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SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q   (Mark One) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
 For the quarterly period ended June 30, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.
 For the transition period from _________________ to _______________ 0-49813
(Commission file number)   MARINER HEALTH CARE, INC.    Delaware
    
    74-2012902(State or Other Jurisdiction of
    
    (I.R.S. EmployerIncorporation or Organization)
    
    Identification No.)One Ravinia Drive, Suite 1500Atlanta, Georgia
    
    30346(Address of Principal Executive Offices)
    
    (Zip Code)
 (678) 443-7000
(Registrants Telephone Number, Including Area Code)   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes
x No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes
x No o There were 20,013,125 shares of Common Stock of the registrant outstanding
as of August 5, 2004. Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes x No
o




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TABLE OF CONTENTS PagePart I FINANCIAL INFORMATIONItem 1. Financial Statements
    
    
    3Item 2.
Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4. Controls and Procedures
    
    
    29Part II OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    30Item 2.
Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
    
    
    30Item 3. Defaults Upon Senior Securities
    
    
    30Item 4. Submission of Matters to a Vote of Security Holders
    
    
    30Item 5. Other Information
    
    
    30Item 6. Exhibits and Reports on Form 8-K
    
    
    30EX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO
 2




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PART I 
 ITEM 1. FINANCIAL STATEMENTS MARINER HEALTH CARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    411,772
    
    
    $
    426,607
    
    
    $
    817,863
    
    
    $
    847,114Costs and expensesOperating expensesWage and related costs
    
    
    231,162
    
    
    
    252,960
    
    
    
    464,251
    
    
    
    505,912Supplies
    
    
    23,012
    
    
    
    25,274
    
    
    
    46,134
    
    
    
    49,908Insurance
    
    
    16,772
    
    
    
    22,350
    
    
    
    32,609
    
    
    
    42,801Provision for bad debt
    
    
    3,822
    
    
    
    4,890
    
    
    
    6,833
    
    
    
    9,257Rent expense
    
    
    8,092
    
    
    
    8,765
    
    
    
    16,351
    
    
    
    17,504Other
    
    
    74,462
    
    
    
    74,574
    
    
    
    145,153
    
    
    
    145,659Total operating expenses
    
    
    357,322
    
    
    
    388,813
    
    
    
    711,331
    
    
    
    771,041General and administrative
    
    
    27,344
    
    
    
    22,074
    
    
    
    53,717
    
    
    
    44,807Merger related costs
    
    
    2,142
    
    
    
    
    
    
    
    2,142
    
    
    
    Depreciation and amortization
    
    
    10,618
    
    
    
    9,296
    
    
    
    20,275
    
    
    
    17,846Total costs and expenses
    
    
    397,426
    
    
    
    420,183
    
    
    
    787,465
    
    
    
    833,694Operating income
    
    
    14,346
    
    
    
    6,424
    
    
    
    30,398
    
    
    
    13,420Other income (expenses)Interest expense
    
    
    (8,489
    )
    
    
    (9,576
    )
    
    
    (17,706
    )
    
    
    (17,789
    )Interest income
    
    
    739
    
    
    
    692
    
    
    
    1,489
    
    
    
    1,520Other
    
    
    (31
    )
    
    
    (1
    )
    
    
    (36
    )
    
    
    (51
    )Income (loss) from continuing operations before taxes
    
    
    6,565
    
    
    
    (2,461
    )
    
    
    14,145
    
    
    
    (2,900
    )Income tax provision (benefit)
    
    
    732
    
    
    
    (1,127
    )
    
    
    1,627
    
    
    
    (1,684
    )Income (loss) from continuing operations
    
    
    5,833
    
    
    
    (1,334
    )
    
    
    12,518
    
    
    
    (1,216
    )Discontinued operations(Loss) gain on sale of discontinued operations,
net of tax
    
    
    (709
    )
    
    
    
    
    
    
    (851
    )
    
    
    3,600Loss from discontinued operations, net of tax
    
    
    (1,772
    )
    
    
    (360
    )
    
    
    (2,088
    )
    
    
    (1,310
    )Net income (loss)
    
    $
    3,352
    
    
    $
    (1,694
    )
    
    $
    9,579
    
    
    $
    1,074Earnings
(loss) per share - basicIncome (loss) from continuing operations
    
    $
    0.29
    
    
    $
    (0.07
    )
    
    $
    0.63
    
    
    $
    (0.06
    )(Loss) gain on sale of discontinued operations
    
    
    (0.03
    )
    
    
    
    
    
    
    (0.04
    )
    
    
    0.18Loss from discontinued operations
    
    
    (0.09
    )
    
    
    (0.01
    )
    
    
    (0.11
    )
    
    
    (0.07
    )Net income (loss) per share
    
    $
    0.17
    
    
    $
    (0.08
    )
    
    $
    0.48
    
    
    $
    0.05Weighted average shares outstanding
    
    
    20,012
    
    
    
    20,000
    
    
    
    20,010
    
    
    
    20,000Earnings
(loss) per share - dilutedIncome (loss) from continuing operations
    
    $
    0.29
    
    
    $
    (0.07
    )
    
    $
    0.62
    
    
    $
    (0.06
    )(Loss) gain on sale of discontinued operations
    
    
    (0.03
    )
    
    
    
    
    
    
    (0.04
    )
    
    
    0.18Loss from discontinued operations
    
    
    (0.09
    )
    
    
    (0.01
    )
    
    
    (0.11
    )
    
    
    (0.07
    )Net income (loss) per share
    
    $
    0.17
    
    
    $
    (0.08
    )
    
    $
    0.47
    
    
    $
    0.05Weighted average shares outstanding
    
    
    20,247
    
    
    
    20,000
    
    
    
    20,328
    
    
    
    20,000
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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MARINER HEALTH CARE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts) June 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assetsCash and cash equivalents
    
    $
    26,815
    
    
    $
    41,934Receivables, net of allowance for doubtful accounts of $102,213
and $97,448, respectively
    
    
    239,912
    
    
    
    234,098Prepaid expenses and other current assets
    
    
    21,887
    
    
    
    25,396Total current assets
    
    
    288,614
    
    
    
    301,428Property and equipment, net of accumulated depreciation
of $79,194 and $59,255, respectively
    
    
    535,946
    
    
    
    544,356Reorganization value in excess of amounts allocable to identifiable assets
    
    
    192,771
    
    
    
    192,771Goodwill, net of accumulated amortization of $970
    
    
    6,797
    
    
    
    6,797Restricted investments
    
    
    17,397
    
    
    
    19,300Other assets
    
    
    35,804
    
    
    
    43,082Total assets
    
    $
    1,077,329
    
    
    $
    1,107,734LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilitiesCurrent maturities of long-term debt
    
    $
    17,381
    
    
    $
    9,663Accounts payable
    
    
    45,961
    
    
    
    69,914Accrued compensation and benefits
    
    
    66,945
    
    
    
    69,330Accrued insurance obligations
    
    
    72,312
    
    
    
    54,315Other current liabilities
    
    
    53,147
    
    
    
    42,202Total current liabilities
    
    
    255,746
    
    
    
    245,424Long-term debt, net of current maturities
    
    
    367,107
    
    
    
    379,973Long-term insurance reserves
    
    
    160,218
    
    
    
    191,124Other liabilities
    
    
    25,253
    
    
    
    31,741Minority interest
    
    
    3,355
    
    
    
    3,319Total liabilities
    
    
    811,679
    
    
    
    851,581Stockholders equityPreferred stock, $.01 par value; 10,000,000 shares
authorized; none issued or outstanding
    
    
    
    
    
    
    Common stock, $.01 par value; 80,000,000 shares authorized;
20,013,125 and 20,007,500 shares issued and outstanding, respectively
    
    
    200
    
    
    
    200Warrants to purchase common stock
    
    
    
    
    
    
    935Capital surplus
    
    
    361,094
    
    
    
    360,141Unearned compensation
    
    
    (403
    )
    
    
    (616
    )Accumulated deficit
    
    
    (95,265
    )
    
    
    (104,844
    )Accumulated other comprehensive income
    
    
    24
    
    
    
    337Total stockholders equity
    
    
    265,650
    
    
    
    256,153Total liabilities and stockholders equity
    
    $
    1,077,329
    
    
    $
    1,107,734
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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MARINER HEALTH CARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited) Six Months EndedJune 30, 2004
    
    June 30, 2003Cash flows from operating activitiesNet income
    
    $
    9,579
    
    
    $
    1,074Adjustments to reconcile net income to net cash
(utilized) provided by operating activitiesProvision for bad debts
    
    
    7,126
    
    
    
    7,514Gain from divestitures and sales of property,
equipment and other assets
    
    
    (1,828
    )
    
    
    (3,600
    )Depreciation and amortization
    
    
    20,275
    
    
    
    17,846Amortization of deferred financing costs
    
    
    981
    
    
    
    608Stock compensation
    
    
    231
    
    
    
    Minority interest and other
    
    
    36
    
    
    
    51Provision (benefit) for income taxes
    
    
    1,627
    
    
    
    (1,684
    )Loss from discontinued operations
    
    
    2,088
    
    
    
    1,310Changes in operating assets and liabilitiesReceivables
    
    
    (15,274
    )
    
    
    (11,054
    )Prepaid expenses and other current assets
    
    
    3,422
    
    
    
    (3,256
    )Accounts payable
    
    
    (23,589
    )
    
    
    6,493Accrued and other current liabilities
    
    
    11,497
    
    
    
    9,456Insurance reserves
    
    
    (12,909
    )
    
    
    7,331Other
    
    
    (5,760
    )
    
    
    1,140Net cash (utilized) provided by operating activities from
continuing operations before reorganization items
    
    
    (2,498
    )
    
    
    33,229Net cash utilized by discontinued operations
    
    
    (2,093
    )
    
    
    (244
    )Payment of reorganization items, net
    
    
    (3,416
    )
    
    
    (5,018
    )Cash flows from investing activitiesPurchases of property and equipment
    
    
    (16,436
    )
    
    
    (35,428
    )Proceeds from divestitures and sales of property,
equipment and other assets
    
    
    7,737
    
    
    
    6,132Restricted investments
    
    
    1,590
    
    
    
    16,420Collections on notes receivable
    
    
    5,145
    
    
    
    82Insurance proceeds
    
    
    
    
    
    
    2,888Net cash utilized by investing activities
    
    
    (1,964
    )
    
    
    (9,906
    )Cash flows from financing activitiesRepayment of long-term debt
    
    
    (5,148
    )
    
    
    (2,993
    )Payment of deferred financing fees
    
    
    
    
    
    
    (1,474
    )Net cash utilized by financing activities
    
    
    (5,148
    )
    
    
    (4,467
    )(Decrease) increase in cash and cash equivalents
    
    
    (15,119
    )
    
    
    13,594Cash and cash equivalents, beginning of period
    
    
    41,934
    
    
    
    38,618Cash and cash equivalents, end of period
    
    $
    26,815
    
    
    $
    52,212
 The accompanying notes are an integral part of these condensed consolidated financial statements. 5




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MARINER HEALTH CARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited) NOTE 1 GENERAL Nature of Business Mariner Health Care, Inc. through its subsidiaries (collectively, the
Company) provides long-term health care services, primarily through the
operation of skilled nursing facilities. As of June 30, 2004, the Company
operated 251 skilled nursing facilities and five stand-alone assisted living
facilities with an aggregate of 30,786 licensed beds. The Company owns 70% of
its facilities. The Company also operates eleven long-term acute care hospitals
(LTACs) in four states, with 613 licensed beds. The Companys facilities are
located in 23 states with significant concentrations in Texas, North Carolina,
California, Colorado, South Carolina and Maryland and clusters in twelve
geographic markets in nine of the states in which the Company operates. Skilled
nursing services and LTACs represent the Companys two reportable segments (see
Note 5). Recent Developments On June 29, 2004, the Company entered into a merger agreement (the Merger
Agreement) with National Senior Care, Inc. (NSC) and NCARE Acquisition Corp.
(NCARE), a wholly-owned subsidiary of NSC established for the purpose of
acquiring the Company. Pursuant to the Merger Agreement, NCARE will acquire
the issued and outstanding shares of common stock of the Company for $30.00 per
share in cash. The merger is expected to close in the fourth quarter of 2004
and is subject to various conditions contained in the Merger Agreement,
including but not limited to the approval of the stockholders of the Company,
receipt of financing by NSC and other regulatory, governmental and licensing
approvals. The Company is not obligated to seek stockholder approval until NSC
and NCARE provide a commitment letter regarding the availability of financing
necessary to consummate the merger. Basis of Presentation The accompanying unaudited condensed consolidated financial statements
have been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission (the SEC). Certain information and disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted in the United States (GAAP) have been condensed
or omitted pursuant to such rules and regulations. Accordingly, these unaudited
condensed consolidated financial statements should be read in conjunction with
the audited consolidated financial statements and notes thereto included in the
Companys Annual Report for the year ended December 31, 2003 on Form 10-K filed
with the SEC. In the opinion of management, the financial information included
herein reflects all adjustments considered necessary for a fair presentation of
interim results and all such adjustments are of a normal and recurring nature.
Operating results for interim periods are not necessarily indicative of the
results that may be expected for the entire year. Use of Estimates The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the amounts reported
in the financial statements and accompanying notes. Although these estimates
are based on managements knowledge of current events, such estimates may
ultimately differ from actual results. 6




