centers,

•

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

•

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

•

the Company’s ability to successfully pursue its development activities and successfully integrate new operations, including the realization of anticipated revenues, economies of scale, cost savings and productivity gains associated with such operations,

•

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

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

Cautionary Statement (Continued)

•

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

•

the Company’s ability to successfully dispose of unprofitable facilities, and

•

the Company’s ability to ensure and maintain an effective system of internal controls over financial reporting.

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

General

The quarterly adjustment information in Note 5 and the business segment data in Note 11 should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that through its subsidiaries operates hospitals, nursing centers, a contract rehabilitation services business and institutional pharmacies across the United States. At September 30, 2006, the Company’s hospital division operated 80 LTAC hospitals (6,359 licensed beds) in 24 states. The Company’s health services division operated 242 nursing centers (30,679 licensed beds) in 28 states. The Company operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings. The Company’s pharmacy division operated an institutional pharmacy business with 45 pharmacies in 26 states and a pharmacy management business servicing substantially all of the Company’s hospitals.

On October 25, 2006, the Company signed a definitive agreement with AmerisourceBergen to combine their respective institutional pharmacy businesses, KPS and PharMerica LTC, into a new, independent, publicly traded company. See Note 2.

Critical Accounting Policies

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

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

Critical Accounting Policies (Continued)

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

Revenue recognition

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

Operating results included income related to the favorable settlement of prior year hospital Medicare cost reports that aggregated $5 million for the third quarter of 2005, and $6 million and $63 million for the nine months ended September 30, 2006 and 2005, respectively.

Operating results for the nine months ended September 30, 2005 included pretax income of $16 million ($31 million of revenues less $15 million of provider taxes classified as operating expenses) related to retroactive nursing center Medicaid rate increases in the state of Indiana, of which approximately $2 million related to the first quarter of 2005 and approximately $14 million related to prior years.

See Note 8 for a summary of the Company’s revenues.

Collectibility of accounts receivable

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

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

The provision for doubtful accounts totaled $10 million and $4 million for the third quarter of 2006 and 2005, respectively, and totaled $28 million and $12 million for the nine months ended September 30, 2006 and 2005, respectively.

Allowances for insurance risks

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

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of or less than the amounts recorded. To the extent that subsequent expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited.

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks aggregated $257 million at September 30, 2006 and $252 million at December 31, 2005. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $269 million at September 30, 2006 and $266 million at December 31, 2005.

As a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary, the Company received a return of capital of $34 million and $30 million during the nine months ended September 30, 2006 and 2005, respectively, from its limited purpose insurance subsidiary. These proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

Changes in the number of professional liability claims and the increasing cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and ultimate actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at September 30, 2006 would impact the Company’s operating income by approximately $3 million. The Company recorded favorable pretax adjustments of $0.4 million and $4 million for the third quarter of 2006 and 2005, respectively, and $17 million and $37 million for the nine months ended September 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas (included in discontinued operations).

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $14 million and $17 million for the third quarter of 2006 and 2005, respectively, and $52 million and $54 million for the nine months ended September 30, 2006 and 2005, respectively.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $85 million at September 30, 2006 and $78 million at December 31, 2005. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $9 million and $11 million for the third quarter of 2006 and 2005, respectively, and $33 million and $36 million for the nine months ended September 30, 2006 and 2005, respectively.

See Note 12 for a summary of the Company’s insurance activities.

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

Critical Accounting Policies (Continued)

Accounting for income taxes

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

The effective income tax rate for the third quarter of 2006 was 51.4% compared to 40.3% for the third quarter of 2005. Operating results in the third quarter of 2006 included a charge of approximately $1 million related to a change in estimate of the Company’s annual effective income tax rate. The effective income tax rate for the nine months ended September 30, 2006 was 43.1% compared to 40.3% for the same period a year ago.

There are significant uncertainties with respect to professional liability costs, future government payments to both the Company’s hospitals and nursing centers and the outcome of income tax examinations which, among other things, could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized and a valuation allowance is provided for deferred tax assets to the extent the realizability of the deferred tax assets is unlikely. The Company recognized deferred tax assets totaling $159 million at September 30, 2006 and $135 million at December 31, 2005.

In November 2004, the IRS proposed certain adjustments to the Company’s 2000 and 2001 federal income tax returns. The principal proposed adjustment relates to the manner of reduction of the Company’s tax attributes, primarily its NOLs, in connection with the Company’s emergence from bankruptcy in 2001. These proposed adjustments could have the effect of substantially eliminating the Company’s NOLs. However, the Company is vigorously contesting the proposed adjustments with the IRS appeals division. Management believes that the ultimate resolution of these disputes will not have a material effect on the Company’s financial position, results of operations or liquidity.

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

Valuation of long-lived assets and goodwill

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

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

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

Critical Accounting Policies (Continued)

Valuation of long-lived assets and goodwill (Continued)

the Company’s ability to renew the lease or divest a particular property), the Company defines the group of facilities under a master lease as the lowest level for which there are independent, identifiable cash flows. Accordingly, the estimated cash flows of all facilities within a master lease are aggregated for purposes of evaluating the carrying values of long-lived assets.

In connection with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company is required to perform an impairment test for goodwill at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company performs its annual impairment test at the end of each year. No impairment charge was recorded at December 31, 2005 in connection with the annual impairment test.

