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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington D.C 20549
 
 Form 10-Q þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2005 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Numbers 333-97293 and 333-116927 EXTENDICARE HEALTH SERVICES, INC. (Exact name of registrant as specified in its charter)
 Delaware
    
    111 West Michigan Street
    
    98-0066268(State or other jurisdiction of
    
    Milwaukee, WI 53203
    
    (I.R.S. Employerincorporation or organization)
    
    (Address of principal executive office
    
    Identification Number)including zip code)
 (414) 908-8000
(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. þ o
 Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act) o þ
 Common Stock  1,000 shares authorized, $1.00 par value per share; 947 shares issued and
outstanding as of May 6, 2005. All issued and outstanding shares of Common Stock
are held indirectly by Extendicare Inc., a publicly traded Canadian company.




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EXTENDICARE HEALTH SERVICES, INC. INDEX PagePart I Financial Information:Item 1 Financial Statements:Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2005 and 2004
    
    
    3Condensed Consolidated Balance Sheets, March 31, 2005 and December 31, 2004
    
    
    4Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2005 and 2004
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    23Item 3 Quantitative and Qualitative Disclosures About Market Risk
    
    
    49Item 4 Controls and Procedures
    
    
    50Part II Other Information:Item 1 Legal Proceedings
    
    
    51Item 6 Exhibits
    
    
    51Signatures
    
    
    52Exhibit Index
    
    
    53Section 302 Certification of CEOSection 302 Certification of CFOWritten Statement
  2




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PART I
FINANCIAL INFORMATION 
 Item 1. Financial Statements EXTENDICARE HEALTH SERVICES, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(In thousands) Three Months Ended March 31,2005
    
    
    2004REVENUES:Nursing and assisted living facilities
    
    $
    286,357
    
    
    $
    224,426Outpatient therapy
    
    
    2,727
    
    
    
    2,665Other
    
    
    5,063
    
    
    
    4,410294,147
    
    
    
    231,501COSTS AND EXPENSES (INCOME):Operating
    
    
    240,427
    
    
    
    189,456General and administrative
    
    
    9,609
    
    
    
    7,490Lease costs
    
    
    4,608
    
    
    
    2,264Depreciation and amortization
    
    
    10,340
    
    
    
    8,681Interest expense, net
    
    
    8,144
    
    
    
    6,585Valuation adjustment on interest rate caps
    
    
    1,298
    
    
    
    73Loss (gain) on disposal of assets and
impairment of long-lived assets
    
    
    (448
    )
    
    
    1,612Loss on refinancing and retirement of debt
    
    
    275
    
    
    
    354274,253
    
    
    
    216,515INCOME BEFORE INCOME TAXES
    
    
    19,894
    
    
    
    14,986Income tax expense
    
    
    7,840
    
    
    
    5,639NET INCOME
    
    $
    12,054
    
    
    $
    9,347
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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EXTENDICARE HEALTH SERVICES, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
March 31, 2005 AND December 31, 2004
(In thousands except share data) March 31,
    
    
    December 31,2005
    
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    9,252
    
    
    $
    29,612Accounts receivable, less allowances of $11,798
and $10,594, respectively
    
    
    126,798
    
    
    
    95,973Supplies, inventories and other current assets
    
    
    24,042
    
    
    
    17,751Income taxes receivable
    
    
    481
    
    
    
    1,654Deferred state income taxes
    
    
    2,843
    
    
    
    2,664Due from shareholder and affiliates:Federal income taxes receivable
    
    
    1,231
    
    
    
    5,231Deferred federal income taxes
    
    
    14,183
    
    
    
    13,258Other
    
    
    
    
    
    
    7,690Total current assets
    
    
    178,830
    
    
    
    173,833Property and equipment, net
    
    
    750,218
    
    
    
    446,085Goodwill and other intangible assets, net
    
    
    74,269
    
    
    
    74,554Deferred state income taxes
    
    
    701
    
    
    
    Other assets
    
    
    43,654
    
    
    
    41,485Total Assets
    
    $
    1,047,672
    
    
    $
    735,957LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Outstanding checks in excess of bank balance
    
    $
    10,091
    
    
    $
    Current maturities of long-term debt
    
    
    4,248
    
    
    
    1,071Accounts payable
    
    
    20,735
    
    
    
    22,297Accrued liabilities
    
    
    134,510
    
    
    
    99,920Current portion of accrual for self-insured liabilities
    
    
    12,500
    
    
    
    18,000Current portion of amounts due to shareholder and
affiliates
    
    
    2,975
    
    
    
    2,975Total current liabilities
    
    
    185,059
    
    
    
    144,263Accrual for self-insured liabilities
    
    
    23,221
    
    
    
    19,725Long-term debt and capital lease obligations
    
    
    538,657
    
    
    
    290,861Deferred state income taxes
    
    
    
    
    
    
    1,833Other long-term liabilities
    
    
    18,634
    
    
    
    12,448Due to shareholder and affiliates:Deferred federal income taxes
    
    
    5,015
    
    
    
    1,853Other
    
    
    14,693
    
    
    
    14,785Total Liabilities
    
    
    785,279
    
    
    
    485,768Shareholders Equity:Common stock, $1 par value, 1,000 shares authorized,
947 shares issued and outstanding
    
    
    1
    
    
    
    1Additional paid-in capital
    
    
    209,389
    
    
    
    209,221Accumulated other comprehensive income
    
    
    323
    
    
    
    342Retained earnings
    
    
    52,680
    
    
    
    40,625Total Shareholders Equity
    
    
    262,393
    
    
    
    250,189Total Liabilities and Shareholders Equity
    
    $
    1,047,672
    
    
    $
    735,957
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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EXTENDICARE HEALTH SERVICES, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(In thousands) Three Months Ended
    
    
    Three Months EndedMarch 31, 2005
    
    
    March 31, 2004OPERATING ACTIVITIES:Net income
    
    $
    12,054
    
    
    $
    9,347Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    10,340
    
    
    
    8,681Amortization of deferred financing costs
    
    
    470
    
    
    
    377Amortization of purchase accounting adjustments for leases and debt
    
    
    (83
    )
    
    
    Provision for uncollectible accounts receivable
    
    
    2,850
    
    
    
    3,184Provision for self-insured liabilities
    
    
    1,995
    
    
    
    1,650Payment of self-insured liability claims
    
    
    (4,902
    )
    
    
    (3,112
    )Deferred income taxes
    
    
    2,518
    
    
    
    (3,811
    )Valuation adjustment on interest rate caps
    
    
    1,298
    
    
    
    73(Gain) loss on disposal of assets and impairment of long-lived assets
    
    
    (448
    )
    
    
    1,612Loss on refinancing and retirement of debt
    
    
    275
    
    
    
    354Changes in assets and liabilities:Accounts receivable attributable to Pennsylvania provider tax
    
    
    (18,971
    )
    
    
    Accounts receivable
    
    
    (11,603
    )
    
    
    (1,557
    )Supplies, inventories and other current assets
    
    
    444
    
    
    
    (1,255
    )Accounts payable
    
    
    (4,392
    )
    
    
    (3,437
    )Accrued liabilities attributable to Pennsylvania provider tax
    
    
    15,541
    
    
    
    Accrued liabilities
    
    
    4,327
    
    
    
    (679
    )Income taxes payable/receivable
    
    
    (314
    )
    
    
    1,477Current due to shareholder and affiliates
    
    
    11,744
    
    
    
    5,580Cash provided by operating activities
    
    
    23,143
    
    
    
    18,484INVESTING ACTIVITIES:Payment for acquisition of Assisted Living Concepts, Inc (ALC)
    
    
    (144,199
    )
    
    
    Cash balances in ALC as of acquisition
    
    
    6,547
    
    
    
    Proceeds from repayment of notes receivable
    
    
    
    
    
    
    4,402Payments for purchase of property and equipment
    
    
    (6,340
    )
    
    
    (5,345
    )Payments for other acquisitions
    
    
    
    
    
    
    (2,129
    )Payments for new construction projects
    
    
    (5,699
    )
    
    
    (3,800
    )Proceeds from sale of property and equipment
    
    
    1,878
    
    
    
    Changes in other non-current assets
    
    
    (243
    )
    
    
    (367
    )Cash used in investing activities
    
    
    (148,056
    )
    
    
    (7,239
    )FINANCING ACTIVITIES:Proceeds from Revolving Credit Facility to finance ALC acquisition
    
    
    60,000
    
    
    
    Proceeds from 6% EHI Term Note to finance ALC acquisition
    
    
    55,000
    
    
    
    Payments of long-term debt
    
    
    (19,280
    )
    
    
    (13,397
    )Payments on line of credit
    
    
    (12,000
    )
    
    
    Proceeds from issuance of long-term debt
    
    
    10,000
    
    
    
    706Payment of deferred financing costs
    
    
    (125
    )
    
    
    Outstanding checks in excess of bank balance
    
    
    10,091
    
    
    
    Other long-term liabilities
    
    
    867
    
    
    
    484Cash provided by (used in) financing activities
    
    
    104,553
    
    
    
    (12,207
    )Decrease in cash and cash equivalents
    
    
    (20,360
    )
    
    
    (962
    )Cash and cash equivalents, beginning of period
    
    
    29,612
    
    
    
    48,855Cash and cash equivalents, end of period
    
    $
    9,252
    
    
    $
    47,893
 The accompanying notes are an integral part of these condensed consolidated financial statements. 5




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EXTENDICARE HEALTH SERVICES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(In thousands) Three Months Ended
    
    
    Three Months EndedMarch 31, 2005
    
    
    March 31, 2004Supplemental schedule of cash flow information:Cash paid during the period for:Interest
    
    $
    7,554
    
    
    $
    10,235Income tax payments, net of refunds
    
    
    889
    
    
    
    2,921Supplemental schedule of noncash investing and financing activities:The Company acquired all of the capital stock of Assisted Living
Concepts, Inc. for $144,199. In connection with the acquisition,
liabilities were assumed as follows:Fair value of assets acquired
    
    $
    310,136
    
    
    $
    Cash paid
    
    
    (144,199
    )
    
    
    Liabilities assumed
    
    $
    165,937
    
    
    $
    Capital lease obligations incurred to purchase properties  See Note 7
    
    $
    12,822
    
    
    $
    
 The accompanying notes are an integral part of these condensed consolidated financial statements. 6




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EXTENDICARE HEALTH SERVICES, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Extendicare Health Services, Inc. and its subsidiaries (hereafter referred to as the
Company, unless the context requires otherwise) operates in one reporting segment, nursing and
assisted living facilities, throughout the United States. The Company is an indirect wholly owned
subsidiary of Extendicare Inc. (Extendicare), a Canadian publicly traded company. Basis of Presentation The accompanying condensed consolidated financial statements as of, and for the three months
ended March 31, 2005 and 2004 are unaudited and have been prepared in accordance with the
instructions to Form 10-Q. Such financial statements do not include all of the information and the
footnotes required by accounting principles generally accepted in the United States of America for
complete statements. In the opinion of the Companys management, all adjustments necessary for a
fair presentation of such financial statements have been included. The condensed consolidated
balance sheet information as of December 31, 2004 has been derived from the Companys audited
consolidated financial statements. The condensed consolidated financial statements of the Company have been prepared in
accordance with accounting principles generally accepted in the United States of America. The
preparation of financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported amount of assets and
liabilities and disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the reporting period.
Managements most significant estimates include provision for bad debts, provision for Medicaid and
Medicare revenue rate settlements, valuation of assets and asset impairment, self-insured
liabilities for general and professional liability, workers compensation and health and dental
claims, and valuation of deferred tax assets. Actual results could differ from those estimates. The condensed consolidated financial statements include those of the Company and its
subsidiaries. All significant intercompany accounts and transactions with subsidiaries have been
eliminated from the consolidated financial statements. These condensed consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto for the year ended December 31, 2004 contained
in the Companys Annual Report on Form 10-K. Certain reclassifications have been made to the 2004
condensed consolidated financial statements to conform to the presentation for 2005. 2. Acquisition of Assisted Living Concepts, Inc. On January 31, 2005, the Company completed the acquisition of Assisted Living Concepts, Inc.,
(ALC) of Dallas, Texas for a total of approximately $285 million, including the assumption of
ALCs existing debt with a book value of approximately $141 million. The acquisition was completed
immediately subsequent to, and pursuant to, the shareholder approval of the merger and acquisition
agreement entered into on November 4, 2004 that provided for the acquisition of all of the
outstanding shares and stock options of ALC for $18.50 per share. The Company financed the
acquisition by using approximately $29 million of cash on hand, a $55 million 6% Term Note due 2010
from the Companys U.S. parent company Extendicare Holdings, Inc. (EHI), and drawing $60 million
from the Revolving Credit Facility. On January 31, 2005 ALC had a portfolio of 177 assisted
living facilities, comprised of 122 owned properties and 55 leased facilities representing 6,838
units, located in 14 states, many in markets where the Company operated. The goal of the
acquisition was to expand the Companys asset portfolio and level of non-government based revenue
sources. 7




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The estimated impact of the acquisition on each asset and liability category in the Companys
condensed consolidated balance sheet is as follows as of January 31, 2005: (in thousands)ASSETS:Cash, net of $29 million used to finance the acquisition
    
    $
    (22,652
    )Accounts receivable
    
    
    3,003Other current assets
    
    
    8,308Total current assets
    
    
    (11,341
    )Property, plant and equipment
    
    
    290,761Other long-term assets
    
    
    4,497Total assets
    
    $
    283,917LIABILITIES:Current maturities of long-term debt
    
    $
    3,418Other current liabilities
    
    
    19,733Total current liabilities
    
    
    23,151Long-term debt:Long-term debt of ALC assumed
    
    
    141,011Proceeds from 6% EHI Term Note to finance acquisition
    
    
    55,000Proceeds from Revolving Credit Facility to finance acquisition
    
    
    60,000Total long-term debt
    
    
    256,011Other long-term liabilities
    
    
    4,755Total liabilities
    
    $
    283,917
 The above reflects the preliminary purchase price allocation. The Company is in the
process of, and will complete by December 2005, the valuation of net assets acquired. Based on
this valuation, the purchase price allocation for accounting purposes may be adjusted in future
periods. The operations of ALC are included in the condensed consolidated statements of income and the
condensed consolidated statement of cash flows beginning February 1, 2005. The assets and
liabilities of ALC are included within our condensed consolidated balance sheet as of March 31,
2005. Below is pro forma income statement information of the Company prepared assuming the
acquisition of ALC occurred as of January 1, 2004 and is consolidated with the Companys statement
of income. This pro forma information includes purchase accounting adjustments but does not
include estimated cost savings. Three MonthsEnded March 31,2005
    
    
    2004( in thousands)Total revenues
    
    $
    309,024
    
    
    $
    274,057Income before income taxes
    
    
    19,037
    
    
    
    14,603Net income
    
    
    11,533
    
    
    
    9,575
 In January 2005, the Company amended its Revolving Credit Facility to permit the loan
from EHI to partially finance the ALC acquisition. Subsequently, Extendicare Inc. advanced $55
million to EHI, who, in turn advanced $55 million as a 6% Term Note due 2010 to the Company. ALCs
debt is non-recourse to the Company and its subsidiaries that existed prior to the acquisition of
ALC, and ALCs debt and earnings will be excluded from existing financial covenants under the
Companys Revolving Credit Facility. 8




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In January 2005, the Company entered into a Memorandum of Understanding (MOU) and later two
new master lease agreements with LTC Properties, Inc. (LTC) in respect of 37 facilities leased to
ALC by LTC. Under the terms of the MOU and master lease agreements, which become effective January
1, 2005, the Company agreed to increase the annual rent paid to LTC by $250,000 per annum for each
of the successive four years, commencing on January 1, 2005, and amended the terms relating to
inflationary increases. Formerly, the 37 leases had expiration dates ranging from 2007 through
2015. Under the terms of the master lease agreements, the initial 10 year lease term commenced on
January 1, 2005, and there are three successive 10 year lease renewal terms at the option of the
Company. There are no significant economic penalties to the Company if it decides not to exercise
the renewal options. The aggregate minimum rent payments for the LTC leases for the calendar years
2005 through 2008 will be $9.4 million, $9.8 million, $10.2 million and $10.7 million,
respectively. The minimum rent will increase by 2% over the prior years minimum rent for each of
the calendar years 2009 through 2014. Annual minimum rent during any extended term will increase a
minimum of 2% over the minimum rent of the immediately preceding year. The MOU provides that LTC
will not assert certain events of default against ALC under the original leases. In accordance
with FASB Technical Bulletin 85-3, the Company accounts for the effect of scheduled rent increases
on a straight-line basis over the lease term. 3. Other Acquisitions and New Construction On February 12, 2004, the Company acquired a nursing facility in Washington, which was
previously leased, for $1.4 million in cash. On June 1, 2004, the Company acquired four nursing
facilities (321 beds) in Indiana for $5.0 million in cash. During 2004, the Company completed four construction projects for a total cost of $10.0
million. The Company added the following beds or units to existing facilities: 16 units to an
assisted living facility in Kentucky in February 2004, 20 nursing beds to a nursing facility in
Wisconsin in March 2004, and 30 units to an assisted living facility in Wisconsin in May 2004. In
addition, the Company opened a new assisted living facility with 40 units in Wisconsin in May 2004. 4. Approval of Pennsylvania and Washington State Plans and Amendments Relating to Medicaid Revenues In January 2005, the States of Pennsylvania and Washington received approval from the Centers
for Medicare and Medicaid Services (CMS) for state plan amendments and waivers, which increase
federal funding for their Medicaid programs and provide nursing facilities with revenue rate
increases to offset new state provider taxes. The Washington approval had no impact on the
Companys income. In March 2005 the State of Pennsylvania officially approved and committed to the
state plan amendment and waiver. As a result of the Pennsylvania approval, in the first quarter of
2005 the Company recognized incremental revenues pertaining to the state plan amendment of $16.5
million and provider tax expense of $13.3 million relating to the period from July 1, 2003 to
December 31, 2004. Offsetting this, the State of Pennsylvania published its final Medicaid rates
for the period commencing July 1, 2004, which resulted in a reduction of previously accrued
revenues of $0.6 million. In the first quarter of 2005, the Company also recognized incremental
revenues pertaining to the Pennsylvania state plan amendment of $2.5 million and provider tax
expense of $2.2 million relating to the period from January 1, 2005 through March 31, 2005. The
receipt of the aggregate incremental revenues pertaining to the Pennsylvania state plan amendments
of $19.0 million, and payment of the aggregate provider taxes of $15.5 million will occur in the
second quarter of 2005, and therefore, are reflected within accounts receivable and accrued
liabilities, respectively. 9