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Comprehensive Income Comprehensive income includes net income, as well as charges and credits
to stockholders equity not included in net income. The components of
comprehensive income, net of income taxes, consist of the following (in
thousands of dollars): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    3,352
    
    
    $
    (1,694
    )
    
    $
    9,579
    
    
    $
    1,074Net unrealized (loss) gain on available-for-sale securities
    
    
    (316
    )
    
    
    16
    
    
    
    (313
    )
    
    
    17Comprehensive income (loss)
    
    $
    3,036
    
    
    $
    (1,678
    )
    
    $
    9,266
    
    
    $
    1,091
 Reclassifications Certain prior year amounts have been reclassified to conform to the
current period financial statement presentation. NOTE 2 STOCK BASED COMPENSATION As of June 30, 2004, the Company maintained two stock-based compensation
plans that are described in Note 3 in the Companys Annual Report on Form 10-K
for the year ended December 31, 2003. The Company accounts for these plans
under the recognition and measurement principles of Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations. The Company recognized stock based compensation expense of
$0.1 million and $0.2 million for the three and six months ended June 30, 2004,
respectively and there was no stock based compensation expense for the three
and six months ended June 30, 2003. On May 13, 2004, warrants to purchase
753,786 shares of common stock at an exercise price of $28.04 expired and
became void, with all rights associated therewith terminated. The Companys pro forma net income (loss) and net income (loss) per share,
assuming the election had been made to recognize compensation expense on
stock-based awards, are as follows (in thousands of dollars, except per share
amounts): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    3,352
    
    
    $
    (1,694
    )
    
    $
    9,579
    
    
    $
    1,074Deduct: Pro forma compensation expense, net of tax
    
    
    (1,122
    )
    
    
    (844
    )
    
    
    (2,210
    )
    
    
    (1,702
    )Pro forma net income (loss)
    
    $
    2,230
    
    
    $
    (2,538
    )
    
    $
    7,369
    
    
    $
    (628
    )Basic net income (loss) per shareAs reported
    
    $
    0.17
    
    
    $
    (0.08
    )
    
    $
    0.48
    
    
    $
    0.05Pro forma
    
    $
    0.11
    
    
    $
    (0.13
    )
    
    $
    0.37
    
    
    $
    (0.03
    )Diluted net income (loss) per shareAs reported
    
    $
    0.17
    
    
    $
    (0.08
    )
    
    $
    0.47
    
    
    $
    0.05Pro forma
    
    $
    0.11
    
    
    $
    (0.13
    )
    
    $
    0.36
    
    
    $
    (0.03
    )
 NOTE 3 NET REVENUE Revenue is recorded based on estimated net realizable amounts due from
patients and third-party payors for health care services provided, including
anticipated settlements under reimbursement agreements with Medicare, Medicaid
and other third-party payors, and is recognized in the period in which the
services are provided. Revenue is recorded net of provisions for discount
arrangements with commercial payors and contractual allowances with third-party
payors, primarily Medicare and Medicaid. Revenue realizable under third-party
payor agreements are subject to change due to examination and retroactive
adjustment. The methods of making such estimates are reviewed periodically, and
differences between the net amounts accrued and subsequent settlements or
estimates of expected settlements are reflected in the current period results
of operations. All providers participating in the Medicare and Medicaid programs are
required to meet certain financial cost reporting 7




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requirements. Federal and state regulations generally require the
submission of annual cost reports covering revenues, costs and expenses
associated with the services provided to Medicare beneficiaries and Medicaid
recipients. Annual cost reports are subject to routine audits and retroactive
adjustments. These audits often require several years to reach the final
determination of amounts due to, or by, the Company under these programs. Retroactive adjustments are estimated in the recording of revenues in the
period in which the related services are rendered. These amounts are adjusted
in future periods as adjustments become known or as cost reporting years are no
longer subject to audits, reviews or investigations. Changes in estimates
related to third party receivables resulted in an increase in net revenue of
$1.5 million and $1.7 million during the three and six months ended June 30,
2004, respectively. Changes in estimates related to third party receivables did
not have a material impact on net revenues for the three and six months ended
June 30, 2003. The Company believes adequate provision has been made to reflect
any adjustments that may result from the audit of cost reports. However, due to
the complexity of the laws and regulations governing the Medicare and Medicaid
programs, there is a possibility that recorded estimates will change by a
material amount in future periods. The following is a summary by dollars and percentage of net revenue by
payor type for the periods indicated (in thousands of dollars): Three Months Ended
    
    Six Months EndedJune 30, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003Medicaid
    
    $
    195,294
    
    
    
    47.4
    %
    
    $
    202,086
    
    
    
    47.4
    %
    
    $
    381,312
    
    
    
    46.6
    %
    
    $
    401,240
    
    
    
    47.4
    %Medicare
    
    
    142,922
    
    
    
    34.7
    %
    
    
    146,186
    
    
    
    34.3
    %
    
    
    288,072
    
    
    
    35.2
    %
    
    
    289,875
    
    
    
    34.2
    %Private and other
    
    
    73,556
    
    
    
    17.9
    %
    
    
    78,335
    
    
    
    18.3
    %
    
    
    148,479
    
    
    
    18.2
    %
    
    
    155,999
    
    
    
    18.4
    %Net revenue
    
    $
    411,772
    
    
    
    100.0
    %
    
    $
    426,607
    
    
    
    100.0
    %
    
    $
    817,863
    
    
    
    100.0
    %
    
    $
    847,114
    
    
    
    100.0
    %
 NOTE 4 DISCONTINUED OPERATIONS AND OTHER DIVESTITURES Discontinued Pharmacy Operations During the six months ended June 30, 2003, the Company earned and received
the payments for post-closing operating results (Earnout Payments) in
connection with the sale of the institutional pharmacy services business (APS
Division) to Omnicare, Inc. of $6.0 million, at which time the Company
recorded a gain on sale of $3.6 million, net of taxes of $2.4 million. Other Discontinued Operations and Other Divestitures The results of operations and cash flows of any divested facilities that
qualify for discontinued operations under Statement of Financial Accounting
Standard (SFAS) No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS No. 144) are reclassified as discontinued operations
for all periods presented. There were no assets held for sale at June 30, 2004,
however, the operations and cash flows of any divested facilities that qualify
for discontinued operations have been reclassified to discontinued operations.
The net assets of the facilities that were sold during the six months ended
June 30, 2004 were $4.2 million at December 31, 2003. During the three and six
months ended June 30, 2004, the Company recorded a loss on sale of $0.7
million, net of tax and a loss on sale of $0.9 million, net of tax,
respectively, for discontinued operations. In addition, during the three and
six months ended June 30, 2004, the Company recorded net gains of $0.9 million
and $2.7 million, respectively, primarily related to sales of certain
non-operating assets, which are included in other operating expenses in the
unaudited condensed consolidated statements of operations. 8




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##### Table of Contents



Operating results for the discontinued operations were as follows for the
periods indicated (in thousands of dollars): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    1,906
    
    
    $
    11,412
    
    
    $
    5,275
    
    
    $
    22,682Total operating costs and expenses
    
    
    3,523
    
    
    
    11,708
    
    
    
    7,360
    
    
    
    23,858Operating loss
    
    
    (1,617
    )
    
    
    (296
    )
    
    
    (2,085
    )
    
    
    (1,176
    )Other expense
    
    
    (155
    )
    
    
    (64
    )
    
    
    (3
    )
    
    
    (134
    )Loss from discontinued operations, net of tax
    
    $
    (1,772
    )
    
    $
    (360
    )
    
    $
    (2,088
    )
    
    $
    (1,310
    )
 NOTE 5 SEGMENT INFORMATION The Company has two reportable segments, skilled nursing services, which
provides long-term health care through the operation of skilled nursing
facilities and assisted living facilities in the United States, and LTACs,
which provide services for the relatively high sub-acute clinical needs
patients. The Company primarily evaluates segment performance and allocates
resources based on operating profit, which is defined as net revenue less
operating, and general and administrative expenses. The Companys reportable
segments are strategic business units that offer different services to
different types of patients. They are each managed separately because they
provide services to patients with different acuity levels, and because the
conditions of participation in the Medicare and Medicaid programs, as well as
the reimbursement methodologies and licensing requirements are different for
each business under these programs. The following table summarizes revenues, operating profit, depreciation
and amortization and total assets for the Company for the periods presented for
the two reportable segments, excluding the results of discontinued operations.
The income statement items included in the Other category consist of
corporate items not considered to be an operating segment and eliminations. The
assets included in the Other category consist primarily of cash, non-facility
related property and equipment, excess reorganization value, goodwill,
restricted investments, notes receivable and deferred financing costs (in
thousands of dollars). 9




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##### Table of Contents



SkilledNursingServices
    
    LTACs
    
    Other
    
    TotalThree Months Ended June 30, 2004Revenue from external customers
    
    $
    379,529
    
    
    $
    32,115
    
    
    $
    128
    
    
    $
    411,772Operating profit (loss) (1)
    
    
    49,833
    
    
    
    4,486
    
    
    
    (27,213
    )
    
    
    27,106Depreciation and amortization
    
    
    8,766
    
    
    
    405
    
    
    
    1,447
    
    
    
    10,618Total assets
    
    
    770,048
    
    
    
    27,405
    
    
    
    279,876
    
    
    
    1,077,329Three Months Ended June 30, 2003Revenue from external customers
    
    $
    398,771
    
    
    $
    28,709
    
    
    $
    (873
    )
    
    $
    426,607Operating profit (loss) (1)
    
    
    34,787
    
    
    
    3,882
    
    
    
    (22,949
    )
    
    
    15,720Depreciation and amortization
    
    
    7,954
    
    
    
    532
    
    
    
    810
    
    
    
    9,296Total assets
    
    
    821,037
    
    
    
    36,818
    
    
    
    339,423
    
    
    
    1,197,278Six Months Ended June 30, 2004Revenue from external customers
    
    $
    752,233
    
    
    $
    65,360
    
    
    $
    270
    
    
    $
    817,863Operating profit (loss) (1)
    
    
    97,162
    
    
    
    9,098
    
    
    
    (53,445
    )
    
    
    52,815Depreciation and amortization
    
    
    16,732
    
    
    
    797
    
    
    
    2,746
    
    
    
    20,275Total assets
    
    
    770,048
    
    
    
    27,405
    
    
    
    279,876
    
    
    
    1,077,329Six Months Ended June 30, 2003Revenue from external customers
    
    $
    789,451
    
    
    $
    58,033
    
    
    $
    (370
    )
    
    $
    847,114Operating profit (loss) (1)
    
    
    69,551
    
    
    
    6,893
    
    
    
    (45,178
    )
    
    
    31,266Depreciation and amortization
    
    
    15,663
    
    
    
    826
    
    
    
    1,357
    
    
    
    17,846Total assets
    
    
    821,037
    
    
    
    36,818
    
    
    
    339,423
    
    
    
    1,197,278
  (1)
    
    Operating profit does not include depreciation and amortization or merger
related costs. Total operating profit less depreciation and amortization
and merger related costs was $14.3 million and $30.4 million for the three
and six months ended June 30, 2004, respectively, and $6.4 million and
$13.4 million for the three and six months ended June 30, 2003,
respectively. NOTE 6 SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION Certain subsidiaries (the Guarantor Subsidiaries) guarantee repayment of
debt under both the Companys $225.0 million senior credit facility (the
Senior Credit Facility), which consists of a $135.0 million term loan
facility and a $90.0 million revolving credit facility, and the Companys
$175.0 million aggregate principal amount of 8 1/4% Senior Subordinated Notes
due 2013 (the Notes). Separate complete financial statements of the
respective Guarantor Subsidiaries are not presented because the Guarantor
Subsidiaries are wholly-owned (directly or indirectly) by the Company and fully
and unconditionally guarantee the debt under the Senior Credit Facility and the
Notes on a joint and several basis. The following unaudited condensed consolidating financial data is
presented to illustrate the composition of Mariner Health Care, Inc. (the
Parent), the Guarantor Subsidiaries, and the Companys subsidiaries that do
not guarantee the debt under the Senior Credit Facility and the Notes (the
Non-Guarantor Subsidiaries) for the periods indicated. The Non-Guarantor Subsidiaries include the Professional Health Care
Management, Inc. (PHCMI) entities, certain joint ventures and our captive
insurance subsidiaries. There are certain restrictions on the ability of the
Non-Guarantor Subsidiaries to pay dividends, make loans or advances and
transfer certain property and assets to the Company and its other subsidiaries. The Company does not have any subsidiaries that are accounted for by the
Parent on the equity method. As such, the principal elimination entries
eliminate intercompany balances and transactions. Information regarding the
Guarantor Subsidiaries and Non-Guarantor Subsidiaries is as follows for the
periods presented (in thousands of dollars): 10