Recent Developments

CMS issued final regulatory changes regarding Medicare reimbursement to LTAC hospitals (the “Hospital Medicare Rule”) on May 2, 2006. Based upon the Company’s historical Medicare patient volumes, the Company expects that the Hospital Medicare Rule will reduce Medicare revenues to the Company’s hospitals associated with short stay outliers and high cost outliers by approximately $46 million on an annual basis. This estimate does not include the negative impact resulting from the elimination of the annual market basket adjustment to the Medicare payment rates that also is contained in the Hospital Medicare Rule. The annual market basket adjustment has typically ranged between 3% and 4%, or approximately $25 million to $30 million annually. The Hospital Medicare Rule became effective for discharges occurring after June 30, 2006. The Hospital Medicare Rule also extends until July 1, 2008 CMS’s authority to impose a one-time prospective budget neutrality adjustment to LTAC hospital rates. This authority was scheduled to expire on October 1, 2006.

On August 1, 2006, CMS issued the final rule to reweight LTAC hospital diagnosis related groups (“DRGs”), among other things, beginning October 1, 2006 for the Company. CMS estimates that the effect of the proposal would decrease Medicare reimbursements to LTAC hospitals by an additional 1.3%. Based upon the Company’s historical Medicare patient volumes, the Company expects the revised DRG reweighting will reduce Medicare revenues to the Company’s hospitals by approximately $6 million to $8 million on an annual basis.

Results of Operations – Continuing Operations

Hospital Division

Revenues increased 4% to $407 million in the third quarter of 2006 from $389 million in the same period a year ago and 5% to $1.3 billion for the nine months ended September 30, 2006 from $1.2 billion in the same period a year ago. Revenue growth was primarily a result of new hospital development and the Commonwealth Acquisition. Revenues associated with the Commonwealth Acquisition approximated $27 million and $67 million in the third quarter and nine months ended September 30, 2006, respectively. Revenues for the nine months ended September 30, 2005 also included $63 million of favorable prior year Medicare cost report settlements.

Admissions rose 5% in the third quarter of 2006 and 8% for the nine months ended September 30, 2006 compared to the respective prior year periods. On a same-store basis, total admissions declined 3% in the third quarter of 2006 and increased 1% for the nine months ended September 30, 2006 compared to the respective prior year periods. Medicare same-store admissions declined 9% in the third quarter of 2006 and declined 3% for the nine months ended September 30, 2006 compared to the respective prior year periods.

Hospital wage and benefit costs increased 12% to $192 million in the third quarter of 2006 from $171 million in the same period a year ago and 11% to $570 million for the nine months ended September 30,

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

Results of Operations – Continuing Operations (Continued)

Hospital Division (Continued)

2006 from $514 million in the same period last year. Average hourly wage rates grew 3% in both the third quarter and nine months ended September 30, 2006 compared to the same periods a year ago, while employee benefit costs increased 11% in the third quarter of 2006 and 10% for the nine months ended September 30, 2006 compared to the same periods a year ago.

Professional liability costs were $5 million in the third quarter of both 2006 and 2005 and $16 million for the nine-month periods ended September 30, 2006 and 2005.

Hospital operating income declined 18% to $75 million in the third quarter of 2006 from $91 million a year ago and declined 13% to $284 million for the nine months ended September 30, 2006 from $327 million a year ago. The reduction in hospital operating income in the third quarter of 2006 was primarily attributable to the Hospital Medicare Rule, lower Medicare admissions and operating inefficiencies associated with reduced volume levels. Hospital operating results for the nine months ended September 30, 2005 were favorably impacted by $63 million of prior year Medicare cost report settlements. Aggregate operating costs per admission increased 6% in the third quarter and 3% for the nine months ended September 30, 2006 compared to the corresponding prior year periods. Operating income associated with the Commonwealth Acquisition approximated $1 million and $5 million in the third quarter and nine months ended September 30, 2006, respectively.

Health Services Division

Revenues increased 13% to $499 million in the third quarter of 2006 from $442 million in the same period a year ago and 9% to $1.5 billion for the nine months ended September 30, 2006 from $1.3 billion in the same period last year. Revenue growth was primarily a result of generally favorable reimbursement rates, an increase in patient days and the Commonwealth Acquisition. Aggregate patient days increased 8% in the third quarter of 2006 and 6% for the nine months ended September 30, 2006 compared to the respective prior year periods. On a same-store basis, aggregate patient days increased 1% in both the third quarter and nine months ended September 30, 2006 compared to the same prior year periods. Revenues associated with the Commonwealth Acquisition approximated $32 million and $73 million in the third quarter and nine months ended September 30, 2006, respectively.

Nursing center wage and benefit costs increased 12% to $266 million in the third quarter of 2006 from $238 million in the same period a year ago and 10% to $773 million for the nine months ended September 30, 2006 from $705 million in the same period a year ago. Average hourly wage rates increased 4% in both the third quarter and nine months ended September 30, 2006 compared to the respective prior year periods, while employee benefit costs increased 8% for the third quarter and 6% for the nine months ended September 30, 2006 compared to the respective prior year periods.

Professional liability costs were $9 million and $11 million in the third quarter of 2006 and 2005, respectively, and $35 million and $37 million for the nine months ended September 30, 2006 and 2005, respectively.

Nursing center operating income increased 27% to $62 million in the third quarter of 2006 from $49 million in the same period a year ago and increased 6% to $173 million for the nine months ended September 30, 2006 from $163 million in the same period a year ago. Aggregate operating costs per patient day increased 3% in the third quarter of 2006 and 4% for the nine months ended September 30, 2006 compared to the respective prior year periods. Nursing center operating income in the third quarter and nine months ended September 30, 2006

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

Results of Operations – Continuing Operations (Continued)

Health Services Division (Continued)

increased primarily due to improved reimbursement rates and increases in patient days (particularly Medicare, private and other patient days). Operating income associated with the Commonwealth Acquisition approximated $3 million and $7 million in the third quarter and nine months ended September 30, 2006, respectively.

