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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 September 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
(State or Other Jurisdiction of
Incorporation or Organization)
    
    74-2012902
(I.R.S. Employer
Identification No.)One Ravinia Drive, Suite 1500
Atlanta, Georgia
(Address of Principal Executive Offices)
    
    30346
(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 20,015,000 shares of Common Stock of the registrant outstanding
as of November 4, 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
    
    
    16Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 4. Controls and Procedures
    
    
    31Part II OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    32Item 2. Changes in Securities, Use of Proceeds and Issuer
    
    
    32Item 3. Defaults Upon Senior Securities
    
    
    32Item 4. Submission of Matters to a Vote of Security Holders
    
    
    32Item 5. Other Information
    
    
    32Item 6. Exhibits and Reports on Form 8-K
    
    
    32EX-31.1 302 Certification of CEOEX-31.2 302 Certification of CFOEX-32.1 906 Certification of CEOEX-32.2 906 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
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    413,103
    
    
    $
    439,789
    
    
    $
    1,229,712
    
    
    $
    1,285,656Costs and expensesOperating expensesWage and related costs
    
    
    237,442
    
    
    
    263,511
    
    
    
    701,098
    
    
    
    767,897Supplies
    
    
    23,179
    
    
    
    25,929
    
    
    
    69,205
    
    
    
    75,733Insurance
    
    
    16,768
    
    
    
    22,579
    
    
    
    49,263
    
    
    
    65,253Provision for bad debt
    
    
    4,507
    
    
    
    4,315
    
    
    
    11,341
    
    
    
    13,572Rent expense
    
    
    8,419
    
    
    
    9,014
    
    
    
    24,770
    
    
    
    26,518Other
    
    
    73,808
    
    
    
    74,149
    
    
    
    218,708
    
    
    
    219,567Total operating expenses
    
    
    364,123
    
    
    
    399,497
    
    
    
    1,074,385
    
    
    
    1,168,540General and administrative
    
    
    27,001
    
    
    
    24,473
    
    
    
    80,717
    
    
    
    70,280Merger related costs
    
    
    4,880
    
    
    
    
    
    
    
    7,023
    
    
    
    Depreciation and amortization
    
    
    10,239
    
    
    
    9,473
    
    
    
    30,430
    
    
    
    27,239Total costs and expenses
    
    
    406,243
    
    
    
    433,443
    
    
    
    1,192,555
    
    
    
    1,266,059Operating income
    
    
    6,860
    
    
    
    6,346
    
    
    
    37,157
    
    
    
    19,597Other (expenses) incomeInterest expense
    
    
    (8,220
    )
    
    
    (8,924
    )
    
    
    (25,926
    )
    
    
    (26,713
    )Interest income
    
    
    756
    
    
    
    710
    
    
    
    2,246
    
    
    
    2,229Other
    
    
    13
    
    
    
    (48
    )
    
    
    (23
    )
    
    
    (99
    )(Loss) income from continuing operations before taxes
    
    
    (591
    )
    
    
    (1,916
    )
    
    
    13,454
    
    
    
    (4,986
    )Income tax provision (benefit)
    
    
    3,415
    
    
    
    (747
    )
    
    
    5,041
    
    
    
    (2,431
    )(Loss) income from continuing operations
    
    
    (4,006
    )
    
    
    (1,169
    )
    
    
    8,413
    
    
    
    (2,555
    )Discontinued operationsGain (loss) on sale of discontinued operations,
net of tax
    
    
    93
    
    
    
    7,200
    
    
    
    (758
    )
    
    
    10,800(Loss) income from discontinued operations, net of tax
    
    
    (1,803
    )
    
    
    48
    
    
    
    (3,791
    )
    
    
    (1,092
    )Net (loss) income
    
    $
    (5,716
    )
    
    $
    6,079
    
    
    $
    3,864
    
    
    $
    7,153(Loss) earnings per share  basic(Loss) income from continuing operations
    
    $
    (0.20
    )
    
    $
    (0.06
    )
    
    $
    0.42
    
    
    $
    (0.13
    )Gain (loss) on sale of discontinued operations
    
    
    
    
    
    
    0.36
    
    
    
    (0.04
    )
    
    
    0.54Loss from discontinued operations
    
    
    (0.09
    )
    
    
    
    
    
    
    (0.19
    )
    
    
    (0.05
    )Net (loss) income per share
    
    $
    (0.29
    )
    
    $
    0.30
    
    
    $
    0.19
    
    
    $
    0.36Weighted average shares outstanding
    
    
    20,013
    
    
    
    20,000
    
    
    
    20,011
    
    
    
    20,000(Loss) earnings per share  diluted(Loss) income from continuing operations
    
    $
    (0.20
    )
    
    $
    (0.06
    )
    
    $
    0.42
    
    
    $
    (0.13
    )Gain (loss) on sale of discontinued operations
    
    
    
    
    
    
    0.36
    
    
    
    (0.04
    )
    
    
    0.54Loss from discontinued operations
    
    
    (0.09
    )
    
    
    
    
    
    
    (0.19
    )
    
    
    (0.05
    )Net (loss) income per share
    
    $
    (0.29
    )
    
    $
    0.30
    
    
    $
    0.19
    
    
    $
    0.36Weighted average shares outstanding
    
    
    20,013
    
    
    
    20,000
    
    
    
    20,432
    
    
    
    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) September 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assetsCash and cash equivalents
    
    $
    46,766
    
    
    $
    41,934Receivables, net of allowance for doubtful accounts of $105,939
and $97,448, respectively
    
    
    213,631
    
    
    
    234,098Prepaid expenses and other current assets
    
    
    22,748
    
    
    
    25,396Total current assets
    
    
    283,145
    
    
    
    301,428Property and equipment, net of accumulated depreciation
of $89,188 and $59,255, respectively
    
    
    530,584
    
    
    
    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
    
    
    16,962
    
    
    
    19,300Other assets
    
    
    35,720
    
    
    
    43,082Total assets
    
    $
    1,065,979
    
    
    $
    1,107,734LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilitiesCurrent maturities of long-term debt
    
    $
    17,183
    
    
    $
    9,663Accounts payable
    
    
    40,699
    
    
    
    69,914Accrued compensation and benefits
    
    
    69,753
    
    
    
    69,330Accrued insurance obligations
    
    
    84,544
    
    
    
    54,315Other current liabilities
    
    
    56,399
    
    
    
    42,202Total current liabilities
    
    
    268,578
    
    
    
    245,424Long-term debt, net of current maturities
    
    
    366,508
    
    
    
    379,973Long-term insurance reserves
    
    
    144,202
    
    
    
    191,124Other liabilities
    
    
    23,251
    
    
    
    31,741Minority interest
    
    
    3,342
    
    
    
    3,319Total liabilities
    
    
    805,881
    
    
    
    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
    
    
    361,083
    
    
    
    360,141Unearned compensation
    
    
    (345
    )
    
    
    (616
    )Accumulated deficit
    
    
    (100,980
    )
    
    
    (104,844
    )Accumulated other comprehensive income
    
    
    140
    
    
    
    337Total stockholders equity
    
    
    260,098
    
    
    
    256,153Total liabilities and stockholders equity
    
    $
    1,065,979
    
    
    $
    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) Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003Cash flows from operating activitiesNet income
    
    $
    3,864
    
    
    $
    7,153Adjustments to reconcile net income to net cash
provided by operating activitiesProvision for bad debts
    
