##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q
 (Mark One)  x
    
    Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the Quarter Ended June 30, 2004 o
    
    Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the Period From to . Commission File Number: 000-32499 SELECT MEDICAL CORPORATION  Delaware
    
    23-2872718(State or other jurisdiction of
    
    (I.R.S. employer identificationincorporation or organization)
    
    number)
 4716 Old Gettysburg Road, P.O. Box 2034, Mechanicsburg, Pennsylvania 17055
(Address of principal executive offices and zip code) (717) 972-1100
(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 periods as the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES X NO Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES X NO As of July 31, 2004, the number of outstanding shares of the Registrants
Common Stock was 101,363,888.




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TABLE OF CONTENTS PART I FINANCIAL INFORMATION
    
    
    3ITEM 1. CONSOLIDATED FINANCIAL STATEMENTSConsolidated balance sheets
    
    
    3Consolidated statements of operations

    
    
    4Consolidated statement of changes in stockholders equity
    
    
    5Consolidated statements of cash flows
    
    
    6Notes to consolidated financial statements
    
    
    7ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    20ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    36ITEM 4. CONTROLS AND PROCEDURES
    
    
    36PART II OTHER INFORMATION
    
    
    36ITEM 1. LEGAL PROCEEDINGS
    
    
    36ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
    
    
    37ITEM 3. DEFAULTS UPON SENIOR SECURITIES
    
    
    37ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    37ITEM 5. OTHER INFORMATION
    
    
    38ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
    
    
    38SIGNATURES
    
    
    39EIGHTH AMENDENT TO THE CREDIT AGREEMENTCERTIFICATION OF PRESIDENT AND CHIEF EXECUTIVE OFFICERCERTIFICATION OF SENIOR VICE PRESIDENT AND CFOCERTIFICATION OF PRESIDENT AND CEO, SECTION 906CERTIFICATION OF SENIOR VP AND CFO, SECTION 906
  -2-




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PART I FINANCIAL INFORMATION 
 ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
 SELECT MEDICAL
CORPORATION 
 CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share and per share amounts)
 June 30,
    
    December 31,2004
    
    2003(unaudited)AssetsCurrent Assets:Cash and cash equivalents
    
    $
    167,945
    
    
    $
    165,507Accounts receivable, net of allowance for doubtful accounts of $110,021
and $111,517 in 2004 and 2003, respectively
    
    
    238,716
    
    
    
    230,171Current deferred tax asset
    
    
    63,787
    
    
    
    61,699Prepaid taxes
    
    
    7,749
    
    
    
    958Other current assets
    
    
    22,918
    
    
    
    26,731Total Current Assets
    
    
    501,115
    
    
    
    485,066Property and equipment, net
    
    
    176,328
    
    
    
    174,902Goodwill
    
    
    304,102
    
    
    
    306,251Trademark
    
    
    58,875
    
    
    
    58,875Other intangibles
    
    
    21,143
    
    
    
    22,876Non-current deferred tax asset
    
    
    3,978
    
    
    
    6,603Other assets
    
    
    18,316
    
    
    
    24,425Total Assets
    
    $
    1,083,857
    
    
    $
    1,078,998Liabilities and Stockholders EquityCurrent Liabilities:Bank overdrafts
    
    $
    17,867
    
    
    $
    11,427Current portion of long-term debt and notes payable
    
    
    4,538
    
    
    
    10,267Accounts payable
    
    
    47,483
    
    
    
    59,569Accrued payroll
    
    
    50,364
    
    
    
    53,260Accrued vacation
    
    
    23,655
    
    
    
    21,529Accrued restructuring
    
    
    7,597
    
    
    
    10,375Accrued other
    
    
    81,128
    
    
    
    78,308Due to third party payors
    
    
    44,279
    
    
    
    51,951Total Current Liabilities
    
    
    276,911
    
    
    
    296,686Long-term debt, net of current portion
    
    
    351,149
    
    
    
    357,236Total Liabilities
    
    
    628,060
    
    
    
    653,922Commitments and ContingenciesMinority interest in consolidated subsidiary companies
    
    
    6,780
    
    
    
    5,901Stockholders Equity:Common stock  $.01 par value: Authorized shares - 200,000,000 in 2004 and
2003
Issued shares - 101,350,000 and 102,219,000 in 2004 and 2003, respectively
    
    
    1,013
    
    
    
    1,022Capital in excess of par
    
    
    269,530
    
    
    
    291,519Retained earnings
    
    
    175,948
    
    
    
    121,560Accumulated other comprehensive income
    
    
    2,526
    
    
    
    5,074Total Stockholders Equity
    
    
    449,017
    
    
    
    419,175Total Liabilities and Stockholders Equity
    
    $
    1,083,857
    
    
    $
    1,078,998
 See accompanying notes. -3-




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Select Medical
Corporation 
 Consolidated Statements of Operations
(dollars in thousands, except per share amounts)
(unaudited)
 For the Quarter Ended
    
    For the Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net operating revenues
    
    $
    418,672
    
    
    $
    326,218
    
    
    $
    840,665
    
    
    $
    638,525Costs and expenses:Cost of services
    
    
    324,427
    
    
    
    258,218
    
    
    
    653,117
    
    
    
    510,487General and administrative
    
    
    13,932
    
    
    
    11,624
    
    
    
    25,545
    
    
    
    21,127Bad debt expense
    
    
    11,639
    
    
    
    12,337
    
    
    
    23,380
    
    
    
    24,520Depreciation and amortization
    
    
    8,714
    
    
    
    7,192
    
    
    
    19,143
    
    
    
    14,706Total costs and expenses
    
    
    358,712
    
    
    
    289,371
    
    
    
    721,185
    
    
    
    570,840Income from operations
    
    
    59,960
    
    
    
    36,847
    
    
    
    119,480
    
    
    
    67,685Other income and expense:Interest income
    
    
    (486
    )
    
    
    (156
    )
    
    
    (851
    )
    
    
    (342
    )Interest expense
    
    
    7,335
    
    
    
    5,622
    
    
    
    16,753
    
    
    
    12,048Income before minority interests and income taxes
    
    
    53,111
    
    
    
    31,381
    
    
    
    103,578
    
    
    
    55,979Minority interest in consolidated subsidiary companies
    
    
    1,146
    
    
    
    713
    
    
    
    2,152
    
    
    
    1,537Income before income taxes
    
    
    51,965
    
    
    
    30,668
    
    
    
    101,426
    
    
    
    54,442Income tax expense
    
    
    20,994
    
    
    
    12,037
    
    
    
    40,885
    
    
    
    21,357Net income
    
    $
    30,971
    
    
    $
    18,631
    
    
    $
    60,541
    
    
    $
    33,085Net income per common share:Basic income per common share
    
    $
    0.30
    
    
    $
    0.20
    
    
    $
    0.59
    
    
    $
    0.35Diluted income per common share
    
    $
    0.29
    
    
    $
    0.18
    
    
    $
    0.56
    
    
    $
    0.33Dividends per share
    
    $
    0.03
    
    
    $
    
    
    
    $
    0.06
    
    
    $
    Weighted average shares outstanding:Basic
    
    
    102,163
    
    
    
    95,054
    
    
    
    102,542
    
    
    
    94,678Diluted
    
    
    106,436
    
    
    
    101,374
    
    
    
    107,283
    
    
    
    100,004
 See accompanying notes. -4-




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Select Medical
Corporation 
 Consolidated Statements of Changes in Stockholders Equity
(dollars in thousands)
(unaudited)
 AccumulatedCommon
    
    Capital in
    
    
    
    
    
    OtherCommon
    
    Stock Par
    
    Excess of
    
    Retained
    
    Comprehensive
    
    ComprehensiveStock
    
    Value
    
    Par
    
    Earnings
    
    Income (Loss)
    
    IncomeBalance at December 31, 2003
    
    
    102,219
    
    
    $
    1,022
    
    
    $
    291,519
    
    
    $
    121,560
    
    
    $
    5,074Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    60,541
    
    
    
    
    
    
    $
    60,541Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,548
    )
    
    
    (2,548
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    57,993Issuance of common stock
    
    
    2,530
    
    
    
    25
    
    
    
    15,016Cash dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,153
    )Repurchases of common stock
    
    
    (3,399
    )
    
    
    (34
    )
    
    
    (48,024
    )Valuation of non-employee options
    
    
    
    
    
    
    
    
    
    
    151Tax benefit of stock option exercises
    
    
    
    
    
    
    
    
    
    
    10,868Balance at June 30, 2004
    
    
    101,350
    
    
    $
    1,013
    
    
    $
    269,530
    
    
    $
    175,948
    
    
    $
    2,526
 See accompanying notes. -5-




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SELECT MEDICAL
CORPORATION 
 CONSOLIDATED STATEMENTS OF CASH FLOW
(dollars in thousands)
(unaudited)
 For the Six Months EndedJune 30,2004
    
    2003Operating activitiesNet income
    
    $
    60,541
    
    
    $
    33,085Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    19,143
    
    
    
    14,706Provision for bad debts
    
    
    23,380
    
    
    
    24,520Minority interests
    
    
    2,152
    
    
    
    1,537Changes in operating assets and liabilities, net of
effects from acquisition of businesses:Accounts receivable
    
    
    (30,649
    )
    
    
    17,880Other current assets
    
    
    4,417
    
    
    
    426Other assets
    
    
    3,258
    
    
    
    861Accounts payable
    
    
    (12,030
    )
    
    
    (1,268
    )Due to third-party payors
    
    
    (10,670
    )
    
    
    5,262Accrued expenses
    
    
    (1,568
    )
    
    
    7,122Income taxes
    
    
    6,466
    
    
    
    (12,859
    )Net cash provided by operating activities
    
    
    64,440
    
    
    
    91,272Investing activitiesPurchases of property and equipment
    
    
    (19,132
    )
    
    
    (15,206
    )Proceeds from disposal of assets
    
    
    
    
    
    
    2,400Earnout payments
    
    
    (2,876
    )
    
    
    (429
    )Proceeds from sale of membership interests
    
    
    4,811
    
    
    
    Acquisition of businesses, net of cash acquired
    
    
    (122
    )
    
    
    (3,786
    )Net cash used in investing activities
    
    
    (17,319
    )
    
    
    (17,021
    )Financing activitiesNet repayments on credit facility debt
    
    
    (8,483
    )
    
    
    (34,191
    )Principal payments on seller and other debt
    
    
    (2,633
    )
    
    
    (2,114
    )Proceeds from issuance of common stock
    
    
    15,041
    
    
    
    2,125Repurchase of common stock
    
    
    (48,058
    )
    
    
    Payment of dividends
    
    
    (6,153
    )
    
    
    Proceeds from (repayment of) bank overdrafts
    
    
    6,440
    
    
    
    (4,356
    )Distributions to minority interests
    
    
    (671
    )
    
    
    (775
    )Net cash used in financing activities
    
    
    (44,517
    )
    
    
    (39,311
    )Effect of exchange rate changes on cash
and cash equivalents
    
    
    (166
    )
    
    
    349Net increase in cash and cash equivalents
    
    
    2,438
    
    
    
    35,289Cash and cash equivalents at beginning of period
    
    
    165,507
    
    
    
    56,062Cash and cash equivalents at end of period
    
    $
    167,945
    
    
    $
    91,351Supplemental Cash Flow InformationCash paid for interest
    
    $
    15,022
    
    
    $
    9,491Cash paid for income taxes
    
    $
    35,740
    
    
    $
    34,790
 See accompanying notes. -6-




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Basis of Presentation The unaudited condensed consolidated financial statements of Select
Medical Corporation (the Company) as of June 30, 2004 and for the three and
six month periods ended June 30, 2004 and 2003, have been prepared in
accordance with generally accepted accounting principles. In the opinion of
management, such information contains all adjustments, consisting only of
normal recurring adjustments, necessary for a fair presentation of the results
for such periods. All significant intercompany transactions and balances have
been eliminated. The results of operations for the three and six months ended
June 30, 2004 are not necessarily indicative of the results to be expected for
the full fiscal year ending December 31, 2004. Certain information and disclosures normally included in the notes to
consolidated financial statements have been condensed or omitted as permitted
by the rules and regulations of the Securities and Exchange Commission,
although the Company believes the disclosure is adequate to make the
information presented not misleading. The accompanying unaudited consolidated
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto for the year ended December 31, 2003
contained in the Companys Form 10-K filed with the Securities and Exchange
Commission. 2. Accounting Policies Use of Estimates The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates. Recent Accounting Pronouncements In December 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 46R (FIN 46R) which replaced Interpretation No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51, Consolidated Financial Statements, to improve
financial reporting of special purpose and other entities. In accordance with
the interpretation, business enterprises that represent the primary beneficiary
of another entity by retaining a controlling financial interest in that
entitys assets, liabilities and results of operations, must consolidate the
entity in their financial statements. Prior to the issuance of FIN 46R,
consolidation generally occurred when an enterprise controlled another entity
through voting interests. The disclosure requirements of FIN 46R are effective
for financial statements issued after December 31, 2003. The initial
recognition provisions of FIN 46R were implemented during the first reporting
period that ended March 31, 2004. The adoption of FIN 46R did not have a
material impact on the Companys financial statements for the three and six
month periods ended June 30, 2004. Stock Option Plans During the six months ended June 30, 2004, the Company granted stock
options under its Second Amended and Restated 1997 Stock Option Plan totaling
2,259,000 shares of Common Stock at exercise prices
ranging from $13.86 to $15.50 per share. In addition, the Company granted
stock options under its 2002 Non-Employee Directors Plan totaling 110,800
shares of Common Stock at the exercise price of $15.50 per share. -7-