Rehabilitation Division

Revenues increased 16% to $76 million in the third quarter of 2006 from $66 million in the same period a year ago and 13% to $221 million for the nine months ended September 30, 2006 from $196 million in the same period a year ago. The increase in revenues in both periods was primarily attributable to price increases and growth in the volume of services provided to existing customers.

Operating income increased 12% in the third quarter of 2006 from the same period a year ago and declined 12% for the nine months ended September 30, 2006 from the same period a year ago. Operating income for the nine months ended September 30, 2006 included a pretax charge of approximately $3 million related primarily to revisions to prior estimates for accrued contract labor costs. Operating income in 2006 also was negatively impacted by increased costs associated with wage rate pressures resulting from an increasingly competitive marketplace for therapists.

Pharmacy Division

Revenues increased 26% to $171 million in the third quarter of 2006 from $135 million in the same period a year ago and 30% to $488 million for the nine months ended September 30, 2006 from $375 million in the same period a year ago due primarily to acquisitions, price increases and higher drug utilization. Revenues associated with pharmacy acquisitions completed in 2006 and 2005 approximated $42 million and $119 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $25 million and $53 million for the respective prior year periods. At September 30, 2006, the Company provided pharmacy services to nursing centers containing 102,500 licensed beds, including 30,200 licensed beds that it operates. At September 30, 2005, the Company provided pharmacy services to nursing centers containing 83,900 licensed beds, including 28,700 licensed beds that it operates.

On January 1, 2006, Medicare Part D became effective. Under this program, Medicare beneficiaries who were entitled to benefits under a state Medicaid program (so-called “dual eligibles”) now have their outpatient prescription drug costs covered by Medicare Part D, subject to certain limitations. Most of the Company’s nursing center residents whose drug costs were previously covered by state Medicaid programs are dual eligibles who qualify for the Medicare Part D drug benefit. Accordingly, since January 1, 2006, Medicaid is no longer a primary payor for the pharmacy services provided to these residents. In fiscal 2005, the Company’s pharmacy division derived approximately 45% of its revenues from the state Medicaid programs.

Pharmacy operating income increased 12% to $16 million in the third quarter of 2006 from $14 million in the same period a year ago and 22% to $48 million for the nine months ended September 30, 2006 from $39 million in the same period a year ago. Operating margins were 9.5% and 9.8% in the third quarter and nine months ended September 30, 2006, respectively, compared to 10.7% and 10.5% in the same prior year periods. The cost of goods sold as a percentage of institutional pharmacy revenues were 63.6% and 64.6% in the third quarter and nine months ended September 30, 2006, respectively, compared to 65.9% and 65.3% in the same prior year periods. Pharmacy operating income in both periods increased from the same periods last year primarily due to acquisitions and volume growth. Operating income associated with pharmacy acquisitions completed in 2006 and 2005 approximated $4 million and $10 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $2 million and $5 million for the respective prior year periods.

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

Results of Operations – Continuing Operations (Continued)

Corporate Overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $38 million and $118 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $33 million and $100 million for the respective prior year periods. Corporate overhead as a percentage of consolidated revenues totaled 3.6% and 3.7% in the third quarter and nine months ended September 30, 2006, respectively, compared to 3.4% and 3.5% in the same prior year periods. The increase in corporate overhead in the third quarter and nine months ended September 30, 2006 compared to the same periods last year was primarily attributable to increases in stock-based compensation and certain incentive compensation costs.

Corporate expenses included the operating losses of the Company’s limited purpose insurance subsidiary of $1 million and $5 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $3 million and $8 million for the respective prior year periods.

Reorganization Items

Transactions related to the Company’s emergence from bankruptcy have been classified separately in the unaudited condensed consolidated statement of operations. Operating results for the nine months ended September 30, 2005 included income of approximately $1 million resulting from changes in estimates for accrued professional and administrative costs related to the Company’s emergence from bankruptcy.

Capital Costs

Rent expense increased 22% to $82 million in the third quarter of 2006 from $67 million in the same period a year ago and 14% to $226 million for the nine months ended September 30, 2006 from $198 million in the same period a year ago. A substantial portion of the increase resulted from the Ventas rent reset in the third quarter of 2006, acquisition and development activities, and contractual inflation increases, including those associated with the Master Leases. See Note 3.

Depreciation and amortization expense increased 24% to $31 million in the third quarter of 2006 from $26 million in the same period a year ago and 21% to $89 million for the nine months ended September 30, 2006 from $74 million in the same period a year ago. The increase was primarily a result of the Company’s ongoing capital expenditure program and acquisition and development activities.

Interest expense increased to $5 million in the third quarter of 2006 from $2 million in the same period a year ago and to $11 million for the nine months ended September 30, 2006 from $6 million in the same period a year ago. The increase was primarily a result of increased borrowings under the Company’s revolving credit facility as a result of the Commonwealth Acquisition.

Investment income, related primarily to the Company’s excess cash balances and insurance subsidiary investments, approximated $3 million and $10 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $3 million and $8 million for the respective prior year periods.

Consolidated Results

Income from continuing operations before income taxes declined 79% to $7 million in the third quarter of 2006 from $34 million in the same period a year ago and 51% to $87 million for the nine months ended September 30, 2006

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

Results of Operations – Continuing Operations (Continued)

Consolidated Results (Continued)

from $177 million in the same period a year ago. Net income from continuing operations declined 83% to $4 million in the third quarter of 2006 from $21 million in the same period a year ago and 53% to $50 million for the nine months ended September 30, 2006 from $106 million in the same period a year ago. See Note 5.