    
    11,923
    
    
    
    11,829Gain from divestitures and sales of property,
equipment and other assets
    
    
    (2,600
    )
    
    
    (10,800
    )Depreciation and amortization
    
    
    30,430
    
    
    
    27,239Amortization of deferred financing costs
    
    
    1,464
    
    
    
    948Stock compensation
    
    
    278
    
    
    
    Minority interest and other
    
    
    23
    
    
    
    99Provision (benefit) for income taxes
    
    
    5,041
    
    
    
    (2,431
    )Loss from discontinued operations
    
    
    3,791
    
    
    
    1,092Changes in operating assets and liabilitiesReceivables
    
    
    6,864
    
    
    
    (17,515
    )Prepaid expenses and other current assets
    
    
    1,613
    
    
    
    (3,073
    )Accounts payable
    
    
    (28,682
    )
    
    
    (7,197
    )Accrued and other current liabilities
    
    
    14,090
    
    
    
    12,613Insurance reserves
    
    
    (16,693
    )
    
    
    19,515Other
    
    
    (8,273
    )
    
    
    (1,078
    )Net cash provided by operating activities from
continuing operations before reorganization items
    
    
    23,133
    
    
    
    38,394Net cash (utilized) provided by discontinued operations
    
    
    (3,872
    )
    
    
    231Payment of reorganization items, net
    
    
    (3,956
    )
    
    
    (7,359
    )Cash flows from investing activitiesPurchases of property and equipment
    
    
    (25,002
    )
    
    
    (52,411
    )Proceeds from divestitures and sales of property,
equipment and other assets
    
    
    12,293
    
    
    
    18,132Restricted investments
    
    
    2,141
    
    
    
    16,727Collections on notes receivable
    
    
    6,040
    
    
    
    369Insurance proceeds
    
    
    
    
    
    
    2,896Net cash utilized by investing activities
    
    
    (4,528
    )
    
    
    (14,287
    )Cash flows from financing activitiesRepayment of long-term debt
    
    
    (5,945
    )
    
    
    (4,498
    )Payment of deferred financing fees
    
    
    
    
    
    
    (1,474
    )Net cash utilized by financing activities
    
    
    (5,945
    )
    
    
    (5,972
    )Increase in cash and cash equivalents
    
    
    4,832
    
    
    
    11,007Cash and cash equivalents, beginning of period
    
    
    41,934
    
    
    
    38,618Cash and cash equivalents, end of period
    
    $
    46,766
    
    
    $
    49,625
 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 September 30, 2004, the Company
operated 252 skilled nursing facilities and two stand-alone assisted living
facilities with an aggregate of 30,614 licensed beds. The Company owns 70% of
its facilities. The Company also operates twelve long-term acute care hospitals
(LTACs) in four states, with 640 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. The parties to the Merger Agreement entered into the
First Amendment (First Amendment) to the Merger Agreement on October 21,
2004. The terms of the First Amendment are summarized in the Current Report on
Form 8-K filed by the Company on October 22, 2004. 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. On October 22, 2004, the Company filed
its definitive proxy statement to obtain shareholder approval of the merger.
The Annual Shareholders meeting to elect directors, amend the bylaws and
approve the merger will be held on November 30, 2004. In connection with the Companys
pending merger with NSC, on November 2, 2004, the Company announced and commenced a cash
tender offer and consent
solicitation for all of its outstanding 8 1/4% Senior Subordinated Notes due
2013. The tender offer and consent solicitation are being made pursuant to an
Offer to Purchase and Consent Solicitation Statement and related Consent and
Letter of Transmittal dated November 2, 2004, which set forth a more detailed
description of the tender offer and consent solicitation. The tender offer
will expire at 5:00 p.m. (EST) on December 1, 2004, unless extended or
terminated and is conditioned on the consummation of the merger. The consent
solicitation will expire at 5:00 p.m. (EST) on November 16, 2004, unless
extended or terminated and is also conditioned on the
consummation of 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 (Loss) Income Comprehensive
(loss) income includes net (loss) income, as well as charges and
credits to stockholders equity not included in net (loss) income. The
components of comprehensive (loss) income, net of income taxes, consist of the
following (in thousands of dollars): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net (loss) income
    
    $
    (5,716
    )
    
    $
    6,079
    
    
    $
    3,864
    
    
    $
    7,153Net unrealized gain (loss) on available-for-sale securities
    
    
    116
    
    
    
    (97
    )
    
    
    (197
    )
    
    
    (80
    )Comprehensive (loss) income
    
    $
    (5,600
    )
    
    $
    5,982
    
    
    $
    3,667
    
    
    $
    7,073
 Reclassifications Certain prior year amounts have been reclassified to conform to the
current period financial statement presentation. NOTE 2 STOCK BASED COMPENSATION As of September 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 (APB) No. 25, Accounting for Stock Issued to
Employees, and related interpretations (APB 25). The Company recognized
stock based compensation expense of $0.05 million and $0.3 million for the
three and nine months ended September 30, 2004, respectively, and there was no
stock based compensation expense for the three and nine months ended September
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, and all rights
associated therewith were terminated. In March 2004, the Financial Accounting Standards Board (FASB) issued an
Exposure Draft of a proposed Statement of Financial Accounting Standards
entitled Share-Based Payment. This proposed Statement addresses accounting
for stock based compensation and would result in stock based compensation
costs, including options, being recognized as an expense in the financial
statements. The proposed Statement would eliminate the ability to account for
stock based compensation transactions using APB No. 25, and generally would
require that such transactions be accounted for using a fair value based
method. In October 2004, the FASB voted to delay the effective date of its
proposed standard such that if approved, the proposed Statement would be
applied prospectively to public entities for awards that are granted, modified
or settled in cash in interim or annual periods beginning after June 15, 2005. The Companys pro forma basic net (loss) income and diluted net (loss)
income 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): 7




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Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net (loss) income
    
    $
    (5,716
    )
    
    $
    6,079
    
    
    $
    3,864
    
    
    $
    7,153Deduct: Pro forma compensation expense, net of tax
    
    
    (1,087
    )
    
    
    (540
    )
    
    
    (3,198
    )
    
    
    (2,242
    )Pro forma net (loss) income
    
    $
    (6,803
    )
    
    $
    5,539
    
    
    $
    666
    
    
    $
    4,911Basic net (loss) income per shareAs reported
    
    $
    (0.29
    )
    
    $
    0.30
    
    
    $
    0.19
    
    
    $
    0.36Pro forma
    
    $
    (0.34
    )
    
    $
    0.28
    
    
    $
    0.03
    
    
    $
    0.25Diluted net (loss) income per shareAs reported
    
    $
    (0.29
    )
    
    $
    0.30
    
    
    $
    0.19
    
    
    $
    0.36Pro forma
    
    $
    (0.34
    )
    
    $
    0.28
    
    
    $
    0.03
    
    
    $
    0.25
 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 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
$1.7 million during the nine months ended September 30, 2004. Changes in
estimates related to third party receivables did not have a material impact on
net revenues for the three months ended September 30, 2004 and the three and
nine months ended September 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 at least a reasonable possibility
that recorded estimates will change by a material amount in the near term. 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
    
    Nine Months EndedSeptember 30, 2004
    
    September 30, 2003
    
    September 30, 2004
    
    September 30, 2003Medicaid
    
    $
    198,887
    
    
    