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As permitted by Statement of Financial Accounting Standards No. 123,
Accounting for Stock Based Compensation (SFAS No. 123), the Company has
chosen to apply APB Opinion No. 25, Accounting for Stock Issued to Employees
(APB 25) and related interpretations in accounting for its Plans. Accordingly,
no compensation cost has been recognized for options granted under the Plans. For purposes of pro forma disclosures, the estimated fair value of the
options is expensed over the options vesting period. The Companys pro forma
net earnings and earnings per share assuming compensation costs had been
recognized consistent with the fair value method under SFAS No. 123 were as
follows: For the Three Months Ended
    
    For the Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands, except per share amounts)Net income  as reported
    
    $
    30,971
    
    
    $
    18,631
    
    
    $
    60,541
    
    
    $
    33,085Deduct: Total stock based employee
compensation expense determined
under fair value based method for
all awards, net of related tax
effects
    
    
    3,515
    
    
    
    828
    
    
    
    10,044
    
    
    
    1,908Net income  pro forma
    
    $
    27,456
    
    
    $
    17,803
    
    
    $
    50,497
    
    
    $
    31,177Weighted average grant-date fair value
    
    $
    7.37
    
    
    $
    5.19
    
    
    $
    6.57
    
    
    $
    3.58Basic earnings per share  as reported
    
    
    0.30
    
    
    
    0.20
    
    
    
    0.59
    
    
    
    0.35Basic earnings per share  pro forma
    
    
    0.27
    
    
    
    0.19
    
    
    
    0.49
    
    
    
    0.33Diluted earnings per share  as
reported
    
    
    0.29
    
    
    
    0.18
    
    
    
    0.56
    
    
    
    0.33Diluted earnings per share  pro forma
    
    
    0.26
    
    
    
    0.18
    
    
    
    0.47
    
    
    
    0.31
 Accumulated Other Comprehensive Income Accumulated other comprehensive income consists of cumulative translation
adjustment gains associated with the Companys Canadian operations of
$2,526,000 and $5,123,000 at June 30, 2004 and December 31, 2003, respectively.
Also, included in other comprehensive income at December 31, 2003 were
unrealized losses on available-for-sale securities of $49,000, net of tax.
Following is a reconciliation of net income to comprehensive income: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Net income
    
    $
    30,971
    
    
    $
    18,631
    
    
    $
    60,541
    
    
    $
    33,085Unrealized gains (losses) on available for sale
securities
    
    
    
    
    
    
    222
    
    
    
    (4
    )
    
    
    (111
    )Realized losses on available for sale securities
    
    
    53
    
    
    
    
    
    
    
    53
    
    
    
    Realized loss on interest rate swap
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    313Changes in foreign currency translation
    
    
    (1,137
    )
    
    
    2,323
    
    
    
    (2,597
    )
    
    
    4,318Total comprehensive income
    
    $
    29,887
    
    
    $
    21,176
    
    
    $
    57,993
    
    
    $
    37,605
 -8-




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3. Intangible Assets Amortization expense for intangible assets for the three months ended June
30, 2004 and 2003 was $857,000 and $7,000, respectively. Amortization expense
for intangible assets for the six months ended June 30, 2004 and 2003 was
$1,714,000 and $14,000, respectively. Estimated amortization expense for
intangible assets for each of the five years commencing January 1, 2004 will be
approximately $3,429,000 and primarily relates to the amortization of the
non-compete agreement associated with the acquisition of Kessler Rehabilitation
Corporation that occurred in September 2003. Intangible assets consist of the following: As of June 30, 2004Gross Carrying
    
    AccumulatedAmount
    
    Amortization(dollars in thousands)Amortized intangible assetsNon-Compete agreements
    
    $
    24,000
    
    
    $
    (2,857
    )Unamortized intangible assetsGoodwill
    
    $
    304,102Trademarks
    
    
    58,875Total
    
    $
    362,977
 The changes in the carrying amount of goodwill for the Companys
reportable segments for the six months ended June 30, 2004 are as follows: Specialty
    
    OutpatientHospitals
    
    Rehabilitation
    
    All Other
    
    Total(dollars in thousands)Balance as of December 31, 2003
    
    $
    180,011
    
    
    $
    125,656
    
    
    $
    584
    
    
    $
    306,251Goodwill acquired during year
    
    
    
    
    
    
    459
    
    
    
    
    
    
    
    459Assignment of membership
interests
    
    
    
    
    
    
    (1,395
    )
    
    
    
    
    
    
    (1,395
    )Income tax benefits recognized
    
    
    
    
    
    
    (2,056
    )
    
    
    
    
    
    
    (2,056
    )Earn-out payments
    
    
    
    
    
    
    2,876
    
    
    
    
    
    
    
    2,876Translation adjustment
    
    
    
    
    
    
    (988
    )
    
    
    
    
    
    
    (988
    )Other
    
    
    
    
    
    
    (1,045
    )
    
    
    
    
    
    
    (1,045
    )Balance as of June 30, 2004
    
    $
    180,011
    
    
    $
    123,507
    
    
    $
    584
    
    
    $
    304,102
 -9-




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4. Restructuring Charges The following summarizes the Companys restructuring activity: LeaseTerminationCosts
    
    Severance
    
    Total(dollars in thousands)January 1, 2004
    
    $
    5,805
    
    
    $
    4,570
    
    
    $
    10,375Amounts paid in 2004
    
    
    (1,496
    )
    
    
    (1,282
    )
    
    
    (2,778
    )June 30, 2004
    
    $
    4,309
    
    
    $
    3,288
    
    
    $
    7,597
 The Company expects to pay out the remaining lease termination costs through
2007 and severance related to workforce reductions of 36 employees through
2005. 5. Segment Information The Companys segments consist of (i) specialty hospitals and (ii)
outpatient rehabilitation. The accounting policies of the segments are the
same as those described in the summary of significant accounting policies.
The Company evaluates performance of the segments based on Adjusted EBITDA.
Adjusted EBITDA is defined as net income (loss) before interest, income taxes,
depreciation and amortization, special charges, loss on early retirement of
debt, equity in earnings from joint ventures and minority interest. For the
periods presented there were no special charges, loss on early retirement of
debt or equity in earnings from joint ventures that effect Adjusted EBITDA. The following table summarizes selected financial data for the Companys
reportable segments: Three Months Ended June 30, 2004Specialty
    
    OutpatientHospitals
    
    Rehabilitation
    
    All Other
    
    Total(dollars in thousands)Net revenue
    
    $
    271,353
    
    
    $
    144,279
    
    
    $
    3,040
    
    
    $
    418,672Adjusted EBITDA
    
    
    58,605
    
    
    
    24,170
    
    
    
    (14,101
    )
    
    
    68,674Total assets
    
    
    525,438
    
    
    
    368,098
    
    
    
    190,321
    
    
    
    1,083,857Capital expenditures
    
    
    9,147
    
    
    
    1,406
    
    
    
    817
    
    
    
    11,370
 Three Months Ended June 30, 2003Specialty
    
    OutpatientHospitals
    
    Rehabilitation
    
    All Other
    
    Total(dollars in thousands)Net revenue
    
    $
    191,763
    
    
    $
    132,047
    
    
    $
    2,408
    
    
    $
    326,218Adjusted EBITDA
    
    
    30,708
    
    
    
    23,391
    
    
    
    (10,060
    )
    
    
    44,039Total assets
    
    
    293,106
    
    
    
    333,686
    
    
    
    111,068
    
    
    
    737,860Capital expenditures
    
    
    4,529
    
    
    
    1,790
    
    
    
    1,914
    
    
    
    8,233
 -10-




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##### Table of Contents



Six Months Ended June 30, 2004Specialty
    
    OutpatientHospitals
    
    Rehabilitation
    
    All Other
    
    Total(dollars in thousands)Net revenue
    
    $
    544,256
    
    
    $
    289,943
    
    
    $
    6,466
    
    
    $
    840,665Adjusted EBITDA
    
    
    116,989
    
    
    
    47,078
    
    
    
    (25,444
    )
    
    
    138,623Total assets
    
    
    525,438
    
    
    
    368,098
    
    
    
    190,321
    
    
    
    1,083,857Capital expenditures
    
    
    13,025
    
    
    
    3,151
    
    
    
    2,956
    
    
    
    19,132
 Six Months Ended June 30, 2003Specialty
    
    OutpatientHospitals
    
    Rehabilitation
    
    All Other
    
    Total(dollars in thousands)Net revenue
    
    $
    375,191
    
    
    $
    257,622
    
    
    $
    5,712
    
    
    $
    638,525Adjusted EBITDA
    
    
    56,194
    
    
    
    42,894
    
    
    
    (16,697
    )
    
    
    82,391Total assets
    
    
    293,106
    
    
    
    333,686
    
    
    
    111,068
    
    
    
    737,860Capital expenditures
    
    
    7,416
    
    
    
    4,530
    
    
    
    3,260
    
    
    
    15,206
 A reconciliation of net income to Adjusted EBITDA is as follows: For the Three Months Ended June 30,
    
    For the Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Net income
    
    $
    30,971
    
    
    $
    18,631
    
    
    $
    60,541
    
    
    $
    33,085Income tax expense
    
    
    20,994
    
    
    
    12,037
    
    
    
    40,885
    
    
    
    21,357Minority interest
    
    
    1,146
    
    
    
    713
    
    
    
    2,152
    
    
    
    1,537Interest expense, net
    
    
    6,849
    
    
    
    5,466
    
    
    
    15,902
    
    
    
    11,706Depreciation and
amortization
    
    
    8,714
    
    
    
    7,192
    
    
    
    19,143
    
    
    
    14,706Adjusted EBITDA
    
    $
    68,674
    
    
    $
    44,039
    
    
    $
    138,623
    
    
    $
    82,391
 -11-




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##### Table of Contents



6. Net Income per Share The following table sets forth for the periods indicated the calculation of net
income per share in the Companys consolidated statement of operations and the
differences between basic weighted average shares outstanding and diluted
weighted average shares outstanding used to compute diluted earnings per share: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands, except per share data)Numerator:Net income
    
    $
    30,971
    
    
    $
    18,631
    
    
    $
    60,541
    
    
    $
    33,085Denominator:Denominator for basic earnings per share -
weighted average shares
    
    
    102,163
    
    
    
    95,054
    
    
    
    102,542
    
    
    
    94,678Effect of dilutive securities:a) Stock options
    
    
    4,273
    
    
    
    5,392
    
    
    
    4,741
    
    
    
    4,148b) Warrants
    
    
    
    
    
    
    928
    
    
    
    
    
    
    
    1,178Denominator for diluted earnings per
share-adjusted weighted average shares and
assumed conversions
    
    
    106,436
    
    
    
    101,374
    
    
    
    107,283
    
    
    
    100,004Basic income per common share:
    
    $
    0.30
    
    
    $
    0.20
    
    
    $
    0.59
    
    
    $
    0.35Diluted income per common share:
    
    $
    0.29
    
    
    $
    0.18
    
    
    $
    0.56
    
    
    $
    0.33Anti-dilutive shares excluded in the
computation of diluted income per common
share
    
    
    4,732
    
    
    
    13
    
    
    
    2,770
    
    
    
    71
 7. Supplemental Disclosures of Cash Flow Information Non-cash investing and financing activities are comprised of the
following: For the Six Months EndedJune 30,2004
    
    2003(dollars in thousands)Tax benefit of stock option exercises
    
    $
    10,868
    
    
    $
    391Notes issued with acquisitions
    
    
    
    
    
    
    316
 -12-




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##### Table of Contents



8. Stock Repurchase Program On February 23, 2004, the Companys Board of Directors authorized a
program to repurchase up to $80.0 million of its common stock. The program
will remain in effect until August 31, 2005, unless extended or cancelled by
the Board of Directors. The extent to which the Company repurchases its shares
and the timing of any purchases will depend on prevailing market conditions and
other corporate considerations. The Company anticipates funding for this
program to come from available corporate funds, including cash on hand and
future cash flow. The repurchased shares will be immediately retired. During
the six months ended June 30, 2004, the Company repurchased and retired a total
of 3,399,400 shares at a cost, including fees and commissions, of $48.1
million. 9. Commitments and Contingencies In February 2002, PHICO Insurance Company (PHICO), at the request of the
Pennsylvania Insurance Department, was placed in liquidation by an order of the
Commonwealth Court of Pennsylvania (Liquidation Order). The Company had
placed its primary malpractice insurance coverage through PHICO from June 1998
through December 2000. In January 2001, these policies were replaced by
policies issued with other insurers. Currently, the Company has approximately
seven unsettled cases in six states from the policy years covered by PHICO
issued policies. The Liquidation Order refers these claims to the various
state guaranty associations. These state guaranty association statutes
generally provide for coverage between $100,000-$300,000 per insured claim,
depending upon the state. Some states also have catastrophic loss funds to
cover settlements in excess of the available state guaranty funds. Most state
insurance guaranty statutes provide for net worth and residency limitations
that, if applicable, may limit or prevent the Company from recovering from
these state guaranty association funds. At this time, the Company believes
that it will meet the requirements for coverage under most of the applicable
state guarantee association statutes, and that the resolution of these claims
will not have a material adverse effect on the Companys financial position,
cash flow or results of operations. However, because the rules related to
state guaranty association funds are subject to interpretation, and because
these claims are still in the process of resolution, the Companys conclusions
may change as this process progresses. The Company is subject to legal proceedings and claims that have arisen in
the ordinary course of its business and have not been finally adjudicated,
which include malpractice claims covered (subject to the above discussion
regarding PHICO Insurance Company) under the Companys insurance policy. In the
opinion of management, the outcome of these actions will not have a material
adverse effect on the financial position or results of operations of the
Company. 10. Subsequent Event  Regulatory Changes On August 2, 2004, the Centers for Medicare & Medicaid Services (CMS)
announced final regulatory changes applicable to long-term acute care hospitals
operated as hospitals within hospitals (HIHs) or as satellites.
Effective for hospital cost reporting periods beginning on or after October 1,
2004, the final rule eliminates the current standards concerning performance of
basic hospital functions as applied to long-term acute care HIHs and satellites
and, subject to certain exceptions, provides these facilities with lower rates
of reimbursement for Medicare admissions from their hosts that are in excess of
specified percentages. For new
long-term acute care HIHs and satellites, the admissions threshold will
be
25%. For existing long-term acute care HIHs and satellites and those under
development that meet specified criteria, the admissions threshold will -13-