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##### Table of Contents



CONDENSED SELECTED COMBINING BALANCE SHEET
June 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCurrent assets
    
    $
    
    
    
    $
    309,512
    
    
    $
    32,602
    
    
    $
    (53,500
    )
    
    $
    288,614Total assets
    
    
    618,965
    
    
    
    957,322
    
    
    
    114,654
    
    
    
    (613,612
    )
    
    
    1,077,329Current liabilities
    
    
    3,187
    
    
    
    237,212
    
    
    
    68,846
    
    
    
    (53,499
    )
    
    
    255,746Total liabilities
    
    
    320,678
    
    
    
    405,883
    
    
    
    138,617
    
    
    
    (53,499
    )
    
    
    811,679Stockholders equity (deficit)
    
    
    298,287
    
    
    
    551,439
    
    
    
    (23,963
    )
    
    
    (560,113
    )
    
    
    265,650
 CONDENSED SELECTED COMBINING BALANCE SHEET
December 31, 2003 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCurrent assets
    
    $
    
    
    
    $
    330,562
    
    
    $
    23,394
    
    
    $
    (52,528
    )
    
    $
    301,428Total assets
    
    
    636,064
    
    
    
    982,313
    
    
    
    101,997
    
    
    
    (612,640
    )
    
    
    1,107,734Current liabilities
    
    
    2,881
    
    
    
    234,674
    
    
    
    60,396
    
    
    
    (52,527
    )
    
    
    245,424Total liabilities
    
    
    324,618
    
    
    
    449,299
    
    
    
    130,191
    
    
    
    (52,527
    )
    
    
    851,581Stockholders equity (deficit)
    
    
    311,446
    
    
    
    533,014
    
    
    
    (28,194
    )
    
    
    (560,113
    )
    
    
    256,153
 CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the three months ended June 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    370,395
    
    
    $
    42,251
    
    
    $
    (874
    )
    
    $
    411,772Operating (loss) income
    
    
    (393
    )
    
    
    6,612
    
    
    
    8,127
    
    
    
    
    
    
    
    14,346(Loss) income from continuing operations
before income taxes
    
    
    (6,499
    )
    
    
    8,944
    
    
    
    4,120
    
    
    
    
    
    
    
    6,565Net (loss) income
    
    
    (6,499
    )
    
    
    5,731
    
    
    
    4,120
    
    
    
    
    
    
    
    3,352
 CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the three months ended June 30, 2003 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    391,024
    
    
    $
    36,376
    
    
    $
    (793
    )
    
    $
    426,607Operating (loss) income
    
    
    (624
    )
    
    
    3,479
    
    
    
    3,569
    
    
    
    
    
    
    
    6,424(Loss) income from continuing operations
before income taxes
    
    
    (7,041
    )
    
    
    3,326
    
    
    
    704
    
    
    
    550
    
    
    
    (2,461
    )Net (loss) income
    
    
    (7,041
    )
    
    
    4,096
    
    
    
    701
    
    
    
    550
    
    
    
    (1,694
    )
 11




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##### Table of Contents



CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the six months ended June 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    740,613
    
    
    $
    78,978
    
    
    $
    (1,728
    )
    
    $
    817,863Operating (loss) income
    
    
    (887
    )
    
    
    18,542
    
    
    
    12,743
    
    
    
    
    
    
    
    30,398(Loss) income from continuing operations
before taxes
    
    
    (13,160
    )
    
    
    23,075
    
    
    
    4,230
    
    
    
    
    
    
    
    14,145Net (loss) income
    
    
    (13,160
    )
    
    
    18,509
    
    
    
    4,230
    
    
    
    
    
    
    
    9,579
 CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the six months ended June 30, 2003 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    776,023
    
    
    $
    72,653
    
    
    $
    (1,562
    )
    
    $
    847,114Operating (loss) income
    
    
    (1,042
    )
    
    
    7,873
    
    
    
    6,589
    
    
    
    
    
    
    
    13,420(Loss) income from continuing operations
before taxes
    
    
    (13,102
    )
    
    
    7,929
    
    
    
    1,266
    
    
    
    1,007
    
    
    
    (2,900
    )Net (loss) income
    
    
    (13,102
    )
    
    
    11,906
    
    
    
    1,263
    
    
    
    1,007
    
    
    
    1,074
 CONDENSED SELECTED COMBINING STATEMENT OF CASH FLOWS
For the six months ended June 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    ConsolidatedNet cash provided (utilized) by
operating activities (1)
    
    $
    4,246
    
    
    $
    (14,307
    )
    
    $
    2,054
    
    
    $
    (8,007
    )Net cash (utilized) provided by
investing activities
    
    
    
    
    
    
    (702
    )
    
    
    (1,262
    )
    
    
    (1,964
    )Net cash utilized by
financing activities
    
    
    (4,246
    )
    
    
    (254
    )
    
    
    (648
    )
    
    
    (5,148
    )(Decrease) increase in cash and
cash equivalents
    
    
    
    
    
    
    (15,263
    )
    
    
    144
    
    
    
    (15,119
    )Cash and cash equivalents,
beginning of period
    
    
    
    
    
    
    39,465
    
    
    
    2,469
    
    
    
    41,934Cash and cash equivalents,
end of period
    
    $
    
    
    
    $
    24,202
    
    
    $
    2,613
    
    
    $
    26,815
 CONDENSED SELECTED COMBINING STATEMENT OF CASH FLOWS
For the six months ended June 30, 2003 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    ConsolidatedNet cash provided (utilized) by
operating activities (1)
    
    $
    1,060
    
    
    $
    26,681
    
    
    $
    226
    
    
    $
    27,967Net cash (utilized) provided by
investing activities
    
    
    
    
    
    
    (9,049
    )
    
    
    (857
    )
    
    
    (9,906
    )Net cash (utilized) provided by
financing activities
    
    
    (1,060
    )
    
    
    (3,764
    )
    
    
    357
    
    
    
    (4,467
    )Increase (decrease) in cash and
cash equivalents
    
    
    
    
    
    
    13,868
    
    
    
    (274
    )
    
    
    13,594Cash and cash equivalents,
beginning of period
    
    
    
    
    
    
    37,734
    
    
    
    884
    
    
    
    38,618Cash and cash equivalents,
end of period
    
    $
    
    
    
    $
    51,602
    
    
    $
    610
    
    
    $
    52,212
  (1)
    
    Net cash provided by operating activities includes net cash provided by
discontinued operations and payment of reorganization items. 12




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##### Table of Contents



NOTE 7 VARIABLE INTEREST ENTITIES In January 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51 (FIN 46), which addresses the consolidation of
entities whose equity holders have either (a) not provided sufficient equity at
risk to allow the entity to finance its own activities or (b) do not possess
certain characteristics of a controlling financial interest. A
revised version of FIN 46 was issued in December 2003 with modifications to clarify some requirements, ease some
implementation problems and add new scope exceptions. FIN 46 sets forth
a model to evaluate potential consolidation of these entities, known as
variable interest entities (VIEs), based on an assessment of which party to
the VIE, if any, absorbs a majority of the exposure to its expected losses,
receives a majority of its expected residual returns, or both, which is
referred to for purposes of FIN 46 as the primary beneficiary. FIN 46 also
requires disclosures about VIEs that a company is not required to consolidate
but in which it has a significant variable interest. FIN 46 is effective for
all new VIEs created or acquired after January 31, 2003. For VIEs created or
acquired prior to February 1, 2003, the provisions of FIN 46 must be applied
for the first interim or annual period beginning after March 15, 2004, except
for companies with special purpose entities which must apply the provisions of
FIN 46 to those special purpose entities no later than the first reporting
period ending after December 15, 2003. The Company has evaluated the impact of FIN 46 on its unaudited condensed
consolidated financial statements and identified three joint ventures as VIEs
for which it has determined that it is the primary beneficiary. These joint
ventures, which operate skilled nursing facilities that are managed by the
Company, are 50% owned and have historically been consolidated due to control.
The Company has historically provided funds for working capital and has other
long-term notes from these joint ventures, which are eliminated in
consolidation. The joint ventures have revenues, which are included in the
unaudited condensed consolidated financial statements of $9.9 million, $19.7
million, $9.1 million, and $17.8 million for the three and six months ended June 30,
2004 and June 30, 2003, respectively. These joint ventures have net liabilities
that are included in the accompanying unaudited condensed consolidated
financial statements of approximately $39.5 million and $39.9 million at June
30, 2004 and December 31, 2003, respectively. During the three months ended December 31, 2003, the Company entered into
an administrative services agreement with a new operator of certain facilities
that the Company divested. The services are for 26 facilities and include
accounting support, procurement of business supplies, billing and collections,
and information technology services. Applying the principles of FIN 46, the
Company has determined that the new operator of the divested facilities is a
VIE. The Company has also determined that it is not the primary beneficiary
and accordingly, the Company is not required to consolidate the new operator.
The total receivable from this new operator at June 30, 2004 is $3.4 million. NOTE 8 EARNINGS PER SHARE As required by SFAS No. 128, Earnings Per Share, the Company has
presented basic and diluted income (loss) per common share amounts in the
accompanying unaudited condensed consolidated financial statements. Basic
income (loss) per common share is calculated based on the weighted average
common shares outstanding during the period. Diluted income (loss) per common
share is calculated similarly to basic income (loss) per common share except
that the weighted average shares outstanding are increased to include
additional shares from the assumed exercise of stock options, if dilutive. The
number of additional shares is calculated by assuming that outstanding stock
options that are dilutive were exercised and that the proceeds from such
exercises were used to acquire shares of common stock at the average market
price during the period. Below is the reconciliation of basic and diluted income from continuing
operations per weighted average common share (in thousands, except per share
data): Income FromContinuing
    
    
    
    
    
    Per ShareOperations
    
    Shares
    
    AmountThree months ended June 30, 2004Basic earnings per common share
    
    $
    5,833
    
    
    
    20,012
    
    
    $
    0.29Effect of dilutive stock options
    
    
    
    
    
    
    235
    
    
    
    Diluted earnings per common share
    
    $
    5,833
    
    
    
    20,247
    
    
    $
    0.29Six months ended June 30, 2004Basic earnings per common share
    
    $
    12,518
    
    
    
    20,010
    
    
    $
    0.63Effect of dilutive stock options
    
    
    
    
    
    
    318
    
    
    
    (0.01
    )Diluted earnings per common share
    
    $
    12,518
    
    
    
    20,328
    
    
    $
    0.62
 For the three months ended June 30, 2004, options to purchase 1,509,000
shares of common stock at option prices ranging from $18.08 to $21.55 per share
were not included in the computation of diluted income per share because the
exercise price was greater than the average market price of the common shares.
For the six months ended June 30, 2004, options to purchase 78,000 shares of
common stock at option prices ranging from $20.50 to $21.55 per share were not
included in the computation of diluted income per share. The options were
still outstanding at June 30, 2004. NOTE 9 COMMITMENTS AND CONTINGENCIES From time to time, the Company is party to various legal proceedings in
the ordinary course of business. As is typical in the health care industry, the
Company expects to remain subject to claims that its services have resulted in
resident injury or other adverse effects. In addition, resident, visitor and
employee injuries will also subject the Company to the risk of litigation. The
health care industry in general continues to experience an increasing trend in
the frequency and severity of litigation and claims. There are currently no
outstanding uninsured litigation matters against the Company that it believes
could have a material adverse effect on its operations or cash flows. Below is
a summary of significant outstanding litigation to which the Company is a
party. 13