Discontinued Operations

Net loss from discontinued operations aggregated $1 million in the third quarter of both 2006 and 2005. Net income from discontinued operations aggregated $7 million for the nine months ended September 30, 2006 compared to $14 million for the same period a year ago. Net income from discontinued operations included favorable pretax adjustments of $0.4 million and $4 million for the third quarter of 2006 and 2005, respectively, and $17 million and $37 million for the nine months ended September 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas. See Notes 4 and 12.

Liquidity

Cash flows from operations (including discontinued operations) aggregated $41 million for the nine months ended September 30, 2006 compared to $107 million for the same period a year ago. During both periods, the Company maintained sufficient liquidity to fund its ongoing capital expenditure program and finance acquisitions.

Cash and cash equivalents totaled $13 million at September 30, 2006 compared to $83 million at December 31, 2005. Based upon the Company’s existing cash levels, expected operating cash flows and capital spending (including planned acquisitions), and the availability of borrowings under the Company’s revolving credit facility, management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.

Long-term debt at September 30, 2006 aggregated $174 million (including $173 million of borrowings under the Company’s revolving credit facility). The Company expects to continue to utilize its revolving credit facility in 2006 to fund working capital and development needs. The Company was in compliance with the terms of its $400 million revolving credit facility at September 30, 2006.

Over the last few years, the Company’s limited purpose insurance subsidiary has achieved improved professional liability underwriting results. As a result, the Company received a return of capital of $34 million and $30 million during the nine months ended September 30, 2006 and 2005, respectively, from its limited purpose insurance subsidiary. These proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

The Company’s Series A warrants and Series B warrants expired on April 20, 2006. In connection with the exercise of these warrants, the Company issued approximately 10.1 million shares of common stock and received net proceeds of approximately $142 million. These proceeds were used to repurchase approximately 5.8 million shares of the Company’s common stock in the open market during the second quarter of 2006.

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

Liquidity (Continued)

During the past several years, the Company’s federal income tax payments have been significantly reduced primarily as a result of certain income tax benefits arising in connection with the Company’s reorganization, including the utilization of NOLs. Beginning in 2006, the Company expects that cash payments of federal income taxes will more closely reflect the Company’s provision for income taxes. Accordingly, the Company’s operating cash flows in 2006 may decline from the levels reported in 2005. Operating cash flows for the nine months ended September 30, 2006 included $44 million of federal income tax payments compared to $1 million in the same period a year ago.

As previously discussed, the Company is contesting certain proposed adjustments by the IRS to its 2000 and 2001 federal income tax returns related primarily to its NOLs.

On October 12, 2006, Ventas exercised a one-time right to reset rent under each of the four Master Leases. These new aggregate annual rents of approximately $239 million became effective retroactively to July 19, 2006 and were determined as fair market rentals by the final independent appraisers engaged in connection with the rent reset process under the four Master Leases. Aggregate annual Ventas rents prior to the rent reset approximated $206 million. As required, Ventas paid the Company a reset fee of approximately $5 million which will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases. In connection with the exercise of the rent reset, the new annual rents were allocated among the facilities subject to the Master Leases in accordance with the determinations made by the final appraisers during the rent reset process. The new contingent annual rent escalator will be 2.7% for Master Leases 1, 3 and 4. The escalator for Master Lease 2 is based upon the CPI with a floor of 2.25% and a ceiling of 4%. Prior to the rent reset, the contingent annual Ventas rent escalator under each Master Lease was 3.5%.

In 2003, the Company had agreed to pay Ventas additional rents in varying amounts generally over seven years in consideration for the divestiture of the Company’s former Florida and Texas nursing centers. For accounting purposes, these additional rent payments were classified as long-term debt. As a result of the rent reset, the remaining obligations under the 2003 agreement were extinguished. For accounting purposes, the Company’s remaining debt obligation to Ventas of $28 million as of July 18, 2006 has been reclassified as a deferred credit in the accompanying unaudited condensed consolidated balance sheet and will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases.

On August 8, 2006, the Company entered into definitive agreements with HCP to acquire the real estate related to 11 unprofitable leased nursing centers operated by the Company for resale in exchange for three hospitals currently owned by the Company. As part of the transaction, the Company will continue to operate the hospitals under a long-term lease arrangement with HCP. In addition, the Company will pay HCP a one-time cash payment of approximately $36 million. The Company also will amend its existing master lease with HCP to (1) terminate the current annual rent of approximately $10 million on the 11 nursing centers, (2) add the three hospitals to the master lease with a current annual rent of approximately $6 million and (3) extend the initial expiration date of the master lease until September 30, 2016. The HCP transaction is subject to the receipt of required approvals and the satisfaction of several conditions to closing.

On November 7, 2006, the Company entered into a definitive agreement to sell the real estate and related operations of these 11 nursing centers for $78 million. The transaction to sell these 11 nursing centers is subject to the receipt of required approvals and the satisfaction of several conditions to closing, including without limitation, the successful closing of the HCP transaction.

Capital Resources

Excluding acquisitions, capital expenditures totaled $100 million in the nine months ended September 30, 2006 compared to $80 million for the same period a year ago. Excluding acquisitions, capital expenditures could

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

Capital Resources (Continued)

approximate $140 million to $150 million in 2006. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. The Company’s capital expenditure program is financed generally through the use of internally generated funds. At September 30, 2006, the estimated cost to complete and equip construction in progress approximated $99 million.