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##### Table of Contents



be
phased-in over a four-year period starting with hospital cost reporting periods
beginning on or after October 1, 2004, as follows: (i) for discharges during
the cost reporting period beginning on or after October 1, 2004 and before
October 1, 2005, there is no admissions threshold except as may apply under
current HIH separateness criteria; (ii) for discharges during the cost
reporting period beginning on or after October 1, 2005 and before October 1,
2006, the admissions threshold is the lesser of the percentage of patients
admitted from the host during fiscal year 2004 or 75%; (iii) for discharges
during the cost reporting period beginning on or after October 1, 2006 and
before October 1, 2007, the admissions threshold is the lesser of the
percentage of patients admitted from the host during fiscal year 2004 or 50%;
and (iv) for discharges during the cost reporting period beginning on or after
October 1, 2007, the admissions threshold is 25%. The new rules are complex
and the Company is currently evaluating the effects of the new rules on the
hospitals it operates and potential changes to existing operations in order to
adapt to the new rules. At June 30, 2004, the Company operated 82 long-term
acute care hospitals. Of this total, 78 were operated as HIHs. 11. Financial Information for Subsidiary Guarantors and Non-Guarantor Subsidiaries The Company conducts a significant portion of its business through its
subsidiaries. Following is condensed consolidating financial information for
the Company, the Subsidiary Guarantors and the Non-Guarantor Subsidiaries at
June 30, 2004 and for the six months ended June 30, 2004 and 2003. The equity method has been used by the Company with respect to investments
in subsidiaries. The equity method has been used by Subsidiary Guarantors with
respect to investments in Non-Guarantor Subsidiaries. Separate financial
statements for Subsidiary Guarantors are not presented. The following table sets forth the Non-Guarantor Subsidiaries at June 30,
2004: Canadian Back Institute Limited
Cupertino Medical Center, P.C.
Kentucky Orthopedic Rehabilitation, LLC.
Medical Information Management Systems, LLC.
Metro Therapy, Inc.
Philadelphia Occupational Health, P.C.
Select Specialty Hospital  Central Pennsylvania, L.P.
Select Specialty Hospital  Houston, L.P.
Select Specialty Hospital  Mississippi Gulf Coast, Inc.
TJ Corporation I, LLC.
U.S. Regional Occupational Health II, P.C. -14-




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##### Table of Contents



Select Medical CorporationCondensed Consolidating Balance SheetJune 30, 2004Select MedicalCorporation (Parent
    
    Subsidiary
    
    Non-GuarantorCompany Only)
    
    Guarantors
    
    Subsidiaries
    
    
    
    
    
    Eliminations
    
    Consolidated(dollars in thousands)AssetsCurrent Assets:Cash and cash equivalents
    
    $
    92,095
    
    
    $
    69,461
    
    
    $
    6,389
    
    
    
    
    
    
    $
    
    
    
    $
    167,945Accounts receivable, net
    
    
    (226
    )
    
    
    227,402
    
    
    
    11,540
    
    
    
    
    
    
    
    
    
    
    
    238,716Current deferred tax asset
    
    
    13,683
    
    
    
    47,901
    
    
    
    2,203
    
    
    
    
    
    
    
    
    
    
    
    63,787Prepaid taxes
    
    
    22,239
    
    
    
    (20,994
    )
    
    
    6,504
    
    
    
    
    
    
    
    
    
    
    
    7,749Other current assets
    
    
    5,905
    
    
    
    12,808
    
    
    
    4,205
    
    
    
    
    
    
    
    
    
    
    
    22,918Total Current Assets
    
    
    133,696
    
    
    
    336,578
    
    
    
    30,841
    
    
    
    
    
    
    
    
    
    
    
    501,115Property and equipment, net
    
    
    9,304
    
    
    
    149,972
    
    
    
    17,052
    
    
    
    
    
    
    
    
    
    
    
    176,328Investment in affiliates
    
    
    564,236
    
    
    
    59,388
    
    
    
    
    
    
    
    
    
    
    
    (623,624)
    (a)
    
    
    Goodwill
    
    
    5,853
    
    
    
    250,880
    
    
    
    47,369
    
    
    
    
    
    
    
    
    
    
    
    304,102Trademark
    
    
    
    
    
    
    58,875
    
    

    
    

    
    


    
    
    
    
    
    
    
    
    
    58,875Other intangibles
    
    
    
    
    
    
    21,143
    
    
    
    

    
    
    
    
    
    
    
    
    
    
    
    21,143Non-current deferred tax asset
    
    
    1,789
    
    
    
    3,586
    
    
    
    (1,397
    )
    
    
    
    
    
    
    
    
    
    
    3,978Other assets
    
    
    11,828
    
    
    
    5,475
    
    
    
    1,013
    
    
    
    
    
    
    
    
    
    
    
    18,316Total Assets
    
    $
    726,706
    
    
    $
    885,897
    
    
    $
    94,878
    
    
    
    
    
    
    $
    (623,624
    )
    
    $
    1,083,857Liabilities and Stockholders EquityCurrent Liabilities:Bank overdrafts
    
    $
    17,867
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    17,867Current portion of long-term debt and notes payable
    
    
    1,380
    
    
    
    2,673
    
    
    
    485
    
    
    
    
    
    
    
    
    
    
    
    4,538Accounts payable
    
    
    1,362
    
    
    
    39,648
    
    
    
    6,473
    
    
    
    
    
    
    
    
    
    
    
    47,483Intercompany accounts
    
    
    128,369
    
    
    
    (126,265
    )
    
    
    (2,104
    )
    
    
    
    
    
    
    
    
    
    
    Accrued payroll
    
    
    1,266
    
    
    
    48,924
    
    
    
    174
    
    
    
    
    
    
    
    
    
    
    
    50,364Accrued vacation
    
    
    2,534
    
    
    
    19,480
    
    
    
    1,641
    
    
    
    
    
    
    
    
    
    
    
    23,655Accrued restructuring
    
    
    
    
    
    
    7,597
    
    
    
    

    
    
    
    
    
    
    
    
    
    
    
    7,597Accrued other
    
    
    26,003
    
    
    
    52,635
    
    
    
    2,490
    
    
    
    
    
    
    
    
    
    
    
    81,128Due to third party payors
    
    
    6,055
    
    
    
    50,438
    
    
    
    (12,214
    )
    
    
    
    
    
    
    
    
    
    
    44,279Total Current Liabilities
    
    
    184,836
    
    
    
    95,130
    
    
    
    (3,055
    )
    
    
    
    
    
    
    
    
    
    
    276,911Long-term debt, net of current portion
    
    
    92,853
    
    
    
    234,078
    
    
    
    24,218
    
    
    
    
    
    
    
    
    
    
    
    351,149Total Liabilities
    
    
    277,689
    
    
    
    329,208
    
    
    
    21,163
    
    
    
    
    
    
    
    
    
    
    
    628,060Commitments and ContingenciesMinority interest in consolidated subsidiary companies
    
    
    
    
    
    
    145
    
    
    
    6,635
    
    
    
    
    
    
    
    
    
    
    
    6,780Stockholders Equity:Common stock
    
    
    1,013
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,013Capital in excess of par
    
    
    269,530
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    269,530Retained earnings
    
    
    175,948
    
    
    
    165,953
    
    
    
    37,914
    
    
    
    
    
    
    
    (203,867)
    (b)
    
    
    175,948Subsidiary investment
    
    
    
    
    
    
    390,591
    
    
    
    29,166
    
    
    
    
    
    
    
    (419,757)
    (a)(b)
    
    
    Accumulated other comprehensive loss
    
    
    2,526
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,526Total Stockholders Equity
    
    
    449,017
    
    
    
    556,544
    
    
    
    67,080
    
    
    
    
    
    
    
    (623,624
    )
    
    
    449,017Total Liabilities and Stockholders Equity
    
    $
    726,706
    
    
    $
    885,897
    
    
    $
    94,878
    
    
    
    
    
    
    $
    (623,624
    )
    
    $
    1,083,857
  (a)
    
    Elimination of investments in subsidiaries.(b)
    
    Elimination of investments in subsidiaries
earnings. -15-




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##### Table of Contents



Select Medical CorporationCondensed Consolidating Statement of OperationsFor the Six Months Ended June 30, 2004Select Medical
    
    
    
    
    
    Non-Corporation (Parent
    
    Subsidiary
    
    GuarantorCompany Only)
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    Consolidated(dollars in thousands)Net operating revenues
    
    $
    22
    
    
    $
    724,564
    
    
    $
    116,079
    
    
    $
    
    
    
    $
    840,665Costs and expenses:Cost of services
    
    
    
    
    
    
    559,425
    
    
    
    93,692
    
    
    
    
    
    
    
    653,117General and administrative
    
    
    24,550
    
    
    
    995
    
    
    
    
    
    
    
    
    
    
    
    25,545Bad debt expense
    
    
    
    
    
    
    22,543
    
    
    
    837
    
    
    
    
    
    
    
    23,380Depreciation and amortization
    
    
    1,288
    
    
    
    15,429
    
    
    
    2,426
    
    
    
    
    
    
    
    19,143Total costs and expenses
    
    
    25,838
    
    
    
    598,392
    
    
    
    96,955
    
    
    
    
    
    
    
    721,185Income (loss) from operations
    
    
    (25,816
    )
    
    
    126,172
    
    
    
    19,124
    
    
    
    
    
    
    
    119,480Other income and expense:Intercompany interest and royalty fees
    
    
    14,800
    
    
    
    (14,774
    )
    
    
    (26
    )
    
    
    
    
    
    
    Intercompany management fees
    
    
    (50,684
    )
    
    
    48,787
    
    
    
    1,897
    
    
    
    
    
    
    
    Interest income
    
    
    (620
    )
    
    
    (231
    )
    
    
    
    
    
    
    
    
    
    
    (851
    )Interest expense
    
    
    5,178
    
    
    
    10,164
    
    
    
    1,411
    
    
    
    
    
    
    
    16,753Income before minority interests and income taxes
    
    
    5,510
    
    
    
    82,226
    
    
    
    15,842
    
    
    
    
    
    
    
    103,578Minority interest in consolidated subsidiary companies
    
    
    
    
    
    
    166
    
    
    
    1,986
    
    
    
    
    
    
    
    2,152Income before income taxes
    
    
    5,510
    
    
    
    82,060
    
    
    
    13,856
    
    
    
    
    
    
    
    101,426Income tax expense
    
    
    4,877
    
    
    
    33,482
    
    
    
    2,526
    
    
    
    
    
    
    
    40,885Equity in earnings of subsidiaries
    
    
    59,908
    
    
    
    7,053
    
    
    
    
    
    
    
    (66,961)
    (a)
    
    
    Net income
    
    $
    60,541
    
    
    $
    55,631
    
    
    $
    11,330
    
    
    $
    (66,961
    )
    
    $
    60,541
  (a)
    
    Elimination of equity in net income (loss) from consolidated subsidiaries. -16-




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##### Table of Contents



Select Medical CorporationCondensed Consolidating Statement of Cash FlowsFor the Six Months Ended June 30, 2004Select MedicalCorporation
    
    
    
    
    
    Non-(Parent Company
    
    Subsidiary
    
    GuarantorOnly)
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    Consolidated(dollars in thousands)Operating activitiesNet income
    
    $
    60,541
    
    
    $
    55,631
    
    
    $
    11,330
    
    
    $
    (66,961
    )(a)
    
    $
    60,541Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    1,288
    
    
    
    15,429
    
    
    
    2,426
    
    
    
    
    
    
    
    19,143Provision for bad debts
    
    
    
    
    
    
    22,543
    
    
    
    837
    
    
    
    
    
    
    
    23,380Minority interests
    
    
    
    
    
    
    166
    
    
    
    1,986
    
    
    
    
    
    
    
    2,152Changes in operating assets and liabilities,
net of
effects from acquisition of businesses:Equity in earnings of subsidiaries
    
    
    (59,908
    )
    
    
    (7,053
    )
    
    
    
    
    
    
    66,961
    (a)
    
    
    Intercompany
    
    
    16,230
    
    
    
    (6,761
    )
    
    
    (9,469
    )
    
    
    
    
    
    
    Accounts receivable
    
    
    258
    
    
    
    (45,231
    )
    
    
    14,324
    
    
    
    
    
    
    
    (30,649
    )Other current assets
    
    
    (1,732
    )
    
    
    1,144
    
    
    
    5,005
    
    
    
    
    
    
    
    4,417Other assets
    
    
    1,897
    
    
    