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##### Table of Contents



Bexar County Investigation On July 30, 2004, the Company received notice from the Bexar County
District Attorneys office that one of the Companys facilities, as well as the
administrator and director of nursing for the facility, are the targets of a
criminal investigation involving possible misdemeanor and felony violations of
state law. The investigation involves the death of a hospice resident that was
possibly caused by a medication error. The Company has retained criminal
counsel to represent it and its employees with respect to this investigation.
The matter is in the investigative stage, and the Company is not aware of any
formal actions that have been brought at this time. In the event a formal
action is brought, the Company intends to vigorously contest any allegations of
misconduct by the Company. Royal Surplus Lines Litigation On June 11, 2001, one of the Companys prior liability insurance carriers,
Royal Surplus Lines Insurance Company (Royal), commenced an adversary
proceeding in the United States Bankruptcy Court for the District of Delaware
(Bankruptcy Court), styled Royal Surplus Lines Insurance Company v. Mariner
Health Group (MHG) et al., Adversary Proceeding No. A-01-4626 (MFW). In its
complaint, Royal sought among other things, declaratory judgments that it would
not be required to insure some claims falling under two professional
and general liability (PL/GL) policies issued
to one of the Companys subsidiaries by Royal. One of the Companys prior
excess liability insurance carriers, Northfield Insurance Company
(Northfield), moved to intervene in the Royal adversary proceeding on July
25, 2001. The Company did not oppose the motion to intervene, and it was
granted. Prior to the commencement of any significant discovery by the parties, we
agreed to mediate the issues arising out of the Royal adversary proceeding.
After the mediation, Royal agreed to dismiss its complaint without prejudice,
the Company agreed to dismiss its counterclaim without prejudice, and Royal and
the Company agreed to work together to resolve claims in an alternative dispute
resolution procedure. Northfield did not agree to dismiss its complaint in
intervention. Accordingly, Northfield and the Company are currently engaged in
discovery. The Company has also filed a bad faith counterclaim against
Northfield arising out of its claims handling and litigation tactics. In April 2003, Northfield filed an insurance coverage action against the
Company in the United States District Court for the Northern District of
Georgia. Northfield sought a declaration that it was not obligated to provide
insurance coverage to the Company in connection with a personal injury and
wrongful death lawsuit filed against the Company styled Louise Sherry Fisher,
Individually, as Representative of all Wrongful Death Beneficiaries, and Legal
Heir of the Estate of Vestal Grant Fisher, deceased v. Mariner Post-Acute
Network, Inc. (MPAN), et al., No. 2000-40818 (28th Judicial District, Harris
County, Texas) (the Fisher Action). The Fisher Action was settled in May
2004. PricewaterhouseCoopers Litigation In August 2002, the Company filed a complaint in the State Court of Fulton
County, Georgia (the Fulton County action) against PricewaterhouseCoopers,
LLP (PwC) and several former officers of MHG referred to as the Individual
Defendants. The Fulton County action asserts claims for fraud and breach of
fiduciary duty against the Individual Defendants and claims for fraud,
professional negligence, negligent misrepresentation and aiding and abetting
breach of fiduciary duty against PwC. Many of these claims arise from the July
1998 acquisition of MHG by Paragon Health Network, Inc., one of the Companys
predecessors. Other claims arise from duties that the Company believes the
Individual Defendants breached as officers of MHG and MPAN, the Companys
successor following the MHG acquisition. In the Fulton County action, the
Company is seeking actual damages (including compensatory and consequential
damages) and punitive damages, in an amount to be determined at trial.
Discovery is ongoing. In response to the action commenced by the Company in Fulton County, the
Individual Defendants filed an action in Chancery Court in Delaware in
September 2002 styled Stratton et al.v. Mariner Health Care, Inc., Civil
Action No. 19879-NC. In the Chancery Court action, the Individual Defendants
generally claim they are not liable for the claims asserted in the Fulton
County action and that the Company is contractually and statutorily obligated
to indemnify them against the claims in the Fulton County action. The Company
removed the Chancery Court action to the Bankruptcy Court, at which time the
action was assigned Adversary Case Nos. 02-5604 and 02-5606 in Chapter 11 Case
Nos. 00-0113 (MFW) and 00-00215 (MFW). After removal, the Company answered the
complaint and filed counterclaims. The Individual Defendants moved to remand
the action back to the Chancery Court. The Company opposed the motion. On
December 16, 2003, the Bankruptcy Court denied the Individual Defendants
remand motion and dismissed their claims, holding, among other things, that the
Individual Defendants indemnification claims had been discharged by
confirmation of the Companys Joint Plan. The Individual Defendants have filed
a motion to alter or amend judgment, which is pending. After the Individual Defendants filed the Chancery Court action, the
Company also filed an adversary proceeding in the Bankruptcy Court styled
Mariner Health Care, Inc. v. Stratton et al., United States Bankruptcy Court
for the District of Delaware, 14




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Chapter 11 Case Nos. 00-00113 (MFW) and 00-00215 (MFW), Adversary Case No.
02-05598 (consolidated with Adversary Case No. 02-05599). In this enforcement
action, the Company generally alleged that it does not have any obligation to
indemnify the Individual Defendants and the Individual Defendants pursuit of
their indemnification claims violated the Companys discharge in bankruptcy.
The Individual Defendants filed counterclaims generally alleging that the
Company has an obligation to indemnify them against the claims in the Fulton
County action and that it is estopped from asserting its claims. The Company
has moved to dismiss the Individual Defendants estoppel counterclaim. The
Individual Defendants opposed the motion, and on April 10, 2003, the Bankruptcy
Court granted the Companys motion to dismiss. After the Company filed the Fulton County action, William R. Bassett as
Trustee for the Charlotte R. Kellett Irrevocable Trust, as Trustee for the
Samuel B. Kellett, Jr. Irrevocable Trust, as Trustee for the Stiles A. Kellett,
III Irrevocable Trust, and as Trustee for the Barbara K. Kellett Irrevocable
Trust, Kellett Family Partners, L.P. f/k/a Kellett Partners, L.P., Samuel B.
Kellett, Stiles A. Kellett, Jr. and SSK Partners, L.P., filed an action in the
Superior Court of Cobb County, Georgia (the Cobb County action) against PwC
and the Individual Defendants based on claims arising out of MHGs acquisition
of Convalescent Services, Inc. in 1995 because of the Individual Defendants
and PwCs alleged misrepresentations. This action is William R. Bassett, et al.
v. PricewaterhouseCoopers, LLP, et al., Superior Court of Cobb County, Georgia,
Case No. 02-1-8314-35. The plaintiffs in the Cobb County action seek damages in
excess of $200 million. The Individual Defendants added the Company as a
third-party defendant in the Cobb County action seeking to recover on
indemnification claims similar to those made by them in the Chancery Court
action, and which are now pending, and subject to resolution before the
Bankruptcy Court in the enforcement action. In November 2003, the Individual
Defendants dismissed the Company without prejudice from the Cobb County action. Indemnity Insurance Company of North America Litigation In May 2003, the Company filed a complaint in the United States District
Court for the Eastern District of Texas, Beaumont Division, entitled Mariner
Health Care, Inc. v. Indemnity Insurance Company of North America, Inc.
(IINA), Case No. 103 CV 0279. The Company is seeking a declaratory judgment
determining its rights and the obligations of IINA, under an IINA policy of
insurance regarding property damage and related losses at the Companys
facilities in Beaumont and Houston, Texas caused by Tropical Storm Allison in
June 2001. The Company additionally asserts breach of contract and unfair
claims handling practices claims against IINA. The Company further seeks
statutory damages, punitive damages and attorneys fees under Texas Insurance
Code and the Texas Civil Practice and Remedies Code. IINA has answered the
Companys complaint and the parties are in the process of pretrial discovery,
with an anticipated trial date in the second quarter of 2005. On January 30, 2004, the Company moved to amend its complaint to include,
as plaintiffs, the Companys affiliates Cornerstone Health Management Company,
Mariner Health Care of Nashville, Inc. and Living Centers of Texas, Inc., and
to make other conforming amendments. The Companys motion to amend the
complaint to add parties, etc. was granted on February 7, 2004. Alabama False Claims Act On June 10, 2004 the Company was served with a complaint filed in the U.S.
District Court of Alabama entitled United States of America ex relPatrick
Bruce Atkins, MD and Patrick Bruce Atkins, MD, a natural person v. Charles M.
McInteer, MD et. al. The complaint alleges violations of the Federal False
Claims Act, conspiracy and common law fraud in connection with psychiatric
services rendered by third party psychiatrists in nursing facilities in
Alabama, including one facility operated by a subsidiary of the Company. To
date, the United States has declined to intervene in this litigation. No
specific allegations of fraud were made against the Company, and accordingly it
filed a motion to dismiss the complaint as to its facility on June 30, 2004.
This motion to dismiss is currently under consideration by the court. While the Company is not able to predict the outcome of any of these
matters, based on currently available facts it does not believe that the
resolution of any of these proceedings will have a material adverse effect on
its financial position, results of operations or cash flows. 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS The following is a discussion of our results of operations and current
financial position. This discussion should be read in conjunction with our
unaudited condensed consolidated financial statements and related notes
included elsewhere in this report and the audited consolidated financial
statements and related notes and the selected financial data included in Item
6, both included in our Annual Report onForm 10-Kfor the year ended December
31, 2003. Our discussion of our results of operations and financial position
includes various forward-looking statements about our markets, the demand for our
services, and our future results. These statements are based on certain assumptions
that we consider reasonable. For information about risks and exposures relating to our
business and our company, you should read the section entitled
Risk Factors included in our Annual Report on Form 10-K for the 15




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year ended December 31, 2003. The following discussion includes EBITDA, which is not a financial measure
compliant with accounting principles generally accepted in the United States,
or GAAP. For purposes of Regulation G promulgated by the SEC, or Regulation G,
a non-GAAP financial measure is a numerical measure of a registrants
historical or future financial performance, financial position or cash flows
that excludes amounts, or is subject to adjustments that have the effect of
excluding amounts, that are included in the most directly comparable financial
measure calculated and presented in accordance with GAAP in the statement of
operations, statement of stockholders equity, balance sheet or statement of
cash flows (or equivalent statements) of the registrant; or includes amounts,
or is subject to adjustments that have the effect of including amounts, that
are excluded from the most directly comparable financial measure so calculated
and presented. Pursuant to the requirements of Regulation G, we have provided
reconciliations of the non-GAAP financial measures to the most directly
comparable GAAP financial measures. Management believes that the presentation of EBITDA provides useful
information to investors regarding our results of operations because it is
useful for trending, analyzing and benchmarking the performance and value of
our business. We use EBITDA primarily as a performance measure and believe that
the GAAP financial measure most directly comparable to EBITDA is net income
(loss). Although we use EBITDA as a financial measure to assess the performance
of our business, the use of EBITDA is limited because it does not consider
certain material costs necessary to operate our business. These costs include
the cost to service our debt, the non-cash depreciation and amortization
associated with our long-lived assets, and the cost of our federal and state
tax obligations. Because EBITDA does not consider these important elements of
our cost structure, a user of our financial information who relies on EBITDA as
the only measure of our performance could draw an incomplete or misleading
conclusion regarding our financial performance. Consequently, a user of our
financial information should consider net income an important measure of our
financial performance because it provides the most complete measure of our
performance. We define EBITDA as net income (loss) before taxes, interest expense,
interest income, and depreciation and amortization. Other companies may define
EBITDA differently and, as a result, our measure of EBITDA may not be directly
comparable to EBITDA of other companies. EBITDA does not represent net income
(loss), as defined by GAAP. We also present certain adjustments to EBITDA that exclude loss (gain) on
sale of discontinued operations, net of tax, loss from discontinued operations,
net of tax, and (income) loss from operations of divested facilities that did
not qualify for discontinued operations. These adjustments are presented
because this is the formula used to calculate compliance with certain ratios
appearing in our $225.0 million senior credit facility, or the Senior Credit
Facility, which consists of a $135.0 million term loan facility and a $90.0
million revolving credit facility, and our $175.0 million aggregate principal
amount of 8 1/4% senior subordinated notes due 2013, or the Notes. In addition,
we have excluded merger related costs because they are non-recurring in nature.
The adjustments to EBITDA presented below are reconciled to net income (loss),
which we believe is the most directly comparable GAAP financial measure. Overview The accompanying unaudited condensed consolidated financial statements set
forth certain information with respect to our financial position, results of
operations and cash flows which should be read in conjunction with the
following discussion and analysis. As used in this report, references to we,
us, our, Mariner or similar terms include Mariner Health Care, Inc. and
its operating subsidiaries. We are one of the largest providers of long-term health care services in
the United States, based on net revenue, the number of facilities operated and
licensed beds. We provide these services primarily through the operation of
skilled nursing facilities (which include skilled nursing facilities under
Medicare and nursing facilities under Medicaid) and long-term acute care
hospitals, or LTACs. Skilled nursing services and LTACs also constitute our
reportable business segments under GAAP. We currently operate 251 skilled
nursing facilities and five stand-alone assisted living facilities with an
aggregate of 30,786 licensed beds. We own 70% of our facilities. We also
operate eleven LTACs with 613 licensed beds. Our facilities are located in 23
states with significant concentrations in Texas, North Carolina, California,
Colorado, South Carolina, and Maryland and clusters in twelve geographic
markets in nine of the states in which we operate. On June 29, 2004, we entered into a merger agreement (the Merger
Agreement) with National Senior Care, Inc. (NSC) and NCARE Acquisition Corp.
(NCARE), a wholly-owned subsidiary of NSC established for the purpose of
acquiring Mariner. Pursuant to the Merger Agreement, NCARE will acquire the
issued and outstanding shares of common stock of Mariner for $30.00 per share
in cash. The merger is expected to close in the fourth quarter of 2004 and is
subject to various conditions contained in the Merger Agreement, including but
not limited to the approval of the Mariners stockholders, receipt of financing
by NSC and other regulatory, governmental and licensing approvals. We are not
obligated to seek stockholder approval until NSC and NCARE provide a commitment
letter regarding the availability of financing necessary to consummate the
merger. 16