The Commonwealth Acquisition was financed primarily through borrowings under the Company’s revolving credit facility.

During the third quarter of 2006, the Company acquired three institutional pharmacies for an aggregate cost of $15 million. During the first nine months of 2005, the Company acquired a hospital and completed both the PPI Acquisition and the SCP Acquisition. The Company financed these acquisitions through the use of operating cash flows and borrowings under the revolving credit facility.

The revolving credit facility includes certain covenants which limit the Company’s acquisitions and annual capital expenditures. At September 30, 2006, the Company’s remaining permitted acquisition amount under its revolving credit facility aggregated $219 million.

Other Information

Effects of Inflation and Changing Prices

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

The Company’s hospitals operate under LTAC PPS. Operating results under this system are subject to changes in patient acuity and expense levels in the Company’s hospitals. These factors, among others, are subject to significant change. Slight variations in patient acuity could significantly change Medicare revenues generated under LTAC PPS. In addition, the Company’s hospitals may not be able to appropriately adjust their operating costs as patient acuity levels change. Under this system, Medicare reimbursements to the Company’s hospitals are based upon a fixed payment system. Operating margins in the hospital division could be negatively impacted if the Company is unable to control the operating costs of the division. As a result of these uncertainties, the Company cannot predict the ultimate long-term impact of LTAC PPS on its hospital operating results and the Company can provide no assurances that such regulations or operational changes resulting from these regulations will not have a material adverse impact on its financial position, results of operations or liquidity. In addition, the Company can provide no assurances that LTAC PPS will not have a material adverse effect on revenues from private and commercial third party payors. Various factors, including a reduction in average length of stay, have had a negative impact on revenues from private and commercial third party payors.

LTAC PPS maintains LTAC hospitals as a distinct provider type, separate from short-term acute care hospitals. Only providers certified as LTAC hospitals may be paid under this system. To maintain certification under LTAC PPS, the average length of stay of Medicare patients must be at least 25 days. Under the previous system, compliance with the 25-day average length of stay threshold was based upon all patient discharges.

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

Other Information (Continued)

Effects of Inflation and Changing Prices (Continued)

CMS is currently evaluating various certification criteria for designating a hospital as a LTAC hospital. If such certification criteria were developed and enacted into legislation, the Company’s hospitals may not be able to maintain their status as LTAC hospitals or may need to adjust their operations.

Medicare payments to the Company’s nursing centers are based upon certain resource utilization grouping (“RUG”) payment rates developed by CMS that provide various levels of reimbursement based upon patient acuity. Beginning January 1, 2006, CMS increased the indexing of RUG categories, expanded the total RUG categories from 44 to 53 and eliminated the 20% payment add-on for the care of higher acuity patients that had been in effect since 2000 under the Balanced Budget Refinement Act of 2000.

On February 1, 2006, Congress passed the Deficit Reduction Act of 2005. This legislation allows, among other things, an annual $1,740 Medicare Part B outpatient therapy cap which went into effect on January 1, 2006. The legislation also requires CMS to implement a broad process for reviewing medically necessary therapy claims, creating an exception to the cap. The exception legislation is scheduled to expire on December 31, 2006.

In January 2005, CMS issued final regulations on Medicare Part D which became effective on January 1, 2006. Medicare beneficiaries who were entitled to benefits under a state Medicaid program (so-called “dual eligibles”) now have their outpatient prescription drug costs covered by Medicare Part D, subject to certain limitations. Most of the Company’s nursing center residents whose drug costs were previously covered by state Medicaid programs are dual eligibles who qualify for the Medicare Part D drug benefit. Accordingly, since January 1, 2006, Medicaid is no longer a primary payor for the pharmacy services provided to these residents.

At this time, the Company cannot assess the overall impact of Medicare Part D on its institutional pharmacy business. The impact of this legislation depends upon a variety of factors, including the Company’s ongoing relationships with the Part D plans and the patient mix of the Company’s customers. This legislation may reduce revenue and impose additional costs to the industry, particularly in the transition phase. In addition, there can be no assurance that Medicare Part D and the regulations promulgated under Medicare Part D will not have a material adverse effect on the Company’s institutional pharmacy business.

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

Litigation

The Company is a party to certain material litigation. See Note 16.

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

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)


	2005 Quarters												2006 Quarters
	First			Second			Third			Fourth			First			Second			Third
Revenues	$	913,128		$	1,017,106		$	951,265		$	971,476		$	1,030,730		$	1,073,994		$	1,058,892

Salaries, wages and benefits		498,882			525,089			520,875			526,474			562,461			582,354			589,753
Supplies		126,495			144,110			144,914			154,660			163,583			167,609			170,815
Rent		64,749			66,347			66,457			67,080			69,293			74,921			81,252
Other operating expenses		144,952			170,869			159,417			155,957			170,910			176,789			176,546
Depreciation and amortization		23,252			24,684			25,916			27,130			27,846			29,828			32,046
Interest expense		2,000			2,439			1,931			1,728			2,649			3,534			4,667
Investment income		(2,347	)		(3,031	)		(2,471	)		(3,210	)		(3,691	)		(3,444	)		(3,530	)

		857,983			930,507			917,039			929,819			993,051			1,031,591			1,051,549

Income from continuing operations before reorganization items and income taxes		55,145			86,599			34,226			41,657			37,679			42,403			7,343
Reorganization items		(1,371	)		–			–			(268	)		–			–			–