    1,430
    
    
    
    (69
    )
    
    
    
    
    
    
    3,258Accounts payable
    
    
    (7,097
    )
    
    
    (4,481
    )
    
    
    (452
    )
    
    
    
    
    
    
    (12,030
    )Due to third-party payors
    
    
    
    
    
    
    (809
    )
    
    
    (9,861
    )
    
    
    
    
    
    
    (10,670
    )Accrued expenses
    
    
    (892
    )
    
    
    (115
    )
    
    
    (561
    )
    
    
    
    
    
    
    (1,568
    )Income taxes
    
    
    6,087
    
    
    
    
    
    
    
    379
    
    
    
    
    
    
    
    6,466Net cash provided by operating activities
    
    
    16,672
    
    
    
    31,893
    
    
    
    15,875
    
    
    
    
    
    
    
    64,440Investing activitiesPurchases of property and equipment, net
    
    
    (2,880
    )
    
    
    (15,031
    )
    
    
    (1,221
    )
    
    
    
    
    
    
    (19,132
    )Earnout payments
    
    
    
    
    
    
    (2,876
    )
    
    
    
    
    
    
    
    
    
    
    (2,876
    )Proceeds from sale of membership interests
    
    
    
    
    
    
    4,811
    
    
    
    
    
    
    
    
    
    
    
    4,811Acquisition of businesses, net of cash acquired
    
    
    
    
    
    
    
    
    
    
    (122
    )
    
    
    
    
    
    
    (122
    )Net cash used in investing activities
    
    
    (2,880
    )
    
    
    (13,096
    )
    
    
    (1,343
    )
    
    
    
    
    
    
    (17,319
    )Financing activitiesIntercompany debt reallocation
    
    
    9,210
    
    
    
    (7,713
    )
    
    
    (1,497
    )
    
    
    
    
    
    
    Net repayments on credit facility debt
    
    
    
    
    
    
    
    
    
    
    (8,483
    )
    
    
    
    
    
    
    (8,483
    )Principal payments on seller and other debt
    
    
    
    
    
    
    (2,501
    )
    
    
    (132
    )
    
    
    
    
    
    
    (2,633
    )Repurchases of common stock
    
    
    (48,058
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (48,058
    )Proceeds from issuance of common stock
    
    
    15,041
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    15,041Payment of common stock dividends
    
    
    (6,153
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,153
    )Proceeds from bank overdrafts
    
    
    6,440
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,440Distributions to minority interests
    
    
    
    
    
    
    
    
    
    
    (671
    )
    
    
    
    
    
    
    (671
    )Net cash used in financing activities
    
    
    (23,520
    )
    
    
    (10,214
    )
    
    
    (10,783
    )
    
    
    
    
    
    
    (44,517
    )Effect of exchange rate changes on cash
and cash equivalents
    
    
    (166
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (166
    )Net increase (decrease) in cash and cash equivalents
    
    
    (9,894
    )
    
    
    8,583
    
    
    
    3,749
    
    
    
    
    
    
    
    2,438Cash and cash equivalents at beginning of period
    
    
    101,989
    
    
    
    60,878
    
    
    
    2,640
    
    
    
    
    
    
    
    165,507Cash and cash equivalents at end of period
    
    $
    92,095
    
    
    $
    69,461
    
    
    $
    6,389
    
    
    $
    
    
    
    $
    167,945
  (a)
    
    Elimination of equity in earnings of subsidiary. -17-




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##### Table of Contents



Select Medical CorporationCondensed Consolidating Statement of OperationsFor the Six Months Ended June 30, 2003Select Medical
    
    
    
    
    
    Non-Corporation (Parent
    
    Subsidiary
    
    GuarantorCompany Only)
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    Consolidated(dollars in thousands)Net operating revenues
    
    $
    5,005
    
    
    $
    527,933
    
    
    $
    105,587
    
    
    $
    
    
    
    $
    638,525Costs and expenses:Cost of services
    
    
    
    
    
    
    422,424
    
    
    
    88,063
    
    
    
    
    
    
    
    510,487General and administrative
    
    
    21,127
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    21,127Bad debt expense
    
    
    
    
    
    
    21,244
    
    
    
    3,276
    
    
    
    
    
    
    
    24,520Depreciation and amortization
    
    
    1,374
    
    
    
    11,383
    
    
    
    1,949
    
    
    
    
    
    
    
    14,706Total costs and expenses
    
    
    22,501
    
    
    
    455,051
    
    
    
    93,288
    
    
    
    
    
    
    
    570,840Income (loss) from operations
    
    
    (17,496
    )
    
    
    72,882
    
    
    
    12,299
    
    
    
    
    
    
    
    67,685Other income and expense:Intercompany interest and royalty fees
    
    
    11,964
    
    
    
    (11,974
    )
    
    
    10
    
    
    
    
    
    
    
    Intercompany management fees
    
    
    (31,646
    )
    
    
    30,032
    
    
    
    1,614
    
    
    
    
    
    
    
    Interest income
    
    
    (180
    )
    
    
    (162
    )
    
    
    
    
    
    
    
    
    
    
    (342
    )Interest expense
    
    
    3,633
    
    
    
    5,833
    
    
    
    2,582
    
    
    
    
    
    
    
    12,048Income (loss) before minority interests and income taxes
    
    
    (1,267
    )
    
    
    49,153
    
    
    
    8,093
    
    
    
    
    
    
    
    55,979Minority interest in consolidated subsidiary companies
    
    
    
    
    
    
    123
    
    
    
    1,414
    
    
    
    
    
    
    
    1,537Income (loss) before income taxes
    
    
    (1,267
    )
    
    
    49,030
    
    
    
    6,679
    
    
    
    
    
    
    
    54,442Income tax expense
    
    
    138
    
    
    
    19,235
    
    
    
    1,984
    
    
    
    
    
    
    
    21,357Equity in earnings of subsidiaries
    
    
    34,490
    
    
    
    1,709
    
    
    
    
    
    
    
    (36,199
    )(a)
    
    
    Net income
    
    $
    33,085
    
    
    $
    31,504
    
    
    $
    4,695
    
    
    $
    (36,199
    )
    
    $
    33,085
  (a)
    
    Elimination of equity in net income (loss) from consolidated subsidiaries. -18-




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##### Table of Contents



Select Medical CorporationCondensed Consolidating Statement of Cash FlowsFor the Six Months Ended June 30, 2003Select MedicalCorporation (Parent
    
    Subsidiary
    
    Non-GuarantorCompany Only)
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    Consolidated(dollars in thousands)Operating activitiesNet income
    
    $
    33,085
    
    
    $
    31,504
    
    
    $
    4,695
    
    
    $
    (36,199
    )(a)
    
    $
    33,085Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    1,374
    
    
    
    11,383
    
    
    
    1,949
    
    
    
    
    
    
    
    14,706Provision for bad debts
    
    
    
    
    
    
    21,244
    
    
    
    3,276
    
    
    
    
    
    
    
    24,520Minority interests
    
    
    
    
    
    
    123
    
    
    
    1,414
    
    
    
    
    
    
    
    1,537Changes in operating assets and liabilities,
net of
effects from acquisition of businesses:Equity in earnings of subsidiaries
    
    
    (34,490
    )
    
    
    (1,709
    )
    
    
    
    
    
    
    36,199
    (a)
    
    
    Intercompany
    
    
    65,326
    
    
    
    (58,239
    )
    
    
    (7,087
    )
    
    
    
    
    
    
    Accounts receivable
    
    
    (255
    )
    
    
    19,401
    
    
    
    (1,266
    )
    
    
    
    
    
    
    17,880Other current assets
    
    
    614
    
    
    
    (387
    )
    
    
    199
    
    
    
    
    
    
    
    426Other assets
    
    
    177
    
    
    
    298
    
    
    
    386
    
    
    
    
    
    
    
    861Accounts payable
    
    
    (1,143
    )
    
    
    (154
    )
    
    
    29
    
    
    
    
    
    
    
    (1,268
    )Due to third-party payors
    
    
    8,049
    
    
    
    (4,950
    )
    
    
    2,163
    
    
    
    
    
    
    
    5,262Accrued expenses
    
    
    3,099
    
    
    
    1,865
    
    
    
    2,158
    
    
    
    
    
    
    
    7,122Income taxes
    
    
    (11,063
    )
    
    
    
    
    
    
    (1,796
    )
    
    
    
    
    
    
    (12,859
    )Net cash provided by operating activities
    
    
    64,773
    
    
    
    20,379
    
    
    
    6,120
    
    
    
    
    
    
    
    91,272Investing activitiesPurchases of property and equipment, net
    
    
    (3,247
    )
    
    
    (9,385
    )
    
    
    (2,574
    )
    
    
    
    
    
    
    (15,206
    )Proceeds from disposal of assets
    
    
    2,400
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,400Earnout payments
    
    
    
    
    
    
    (429
    )
    
    
    
    
    
    
    
    
    
    
    (429
    )Acquisition of businesses, net of cash acquired
    
    
    
    
    
    
    (3,596
    )
    
    
    (190
    )
    
    
    
    
    
    
    (3,786
    )Net cash used in investing activities
    
    
    (847
    )
    
    
    (13,410
    )
    
    
    (2,764
    )
    
    
    
    
    
    
    (17,021
    )Financing activitiesIntercompany debt reallocation
    
    
    7,800
    
    
    
    (6,855
    )
    
    
    (945
    )
    
    
    
    
    
    
    Net repayments on credit facility debt
    
    
    (32,402
    )
    
    
    
    
    
    
    (1,789
    )
    
    
    
    
    
    
    (34,191
    )Principal payments on seller and other debt
    
    
    
    
    
    
    (2,114
    )
    
    
    
    
    
    
    
    
    
    
    (2,114
    )Proceeds from issuance of common stock
    
    
    2,125
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,125Repayment of bank overdrafts
    
    
    (4,356
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,356
    )Distributions to minority interests
    
    
    
    
    
    
    
    
    
    
    (775
    )
    
    
    
    
    
    
    (775
    )Net cash used in financing activities
    
    
    (26,833
    )
    
    
    (8,969
    )
    
    
    (3,509
    )
    
    
    
    
    
    
    (39,311
    )Effect of exchange rate changes on cash
and cash equivalents
    
    
    349
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    349Net increase (decrease) in cash and cash equivalents
    
    
    37,442
    
    
    
    (2,000
    )
    
    
    (153
    )
    
    
    
    
    
    
    35,289Cash and cash equivalents at beginning of period
    
    
    25,378
    
    
    
    28,022
    
    
    
    2,662
    
    
    
    
    
    
    
    56,062Cash and cash equivalents at end of period
    
    $
    62,820
    
    
    $
    26,022
    
    
    $
    2,509
    
    
    $
    
    
    
    $
    91,351
  (a)
    
    Elimination of equity in earnings of subsidiary. -19-




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS You should read this discussion together with our consolidated financial
statements and notes thereto contained in our Form 10-K filed with the
Securities and Exchange Commission on March 15, 2004. Forward Looking Statements This discussion contains forward-looking statements relating to the
financial condition, results of operations, plans, objectives, future
performance and business of Select Medical Corporation. These statements
include, without limitation, statements preceded by, followed by or that
include the words believes, expects, anticipates, estimates or similar
expressions. These forward-looking statements involve risks and uncertainties.
Actual results may differ materially from those contemplated by the
forward-looking statements due to factors including the following:  
    
    a change in government reimbursement for our services that
would affect our revenue;  
    
    changes in Medicare admission guidelines for inpatient
rehabilitation facilities may result in lost patient volume,
operating revenues and profitability;  
    
    the failure of our long term acute care hospitals to
maintain their status as such, which could negatively impact our
profitability;  
    
    a government investigation or assertion that we have
violated applicable regulations may result in increased costs and a
significant use of internal resources;  
    
    shortages in qualified nurses or therapists could increase our operating costs significantly;  
    
    the effects of liability and other claims asserted against us;  
    
    private third party payors of our services may undertake
cost containment initiatives that would decrease our revenue;  
    
    unexpected difficulties in integrating our and Kesslers
operations or realizing the anticipated benefits from our
acquisition of Kessler; and  
    
    future acquisitions may use significant resources and
expose us to unforeseen risks. For a discussion of these and other factors affecting our business, see the
section captioned Risk Factors in our Form 10-K under Item 1  Business. Non-GAAP Financial Measures The SEC recently adopted rules regarding the use of non-GAAP financial
measures, such as EBITDA and Adjusted EBITDA, which we use in this report.
Prior to the quarter ended June 30, 2003, we had defined EBITDA as net income
(loss) before interest, income taxes, depreciation and amortization, special
charges, loss on early retirement of debt and minority interest, and used this
measure to report our consolidated operating results as well as our segment
results. We are now referring to this financial measure as Adjusted EBITDA.
In order to comply with the new rules, we are now using EBITDA, defined as net
income (loss) before interest, income taxes, depreciation and amortization, to
report our consolidated operating results. However, SFAS 131 requires us to
report our segment results in a manner consistent with managements internal
reporting of operating results to our chief operating decision maker (as
defined under SFAS 131) for purposes of evaluating segment performance.
Therefore, since we use Adjusted EBITDA to measure performance of our segments
for internal reporting purposes, we have used Adjusted EBITDA to report our
segment results. The difference
between EBITDA and Adjusted EBITDA for the periods presented in this
report result only from minority interests, which are added back to EBITDA in
the computation of Adjusted EBITDA. We did not experience -20-