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5. Property and Equipment, Net Below is a summary of activity for property and equipment, including properties under capital
leases: Three Months Ended March 31,2005
    
    
    2004(in thousands)Balance at beginning of period
    
    $
    446,085
    
    
    $
    448,743Purchases of properties and equipment
    
    
    6,340
    
    
    
    5,345Payments for new constructions projects
    
    
    5,699
    
    
    
    3,800Properties and equipment acquired in acquisition of ALC
    
    
    290,761
    
    
    
    Other acquisitions
    
    
    
    
    
    
    1,514Properties acquired under capital leases  see Note 7
    
    
    12,822
    
    
    
    Depreciation and amortization
    
    
    (10,056
    )
    
    
    (8,397
    )Impairment of long-lived assets
    
    
    
    
    
    
    (1,362
    )Disposals and other
    
    
    (1,433
    )
    
    
    (5
    )Balance at end of period
    
    $
    750,218
    
    
    $
    449,638
 6. Other Assets Other assets consisted of: March 31,
    
    
    December 31,2005
    
    
    2004(in thousands)Deferred financing costs, net
    
    $
    11,282
    
    
    $
    11,828Non-current accounts receivable from Medicare and Medicaid programs
    
    
    10,214
    
    
    
    10,214Non-current accounts receivable from non-affiliated long-term care operators
    
    
    9,880
    
    
    
    9,469Indemnification escrow
    
    
    3,700
    
    
    
    3,700Funds held under deferred compensation plan
    
    
    2,080
    
    
    
    2,001Debt service and capital expenditure trust funds
    
    
    1,895
    
    
    
    309Cash held by bank as collateral for ALC letters of credit
    
    
    1,019
    
    
    
    3⁄4Prepaid interest rate cap fee
    
    
    504
    
    
    
    984Other
    
    
    3,080
    
    
    
    2,980$
    43,654
    
    
    $
    41,485
 Medicare and Medicaid Settlement Receivables Medicare and Medicaid settlement receivables consisted of: March 31,
    
    
    December 31,2005
    
    
    2004(in thousands)Total settlement receivables from Medicare and
Medicaid programs, less contractual allowance of
$4,370
    
    $
    18,758
    
    
    $
    16,954Less: Current portion of Medicare and Medicaid
settlement receivables (included in accounts
receivable)
    
    
    8,544
    
    
    
    6,740Non-current portion of Settlement Accounts Receivable
(included in other assets)
    
    $
    10,214
    
    
    $
    10,214
 The settlement receivable balances primarily relate to reimbursable Part A co-insurance
receivables under Medicare, which amounted to $11.5 million and $10.6 million as of March 31, 2005
and December 31, 2004, respectively. The remaining amounts relate to amounts the Company expects to
realize under Medicare and Medicaid retrospective reimbursement programs. 10




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Advances and Amounts Due from Non-Affiliated Long-term Care Operators The Company has provided working capital advances to non-affiliated long-term care operators
of $9.9 million, of which $7.1 million are to long-term care operators that the Company provides
consulting services to, and $2.8 million (net of allowance) is to Lakeside Health L.L.C. (Lakeside
Health) as outlined below. In August 2004, the Company transferred the operations of the Lakeside nursing facility in
Chippewa Falls, Wisconsin to Lakeside Health, a subsidiary of Benedictine Health Dimensions, Inc.
(Benedictine) under a three-year lease arrangement. The transfer of operations was in response
to facility citations for survey deficiencies and an agreement with the State of Wisconsin to
transfer the operations to a new licensee. Under the terms of the agreement, Lakeside Health is
responsible for all operating costs, including rent payable to the Company and management fees
payable to Benedictine. The Company receives rental income of $0.5 million per annum; however, it
is responsible for funding Lakeside Healths operating losses from the nursing facility, as defined
in the agreement, and to provide working capital advances sufficient to maintain an operating cash
account of $1.5 million. As of March 31, 2005, the Company has a receivable of $2.8 million for
advances to Lakeside Health. These advances are secured by a first security interest in Lakeside
Healths accounts receivable and are repayable from the assets and future cash flow of Lakeside
Health, if any. Lakeside Health reported a net loss of $1.7 million for the three months ended
March 31, 2005 and a net loss of $1.8 million for the five months ended December 31, 2004. The
Company has provided for possible non-collection of advances to Lakeside Health in its statements
of income. 11




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7. Line of Credit and Long-term Debt Summary of Long-term Debt Long-term debt consisted of the following: March 31,
    
    
    December 312005
    
    
    2004(in thousands)9.50% Senior Notes due 2010
    
    $
    149,724
    
    
    $
    149,7146.875% Senior Subordinated Notes due 2014
    
    
    122,079
    
    
    
    122,022Revolving Credit Facility due 2009, at variable
interest rates
    
    
    58,000
    
    
    
    6.00% EHI Term Note due 2010
    
    
    55,000
    
    
    
    6.24% Red Mortgage Capital Note due 2014
    
    
    37,016
    
    
    
    GE Capital Term Loan and Credit Facility, at variable interest
rates, due 2009
    
    
    35,456
    
    
    
    DMG Mortgage notes payable, interest rates ranging from 7.58%
to 8.65%, due 2008
    
    
    28,079
    
    
    
    Revenue Bonds, at variable interest rates, maturing through 2018
    
    
    21,995
    
    
    
    Capital lease obligations, interest rates ranging from 2.84% to
13.54%, maturing through 2009
    
    
    12,801
    
    
    
    11Oregon Trust Deed Notes, interest rates ranging from 0.25% to
10.90%, maturing from 2020 through 2026
    
    
    9,774
    
    
    
    HUD Insured Mortgages, interest rates ranging from 7.40% to
7.55%, due 2036
    
    
    7,727
    
    
    
    Other mortgage notes payable, interest rates ranging from 3.0%
to 7.25%, maturing through 2009
    
    
    4,299
    
    
    
    9,730Industrial Development Revenue Bond due 2014
    
    
    
    
    
    
    9,5006.25% Industrial Development Revenue Bond,
maturing 2008
    
    
    955
    
    
    
    955Long-term debt before current maturities
    
    
    542,905
    
    
    
    291,932Less current maturities
    
    
    4,248
    
    
    
    1,071Total long-term debt
    
    $
    538,657
    
    
    $
    290,861
 Revolving Credit Facility The Company established a senior secured revolving credit facility (the Revolving Credit
Facility) in June 2002. In connection with the April 2004 offering of the 2014 Notes, the Company
amended and restated the Revolving Credit Facility to, among other things, extend the maturity date
from June 28, 2007 to June 28, 2009 and increase the total borrowing capacity from $105 million to
$155 million. In January 2005, the Company amended its Revolving Credit Facility to permit the
loan from EHI to partially finance the ALC acquisition. ALCs debt is non-recourse to the Company
and its subsidiaries that existed prior to the acquisition of ALC, and ALCs debt and earnings are
excluded from existing financial covenants under the Companys Revolving Credit Facility. The
Company is restricted from borrowing under the Revolving Credit Facility to support the ALC
operation and all cash flow from ALC will be retained within the ALC operation. As of March 31,
2005, ALCs cash balance was $4.5 million. In the table above, the ALC debt assumed is listed after
the caption 6.0% EHI Term Note due 2010 and before the caption Other mortgage notes payable. 12




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The Revolving Credit Facility is used to back letters of credit and for general corporate
purposes. Borrowings under the Revolving Credit Facility bear interest, at the Companys option, at
the Eurodollar rate or the prime rate, plus applicable margins. Depending upon the Companys senior
leverage ratio, the interest rate is equal to the Eurodollar rate plus a margin of 2.50% to 3.25%
per annum or the base rate plus a margin of 1.50% to 2.25% per annum. The commitment fee is 0.50%
per annum on the undrawn capacity regardless of utilization. The Revolving Credit Facility is secured by a perfected, first priority security interest in
certain tangible and intangible assets and all of the Companys capital stock and the capital stock
of the Companys subsidiary guarantors, except for ALC and its subsidiaries. The Revolving Credit
Facility is also secured by a pledge of 65% of the voting stock of the Companys foreign
subsidiaries, including the Company subsidiary guarantors foreign subsidiaries, if any. The
Revolving Credit Facility contains customary covenants and events of default and is subject to
various mandatory prepayment and commitment reductions. The Company is permitted to make voluntary
prepayments at any time under the Revolving Credit Facility. As of March 31, 2005 the Company had borrowings under the Revolving Credit Facility of $58.0
million relating to the acquisition of ALC as of January 31, 2005. There were no borrowings as of
December 31, 2004. The unused portion of the Revolving Credit Facility that is available for
working capital and corporate purposes, after reduction for outstanding letters of credit of $17.4
million, was $79.6 million as of March 31, 2005. The Revolving Credit Facility requires the Company to comply with various financial covenants,
including fixed charge coverage, debt leverage, and tangible net worth ratios. 6.0% EHI Term Note due 2010 In January 2005, Extendicare Inc. advanced $55 million to EHI who, in turn, advanced $55
million to the Company to partially finance the ALC acquisition. The Term Note has a term of five
years and bears interest at 6%. The Term Loan can be repaid at any time by the Company. 6.24% Red Mortgage Capital Note due 2014 The Red Mortgage Capital Note has a fixed interest rate of 6.24%, with a 25-year principal
amortization, and is secured by 24 ALC assisted living facilities. The Red Mortgage Capital Note
was entered into by subsidiaries of ALC and is non-recourse to ALC, subject to a limited guaranty
by ALC. GE Capital Term Loan and Credit Facility due 2009 The GE Capital Term Loan (GE Term Loan) and the GE Capital Credit Facility (GE Credit
Facility) were entered into by ALC in December 2003. The GE Term Loan and GE Credit Facility
mature in 2009 and are secured by a collective pool of 30 ALC assisted living facilities. The GE
Term Loan requires monthly interest payments and principal reductions based on a 25-year principal
amortization schedule, with a balloon payment at maturity. The Company has a $15.0 million credit
facility with GE, which has the same payment terms as the GE Term Loan. Under the GE Credit
Facility, a fee is charged on the unused borrowing capacity at a rate of 0.75% per year, which is
paid quarterly. Both the GE Term Loan and GE Credit Facility accrue interest at LIBOR plus 4.0%,
with an interest rate floor of 5.75%. The GE Term Loan and the GE Credit Facility both contain
financial covenants that require a certain level of financial performance for the GE- financed ALC
assisted living facilities. The GE Term Loan and GE Credit Facility were entered into by
subsidiaries of ALC and are non-recourse to ALC, subject to a limited guaranty by ALC. ALC had no
borrowings on the GE Credit Facility as of March 31, 2005. 13




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DMG Mortgage Notes Payable due 2008 DMG Mortgage Notes Payable (DMG Notes) include three fixed rate notes that are secured by 13
ALC assisted living facilities located in Texas, Oregon and New Jersey. These notes collectively
require monthly principal and interest payments of $230,000, with balloon payments of $11.8
million, $5.3 million and $7.2 million due at maturity in May, August and September 2008,
respectively. These loans bear interest at fixed rates ranging from 7.6% to 8.7%. Revenue Bonds Revenue Bonds include three variable rate revenue bonds secured by 15 ALC assisted living
facilities located in the States of Washington, Idaho and Ohio. ALC has a series of Reimbursement
Agreements with U.S. Bank for letters of credit that support certain of ALCs Variable Rate Revenue
Bonds. The letters of credit expire in July 2005 and have an annual commitment fee of
approximately 2.0%. The total amount of these letters of credit was approximately $22.8 million as
of March 31, 2005. The Washington bonds had an interest rate of 2.1% at March 31, 2005 and are
secured by a $7.1 million letter of credit and buildings, land, furniture and fixtures of the five
Washington assisted living facilities.
The Idaho bonds had an interest rate of 2.1% at March 31, 2005 and are secured by a $6.2 million
letter of credit and buildings, land, furniture and fixtures of four Idaho assisted living
facilities. The Ohio bonds had an interest rate of 2.0% at March 31, 2005 and are secured by a
$10.3 million letter of credit and buildings, land, furniture and fixtures of six Ohio assisted
living facilities. Under debt agreements relating to the Revenue Bonds, ALC is required to comply with the terms
of certain regulatory agreements that provide, among other things, that in order to preserve the
federal income tax exempt status of the bonds, ALC is required to lease at least 20% of the units
of the projects to low or moderate income persons as defined in Section 142(d) of the Internal
Revenue Code. There are additional requirements as to the age and physical condition of the
residents with which the Company must also comply. Non-compliance with these restrictions may
result in an event of default and cause acceleration of the scheduled repayment. ALCs Reimbursement Agreements with U.S. Bank contain financial covenants which include the
following: (1) minimum net worth; (2) minimum debt service coverage; (3) minimum liquidity; and (4)
minimum earnings of ALC. Failure to comply with these covenants could constitute an event of
default, which would allow U.S. Bank to declare any amounts outstanding under the loan documents to
be due and payable. The agreements also require ALC to deposit $500,000 in cash collateral with
U.S. Bank in the event certain regulatory actions are commenced with respect to the properties
securing ALCs obligations to U.S. Bank. U.S. Bank is required to release such deposits upon
satisfactory resolution of the regulatory action. Capital Lease Obligations In March 2005, the Company amended lease agreements with Assisted Living Facilities, Inc.,
(ALF) an unrelated party, relating to five ALC assisted living facilities located in Oregon that
provided ALC with an option to purchase the facilities in 2009 at a fixed price. The option to
purchase was determined to be a bargain purchase price, requiring that the classification of these
leases be changed from operating to capital. As a result, a capital lease obligation of $12.8
million was recorded, which represents the estimated market value of the properties as of March 31,
2005 and also approximates the present value of future payments due under the lease agreements,
including the purchase option payment. The option to purchase must be exercised prior to July 1,
2009 with closing on or about December 31, 2009. Oregon Trust Deed Notes The Oregon Trust Deed Notes are secured by buildings, land, furniture and fixtures of six
Oregon ALC assisted living facilities. The notes are payable in monthly installments including
interest at effective rates ranging from 7.4% to 9.0%. 14




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##### Table of Contents



Under debt agreements relating to the Oregon Trust Deed Notes, ALC is required to comply with
the terms of certain regulatory agreements which provide, among other things, that in order to
preserve the federal income tax exempt status of the bonds, ALC is required to lease at least 20%
of the units of the projects to low or moderate income persons as defined in Section 142(d) of the
Internal Revenue Code. There are additional requirements as to the age and physical condition of
the residents with which the Company must also comply. Non-compliance with these restrictions may
result in an event of default and cause acceleration of the scheduled repayment. ALC is also
required to maintain a capital replacement escrow account to cover expected capital expenditure
requirements for the leased properties. HUD Insured Mortgages due 2036 The HUD insured mortgages include three separate loan agreements entered into in 2001. The
mortgages are each secured by a separate ALC assisted living facility located in Texas. These loans
mature between July 1, 2036 and August 1, 2036 and collectively require monthly principal and
interest payments. The loans bear interest at fixed rates ranging from 7.40% to 7.55%. Mortgage Notes Payable In February 2005, the Company prepaid in full a mortgage totaling $5.3 million which resulted
in a charge to income of $0.1 million to write off deferred financing costs. Industrial Development Revenue Bond due 2014 In January 2005, the Company prepaid in full a $9.5 million Variable Rate Industrial
Development Revenue Bond due 2014, which resulted in a pre-tax charge to income of $0.1 million to
write off deferred financing costs. 8. Accounting for Derivative Instruments and Hedging Activities Objectives and Strategies As of March 31, 2005, the Company has approximately $427 million of fixed rate debt
outstanding. To hedge the fair value of fixed-rate Senior Note and Senior Subordinated Note debt
obligations, the Company has entered into interest rate swap agreements with a total notional
amount of $275 million under which it pays a variable rate of interest and receives a fixed rate of
interest. These interest rate swaps are designated as fair value hedges under SFAS 133 and changes
in the market value of the interest rate swaps have no impact on the statements of income unless
they are terminated or are no longer designated as hedges. In addition, the Company has entered
into interest rate cap agreements to limit its exposure to increases in interest rates. The Company does not speculate using derivative instruments. Interest Rate Swap and Cap Agreements Entered into in April 2004 and Maturing in 2010 and 2014 On April 22, 2004, the Company entered into two new interest rate swap agreements and two new
interest rate cap agreements relating to the 2010 Senior Notes and the 2014 Notes. 15