Income from continuing operations before income taxes		56,516			86,599			34,226			41,925			37,679			42,403			7,343
Provision for income taxes		22,787			34,793			13,809			16,486			15,743			18,163			3,774

Income from continuing operations		33,729			51,806			20,417			25,439			21,936			24,240			3,569
Discontinued operations, net of income taxes:
Income (loss) from operations		3,161			11,614			(916	)		1,040			1,866			5,741			(757	)
Gain (loss) on divestiture of operations		–			2,647			(3,147	)		(881	)		157			(308	)		126

Net income	$	36,890		$	66,067		$	16,354		$	25,598		$	23,959		$	29,673		$	2,938

Earnings per common share:
Basic:
Income from continuing operations	$	0.93		$	1.38		$	0.54		$	0.68		$	0.60		$	0.58		$	0.09
Discontinued operations:
Income (loss) from operations		0.09			0.31			(0.03	)		0.03			0.05			0.14			(0.02	)
Gain (loss) on divestiture of operations		–			0.07			(0.08	)		(0.03	)		–			(0.01	)		–

Net income	$	1.02		$	1.76		$	0.43		$	0.68		$	0.65		$	0.71		$	0.07

Diluted:
Income from continuing operations	$	0.76		$	1.12		$	0.45		$	0.58		$	0.53		$	0.57		$	0.09
Discontinued operations:
Income (loss) from operations		0.07			0.25			(0.02	)		0.03			0.05			0.13			(0.02	)
Gain (loss) on divestiture of operations		–			0.06			(0.07	)		(0.02	)		–			(0.01	)		–

Net income	$	0.83		$	1.43		$	0.36		$	0.59		$	0.58		$	0.69		$	0.07

Shares used in computing earnings per common share:
Basic		36,312			37,495			38,013			37,472			36,576			41,695			39,014
Diluted		44,410			46,367			46,033			43,736			41,091			42,956			39,769

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

Operating Data

(Unaudited)

(In thousands)


	2005 Quarters												2006 Quarters
	First			Second			Third			Fourth			First			Second			Third
Revenues:
Hospital division	$	393,040		$	434,562		$	389,776		$	390,742		$	430,814		$	439,308		$	406,923
Health services division		423,605			463,740			441,937			450,727			460,038			493,067			499,072
Rehabilitation division		64,947			65,365			65,553			66,908			71,162			74,376			76,003
Pharmacy division		107,957			131,849			135,165			147,254			157,214			159,926			170,443

		989,549			1,095,516			1,032,431			1,055,631			1,119,228			1,166,677			1,152,441
Eliminations:
Rehabilitation		(47,231	)		(47,906	)		(49,779	)		(50,409	)		(53,975	)		(57,071	)		(57,019	)
Pharmacy		(29,190	)		(30,504	)		(31,387	)		(33,746	)		(34,523	)		(35,612	)		(36,530	)

		(76,421	)		(78,410	)		(81,166	)		(84,155	)		(88,498	)		(92,683	)		(93,549	)

	$	913,128		$	1,017,106		$	951,265		$	971,476		$	1,030,730		$	1,073,994		$	1,058,892

Income from continuing operations:
Operating income (loss):
Hospital division	$	101,801		$	134,263		$	90,728		$	92,754		$	104,064		$	105,307		$	74,793	(a)
Health services division		51,301			63,157			48,286			53,771			47,925			63,297			61,293
Rehabilitation division		9,711			6,989			7,913			7,439			4,239			8,453			8,857
Pharmacy division		11,454			13,298			14,455			17,630			16,729			15,139			16,152	(b)
Corporate:
Overhead		(29,115	)		(38,052	)		(32,631	)		(34,716	)		(37,334	)		(43,257	)		(37,683	) (c)(d)
Insurance subsidiary		(2,353	)		(2,617	)		(2,692	)		(2,493	)		(1,847	)		(1,697	)		(1,634	)

		(31,468	)		(40,669	)		(35,323	)		(37,209	)		(39,181	)		(44,954	)		(39,317	)

		142,799			177,038			126,059			134,385			133,776			147,242			121,778
Reorganization items		1,371			–			–			268			–			–			–

Operating income		144,170			177,038			126,059			134,653			133,776			147,242			121,778
Rent		(64,749	)		(66,347	)		(66,457	)		(67,080	)		(69,293	)		(74,921	)		(81,252	)
Depreciation and amortization		(23,252	)		(24,684	)		(25,916	)		(27,130	)		(27,846	)		(29,828	)		(32,046	)
Interest, net		347			592			540			1,482			1,042			(90	)		(1,137	)

Income from continuing operations before income taxes		56,516			86,599			34,226			41,925			37,679			42,403			7,343
Provision for income taxes		22,787			34,793			13,809			16,486			15,743			18,163			3,774

	$	33,729		$	51,806		$	20,417		$	25,439		$	21,936		$	24,240		$	3,569

(a)	Includes income of $1.0 million related to an insurance recovery.

(b)	Includes costs of $1.1 million incurred in connection with the planned spin-off of the Company’s institutional pharmacy business.

(c)	Includes costs of $2.4 million incurred in connection with the planned spin-off of the Company’s institutional pharmacy business and professional fees incurred in connection with the rent reset issue with Ventas.

(d)	Includes income of $0.3 million related to a favorable adjustment of a prior year tax dispute.