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##### Table of Contents



any special
charges, loss on early retirement of debt or equity in earnings from joint
ventures during the periods presented in this report. Overview We are a leading operator of specialty hospitals in the United States. We
are also a leading operator of outpatient rehabilitation clinics in the United
States and Canada. As of June 30, 2004 we operated 82 long-term acute care
hospitals in 25 states, four acute medical rehabilitation hospitals in New
Jersey and 761 outpatient rehabilitation clinics in 26 states, the District of
Columbia and seven Canadian provinces. We also provide medical rehabilitation
services on a contract basis at nursing homes, assisted living and senior care
centers, schools and work sites. We began operations in 1997 under the
leadership of our current management team. We manage the company through two business segments, our specialty
hospital segment and our outpatient rehabilitation segment. For the six months
ended June 30, 2004, we had net operating revenues of $840.7 million. Of this
total, we earned approximately 65% of our net operating revenues from our
specialty hospitals and approximately 34% from our outpatient rehabilitation
business. Our specialty hospital segment consists of hospitals designed to serve the
needs of long-term stay acute patients and hospitals designed to serve patients
that require intensive medical rehabilitation care. Patients in our long-term
acute care hospitals typically suffer from serious and often complex medical
conditions that require a high degree of care. Patients in our acute medical
rehabilitation hospitals typically suffer from debilitating injuries, including
traumatic brain and spinal cord injuries, and require rehabilitation care in
the form of physical, psychological, social and vocational rehabilitation
services. Our outpatient rehabilitation business consists of clinics and
contract services that provide physical, occupational and speech rehabilitation
services. Our outpatient rehabilitation patients are typically diagnosed with
musculoskeletal impairments that restrict their ability to perform normal
activities of daily living. On August 2, 2004, the Center for Medicare & Medicaid Services (CMS)
adopted final regulatory changes applicable to long-term acute care hospitals
(LTACH) that are operated as hospitals within hospitals or as satellites.
The new rules will be effective for hospital cost reporting periods beginning
on or after October 1, 2004. For existing long-term acute care hospitals
operated as hospitals within hospitals, the admissions thresholds will be
phased in over a four-year period starting with cost reporting periods
beginning on or after October 1, 2004. The new rules are complex and we are
currently evaluating the effects of the new rules on the LTACH hospitals
within hospitals that we operate and potential changes to existing operations
to adapt to the new rules. We operated 78 LTACHs as hospitals within
hospitals at June 30, 2004. For a discussion of the regulatory changes, see
Regulatory Changes. For the three months ended June 30, 2004, our net operating revenues
increased 28.3%, income from operations increased 62.7%, net income increased
66.2% and diluted earnings per share increased 61.1% compared to the three
months ended June 30, 2003. Our specialty hospital segment was the primary
source of this growth. In our specialty hospital segment, we experienced
growth in patient days and admissions that resulted from the expansion of the
number of hospitals we operate. Additionally, the inclusion of the Kessler
acquired hospitals and an increase in our revenue per patient day contributed
to the growth in this segment. Income from operations in our specialty
hospital segment increased because of the higher operating margins generated by
the Kessler rehabilitation hospitals and the improved operating margins we are
generating in our long-term acute care hospitals under the new prospective
payment reimbursement system. Our outpatient segment experienced an increase
in income from operations that resulted from the addition of the Kessler
outpatient operations. For the six months ended June 30, 2004, our net operating revenues
increased 31.7%, income from operations increased 76.5%, net income increased
83.0% and diluted earnings per share increased 69.7% -21-




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##### Table of Contents



compared to the six months
ended June 30, 2003. Our growth for the six month period occurred as a result
of factors that are consistent with those described above for the current
quarter ended June 30, 2004. For the six months ended June 30, 2004, our cash flow from operations was
$64.4 million. Our operating cash flow was consistent with our operating
profit. In the past, our operating cash flows have exceeded our operating
profit as we benefited from reductions in accounts receivable days outstanding.
During the quarter we also continued our stock repurchase program and
repurchased an additional 2,149,900 shares for $28.1 million. This brings the
total number of shares repurchased to 3,399,400 for an aggregate cost,
including fees and commissions, of $48.1 million. Additional explanation and
analysis of these topics are found in the following discussion. The following table sets forth operating statistics for our specialty
hospitals and our outpatient rehabilitation clinics for each of the periods
presented. The data in the table reflect the changes in the number of
specialty hospitals and outpatient rehabilitation clinics we operate that
resulted from acquisitions, start-up activities and
closures/sales/consolidations. The operating statistics reflect data for the
period of time these operations were managed by us. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Specialty Hospital Data# of Hospitals  Start of Period
    
    
    83
    
    
    
    72
    
    
    
    83
    
    
    
    72# of Hospital Start-ups
    
    
    3
    
    
    
    4
    
    
    
    3
    
    
    
    4# of Hospitals Closed
    
    
    
    
    
    
    (1
    )
    
    
    
    
    
    
    (1
    )# of Hospitals  End of Period
    
    
    86
    
    
    
    75
    
    
    
    86
    
    
    
    75# of Licensed Beds
    
    
    3,359
    
    
    
    2,758
    
    
    
    3,359
    
    
    
    2,758# of Admissions
    
    
    8,306
    
    
    
    6,117
    
    
    
    17,044
    
    
    
    12,075# of Patient Days
    
    
    204,525
    
    
    
    167,945
    
    
    
    417,252
    
    
    
    333,763Average Length of Stay
    
    
    24
    
    
    
    27
    
    
    
    24
    
    
    
    28Net Revenue Per Patient Day (a)
    
    $
    1,285
    
    
    $
    1,138
    
    
    $
    1,264
    
    
    $
    1,122Occupancy Rate
    
    
    69
    %
    
    
    70
    %
    
    
    70
    %
    
    
    70
    %% Patient Days  Medicare
    
    
    73
    %
    
    
    77
    %
    
    
    74
    %
    
    
    77
    %Outpatient Rehabilitation Data# of Clinics Owned  Start of Period
    
    
    741
    
    
    
    708
    
    
    
    758
    
    
    
    679# of Clinics Acquired
    
    
    
    
    
    
    
    
    
    
    2
    
    
    
    33# of Clinic Start-ups
    
    
    9
    
    
    
    11
    
    
    
    13
    
    
    
    17# of Clinics Closed/Sold/Consolidated
    
    
    (22
    )
    
    
    (12
    )
    
    
    (45
    )
    
    
    (22
    )# of Clinics Owned  End of Period
    
    
    728
    
    
    
    707
    
    
    
    728
    
    
    
    707# of Clinics Managed  End of Period
    
    
    33
    
    
    
    30
    
    
    
    33
    
    
    
    30Total # of Clinics (All)  End of Period
    
    
    761
    
    
    
    737
    
    
    
    761
    
    
    
    737# of Visits (U.S.)
    
    
    993,237
    
    
    
    1,019,028
    
    
    
    1,997,343
    
    
    
    2,000,600Net Revenue Per Visit (U.S.) (b)
    
    $
    89
    
    
    $
    88

    
    
    $
    90
    
    
    $
    88
  (a)
    
    Net revenue per patient day is calculated by dividing specialty
hospital patient service revenues by the total number of patient
days. For purposes of this computation, hospital patient service
revenue excludes the net operating revenues and -22-




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##### Table of Contents



patient days of the
one skilled nursing facility operated as part of this segment and net
revenue for outpatient services provided at the hospitals.  (b)
    
    Net revenue per visit (U.S.) is calculated by dividing
outpatient rehabilitation clinic revenue by the total number of
visits. For purposes of this computation, outpatient rehabilitation
clinic revenue does not include our Canadian subsidiary and contract
services revenue. Our goal historically has been to open approximately eight to ten new
long-term acute care hospitals each year, utilizing primarily our hospital
within a hospital model. As a result of the regulatory changes adopted by CMS
on August 2, 2004, we are evaluating the effect of the new rules on our
hospital within a hospital model including the mix and pace of development of
future LTACHs. The regulatory changes are complex and we are currently
evaluating the effects of the new rules on our LTACH development strategy. We
also may open new specialty hospitals in freestanding buildings. We also
intend to open new clinics in our current markets where we can benefit from
existing referral relationships and brand awareness to produce incremental
growth. With the acquisition of the four acute medical rehabilitation
hospitals through the Kessler transaction, we are also evaluating opportunities
to develop additional freestanding acute medical rehabilitation hospitals.
From time to time, we also intend to evaluate acquisition opportunities that
may enhance the scale of our business and expand our geographic reach. Regulatory Changes On August 2, 2004, the Centers for Medicare & Medicaid Services (CMS)
announced final regulatory changes applicable to long-term acute care hospitals
operated as hospitals within hospitals (HIHs) or as satellites. Under
current rules, an HIH must establish itself as a hospital separate from its
host by, among other things, obtaining separate licensure and certification,
maintaining a separate governance and administration, and demonstrating that it
performs its own basic hospital functions, either by limiting the services it
purchases directly from its host to 15% of its total operating costs or by
limiting the number of patient admissions from its host to 25% of total
admissions. Historically, most of our HIHs have satisfied the basic hospital
functions standard by meeting the 15%-of-costs test. A
satellite facility
must not only satisfy standards that demonstrate its separateness from its host
but must also meet requirements that show its integration with the main
provider hospital of which it is a part. Sixteen of our long-term acute care
hospitals operate as satellites. Effective for hospital cost reporting periods beginning on or after
October 1, 2004, the final rule eliminates the current standards concerning
performance of basic hospital functions as applied to long-term acute care HIHs
and satellites and, subject to certain exceptions, provides these facilities
with lower rates of reimbursement for Medicare admissions from their hosts that
are in excess of specified percentages. For new long-term acute care HIHs and
satellites, the admissions threshold will be 25%. For existing long-term acute
care HIHs and satellites and those under development that meet specified
criteria, the admissions threshold will be phased-in over a four-year period
starting with hospital cost reporting periods beginning on or after October 1,
2004, as follows: (i) for discharges during the cost reporting periods
beginning on or after October 1, 2004 and before October 1, 2005, there is no
admissions threshold except as may apply under current HIH separateness
criteria; (ii) for discharges during the cost reporting periods beginning on or
after October 1, 2005 and before October 1, 2006, the admissions threshold is
the lesser of the percentage of patients admitted from the host during fiscal
year 2004 or 75%; (iii) for discharges during the cost reporting periods
beginning on or after October 1, 2006 and before October 1, 2007, the
admissions threshold is the lesser of the percentage of patients admitted from
the host during fiscal year 2004 or 50%; and (iv) for discharges during the
cost reporting periods beginning on or after October 1, 2007, the admissions
threshold is 25%. The final rule establishes several exceptions to the Medicare admissions
thresholds. First, patients on whose behalf an outlier payment was made to the
host will not be counted toward any admissions threshold. -23-




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Second, HIHs and
satellites located in rural areas will be subject to no lower than a 50%
admissions threshold. Third, the admissions threshold applicable to HIHs and
satellites whose host hospital is the only other (or the dominant) hospital in
its Metropolitan Statistical Area (MSA) will be the percentage of total
Medicare discharges in the MSA that are from the host, subject to a minimum of
25% and a maximum of no lower than 50%. In its preamble to the final rule, CMS
also stated its intention to evaluate and discuss in the proposed fiscal year
2006 update to the long-term acute care prospective payment system
recommendations made by the Medicare Payment Advisory Commission in its June
2004 Report to the Congress concerning the development of new facility and
clinical criteria to define long-term acute care. Critical Accounting Matters Sources of Revenue Our net operating revenues are derived from a number of sources, including
commercial, managed care, private and governmental payors. Our net operating
revenues include amounts estimated by management to be reimbursable from each
of the applicable payors and the federal Medicare program. Amounts we receive
for treatment of patients are generally less than the standard billing rates.
We account for the differences between the estimated reimbursement rates and
the standard billing rates as contractual adjustments, which we deduct from
gross revenues to arrive at net operating revenues. Net operating revenues generated directly from the Medicare program from
all segments represented approximately 47% and 45% of net operating revenues
for the six months ended June 30, 2004 and 2003, respectively. The increase in
the percentage of our revenues generated from the Medicare program is due to
the growth in the number of specialty hospitals and their higher respective
share of Medicare revenues generated in this segment of our business compared
to our outpatient rehabilitation segment. Approximately 68% of our specialty hospital revenues for both the six
months ended June 30, 2004 and 2003 were received in respect of services
provided to Medicare patients. For the quarter ended June 30, 2004, all of our
Medicare payments are being paid under a prospective payment system. For the
quarter ended June 30, 2003, approximately 45% was paid by Medicare under a
cost-based reimbursement methodology. These payments are subject to final cost
report settlements based on administrative review and audit by third parties.
An annual cost report was filed for each provider to report the cost of
providing services and to settle the difference between the interim payments we
receive and final costs. We record adjustments to the original estimates in
the periods that such adjustments become known. Historically these adjustments
have not been significant. Substantially all of our Medicare cost reports are
settled through 2000. Because our routine payments from Medicare are different
than the final reimbursement due to us under the cost based reimbursement
system, we record a receivable or payable for the difference. On August 30, 2002, CMS published final regulations establishing a
prospective payment system for Medicare payment of long-term acute care
hospitals (LTCH-PPS), which replaces the reasonable cost-based payment system
previously in effect. Under LTCH-PPS, each discharged patient will be assigned
to a distinct long-term care diagnosis-related group (LTC-DRG), and a
long-term acute care hospital will generally be paid a pre-determined fixed
amount applicable to the assigned LTC-DRG (adjusted for area wage differences).
As required by Congress, LTC-DRG payment rates have been set to maintain
budget neutrality with total expenditures that would have been made under the
reasonable cost-based payment system. As of July 1, 2004, 80 of our long-term
acute care hospitals have implemented LTCH-PPS. We expect that the remaining
two
hospitals, both of which opened in 2004, will eventually be certified as
long-term acute care hospitals when conditions for qualification have been met. -24-