    48.2
    %
    
    $
    213,845
    
    
    
    48.6
    %
    
    $
    579,889
    
    
    
    47.1
    %
    
    $
    614,753
    
    
    
    47.8
    %Medicare
    
    
    140,617
    
    
    
    34.0
    %
    
    
    145,041
    
    
    
    33.0
    %
    
    
    428,689
    
    
    
    34.9
    %
    
    
    434,916
    
    
    
    33.8
    %Private and other
    
    
    73,599
    
    
    
    17.8
    %
    
    
    80,903
    
    
    
    18.4
    %
    
    
    221,134
    
    
    
    18.0
    %
    
    
    235,987
    
    
    
    18.4
    %Net revenue
    
    $
    413,103
    
    
    
    100.0
    %
    
    $
    439,789
    
    
    
    100.0
    %
    
    $
    1,229,712
    
    
    
    100.0
    %
    
    $
    1,285,656
    
    
    
    100.0
    %
 8




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##### Table of Contents



NOTE 4 DISCONTINUED OPERATIONS AND OTHER DIVESTITURES Discontinued Pharmacy Operations During the nine months ended September 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 $18.0 million, at which time the Company
recorded a gain on sale of $10.8 million, net of taxes of $7.2 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 September 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 nine
months ended September 30, 2004 were $8.0 million at December 31, 2003. In
addition, during the three and nine months ended September 30, 2004, the
Company recorded net gains of $0.5 million and $3.2 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. Operating results for the discontinued operations were as follows for the
periods indicated (in thousands of dollars): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    151
    
    
    $
    11,721
    
    
    $
    6,680
    
    
    $
    35,650Total operating costs and expenses
    
    
    1,954
    
    
    
    11,605
    
    
    
    10,471
    
    
    
    36,540Operating (loss) income
    
    
    (1,803
    )
    
    
    116
    
    
    
    (3,791
    )
    
    
    (890
    )Other expense
    
    
    
    
    
    
    (68
    )
    
    
    
    
    
    
    (202
    )(Loss) income from discontinued operations, net of tax
    
    $
    (1,803
    )
    
    $
    48
    
    
    $
    (3,791
    )
    
    $
    (1,092
    )
 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 need
patients. The Company primarily evaluates segment performance and allocates
resources based on operating profit (loss), 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 (loss),
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 September 30, 2004Revenue from external customers
    
    $
    380,094
    
    
    $
    32,891
    
    
    $
    118
    
    
    $
    413,103Operating profit (loss) (1)
    
    
    43,507
    
    
    
    5,354
    
    
    
    (26,882
    )
    
    
    21,979Depreciation and amortization
    
    
    8,599
    
    
    
    425
    
    
    
    1,215
    
    
    
    10,239Total assets
    
    
    721,485
    
    
    
    31,058
    
    
    
    313,436
    
    
    
    1,065,979Three Months Ended September 30, 2003Revenue from external customers
    
    $
    409,845
    
    
    $
    29,538
    
    
    $
    406
    
    
    $
    439,789Operating profit (loss) (1)
    
    
    35,649
    
    
    
    4,239
    
    
    
    (24,069
    )
    
    
    15,819Depreciation and amortization
    
    
    8,186
    
    
    
    365
    
    
    
    922
    
    
    
    9,473Total assets
    
    
    826,441
    
    
    
    28,357
    
    
    
    348,205
    
    
    
    1,203,003Nine Months Ended September 30, 2004Revenue from external customers
    
    $
    1,131,073
    
    
    $
    98,251
    
    
    $
    388
    
    
    $
    1,229,712Operating profit (loss) (1)
    
    
    140,484
    
    
    
    14,452
    
    
    
    (80,326
    )
    
    
    74,610Depreciation and amortization
    
    
    25,247
    
    
    
    1,222
    
    
    
    3,961
    
    
    
    30,430Total assets
    
    
    721,485
    
    
    
    31,058
    
    
    
    313,436
    
    
    
    1,065,979Nine Months Ended September 30, 2003Revenue from external customers
    
    $
    1,198,049
    
    
    $
    87,571
    
    
    $
    36
    
    
    $
    1,285,656Operating profit (loss) (1)
    
    
    105,947
    
    
    
    11,132
    
    
    
    (70,243
    )
    
    
    46,836Depreciation and amortization
    
    
    23,770
    
    
    
    1,191
    
    
    
    2,278
    
    
    
    27,239Total assets
    
    
    826,441
    
    
    
    28,357
    
    
    
    348,205
    
    
    
    1,203,003
  (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 $6.9 million and $37.2 million for the three
and nine months ended September 30, 2004, respectively, and $6.3 million
and $19.6 million for the three and nine months ended September 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 under 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
September 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCurrent assets
    
    $
    
    
    
    $
    307,182
    
    
    $
    29,974
    
    
    $
    (54,011
    )
    
    $
    283,145Total assets
    
    
    615,336
    
    
    
    950,173
    
    
    
    114,593
    
    
    
    (614,123
    )
    
    
    1,065,979Current liabilities
    
    
    6,281
    
    
    
    248,553
    
    
    
    67,754
    
    
    
    (54,010
    )
    
    
    268,578Total liabilities
    
    
    323,334
    
    
    
    398,864
    
    
    
    137,693
    
    
    
    (54,010
    )
    
    
    805,881Stockholders equity (deficit)
    
    
    292,003
    
    
    
    551,309
    
    
    
    (23,101
    )
    
    
    (560,113
    )
    
    
    260,098
 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 September 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    370,577
    
    
    $
    43,646
    
    
    $
    (1,120
    )
    
    $
    413,103Operating (loss) income
    
    
    (438
    )
    
    
    2,745
    
    
    
    4,553
    
    
    
    
    
    
    
    6,860(Loss) income from continuing operations
before income taxes
    
    
    (6,283
    )
    
    
    4,826
    
    
    
    866
    
    
    
    
    
    
    
    (591
    )Net (loss) income
    
    
    (6,283
    )
    
    
    (296
    )
    
    
    863
    
    
    
    
    
    
    
    (5,716
    )
 CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the three months ended September 30, 2003 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    402,707
    
    
    $
    37,959
    
    
    $
    (877
    )
    
    $
    439,789Operating (loss) income
    
    
    (678
    )
    
    
    2,064
    
    
    
    4,960
    
    
    
    
    
    
    
    6,346(Loss) income from
continuing operations
before income taxes
    
    
    (7,107
    )
    
    
    1,991
    
    
    
    2,727
    
    
    
    473
    
    
    
    (1,916
    )Net (loss) income
    
    
    (7,107
    )
    
    
    9,986
    
    
    
    2,727
    
    
    
    473
    
    
    
    6,079
 11




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##### Table of Contents



CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the nine months ended September 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    1,109,936
    
    
    $
    122,624
    
    
    $
    (2,848
    )
    
    $
    1,229,712Operating (loss) income
    
    
    (1,325
    )
    
    
    21,186
    
    
    
    17,296
    
    
    
    
    
    
    
    37,157(Loss) income from continuing operations
before income taxes
    
    
    (19,443
    )
    
    
    27,801
    
    
    
    5,096
    
    
    
    
    
    
    
    13,454Net (loss) income
    
    
    (19,443
    )
    
    
    18,214
    
    
    
    5,093
    
    
    
    
    
    
    
    3,864
 CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the nine months ended September 30, 2003 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    
    