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

Operating Data (Continued)

(Unaudited)

(In thousands)


	2005 Quarters								2006 Quarters
	First		Second		Third		Fourth		First		Second		Third
Rent:
Hospital division	$	24,717	$	25,244	$	25,366	$	25,529	$	26,619	$	29,588	$	32,245
Health services division		38,239		38,993		38,969		39,039		40,447		43,048		46,552
Rehabilitation division		800		817		817		809		869		897		932
Pharmacy division		926		1,169		1,226		1,614		1,280		1,316		1,448
Corporate		67		124		79		89		78		72		75

	$	64,749	$	66,347	$	66,457	$	67,080	$	69,293	$	74,921	$	81,252

Depreciation and amortization:
Hospital division	$	9,554	$	9,836	$	10,579	$	10,979	$	11,107	$	11,658	$	12,363
Health services division		6,960		7,385		7,721		8,396		9,287		10,260		10,966
Rehabilitation division		54		56		57		64		80		115		127
Pharmacy division		926		1,521		1,525		1,779		1,797		1,857		2,594
Corporate		5,758		5,886		6,034		5,912		5,575		5,938		5,996

	$	23,252	$	24,684	$	25,916	$	27,130	$	27,846	$	29,828	$	32,046

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	8,235	$	11,289	$	11,634	$	14,145	$	15,365	$	14,105	$	16,535
Health services division		6,957		10,986		14,488		17,915		5,225		11,151		12,849
Rehabilitation division		2		96		17		538		19		130		146
Pharmacy division		1,075		1,506		1,562		2,820		2,057		2,219		2,581
Corporate:
Information systems		1,462		4,171		5,580		9,191		2,514		8,958		5,376
Other		232		550		271		1,341		115		177		232

	$	17,963	$	28,598	$	33,552	$	45,950	$	25,295	$	36,740	$	37,719

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

Operating Data (Continued)

(Unaudited)


	2005 Quarters								2006 Quarters
	First		Second		Third		Fourth		First		Second		Third
Hospital data:
End of period data:
Number of hospitals		73		73		73		74		80		80		80
Number of licensed beds		5,603		5,603		5,603		5,694		6,347		6,363		6,359
Revenue mix % (a):
Medicare		65		71		65		65		64		62		60
Medicaid		6		6		7		6		7		9		10
Private and other		29		23		28		29		29		29		30
Admissions:
Medicare		7,397		7,080		7,106		7,287		7,810		7,330		6,978
Medicaid		727		823		845		827		913		1,018		1,031
Private and other		1,564		1,528		1,495		1,503		1,919		1,957		1,891

		9,688		9,431		9,446		9,617		10,642		10,305		9,900

Admissions mix %:
Medicare		76		75		75		76		73		71		71
Medicaid		8		9		9		8		9		10		10
Private and other		16		16		16		16		18		19		19
Patient days:
Medicare		207,670		209,670		197,725		199,857		212,116		211,255		200,154
Medicaid		26,660		28,361		30,489		29,867		37,635		50,232		51,743
Private and other		61,052		55,622		53,535		57,633		66,399		70,880		71,991

		295,382		293,653		281,749		287,357		316,150		332,367		323,888

Average length of stay:
Medicare		28.1		29.6		27.8		27.4		27.2		28.8		28.7
Medicaid		36.7		34.5		36.1		36.1		41.2		49.3		50.2
Private and other		39.0		36.4		35.8		38.3		34.6		36.2		38.1
Weighted average		30.5		31.1		29.8		29.9		29.7		32.3		32.7
Revenues per admission (a):
Medicare	$	34,750	$	43,798	$	35,871	$	34,960	$	35,247	$	37,025	$	34,866
Medicaid		30,295		30,887		32,385		29,014		34,228		40,231		40,604
Private and other		72,872		64,824		71,913		74,516		64,766		64,874		64,394
Weighted average		40,570		46,078		41,264		40,630		40,483		42,631		41,103
Revenues per patient day (a):
Medicare	$	1,238	$	1,479	$	1,289	$	1,275	$	1,298	$	1,285	$	1,216
Medicaid		826		896		898		803		830		815		809
Private and other		1,867		1,781		2,008		1,943		1,872		1,791		1,691
Weighted average		1,331		1,480		1,383		1,360		1,363		1,322		1,256

Medicare case mix index (discharged patients only)		1.22		1.25		1.20		1.11		1.12		1.12		1.11

Average daily census		3,282		3,227		3,062		3,123		3,513		3,652		3,521
Occupancy %		61.2		59.9		56.9		58.5		65.3		63.3		61.2

(a)

Includes income of $2.9 million in the first quarter of 2005, $54.6 million in the second quarter of 2005, $5.9 million in the third quarter of 2005, $1.9 million in the fourth quarter of 2005, $1.9 million in the first quarter of 2006 and $4.3 million in the second quarter of 2006 related to certain Medicare reimbursement issues.

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

Operating Data (Continued)

(Unaudited)


	2005 Quarters									2006 Quarters
	First		Second			Third		Fourth		First		Second		Third
Nursing center data:
End of period data:
Number of nursing centers:
Owned or leased		225		226			226		226		237		237		237
Managed		7		5			5		5		5		5		5

		232		231			231		231		242		242		242

Number of licensed beds:
Owned or leased		28,407		28,512			28,510		28,510		30,064		30,074		30,074
Managed		803		605			605		605		605		605		605

		29,210		29,117			29,115		29,115		30,669		30,679		30,679

Revenue mix %:
Medicare		35		32			33		33		35		35		33
Medicaid		47		51	(a)		49		48		46		46		47
Private and other		18		17			18		19		19		19		20

Patient days (excludes managed facilities):
Medicare		379,222		382,924			365,962		368,264		393,257		413,028		392,114
Medicaid		1,473,126		1,475,430			1,508,298		1,499,119		1,484,160		1,551,903		1,584,093
Private and other		369,405		367,998			380,276		397,870		396,482		429,822		453,304