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Services provided at our skilled nursing facilities and assisted living
facilities are our primary service offering and account for 92% of our revenue.
Through our skilled nursing facilities, we provide 24-hour care to patients
requiring skilled nursing services, including assistance with activities of
daily living, or ADL, therapy and rehabilitation services. Our LTACs
accommodate the relatively high acuity needs of patients discharged from
short-term, acute-care hospitals when the patients condition warrants more
intensive care than can be provided in a typical nursing facility. The following table sets forth our revenues, operating profit,
depreciation and amortization and total assets for our two reportable segments,
skilled nursing services and LTACs. The operating profit is defined as net
revenue less operating and general and administrative expenses. The income
statement items included in the Other category consist of corporate items not
considered to be an operating segment and eliminations. The assets included in
the Other category consist primarily of cash, non-facility property and
equipment, excess reorganization value, goodwill, restricted investments, notes
receivable and deferred financing costs (in thousands of dollars). SkilledNursingServices
    
    LTACs
    
    Other
    
    TotalThree Months Ended June 30, 2004Revenue from external customers
    
    $
    379,529
    
    
    $
    32,115
    
    
    $
    128
    
    
    $
    411,772Operating profit (loss) (1)
    
    
    49,833
    
    
    
    4,486
    
    
    
    (27,213
    )
    
    
    27,106Depreciation and amortization
    
    
    8,766
    
    
    
    405
    
    
    
    1,447
    
    
    
    10,618Total assets
    
    
    770,048
    
    
    
    27,405
    
    
    
    279,876
    
    
    
    1,077,329Three Months Ended June 30, 2003Revenue from external customers
    
    $
    398,771
    
    
    $
    28,709
    
    
    $
    (873
    )
    
    $
    426,607Operating profit (loss) (1)
    
    
    34,787
    
    
    
    3,882
    
    
    
    (22,949
    )
    
    
    15,720Depreciation and amortization
    
    
    7,954
    
    
    
    532
    
    
    
    810
    
    
    
    9,296Total assets
    
    
    821,037
    
    
    
    36,818
    
    
    
    339,423
    
    
    
    1,197,278Six Months Ended June 30, 2004Revenue from external customers
    
    $
    752,233
    
    
    $
    65,360
    
    
    $
    270
    
    
    $
    817,863Operating profit (loss) (1)
    
    
    97,162
    
    
    
    9,098
    
    
    
    (53,445
    )
    
    
    52,815Depreciation and amortization
    
    
    16,732
    
    
    
    797
    
    
    
    2,746
    
    
    
    20,275Total assets
    
    
    770,048
    
    
    
    27,405
    
    
    
    279,876
    
    
    
    1,077,329Six Months Ended June 30, 2003Revenue from external customers
    
    $
    789,451
    
    
    $
    58,033
    
    
    $
    (370
    )
    
    $
    847,114Operating profit (loss) (1)
    
    
    69,551
    
    
    
    6,893
    
    
    
    (45,178
    )
    
    
    31,266Depreciation and amortization
    
    
    15,663
    
    
    
    826
    
    
    
    1,357
    
    
    
    17,846Total assets
    
    
    821,037
    
    
    
    36,818
    
    
    
    339,423
    
    
    
    1,197,278
  (1)
    
    Operating profit does not include depreciation and amortization or merger
related costs. Total operating profit less depreciation and amortization
and merger related costs was $14.3 million and $30.4 million for the three
and six months ended June 30, 2004, respectively, and $6.4 million and
$13.4 million for the three and six months ended June 30, 2003,
respectively. Critical Accounting Policies and Estimates General The unaudited condensed consolidated financial statements are based on the
application of critical accounting policies and estimates, which require
management to make estimates and assumptions. We believe that some of the more
critical judgment areas in the application of accounting policies that affect
our financial condition and results of operations are estimates and assumptions
pertaining to (a) revenue recognition, (b) collectibility of accounts
receivable, (c) insurance and professional liability risks and (d) income
taxes. 17




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Revenue Recognition We have agreements with third-party payors that provide for payments to
our skilled nursing facilities and LTACs. These payment arrangements may be
based upon prospective rates, reimbursable costs, established charges,
discounted charges or per diem payments. Revenue is reported at the estimated
net realizable amounts from Medicare, Medicaid, other third-party payors and
individual patients for services rendered. Retroactive adjustments that are
likely to result from future examinations by third-party payors are accrued on
an estimated basis in the period the related services are rendered and adjusted
as necessary in future periods based on final settlements. There is a
possibility that recorded estimates may change by a material amount. Consistent
with health care industry accounting practices, changes to these third-party
revenue estimates are recorded in the year of change or at the time the
adjustment becomes known. Receivables Receivables consist primarily of amounts due from the Medicare and
Medicaid programs, other government programs, managed care health plans,
commercial insurance companies and individual patients. Allowances for doubtful
accounts are established to the extent that a portion of these receivables may
become uncollectible. In establishing the allowance for doubtful accounts, we
consider a number of factors, including the age of the accounts, changes in
collection patterns, the composition of patient accounts by payor type, the
status of ongoing disputes with third-party payors and general industry
conditions. Changes in these estimates are charged or credited to the results
of operations in the period of the change. If circumstances occur, such as an
economic downturn, higher than expected defaults or denials, or reduced
collections, the estimates of the recoverability of our receivables could be
reduced by a material amount. During the six months ended June 30, 2004, we
collected net cash of $5.6 million of previously reserved accounts receivable
balances related to facilities divested during the three months ended December
31, 2003. Our provision for bad debt totaled $4.1 million, $7.1 million, $3.5
million, and $7.5 million for the three and six months ended June 30, 2004 and
June 30, 2003, respectively, which represented 1.0%, 0.9%, 0.8%, and 0.9% of
net revenue for the respective periods. Our allowance for doubtful accounts
related to patient accounts receivable was $102.2 million and $97.4 million as
of June 30, 2004 and December 31, 2003 respectively, which represented 32.4%
and 30.8% of patient accounts receivable at June 30, 2004 and December 31,
2003, respectively. Accrued Insurance Obligation for Professional and General Liability PL/GL costs for the long-term care
industry have become increasingly expensive and difficult to estimate.
Specifically, rising costs of eldercare malpractice litigation, losses stemming
from these malpractice lawsuits and a declining number of insurers willing to
write insurance policies in our industry has caused many insurance carriers to
raise the cost of insurance premiums. We are currently self-insured for individual claims up to $1.0 million for
professional liability, except in Colorado, where we maintain first dollar
coverage. The accrued insurance obligation related to self-insured losses for
professional liability are recorded on an undiscounted basis and are based upon
internal and external evaluations of the merits of individual claims, analysis
of claims history and independent actuarially determined estimates. We
periodically review the methods of determining these estimates and establishing
the resulting accrued insurance obligation and provision for loss with any
resulting adjustments being reflected in current earnings. Insurance expense
for PL/GL was $16.2 million, $31.5 million, $21.7 million, and $41.5 million
for the three and six months ended June 30, 2004 and June 30, 2003,
respectively. The decrease in insurance expense for PL/GL is due primarily to
facilities divested during the three months ended December 31, 2003, partially
offset by rising rates. Although we believe that the accrued insurance obligation is adequate, the
ultimate liability may be in excess of or less than the amounts recorded.
Changes in the number of PL/GL claims and increases in costs to settle these
claims could significantly impact our accrued insurance obligation. A
relatively small variance between our estimated and ultimate actual number of
claims or average cost per claim could have a material impact, either favorable
or unfavorable, on the adequacy of the accrued insurance obligation. Accounting for Income Taxes The provision (benefit) for income taxes is allocated between continuing
operations, discontinued operations, and extraordinary items in accordance with
SFAS No. 109, Accounting for Income Taxes, or SFAS No. 109. For the three and
six months ended June 30, 2004, no federal income tax provision and a state
income tax provision of $0.7 million and $1.6 million, respectively, was
recorded. The effective tax rate varies from statutory federal and state tax
rates primarily due to the utilization of net operating loss
carryforwards in
the six months ended June 30, 2004. The provision for income taxes is based upon our estimate of taxable
income or loss for each respective accounting period. We 18




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recognize an asset or liability for the deferred tax consequences of
temporary differences between the tax basis of assets and liabilities and their
reported amounts in the financial statements. These temporary differences will
result in taxable or deductible amounts in future years when the reported
amounts of assets are recovered or liabilities are settled. We also recognize
as deferred tax assets the future tax benefits from net operating and capital
loss carryforwards. SFAS
No. 109 requires that a valuation allowance be established when it is
more likely than not that all or a portion of a deferred tax asset will not be
realized. The ultimate realization of deferred tax assets is dependent upon the
generation of future taxable income during the periods in which those temporary
differences are deductible. In making this determination, we consider all
available positive and negative evidence affecting specific deferred tax
assets, including our past and anticipated future performance, the reversal of
deferred tax liabilities, and the implementation of tax planning strategies. Objective positive evidence is necessary to support a conclusion that a
valuation allowance is not needed for all or a portion of deferred tax assets
when significant negative evidence exists. Cumulative losses in recent years
are the most compelling form of negative evidence considered by management in
this determination. We believe the deferred tax assets will not be recognized
under the more likely than not standard. As the bankruptcy pre-emergence net
deferred tax assets are realized, a reduction in the valuation allowance
established in connection with fresh-start reporting will be recorded. Pursuant
to American Institute of Certified Public Accountants Statement of Position
90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy
Code, any reduction in the valuation allowance will first reduce
reorganization value in excess of amount allocable to identified assets
recorded in fresh-start reporting and other intangible assets, with any excess
being treated as an increase to capital surplus. As of December 31, 2003, we had approximately $563.5 million of net
operating loss, or NOL, carryforwards the utilization of which is subject to
limitations pursuant to Section 382 of the Internal Revenue Code. Of the total
NOL carryforwards, $118.4 million is unencumbered by any Section 382
limitations. Of the remainder, approximately $143.0 million of NOL
carryforwards are subject only to restrictions under Section 382 that apply to
a company that emerges from bankruptcy. The remaining approximately $302.1
million of NOL carryforwards are subject to the additional Section 382
restrictions requiring the existence of net unrealized built-in gain at the
time of a December 1999 ownership change that occurred when our largest
shareholder sold its equity interest in the Company to another entity prior to
our filing bankruptcy. These restrictions require the recognition of built-in
gain within five years of such date, or by December 31, 2004. While we are
still currently in the process of evaluating the full extent of the limitations
and restrictions on the utilization of the NOL carryforwards under the
provisions of Section 382, it is likely that the use of approximately $302.1
million of NOL carryforwards originating prior to the ownership change in
December 1999 will be subject to significant limitation on utilization. If
there is a cumulative ownership change involving stockholders who own
5% or more of our common stock of more than 50% during the two year period
following our emergence from bankruptcy (May 13, 2002), the remaining NOL
carryforwards will be foregone with no net impact to our consolidated financial
statements. This could result in higher future tax payments if we are
profitable. The Company is unaware of any such changes to date. However,
because of the SEC rules and regulations regarding the timing of public
filings, management will continue to evaluate the status of the potential
ownership change as additional information becomes available. Asset Impairment Long-lived Assets We review the carrying value of our long-lived assets for impairment
whenever events or circumstances indicate that the carrying amount may not
exceed the future undiscounted cash flows or an adjustment to the amortization
period is necessary in accordance with Statement of Financial Accounting
Standard No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets, or SFAS No. 144. These indicators of impairment can include, but are
not limited to, a history of operating losses with expected future losses,
changes in the regulatory environment affecting reimbursement, decreases in
cash flows or cash flow deficiencies, changes in the way an asset is used in
the business, and commitment to a plan to sell or otherwise dispose of an
asset. Impairment of Reorganization Value in Excess of Amounts Allocable to
Identifiable Assets and Goodwill Reorganization value in excess of amounts allocable to identifiable
assets, or excess reorganization value, represents the portion of
reorganization value that could not be attributed to specific tangible or
identified intangible assets recorded in connection with our adoption of
fresh-start reporting. In lieu of amortization, we are required to review the excess
reorganization value and goodwill for impairment at least annually or more
frequently if events or changes in circumstances indicate the asset might be
impaired. 19