    
    $
    1,177,483
    
    
    $
    110,612
    
    
    $
    (2,439
    )
    
    $
    1,285,656Operating (loss) income
    
    
    (1,720
    )
    
    
    9,768
    
    
    
    11,549
    
    
    
    
    
    
    
    19,597(Loss) income from continuing operations
before income taxes
    
    
    (20,209
    )
    
    
    9,750
    
    
    
    3,993
    
    
    
    1,480
    
    
    
    (4,986
    )Net (loss) income
    
    
    (20,209
    )
    
    
    21,892
    
    
    
    3,990
    
    
    
    1,480
    
    
    
    7,153
 CONDENSED SELECTED COMBINING STATEMENT OF CASH FLOWS
For the nine months ended September 30, 2004 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    ConsolidatedNet cash provided (utilized) by
operating activities (1)
    
    $
    4,583
    
    
    $
    12,270
    
    
    $
    (1,548
    )
    
    $
    15,305Net cash (utilized) provided by
investing activities
    
    
    
    
    
    
    (6,382
    )
    
    
    1,854
    
    
    
    (4,528
    )Net cash utilized by
financing activities
    
    
    (4,583
    )
    
    
    (360
    )
    
    
    (1,002
    )
    
    
    (5,945
    )Increase (decrease) in cash and
cash equivalents
    
    
    
    
    
    
    5,528
    
    
    
    (696
    )
    
    
    4,832Cash and cash equivalents,
beginning of period
    
    
    
    
    
    
    39,465
    
    
    
    2,469
    
    
    
    41,934Cash and cash equivalents,
end of period
    
    $
    
    
    
    $
    44,993
    
    
    $
    1,773
    
    
    $
    46,766
 12




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##### Table of Contents



CONDENSED SELECTED COMBINING STATEMENT OF CASH FLOWS
For the nine months ended September 30, 2003 Guarantor
    
    Non-GuarantorParent
    
    Subsidiaries
    
    Subsidiaries
    
    ConsolidatedNet cash provided (utilized) by
operating activities (1)
    
    $
    1,590
    
    
    $
    34,680
    
    
    $
    (5,004
    )
    
    $
    31,266Net cash (utilized) provided by
investing activities
    
    
    
    
    
    
    (19,376
    )
    
    
    5,089
    
    
    
    (14,287
    )Net cash (utilized) provided by
financing activities
    
    
    (1,590
    )
    
    
    (4,891
    )
    
    
    509
    
    
    
    (5,972
    )Increase in cash and cash
equivalents
    
    
    
    
    
    
    10,413
    
    
    
    594
    
    
    
    11,007Cash and cash equivalents,
beginning of period
    
    
    
    
    
    
    37,734
    
    
    
    884
    
    
    
    38,618Cash and cash equivalents,
end of period
    
    $
    
    
    
    $
    48,147
    
    
    $
    1,478
    
    
    $
    49,625
  (1)
    
    Net cash provided by operating activities includes net cash
(utilized) provided by discontinued operations and payment of
reorganization items. NOTE 7 VARIABLE INTEREST ENTITIES In January 2003, the FASB 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 $9.8 million, $29.5
million, $9.6 million, and $27.4 million for the three and nine months ended
September 30, 2004 and September 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 September 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 September 30, 2004 is $2.2
million. 13




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##### Table of Contents



NOTE 8 EARNINGS PER SHARE As required by SFAS No. 128, Earnings Per Share, the Company has
presented basic and diluted income per common share amounts in the
accompanying unaudited condensed consolidated financial statements. Basic
income per common share is calculated based on the weighted average
common shares outstanding during the period. Diluted income per common
share is calculated similarly to basic income 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
    
    AmountNine months ended September 30, 2004Basic income per common share
    
    $
    8,413
    
    
    
    20,011
    
    
    $
    0.42Effect of dilutive stock options
    
    
    
    
    
    
    421
    
    
    
    Diluted income per common share
    
    $
    8,413
    
    
    
    20,432
    
    
    $
    0.42
 For the nine months ended September 30, 2004, options to purchase 30,000
shares of common stock at an option price of $21.55 per share were not included
in the computation of diluted income per share because the option price
exceeded the average market price. The options were still outstanding at
September 30, 2004. NOTE 9 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 (SFAS No. 109). For the three and
nine months ended September 30, 2004, no federal income tax provision and a
state income tax provision of $3.4 million and $5.0 million, respectively, was
recorded. The effective tax rates vary from statutory tax rates primarily due
to the utilization of net operating loss (NOL) carryforwards. In addition,
income earned in certain states for which state NOLs are not available and a
revision to the Companys assessment of its NOL position resulted in a higher
effective tax rate in the three and nine months ended September 30, 2004. As of December 31, 2003, the Company had approximately $563.5 million of
NOL carryforwards, utilization of which were 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 to
certain restrictions under Section 382 that apply to a company that emerges
from bankruptcy. The remaining $302.1 million of NOL carryforwards are subject
to the additional Section 382 restrictions in connection with the existence of
net unrealized built-in gain at the time of a December 1999 ownership change
that occurred when the largest shareholder sold its equity interest in the
Company to another entity prior to the Company filing bankruptcy. Utilization
of these NOLs will require the recognition of built-in gain within five years
of such date, or by December 31, 2004. While the Company is 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 $302.1 million of NOL carryforwards
originating prior to the ownership change in December 1999 will be subject to
significant limitation and thus the Companys estimate of their availability
has changed this quarter. Management performed extensive analysis on all
restrictions impacting the NOLs in the current period. While all aspects of
these restrictions
continue to be analyzed, the current period analysis indicated that the state
NOLs utilized in the computation of prior period tax expense should be limited
due to the lack of the generation of built-in gains. As a result, the Company
recorded an additional $2.1 million of state income tax during the three months
ended September 30, 2004. 14




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##### Table of Contents



NOTE 10 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. 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 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. PricewaterhouseCoopers Litigation On July 22, 2004, the Company voluntarily dismissed without prejudice its
complaint in the State Court of Fulton County, Georgia (originally filed in
August 2002) against PricewaterhouseCoopers, LLP (PwC) and several former
officers of MHG (the Individual Defendants) and re-filed the action in the
Superior Court of Fulton County, Georgia. In response, PwC filed motions in
the State Court seeking attorneys fees and expenses relating to the State
Court action and to strike Mariners voluntary dismissal of the State Court
action. On September 30, 2004, the State Court granted PwCs motion to strike
Mariners voluntary dismissal and granted a motion by PwC to dismiss Mariners
complaint with prejudice. The Company believes the Court erred in its rulings
and is considering all available options, including appeal. The State Court action asserted claims for fraud against the Individual
Defendants and claims for fraud and negligent misrepresentation against PwC.
These claims arose from the July 1998 acquisition of MHG by Paragon, one of the
Companys predecessors. The Company sought actual damages (including
compensatory and consequential damages) and punitive damages, in an amount to
be determined at trial. 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 15