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As of June 30, 2004 and December 31, 2003 we had a net amount due to
Medicare of $29.2 million and $33.9 million, related to our specialty
hospitals. We recorded this amount as due to third party payors on our balance
sheet. Other revenue primarily represents amounts we have received for other
services, which include sales of computer software, home medical equipment,
orthotics, prosthetics and infusion/intravenous services. Insurance Under a number of our insurance programs, which include our employee
health insurance program and certain components under our property and casualty
insurance program, we are liable for a portion of our losses. In these cases
we accrue for our losses under an occurrence based principal whereby we
estimate the losses that will be incurred by us in a respective accounting
period and accrue that estimated liability. Where we have substantial
exposure, we utilize actuarial methods in estimating the losses. In cases
where we have minimal exposure, we will estimate our losses by analyzing
historical trends. We monitor these programs quarterly and revise our
estimates as necessary to take into account additional information. At June
30, 2004 and December 31, 2003, we have recorded a liability of $37.7 million
and $29.8 million, respectively, for our estimated losses under these insurance
programs. Bad Debts We estimate our bad debts based upon the age of our accounts receivable
and our historical collection percentages. These estimates are sensitive to
changes in the economy that affect our customers. Related Party We are party to various rental and other agreements with companies
affiliated through common ownership. Our payments to these related parties
amounted to $1.1 million and $0.8 million for the six months ended June 30,
2004 and 2003, respectively. Our future commitments are related to commercial
office space we lease for our corporate headquarters in Mechanicsburg,
Pennsylvania. These future commitments amount to $19.0 million through 2014.
These transactions and commitments are described more fully in Note 16 to
Select Medical Corporations consolidated financial statements contained in our
form 10-K for the year ended December 31, 2003. -25-




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Results of Operations The following table outlines, for the periods indicated, selected
operating data as a percentage of net operating revenues. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net Operating revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of services (a)
    
    
    77.5
    %
    
    
    79.2
    %
    
    
    77.7
    %
    
    
    80.0
    %General and administrative
    
    
    3.3
    %
    
    
    3.5
    %
    
    
    3.0
    %
    
    
    3.3
    %Bad debt expense
    
    
    2.8
    %
    
    
    3.8
    %
    
    
    2.8
    %
    
    
    3.8
    %Depreciation and amortization
    
    
    2.1
    %
    
    
    2.2
    %
    
    
    2.3
    %
    
    
    2.3
    %Income from operations
    
    
    14.3
    %
    
    
    11.3
    %
    
    
    14.2
    %
    
    
    10.6
    %Interest expense, net
    
    
    1.6
    %
    
    
    1.7
    %
    
    
    1.9
    %
    
    
    1.8
    %Income before minority
interests, and income taxes
    
    
    12.7
    %
    
    
    9.6
    %
    
    
    12.3
    %
    
    
    8.8
    %Minority interests
    
    
    0.3
    %
    
    
    0.2
    %
    
    
    0.2
    %
    
    
    0.3
    %Income before income taxes
    
    
    12.4
    %
    
    
    9.4
    %
    
    
    12.1
    %
    
    
    8.5
    %Income tax expense
    
    
    5.0
    %
    
    
    3.7
    %
    
    
    4.9
    %
    
    
    3.3
    %Net income
    
    
    7.4
    %
    
    
    5.7
    %
    
    
    7.2
    %
    
    
    5.2
    %
 -26-




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##### Table of Contents



The following table summarizes selected financial data by business segment, for
the periods indicated. Three Months Ended
    
    
    
    
    
    Six Months EndedJune 30,
    
    %
    
    June 30,
    
    %2004
    
    2003
    
    Change
    
    2004
    
    2003
    
    Change(dollars in thousands)Net operating revenues:Specialty hospitals
    
    $
    271,353
    
    
    $
    191,763
    
    
    
    41.5
    %
    
    $
    544,256
    
    
    $
    375,191
    
    
    
    45.1
    %Outpatient rehabilitation
    
    
    144,279
    
    
    
    132,047
    
    
    
    9.3
    
    
    
    289,943
    
    
    
    257,622
    
    
    
    12.5Other
    
    
    3,040
    
    
    
    2,408
    
    
    
    26.2
    
    
    
    6,466
    
    
    
    5,712
    
    
    
    13.2Total company
    
    $
    418,672
    
    
    $
    326,218
    
    
    
    28.3
    %
    
    $
    840,665
    
    
    $
    638,525
    
    
    
    31.7
    %Income (loss) from operations:Specialty hospitals
    
    $
    54,375
    
    
    $
    27,162
    
    
    

    100.2
    %
    
    $
    107,690
    
    
    $
    49,021
    
    
    
    119.7
    %Outpatient rehabilitation
    
    
    20,728
    
    
    
    20,292
    
    
    
    2.1
    
    
    
    40,067
    
    
    
    36,880
    
    
    
    8.6Other
    
    
    (15,143
    )
    
    
    (10,607
    )
    
    
    (42.8
    )
    
    
    (28,277
    )
    
    
    (18,216
    )
    
    
    (55.2
    )Total company
    
    $
    59,960
    
    
    $
    36,847
    
    
    
    62.7
    %
    
    $
    119,480
    
    
    $
    67,685
    
    
    
    76.5
    %Adjusted EBITDA: (b)Specialty hospitals
    
    $
    58,605
    
    
    $
    30,708
    
    
    
    90.8
    %
    
    $
    116,989
    
    
    $
    56,194
    
    
    
    108.2
    %Outpatient rehabilitation
    
    
    24,170
    
    
    
    23,391
    
    
    
    3.3
    
    
    
    47,078
    
    
    
    42,894
    
    
    
    9.8Other
    
    
    (14,101
    )
    
    
    (10,060
    )
    
    
    (40.2
    )
    
    
    (25,444
    )
    
    
    (16,697
    )
    
    
    (52.4
    )Adjusted EBITDA margins: (b)Specialty hospitals
    
    
    21.6
    %
    
    
    16.0
    %
    
    
    35.0
    %
    
    
    21.5
    %
    
    
    15.0
    %
    
    
    43.3
    %Outpatient rehabilitation
    
    
    16.8
    
    
    
    17.7
    
    
    
    (5.1
    )
    
    
    16.2
    
    
    
    16.6
    
    
    
    (2.4
    )Other
    
    
    N/M
    
    
    
    N/M
    
    
    
    N/M
    
    
    
    N/M
    
    
    
    N/M
    
    
    
    N/MTotal assets:Specialty hospitals
    
    $
    525,438
    
    
    $
    293,106
    
    
    
    
    
    
    $
    525,438
    
    
    $
    293,106Outpatient rehabilitation
    
    
    368,098
    
    
    
    333,686
    
    
    
    
    
    
    
    368,098
    
    
    
    333,686Other
    
    
    190,321
    
    
    
    111,068
    
    
    
    
    
    
    
    190,321
    
    
    
    111,068Total company
    
    $
    1,083,857
    
    
    $
    737,860
    
    
    
    
    
    
    $
    1,083,857
    
    
    $
    737,860Purchases of property and
equipment, net:Specialty hospitals
    
    $
    9,147
    
    
    $
    4,529
    
    
    
    
    
    
    $
    13,025
    
    
    $
    7,416Outpatient rehabilitation
    
    
    1,406
    
    
    
    1,790
    
    
    
    
    
    
    
    3,151
    
    
    
    4,530Other
    
    
    817
    
    
    
    1,914
    
    
    
    
    
    
    
    2,956
    
    
    
    3,260Total company
    
    $
    11,370
    
    
    $
    8,233
    
    
    
    
    
    
    $
    19,132
    
    
    $
    15,206
 -27-




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The following tables reconcile net income to EBITDA for the Company and
provides the calculation of our EBITDA margin for each of the periods
presented. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Net income
    
    $
    30,971
    
    
    $
    18,631
    
    
    $
    60,541
    
    
    $
    33,085Income tax expense
    
    
    20,994
    
    
    
    12,037
    
    
    
    40,885
    
    
    
    21,357Interest expense, net
    
    
    6,849
    
    
    
    5,466
    
    
    
    15,902
    
    
    
    11,706Depreciation and amortization
    
    
    8,714
    
    
    
    7,192
    
    
    
    19,143
    
    
    
    14,706EBITDA (b)
    
    $
    67,528
    
    
    $
    43,326
    
    
    $
    136,471
    
    
    $
    80,854Net revenue
    
    $
    418,672
    
    
    $
    326,218
    
    
    $
    840,665
    
    
    $
    638,525EBITDA margin (b)
    
    
    16.1
    %
    
    
    13.3
    %
    
    
    16.2
    %
    
    
    12.7
    %
 The following table reconciles same hospitals information. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Net Operating RevenueSpecialty hospitals net operating revenue
    
    $
    271,353
    
    
    $
    191,763
    
    
    $
    544,256
    
    
    $
    375,191Less: Specialty hospitals opened or acquired after
1/1/03
    
    
    55,639
    
    
    
    289
    
    
    
    107,236
    
    
    
    289Closed specialty hospital
    
    
    
    
    
    
    10
    
    
    
    
    
    
    
    1,473Specialty hospitals same store net operating revenue
    
    $
    215,714
    
    
    $
    191,464
    
    
    $
    437,020
    
    
    $
    373,429Adjusted EBITDA (b)Specialty hospitals Adjusted EBITDA (b)
    
    $
    58,605
    
    
    $
    30,708
    
    
    $
    116,989
    
    
    $
    56,194Less: Specialty hospitals opened or acquired after
1/1/03
    
    
    11,678
    
    
    
    (1,307
    )
    
    
    24,283
    
    
    
    (1,623
    )Closed specialty hospital
    
    
    
    
    
    
    (246
    )
    
    
    
    
    
    
    (39
    )Specialty hospitals same store Adjusted EBITDA (b)
    
    $
    46,927
    
    
    $
    32,261
    
    
    $
    92,706
    
    
    $
    57,856All specialty hospitals Adjusted EBITDA margin (b)
    
    
    21.6
    %
    
    
    16.0
    %
    
    
    21.5
    %
    
    
    15.0
    %Specialty hospitals same store Adjusted EBITDA margin
(b)
    
    
    21.8
    %
    
    
    16.8
    %
    
    
    21.2
    %
    
    
    15.5
    %
 NM  Not Meaningful  (a)
    
    Cost of services include salaries, wages and benefits, operating
supplies, lease and rent expense and other operating costs.(b)
    
    We define Adjusted EBITDA as net income before interest, income taxes,
depreciation and amortization and minority interest. Minority interest is
then deducted from Adjusted EBITDA to derive EBITDA. We believe that the
presentation of EBITDA is important to investors because EBITDA is
commonly used as an analytical indicator of performance by investors
within the healthcare industry. Adjusted EBITDA is used by management to
evaluate financial performance and determine resource allocation for each
of our operating units. EBITDA and Adjusted EBITDA are not measures of
financial performance under generally accepted accounting principles.
Items excluded from EBITDA and Adjusted EBITDA are significant components
in understanding and assessing financial performance. EBITDA and Adjusted
EBITDA should not be considered in isolation or as an alternative to, or
substitute for, net income, cash flows generated by operations, investing
or financing activities, or other financial statement data presented in
the consolidated financial statements as indicators of financial
performance or liquidity. Because EBITDA and Adjusted EBITDA are not
measurements determined in accordance with generally accepted accounting
principles and are thus susceptible to varying calculations, EBITDA and
Adjusted EBITDA as presented may not be comparable to other similarly
titled measures of other companies. See footnote 5 to our unaudited
consolidated interim financial statements for a reconciliation of net
income to Adjusted EBITDA as utilized by us in reporting our segment
performance in accordance with SFAS No. 131. -28-