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Assets Held for Sale and Discontinued Operations SFAS No. 144 also addresses the accounting for and disclosure of
long-lived assets to be disposed of by sale. Under SFAS No. 144, when a
long-lived asset or group of assets or disposal group meets certain criteria
set forth in SFAS No. 144, including a commitment by a company to a plan to
sell the long-lived asset or disposal group within one year, the long-lived
asset or disposal group will be measured at the lower of its carrying value or
fair value less costs to sell and classified as held for sale on the
consolidated balance sheet and is no longer depreciated. We must estimate the
fair value less costs to sell in order to determine if there is any potential
impairment of the assets held for sale. Estimates may include comparable sales,
future cash flows and the use of an outside expert in determining the fair
value. If additional criteria are met under SFAS No. 144, the related operations
and cash flows of the long-lived asset or disposal group will be reported as
discontinued operations in the consolidated statements of operations, with all
comparable periods restated. Recent Accounting Pronouncements In January 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51, or FIN 46, which addresses the consolidation of
entities whose equity holders have either (a) not provided sufficient equity at
risk to allow the entity to finance its own activities or (b) do not possess
certain characteristics of a controlling financial interest. FIN 46 sets forth
a model to evaluate potential consolidation of these entities, known as
variable interest entities, or VIEs, based on an assessment of which party to
the VIE, if any, absorbs a majority of the exposure to its expected losses,
receives a majority of its expected residual returns, or both, which is
referred to for purposes of FIN 46 as the primary beneficiary. FIN 46 also
requires disclosures about VIEs that a company is not required to consolidate
but in which it has a significant variable interest. FIN 46 is effective for
all new VIEs created or acquired after January 31, 2003. For VIEs created or
acquired prior to February 1, 2003, the provisions of FIN 46 must be applied
for the first interim or annual period beginning after March 15, 2004 except
for companies with special purpose entities which must apply the provisions of
FIN 46 to those special purpose entities no later than the first reporting
period ending after December 15, 2003. We have evaluated the impact of FIN 46 on our unaudited condensed
consolidated financial statements and identified three joint ventures as VIEs
for which we have determined that we are the primary beneficiary. These joint
ventures, which operate skilled nursing facilities that are managed by us, are
fifty percent owned by us and have historically been consolidated due to
control. We have historically provided funds for working capital and have other
long-term notes from these joint ventures, which are eliminated in
consolidation. The joint ventures have revenues, which are included in our
unaudited condensed consolidated financial statements of $9.9 million, $19.7
million, $9.1 million, and $17.8 million for the three and six months ended
June 30, 2004 and June 30, 2003, respectively. These joint ventures have net
liabilities that are included in the accompanying unaudited condensed
consolidated financial statements of approximately $39.5 million and $39.9
million at June 30, 2004 and December 31, 2003, respectively. During the three months ended December 31, 2003, we entered into an
administrative services agreement with a new operator of certain facilities
that we divested. The services are for 26 facilities and include accounting
support, procurement of business supplies, billing and collections, and
information technology services. Applying the principles of FIN 46, we have
determined that the new operator of the divested facilities is a VIE. We have
also determined that we are not the primary beneficiary and accordingly, we
are not required to consolidate the new operator. The total receivable from
this new operator at June 30, 2004 is $3.4 million. 20




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Results of Operations The following table represents the unaudited condensed consolidated
statements of operations for the periods indicated (in thousands of dollars): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    411,772
    
    
    $
    426,607
    
    
    $
    817,863
    
    
    $
    847,114Costs and expensesOperating expensesWage and related costs
    
    
    231,162
    
    
    
    252,960
    
    
    
    464,251
    
    
    
    505,912Supplies
    
    
    23,012
    
    
    
    25,274
    
    
    
    46,134
    
    
    
    49,908Insurance
    
    
    16,772
    
    
    
    22,350
    
    
    
    32,609
    
    
    
    42,801Provision for bad debt
    
    
    3,822
    
    
    
    4,890
    
    
    
    6,833
    
    
    
    9,257Rent expense
    
    
    8,092
    
    
    
    8,765
    
    
    
    16,351
    
    
    
    17,504Other
    
    
    74,462
    
    
    
    74,574
    
    
    
    145,153
    
    
    
    145,659Total operating expenses
    
    
    357,322
    
    
    
    388,813
    
    
    
    711,331
    
    
    
    771,041General and administrative
    
    
    27,344
    
    
    
    22,074
    
    
    
    53,717
    
    
    
    44,807Merger related costs
    
    
    2,142
    
    
    
    
    
    
    
    2,142
    
    
    
    Depreciation and amortization
    
    
    10,618
    
    
    
    9,296
    
    
    
    20,275
    
    
    
    17,846Total costs and expenses
    
    
    397,426
    
    
    
    420,183
    
    
    
    787,465
    
    
    
    833,694Operating income
    
    
    14,346
    
    
    
    6,424
    
    
    
    30,398
    
    
    
    13,420Other income (expenses)Interest expense
    
    
    (8,489
    )
    
    
    (9,576
    )
    
    
    (17,706
    )
    
    
    (17,789
    )Interest income
    
    
    739
    
    
    
    692
    
    
    
    1,489
    
    
    
    1,520Other
    
    
    (31
    )
    
    
    (1
    )
    
    
    (36
    )
    
    
    (51
    )Income (loss) from continuing operations before taxes
    
    
    6,565
    
    
    
    (2,461
    )
    
    
    14,145
    
    
    
    (2,900
    )Income tax provision (benefit)
    
    
    732
    
    
    
    (1,127
    )
    
    
    1,627
    
    
    
    (1,684
    )Income (loss) from continuing operations
    
    
    5,833
    
    
    
    (1,334
    )
    
    
    12,518
    
    
    
    (1,216
    )Discontinued operations(Loss) gain on sale of discontinued operations,
net of tax
    
    
    (709
    )
    
    
    
    
    
    
    (851
    )
    
    
    3,600Loss from discontinued operations, net of tax
    
    
    (1,772
    )
    
    
    (360
    )
    
    
    (2,088
    )
    
    
    (1,310
    )Net income (loss)
    
    $
    3,352
    
    
    $
    (1,694
    )
    
    $
    9,579
    
    
    $
    1,074
 Reconciliation of EBITDA to net income (in thousands of dollars) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    3,352
    
    
    $
    (1,694
    )
    
    $
    9,579
    
    
    $
    1,074Add back:Provision (benefit) for income taxes
    
    
    732
    
    
    
    (1,127
    )
    
    
    1,627
    
    
    
    (1,684
    )Interest expense
    
    
    8,489
    
    
    
    9,576
    
    
    
    17,706
    
    
    
    17,789Interest income
    
    
    (739
    )
    
    
    (692
    )
    
    
    (1,489
    )
    
    
    (1,520
    )Depreciation and amortization
    
    
    10,618
    
    
    
    9,296
    
    
    
    20,275
    
    
    
    17,846EBITDA (1)
    
    $
    22,452
    
    
    $
    15,359
    
    
    $
    47,698
    
    
    $
    33,505
 21




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(1) The table presented below contains items that are excluded when
calculating EBITDA for the purpose of determining our compliance with
certain ratios contained in our Senior Credit Facility and the indenture
pertaining to our Notes. This is our Debt Financing EBITDA. In addition,
we have excluded merger related costs, because we believe these amounts
are non-recurring in nature (Debt Financing EBITDA and MRCs). The ratios
contained in our Senior Credit Facility determine our compliance with
certain covenants contained in the documents relevant to both debt
obligations as well as our ability to draw on our Revolving Credit
Facility, issue additional Notes and undertake certain desired corporate
actions. If these items were excluded from EBITDA as presented in the
table above, Debt Financing EBITDA and MRCs would be $27.1 million, $14.7
million, $52.8 million, and $32.5 million for the three months ended June
30, 2004 and 2003 and the six months ended June 30, 2004 and 2003,
respectively. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Loss (gain) on sale of discontinued operations, net of tax
    
    $
    709
    
    
    $
    
    
    
    $
    851
    
    
    $
    (3,600
    )Loss from discontinued operations, net of tax
    
    
    1,772
    
    
    
    360
    
    
    
    2,088
    
    
    
    1,310(Income) loss from operations of divested facilities (2)
    
    
    
    
    
    
    (1,050
    )
    
    
    
    
    
    
    1,296Merger related costs
    
    
    2,142
    
    
    
    
    
    
    
    2,142
    
    
    
    Increase (decrease) to EBITDA
    
    $
    4,623
    
    
    $
    (690
    )
    
    $
    5,081
    
    
    $
    (994
    )
  (2)
    
    The loss from operations of divested facilities relates to divestitures
of facilities that did not qualify for discontinued operations
presentation. Three Months Ended June 30, 2004 Compared to the Three Months Ended June 30,
2003 We reported net revenues of $411.8 million during the quarter ended June
30, 2004, compared to $426.6 million for the quarter ended June 30, 2003. The
decrease of $14.8 million, or 3.5%, consists primarily of the following:  
    
    A decrease of $50.2 million related to divested facilities that do
not qualify for discontinued operations presentation.
    
    An increase of $30.9 million in skilled nursing facilities we
operated as of June 30, 2004, or same facility operations. This increase
is due primarily to:  
    
    A net increase of $14.4 million in Medicaid revenues due
primarily to a rate increase averaging $10.10 per patient day
resulting in a $16.0 million increase in revenues, which was partially
offset by a decrease in patient days of 13,907 resulting in a decrease
in revenues of $1.5 million. The rate increase was primarily due to an increase of
$6.9 million associated with the provider tax based Medicaid rate
increases in Georgia, Massachusetts, Michigan, North Carolina, and
Wisconsin. In addition, the recently approved Michigan rate increase
was retroactive to October 1, 2003, and accordingly, $3.7 million of
revenue was recognized during the three months ended June 30, 2004 for
this retroactive adjustment. The provider tax paid in connection with
this program offsets a portion of the revenue and is included in other
operating expenses.
    
    An increase of $9.5 million in Medicare revenues due primarily to
a rate increase of $23.29 per patient day resulting in a $7.6 million
increase in revenues and an increase in patient days of 6,155
resulting in a $1.9 million increase in revenues. The rate increase
is due primarily to the Medicare administrative fix and market basket
increase effective October 1, 2003. The increase in patient days was
a direct result of our focus on attracting a higher acuity patient
population.
    
    A net overall increase of $7.0 million in private and other
revenues due to an increase in rate of $21.88 per patient day
resulting in a $9.4 million increase in revenues, which was partially
offset by a decrease in patient days of 14,285 that resulted in a $2.4
million reduction of revenues. The increase in rate was attributable
to a rate increase we made in July 2003. The reduction in days is due
primarily to the market for private payors shifting to assisted living
facilities.  
    
    An increase of $3.4 million related to LTAC revenues primarily
related to an increase in total patient days of 3,524 resulting in a
$3.6 million increase in revenues, partially offset by a decrease to the
rate per patient day of $5.02 resulting in a decrease of revenues of
$0.2 million. 22




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Operating Expenses We reported operating expenses of $357.3 million during the quarter ended
June 30, 2004, compared to $388.8 million during the quarter ended June 30,
2003. The decrease of $31.5 million, or 8.1% primarily relates to the
following:  
    
    Wage and related costs decreased $21.8 million due primarily to:  
    
    A decrease of $28.3 million related to divested facilities that do not qualify for discontinued operations presentation.
    
    A partially offsetting increase in same facility operations and
LTAC of $6.5 million, primarily related to annual salary and benefit
cost increases and an increase in workers compensation expenses.  
    
    Supplies decreased $2.3 million due primarily to:  
    
    A decrease of $2.6 million related to divested facilities that do not qualify for discontinued operations presentation.  
    
    Insurance, which consists primarily of professional and general
liability insurance costs, decreased $5.6 million due primarily to:  
    
    A decrease of $7.2 million related to divested facilities that do not qualify for discontinued operations presentation.
    
    An increase of $1.6 million in same facility operations and LTAC due primarily to rising PL/GL costs.  
    
    Provision for bad debt decreased $1.1 million primarily due to:  
    
    A decrease of $2.0 million of bad debt expense related to
divested facilities that do not qualify for discontinued operations
presentation.
    
    An increase of $0.9 million of bad debt expense in same facility operations and LTAC.  
    
    Other operating expenses decreased $0.1 million primarily related to:  
    
    A decrease of $9.7 million of other operating expense related to
divested facilities that do not qualify for discontinued operations
presentation.
    