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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 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 or third 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. That motion was granted on February 7,
2004 and the first amended complaint was filed on March 16, 2004. Alabama False Claims Act Litigation 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.
On October 27, 2004 the Court granted the Companys motion to dismiss. 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. Formation Notice Letter On October 26, 2004 and October 27, 2004, the Company received notices
from Formation Properties III, LLC (Formation) and its counsel seeking
indemnification under the asset purchase agreement dated as of August 19, 2003
by and among Formation, the Company, and various of its subsidiaries for $10.5
million plus interest. Pursuant to the asset purchase agreement, Formation
purchased a majority of the Companys Florida facilities in the fourth quarter
of 2003. In its notice, Formation alleges breaches of representations,
warranties and covenants contained in the asset purchase agreement with respect
to certain financial statements delivered by the Company pursuant to such
agreement. The asset purchase agreement limits the amount that Formation can
recover on an indemnification claim to $4.0 million unless it is determined
that the Company committed fraud or intentionally and knowingly made a
misrepresentation. Accordingly, Formation also alleges that the Companys
actions constituted fraud and/or an intentional and knowing misrepresentation.
The Company is in the process of evaluating Formations claim. 
 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 onForm 10-Kfor the 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, 16




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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 (loss)
income. 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 (loss) income an important measure
of our financial performance because it provides the most complete measure of
our performance. We define EBITDA as net (loss) income 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 (loss)
income, as defined by GAAP. We also present certain adjustments to EBITDA that exclude (gain) loss on
sale of discontinued operations, net of tax, loss (income) from discontinued
operations, net of tax, and loss (income) 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
(loss) income, 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 252 skilled
nursing facilities and two stand-alone assisted living facilities with an
aggregate of 30,614 licensed beds. We own 70% of our facilities. We also
operate twelve LTACs with 640 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, or 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. The parties to the Merger Agreement entered into the First
Amendment, or the First Amendment, to the Merger Agreement on October 21, 2004.
The terms of the First Amendment are summarized in the Current Report on Form
8-K we filed on October 22, 2004. 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. On October 22, 2004, we filed our
definitive proxy statement to obtain shareholder approval of the merger. The
Annual Shareholders meeting to elect directors, amend the bylaws and approve
the merger will be held on November 30, 2004. 17




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In connection with our
pending merger with NSC, on November 2, 2004, we
announced and commenced a cash tender offer and consent solicitation for all of
our outstanding 8 1/4% Senior Subordinated Notes due 2013. The tender offer and
consent solicitation are being made pursuant to an Offer to Purchase and
Consent Solicitation Statement and related Consent and Letter of Transmittal
dated November 2, 2004, which set forth a more detailed description of the
tender offer and consent solicitation. The tender offer will expire at 5:00
p.m. (EST) on December 1, 2004, unless extended or terminated and is
conditioned on the consummation of the merger. The consent solicitation will
expire at 5:00 p.m. (EST) on November 16, 2004, unless extended or terminated
and is also conditioned on the consummation of the merger. 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 (loss),
depreciation and amortization and total assets for our two reportable segments,
skilled nursing services and LTACs. The operating profit (loss) 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 September 30, 2004Revenue from external customers
    
    $
    380,094
    
    
    $
    32,891
    
    
    $
    118
    
    
    $
    413,103Operating profit (loss) (1)
    
    
    43,507
    
    
    
    5,354
    
    
    
    (26,882
    )
    
    
    21,979Depreciation and amortization
    
    
    8,599
    
    
    
    425
    
    
    
    1,215
    
    
    
    10,239Total assets
    
    
    721,485
    
    
    
    31,058
    
    
    
    313,436
    
    
    
    1,065,979Three Months Ended September 30, 2003Revenue from external customers
    
    $
    409,845
    
    
    $
    29,538
    
    
    $
    406
    
    
    $
    439,789Operating profit (loss) (1)
    
    
    35,649
    
    
    
    4,239
    
    
    
    (24,069
    )
    
    
    15,819Depreciation and amortization
    
    
    8,186
    
    
    
    365
    
    
    
    922
    
    
    
    9,473Total assets
    
    
    826,441
    
    
    
    28,357
    
    
    
    348,205
    
    
    
    1,203,003Nine Months Ended September 30, 2004Revenue from external customers
    
    $
    1,131,073
    
    
    $
    98,251
    
    
    $
    388
    
    
    $
    1,229,712Operating profit (loss) (1)
    
    
    140,484
    
    
    
    14,452
    
    
    
    (80,326
    )
    
    
    74,610Depreciation and amortization
    
    
    25,247
    
    
    
    1,222
    
    
    
    3,961
    
    
    
    30,430Total assets
    
    
    721,485
    
    
    
    31,058
    
    
    
    313,436
    
    
    
    1,065,979Nine Months Ended September 30, 2003Revenue from external customers
    
    $
    1,198,049
    
    
    $
    87,571
    
    
    $
    36
    
    
    $
    1,285,656Operating profit (loss) (1)
    
    
    105,947
    
    
    
    11,132
    
    
    
    (70,243
    )
    
    
    46,836Depreciation and amortization
    
    
    23,770
    
    
    
    1,191
    
    
    
    2,278
    
    
    
    27,239Total assets
    
    
    826,441
    
    
    
    28,357
    
    
    
    348,205
    
    
    
    1,203,003
  (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 $6.9 million and $37.2 million for the three
and nine months ended September 30, 2004, respectively, and $6.3 million
and $19.6 million for the three and nine months ended September 30, 2003,
respectively. 18




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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. 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 at least a
reasonable possibility that recorded estimates may change by a material amount
in the near term. 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 nine months ended September 30, 2004,
we collected net cash of $6.2 million of previously reserved accounts
receivable balances primarily related to facilities divested during the three
months ended December 31, 2003. Our provision for bad debt totaled $4.8
million, $11.9 million, $4.3 million, and $11.8 million for the three and nine
months ended September 30, 2004 and September 30, 2003, respectively, which
represented 1.2%, 1.0%, 1.0%, and 0.9% of net revenue for the respective
periods. Our allowance for doubtful accounts related to patient accounts
receivable was $105.9 million and $97.4 million as of September 30, 2004 and
December 31, 2003 respectively, which represented 35.5% and 30.8% of patient
accounts receivable at September 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 liability 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. Additionally, the Company has experienced an increase in
severity as well as frequency of claims asserted resulting in increased defense
costs. 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 $16.3 million, $47.7 million, $21.6 million,
and $63.1 million for the three and nine months ended September 30, 2004 and
September 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 and defense costs. 19




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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
nine months ended September 30, 2004, no federal income tax provision and a
state income tax provision of $3.4 million and $5.0 million, respectively, was
recorded. The effective tax rates vary from statutory tax rates primarily due
to the utilization of net operating loss, or NOLs, carryforwards. In addition,
income earned in certain states for which state NOLs are not available and a
revision to our assessment of its NOL position resulted in a higher effective
tax rate in the three and nine months ended September 30, 2004. As of December 31, 2003, we had approximately $563.5 million of NOL
carryforwards utilization, of which were 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 to
certain restrictions under Section 382 that apply to a company that emerges
from bankruptcy. The remaining $302.1 million of NOL carryforwards are subject
to the additional Section 382 restrictions in connection with 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. Utilization of these
NOLs will 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 $302.1 million of NOL carryforwards originating prior to
the ownership change in December 1999 will be subject to significant limitation
and thus our estimates of their availability has changed this quarter.
Management performed extensive analysis on all restrictions impacting the NOLs
in the current period. While all aspects of these restrictions continue to be
analyzed, the current period analysis indicated that the state NOLs utilized in
our computation of prior period tax expense should be limited due to the lack
of the generation of built-in gains. As a result, we recorded an additional
$2.2 million of state income tax during the three months ended September 30,
2004. The provision for income taxes is based upon our estimate of taxable
income or loss for each respective accounting period. We 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 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. If there is a cumulative ownership change involving share holders 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 20