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Three Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003 Net Operating Revenues Our net operating revenues increased by 28.3% to $418.7 million for the
three months ended June 30, 2004 compared to $326.2 million for the three
months ended June 30, 2003. The reasons for the increase in net operating
revenues are discussed below. Specialty Hospitals.Our specialty hospital net operating revenues
increased 41.5% to $271.4 million for the three months ended June 30, 2004
compared to $191.8 million for the three months ended June 30, 2003. Net
operating revenues for the 71 specialty hospitals opened before January 1, 2003
and operated throughout both periods increased 12.7% to $215.7 million for the
three months ended June 30, 2004 from $191.5 million for the three months ended
June 30, 2003. The increase in same hospital revenues resulted primarily from
higher net revenue per patient day, which is primarily attributable to the
improved reimbursement we are receiving from Medicare under the LTCH-PPS. The
remaining increase of $55.4 million resulted from the acquisition of the
Kessler facilities, which contributed $38.2 million of net revenue, and the
internal development of new specialty hospitals that commenced operations in
2003 and 2004. Outpatient Rehabilitation.Our outpatient rehabilitation net operating
revenues increased 9.3% to $144.3 million for the three months ended June 30,
2004 compared to $132.0 million for the three months ended June 30, 2003. The
increase in net operating revenues was principally related to the acquisition
of the Kessler operations, which contributed $14.9 million of net operating
revenue. Net revenue per visit in our U.S. based outpatient rehabilitation
clinics increased to $89 for the three months ended June 30, 2004 compared to
$88 for the three months ended June 30, 2003. The number of patient visits in
these clinics for the three months ended June 30, 2004 were 993,237 compared to
1,019,028 visits for the three months ended June 30, 2003. Excluding the
effects of the Kessler operations, the number of U.S. based visits would have
been 899,484. This reflects an 11.7% decline in visits for the three months
ended June 30, 2004 compared to the three months ended June 30, 2003. The
majority of this decline is related to clinic closures, in addition, various
market factors such as elimination of unprofitable contracts and competition
from referring physicians who are now developing their own rehabilitation
therapy practices have contributed to the decline. Other.Our other revenues increased to $3.0 million for the three months
ended June 30, 2004 compared to $2.4 million for the three months ended June
30, 2003. The increase in revenues was related to the other businesses we
acquired from Kessler that are now being reported under this category. These
businesses generated approximately $2.7 million of net operating revenues
during the three months ended June 30, 2004. We experienced a decline of $2.2
million in Medicare net operating revenues associated with reimbursement for
our general and administrative costs. This revenue item has been eliminated as
a result of our long-term acute care hospitals converting to LTCH-PPS. See
Critical Accounting Matters-Sources of Revenue for a further discussion of
this change. Operating Expenses Our operating expenses increased by 24.0% to $350.0 million for the three
months ended June 30, 2004 compared to $282.2 million for the three months
ended June 30, 2003. Our operating expenses include our cost of services,
general and administrative expense and bad debt expense. The increase in
operating expenses was principally related to the acquisition of Kessler and
the internal development of new specialty hospitals that commenced operations
in 2003 and 2004. As a percentage of our net operating revenues, our operating
expenses were 83.6% for the three months ended June 30, 2004 compared to 86.5%
for the three months ended June 30, 2003. Cost of services as a percentage of
operating revenues decreased to 77.5% for the three months ended June 30, 2004
from 79.2% for the three months ended June 30, 2003. These costs primarily
reflect our -29-




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labor expenses. This decrease resulted because we experienced a larger
rate of growth in our specialty hospital revenues compared to the growth in our
specialty hospital cost of services. Another component of cost of services is
rent expense, which was $26.4 million for the three months ended June 30, 2004
compared to $22.5 million for the three months ended June 30, 2003. This
increase is principally related to our new hospitals that opened during 2003
and 2004 and the rent expense for the acquired Kessler clinics. During the
same time period, general and administrative expense as a percentage of net
operating revenues declined to 3.3% for the three months ended June 30, 2004
from 3.5% for the three months ended June 30, 2003. This decrease in general
and administrative expense as a percentage of net operating revenue is the
result of growth in net operating revenues that exceeded the growth in our
general and administrative costs. Our bad debt expense as a percentage of net
operating revenues was 2.8% for the three months ended June 30, 2004 compared
to 3.8% for the three months ended June 30, 2003. This decrease in bad debt
expense resulted from an improvement in the composition and aging of our
accounts receivable. EBITDA and Adjusted EBITDA Our total EBITDA increased 55.9% to $67.5 million for the three months
ended June 30, 2004 compared to $43.3 million for the three months ended June
30, 2003. Our EBITDA margins increased to 16.1% for the three months ended June
30, 2004 compared to 13.3% for the three months ended June 30, 2003. For cash
flow information, see -Capital Resources and Liquidity. Specialty Hospitals.Adjusted EBITDA increased by 90.8% to $58.6 million
for the three months ended June 30, 2004 compared to $30.7 million for the
three months ended June 30, 2003. Our Adjusted EBITDA margins increased to
21.6% for the three months ended June 30, 2004 from 16.0% for the three months
ended June 30, 2003. The hospitals opened before January 1, 2003 and operated
throughout both periods had Adjusted EBITDA of $46.9 million, an increase of
45.5% over the Adjusted EBITDA of these hospitals in the same period last year.
This increase in same hospital Adjusted EBITDA resulted from an increase in
revenue per patient day, which is primarily attributable to the improved
reimbursement we are receiving from Medicare under LTCH-PPS. For additional
information on LTCH-PPS see Critical Accounting Matters  Sources of Revenue.
Our Adjusted EBITDA margin in these same store hospitals increased to 21.8%
for the three months ended June 30, 2004 from 16.8% for the three months ended
June 30, 2003. Outpatient Rehabilitation.Adjusted EBITDA increased by 3.3% to $24.2
million for the three months ended June 30, 2004 compared to $23.4 million for
the three months ended June 30, 2003. Our Adjusted EBITDA margins were 16.8%
for the three months ended June 30, 2004 compared to 17.7% for the three months
ended June 30, 2003. This Adjusted EBITDA margin decline was the result of an
increase in labor costs offset by a decline in bad debt expense. We have
experienced an increase in labor costs due to increased competition for hiring
therapists. Other.The Adjusted EBITDA loss was $14.1 million for the three months
ended June 30, 2004 compared to a loss of $10.1 million for the three months
ended June 30, 2003. This decrease in Adjusted EBITDA was primarily the result
of the decline in Medicare reimbursements for corporate support costs of $2.2
million resulting from the implementation of LTCH-PPS and an increase in
general and administrative costs of $2.3 million. The increase in general and
administrative costs is principally related to an increase in incentive
compensation tied to our improved performance. Income from Operations Income from operations increased 62.7% to $60.0 million for the three
months ended June 30, 2004 compared to $36.8 million for the three months ended
June 30, 2003. The increase in income from operations resulted from the
Adjusted EBITDA increases described above, and was offset by an increase in
depreciation and amortization expense of $1.5 million. The increase in
depreciation and amortization expense resulted primarily from the additional
depreciation associated with the acquired Kessler assets, the amortization of
the -30-




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value of the seven year non-compete agreement that we received from
Kesslers selling stockholder, and increases in depreciation on fixed asset
additions that are principally related to new hospital and clinic development. Interest Expense Interest expense increased by $1.7 million to $7.3 million for the three
months ended June 30, 2004 from $5.6 million for the three months ended June

30, 2003. The increase in interest expense is the result of higher debt levels
outstanding in 2004 compared to 2003 resulting from the issuance of $175.0
million of 71/2% senior subordinated notes due 2013 on August 12, 2003 to
fund the Kessler acquisition, offset by a reduction in borrowings under our
senior credit facility. The lower debt levels on our senior credit facility
resulted from scheduled term amortization payments and principal pre-payments.
All repayments have been made with cash flows generated from operations. Minority Interests Minority interests in consolidated earnings were $1.1 million for the
three months ended June 30, 2004 compared to $0.7 million for the three months
ended June 30, 2003. This increase is the result of the improved profitability
of these jointly owned entities. Income Taxes We recorded income tax expense of $21.0 million for the three months ended
June 30, 2004. The expense represented an effective tax rate of 40.4%. We
recorded income tax expense of $12.0 million for the three months ended June
30, 2003. This expense represented an effective tax rate of 39.2%. The
effective tax rates in both 2004 and 2003 approximate the federal and state
statutory tax rates. The increase in the effective tax rate is the result of a
larger portion of our net income being earned in states with higher tax rates. Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003 Net Operating Revenues Our net operating revenues increased by 31.7% to $840.7 million for the
six months ended June 30, 2004 compared to $638.5 million for the six months
ended June 30, 2003. The reasons for the increase in net operating revenues
are discussed below. Specialty Hospitals.Our specialty hospital net operating revenues
increased 45.1% to $544.3 million for the six months ended June 30, 2004
compared to $375.2 million for the six months ended June 30, 2003. Net
operating revenues for the 71 specialty hospitals opened before January 1, 2003
and operated throughout both periods increased 17.0% to $437.0 million for the
six months ended June 30, 2004 from $373.4 million for the six months ended
June 30, 2003. The increase in same hospital revenues resulted primarily from
higher net revenue per patient day, which is primarily attributable to the
improved reimbursement we are receiving from Medicare under LTCH-PPS. The
remaining increase of $105.5 million resulted from the acquisition of the
Kessler facilities, which contributed $76.0 million of net revenue, and the
internal development of new specialty hospitals that commenced operations in
2003 and 2004. Outpatient Rehabilitation.Our outpatient rehabilitation net operating
revenues increased 12.5% to $289.9 million for the six months ended June 30,
2004 compared to $257.6 million for the six months ended June 30, 2003. The
increase in net operating revenues was principally related to the acquisition
of the Kessler operations, which contributed $31.4 million of net operating
revenue. Net revenue per visit in our U.S. based outpatient rehabilitation
clinics increased to $90 for the six months ended June 30, 2004 compared to $88
for the six months ended June 30, 2003. The number of patient visits in these
clinics for the six months ended June 30, 2004 were 1,997,343 visits compared
to 2,000,600 visits for the six months ended June 30, 2003. Excluding the
effects of the Kessler operations, the number of U.S. based visits would have
been 1,804,238. This reflects a -31-




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9.8% decline in visits for the six months ended June 30, 2004 compared to
the six months ended June 30, 2003. The majority of this decline is related to
clinic closures, in addition, various market factors such as elimination of
unprofitable contracts and competition from referring physicians who are now
developing their own rehabilitation therapy practices have contributed to the
decline. Other.Our other revenues increased to $6.5 million for the six months
ended June 30, 2004 compared to $5.7 million for the six months ended June 30,
2003. The increase in revenues was related to the other businesses we acquired
from Kessler that are now being reported under this category. These businesses
generated approximately $5.7 million of net operating revenues during the six
months ended June 30, 2004. We experienced a decline of $5.0 million in
Medicare net operating revenues associated with reimbursement for our general
and administrative costs. This revenue item has been eliminated as a result of
our long-term acute care hospitals converting to LTCH-PPS. See Critical
Accounting Matters-Sources of Revenue for a further discussion of this change. Operating Expenses Our operating expenses increased by 26.2% to $702.0 million for the six
months ended June 30, 2004 compared to $556.1 million for the six months ended

June 30, 2003. Our operating expenses include our cost of services, general and
administrative expense and bad debt expense. The increase in operating
expenses was principally related to the acquisition of Kessler and the internal
development of new specialty hospitals that commenced operations in 2003 and
2004. As a percentage of our net operating revenues, our operating expenses
were 83.5% for the six months ended June 30, 2004 compared to 87.1% for the six
months ended June 30, 2003. Cost of services as a percentage of operating
revenues decreased to 77.7% for the six months ended June 30, 2004 from 80.0%
for the six months ended June 30, 2003. These costs primarily reflect our
labor expenses. This decrease resulted because we experienced a greater rate of
growth in our specialty hospital revenues compared to the growth in our
specialty hospital cost of services. Another component of cost of services is
rent expense, which was $52.9 million for the six months ended June 30, 2004
compared to $44.7 million for the six months ended June 30, 2003. This
increase is principally related to our new hospitals that opened during 2003
and 2004 and the rent expense for the acquired Kessler clinics. During the
same time period, general and administrative expense as a percentage of net
operating revenues declined to 3.0% for the six months ended June 30, 2004 from
3.3% for the six months ended June 30, 2003. This decrease in general and
administrative expense as a percentage of net operating revenue is the result
of growth in net operating revenues that exceeded the growth in our general and
administrative costs. Our bad debt expense as a percentage of net operating
revenues was 2.8% for the six months ended June 30, 2004 compared to 3.8% for
the six months ended June 30, 2003. This decrease in bad debt expense resulted
from an improvement in the composition and aging of our accounts receivable. EBITDA and Adjusted EBITDA Our total EBITDA increased 68.8% to $136.5 million for the six months
ended June 30, 2004 compared to $80.9 million for the six months ended June 30,
2003. Our EBITDA margins increased to 16.2% for the six months ended June 30,
2004 compared to 12.7% for the six months ended June 30, 2003. For cash flow
information, see -Capital Resources and Liquidity. Specialty Hospitals.Adjusted EBITDA increased by 108.2% to $117.0
million for the six months ended June 30, 2004 compared to $56.2 million for
the six months ended June 30, 2003. Our Adjusted EBITDA margins increased to
21.5% for the six months ended June 30, 2004 from 15.0% for the six months
ended June 30, 2003. The hospitals opened before January 1, 2003 and operated
throughout both periods had Adjusted EBITDA of $92.7 million, an increase of
60.2% over the Adjusted EBITDA of these hospitals in the same period last year.
This increase in same hospital Adjusted EBITDA resulted from an increase in
revenue per patient day, which is primarily attributable to the improved
reimbursement we are receiving from Medicare -32-