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##### Table of Contents



With respect to the 2010 Senior Notes, the Company entered into an interest rate swap
agreement expiring July 1, 2010 (the 2010 Swap) with a notional amount of $150 million. The 2010
Swap effectively converted up to $150 million of fixed- rate indebtedness into variable interest
rate indebtedness. Under the terms of the 2010 Swap, the counterparty can call the swap at any time
on or after July 1, 2006 with payments as determined under the agreement. This call option is a
mirror image of the embedded call option in the debt instrument. The swap was designated as a
highly-effective fair value hedge, and as a result, changes in market value of the swap are
recorded in income but are offset by changes in market value of the indebtedness so that there is
no net impact on the statement of income unless the swap is terminated or no longer qualifies as a
hedge. The Company also entered into an interest rate cap agreement expiring July 1, 2010 (the
2010 Cap) with a notional amount of $150 million. Under the 2010 Cap, the Company paid on April
22, 2004 an upfront fee of $3.5 million to the counterparty. The Company will receive a variable
rate of interest equal to the excess, if any, of the six-month LIBOR rate, adjusted semi-annually,
over the cap rate of 7%. The Company uses the 2010 Cap to offset possible increases in interest
payments under the 2010 Swap caused by increases in market interest rates over a certain level.
Under the terms of the 2010 Cap, the counterparty can call the cap if the 2010 Swap is terminated.
The 2010 Cap was not designated as a hedging instrument under SFAS 133 and, therefore, changes in
market value are recorded in the statements of income. With respect to the 2014 Notes, the Company entered into an interest rate swap agreement
expiring May 1, 2014 (the 2014 Swap) with a notional amount of $125 million. The 2014 Swap
effectively converted up to $125 million of fixed interest rate indebtedness into variable interest
rate indebtedness. Under the terms of the 2014 Swap, the counterparty can call the 2014 Swap at any
time on or after May 1, 2009 with payments as determined under the agreement. This call option is a
mirror image of the embedded call option in the debt instrument. The 2014 Swap was designated as a
highly-effective fair value hedge and, as a result, changes in market value of the swap are
recorded in income but are offset by changes in market value of the indebtedness so that there is
no net impact on the statement of income unless the swap is terminated or no longer qualifies as a
hedge. The Company also entered into an interest rate cap agreement expiring May 1, 2014 (2014
Cap) with a notional amount of $125 million. Under the 2014 Cap, the Company pays a fixed rate of
interest equal to 0.75% to the counterparty and receives a variable rate of interest equal to the
excess, if any, of the six-month LIBOR rate, adjusted semi-annually, over the cap rate of 7%. The
Company uses the 2014 Cap to offset possible increases in interest payments under the 2014 Swap
caused by increases in market interest rates over a certain level. Under the terms of the 2014 Cap,
the counterparty can call the cap if the 2014 Swap is terminated. The 2014 Cap was not designated
as a hedging instrument under SFAS 133 and, therefore, changes in market value are recorded in the
statements of income. Quantitative Disclosures Changes in the fair value of a derivative that is highly effective and that is designated and
qualifies as a fair value hedge, along with the loss or gain on the hedged asset or liability of
the hedged item that is attributable to the hedged risk, are recorded in income. Changes in the
fair value of cash flow hedges are reported as Accumulated Other Comprehensive Income (AOCI) as a
component of Shareholders Equity. There were no cash flow hedges after the termination of the 2007
Cap in April 2004. Changes in the fair value of interest rate caps not designated as a hedging
instrument are reported in the statement of income. As of March 31, 2005, the fair value of the interest rate swaps designated as fair value
hedges is a liability of $5.0 million and is offset by a asset of $5.0 million relating to the
changes in market value of the hedged items (long-term debt obligations). As of March 31, 2005, the
fair value of the 2010 Cap is an asset of $0.5 million recorded in other long-term assets and the
fair value of the 2014 Cap is a liability of $5.8 million recorded in other long-term liabilities. The fair value of the Companys interest rate caps are dependent on projected six-month LIBOR
that are influenced by long-term rates and the volatility of these rates. As a result of a decline
in the volatility of rates in 2005, the value of the Companys interest rate caps declined,
resulting in a valuation adjustment expense of $1.3 million for the three months ended March 31,
2005. For the three months ended March 31, 2004, the Company reported valuation adjustment expense
of $0.1 million. 16




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##### Table of Contents



9. Due to Shareholder and Affiliate The Company had non-interest bearing amounts due from (to) its shareholder and affiliates as
follows: March 31,
    
    
    December 31,2005
    
    
    2004(in thousands)Affiliate
    
    Purpose
    
    Receivable (payable)Current assets:Extendicare Holdings, Inc.
    
    Federal income taxes receivable
    
    $
    1,231
    
    
    $
    5,231Extendicare Holdings, Inc.
    
    Deferred federal income taxes
    
    
    14,183
    
    
    
    13,258Extendicare Inc.
    
    Working capital advances
    
    
    3⁄4
    
    
    
    7,69015,414
    
    
    
    26,179Current liabilities:Virtual Care Provider, Inc.
    
    Working capital advances
    
    
    (3,000
    )
    
    
    (3,000
    )The Northern Group, Inc.
    
    Intercompany operating expenses
    
    
    16
    
    
    
    19Laurier Indemnity Company
    
    Intercompany insurance premium
    
    
    6
    
    
    
    3Extendicare Holdings, Inc.
    
    Working capital advances
    
    
    3
    
    
    
    3(2,975
    )
    
    
    (2,975
    )Long-term liabilities:Extendicare Holdings, Inc.
    
    Deferred federal income taxes
    
    
    (5,015
    )
    
    
    (1,853
    )Other:Extendicare Inc.
    
    Advances
    
    
    (8,900
    )
    
    
    (8,900
    )Extendicare Inc.
    
    Advances
    
    
    1,574
    
    
    
    1,218Extendicare Holdings, Inc.
    
    Advances
    
    
    (3,483
    )
    
    
    (3,483
    )Virtual Care Provider, Inc.
    
    Advances
    
    
    (3,884
    )
    
    
    (3,620
    )(14,693
    )
    
    
    (14,785
    )$
    (7,269
    )
    
    $
    6,566
 In addition to the above, in January 2005, Extendicare Inc. advanced $55 million to EHI,
who, in turn, advanced $55 million as a Term Loan to the Company to partially finance the ALC
acquisition. The Term Note has a term of five years and bears interest at 6%. The Term Loan can
be repaid at any time by the Company. 10. Loss (Gain) on Disposal of Assets and Impairment of Long-lived Assets The following summarizes the components of the loss (gain) on the disposal of assets and
impairment of long-lived assets: Three Months Ended March 31,2005
    
    
    2004(in thousands)Gain on sale of Maryland property
    
    $
    448
    
    
    $
    Impairment of nursing facility in Indiana
    
    
    
    
    
    
    (1,612
    )$
    448
    
    
    $
    (1,612
    )
 In the first quarter 2005, the Company sold for $1.9 million in cash a property in Maryland
that formerly was a nursing facility, but was closed in 1998. The pre-tax gain on this disposition
was $0.4 million. In March 2004, the Company concluded the evaluation of two nursing facilities that operate
adjacent to one another in Indiana, both of which require capital renovations. After evaluation of
the respective operations, the Company made a decision, subject to State of Indiana approval, to
consolidate the two operations into one renovated facility, which, upon completion, will
accommodate all residents from both facilities; however, the total available nursing beds will
decrease by 46. The consolidation of the two operations has been approved by the State of Indiana
and is expected to be completed by September 2005. As a result of the decision to close the one
facility, the Company recorded a provision of $1.6 million for impairment of long-lived assets. 17




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##### Table of Contents



Reserves for divested operations and facility closures primarily relate to provisions for the
settlement of Medicare and Medicaid claims and other amounts with third parties. The settlement of
such amounts depends on actions by those third parties and negotiations by the Company, and,
therefore, may not be resolved within the next or several years. Below is a summary of activity of
the accrued liabilities balance relating to divested operations and facility closures: Medicare, Medicaid
    
    
    Resident andand Supplier
    
    
    EmployeeClaims
    
    
    Claims
    
    
    Other
    
    
    Total(in thousands)Balance December 31, 2003
    
    $
    6,637
    
    
    $
    494
    
    
    $
    160
    
    
    $
    7,291Provisions (charges) (1)
    
    
    (3,198
    )
    
    
    
    
    
    
    
    
    
    
    (3,198
    )Cash Payments
    
    
    (1,410
    )
    
    
    3⁄4
    
    
    
    (160
    )
    
    
    (1,570
    )Balance December 31, 2004
    
    
    2,029
    
    
    
    494
    
    
    
    3⁄4
    
    
    
    2,523Cash Payments
    
    
    (499
    )
    
    
    3⁄4
    
    
    
    3⁄4
    
    
    
    (499
    )Balance March 31, 2005
    
    $
    1,530
    
    
    $
    494
    
    
    $
    3⁄4
    
    
    $
    2,024
   (1)
    
    Provisions (charges) for 2004 include a $3.2 million write-off of previously
accrued Medicare claims receivable relating to discontinued operations. 11. Loss on Refinancing and Retirement of Debt The following summarizes the components of the loss on refinancing and retirement of debt: Three Months Ended March 31,2005
    
    
    2004( in thousands)Loss on early retirement of Mortgage Note (note 7)
    
    $
    140
    
    
    $
    3⁄4Loss on early retirement of Industrial
Development Revenue Bond (note 7)
    
    
    135
    
    
    
    354$
    275
    
    
    $
    354
 12. Interest expense, net The following summarizes the components of interest expense, net: Three MonthsEnded March 31,2005
    
    
    2004(dollars in thousands)Interest expense
    
    $
    8,557
    
    
    $
    8,200Interest income
    
    
    (413
    )
    
    
    (1,615
    )$
    8,144
    
    
    $
    6,585
 18




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##### Table of Contents



13. Lease Commitments As of March 31, 2005, as a lessee, the Company was committed under non-cancelable leases
requiring future minimum rentals as follows: Operating
    
    
    CapitalLeases
    
    
    Leases
    
    
    Total(in thousands)Year Ended March 31:2006
    
    $
    20,945
    
    
    $
    1,454
    
    
    $
    22,3992007
    
    
    17,830
    
    
    
    1,163
    
    
    
    18,9932008
    
    
    16,714
    
    
    
    1,193
    
    
    
    17,9072009
    
    
    16,932
    
    
    
    1,222
    
    
    
    18,1542010
    
    
    16,928
    
    
    
    11,246
    
    
    
    28,174After 2010
    
    
    77,695
    
    
    
    
    
    
    
    77,695Total minimum payments
    
    
    167,044
    
    
    
    16,278
    
    
    
    183,322Less imputed interest
    
    
    
    
    
    
    3,477
    
    
    
    3,477Net minimum lease payments
    
    $
    167,044
    
    
    $
    12,801
    
    
    $
    179,845
 ALC has five leased properties with ALF in the State of Oregon and five leased properties
with LTC in the State of Washington. Both lessors obtained funding for these leased properties
through the sale of Revenue Bonds issued by, the State of Oregon, Housing and Community Services
Department (OHCS) for the ALF leases, and the Washington State Housing Finance Commission
(WSHFC) for the LTC leases. Pursuant to the Lease Approval Agreements with OHCS and
WSHFC and the lessor, the agreement obligates ALC to comply with the terms and conditions of the
underlying trust deed relating to the leased properties and to comply with the terms of certain
regulatory agreements that provide, among other things, that in order to preserve the federal
income tax exempt status of the bonds, ALC is required to lease at least 20% of the units of the
projects to low or moderate income persons as defined in Section 142(d) of the Internal Revenue
Code. There are additional requirements as to the age and physical condition of the residents with
which the Company must also comply. Non-compliance with these restrictions may result in an event
of default and cause acceleration of the scheduled repayment. ALC is also required to maintain a
capital replacement escrow account for the ALF leases to cover expected capital expenditure
requirements for the leased properties. 14. Other Commitments and Contingencies Capital Expenditures As of March 31, 2005, the Company had capital expenditure purchase commitments outstanding of
approximately $7.9 million not including commitment on new construction projects discussed below. As of March 31, 2005, the Company had 10 new construction projects in progress, which are
expected to add 18 nursing beds and 317 assisted living units. The total estimated cost of the
projects is $33.9 million, and they are expected to be completed in 2005 and 2006. Costs incurred
through March 31, 2005 on these projects were approximately $15.0 million and purchase commitments
of $9.4 million are outstanding. Subsequent to March 31, 2005, five of these projects were
completed. Refer to Note 17. Insurance and Self-insured Liabilities The Company insures certain risks with affiliated insurance subsidiaries of Extendicare and
third-party insurers. The insurance policies cover comprehensive general and professional liability
(including malpractice insurance) for the Companys health providers, assistants and other staff as
it relates to their respective duties performed on the Companys behalf, workers compensation and
employers liability in amounts and with such coverage and deductibles as determined by the
Company, based on the nature and risk of its businesses, historical experiences, availability and
industry standards. The Company also self insures for health and dental claims, in certain states
for workers compensation and employers liability and for general and professional liability
claims up to a certain amount per incident. Self-insured liabilities with respect to general and
professional liability claims are included within the accrual for self-insured liabilities. 19




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##### Table of Contents



Litigation The Company and its subsidiaries are defendants in actions brought against them from time to
time in connection with their operations. While it is not possible to estimate the final outcome of
the various proceedings at this time, such actions generally are resolved within amounts provided. The U.S. Department of Justice and other federal agencies are increasing resources dedicated
to regulatory investigations and compliance audits of healthcare providers. The Company is diligent
to address these regulatory efforts. Regulatory Risks All providers are subject to surveys and inspections by state and federal authorities to
ensure compliance with applicable laws and licensure requirements of the Medicare and Medicaid
programs. The survey process is intended to review the actual provision of care and services, and
remedies for assessed deficiencies can be levied based upon the scope and severity of the cited
deficiencies. Remedies range from the assessment of fines to the withdrawal of payments under the
Medicare and Medicaid programs. Should a deficiency not be addressed through a plan of correction,
a facility can be decertified from the Medicare and Medicaid program. As of March 31, 2005, the
Company has certain facilities under plans of correction. While it is not possible to estimate the
final outcome of the required corrective action, the Company has accrued for known costs. In addition, Federal law requires each state to have a Medicaid Fraud Control Unit, which is
responsible for investigating provider fraud and resident abuse. The Company is aware of an
investigation by this unit in Kentucky, but this investigation has been inactive for a substantial
period of time. Cash Flow Commitment to Lakeside Health Under the terms of the agreement with Lakeside Health (refer to Note 6), the Company is
responsible for funding operating losses of the Lakeside nursing facility during the term of the
agreement. If, beginning after a date which is 60 days after the facility has cleared all
regulatory deficiencies in existence as of July 31, 2004, Lakeside Health incurs operating losses
totaling more than $3 million, or if Lakeside Health incurs operating losses for any consecutive
three month period in excess of $1 million, the Company may terminate the agreement. In September
2004, Lakeside Health cleared all regulatory deficiencies existing as of July 31, 2004. Lakeside
Health incurred net losses of $1.7 million for the three months ended March 31, 2005 and $1.8
million for the five months ended December 31, 2004. The Company has advanced to date $6.2 million
to fund operating losses of Lakeside Health. As of March 31, 2005 the Company had advances due from Lakeside Health of $2.8 million. These
advances are secured by a first security interest in Lakeside Healths accounts receivable. The
Company reduced the carrying value of the Lakeside property by $6.8 million in the fourth quarter
of 2004, to $6.2 million. There can be no assurance that a future provision will not be required,
if the estimate of the fair value changes. Omnicare Preferred Provider Agreement In 1998, the Company entered into a Preferred Provider Agreement, the terms of which enabled
Omnicare to execute Pharmacy Service Agreements and Consulting Service Agreements with all of the
Companys skilled nursing facilities. In 2002, in connection with its agreements to provide
pharmacy services to the Company, Omnicare requested arbitration for an alleged lost profits claim
related to the Companys disposition of assets, primarily in Florida. Damage amounts, if any,
cannot be reasonably estimated based on information available at this time. An arbitration hearing
has not yet been scheduled. The Company believes it has interpreted correctly and has complied with
the terms of the Preferred Provider Agreement; however, there can be no assurance that other claims
will not be made with respect to the agreement. In addition, the Company is currently negotiating
the pricing for drugs for Medicare residents for the years 2001 and 2002, and should this matter
not be settled, the matter will be taken to arbitration. Provisions for this claim are included
within the condensed consolidated financial statements. There has been no change in the status of the above issues since December 31, 2004. 20




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15. Uncertainties and Certain Significant Risks Revenues The long-term care industry is currently receiving a Medicare funding enhancement referred to
as RUGs Refinements, which are a 20% add-on to rates for 15 Resource Utilization Groups, or RUGs.
The 20% add-ons from three RUGs categories were later redistributed to 14 rehabilitation categories
at an add-on rate of 6.7% each. Based upon a July 2004 CMS announcement, the RUGs Refinements
extend only until September 30, 2005. Congress has enacted legislation directing CMS to conduct a
study on the RUGs classification system and report its recommendations prior to the implementation
of a RUGs Refinement change whereby all or part of the enhancement is
discontinued. In February 2003, CMS announced its plan to reduce its level of reimbursement for
uncollectible Part A co-insurance. Under the plan announced by CMS, the reimbursement level would
be reduced to 70% over a three-year period as follows: 90% effective for the government fiscal year
commencing October 1, 2003; 80% effective for the government fiscal year commencing October 1,
2004; and 70% effective for government fiscal years commencing on or after October 1, 2005. This
plan is consistent with the Part A co-insurance reimbursement plan applicable to hospitals. CMS did
not implement the rule change effective October 1, 2003, and continues to review the proposed plan. Interests in Unrelated Long-Term Care Providers Through the divestiture program in Texas and Florida, the Company has retained ownership of
certain nursing facility properties which the Company leases to other unrelated long-term care
providers. The Company also has an obligation to fund operating losses of a nursing facility
operated by an unrelated long-term care provider in Wisconsin (refer to Note 14). In addition, due
to the divestiture agreements and on-going consulting agreements, the Company has amounts due from
other unrelated long-term providers. In aggregate, as of March 31, 2005, the Company owns $19.7
million in nursing home properties in Florida, Texas and Wisconsin and has $9.9 million in
non-current amounts receivable due from unrelated long-term care providers in Florida, Texas and
Wisconsin. Income and cash flow of the Company could be influenced by the financial stability of
these unrelated long-term care providers. Accrual for Self-Insured Liabilities The Company had $35.7 million and $37.7 million in accruals for self-insured liabilities as of
March 31, 2005 and December 31, 2004, respectively. An actuarial valuation was completed as of
December 31, 2004 and it was determined that no adjustment was required to the accrual for
self-insured liability amounts on the balance sheet. Though the Company has been successful in
exiting from the states of Texas and Florida and limiting future exposure to general liability
claims, the timing and eventual settlement costs for these claims cannot be precisely defined. 21