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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 estimated
useful life 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 accordance with SFAS No.142, Goodwill and Other Intangible Assets,
(SFAS No. 142), 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. 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 21




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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 $9.8 million, $29.5
million, $9.6 million, and $27.4 million for the three and nine months ended
September 30, 2004 and September 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 September 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 September 30, 2004 is $2.2 million. 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
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    413,103
    
    
    $
    439,789
    
    
    $
    1,229,712
    
    
    $
    1,285,656Costs and expensesOperating expensesWage and related costs
    
    
    237,442
    
    
    
    263,511
    
    
    
    701,098
    
    
    
    767,897Supplies
    
    
    23,179
    
    
    
    25,929
    
    
    
    69,205
    
    
    
    75,733Insurance
    
    
    16,768
    
    
    
    22,579
    
    
    
    49,263
    
    
    
    65,253Provision for bad debt
    
    
    4,507
    
    
    
    4,315
    
    
    
    11,341
    
    
    
    13,572Rent expense
    
    
    8,419
    
    
    
    9,014
    
    
    
    24,770
    
    
    
    26,518Other
    
    
    73,808
    
    
    
    74,149
    
    
    
    218,708
    
    
    
    219,567Total operating expenses
    
    
    364,123
    
    
    
    399,497
    
    
    
    1,074,385
    
    
    
    1,168,540General and administrative
    
    
    27,001
    
    
    
    24,473
    
    
    
    80,717
    
    
    
    70,280Merger related costs
    
    
    4,880
    
    
    
    
    
    
    
    7,023
    
    
    
    Depreciation and amortization
    
    
    10,239
    
    
    
    9,473
    
    
    
    30,430
    
    
    
    27,239Total costs and expenses
    
    
    406,243
    
    
    
    433,443
    
    
    
    1,192,555
    
    
    
    1,266,059Operating income
    
    
    6,860
    
    
    
    6,346
    
    
    
    37,157
    
    
    
    19,597Other (expenses) incomeInterest expense
    
    
    (8,220
    )
    
    
    (8,924
    )
    
    
    (25,926
    )
    
    
    (26,713
    )Interest income
    
    
    756
    
    
    
    710
    
    
    
    2,246
    
    
    
    2,229Other
    
    
    13
    
    
    
    (48
    )
    
    
    (23
    )
    
    
    (99
    )(Loss) income from continuing operations before taxes
    
    
    (591
    )
    
    
    (1,916
    )
    
    
    13,454
    
    
    
    (4,986
    )Income tax provision (benefit)
    
    
    3,415
    
    
    
    (747
    )
    
    
    5,041
    
    
    
    (2,431
    )(Loss) income from continuing operations
    
    
    (4,006
    )
    
    
    (1,169
    )
    
    
    8,413
    
    
    
    (2,555
    )Discontinued operationsGain (loss) on sale of discontinued operations,
net of tax
    
    
    93
    
    
    
    7,200
    
    
    
    (758
    )
    
    
    10,800(Loss) income from discontinued operations, net of tax
    
    
    (1,803
    )
    
    
    48
    
    
    
    (3,791
    )
    
    
    (1,092
    )Net (loss) income
    
    $
    (5,716
    )
    
    $
    6,079
    
    
    $
    3,864
    
    
    $
    7,153
 22




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Reconciliation of EBITDA to net income (in thousands of dollars) Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net (loss) income
    
    $
    (5,716
    )
    
    $
    6,079
    
    
    $
    3,864
    
    
    $
    7,153Add back:Provision (benefit) for income taxes
    
    
    3,415
    
    
    
    (747
    )
    
    
    5,041
    
    
    
    (2,431
    )Interest expense
    
    
    8,220
    
    
    
    8,924
    
    
    
    25,926
    
    
    
    26,713Interest income
    
    
    (756
    )
    
    
    (710
    )
    
    
    (2,246
    )
    
    
    (2,229
    )Depreciation and amortization
    
    
    10,239
    
    
    
    9,473
    
    
    
    30,430
    
    
    
    27,239EBITDA (1)
    
    $
    15,402
    
    
    $
    23,019
    
    
    $
    63,015
    
    
    $
    56,445
 (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.
This is our 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 $22.5
million, $16.8 million, $74.6 million, and $49.1 million for the three months
ended September 30, 2004 and 2003 and the nine months ended September 30, 2004
and 2003, respectively. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(Gain) loss on sale of discontinued operations, net of tax
    
    $
    (93
    )
    
    $
    (7,200
    )
    
    $
    758
    
    
    $
    (10,800
    )Loss (income) from discontinued operations, net of tax
    
    
    1,803
    
    
    
    (48
    )
    
    
    3,791
    
    
    
    1,092Loss (income) from operations of divested facilities (2)
    
    
    504
    
    
    
    1,037
    
    
    
    (36
    )
    
    
    2,326Merger related costs
    
    
    4,880
    
    
    
    
    
    
    
    7,023
    
    
    
    Increase (decrease) to EBITDA
    
    $
    7,094
    
    
    $
    (6,211
    )
    
    $
    11,536
    
    
    $
    (7,382
    )
 (2) The loss from operations of divested facilities relates to divestitures
of facilities that did not qualify for discontinued operations
presentation. Three Months Ended September 30, 2004 Compared to the Three Months Ended September 30, 2003 We reported net revenues of $413.1 million during the quarter ended
September 30, 2004, compared to $439.8 million for the quarter ended September
30, 2003. The decrease of $26.7 million, or 6.1%, consists primarily of the
following:  
    
    A decrease of $49.3 million related to divested facilities that do
not qualify for discontinued operations presentation.
    
    An increase of $19.5 million in skilled nursing facilities we
operated as of September 30, 2004, or same facility operations. This
increase is due primarily to:  
    
    A net increase of $10.9 million in Medicaid revenues due
primarily to a rate increase averaging $7.50 per patient day resulting
in a $12.2 million increase in revenues, which was partially offset by
a decrease in patient days of 10,978, or 0.7% resulting in a decrease
in revenues of $1.3 million. The rate increase was primarily due to an
increase of $10.8
million associated with the provider tax based Medicaid rate increases in
Alabama, California, Georgia, Michigan, Mississippi, and North Carolina.
The provider tax paid in connection with these programs offsets a
portion of the revenue and is included in other operating expenses. 23




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
    
    A net increase of $5.7 million in Medicare revenues due primarily
to a rate increase of $25.88 per patient day resulting in a $8.0
million increase in revenues offset by a decrease in patient days of
7,608, or 2.4% resulting in a $2.3 million decrease in revenues. The
rate increase is due primarily to the October 1, 2003 final rules for
Medicare Prospective Payment System (PPS) for the federal
governments 2004 fiscal year, which consisted of an annual market
basket increase effective October 1, 2003 and an upward adjustment in
base rates to correct previous forecast errors.
    
    A net increase of $2.9 million in private and other revenues due
to an increase in rate of $16.11 per patient day resulting in a $6.8
million increase in revenues, which was partially offset by a decrease
in patient days of 22,392, or 5.0% that resulted in a $3.9 million
reduction of revenues. The increase in rate was attributable to a
favorable change in payor mix. The reduction in days is due primarily
to the market for private payors continuing to shift to assisted
living facilities.  
    