		2,221,753		2,226,352			2,254,536		2,265,253		2,273,899		2,394,753		2,429,511

Patient day mix %:
Medicare		17		17			16		16		17		17		16
Medicaid		66		66			67		66		65		65		65
Private and other		17		17			17		18		18		18		19

Revenues per patient day:
Medicare Part A	$	349	$	348		$	351	$	365	$	376	$	377	$	381
Total Medicare (including Part B)		390		390			396		405		412		411		419
Medicaid		135		160	(a)		145		145		143		147		149
Private and other		207		212			207		212		217		221		219
Weighted average		191		208			196		199		202		206		205

Average daily census		24,686		24,465			24,506		24,622		25,266		26,316		26,408
Occupancy %		86.5		85.8			85.9		86.4		87.1		87.9		88.1

Rehabilitation data:
Revenue mix %:
Company-operated		76		77			78		77		78		78		75
Non-affiliated		24		23			22		23		22		22		25

Pharmacy data:
Number of customer licensed beds at end of period:
Company-operated		29,105		28,649			28,649		28,657		30,449		30,287		30,232
Non-affiliated		46,745		56,112			55,201		64,625		63,683		65,036		72,268

		75,850		84,761			83,850		93,282		94,132		95,323		102,500

(a)	Includes income of $30.5 million for periods prior to April 1, 2005 related to retroactive Medicaid rate increases in the state of Indiana. Related provider tax expense of $15.4 million under this program was recorded in other operating expenses.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

Interest Rate Sensitivity

Principal (Notional) Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)


	Expected maturities																				Fair value 9/30/06
	2006			2007			2008			2009			2010			Thereafter			Total		Fair value 9/30/06
Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate	$	17		$	71		$	76		$	81		$	86		$	648		$	979	$	924

Average interest rate		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%

Variable rate (a)	$	–		$	–		$	–		$	173,300		$	–		$	–		$	173,300	$	173,300

(a)

Interest on borrowings under the Company’s revolving credit facility is payable, at the Company’s option, at (1) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (2) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based upon the Company’s adjusted leverage ratio as defined in the Company’s revolving credit facility.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures and Changes in Internal Control Over Financial Reporting

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2006, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings

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

PART II. OTHER INFORMATION (Continued)

Item 6.

Exhibits



10.1		Exhibit C to the Amended and Restated Master Lease Agreement No. 1 dated as of April 20, 2001 for Lease Executed by Ventas Realty, Limited Partnership, as Lessor and Vencor, Inc. and Vencor Operating, Inc. as Tenant. Exhibit 10.1 to the Company’s Current Report on Form 8-K dated October 12, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.

10.2		Exhibit C to the Amended and Restated Master Lease Agreement No. 2 dated as of April 20, 2001 for Lease Executed by Ventas Realty, Limited Partnership, as Lessor and Vencor, Inc. and Vencor Operating, Inc. as Tenant. Exhibit 10.2 to the Company’s Current Report on Form 8-K dated October 12, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.

10.3		Exhibit C to the Amended and Restated Master Lease Agreement No. 3 dated as of April 20, 2001 for Lease Executed by Ventas Realty, Limited Partnership, as Lessor and Vencor, Inc. and Vencor Operating, Inc. as Tenant. Exhibit 10.3 to the Company’s Current Report on Form 8-K dated October 12, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.

10.4		Exhibit C to the Amended and Restated Master Lease Agreement No. 4 dated as of April 20, 2001 for Lease Executed by Ventas Realty, Limited Partnership, as Lessor and Vencor, Inc. and Vencor Operating, Inc. as Tenant. Exhibit 10.4 to the Company’s Current Report on Form 8-K dated October 12, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.

10.5		Kindred Deferred Compensation Plan, Second Amendment and Restatement effective as of January 1, 2005.

10.6		Amendment No. Five to Supplemental Executive Retirement Plan.

10.7		Amendment No. 3 to Credit Agreement dated as of October 19, 2006, to the $400,000,000 Amended and Restated Credit Agreement dated as of June 28, 2004 among Kindred Healthcare, Inc., the Lenders party thereto, and JPMorgan Chase Bank, N.A. (formerly known as JPMorgan Chase Bank), as Administrative Agent and Collateral Agent. Exhibit 10.1 to the Company’s Current Report on Form 8-K dated October 19, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.

10.8		Master Transaction Agreement, dated as of October 25, 2006, by and among AmerisourceBergen Corporation, PharMerica, Inc., Kindred Healthcare, Inc., Kindred Healthcare Operating, Inc., Kindred Pharmacy Services, Inc., Safari Holding Corporation, Hippo Merger Corporation and Rhino Merger Corporation. Exhibit 10.1 to the Company’s Current Report on Form 8-K dated October 25, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.

10.9		Tax Matters Agreement, by and among AmerisourceBergen Corporation, PharMerica, Inc., Kindred Healthcare, Inc., Kindred Pharmacy Services, Inc. and Safari Holding Corporation, in each case on behalf of itself and its Affiliates. Exhibit 10.2 to the Company’s Current Report on Form 8-K dated October 25, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.

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

32		Section 1350 Certifications.

SIGNATURES

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


				KINDRED HEALTHCARE, INC.

Date: November 9, 2006				/s/ PAUL J. DIAZ
				Paul J. Diaz
				President and Chief Executive Officer

Date: November 9, 2006				/s/ RICHARD A. LECHLEITER
				Richard A. Lechleiter
				Executive Vice President and Chief Financial Officer