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under LTCH-PPS. For additional information on LTCH-PPS see Critical
Accounting Matters  Sources of Revenue. Our Adjusted EBITDA margin in these
same store hospitals increased to 21.2% for the six months ended June 30, 2004
from 15.5% for the six months ended June 30, 2003. Outpatient Rehabilitation.Adjusted EBITDA increased by 9.8% to $47.1
million for the six months ended June 30, 2004 compared to $42.9 million for
the six months ended June 30, 2003. Our Adjusted EBITDA margins were 16.2% for
the six months ended June 30, 2004 compared to 16.6% for the six months ended
June 30, 2003. This Adjusted EBITDA margin decline was the result of an
increase in labor costs offset by a decline in bad debt expense. We have
experienced an increase in labor costs due to increased competition for hiring
therapists. Other.The Adjusted EBITDA loss was $25.4 million for the six months
ended June 30, 2004 compared to a loss of $16.7 million for the six months
ended June 30, 2003. This decrease in Adjusted EBITDA was primarily the result
of the decline in Medicare reimbursements for corporate support costs of $5.0
million resulting from the implementation of LTCH-PPS and an increase in
general and administrative costs of $4.4 million. Income from Operations Income from operations increased 76.5% to $119.5 million for the six
months ended June 30, 2004 compared to $67.7 million for the six months ended
June 30, 2003. The increase in income from operations resulted from the
Adjusted EBITDA increases described above, and was offset by an increase in
depreciation and amortization expense of $4.4 million. The increase in
depreciation and amortization expense resulted primarily from the additional
depreciation associated with the acquired Kessler assets, the amortization of
the value of the seven year non-compete agreement that we received from
Kesslers selling stockholder, and increases in depreciation on fixed asset
additions that are principally related to new hospital and clinic development. Interest Expense Interest expense increased by $4.8 million to $16.8 million for the six
months ended June 30, 2004 from $12.0 million for the six months ended June 30,
2003. The increase in interest expense is the result of higher debt levels
outstanding in 2004 compared to 2003 resulting from the issuance of $175.0
million of 71/2% senior subordinated notes due 2013 on August 12, 2003,
offset by a reduction in borrowings under our senior credit facility. The lower
debt levels on our senior credit facility resulted from scheduled term
amortization payments and principal pre-payments. All repayments have been
made with cash flows generated from operations. Minority Interests Minority interests in consolidated earnings were $2.2 million for the six
months ended June 30, 2004 compared to $1.5 million for the six months ended
June 30, 2003. This increase is the result of the improved profitability of
these jointly owned entities. Income Taxes We recorded income tax expense of $40.9 million for the six months ended
June 30, 2004. The expense represented an effective tax rate of 40.3%. We
recorded income tax expense of $21.4 million for the six months ended June 30,
2003. This expense represented an effective tax rate of 39.2%. The effective
tax rates in both 2004 and 2003 approximate the federal and state statutory tax
rates. The increase in the effective tax rate is the result of a larger
portion of our net income being earned in states with higher tax rates. -33-




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Capital Resources and Liquidity For the six months ended June 30, 2004, operating activities provided
$64.4 million of cash flow. Our accounts receivable days outstanding were 52
days at June 30, 2004 and December 31, 2003. Our accounts receivable days
outstanding were 56 days at June 30, 2003 compared to 73 days at December 31,
2002. Because our days in accounts receivable at December 31, 2003 and June
30, 2004 were the same, our cash flow from operations did not benefit as it did
in the comparable period last year from a reduction in accounts receivable days
outstanding. Our cash flow from operations is comparable with our net income
for the six months ended June 30, 2004 of $60.5 million, as we have been able
to convert our revenue into cash on a timely basis. For the six months ended
June 30, 2003, operating activities provided $91.3 million of cash flow. This
substantial cash flow was generated because of our strong collection of
accounts receivable during this period. Investing activities used $17.3 and $17.0 million of cash flow for the six
months ended June 30, 2004 and 2003, respectively. This usage resulted from
purchases of property and equipment of $19.1 and $15.2 million in 2004 and
2003, respectively, that relate principally to new hospital and clinic
development. Additionally in 2004, we incurred $2.9 million in earn out
payments and $0.1 million in acquisition costs. This compares to $0.4 million
in earn out payments and $3.8 million of acquisition costs in the six months
ended June 30, 2003. During the quarter ended June 30, 2004, we sold our
interest in a joint venture that was part of the Kessler acquisition for $4.8
million. Financing activities used $44.5 million of cash for the six months ended
June 30, 2004. This principally relates to the repurchase of our common stock
during 2004 in accordance with the stock repurchase program we announced on
February 23, 2004. During 2004, we have repurchased a total of 3,399,400
shares at a cost, including fees and commissions, of $48.1 million. The
repurchase program provides for the repurchase of up to $80 million of our
common stock through August 31, 2005. Additionally, during 2004, we repaid all
outstanding balances under our credit facility of $8.5 million and repaid $2.6
million of seller loans. Cash dividend payments in the first six months of
2004 were $6.2 million. We had $15.0 million of cash flow from the issuance of
common stock under our stock option plan. During the six months ended June 30,
2003, financing activities used $39.3 million of cash. This principally
related to the repayment of our credit facility debt. Capital Resources Net working capital increased to $224.2 million at June 30, 2004 compared
to $188.4 million at December 31, 2003. The increase in working capital is
principally related to the reduction in our current liabilities. A reduction
in accounts payable and amounts due to third party payors were the primary
contributors to the reduction in current liabilities. Our accounts payable
balance was larger at December 31, 2003 due to a slow down in payable
processing over the year-end holidays. The reduction in amounts due to third
party payors is a result of filing and settling cost reports and refinements in
the bi-weekly payments we receive from our Medicare fiscal intermediary related
to our Medicare patients. We expect this liability to continue to decline over
the next few quarters. At June 30, 2004, our credit facility consisted of a revolving credit
facility of approximately $152.4 million. As of June 30, 2004 there were no
borrowings under our credit facility. We have $12.5 million outstanding under
letters of credit issued through the credit facility. As of June 30, 2004 we
had the ability to borrow an additional $139.9 million under our revolving
facility subject to certain limitations. The revolving credit facility
terminates in September 2005. Borrowings under the credit facility bear
interest at a fluctuating rate of interest based upon financial covenant ratio
tests. During the six months ended June 30, 2004, our Board of Directors have
declared and paid cash dividends of $0.06 per share. -34-




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We believe that existing cash balances, internally generated cash flows
and borrowings under our revolving credit facility will be sufficient to
finance capital expenditures and working capital requirements related to our
routine operations and development activities for at least the next twelve
months. Our goal historically has been to open eight to ten long-term acute care
hospitals per year utilizing our hospital within a hospital model. A new
long-term acute care hospital using the hospital within a hospital model has
typically required approximately $3.6 million per hospital over the initial
year of operations to fund leasehold improvements, equipment, start-up losses
and working capital. As a result of the regulatory changes adopted by CMS on
August 2, 2004, we are evaluating the effect of the new rules on our hospital
within a hospital model including the mix and pace of development of future
LTACHs. From time to time, we may complete acquisitions of specialty hospitals
and outpatient rehabilitation businesses. We currently have approximately
$139.9 million of unused capacity under our revolving credit facility which can
be used for acquisitions. Based on the size of the acquisition, approval of
the acquisition by our lenders may be required. If funds required for future
acquisitions exceed existing sources of capital, we will need to increase our
credit facilities or obtain additional capital by other means. We also have the ability to call our 91/2 % senior subordinated notes
due 2009 on or after June 15, 2005. The redemption price would be $183.3
million on June 15, 2005. We currently intend to call the notes, although, our
intentions may change based upon changes in our business, cash flows or
interest rates over the next twelve months. Inflation The health care industry is labor intensive. Wages and other expenses
increase during periods of inflation and when labor shortages occur in the
marketplace. In addition, suppliers pass along rising costs to us in the form
of higher prices. We have implemented cost control measures, including our case
and resource management program, to curtail increases in operating costs and
expenses. We have, to date, offset increases in operating costs by increasing
reimbursement for services and expanding services. However, we cannot predict
our ability to cover or offset future cost increases. Recent Accounting Pronouncements In December 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 46R (FIN 46R) which replaced Interpretation No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51, Consolidated Financial Statements, to improve
financial reporting of special purpose and other entities. In accordance with
the interpretation, business enterprises that represent the primary beneficiary
of another entity by retaining a controlling financial interest in that
entitys assets, liabilities and results of operations, must consolidate the
entity in their financial statements. Prior to the issuance of FIN 46R,
consolidation generally occurred when an enterprise controlled another entity
through voting interests. The disclosure requirements of FIN 46R are effective
for financial statements issued after December 31, 2003. The initial
recognition provisions of FIN 46R were implemented during the reporting period
that ended March 31, 2004. The adoption of FIN 46R did not have a material
impact on our financial statements for the three and six months ended June 30,
2004. -35-




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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Quantitative and Qualitative Disclosures About Market Risk We are exposed to interest rate changes, primarily as a result of floating
interest rates on borrowings under our credit facility. As of June 30, 2004
there were no borrowings under our credit facility. 
 ITEM 4. CONTROLS AND PROCEDURES We carried out an evaluation, under the supervision and with the
participation of our principal executive officer and principal financial
officer, of the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered in this report.
Based on this evaluation, our principal executive officer and principal
financial officer concluded that our disclosure controls and procedures provide
reasonable assurance that material information required to be included in our
periodic SEC reports is recorded, processed, summarized and reported within the
time periods specified in the relevant SEC rules and forms. In addition, we reviewed our internal controls, and there have been no
significant changes in our internal controls or in other factors that could
significantly affect those controls subsequent to the date of their last
evaluation. 
 PART II OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS As part of our business, we are subject to legal actions alleging
liability on our part. To cover claims arising out of the operations of our
hospitals and outpatient rehabilitation facilities, we maintain professional
malpractice liability insurance and general liability insurance in amounts and
with deductibles that we believe to be sufficient for our operations. We also
maintain umbrella liability coverage covering claims which, due to their nature
or amount, are not covered by our insurance policies. We cannot assure you
that professional liability insurance will cover all claims against us or
continue to be available at reasonable costs for us to maintain adequate levels
of insurance. These insurance policies also do not cover punitive damages. In recent years, physicians, hospitals and other healthcare providers have
become subject to an increasing number of legal actions alleging malpractice,
product liability or related legal theories. Many of these actions involve
large claims and significant defense costs. We are also subject to lawsuits
under a federal whistleblower statute designed to combat fraud and abuse in the
healthcare industry. These lawsuits can involve significant monetary damages
and award bounties to private plaintiffs who successfully bring the suits. -36-




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ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES The following table contains information regarding the Companys
repurchase of its common stock during the quarter. ApproximateDollar Value ofTotal Number of
    
    Shares thatShares Purchased
    
    May Yet beTotal
    
    
    
    
    
    as Part of
    
    PurchasedNumber of
    
    Average Price
    
    Publicly
    
    Under theShares
    
    Paid per
    
    Announced Plans
    
    Plans orPeriod
    
    Purchased
    
    Share
    
    or Programs (a)
    
    ProgramsApril 1 through April 30, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    60,185,000May 1 through May 31, 2004
    
    
    2,149,900
    
    
    $
    13.09
    
    
    
    2,149,900
    
    
    $
    32,044,000June 1 through June 30, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    32,044,000Total
    
    
    2,149,900
    
    
    $
    13.09
    
    
    
    2,149,900
 (a) On, February 23, 2004, the Companys Board of Directors authorized and
publicly announced a program to repurchase up to $80.0 million of our
common stock. This program will remain in effect until August 31, 2005,
unless extended or cancelled by the Board of Directors. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On May 10, 2004, the Company held its Annual Meeting of Stockholders. At
this meeting the stockholders voted in favor of the following items listed and
described in the Companys Proxy statement dated April 19, 2004. 1) Election of Directors. For
    
    WithheldRussell L. Carson
    
    
    90,085,844
    
    
    
    5,993,700Rocco A. Ortenzio
    
    
    89,233,380
    
    
    
    6,846,164Leopold Swergold
    
    
    91,527,904
    
    
    
    4,551,640
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The following directors term of office as directors continued after this
meeting: David S. Chernow
Bryan C. Cressey

James E. Dalton, Jr.
Meyer Feldberg
Robert A. Ortenzio
Thomas A. Scully
LeRoy S. Zimmerman  2)
    
    Ratification of the appointment of PricewaterhouseCoopers LLP as the
Companys independent auditors for the fiscal year ending December 31,
2004. For
    
    Against
    
    Abstain94,004,765
    
    
    2,062,643
    
    
    
    12,136
 
 ITEM 5. OTHER INFORMATION None. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a. Exhibits The exhibits to this report are listed in the Exhibit Index
appearing on page 40 hereof. b. Reports on Form 8-K Form 8-K dated April 19, 2004, furnished pursuant to Item 9,
attaching glossy pages accompanying the Companys Form 10-K for
distribution to stockholders. Form 8-K dated April 28, 2004, furnished pursuant to Item 12, in
connection with our issuance of a press release on April 27, 2004
reporting our results for the three months ended March 31, 2004. Form 8-K dated May 12, 2004, furnished pursuant to Item 9, in
connection with our issuance of a press release on May 11, 2004
announcing a proposed regulatory change by the Centers for Medicare &
Medicaid Services. Form 8-K dated May 14, 2004, furnished pursuant to Item 9, in
connection with our issuance of a press release on May 13, 2004
announcing the declaration of a quarterly cash dividend. Form 8-K dated June 15, 2004, furnished pursuant to Item 9, in
connection with an investor presentation. -38-




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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. SELECT MEDICAL CORPORATIONBy:
    
    /s/ Martin F. JacksonMartin F. JacksonSenior Vice President and Chief Financial Officer(Duly Authorized Officer)By:
    
    /s/ Scott A. RombergerScott A. RombergerVice President, Chief Accounting Officer and Controller(Principal Accounting Officer)Dated:
August 6, 2004
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EXHIBIT INDEX Exhibit
    
    Description10.1
    
    Eighth Amendment dated as of May 27, 2004 to the credit agreement
dated as of September 22, 2000 among Select Medical Corporation,
Canadian Back Institute Limited, the Lenders party thereto, JP Morgan
Chase Bank, JP Morgan Chase Bank, Toronto Branch, Banc of America
Securities, LLC and CIBC, Inc.31.1
    
    Certification of President and Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Senior Vice President and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of President and Chief Executive Officer Pursuant to 18
U.S.C Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Senior Vice President and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
 -40-