    An increase of $9.6 million of other operating expenses in same
facility operations and LTAC due primarily to:  
    
    An increase of $3.1 million for provider tax expense
related to state Medicaid programs in Georgia, Massachusetts, North
Carolina, Michigan and Wisconsin. In addition, the recently
approved Michigan provider tax program was retroactive to October
1, 2003, and accordingly, $1.8 million of provider tax was
recognized during the three months ended June 30, 2004 for this
retroactive adjustment. The provider tax partially offsets
Medicaid revenues. General and Administrative We reported general and administrative expenses of $27.3 million during
the quarter ended June 30, 2004, compared to $22.1 million during the quarter
ended June 30, 2003. The increase of $5.3 million, or 23.9%, relates primarily
to the following:  
    
    An increase of $2.7 million primarily related to increases in wage
and related costs.
    
    The remaining net increase of $2.6 million relates to costs
associated with a new centralized back office support services center
business, costs incurred for compliance with Sarbanes-Oxley, and legal
costs, primarily related to our claim against an insurance company for
certain owned and leased facilities that were damaged by floods. Merger Related Costs We reported merger related costs of $2.1 million during the quarter ended
June 30, 2004. The merger related costs consist primarily of professional and
legal expenses related to merger activities. 23




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Depreciation and Amortization We reported depreciation and amortization expense of $10.6 million during
the quarter ended June 30, 2004, compared to $9.3 million during the quarter
ended June 30, 2003. The increase of $1.3 million, or 14.2%, primarily relates
to the following:  
    
    A net increase of $1.9 million related to incremental depreciation
expense on capital expenditures in same facility operations, LTAC and
corporate locations.
    
    A decrease of $0.6 million due to the divested facilities that do not
qualify for discontinued operations presentation. Interest Expense We reported interest expense of $8.5 million during the quarter ended June
30, 2004, compared to $9.6 million during the quarter ended June 30, 2003. The
decrease of $1.1 million, or 11.4%, primarily relates to lower interest rates
and outstanding debt as a result of debt pay downs and the refinancing
completed during the fourth quarter of 2003. Discontinued Operations Loss from Discontinued Operations The results of operations of any disposed facilities that qualify for
discontinued operations under SFAS No. 144 have been reported as discontinued
operations for all periods presented in the accompanying unaudited consolidated
statements of operations. A summary of the discontinued operations for the
periods presented is as follows (in thousands of dollars): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    1,906
    
    
    $
    11,412
    
    
    $
    5,275
    
    
    $
    22,682Total operating costs and expenses
    
    
    3,523
    
    
    
    11,708
    
    
    
    7,360
    
    
    
    23,858Operating loss
    
    
    (1,617
    )
    
    
    (296
    )
    
    
    (2,085
    )
    
    
    (1,176
    )Other expense
    
    
    (155
    )
    
    
    (64
    )
    
    
    (3
    )
    
    
    (134
    )Loss from discontinued operations, net of tax
    
    $
    (1,772
    )
    
    $
    (360
    )
    
    $
    (2,088
    )
    
    $
    (1,310
    )
 Six Months Ended June 30, 2004 Compared to the Six Months Ended June 30, 2003 We reported net revenues of $817.9 million during the six months ended
June 30, 2004, compared to $847.1 million for the six months ended June 30,
2003. The decrease of $29.3 million, or 3.5%, consists primarily of the
following:  
    
    A decrease of $97.1 million related to divested facilities that do
not qualify for discontinued operations presentation.
    
    An increase of $59.9 million in skilled nursing facilities we
operated as of June 30, 2004, or same facility operations. This increase
is due primarily to:  
    
    A net increase of $25.1 million in Medicaid revenues due
primarily to a rate increase averaging $8.65 per patient day resulting
in a $27.3 million increase in revenues, which was partially offset by a decrease
in patient days of 19,728 resulting in decrease in revenues of $2.2 million. The
rate increase was primarily due to an increase of $15.2 million
associated with the provider tax based Medicaid rate increases in
Georgia, Massachusetts, Michigan, North Carolina, and Wisconsin. In
addition, the recently approved Michigan rate increase was retroactive
to October 1, 2003, and accordingly, $1.8 million of revenue was
recognized during the six months ended June 30, 2004 for this
retroactive adjustment. The provider tax paid in connection with this
program offsets a portion of the revenue and is included in other
operating expenses.
    
    An increase of $23.8 million in Medicare revenues due primarily
to a rate increase averaging $26.64 per patient day resulting in a
$17.6 million increase in revenues and an increase in patient days of
20,779 resulting in a $6.2 million increase in revenues. The rate
increase is due primarily to the Medicare Administrative fix and
market basket increase effective October 1, 2003. The increase in
patient days was a direct result of our focus on attracting a higher
acuity patient population. 24




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
    
    A net overall increase of $11.0 million in private and other
revenues due to an increase in rate of $18.96 per patient day
resulting in a $16.3 million increase in revenues, which was partially
offset by a decrease in patient days of 31,797 that resulted in a $5.3
million reduction of revenues. The increase in rate was attributable
to a rate increase we made in July 2003. The reduction in days is due
primarily to the market for private payors shifting to assisted living
facilities.  
    
    An increase of $7.3 million related to LTAC revenues primarily
related to an increase in total patient days of 7,338 resulting in a
$7.1 million increase in revenues. Operating Expenses We reported operating expenses of $711.3 million during the six months
ended June 30, 2004, compared to $771.0 million during the six months ended
June 30, 2003. The decrease of $59.7 million, or 7.7% primarily relates to the
following:  
    
    Wage and related costs decreased $41.7 million due primarily to:  
    
    A decrease of $56.5 million related to divested facilities that do not qualify for discontinued operations presentation.
    
    A partially offsetting increase in same facility operations and
LTAC of $14.9 million, primarily related to annual salary and benefit
cost increases and an increase in workers compensation expenses.  
    
    Supplies decreased $3.8 million due primarily to:  
    
    A decrease of $5.1 million related to divested facilities that do not qualify for discontinued operations presentation.
    
    An increase of $1.3 million in supplies expense for same facility operations and LTAC.  
    
    Insurance, which consists primarily of professional and general
liability insurance costs, decreased $10.2 million due primarily to:  
    
    A decrease of $14.6 million related to divested facilities that do not qualify for discontinued operations presentation.
    
    An increase of $4.4 million in same facility operations and LTAC due primarily to rising PL/GL costs.  
    
    Provision for bad debt decreased $2.4 million primarily due to:  
    
    A decrease of $3.4 million related to divested facilities that do not qualify for discontinued operations presentation.
    
    An increase of $1.0 million in same facility operations and LTAC.  
    
    Rent expense decreased $1.2 million primarily due to a $1.3 million
decrease related to divested facilities that do not qualify for
discontinued operations presentation.  
    
    Other operating expenses decreased $0.5 million primarily related to:  
    
    A decrease of $20.8 million of other operating expense related to
divested facilities that do not qualify for discontinued operations
presentation.
    
    An increase of $20.3 million of other operating expenses in same
facility operations and LTAC due primarily to:  
    
    An increase of $6.3 million for provider tax expense
related to state Medicaid programs in Georgia, Massachusetts, North
Carolina, Michigan and Wisconsin. In addition, the recently
approved Michigan provider tax program was retroactive to October
1, 2003, and accordingly, $0.9 million of provider tax was
recognized during the six months ended June 30, 2004 for this
retroactive adjustment. The provider tax partially offsets
Medicaid revenues. General and Administrative We reported general and administrative expenses of $53.7 million during
the six months ended June 30, 2004, compared to $44.8 million during the six
months ended June 30, 2003. The increase of $8.9 million, or 19.9%, relates
primarily to the following: 25




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
    
    An increase of $3.1 million primarily related to increases in wage
and related costs.
    
    The remaining net increase of $5.8 million relates to costs
associated with the implementation of new information technology
infrastructure systems and a new centralized back office support
services center business model, costs incurred for compliance with
Sarbanes-Oxley, and legal costs, primarily related to our claim against
an insurance company for certain owned and leased facilities that were
damaged by floods. Merger Related Costs We reported merger related costs of $2.1 million during the six months
ended June 30, 2004. The merger related costs consist primarily of professional
and legal expenses related to merger activities. Depreciation and Amortization We reported depreciation and amortization expense of $20.3 million during
the six months ended June 30, 2004, compared to $17.8 million during the six
months ended June 30, 2003. The increase of $2.4 million, or 13.6%, primarily
relates to the following:  
    
    An increase of $3.6 million related to incremental depreciation
expense on capital expenditures in same facility operations and at
corporate locations.
    
    A decrease of $1.2 million due to the divested facilities that do not
qualify for discontinued operations presentation. Discontinued Operations Gain on Sale of Discontinued Operations During the six months ended June 30, 2003, we earned and received the
payments for post-closing operating results, or Earnout Payments in connection
with the sale of the institutional pharmacy services business, or APS Division
to Omnicare, Inc. of $6.0 million, at which time we recorded a gain of $3.6
million, net of taxes of $2.4 million. Liquidity and Capital Resources At June 30, 2004, we had working capital of $32.9 million and cash and
cash equivalents of $26.8 million, compared to working capital of $56.0 million
and cash and cash equivalents of $41.9 million at December 31, 2003. The $23.1
million decrease in working capital related primarily to an increase of
payments for PL/GL claims, costs and expenses. Net cash (utilized) provided by
operating activities of continuing operations was $(2.5) million and $33.2
million for the six months ended June 30, 2004 and 2003, respectively. This
decrease of $35.7 million relates primarily to an increase in receivables due
to the timing of payments received from the Medicaid program, the timing of
payments of accounts payable and an increase in PL/GL settlement
and cost payments for the six months ended June 30, 2004. Total purchases of property and equipment, including expenditures related
to our information technology infrastructure, were $16.4 million for the six
months ended June 30, 2004 and we project future expenditures to be up to
approximately $66.0 million during the next twelve months. We expect to fund
these purchases through internally generated funds. We are in the process of developing and implementing a new information
technology infrastructure to improve customer service, enhance operating
efficiencies and provide for more effective management of business operations.
These improvements will include a new centralized clinical billing function and
enhancements to other accounting and human resource systems. Implementation of
the new systems and software carries risks such as cost overruns, project
delays and business interruptions. If we experience a material business
interruption as a result of the implementation of our future information
technology infrastructure or if we are unable to obtain the projected benefits
of this new infrastructure, we could experience a material impact on our
liquidity and cash flows, as well as potential impairment of the related
information technology assets. Our capitalized software costs not yet placed
into service at June 30, 2004 were $31.0 million. At June 30, 2004, we were in compliance with requirements associated with
our Senior Credit Facility and Notes. We were also in compliance with the
terms of our $59.7 million mortgage loan, or Omega Loan, from Omega Healthcare
Investors, Inc. at June 30, 2004. Long-term debt at June 30, 2004 aggregated
$384.5 million compared to $389.6 million at December 31, 2003. The decrease of
$5.1 million relates primarily to a repayment of our term loan of $4.2 million.
There were no outstanding borrowings under the Senior Credit Facility at June
30, 2004 although we had net letters of credit outstanding of $46.0 million
(which decreases the amount available to us under the revolving credit facility
of our Senior Credit Facility). Our Notes and the Omega Loan also contain 26