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16. Comprehensive Income Comprehensive Income is as follows for the periods shown: Three Months
    
    
    Three MonthsEnded
    
    
    EndedMar. 31, 2005
    
    
    Mar. 31, 2004( in thousands)NET INCOME
    
    $
    12,054
    
    
    $
    9,347OTHER COMPREHENSIVE INCOME (LOSS):Unrealized gain (loss) on investments, before tax
    
    
    (32
    )
    
    
    958Gain on cash flow hedges, before tax
    
    
    
    
    
    
    67Other comprehensive income (loss), before tax
    
    
    (32
    )
    
    
    1,025Income tax benefit (provision) related to items
of other comprehensive income
    
    
    13
    
    
    
    (410
    )Other comprehensive income (loss), net of tax
    
    
    (19
    )
    
    
    615COMPREHENSIVE INCOME
    
    $
    12,035
    
    
    $
    9,962
 17. Subsequent Events In April and May 2005, the Company completed five construction projects that resulted in the
opening of one new assisted living facility (60 units), and increasing the operational capacity at
three assisted living facilities (75 units) and one nursing facility (18 beds). In May 2005, the Company entered into a definitive agreement to acquire a nursing facility
(127 beds) in Kentucky for $8.3 million in cash. The Company anticipates completing the
acquisition on May 31, 2005. In May 2005, the State of Indiana announced that it had received approval from CMS of a state
plan amendment and waiver, which will increase federal funding to the Medicaid program
retroactively back to July 1, 2003. The state plan amendment is subject to final approval by the
State. Though amounts for certain periods have to be quantified, initial estimates indicate that
the impact will be to increase income before income taxes for the period from July 1, 2003 to March
31, 2005 by approximately $5.5 million. 22




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations We are one of the largest providers of long-term care and related services in the United
States. We are an indirect wholly owned subsidiary of Extendicare Inc., or Extendicare, a Canadian
publicly traded company. Through our subsidiary network of geographically clustered facilities, we
offer a continuum of healthcare services, including nursing care, assisted living and related
medical specialty services, such as subacute care and rehabilitative therapy. As of March 31, 2005,
we operated or managed 362 long-term care facilities with 23,464 beds in 19 states, of which 148
were nursing facilities with 14,871 beds and 214 were assisted living and retirement facilities
with 8,593 units. We also provided consulting services to 77 facilities with 9,446 beds in five
states. In addition, we operated 20 outpatient rehabilitation clinics in four states. We receive
payment for our services from Medicare, Medicaid, private insurance, self-pay residents and other
third party payors. Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements that are intended to
qualify for the safe harbors from liability established by the Private Securities Litigation Reform
Act of 1995. All statements other than statements of historical fact, including statements
regarding anticipated financial performance, business strategy and goals for future operations, are
forward-looking statements. These forward-looking statements can be identified as such because the
statements generally include words such as expect, intend, believe, anticipate, estimate,
plan or objective or other similar expressions. These forward-looking statements reflect our
beliefs and assumptions, and are based on information currently available to us. Forward-looking
statements are subject to risks, uncertainties and other factors that could cause actual results,
performance or achievements or industry results to be materially different from those expressed in,
or implied by, these statements. Some, but not all, of the risks and uncertainties include those
described in the Risk Factors  section of our Annual Report on Form 10-K for the year ended
December 31, 2004, and other filings with the Securities and Exchange Commission, and include the
following:  
    Medicare and Medicaid payment levels and reimbursement methodologies and the application
of such methodologies and policies adopted by the government and its fiscal intermediaries;
    liabilities and claims asserted against us, such as resident care litigation, including
our exposure for punitive damage claims and increased insurance costs;
    national and local economic conditions, including their effect on the ability to hire and
retain qualified staff and employees and the associated costs;
    federal and state regulation of our business and change in such regulations, as well as
our compliance with such regulations;
    actions by our competitors;
    our ability to maintain and increase census levels; and
    the successful integration of Assisted Living Concepts, Inc. within our operations. All forward-looking statements contained in this Quarterly Report on Form 10-Q are expressly
qualified in their entirety by the cautionary statements set forth or referred to above. We assume
no obligation to update any forward-looking statement. 23




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##### Table of Contents



Executive Overview Our business strategy and competitive strengths are outlined in Item 1 of our Annual Report on
Form 10-K for the year ended December 31, 2004. Our key business goals are to:  
    strengthen both Medicare and total average daily census, or ADC;
    improve operating cash flow;
    expand our asset portfolio through acquisition or internal growth, and actively manage
our asset portfolio, including where appropriate, divesting facilities that fail to meet our
performance goals;
    expand non-government based revenue sources, thereby decreasing the level of risk and
reliance on government funding;
    diversify within the long-term care industry through growth of facilities under full
management or selected consulting agreements and rehabilitation clinics; and
    increase our operating efficiency. Total census on a same facility basis in our nursing facilities increased 1.1% to 12,951 in
the first quarter of 2005 compared to 12,812 in the fourth quarter of 2004. In addition, Medicare
census on a same facility basis increased 13.6% to 2,433 in the first quarter of 2005 from 2,142 in
the fourth quarter of 2004. On January 31, 2005, we completed the acquisition of Assisted Living Concepts, Inc., or ALC,
of Dallas, Texas for a total of approximately $285 million, including the assumption of ALCs
existing debt with a book value of approximately $141 million. The acquisition was completed
immediately subsequent to, and pursuant to, the shareholder approval of the merger and acquisition
agreement entered into on November 4, 2004 that provided for the acquisition of all of the
outstanding shares and stock options of ALC for $18.50 per share. We financed the acquisition by
using approximately $29 million in cash on hand, a $55 million 6% Term Loan from Extendicare
Holdings, Inc. and drawing down $60 million from our revolving credit facility. On January 31,
2005, ALC had a portfolio of 177 assisted living facilities, comprised of 122 owned properties and
55 leased facilities, representing 6,838 units located in 14 states, many in markets where we
operated. The goal of the acquisition was to expand our asset portfolio and level of
non-government based revenue sources. The operations of ALC are included in our condensed
consolidated statements of income, our condensed consolidated statement of cash flows, and our key
performance indicators beginning February 1, 2005. In addition, ALCs assets and liabilities are
included within our condensed consolidated balance sheet as at March 31, 2005. Revenues We derive revenues by providing routine and ancillary healthcare services to residents in our
network of facilities. Long-term healthcare services provided to our residents include services
such as nursing care, assisted living and related medical services, such as subacute care. We also
derive revenues by providing rehabilitative therapy to outside third parties at our rehabilitation
clinics and earn management and consulting revenues from other long-term care organizations. 24




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##### Table of Contents



Nursing and Assisted Living Facilities.The following table sets forth our Medicare, Medicaid
and private pay sources of revenues for all of our nursing and assisted living facilities by
percentage of total revenue and the level of quality mix, excluding revenues from prior year
adjustments. Percentage of Total Nursing andAssisted Living RevenuesFor Three Months Ended March 312005
    
    
    2004Medicare
    
    
    30.5
    %
    
    
    31.5
    %Private and other
    
    
    24.6
    %
    
    
    21.2
    %Quality mix
    
    
    55.1
    %
    
    
    52.7
    %Medicaid
    
    
    44.9
    %
    
    
    47.3
    %Total

    
    
    100.0
    %
    
    
    100.0
    %
 The increase in percentage of private and other revenues is primarily due to the acquisition of
ALC. Nursing Facilities.Within our nursing facilities, we generate our revenue from Medicare,
Medicaid and private pay sources. Medicaid rates are generally lower than rates earned from
Medicare, private, commercial insurance and other sources, and therefore, an important performance
measurement is Quality Mix, which is defined as revenues or census earned from payor sources
other than from Medicaid programs. The following table sets forth our Medicare, Medicaid and
private pay sources of revenue for all of our nursing facilities by percentage of total revenue and
the level of quality mix, excluding revenues from prior year adjustments. Percentage of Total Nursing RevenuesFor Three Months Ended March 312005
    
    
    2004Medicare
    
    
    35.6
    %
    
    
    32.9
    %Private and other
    
    
    15.6
    %
    
    
    17.9
    %Quality mix
    
    
    51.2
    %
    
    
    50.8
    %Medicaid
    
    
    48.8
    %
    
    
    49.2
    %Total
    
    
    100.0
    %
    
    
    100.0
    %
 Assisted Living Facilities.Within our assisted living facilities, we generate our revenue
from Medicaid and private pay sources. Medicaid rates are generally lower than rates earned from
private sources. The following table sets forth our Medicaid and private pay sources of revenue
for all of our assisted living facilities by percentage of total revenue and the level of quality
mix. Percentage of TotalAssisted Living RevenuesFor Three Months Ended March 312005
    
    
    2004Private and other
    
    
    78.7
    %
    
    
    92.5
    %Medicaid
    
    
    21.3
    %
    
    
    7.5
    %Total
    
    
    100.0
    %
    
    
    100.0
    %
 The increase in Medicaid revenues was attributable to the acquisition of ALC. Other Revenues.We derive outpatient therapy revenues by providing rehabilitation therapy
services to outside third parties at our clinics. The revenue sources are primarily HMOs and
commercial insurance, workers compensation, Medicare, Medicaid and other sources, including
self-pay clients. Management and consulting fees are paid directly from the long-term care
organizations that we contract with to provide services. 25




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##### Table of Contents



Legislative Actions Affecting Revenues Future Medicare Changes.The long-term care industry is currently receiving a Medicare funding
enhancement referred to as RUGs Refinements, which are a 20% add-on to rates for 15 Resource
Utilization Groups, or RUGs. The 20% add-ons from three RUGs categories were later redistributed to
14 rehabilitation categories at an add-on rate of 6.7% each. Based upon a July 2004 CMS
announcement, the RUGs Refinements extend only until September 30, 2005. Congress has enacted
legislation directing CMS to conduct a study on the RUGs classification system and report its
recommendations prior to the implementation of a RUGs Refinement change whereby all or part of the
enhancement is discontinued. In February 2005, the Presidents Proposed Budget provides for the
discontinuance of the RUGs Refinements effective October 1, 2005. The Presidents Proposed Budget
is subject to legislative review and the budget being passed by the United States Government. Based
upon the Medicare case mix and census for the quarter ended March 31, 2005, we estimate that we
receive an average $25.65 per resident day, which on an annualized basis amounts to $23.1 million
related to the RUGs Refinements. The implementation of a RUGs Refinement change whereby all or part
of the enhancement is discontinued could have a significant adverse effect on us. In February 2003, CMS announced its plan to reduce its level of reimbursement for
uncollectible Part A co-insurance. Under the plan announced by CMS, the reimbursement level would
be reduced to 70% over a three year period as follows: 90% effective for the government fiscal year
commencing October 1, 2003; 80% effective for the government fiscal year commencing October 1,
2004; and 70% effective for government fiscal years commencing on or after October 1, 2005. This
plan is consistent with the Part A co-insurance reimbursement plan applicable to hospitals. CMS did
not implement the rule change effective October 1, 2003, and continues to review the proposed plan.
In February 2005, the Presidents Proposed Budget provides for the implementation of the reduced
reimbursement plan over a three year period commencing October 1, 2005. The Presidents Proposed
Budget is subject to legislative review and the budget being passed by the United States
Government. Should that occur, we estimate that the negative impact to our pre-tax income would be
$0.4 million in 2005, $1.7 million in 2006, $2.9 million in 2007, and $3.8 million in 2008. Regulatory Environment Affecting Operations We operate in a competitive marketplace and depend substantially on revenues derived from
governmental third-party payors, with the remainder of our revenues derived from commercial
insurers, managed care plans, and private individuals. The on-going pressures from the Medicare and
Medicaid programs, along with other payors seeking to control costs and/or limit reimbursement
rates for medical services, are but one of the business risks that we face. We also operate in a
heavily regulated industry, subject to the scrutiny of federal and state regulators. Each of our
facilities must comply with regulations regarding staffing levels, resident care standards,
occupational health and safety, resident confidentiality, billing and reimbursement, environmental
and biological and other standards. We are required to comply with laws governing the transmission and privacy of health
information. Our ability to comply with the transaction and security standards are in part,
dependent upon other third parties, including the fiscal intermediaries and state program providers
also complying with the Health Insurance Portability and Accountability Act of 1996, or HIPAA.
Should it be determined that we have not complied with the new standards, we could be subject to
civil sanctions. We do not believe our on-going implementation to comply with the HIPAA standards
will have a material impact on our condensed consolidated financial statements. Significant Events and Developments Events of 2005 Improvement in Medicare Census.In our nursing facilities, Medicare ADC for the three months
ended March 31, 2005, or 2005 quarter, increased to 2,466 from 2,163 for the three months ended
March 31, 2004, or 2004 quarter, representing a 14.0% increase over 2004. Total ADC for the 2005
quarter increased 1.1% to 13,147 from 13,002 for the 2004 quarter. The improvement in Medicare
census was the direct result of an intense focus on the growth of Medicare census by our marketing
group in the first quarter of 2005. As we have previously disclosed, we have implemented
consistent admission practices, have certified all of our nursing facility beds under the Medicare
program and implemented routines that commit senior management to focus on census. All of these
initiatives have driven the improved Medicare census results for the 2005 quarter. 26




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Acquisition of ALC.On January 31, 2005, the shareholders of ALC approved the merger and
acquisition agreement between us and ALC, and we completed the acquisition for a total of
approximately $285 million, including the assumption of ALCs existing debt with a book value of
approximately $141 million. We financed the acquisition by using approximately $29 million in
cash on hand, a $55 million 6% Term Loan from Extendicare Holdings, Inc., or EHI, and drawing $60
million from our Revolving Credit Facility. The estimated impact of the acquisition on each asset
and liability category in the Companys balance sheet as of January 31, 2005 is as follows: (in thousands)ASSETS:Cash, net of $29 million used to finance the acquisition
    
    $
    (22,652
    )Accounts receivable
    
    
    3,003Other current assets
    
    
    8,308Total current assets
    
    
    (11,341
    )Property, plant and equipment
    
    
    290,761Other long-term assets
    
    
    4,497Total assets
    
    $
    283,917LIABILITIES:Current maturities of long-term debt
    
    $
    3,418Other current liabilities
    
    
    19,733Total current liabilities
    
    
    23,151Long-term debt:Long-term debt of ALC assumed
    
    
    141,011Proceeds from 6% from EHI Term Loan to finance acquisition
    
    
    55,000Proceeds from revolving credit facility to finance acquisition
    
    
    60,000Total long-term debt
    
    
    256,011Other long term liabilities
    
    
    4,755Total liabilities
    
    $
    283,917
 The above reflects the preliminary purchase price allocation. We are in the process of,
and will complete by December 2005, the valuation of net assets acquired. Based upon this
valuation, the purchase price allocation for accounting purposes may be adjusted in future periods. The operations of ALC are included in our condensed consolidated statements of income, our
condensed consolidated statement of cash flows and our key performance indicators beginning
February 1, 2005. The assets and liabilities of ALC are included within our condensed consolidated
balance sheet as of March 31, 2005. In January 2005, we amended our Revolving Credit Facility to permit the loan from EHI and to
partially finance the ALC acquisition. The ALC debt we assumed in the acquisition is non-recourse
to us and our subsidiaries that existed prior to the acquisition of ALC, and the debt and earnings
of ALC are excluded from existing financial covenants under our Revolving Credit Facility. ALC and
its subsidiaries are excluded from the list of our subsidiaries which are guarantors of the Senior
Notes and Senior Subordinated Notes. We are restricted from borrowing further under our Revolving
Credit Facility and under the ALC credit facility to finance any ALC operating deficiencies, and
all cash flow from ALC will be retained within the ALC operations. Any cash flow deficiencies
within ALC will be financed by way of advances from Extendicare directly to ALC, and we believe
Extendicare has the financial capacity to meet any such deficiency. In January 2005, Extendicare Inc. advanced $55.0 million to EHI, who, in turn, advanced $55.0
million as a Term Loan to us, as part of the financing of the ALC acquisition. This Term Loan has
a term of five years, can be repaid at any time by us and bears interest at 6%. 27