    An increase of $3.4 million related to LTAC revenues primarily
related to an increase in total patient days of 1,536, or 5.4% resulting
in a $1.6 million increase in revenues and an increase in the average
rate per patient day of $58.62 resulting in an increase in revenues of
$1.8 million. The rate increase is due primarily to a 3.1% Medicare
federal rate increase and a 5.5% increase in the Medicare budget
neutrality rate factor in July 2004. Operating Expenses We reported operating expenses of $364.1 million during the quarter ended
September 30, 2004, compared to $399.5 million during the quarter ended
September 30, 2003. The decrease of $35.4 million, or 8.9% primarily relates to
the following:  
    
    Wage and related costs decreased $26.1 million due primarily to:  
    
    A decrease of $29.3 million related to divested facilities that do not qualify for discontinued operations presentation.  
    
    A partially offsetting increase in same facility operations and
LTAC of $3.2 million, primarily related to annual salary and benefit
cost increases and an increase in workers compensation expenses.  
    
    Supplies decreased $2.8 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 $5.8 million due primarily to:  
    
    A decrease of $7.3 million related to divested facilities that do not qualify for discontinued operations presentation.  
    
    An increase of $1.5 million in same facility operations and LTAC due primarily to rising PL/GL costs.  
    
    Other operating expenses decreased $0.3 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 $9.4 million of other operating expenses in same
facility operations and LTAC due primarily to:  
    
    An increase of $3.4 million for provider tax expense related to
state Medicaid programs in Alabama, California, Georgia, Michigan,
Mississippi, and North Carolina. The provider tax partially offsets
Medicaid revenues.
    
    An increase of $6.9 million primarily related to certain
contracted and ancillary services that are now outsourced such as
physical, speech and occupational therapy and housekeeping and
laundry that were previously performed by salaried employees. 24




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##### Table of Contents



General and Administrative We reported general and administrative expenses of $27.0 million during
the quarter ended September 30, 2004, compared to $24.5 million during the
quarter ended September 30, 2003. The increase of $2.5 million, or 10.2%,
relates primarily to the following:  
    
    An increase of $1.2 million primarily related to increases in wage
and related costs.  
    
    The remaining net increase of $1.3 million relates to miscellaneous
expenses, including 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 $4.9 million during the quarter ended
September 30, 2004. The merger related costs consist primarily of professional
and legal expenses related to our pending merger. Depreciation and Amortization We reported depreciation and amortization expense of $10.2 million during
the quarter ended September 30, 2004, compared to $9.5 million during the
quarter ended September 30, 2003. The increase of $0.7 million, or 7.4%,
primarily relates to the following:  
    
    An increase of $1.2 million related to incremental depreciation
expense on capital expenditures in same facility operations, LTAC and
corporate locations.  
    
    A decrease of $0.4 million due to the divested facilities that do not
qualify for discontinued operations presentation. Interest Expense We reported interest expense of $8.2 million during the quarter ended
September 30, 2004, compared to $8.9 million during the quarter ended September
30, 2003. The decrease of $0.7 million, or 7.9%, 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) income from Discontinued Operations On July 23, 2003, we earned and received $12.0 million as the final
payment 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. at which time we recorded a gain of $7.2 million, net of
taxes of $4.8 million. 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
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    151
    
    
    $
    11,721
    
    
    $
    6,680
    
    
    $
    35,650Total operating costs and expenses
    
    
    1,954
    
    
    
    11,605
    
    
    
    10,471
    
    
    
    36,540Operating (loss) income
    
    
    (1,803
    )
    
    
    116
    
    
    
    (3,791
    )
    
    
    (890
    )Other expense
    
    
    
    
    
    
    (68
    )
    
    
    
    
    
    
    (202
    )(Loss) income from discontinued operations, net of tax
    
    $
    (1,803
    )
    
    $
    48
    
    
    $
    (3,791
    )
    
    $
    (1,092
    )
 25




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Nine Months Ended September 30, 2004 Compared to the Nine Months Ended September 30, 2003 We reported net revenues of $1,229.7 million during the nine months ended
September 30, 2004, compared to $1,285.7 million for the nine months ended
September 30, 2003. The decrease of $56.0 million, or 4.4%, consists primarily
of the following:  
    
    A decrease of $146.4 million related to divested facilities that do
not qualify for discontinued operations presentation.  
    
    An increase of $79.4 million in skilled nursing facilities we
operated as of September 30, 2004, or same facility operations. This
increase is due primarily to:  
    
    A net increase of $36.0 million in Medicaid revenues due
primarily to a rate increase averaging $8.27 per patient day resulting
in a $39.4 million increase in revenues, which was partially offset by
a decrease in patient days of 30,488, or 0.6% resulting in decrease in
revenues of $3.4 million. The rate increase was primarily due to an
increase of $30.5 million associated with the provider tax based
Medicaid rate increases in Alabama, California, Georgia, Michigan,
Mississippi, and North Carolina. 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 nine
months ended September 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 $29.5 million in Medicare revenues due primarily
to a rate increase averaging $26.34 per patient day resulting in a
$25.6 million increase in revenues and an increase in patient days of
13,171, or 1.4% resulting in a $3.9 million increase in revenues. The
rate increase is due primarily to the October 1, 2003 final rules for
Medicare Prospective Payment System (PPS) for the federal
governments 2004 fiscal year, which consisted of an annual market
basket increase effective October 1, 2003 and an upward adjustment in
base rates to correct previous forecast errors. The increase in
patient days was a direct result of our focus on attracting a higher
acuity patient population.  
    
    A net increase of $13.9 million in private and other revenues due
to an increase in rate of $18.32 per patient day resulting in a $23.2
million increase in revenues, which was partially offset by a decrease
in patient days of 54,392, or 4.1% that resulted in a $9.3 million
reduction of revenues. The increase in rate was attributable to a rate
increase we made in July 2003 and to a favorable change in payor mix.
The reduction in days is due primarily to the market for private
payors shifting to assisted living facilities.  
    
    An increase of $10.7 million related to LTAC revenues related to an
increase in total patient days of 8,874, or 10.0% resulting in a $8.8
million increase in revenues and an increase in rate of $19.53 resulting
in a $1.9 million increase in revenues. The increase in patient days is
due to an increase of additional licensed beds and additional admitting
physicians and the increase in rate is due to an 8.6% rate increase in
Medicare during July 2004. Operating Expenses We reported operating expenses of $1,074.4 million during the nine months
ended September 30, 2004, compared to $1,168.5 million during the nine months
ended September 30, 2003. The decrease of $94.1 million, or 8.0% primarily
relates to the following:  
    
    Wage and related costs decreased $66.8 million due primarily to:  
    
    A decrease of $85.8 million related to divested facilities that do not qualify for discontinued operations presentation.  
    
    A partially offsetting net increase in same facility operations
and LTAC of $19.0 million, primarily related to annual salary and
benefit cost increases and an increase in workers compensation
expenses.  
    
    Supplies decreased $6.5 million due primarily to:  
    
    A decrease of $7.7 million related to divested facilities that do not qualify for discontinued operations presentation.  
    
    A net increase of $1.2 million in supplies expense for same facility operations and LTAC. 26




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##### Table of Contents




    
    Insurance, which consists primarily of professional and general
liability insurance costs, decreased $16.0 million due primarily to:  
    
    A decrease of $21.9 million related to divested facilities that do not qualify for discontinued operations presentation.  
    