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restrictions on repurchases of stock and payment of dividends (although
with respect to the Omega Loan these restrictions apply only to our subsidiary,
Professional Healthcare Management, Inc. and its subsidiaries). The terms of our Senior Credit Facility include certain covenants, which
limit our annual capital expenditures. In addition, this agreement generally
restricts repurchases of common stock and the payment of cash dividends. Seven of our skilled nursing facilities and one of our LTACs were damaged
during tropical storm Allison in June 2001. We have made in the past and expect
to continue to make substantial expenditures necessary to repair or replace
these facilities as a result of the damage caused by the storm. Over the next
several years we estimate that we may spend approximately $28.5 million to
complete all work necessary to complete this project. As described in more
detail in Item 3, Legal Proceedings included in our Annual Report on Form
10-K for the year ended December 31, 2003, we are currently in litigation
regarding our property insurance coverage for this loss. While we cannot
predict the outcome of this litigation, based on currently available facts, we
do not believe that the resolution of this proceeding will have a material
adverse effect on our financial position, results of operations or cash flows. In connection with the NSC merger, we incurred $2.1 million merger related
costs during the three months ended June 30, 2004 and we expect to incur an
additional $10.9 million in merger related costs, of which $4.0 million is
contingent upon the merger being consummated. Other Factors Affecting Liquidity and Capital Resources Revenue Sources We derive a substantial portion of our revenue from third-party payors,
including the Medicare and Medicaid programs. For the three and six months
ended June 30, 2004 and June 30, 2003, we derived 82.1%, 81.8%, 81.6%, and
81.6%, respectively, of our total revenue from the Medicare and Medicaid
programs. Third-party payor programs are highly regulated and are subject to
frequent and substantial changes. Changes in the reimbursement rate or methods
of payment from third-party payors, including the Medicare and Medicaid
programs, or the implementation of other measures to reduce reimbursements for
our services has in the past, and could in the future, result in a substantial
reduction in our revenues and operating margins. Additionally, net revenue
realizable under third-party payor agreements can change after examination and
retroactive adjustment by payors during the claims settlement processes or as a
result of post-payment audits. Payors may disallow requests for reimbursement
based on determinations that certain costs are not reimbursable or reasonable
because additional documentation is necessary or because certain services were
not covered or were not reasonable and medically necessary. There also continue
to be new legislative and regulatory proposals that could impose further
limitations on government and private payments to health care providers. In
some cases, states have enacted or are considering enacting measures designed
to reduce their Medicaid expenditures and to make changes to private health
care insurance. We cannot assure you that adequate reimbursement levels will
continue to be available for the services provided by us, which are currently
being reimbursed by Medicare, Medicaid or private third-party payors. Further
limits on the scope of services reimbursed and on reimbursement rates could
have a material adverse effect on our liquidity, financial condition and
results of operations. It is possible that further refinements to Medicare
coverage or payment policies, including the Medicare skilled nursing facility
prospective payment system, or PPS, that result in lower payments to us or cuts
in state Medicaid funding could have a material adverse effect on our results
of operations. Congress enacted the Medicare Balanced Budget Refinement Act of
1999, or BBRA, to, among other things, mitigate the impact of the skilled
nursing facility PPS, by temporarily increasing the PPS per diem rates for
certain patient categories. In addition, the Medicare, Medicaid and SCHIP
Benefits Improvement Act of 2000, or BIPA, brought additional relief to
long-term care providers by eliminating certain scheduled reductions in skilled
nursing facility reimbursement rates. When Congress enacted the BBRA and BIPA,
it scheduled the relief under those acts to sunset starting October 1, 2002
unless additional action was taken by Congress or the Center for Medicare and Medicaid
Services, or CMS. Although some of the relief afforded by the BBRA and BIPA
has been extended through at least September 30, 2004, there can be no
assurance that it will be extended beyond such time. Moreover, the CMS issued a final rule on May 7, 2004 making
a number of Medicare payment and policy changes affecting LTACs. Among other
things, the rule increases Medicare LTAC payments by 3.1% for the 2005
long-term care hospital rate year, which began on July 1, 2004. In addition,
CMS issued a proposed rule on May 18, 2004 that would make significant changes
to the qualification criteria for LTACs operating as hospitals within
hospitals. CMS also expressed its concern about several other developments
within the LTAC industry, including growth in the number of LTACs, which could
result in additional regulatory restrictions in the future. CMS also announced
on July 29, 2004 an increase in Medicare payment rates for SNFs. The increase
reflects a 2.8% annual update in payment rates. Although it is too early to
predict the impact of these CMS initiatives, there can be no assurances that
the new rules or future proposals will not have a material adverse effect on
our financial position, results of operations or cash flows. Professional and General Liability As is typical in the health care industry, we are and will continue to be
subject to claims that our services have resulted in resident 27




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injury or other adverse effects. We, like our industry peers, have
experienced an increasing trend in the frequency and severity of PL/GL claims
and litigation asserted against us. In some states in which we have significant
operations, insurance coverage for the risk of punitive damages arising from
PL/GL claims and/or litigation may not, in certain cases, be available due to
state law prohibitions or limitations of availability. We cannot assure you
that we will not be liable for punitive damage awards that are either not
covered or are in excess of our insurance policy limits. We also believe that
there has been, and will continue to be, an increase in governmental
investigations of long-term care providers, particularly in the area of
Medicare/Medicaid false claims, as well as an increase in enforcement actions
resulting from these investigations. Insurance is not available to cover such
losses. Any adverse determination in a legal proceeding or governmental
investigation, whether currently asserted or arising in the future, could have
a material adverse effect on our financial condition. In spite of the fact that
we recently exited the State of Florida, we will continue to be subject to
claims arising from our prior operations for some time. Additionally, the
enactment of Texas tort reform resulted in a significant increase in the number
of cases being filed prior to the effective date of the new legislation. These
two factors could result in significant PL/GL costs in future years although
such amounts are related to prior periods. Also, the large increase in the
number of claims filed in these states, together with rising costs in other
states, could subject us to costs in excess of the reserves we have set aside
for these periods. While our actuarial analysis indicates that we currently
have sufficient insurance and reserves set aside to address these matters, as
these claims mature no assurance can be given that we will not be required to
expend additional funds in future periods for claims related to prior periods. Labor Costs We could experience significant increases in our operating costs due to
shortages in qualified nurses, health care professionals and other key
personnel. The market for these key personnel is highly competitive. We, like
other health care providers, have experienced difficulties in attracting and
retaining qualified personnel, especially facility administrators, nurses,
certified nurses aides and other important health care providers. Our LTACs
are particularly dependent on nurses for patient care. There is currently a
shortage of nurses, and trends indicate this shortage will worsen in the
future. The difficulty our skilled nursing facilities are experiencing in
hiring and retaining qualified personnel has increased our average wage rate.
We may continue to experience increases in our labor costs primarily due to
higher wages and greater benefits required to attract and retain qualified
health care personnel. Our ability to control labor costs will significantly
affect our future operating results. In addition, wages and other labor-related costs are especially sensitive
to inflation. Increases in wages and other labor-related costs as a result of
inflation or the increase in minimum wage requirements without a corresponding
increase in Medicaid and Medicare reimbursement rates would, and have,
adversely impacted us. In some of our markets there is a labor shortage that
could have an adverse effect upon our ability to attract or retain sufficient
numbers of skilled and unskilled personnel at reasonable wages. Accordingly,
rising wage rates have had an adverse effect on us in some of our markets. Rent We also have significant rent obligations relating to our leased
facilities. Total rent expense for leased facilities, including rent expense
for discontinued operations and corporate locations was $8.7 million, $17.7
million, $9.6 million, and $19.3 million for the three and six months ended
June 30, 2004 and June 30, 2003, respectively. Based upon existing cash levels, expected operating cash flows, capital
spending, and the availability of borrowings under our revolving credit
facility, management believes that we have the necessary financial resources to
satisfy our liquidity needs for the foreseeable future. For a discussion of
items that may have an adverse impact on our future liquidity, see Cautionary
Note Regarding Forward-Looking Statements below. Cautionary Note Regarding Forward-Looking Statements Certain statements in this quarterly report on Form 10-Q may constitute
forward-looking statements as defined in Section 27A of the Securities Act of
1933, or the Securities Act, Section 21E of the Securities Exchange Act of
1934, or the Exchange Act, the Private Securities Litigation Reform Act of
1995, or the PSLRA, or in releases made by the Securities and Exchange
Commission or the SEC, all as may be amended from time to time. Statements
contained in this quarterly report that are not historical facts may be
forward-looking statements within the meaning of the PSLRA. Any such
forward-looking statements reflect our beliefs and assumptions and are based on
information currently available to us. Forward-looking statements are only
predictions and involve known and unknown risks, uncertainties and other
factors that may cause our actual results, performance or achievements, or
industry results, to be materially different from any future results,
performance or achievements expressed or implied by such forward-looking
statements. These cautionary statements are being made pursuant to the
Securities Act, the Exchange Act and the PSLRA with the intention of obtaining
the benefits of the safe harbor provisions of such laws.
We caution
investors that any forward-looking statements we make are not guarantees or
indicative of future performance. For additional information regarding factors
that may cause our results of operations to differ materially from those
presented herein, please see Risk Factors contained in our Annual Report on
Form 10-K 28




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for the fiscal year ended December 31, 2003. You can identify forward-looking statements as those that are not historical in
nature, particularly those that use terminology such as may, will,
should, expect, anticipate, contemplate, estimate, believe, plan,
project, predict, potential or continue, or the negative of these, or
similar terms. In evaluating these forward-looking statements, you should
consider the following factors, as well as others contained in our public
filings from time to time, which may cause our actual results to differ
materially from any forward-looking statement:  
    
    our existing and future indebtedness;
    
    changes in Medicare, Medicaid and certain private payors reimbursement levels;
    
    existing government regulations and changes in, or the failure to comply with, governmental regulations;
    
    the ability to control costs and implement measures designed to enhance operating efficiencies;
    
    legislative proposals for health care or tort reform;
    
    competition;
    
    the ability to attract and retain qualified personnel at a reasonable cost;
    
    changes in current trends in the cost and volume of general and professional liability claims;
    
    possible investigations or proceedings against us initiated by states or the federal government;
    
    state regulation of the construction or expansion of health care providers;
    
    litigation;
    
    unavailability of adequate insurance coverage on reasonable terms; and
    
    an increase in senior debt or reduction in cash flow upon our purchase or sale of assets. Any subsequent written or oral forward-looking statements attributable to
us or persons acting on our behalf are expressly qualified in their entirety by
the cautionary statements set forth or referred to above, as well as the risk
factors contained in our Annual Report on Form 10-K for the year ended December
31, 2003. Except as required by law, we disclaim any obligation to update such
statements or to publicly announce the result of any revisions to any of the
forward-looking statements contained herein to reflect future events or
developments. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK At June 30, 2004, the fair value of our fixed rate long-term debt exceeded
its carrying value by $9.3 million, which represented an increase in fair value
since year-end. See the discussion of our market risk in our Annual Report on
Form 10-K for the year ended December 31, 2003 filed with the SEC. 
 ITEM 4. CONTROLS AND PROCEDURES We currently have in place systems relating to disclosure controls and
procedures with respect to the accurate and timely recording, processing,
summarizing and reporting of information required to be disclosed in our
periodic Exchange Act reports. We periodically review and evaluate these
disclosure controls and procedures systems to ensure that such information is
accumulated and communicated to management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow timely decisions
about required disclosure. In completing our review and evaluation of the
effectiveness of our disclosure controls and procedures as of June 30, 2004,
our Chief Executive Officer and Chief Financial Officer have concluded that
these controls and procedures were effective as of June 30, 2004. No changes in
our internal control over financial reporting were identified as having
occurred in the fiscal quarter ended June 30, 2004 that have materially
affected, or are reasonable likely to materially affect, our internal control
over financial reporting. 
 PART II 29




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ITEM 1. LEGAL PROCEEDINGS  See Note 9  Commitments and Contingencies to the Unaudited Condensed
Consolidated Financial Statements in PART I, Item 1 hereto, which is included
elsewhere in this document. 
 ITEM 2. CHANGES IN
SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES  Not applicable. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES  Not applicable. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS  Not applicable. 
 ITEM 5. OTHER INFORMATION  Not applicable. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits Exhibit Number
    
    Description of Exhibit2.1
    
    Agreement and Plan of Merger dated June 29, 2004 between Mariner Health Care,
Inc., National Senior Care, Inc. and NCARE Acquisition Corp. (incorporated herein
by reference to Exhibit 2.1 to the Current Report on Form 8-K/A filed on July 2,
2004).31.1
    
    Rule 13a-14(a)/15d-14(a) Certification of the Chief Executive Officer.31.2
    
    Rule 13a-14(a)/15d-14(a) Certification of the Chief Financial Officer.32.1
    
    Section 1350 Certification of the Chief Executive Officer.32.2
    
    Section 1350 Certification of the Chief Financial Officer.
 (b) Reports on Form 8-K  (1)
    
    The Company filed a Current Report on Form 8-K on May 11, 2004
announcing its financial results for the first quarter of fiscal
2004.(2)
    
    The Company filed a Current Report on Form 8-K on June 29,
2004, announcing the execution of an agreement and plan of merger,
dated as of June 29, 2004 between Mariner Health Care, Inc., National
Senior Care, Inc. and NCARE Acquisition Corp.(3)
    
    The Company filed a Current Report on Form 8-K/A on July 2,
2004, amending the Current Report on Form 8-K filed on June 29, 2004.
The amendment was filed to correct certain typographical errors in
the agreement and plan of merger filed as exhibit to the Current
Report on Form 8-K on June 29, 2004. 30




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SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized. MARINER HEALTH CARE, INC.By:
    
    /s/ C. Christian WinkleC. Christian WinklePresident and Chief Executive Officer
 Date: August 6, 2004 Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated. Signature
    
    Title
    
    Date/s/ C. Christian Winkle

C. Christian Winkle
    
    President, Chief Executive Officer and
Director (Principal Executive Officer)
    
    August 6, 2004/s/ Michael E. Boxer

Michael E. Boxer
    
    Executive Vice President and
Chief Financial Officer (Principal
Financial Officer)
    
    August 6, 2004/s/ Bruce H. Duner

Bruce H. Duner
    
    Senior Vice President, Chief
Accounting Officer (Principal
Accounting Officer)
    
    August 6, 2004
 31