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##### Table of Contents



In January 2005, we entered into a Memorandum of Understanding, or MOU, and later two new
master lease agreements with LTC Properties, Inc., or LTC, in respect of the 37 facilities leased
by ALC from LTC. Under the terms of the MOU and master lease agreements, which became effective
January 1, 2005, we agreed to increase the annual rent paid to LTC by $250,000 per annum for each
of the successive four years, commencing on January 1, 2005, and amended the terms relating to
inflationary increases. Formerly, the 37 leases had expiration dates ranging from 2007 through
2015. Under the terms of the master lease agreements, the initial 10-year lease commenced on
January 1, 2005, and there are three successive 10 year lease renewal terms at our option. There
are no significant economic penalties to us if we decide not to exercise the renewal options. The
aggregate minimum rent payments for the LTC leases for the calendar years 2005 through 2008 will be
$9.4 million, $9.8 million, $10.2 million and $10.7 million, respectively. The minimum rent will
increase by 2% over the prior years minimum rent for each of the calendar years 2009 through 2014.
Annual minimum rent during any extended term will increase a minimum of 2% over the minimum rent
of the immediately preceding year. The MOU provides that LTC will not assert certain events of
default against ALC under the original leases. In accordance with FASB Technical Bulletin 85-3, we
have accounted for the effect of scheduled rent increases on a straight-line basis over the lease
term. Prior to completion of the acquisition, we conducted a due diligence review to ascertain the
risks associated with the acquisition. Though we believe these due diligence efforts identified
and quantified those risks, by virtue of this acquisition we assumed all current and former
financial, legal, regulatory and environmental risks associated with ALC. Since February 1, 2005
we have commenced the integration of ALC within our operations, which has included changes in
senior and middle management personnel at ALC. We have relocated the head office of ALC, and as of
May 1, 2005, moved all accounting and information systems from Dallas, Texas to Milwaukee,
Wisconsin. Amendment
to Lease Agreement and Option to Purchase. In March 2005, we amended the lease
agreements with Assisted Living Facilities, Inc., or ALF, an unrelated party, under which ALC
leases five assisted living facilities located in the State of Oregon. Under the terms of the
agreement, the termination date of the leases was changed to December 31, 2009 and ALC received an
option to purchase the facilities in 2009 at a fixed price. The option to purchase was determined
to be a bargain purchase price, requiring the classification of these leases be changed from
operating to capital. As a result, a capital lease obligation of $12.8 million was recorded, which
represents the estimated market value of the properties as of March 31, 2005 and also approximates
the present value of future payments due under the lease agreements, including the purchase option
payment. The option to purchase must be exercised prior to July 1, 2009, with closing to occur on
or about December 31, 2009. Medicaid Rates.In January 2005, the States of Pennsylvania and Washington received approval
from CMS for state plan amendments and waivers, which increase federal funding for their Medicaid
programs and provide nursing facilities with revenue rate increases to offset new state provider
taxes. The Washington approval had no impact on our income. In March 2005, the Sate of
Pennsylvania officially approved and committed to the state plan amendment and waiver. As a result
of the Pennsylvania approval, in the first quarter of 2005 we recognized incremental revenues
pertaining to the state plan amendment of $16.5 million and provider tax expense of $13.3 million
relating to the period from July 1, 2003 to December 31, 2004. Offsetting this, the State of
Pennsylvania published its final Medicaid rates for the period commencing July 1, 2004, which
resulted in a reduction of previously accrued revenues of $0.6 million. In the first quarter of
2005, we also recognized incremental revenues pertaining to the Pennsylvania state plan amendment
of $2.5 million and provider tax expense of $2.2 million relating to the period from January 1,
2005 through March 31, 2005. The receipt of the aggregate incremental revenues pertaining to the
Pennsylvania state plan amendments of $19.0 million, and payment of the aggregate provider taxes of
$15.5 million will occur in the second quarter of 2005, and therefore are reflected within accounts
receivable and accrued liabilities, respectively. Loan Repayments.In January 2005, we prepaid an Industrial Development Revenue Bond totaling
$9.5 million, which resulted in a pre-tax charge to income of $0.1 million to write off deferred
financing costs. In February 2005, we prepaid a mortgage totaling $5.3 million, which resulted in
a pre-tax charge to income of $0.2 million to write off deferred financing costs. Divestitures.In January 2005, we sold for $1.9 million in cash a property in Maryland that
formerly was a nursing facility but was closed in 1998. The pre-tax gain on the disposition was
$0.4 million. 28




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##### Table of Contents



Events subsequent to March 31, 2005 Acquisition and New Developments.In April and May 2005, we completed five construction
projects that resulted in the opening of one new assisted living facility (60 units), and
increasing the operational capacity at three assisted living facilities (75 units) and one nursing
facility (18 beds). We have five remaining projects that will add three new assisted living
facilities (145 units) and also increase the operational capacity at two assisted living facilities
(37 units). In May 2005, we entered into a definitive agreement to acquire a nursing facility (127 beds)
in Kentucky for $8.3 million in cash. We anticipate to completing the acquisition on May 31, 2005. Approval
of Indiana State Plan Amendment and Waiver. In May 2005, the State of Indiana announced that it had received approval from CMS of a state
plan amendment and waiver, which will increase federal funding to the Medicaid program
retroactively back to July 1, 2003. The state plan amendment is subject to final approval by the
State. Though amounts for certain periods have to be quantified, initial estimates indicate that
the impact will be to increase income before income taxes for the period from July 1, 2003 to March
31, 2005 by approximately $5.5 million. Events prior to 2005 Improvement in Medicare and Total Census.In our nursing facilities, Medicare ADC increased
8.5% to 2,100 for 2004 from 1,935 for 2003 on a same facility basis. Total ADC increased 0.9% to
12,607 for 2004 from 12,490 for 2003 on a same facility basis. The improvement in Medicare census
was the direct result of a number of our initiatives, including the implementation of consistent
admission practices, the Medicare certification of all our nursing facility beds and senior
managements focus on census. Acquisitions of Nursing Facilities.On February 12, 2004, we acquired a nursing facility in
Washington, which we had previously leased, for $1.4 million. On June 1, 2004, we acquired four
nursing facilities (321 beds) in Indiana for cash of approximately $5.0 million. Construction Projects. During 2004, we completed four construction projects for a total cost
of $10.0 million, which included a new free-standing assisted living facility with 40 units, two
additions to existing assisted living facilities adding 46 units and an addition of 20 nursing beds
to an existing nursing facility. Tender Offer/Redemption of 2007 Notes and Sale and Issuance of 2014 Notes.On April 22, 2004,
we sold and issued $125 million aggregate principal amount of 2014 Notes pursuant to Rule 144A and
Regulation S under the Securities Act of 1933, as amended, or the Securities Act. The 2014 Notes
were issued at a price of 97.5001% of par to yield 7.23%. The net proceeds from the sale and
issuance of the 2014 Notes were approximately $117.4 million, net of a $3.1 million discount and
fees and expenses of $4.5 million. We used these net proceeds, together with cash on hand and
borrowings under our amended and restated revolving credit facility, to purchase for cash all
$200.0 million of our 9.35% Senior Subordinated Notes due 2007, or 2007 Notes. Amendment and Restatement of Revolving Credit Facility.In connection with the April 22, 2004
closing of the sale and issuance of the 2014 Notes, we amended and restated our revolving credit
facility. The terms of our amended and restated revolving credit facility include the following
changes, among other things:  
    a two year maturity extension to June 28, 2009;
    an additional $50.0 million of senior secured financing on a revolving basis,
resulting in total borrowing capacity of $155.0 million;
    an interest rate spread which ranges from the Eurodollar rate plus 2.50% per annum
to 3.25% per annum or the base rate plus 1.50% per annum to 2.25% per annum, subject, in
each case, to adjustments based on our senior leverage ratio;
    a commitment fee of 0.50% per annum on the undrawn capacity regardless of utilization;
    changes to the collateral securing the facility to permit us to substitute certain assets with other assets. 29




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##### Table of Contents



Prepayment of Tandem Notes Receivable.In February 2004, Tandem Health Care, Inc., or Tandem,
refinanced two of its nursing facilities and we subsequently received prepayment in full of $4.4
million of notes receivable held in respect of certain properties. In June 2004, we accepted and
received a cash prepayment of $16.2 million for the remaining $17.0 million of notes receivable due
from Tandem. After payment of the associated selling expenses of $0.5 million, we recognized a
loss of $1.3 million on this transaction. Completion of Greystone Divestiture Agreement.In June 2004, we concluded a deferred sales
transaction with Greystone Tribeca Acquisition, L.L.C., or Greystone, by receipt of the final
consideration of $10.0 million on the Vendor Take Back Note plus $2.6 million of interest.
Finalizing this transaction resulted in the recognition of a gain on the sale of assets of $4.9
million and interest income of $1.7 million. The initial transaction in 2000 was treated as a
deferred sale since a significant portion of the proceeds was contingent and we held an option to
repurchase the facilities. Settlement of Medicare Receivable Issues.During 2004, we reached negotiated settlements with
our Fiscal Intermediaries, or FIs, of all significant outstanding Medicare settlement issues
pertaining to revenues earned prior to the implementation of the Prospective Payment System, or PPS.
As a result of the settlements discussed below, settlement receivables decreased by $20.2 million,
from a balance of $37.2 million as of December 31, 2003 to $17.0 million as of December 31, 2004. Divestitures.In August 2004, we sold all of our Arkansas facilities, consisting of one
nursing (96 beds) and three assisted living facilities (181 units), for $6.1 million. Proceeds
consisted of cash of $5.2 million and a five-year interest-bearing note of $0.9 million. The sale
resulted in a pre-tax loss of $0.6 million. For 2004 and 2003, respectively, the Arkansas
facilities had revenues of $5.3 million and $7.4 million and income before interest, depreciation
and income taxes of $0.7 million and $0.6 million. Management and Consulting Services.We commenced managing two new nursing facilities and
providing consulting services to five new nursing and assisted living facilities. We also
transferred management responsibilities for nine nursing facilities to another long-term care
provider while retaining consulting services for these nursing facilities. We also assumed full
management responsibilities for two facilities and new consulting service responsibilities for six
facilities in 2004. Income Tax Benefits.In December 2004, we recorded an aggregate $33.6 million of income tax
benefits that resulted primarily from two events. We recorded a tax benefit of $31.9 million for
an additional loss claimed from the December 1999 sale of our former subsidiary Arbor to Tandem.
This additional loss was primarily due to the issuance of additional guidance by the IRS regarding
the method to calculate the loss on the sale of subsidiary stock and partially due to the
settlement of an IRS audit for the tax years ending December 1997 through December 2002. In
addition, we recorded a tax benefit of $1.7 million relating to this Internal Revenue Service, or
IRS, audit and other issues . Key Performance Indicators We manage our business through monitoring certain key performance indicators. The most
important key performance indicators are: Census Census is defined as the number of residents occupying a bed (or unit in the case of an
assisted living facility). Average Daily Census Average Daily Census, or ADC, is the number of residents occupying a bed (or a unit in the
case of an assisted living facility) over a period of time, divided by the number of days in that
period. Occupancy Percentage Occupancy is measured as the percentage of census relative to the total available resident
beds. Total available resident beds is the number of beds (or units in the case of an assisted
living facility) available for occupancy multiplied by the number of days in the period. 30




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##### Table of Contents



Quality Mix Quality mix is the measure of the level of non-Medicaid census. In most states, Medicaid is
the most unattractive payor source as rates are the lowest of all payor types. Average Revenue Rate by Payor Source The average revenue rate by each payor source influences our focus and marketing efforts to
place certain resident payor types and in certain states varies based on the acuity of care
required by a resident. The change in revenue rates is largely dictated by CMS and state
governments. EBITDA and EBITDA Percentage EBITDA is defined as net earnings (loss) before income taxes, interest expense net of interest
income, valuation adjustment on interest rate caps, depreciation and amortization, and non-cash,
non-recurring (gains) and losses, including disposal of assets, provision for closure and exit
costs and impairment of long-lived assets and retirement of debt. EBITDA is not a measure of
performance under accounting principles generally accepted in the United States of America, or
GAAP. We use EBITDA as a key performance indicator and EBITDA expressed as a percentage of total
revenues as a measurement of margin. We understand that EBITDA, or derivatives thereof, are
customarily used by lenders, financial and credit analysts, and many investors as a performance
measure in evaluating healthcare acquisitions. Moreover, substantially all of our financing
agreements, including the indenture governing our 2010 Senior Notes and our Revolving Credit
Facility, contain covenants in which EBITDA is used as a measure of compliance. Thus, we use EBITDA
to monitor our compliance with these financing agreements. EBITDA should not be considered in
isolation or as a substitute for net income, cash flows from operating activities and other income
or cash flow statement data prepared in accordance with GAAP, or as a measure of profitability or
liquidity. Review of Key Performance Indicators In order to compare our performance between periods, we assess the key performance indicators
for all of our facilities, as well as the facilities that we operated in all reported periods, or
same facility operations. Set forth below, we provide an analysis of our key performance indicators
in total, and, where appropriate, on a same facility basis and discuss the significant trends when
comparing the 2005 quarter to the 2004 quarter. The same facility basis figures exclude results of
the following facilities: (1) 177 assisted living facilities acquired from ALC on January 31, 2005,
(2) the newly-constructed assisted living facility completed in May 2004, (3) four nursing
facilities in Indiana acquired in June 2004, (4) a nursing facility and three assisted living
facilities located in Arkansas sold in August 2004, and (5) a nursing facility in Wisconsin
transferred in August 2004 to Benedictine. 31




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##### Table of Contents



Nursing Facilities  ADC and Quality Mix The following table sets forth the ADC, by type of payor, and the quality mix for all of our
nursing facilities. Three MonthsEnded March 312005
    
    
    2004Medicare
    
    
    2,466
    
    
    
    2,225Private and other
    
    
    2,032
    
    
    
    2,179Quality Mix
    
    
    4,498
    
    
    
    4,404Medicaid
    
    
    8,649
    
    
    
    8,574Total
    
    
    13,147
    
    
    
    12,978
 The following table sets forth for the 2005 quarter and the 2004 quarter ADC, by type of payor
and percentage of ADC by payor type for all of our nursing facilities, presented on a same-facility
basis, and showing the percentage change in ADC between years. Three Months Ended March 312005
    
    
    2004
    
    
    % Change% of
    
    
    
    
    
    
    % of
    
    
    2005 toADC
    
    
    Total
    
    
    ADC
    
    
    Total
    
    
    2004Medicare
    
    
    2,433
    
    
    
    18.8
    %
    
    
    2,173
    
    
    
    17.2
    %
    
    
    12.0
    %Private and other
    
    
    2,018
    
    
    
    15.6
    %
    
    
    2,110
    
    
    
    16.8
    %
    
    
    (4.4
    %)Quality Mix
    
    
    4,451
    
    
    
    34.4
    %
    
    
    4,283
    
    
    
    34.0
    %
    
    
    3.9
    %Medicaid
    
    
    8,500
    
    
    
    65.6
    %
    
    
    8,314
    
    
    
    66.0
    %
    
    
    2.3
    %Total
    
    
    12,951
    
    
    
    100.0
    %
    
    
    12,597
    
    
    
    100.0
    %
    
    
    2.8
    %
 On a same facility basis, total ADC increased 2.8% between the 2005 quarter and the 2004
quarter. On a same facility basis, Medicare ADC increased 12.0% between the 2005 quarter and the
2004 quarter. As a result, the percentage of Medicare ADC to all payor sources increased to 18.8%
in the 2005 quarter, as compared to 17.2% in the 2004 quarter. The improvement in census was the
direct result of a number of initiatives, including an implementation of consistent admission
practices, the Medicare certification of all nursing facility beds, and senior managements focus
on census, all of which drove the improved financial results for 2005. Assisted Living Facilities  ADC and Quality Mix The following table sets forth the ADC, by type of payor, and the quality mix for all of our
assisted living facilities. Three MonthsEnded March 312005
    
    
    2004Private and other
    
    
    3,928
    
    
    
    1,334Medicaid
    
    
    1,459
    
    
    
    154Total
    
    
    5,387
    
    
    
    1,488
 The increase in ADC is due to the acquisition of ALC on January 31, 2005. 32




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##### Table of Contents



The following table sets forth for the 2005 quarter and the 2004 quarter the ADC, by type of
payor and percentage of ADC by payor type for all of our assisted living facilities, presented on a
same-facility basis, and showing the percentage change in ADC between years. Three Months Ended March 312005
    
    
    2004
    
    
    % Change% of
    
    
    
    
    
    
    % of
    
    
    2005 toADC
    
    
    Total
    
    
    ADC
    
    
    Total
    
    
    2004Private and other
    
    
    1,134
    
    
    
    86.2
    %
    
    
    1,175
    
    
    
    88.4
    %
    
    
    (3.5
    %)Medicaid
    
    
    181
    
    
    
    13.8
    %
    
    
    154
    
    
    
    11.6
    %
    
    
    17.5
    %Total
    
    
    1,315
    
    
    
    100.0
    %
    
    
    1,329
    
    
    
    100.0
    %
    
    
    (0.9
    %)
 All Nursing and Assisted Living Facilities  Occupancy and Number of Facilities Under Operation Below are tables setting forth occupancy percentages, ADC and operational resident capacity
for the 2005 quarter and the 2004 quarter. All Facilities: The following table is for all our nursing and assisted living facilities in total for the
three months ended March 31: Occupancy
    
    
    
    
    
    
    
    
    
    
    Operational ResidentPercentage
    
    
    ADC
    
    
    Capacity2005
    
    
    2004
    
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004Nursing
    
    
    93.5
    %
    
    
    91.3
    %
    
    
    13,147
    
    
    
    12,978
    
    
    
    14,058
    
    
    
    14,215Assisted Living:Mature facilities
    
    
    85.7
    %
    
    
    86.7
    %
    
    
    1,212
    
    
    
    1,394
    
    
    
    1,415
    
    
    
    1,608Developmental facilities
    
    
    69.2
    %
    
    
    87.3
    %
    
    
    127
    
    
    
    94
    
    
    
    184
    
    
    
    108ALC acquisition (all mature)
    
    
    90.1
    %
    
    
    
    
    
    
    4,048
    
    
    
    
    
    
    
    4,491
    
    
    
    Total Assisted Living
    
    
    88.5
    %
    
    
    86.7
    %
    
    
    5,387
    
    
    
    1,488
    
    
    
    6,090
    
    
    
    1,716Nursing and Assisted Living
    
    
    92.0
    %
    
    
    90.8
    %
    
    
    18,534
    
    
    
    14,466
    
    
    
    20,148
    
    
    
    15,931
 The ALC facilities ADC (of 4,048) and operational resident capacity (of 4,491) are included
from February 1, 2005, the day after the date of acquisition, but the averages shown above are
computed using all days in the 2005 quarter. For the period from February 1, 2005 to March 31,
2005, the average daily census for ALC was 6,174 and the average operational resident capacity was
6,850 units, for an occupancy percentage of 90.1%. Due to our expansion and development plans, which involve both new assisted living facilities,
and the expansion of existing facilities, the occupancy and ADC information is split between mature
and developmental facilities. Mature facilities are those which have been operational for at least
12 months and developmental facilities include either facilities which have undergone additions or
have opened during 2004 or 2005. 33




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##### Table of Contents



Same Facility Basis: The following table is for all of our nursing and assisted living facilities on a same
facility basis: Occupancy
    
    
    
    
    
    
    
    
    
    
    Operational ResidentPercentage
    
    
    ADC
    
    
    Capacity2005
    
    
    2004
    
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004Nursing
    
    
    93.8
    %
    
    
    91.4
    %
    
    
    12,951
    
    
    
    12,597
    
    
    
    13,812
    
    
    
    13,783Assisted Living:Mature facilities
    
    
    85.7
    %
    
    
    86.5
    %
    
    
    1,212
    
    
    
    1,234
    
    
    
    1,415
    
    
    
    1,427Developmental facilities
    
    
    72.0
    %
    
    
    87.3
    %
    
    
    104
    
    
    
    94
    
    
    
    144
    
    
    
    108Total Assisted Living
    
    
    84.4
    %
    
    
    86.5
    %
    
    
    1,316
    
    
    
    1,328
    
    
    
    1,559
    
    
    
    1,535Nursing and Assisted Living.
    