    A net increase of $5.9 million in same facility operations and LTAC due primarily to rising PL/GL costs.  
    
    Provision for bad debt decreased $2.2 million primarily due to:  
    
    A decrease of $3.9 million related to divested facilities that do not qualify for discontinued operations presentation.  
    
    An increase of $1.7 million in same facility operations and LTAC.  
    
    Rent expense decreased $1.7 million primarily due to a $1.9 million
decrease related to divested facilities that do not qualify for
discontinued operations presentation.  
    
    Other operating expenses decreased $0.9 million primarily related to:  
    
    A decrease of $30.5 million of other operating expense related to
divested facilities that do not qualify for discontinued operations
presentation.  
    
    An increase of $29.6 million of other operating expenses in same
facility operations and LTAC due primarily to:  
    
    An increase of $9.7 million for provider tax expense related to
state Medicaid programs in Alabama, California, Georgia, Michigan,
Mississippi, and North Carolina. The provider tax partially offsets
Medicaid revenues. 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
nine months ended September 30, 2004 for this retroactive adjustment.
The provider tax partially offsets Medicaid revenues.  
    
    A net increase of $12.2 million primarily related to certain
contracted and ancillary services that are now outsourced such as
physical, speech and occupational therapy and housekeeping and
laundry that were previously performed by salaried employees. General and Administrative We reported general and administrative expenses of $80.7 million during
the nine months ended September 30, 2004, compared to $70.3 million during the
nine months ended September 30, 2003. The increase of $10.4 million, or 14.8%,
relates primarily to the following:  
    
    An increase of $3.2 million primarily related to increases in wage
and related costs.  
    
    The remaining net increase of $7.2 million relates to miscellaneous
expenses, including 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 $7.0 million during the nine months
ended September 30, 2004. The merger related costs consist primarily of
professional and legal expenses related to our pending merger. Depreciation and Amortization We reported depreciation and amortization expense of $30.4 million during
the nine months ended September 30, 2004, compared to $27.2 million during the
nine months ended September 30, 2003. The increase of $3.2 million, or 11.8%,
primarily relates to the following: 27




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
    
    An increase of $4.8 million related to incremental depreciation
expense on capital expenditures in same facility operations, LTAC and at
corporate locations.  
    
    A decrease of $1.6 million due to the divested facilities that do not
qualify for discontinued operations presentation. Discontinued Operations Gain on Sale of Discontinued Operations During the nine months ended September 30, 2003, we earned and received
the Earnout Payments in connection with the sale of the institutional pharmacy
services business, or APS Division to Omnicare, Inc. of $18.0 million, at which
time we recorded a gain of $10.8 million, net of taxes of $7.2 million. Liquidity and Capital Resources At September 30, 2004, we had working capital of $14.6 million and cash
and cash equivalents of $46.8 million, compared to working capital of $56.0
million and cash and cash equivalents of $41.9 million at December 31, 2003.
The $41.4 million decrease in working capital related primarily to an increase
in current maturities of long-term debt related to capital leases, an increase
of payments of costs and expenses, and an increase in expected amounts to be
paid in the next twelve months related to PL/GL costs and expenses. Net cash
provided by operating activities of continuing operations was $23.1 million and
$38.4 million for the nine months ended September 30, 2004 and 2003,
respectively. This decrease of $15.3 million relates primarily to the timing of
payments of accounts payable and an increase in PL/GL settlement and cost
payments for the nine months ended September 30, 2004. Total purchases of property and equipment, including expenditures related
to our information technology infrastructure, were $25.0 million for the nine
months ended September 30, 2004 and we project future expenditures to be
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 September 30, 2004 were $32.3 million. At September 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 September 30, 2004. Long-term debt at September 30, 2004
aggregated $383.7 million compared to $389.6 million at December 31, 2003. The
decrease of $5.9 million relates primarily to a repayment of our term loan of
$4.6 million. There were no outstanding borrowings under the Senior Credit
Facility at September 30, 2004 although we had net letters of credit
outstanding of $44.5 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 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 $28.0 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 28




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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 $4.9 and $7.0 million
merger related costs during the three and nine months ended September 30, 2004
and we expect to incur an additional $6.0 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 nine months
ended September 30, 2004 and September 30, 2003, we derived 82.2%, 82.0%,
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, 2005, 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 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 29




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future, could have a material adverse effect on our financial
condition. In spite of the fact that we exited the State of Florida in the
three months ended December 31, 2003, we will continue to be subject to claims
arising from our prior operations for at least an additional year.
Additionally, the enactment of Texas and Mississippi 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 $9.2 million, $27.0
million, $9.8 million, and $29.2 million for the three and nine months ended
September 30, 2004 and September 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 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 30




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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 September 30, 2004, the fair value of our fixed rate long-term debt
exceeded its carrying value by $15.3 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 September 30,
2004, our Chief Executive Officer and Chief Financial Officer have concluded
that these controls and procedures were effective as of September 30, 2004. No
changes in our internal control over financial reporting were identified as
having occurred in the fiscal quarter ended September 30, 2004 that have
materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting. Pursuant to the Sarbanes-Oxley Act of 2002, we will be required to include
in our Annual Report on Form 10-K, beginning with the Annual Report on Form
10-K for the year ending December 31, 2004, a report by management as to the
effectiveness of 31




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our internal controls over financial reporting. Our
independent auditors will be required to attest to, and report on, this
evaluation by management. We have devoted, and continue to devote, substantial resources toward
fulfilling our obligations in a timely manner. Notwithstanding that, however,
management and the Audit Committee have received a letter from our independent
accountants expressing concern that we may not be able to complete the required
processes and procedures in sufficient time, or in time to allow our
independent auditors the ability to complete their required assessment, and
report prior to the deadline for such disclosure. Management is taking steps
to ensure that such processes and procedures are completed in a timely manner,
but we can provide no assurances that we will meet this objective. In the event that the pending merger with NSC is completed during the
fourth quarter of 2004, we expect that we will no longer be required to file
periodic reports pursuant to the Securities Exchange Act of 1934, as amended,
and will therefore not be required file an Annual Report on 10-K. 
 PART II 
 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, particularly with respect to the
recent dismissal with prejudice of the litigation brought by us
against PricewaterhouseCoopers, LLP and the receipt by us of a notice of a claim for
indemnification from Formation Properties III, LLC. 
 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.
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(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.(4)
    
    The Company filed a Current Report on Form 8-K on August 9, 2004
announcing its financial results for the second quarter of fiscal 2004.(5)
    
    The Company filed a Current Report on Form 8-K on October 15, 2004
announcing the dismissal of the PricewaterhouseCoopers, LLP litigation
discussed in the Legal Proceedings Section of the Companys Form 10-K
filed March 15, 2004.(6)
    
    The Company filed a Current Report on Form 8-K on October 22, 2004
announcing the first amendment entered into on October 21, 2004 to the
merger agreement dated June 29, 2004 between the Company, National Senior
Care, Inc. and NCARE Acquisition Corp. 33




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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: November 4, 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)
    
    November 5, 2004/s/ Michael E. Boxer

Michael E. Boxer
    
    Executive Vice President and
Chief Financial Officer
(Principal
Financial Officer)
    
    November 5, 2004/s/ Bruce H. Duner

Bruce H. Duner
    
    Senior Vice President, Chief
Accounting Officer
(Principal Accounting Officer)
    
    November 5, 2004
 34