    
    92.8
    %
    
    
    90.9
    %
    
    
    14,267
    
    
    
    13,925
    
    
    
    15,371
    
    
    
    15,318
 On a same-facility basis, occupancy percentages decreased within the assisted living
facilities to 84.4% for the 2005 quarter from 86.5% in the 2004 quarter. The decrease in occupancy
percentage within the assisted living facilities was primarily due to the opening in 2004 of
several new wings at certain of the facilities that were not yet fully occupied as of March 31,
2005. However, mature facilities also had a slight softening in census. Facilities Under Operation and Percent Ownership: The following table sets forth the number of facilities under operation. As of
    
    
    As ofMarch 31,
    
    
    December 31,2005
    
    
    2004Number of facilities under operation:Nursing
    
    
    141
    
    
    
    141Assisted Living
    
    
    209
    
    
    
    32Total
    
    
    350
    
    
    
    173Number of facilities owned:Nursing
    
    
    132
    
    
    
    132Assisted Living
    
    
    153
    
    
    
    31Total
    
    
    285
    
    
    
    163Number of facilities under capital leases:Assisted Living
    
    
    5
    
    
    
    Percent of facilities:Owned
    
    
    81.4
    %
    
    
    94.2
    %Under capital leases
    
    
    1.4
    %
    
    
    Under operating leases
    
    
    17.2
    %
    
    
    5.8
    %100.0
    %
    
    
    100.0
    %
 34




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##### Table of Contents



Nursing Facilities  Average Revenue per Resident Day by Payor Source The following table sets forth the average revenue rate by payor source, excluding prior year
revenue adjustments, and the percentage changes between years. Three MonthsEnded March 312005
    
    
    2004
    
    
    ChangeMedicare (Part A and Part B)
    
    $
    370.68
    
    
    $
    346.82
    
    
    
    6.9
    %Private and other
    
    $
    196.61
    
    
    $
    192.77
    
    
    
    2.0
    %Medicaid
    
    $
    144.87
    
    
    $
    134.37
    
    
    
    7.8
    %Total
    
    $
    195.22
    
    
    $
    180.60
    
    
    
    8.1
    %Medicare Part A only
    
    $
    340.14
    
    
    $
    317.99
    
    
    
    7.0
    %
 The Medicare rate increased 6.9% in the 2005 quarter compared to the 2004 quarter, of which
2.8% was the result of the October 2004 Medicare rate increase. The balance of the increase is
attributable to an increase in the acuity and level of rehabilitative residents admitted.
Comparing the same quarters, the Medicaid rate increased 7.8%, including increases relating to
increases in state provider taxes, which are included in operating expenses. Net of these
increases in state provider taxes, the Medicaid rate increased 4.8%. Assisted Living Facilities  Average Revenue per Resident Day by Payor Source The following table sets forth the average revenue rate by payor source and the percentage
changes between years. Three MonthsEnded March 312005
    
    
    2004
    
    
    ChangePrivate and other
    
    $
    85.55
    
    
    $
    74.56
    
    
    
    14.7
    %Medicaid
    
    $
    62.25
    
    
    $
    52.43
    
    
    
    18.7
    %Total
    
    $
    79.24
    
    
    $
    72.28
    
    
    
    8.1
    %
 The increase in average rates for assisted living facilities relates primarily to the
acquisition of ALC on January 31, 2005. The total increase in rates of 8.1% is less than the
increase in private and Medicaid rates because the percentage of Medicaid ADCs to total ADCs
increased to 27.1% in the 2005 quarter compared to 10.7% in the 2004 quarter. 35




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##### Table of Contents



EBITDA and EBITDA Percentage The following table sets forth a reconciliation of income before taxes and EBITDA. Three MonthsEnded March 312005
    
    
    2004(in thousands)Income before income taxes
    
    $
    19,894
    
    
    $
    14,986Add (deduct):Depreciation and amortization
    
    
    10,340
    
    
    
    8,681Interest expense, net
    
    
    8,144
    
    
    
    6,585Valuation adjustment on interest rate caps
    
    
    1,298
    
    
    
    73Loss (gain) on disposal of assets and
impairment of long-lived assets
    
    
    (448
    )
    
    
    1,612Loss on refinancing and retirement of debt
    
    
    275
    
    
    
    354EBITDA
    
    $
    39,503
    
    
    $
    32,291
 The following table sets forth the calculations of EBITDA percentages: Three MonthsEnded March 312005
    
    
    2004(in thousands)EBITDA
    
    $
    39,503
    
    
    $
    32,291Total Revenues
    
    $
    294,147
    
    
    $
    231,501EBITDA as percentage of total revenues
    
    
    13.4
    %
    
    
    13.9
    %
 EBITDA as a percentage of total revenues decreased to 13.4% in the 2005 quarter from 13.9% in
the 2004 quarter. The decrease is largely attributable to an increase in state provider taxes
(included in operating expenses) which are used by state governments to fund increases in Medicaid
revenue rates. Results from Operations The following table sets forth details of our revenues and income as a percentage of total
revenues: Three MonthsEnded March 312005
    
    
    2004RevenuesNursing and assisted living facilities
    
    
    97.4
    %
    
    
    96.9
    %Outpatient therapy
    
    
    0.9
    
    
    
    1.2Other
    
    
    1.7
    
    
    
    1.9100.0
    
    
    
    100.0Operating and general and administrative costs
    
    
    85.0
    
    
    
    85.1Lease costs, depreciation and amortization
    
    
    5.1
    
    
    
    4.7Interest expense, net
    
    
    2.8
    
    
    
    2.8Valuation adjustment on interest rate cap
    
    
    0.4
    
    
    
    0.1Loss (gain) on disposal of assets and
impairment of long-lived assets
    
    
    (0.2
    )
    
    
    0.7Loss on refinancing and retirement of debt
    
    
    0.1
    
    
    
    0.2Income before income taxes
    
    
    6.8
    
    
    
    6.4Income tax expense
    
    
    2.7
    
    
    
    2.4Net income
    
    
    4.1
    %
    
    
    4.0
    %
 36




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##### Table of Contents



2005 Quarter Compared with 2004 Quarter Revenues Revenues in the 2005 quarter increased $62.6 million, or 27.1%, to $294.1 million from $231.5
million in the 2004 quarter. Outpatient therapy and other revenues increased by $0.7 million in
the 2005 quarter due to increased lease revenue and management and consulting revenue. Revenues from nursing and assisted living facilities increased $61.9 million in the 2005
quarter compared to the 2004 quarter, including $26.1 million as a result of the following: (1)
the acquisition of 177 assisted living facilities from ALC on January 31, 2005, (2) a
newly-constructed assisted living facility completed in May 2004 in Wisconsin (3) the acquisition
of four nursing facilities in Indiana in June 2004, partially offset by (4) the sale of facilities
in Arkansas in August 2004 and (5) the transfer to a third party of the operations of a nursing
facility in Wisconsin in August 2004. On a same facility basis, revenues from nursing and assisted
living facilities before prior year revenue adjustments increased $20.1 million, or 8.5%, in the
2005 quarter. On a same facility basis, but after prior year revenue adjustments, these revenues
increased $35.8 million. This increase was attributable to the following: Dollars inmillions a 5.3% increase (excluding prior year adjustments) in the average daily nursing Medicaid rate (which
included cost-offset funding as a result of increased state assessments and bed taxes of $1.3 million)
    
    $
    5.4 an increase in current year Pennsylvania Medicaid revenues due to final approval of the Pennsylvania
state plan amendment and waiver (which included cost-offset funding relating to increased state
assessments of $2.2 million)
    
    
    2.5 an increase in Medicare revenues due to the 2.8% Medicare Part A rate increase effective October 1, 2004
    
    
    2.0 an increase in Medicare residents from 17.1% of total in the 2004 quarter to 18.8% in the 2005 quarter
    
    
    3.9 an increase in nursing resident ADC from 12,597 in the 2004 quarter to 12,951 in the 2005 quarter
    
    
    5.6 an increase in nursing ancillary revenues
    
    
    1.0 an increase in Medicare revenues due to the improvement in RUGs mix and other factors
    
    
    2.0 decreases due to one less day in the 2005 quarter
    
    
    (2.3
    )20.1Adjustments relating to prior years: an increase in prior year Pennsylvania Medicaid revenues due to final approval of the Pennsylvania
state plan amendment and waiver for the period July 1, 2003 through December 31, 2004 (which included
cost-offset funding relating to increased state assessments of $13.3 million)
    
    
    15.8 Other favorable prior year revenue adjustments of $1.2 million recorded in the 2005 quarter compared to
net favorable prior year adjustments of $1.3 million recorded in the 2004 quarter
    
    
    (0.1
    )Total increase in revenues from same facility nursing and assisted living facilities
    
    $
    35.8
 Operating and General and Administrative Costs Operating and general and administrative costs increased $53.1 million, or 27.0%, in the 2005
quarter compared to the 2004 quarter, including $19.7 million as a result of the following: (1)
acquisition of 177 assisted living facilities from ALC on January 31, 2005, (2) the
newly-constructed assisted living facility completed in May 2004 in Wisconsin, and (3) the
acquisition of four nursing facilities in Indiana in June 2004, partially offset by (4) the sale of
the facilities in Arkansas in August 2004 and (5) the transfer to a third party of the operations
of a nursing facility in Wisconsin in August 2004. On a same facility basis, operating and general
and administrative costs before prior year Pennsylvania state assessment taxes increased $20.1
million, or 10.5%. On a same facility basis, but after these taxes, operating and general and
administrative costs increased $33.4 million. This increase was attributable to the following: 37




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##### Table of Contents



Dollars inMillions wages, benefits and contracted staffing, which included an average wage rate increase of 1.2%
    
    $
    12.4 state assessment tax in Pennsylvania for the period January 1, 2005 through March 31, 2005
due to final approval of the Pennsylvania state plan amendment and waiver
    
    
    2.2 other state assessments and bed taxes
    
    
    1.3 drug expense due to higher resident census, Medicare mix and drug prices
    
    
    1.4 supplies expense
    
    
    0.9 other operating and administrative expenses
    
    
    1.920.1Adjustment relating to prior year: state assessment tax in Pennsylvania for the period July 1, 2003 through December 31, 2004
due to final approval of the Pennsylvania state plan amendment and waiver
    
    
    13.3Total increase in same facility operating and general and administrative costs
    
    $
    33.4
 Lease Costs, Depreciation and Amortization Lease costs increased $ 2.3 million to $4.6 million when comparing the 2005 quarter to the
2004 quarter as a result of the ALC acquisition on January 31, 2005. Depreciation and amortization
increased $1.7 million to $10.3 million in the 2005 quarter compared to $8.7 million in the 2004
quarter. This increase was primarily due to an increase of $1.5 million as a result of the ALC
acquisition. Interest Expense, Net Interest expense, net of interest income, increased $1.5 million to $8.1 million for the 2005
quarter compared to $6.6 million for the 2004 quarter. This increase was due to (1) an increase of
$2.8 million relating to the ALC acquisition, (2) an increase of $1.0 million relating to interest
income recognized in the 2004 quarter from the deferred sale of facilities in 2000 to Greystone,
offset by (3) decreases in interest expense of approximately $2.3 million primarily relating to our
debt refinancing in April 2004 and early retirement of industrial revenue bonds in 2004 and the
first quarter of 2005. The weighted average interest rate of all long-term debt decreased to
approximately 6.80% during the 2005 quarter compared to approximately 7.79% during the 2004
quarter. The average debt level increased to $463.3 million during the 2005 quarter compared to
$384.7 million during the 2004 quarter, resulting primarily from the ALC acquisition. Valuation Adjustment on Interest Rate Caps The valuation adjustment on interest rate caps was an expense of $1.3 million in the 2005
quarter compared to $0.1 million in the 2004 quarter. The value of the caps decreased in the 2005
quarter due to a decrease in volatility of the projected future six-month LIBOR. Loss (Gain) on Disposal of Assets and Impairment of Long-Lived Assets Gain on disposal of assets and impairment of long-lived assets was $0.4 million for the 2005
quarter due to the sale of a property in Maryland that formerly was a nursing facility, but was
closed in 1998. The loss on disposal of assets and impairment of long-lived assets in the 2004
quarter represents a loss on the impairment of long-lived assets when we concluded the evaluation
of two nursing facilities in Indiana and made the decision, subject to State of Indiana approval,
and after renovation of one of the two facilities, to consolidate the two operations into one. As a
result of the decision to close the one facility, we recorded a provision of $1.6 million. 38




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##### Table of Contents



Loss on Refinancing and Retirement of Debt Loss on refinancing and retirement of debt in the 2005 quarter of $0.3 million was due to the
extinguishment, in January 2005, of an Industrial Development Revenue Bond totaling $9.5 million,
which resulted in a charge to income of $0.1 million to write off deferred financing costs and the
prepayment, in February 2005, of a mortgage totaling $5.3 million, which resulted in a pre-tax
charge to income of $0.2 million to write off deferred financing costs. The loss on refinancing and retirement of debt in the 2004 quarter of $0.4 million was due to
the extinguishment, in February 2004, of two Industrial Development Revenue Bonds totaling $13.0
million, which resulted in the write-off of related deferred financing costs. Income Taxes Income tax expense for the 2005 quarter was $7.8 million compared to $5.6 million for the 2004
quarter. Our effective tax rate was 39.4% for the 2005 quarter compared to 37.6% for the 2004
quarter. The increase in the effective tax rate primarily related to state income taxes. When we
assess the realizability of deferred tax assets, we consider whether it is more likely than not
that some portion or all of the deferred tax assets will not be realized and record a valuation
allowance, if required. The ultimate realization of deferred tax assets depends upon us generating
future taxable income during the periods in which those temporary differences become deductible. We
consider the scheduled reversal of deferred tax liabilities, projected future taxable income and
tax planning strategies when we make this assessment. Net Income Net income for the 2005 quarter was $12.1 million compared to $9.3 million for the 2004
quarter. The improvement in net income was due to the reasons described herein. Related Party Transactions We insure certain risks, including comprehensive general liability, property coverage, excess
workers compensation and employers liability insurance, with Laurier Indemnity Company and
Laurier Indemnity Ltd., affiliated insurance subsidiaries of Extendicare. We recorded approximately
$3.0 million and $2.8 million of expenses for this purpose for the 2005 quarter and 2004 quarter,
respectively. Also, we recorded credits to expense of $0.3 million and $1.0 million for the 2005
quarter and 2004 quarter, respectively, relating to refunds from prior year workers compensation
policies with Laurier Indemnity Company. We purchase computer hardware and software support services from Virtual Care Provider, Inc.,
an affiliated subsidiary of Extendicare Inc. Expenses related to these services were $1.2 million
for both the 2005 quarter and the 2004 quarter. 39




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##### Table of Contents



In December 2004, we advanced $7.7 million to Extendicare, which we subsequently repaid in
January 2005. The Company has non-interest bearing amounts due from (to) affiliates as follows: March 31,
    
    
    December 31,2005
    
    
    2004(in thousands)Affiliate
    
    Purpose
    
    Receivable (payable)Current assets:Extendicare Holdings, Inc.
    
    Federal income taxes receivable
    
    $
    1,231
    
    
    $
    5,231Extendicare Holdings, Inc.
    
    Deferred federal income taxes
    
    
    14,183
    
    
    
    13,258Extendicare Inc.
    
    Working capital advances
    
    
    3⁄4
    
    
    
    7,69015,414
    
    
    
    26,179Current liabilities:Virtual Care Provider, Inc.
    
    Working capital advances
    
    
    (3,000
    )
    
    
    (3,000
    )The Northern Group, Inc.
    
    Intercompany operating expenses
    
    
    16
    
    
    
    19Laurier Indemnity Company
    
    Intercompany insurance premium
    
    
    6
    
    
    
    3Extendicare Holdings, Inc.
    
    Working capital advances
    
    
    3
    
    
    
    3(2,975
    )
    
    
    (2,975
    )Long-term liabilities:Extendicare Holdings, Inc.
    
    Deferred federal income taxes
    
    
    (5,015
    )
    
    
    (1,853
    )Other:Extendicare Inc.
    
    Advances
    
    
    (8,900
    )
    
    
    (8,900
    )Extendicare Inc.
    
    Advances
    
    
    1,574
    
    
    
    1,218Extendicare Holdings, Inc.
    
    Advances
    
    
    (3,483
    )
    
    
    (3,483
    )Virtual Care Provider, Inc.
    
    Advances
    
    
    (3,884
    )
    
    
    (3,620
    )(14,693
    )
    
    
    (14,785
    )$
    (7,269
    )
    
    $
    6,566
 In addition to the above, in January 2005 we amended our Revolving Credit Facility to
permit a loan from EHI and partially finance the ALC acquisition. In January 2005, Extendicare
Inc. advanced $55.0 million to EHI, who, in turn, advanced $55.0 million as a Term Loan to us, as
part of the financing of the ALC acquisition. This Term Loan has a term of five years and bears
interest at 6%. The Term Loan can be repaid at any time by us, but is subject to certain
restrictions under the Revolving Credit Facility which currently prevents prepayments of the Term
Loan. The ALC debt we assumed on the acquisition is non-recourse to us and our subsidiaries that
existed prior to the acquisition of ALC, and the debt and earnings of ALC are excluded from
existing financial covenants under our Revolving Credit Facility. We are restricted from borrowing
further under our Revolving Credit Facility and under the ALC credit facility to finance any ALC
operating deficiencies and all cash flow from ALC will be retained within the ALC operations. Any
cash flow deficiencies within ALC will be financed by way of advances from Extendicare directly to
ALC, and we believe Extendicare has the financial capacity to meet any such deficiency. Liquidity and Capital Resources Sources and Uses of Cash We had cash and cash equivalents of $9.3 million at March 31, 2005 and $29.6 million at
December 31, 2004. The table below sets forth a summary of the significant sources and uses of
cash: Three Months EndedMarch 312005
    
    
    2004(in thousand)Cash provided by operating activities
    
    $
    23,143
    
    
    $
    18,484Cash used in investing activities
    
    
    (148,056
    )
    
    
    (7,239
    )Cash provided by (used in) financing activities
    
    
    104,553
    
    
    
    (12,207
    )Increase (decrease) in cash and cash equivalents
    
    
    (20,360
    )
    
    
    (962
    )
 40




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##### Table of Contents



The increase in cash flow from operating activities of $4.6 million in the 2005 quarter
compared to the 2004 quarter was primarily due to an improvement in net income and an increase of
$6.2 million in amounts due to shareholder and affiliates, partially offset by an increase of $1.8
million in payments for self-insured liabilities. Our working capital decreased $41.3 million from $29.6 million at December 31, 2004 to a
negative $6.3 million at March 31, 2005. Working capital decreased primarily due to the cash
payment for acquisition of ALC, the increase in accounts payable and accrued liabilities pertaining
to ALC in relation to ALCs receivables, the early retirement of debt and increased payments for
self-insured liabilities, partially offset by cash flow from operating activities. Although we
have a negative working capital, as of March 31, 2005 the unused portion of the Revolving Credit
Facility that is available for working capital and corporate purposes was $79.6 million. Accounts receivable at March 31, 2005 were $126.8 million compared with $96.0 million at
December 31, 2004, representing an increase of $30.8 million, including a $19.0 million increase
resulting from revenue recorded based on the CMS approval of the State of Pennsylvania state plan
amendment and waiver, and a $2.9 million increase relating to the acquisition of ALC. The remaining
$8.9 million increase in accounts receivable included a $8.6 million increase within the nursing
operations and an increase of $0.3 million in outpatient therapy receivables. Within the nursing
operations, billed patient care and other receivables increased $6.8 million and third-party payor
settlement receivables increased $1.8 million. The increase in settlement receivables of $1.8 million from December 31, 2004 to March 31,
2005 included increases of $3.6 million relating to revenue recorded in the 2005 period for
anticipated Medicare reimbursement for uncollectible Part A co-insurance and $1.7 million from
Medicaid cost report settlements and other items. These increases were partially offset by
decreases of $2.7 million from the collection of Medicare co-insurance amounts and $0.8 million
from the collection of Medicare settlements. Property and equipment increased $304.1 million from $446.1 million as of December 31, 2004 to
$750.2 million at March 31, 2005. Property and equipment increased by (1) $ 290.8 million due to
the ALC acquisition, (2) $12.8 million due to a capital lease obligation incurred when we modified
our lease between ALC and ALF (3) $6.3 million due to normal capital expenditures and (4) $5.7
million from new construction projects. These increases were offset by decreases of (1) $10.1
million in depreciation expense, and (2) $1.4 million resulting from the sale of the Maryland
property. Total long-term debt, including both current and long-term maturities of debt, was $542.9
million at March 31, 2005. This represents an increase of $251.0 million from December 31, 2004,
including (1) $144.4 million of debt (at market value) assumed in the acquisition of ALC, (2)
borrowings of $115.0 million in order to finance the acquisition of ALC ($60.0 million on our
Revolving Credit Facility and $55.0 million from a 6% Term Note from EHI), (3) borrowings of $10.0
million on the Revolving Credit Facility for working capital needs, and (4) a capital lease
obligation of $12.8 million incurred when we modified our lease between ALC and ALF. These
increases were partially offset by decreases of (1) $9.5 million due to the prepayment of
Industrial Development Revenue Bonds, (2) $5.3 million due to the prepayment of a mortgage note,
(3) $12.0 million in payments on the Revolving Credit Facility, and (4) $4.4 million of other debt
payments. Cash used in investing activities was $148.1 million for the 2005 quarter compared to $7.2
million for the 2004 quarter, an increase of $140.9 million. Of this increase, $137.7 million was
due to the ALC acquisition, consisting of the acquisition price of $144.2 million offset by cash
balances of $6.5 million acquired in the ALC acquisition. Cash provided from financing activities was $104.6 million for the 2005 quarter compared to
$12.2 million used in financing activities for the comparable 2004 quarter. The change of $116.8
million primarily related to (1) borrowings totaling $115.0 million associated with the financing
of the ALC acquisition, (2) borrowings on the line of credit for operational purposes of $10.0
million, (3) an increase in outstanding checks in excess of bank balance of $10.1 million,
partially offset by (4) payments on the Revolving Credit Facility in the 2005 quarter of $12.0
million, (5) increased payments of debt in the 2005 quarter compared to the 2004 quarter of $5.9
million and (6) other decreases of $0.4 million. 41




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##### Table of Contents



Debt Instruments Summary of Long-term Debt Long-term debt consists of the following: March 31,
    
    
    December 312005
    
    
    2004(dollars in thousands)9.50% Senior Notes due 2010
    
    $
    149,724
    
    
    $
    149,7146.875% Senior Subordinated Notes due 2014
    
    
    122,079
    
    
    
    122,022Revolving Credit Facility due 2009, at variable
interest rates
    
    
    58,000
    
    
    
    6.00% EHI Term Note due 2010
    
    
    55,000
    
    
    
    6.24% Red Mortgage Capital Note due 2014
    
    
    37,016
    
    
    
    GE Capital Term Loan and Credit Facility, at variable interest
rates, due 2009
    
    
    35,456
    
    
    
    DMG Mortgage notes payable, interest rates ranging from 7.58%
to 8.65%, due 2008
    
    
    28,079
    
    
    
    Revenue Bonds, at variable interest rates, maturing through 2018
    
    
    21,995
    
    
    
    Capital lease obligations, interest rates ranging from 2.84% to
13.54%, maturing through 2009
    
    
    12,801
    
    
    
    11Oregon Trust Deed Notes, interest rates ranging from 0.25% to
10.90%, maturing from 2020 through 2026
    
    
    9,774
    
    
    
    HUD Insured Mortgages, interest rates ranging from 7.40% to
7.55%, due 2036
    
    
    7,727
    
    
    
    Other mortgage notes payable, interest rates ranging from 3.0%
to 7.25%, maturing through 2009
    
    
    4,299
    
    
    
    9,730Industrial Development Revenue Bond due 2014
    
    
    
    
    
    
    9,5006.25% Industrial Development Revenue Bond,
maturing 2008
    
    
    955
    
    
    
    955Long-term debt before current maturities
    
    
    542,905
    
    
    
    291,932Less current maturities
    
    
    4,248
    
    
    
    1,071Total long-term debt
    
    $
    538,657
    
    
    $
    290,861
 The weighted average interest rate of all of our long-term debt (including the effects of the
interest rate swap and cap agreements discussed below) was 6.49% and 6.26% as of March 31, 2005 and
December 31, 2004, respectively. Our long-term debt instruments have maturities ranging from 2005
to 2036. 9.50% Senior Notes due 2010 On June 28, 2002, we completed a private placement of $150 million of our 9.5% Senior Notes
due July 1, 2010 (the 2010 Senior Notes), which were issued at a discount of 0.25% of par to
yield 9.54%. In January 2003, we completed our offer to exchange new 9.5% Senior Notes due 2010
that have been registered under the Securities Act for the Notes issued in June 2002. The terms of
the new 2010 Senior Notes are identical to the terms of the 2010 Senior Notes issued in June 2002.
Also on June 28, 2002, we entered into an interest rate swap agreement and an interest rate cap
agreement. We terminated these agreements in April 2004 in connection with the sale and issuance of
the 2014 Notes. See Note 8 of the footnotes to the condensed consolidated financial statements for
more information on the swap and cap agreements. 42




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The indenture governing the 2010 Senior Notes contains customary covenants and events of
default. Under this indenture, we are restricted from incurring indebtedness if the fixed charge
coverage ratio, determined on a pro forma basis, is less than or equal to 2.0 to 1. Our fixed
charge coverage ratio is currently in excess of this minimum requirement. The fixed charge coverage
ratio is defined in the indenture governing the 2010 Senior Notes, and is represented by a ratio of
consolidated cash flow to fixed charges. In general, fixed charges consist of interest expense,
including capitalized interest, amortization of fees related to debt financing and rent expense
deemed to be interest, and consolidated cash flow consists of net income prior to the
aforementioned fixed charges, and prior to income taxes and losses on disposal of assets. We are required to make mandatory prepayments of principal upon the occurrence of certain
events, such as certain asset sales and certain issuances of securities. The 2010 Senior Notes are
redeemable at our option starting on July 1, 2006. The redemption prices, if redeemed during the
12-month period beginning on July 1 of the year indicated, are as follows: Year
    
    Redemption Price2006
    
    
    104.750
    %2007
    
    
    102.375
    %2008 and thereafter
    
    
    100.000
    %
 The assets and operations of ALC and its subsidiaries do not guarantee the 2010 Senior Notes.
In addition, we are restricted from borrowing under our Revolving Credit Facility to support our
ALC operations, and all cash flow from ALC will be retained within the ALC operation. As of March
31, 2005, ALC had a cash balance of $4.5 million. However, except for ALC and its subsidiaries, we
have no independent assets or operations and the guarantees of the 2010 Senior Notes are full and
unconditional, and joint and several, and any of our subsidiaries that do not guarantee the 2010
Senior Notes are minor. The Senior Notes are guaranteed by all of our existing and future active
subsidiaries, except for ALC and its subsidiaries. There are no significant restrictions on our
ability to obtain funds from our subsidiaries by loan or dividend. 6.875% Senior Subordinated Notes due 2014 On April 22, 2004, we sold and issued $125 million aggregate principal amount of 6.875% Senior
Subordinated Notes due May 1, 2014 (the 2014 Notes) pursuant to Rule 144A and Regulation S under
the Securities Act of 1933, as amended (the Securities Act). The 2014 Notes were issued at a
price of 97.5001% of par to yield 7.23%.The net proceeds from the issuance of the 2014 Notes were
approximately $117.4 million, net of a discount of $3.1 million and fees and expenses of $4.5
million. We used these net proceeds, along with cash on hand and borrowings under our amended and
restated Revolving Credit Facility described below, to purchase for cash the 9.35% Senior
Subordinated Notes due 2007 (the 2007 Notes), tendered in the tender offer described below, to
redeem the 2007 Notes not tendered in the tender offer prior to May 24, 2004 and to pay related
fees and expenses of the tender offer and redemption. Also on April 22, 2004, we entered into two
interest rate swap agreements and two interest rate cap agreements. See Note 8 for the terms of
the interest rate swap and cap agreements. In August 2004, we completed our offer to exchange new
6.875% Senior Subordinated Notes due 2014 that have been registered under the Securities Act for
the Senior Subordinated Notes issued in April 2004. The terms of the new 2014 Notes are identical
to the terms of the 2014 Notes issued in April 2004. The assets and operations of ALC and its subsidiaries do not guarantee the 2010 Senior Notes.
In addition, we are restricted from borrowing under our Revolving Credit Facility to support our
ALC operations, and all cash flow from ALC will be retained within the ALC operation. However,
except for ALC and its subsidiaries, the 2014 Notes are fully and unconditionally guaranteed on a
senior subordinated unsecured basis, jointly and severally, by all of our existing and future
domestic significant subsidiaries, all of our existing and future domestic subsidiaries that
guarantee or incur any indebtedness and any other existing and future significant subsidiaries or
restricted subsidiaries that guarantee or otherwise provide direct credit support for our
indebtedness or the indebtedness of any of our domestic subsidiaries. The 2014 Notes and guarantees
are our general unsecured obligations and the general unsecured obligations of our subsidiaries. 43




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On or after May 1, 2009, we may redeem all or part of the 2014 Notes, at the redemption prices
(expressed as percentages of principal amount) listed below, plus accrued and unpaid interest, if
any, to the date of redemption, if redeemed during the twelve-month period commencing on May 1 of
the years set forth below: Year
    
    Redemption Price2009
    
    
    103.438
    %2010
    
    
    102.292
    %2011
    
    
    101.146
    %2012 and thereafter
    
    
    100.000
    %
 Revolving Credit Facility We established a senior secured Revolving Credit Facility (the Revolving Credit Facility) in
June 2002. In connection with the April 2004 offering of the 2014 Notes, we amended and restated
the Revolving Credit Facility to, among other things, extend the maturity date from June 28, 2007
to June 28, 2009 and increase the total borrowing capacity from $105 million to $155 million. In
January 2005, we amended our Revolving Credit Facility to permit the loan from EHI to partially
finance the ALC acquisition. ALCs debt is non-recourse to us and our subsidiaries that existed
prior to the acquisition of ALC, and ALCs debt and earnings are excluded from existing financial
covenants under our Revolving Credit Facility. We are restricted from borrowing under our
Revolving Credit Facility to support our ALC operation, and all cash flows from ALC will be
retained within ALC. In the table above, the ALC debt assumed is listed after the caption 6.0% EHI
Term Note due 2010 and before the caption Other mortgage notes payable. The Revolving Credit Facility is used to back letters of credit and for general corporate
purposes. Borrowings under the Revolving Credit Facility bear interest, at our option, at the
Eurodollar rate or the prime rate, plus applicable margins. Depending upon our senior leverage
ratio, the interest rate is equal to the Eurodollar rate plus a margin of 2.50% to 3.25% per annum
or the base rate plus a margin of 1.50% to 2.25% per annum. The commitment fee is 0.50% per annum
on the undrawn capacity regardless of utilization. The Revolving Credit Facility is secured by a perfected, first priority security interest in
certain tangible and intangible assets and all of our capital stock and the capital stock of our
subsidiary guarantors, excluding ALC and its subsidiaries. The Revolving Credit Facility is also
secured by a pledge of 65% of the voting stock of our foreign subsidiaries, including our
subsidiary guarantors foreign subsidiaries, if any. The Revolving Credit Facility contains
customary covenants and events of default and is subject to various mandatory prepayment and
commitment reductions. We are permitted to make voluntary prepayments at any time under the
Revolving Credit Facility. As of March 31, 2005, we had borrowings under the Revolving Credit Facility of $58.0 million
relating to the acquisition of ALC as of January 31, 2005. There were no borrowings as of December
31, 2004. The unused portion of the Revolving Credit Facility that is available for working capital
and corporate purposes, after reduction for outstanding letters of credit of $17.4 million, was
$79.6 million as of March 31, 2005. The Revolving Credit Facility requires that we comply with various financial covenants,
including fixed charge coverage, debt leverage, and tangible net worth ratios. The financial
covenants exclude the operations of ALC. We are in compliance with all of the financial covenants
as of March 31, 2005. 6.0% EHI Term Note due 2010 In January 2005, Extendicare Inc. advanced $55 million to EHI who, in turn, advanced $55
million to us to accommodate the ALC acquisition. The Term Note has a term of five years and bears
interest at 6%. The Term Loan can be repaid at any time by us. 44




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6.24% Red Mortgage Capital Note due 2014 The Red Mortgage Capital Note has a fixed interest rate of 6.24% with a 25-year principal
amortization and is secured by 24 assisted living facilities within ALC. The Red Mortgage Capital
Note was entered into by subsidiaries of ALC and is non-recourse to ALC, subject to a limited
guaranty by ALC. GE Capital Term Loan and Credit Facility due 2009 The GE Capital Term Loan (GE Term Loan) and the GE Capital Credit Facility (GE Credit
Facility) were entered into by ALC in December 2003. The GE Term Loan and GE Credit Facility
mature in 2009 and are secured by a collective pool of 30 ALC assisted living facilities. The GE
Term Loan requires monthly interest payments and principal reductions based on a 25-year principal
amortization schedule, with a balloon payment at maturity. The Company has a $15.0 million Credit
Facility with GE, which has the same payment terms as the GE Term Loan. Under the Credit Facility,
a fee is charged on the unused borrowing capacity at a rate of 0.75% per year, which is paid
quarterly. Both the GE Term Loan and GE Credit Facility accrue interest at LIBOR plus 4.0%, with an
interest rate floor of 5.75%. The GE Term Loan and the GE Credit Facility both contain financial
covenants that require a certain level of financial performance for the GE financed ALC assisted
living facilities. The GE Term Loan and GE Credit Facility were entered into by subsidiaries of
ALC and are non-recourse to ALC, subject to a limited guaranty by ALC. ALC had no borrowings on
the GE Credit Facility as of March 31, 2005. We are in compliance with the GE financial covenants
as of March 31, 2005. DMG Mortgage Notes Payable due 2008 DMG Mortgage Notes Payable (DMG Notes) include three fixed rate notes that are secured by 13
ALC assisted living facilities located in Texas, Oregon and New Jersey. These notes collectively
require monthly principal and interest payments of $230,000, with balloon payments of $11.8
million, $5.3 million and $7.2 million due at maturity in May, August and September 2008,
respectively. These loans bear interest at fixed rates ranging from 7.6% to 8.7%. Revenue Bonds Revenue Bonds include three variable rate revenue bonds secured by 15 ALC assisted living
facilities located in the States of Washington, Idaho and Ohio. ALC has a series of Reimbursement
Agreements with U.S. Bank for letters of credit that support certain of ALCs Variable Rate Revenue
Bonds. The letters of credit expire in July 2005 and have an annual commitment fee of
approximately 2.0%. The total amount of these letters of credit was approximately $22.8 million as
of March 31, 2005. The Washington bonds had an interest rate of 2.1% at March 31, 2005, and are
secured by a $7.1 million letter of credit and buildings, land, furniture and fixtures of the five
Washington assisted living facilities. The Idaho bonds had an interest rate of 2.1% at March 31,
2005, and are secured by a $6.2 million letter of credit and buildings, land, furniture and
fixtures of four Idaho assisted living facilities. The Ohio bonds had an interest rate of 2.0% at
March 31, 2005, and are secured by a $10.3 million letter of credit and buildings, land, furniture
and fixtures of six Ohio assisted living facilities. Under debt agreements relating to the Revenue Bonds, ALC is required to comply with the terms
of certain regulatory agreements that provide, among other things, that in order to preserve the
federal income tax exempt status of the bonds, ALC is required to lease at least 20% of the units
of the projects to low or moderate income persons as defined in Section 142(d) of the Internal
Revenue Code. There are additional requirements as to the age and physical condition of the
residents with which the Company must also comply. Non-compliance with these restrictions may
result in an event of default and cause acceleration of the scheduled repayment. ALCs Reimbursement Agreements with U.S. Bank contain financial covenants which include the
following: (1) minimum net worth; (2) minimum debt service coverage; (3) minimum liquidity; and (4)
minimum earnings of ALC. Failure to comply with these covenants could constitute an event of
default, which would allow U.S. Bank to declare any amounts outstanding under the loan documents to
be due and payable. The agreements also require ALC to deposit $500,000 in cash collateral with
U.S. Bank in the event certain regulatory actions are commenced with respect to the properties
securing ALCs obligations to U.S. Bank. U.S. Bank is required to release such deposits upon
satisfactory resolution of the regulatory action. We are in compliance with the U.S. Bank financial
covenants as of March 31, 2005. 45




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Capital Lease Obligations In March 2005, we amended lease agreements with ALF relating to five ALC assisted living
facilities located in Oregon that provided ALC with an option to purchase the facilities in 2009 at
a fixed price. The option to purchase was determined to be a bargain purchase price, requiring the
classification of these leases be changed from operating to capital. As a result, a capital lease
obligation of $12.8 million was recorded, which represents the estimated market value of the
properties as of March 31, 2005 and also approximates the present value of future payments due
under the lease agreements, including the purchase option payment. The option to purchase must be
exercised prior to July 1, 2009 with closing on or about December 31, 2009. The lessor obtained funding for these leased properties through the sale of bonds issued by
the State of Oregon, Housing and Community Services Department (OHCS). ALC entered into Lease
Approval Agreements with OHCS and the lessor which obligates ALC to comply with the terms and
conditions of the underlying trust deed relating to the leased properties. ALC is required to
maintain a capital replacement escrow account to cover expected capital expenditure requirements
for the leased properties. Oregon Trust Deed Notes The Oregon Trust Deed Notes are secured by buildings, land, furniture and fixtures of six
Oregon ALC assisted living facilities. The notes are payable in monthly installments including
interest at effective rates ranging from 7.4% to 9.0%. Under debt agreements relating to the Oregon Trust Deed Notes, ALC is required to comply with
the terms of certain regulatory agreements which provide, among other things, that in order to
preserve the federal income tax exempt status of the bonds, ALC is required to lease at least 20%
of the units of the projects to low or moderate income persons as defined in Section 142(d) of the
Internal Revenue Code. There are additional requirements as to the age and physical condition of
the residents with which the Company must also comply. Non-compliance with these restrictions may
result in an event of default and cause acceleration of the scheduled repayment. ALC is also
required to maintain a capital replacement escrow account to cover expected capital expenditure
requirements for the leased properties. HUD Insured Mortgages due 2036 The HUD insured mortgages include three separate loan agreements entered into in 2001. The
mortgages are each secured by a separate ALC assisted living facility located in Texas. These loans
mature between July 1, 2036 and August 1, 2036 and collectively require monthly principal and
interest payments. The loans bear interest at fixed rates ranging from 7.40% to 7.55%. Mortgage Notes Payable In February 2005, we prepaid in full a mortgage totaling $5.3 million which resulted in a
pre-tax charge to income of $0.1 million to write off deferred financing costs. Industrial Development Revenue Bond due 2014 In January 2005, we prepaid in full a $9.5 million Variable Rate Industrial Development
Revenue Bond due 2014, which resulted in a pre-tax charge to income of $0.1 million to write off
deferred financing costs. Credit Ratings In April 2004, the following ratings were assigned to our debt and have not changed as of the
date of this report:  
    Moodys Investors Service assigned a B2 rating to the 2010 Senior Notes.
    S&P assigned a B- rating to the 2014 Notes.
    S&P assigned a BB- rating to the Revolving Credit Facility. 46




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Interest Rate Swap and Cap Agreements As of March 31, 2005, we have $486.7 million of fixed rate debt outstanding. To hedge the fair
value of Senior Note and Subordinated Senior Note fixed-rate debt obligations, we have entered into
interest rate swap agreements with a total notional amount of $275 million under which we pay a
variable rate of interest and we receive a fixed rate of interest. These interest rate swaps are
designated as fair value hedges under SFAS 133 and changes in the market value of the interest rate
swaps have no impact on the statements of income unless they are terminated or are no longer
designated as hedges. In addition, we have entered into interest rate cap agreements to limit our
exposure to increases in interest rates. We do not speculate using derivative instruments. On April 22, 2004, we entered into two new interest rate swap agreements and two new interest
rate cap agreements relating to the 2010 Senior Notes and the 2014 Notes. With respect to the 2010 Senior Notes, we entered into an interest rate swap agreement
expiring July 1, 2010, or 2010 Swap, with a notional amount of $150.0 million. The 2010 Swap
effectively converted up to $150.0 million of fixed interest rate indebtedness into variable
interest rate indebtedness. Under the terms of the 2010 Swap, the counterparty can call the swap at
any time on or after July 1, 2006 with payments as determined under the agreement. This call option
is a mirror image of the embedded call option in the debt instrument. The 2010 Swap was designated
as a highly-effective fair value hedge, and as a result, changes in market value of the swap are
recorded in income but are offset by changes in market value of the indebtedness so that there is
no net impact on the statement of income unless the swap is terminated or no longer qualifies as a
hedge. We also entered into an interest rate cap agreement expiring July 1, 2010, 2010 Cap, with a
notional amount of $150.0 million. Under the 2010 Cap, we paid an upfront fee of $3.5 million to
the counterparty. We will receive a variable rate of interest equal to the excess, if any, of the
six-month LIBOR, adjusted semi-annually, over the cap rate of 7%. We use the 2010 Cap to offset
possible increases in interest payments under the 2010 Swap caused by increases in market interest
rates over a certain level. Under the terms of the 2010 Cap, the counterparty can call the cap if
the 2010 Swap is terminated. The 2010 Cap was not designated as a hedging instrument under SFAS 133
and, therefore, changes in market value are recorded in the statements of income. With respect to the 2014 Notes, we also entered into an interest rate swap agreement expiring
May 1, 2014, or 2014 Swap, with a notional amount of $125.0 million. This agreement effectively
converted up to $125.0 million of fixed interest rate indebtedness into variable interest rate
indebtedness. Under the terms of the 2014 Swap, the counterparty can call the swap at any time on
or after May 1, 2009 with payments as determined under the agreement. This call option is a mirror
image of the embedded call option in the debt instrument. The 2014 Swap was designated as a
highly-effective fair value hedge, and as a result, changes in market value of the swap are
recorded in income but are offset by changes in market value of the indebtedness so that there is
no net impact on the statement of income unless the swap is terminated or no longer qualifies as a
hedge. We also entered into an interest rate cap agreement expiring May 1, 2014, 2014 Cap, with a
notional amount of $125.0 million. Under the 2014 Cap, we pay a fixed rate of interest equal to
0.75% to the counterparty and receive a variable rate of interest equal to the excess, if any, of
the six-month LIBOR, adjusted semi-annually, over the cap rate of 7%. We use the 2014 Cap to offset
possible increases in interest payments under the 2014 Swap caused by increases in market interest
rates over a certain level. Under the terms of the 2014 Cap, the counterparty can call the cap if
the 2014 Swap is terminated. The 2014 Cap was not designated as a hedging instrument under SFAS 133
and, therefore, changes in market value are recorded in the statements of income. Off Balance Sheet Arrangements We have no significant off balance sheet arrangements. Cash Management As of March 31, 2005, we held cash and cash equivalents of $9.3 million. We forecast on a
regular basis monthly cash flows to determine the investment periods, if any, of CDs and monitor
daily the incoming and outgoing expenditures to ensure available cash is invested on a daily basis. 47




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Future Liquidity and Capital Resources We believe that our cash from operations together with other available sources of liquidity,
including borrowings available under our Revolving Credit Facility, will be sufficient for the
foreseeable future to fund anticipated capital expenditures and make required payments of principal
and interest on our debt. During 2004, we completed four construction projects for a total cost of $10.0 million. We
have 10 additional construction projects in progress to add 18 nursing beds and 317 assisted living
units, which are expected to be completed in 2005 and 2006. Total costs incurred through March 31,
2005 on these projects are approximately $15.0 million and purchase commitments of $9.4 million are
outstanding. The total estimated cost of the uncompleted projects is approximately $33.9 million. At March 31, 2005, we had an accrued liability for settlement of self-insured liabilities of
$35.7 million in respect of general and professional liability claims. Claim payments were $4.9
million and $3.1 million for the 2005 quarter and the 2004 quarter, respectively. The accrual for
self-insured liabilities includes estimates of the cost of both reported claims and claims incurred
but not yet reported. We exited the nursing facility markets of the highly litigious States of
Florida and Texas in 2000 and 2001, respectively. As a result, accruals for general and
professional liabilities have declined significantly from the 2002 level. We estimate that $12.5
million of the total $35.7 million liability will be paid within the next fiscal year. The timing
of payments is not directly within our control, and, therefore, estimates are subject to change in
the future. We believe we have provided sufficient provisions as of March 31, 2005. Contractual Obligations Set forth below is a table showing the estimated timing of payments under our contractual
obligations as of March 31, 2005: Payments Due By PeriodLess than
    
    
    
    
    
    
    
    
    
    
    More thanTotal
    
    
    1 Year
    
    
    1-3 Years
    
    
    3-5 Years
    
    
    5 Years(dollars in thousands)Long-term debt
    
    $
    542,905
    
    
    $
    4,248
    
    
    $
    12,551
    
    
    $
    187,648
    
    
    $
    338,458Operating lease commitments
    
    
    167,044
    
    
    
    20,945
    
    
    
    34,544
    
    
    
    33,860
    
    
    
    77,695Capital lease commitments
    
    
    16,278
    
    
    
    1,454
    
    
    
    2,356
    
    
    
    12,468
    
    
    
    Total
    
    $
    726,227
    
    
    $
    26,647
    
    
    $
    49,451
    
    
    $
    233,976
    
    
    $
    416,153
 Critical Accounting Policies Our condensed consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America, or GAAP. For a full
discussion of our accounting policies as required by GAAP, refer to the Managements Discussion and
Analysis section of our Annual Report on Form 10-K for the year ended December 31, 2004. The
information in such report on Form 10-K has not materially changed since that report was filed. We
consider our accounting policies to be critical to an understanding of our financial statements
because their application requires significant judgment and reliance on estimations of matters that
are inherently uncertain. Specific risks relate to the accounting policies applied in revenue
recognition and the valuation of accounts receivable, the valuation of assets and determination of
asset impairment, the measurement of acquired assets and assumed liabilities in business
combinations, the accrual for self-insured liabilities for general and professional liability,
workers compensation and health and dental claims, and valuation of deferred income tax assets. 48




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Item 3. Quantitative and Qualitative Disclosures About Market Risk Qualitative Disclosures We use interest rate swaps to hedge a significant portion of the fair value of our debt
obligations and interest rate caps to limit our exposure to increases in interest rates. For our variable rate debt, changes in interest rates generally do not impact the market value
of the debt instruments, but do affect our future income and cash flows. At March 31, 2005, we had
$272 million of fixed rate debt outstanding that has been effectively converted to variable rate
debt using interest rate swaps. Assuming that the balance of this debt remains constant, each one
percentage point increase in the six-month LIBOR will result in an annual increase in interest
expense, and a corresponding decrease in cash flows, of approximately $2.7 million. Conversely,
each one percentage point decrease in the six-month LIBOR will result in an annual decrease in
interest expense, and a corresponding increase in cash flows, of approximately $2.7 million.
Increases in interest expense are limited by interest rate caps that reimburse us to the extent
that the six-month LIBOR exceeds 7%. In addition, we have $115.5 million of variable rate debt outstanding as of March 31, 2005,
which rates generally move in a manner similar to the six-month LIBOR. Assuming that the balance
of this debt remains constant, each one percentage point increase in the six-month LIBOR will
result in an annual increase in interest expense, and a corresponding decrease in cash flows, of
approximately $1.2 million. Conversely, each one percentage point decrease in the six-month LIBOR
will result in an annual decrease in interest expense, and a corresponding increase in cash flows,
of approximately $1.2 million. We monitor the markets to adequately determine the appropriate market timing to sell or
otherwise act with respect to our stock and warrant holdings in order to maximize their value. With
the exception of the above holdings, we do not enter into derivative instruments for any purpose
other than cash flow hedging purposes. That is, we do not speculate using derivative instruments
and do not engage in trading activity of any kind. Quantitative Disclosures The table below presents principal or notional amounts and related weighted average interest
rates by year of maturity for our debt obligations and interest rate swaps as of March 31, 2005: EstimatedFair Value ofMaturity Date through March 31,
    
    
    Liability2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    Thereafter
    
    
    Total
    
    
    (Asset)(dollars in thousands)LONG-TERM DEBT:Fixed Rate
    
    $
    2,920
    
    
    $
    3,117
    
    
    $
    6,010
    
    
    $
    26,560
    
    
    $
    67,196
    
    
    $
    322,865
    
    
    $
    428,668
    
    
    $
    445,229Average Interest Rate
    
    
    5.38
    %
    
    
    5.38
    %
    
    
    6.24
    %
    
    
    4.82
    %
    
    
    6.04
    %
    
    
    7.94
    %
    
    
    7.42
    %Variable Rate
    
    $
    1,328
    
    
    $
    1,701
    
    
    $
    1,723
    
    
    $
    34,382
    
    
    $
    59,510
    
    
    $
    15,593
    
    
    $
    114,237
    
    
    $
    115,395Average Interest Rate
    
    
    3.63
    %
    
    
    3.17
    %
    
    
    3.03
    %
    
    
    6.35
    %
    
    
    5.32
    %
    
    
    2.05
    %
    
    
    5.16
    %INTEREST RATE SWAPS:(fixed to variable)Notional Amount
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    275,000
    
    
    $
    275,000
    
    
    $
    4,978Average Pay Rate (variable rate)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6.85
    %
    
    
    6.85
    %Average Receive Rate (fixed rate)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8.31
    %
    
    
    8.31
    %INTEREST RATE CAPS:Notional Amount
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    150,000
    
    
    $
    150,000
    

    
    $
    (504
    )Notional Amount
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    125,000
    
    
    $
    125,000
    
    
    $
    5,823
 The above table incorporates only those exposures that existed as of March 31, 2005 and
does not consider those exposures or positions which could arise after that date or future interest
rate movements. As a result, the information presented above has limited predictive value. Our
ultimate results with respect to interest rate fluctuations will depend upon the exposures that
occur, our hedging strategies at the time and interest rate movements. 49




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##### Table of Contents



Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures In accordance with Rule 15d  15 (b) of the Securities Exchange Act of 1934, our management
has evaluated, with the participation of our Chairman of the Board and Chief Executive Officer and
our Senior Vice President, Chief Financial Officer and Treasurer, the effectiveness of the design
and operation of our disclosure controls and procedures as of the end of the 2005 quarter. Based
upon their evaluation of these disclosure controls and procedures, our Chairman of the Board and
Chief Executive Officer and our Senior Vice President, Chief Financial Officer and Treasurer
concluded that the disclosure controls and procedures were effective as of the end of the 2005
quarter to ensure that material information relating to us (including our consolidated
subsidiaries) was made known to them by others within those entities, particularly during the
period in which this Quarterly Report on Form 10-Q was being prepared. Changes in Internal Controls Over Financial Reporting There were no changes in our internal controls over financial reporting that occurred during
the 2005 quarter that have materially affected, or are reasonably likely to materially affect, our
internal controls over financial reporting. 50




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##### Table of Contents



PART II OTHER INFORMATION
 
 Item 1. Legal Proceedings There were no material developments related to our legal proceedings during the 2005 quarter.
For further information regarding our legal proceedings, refer to Item 3  Legal Proceedings in our
Annual Report on Form 10-K for the year ended December 31, 2004 as well as the paragraphs which
discuss litigation and the Omnicare Preferred Provider Agreement in note 14 of the condensed
consolidated financial statements included in this Quarterly Report on Form 10-Q. 
 Item 6. Exhibits The exhibits listed in the accompanying exhibit index are filed (except where otherwise
indicated) as part of this Quarterly Report on Form 10-Q. 51




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##### Table of Contents



EXTENDICARE HEALTH SERVICES, INC. 
 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. EXTENDICARE HEALTH SERVICES, INC. Date: May 13, 2005
    By:
    /s/ Richard L. BertrandRichard L. BertrandSenior Vice President, Chief Financial
Officer and Treasurer and Director
(Principal Accounting Officer) 52




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##### Table of Contents



EXTENDICARE HEALTH SERVICES, INC. 
 EXHIBIT INDEX  31.1
    Certifications of Chairman of the Board and Chief Executive Officer.31.2
    Certifications of Senior Vice President, Chief Financial Officer and Treasurer.32
    Written Statement of Chairman of the Board and Chief Executive Officer and Senior
Vice President, Chief Financial Officer and Treasurer pursuant to 18 U.S.C. Section 1350. 53