UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

| | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| | ------------------------------------------------------------------------------------

| | FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2006
| | --------------------------------------------

OR

| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| | ----------------------------------------------------------------------------------------

For
  the transition period from ________________ to ________________

Commission
  File Number 000-50351

Genesis HealthCare Corporation

(Exact name of Registrant as specified in its charter)



| | Pennsylvania(State or other jurisdiction ofincorporation or organization) | 101 East State StreetKennett Square, PA 19348(Address of principal executiveoffices including zip code) | 20-0023783(I.R.S. EmployerIdentification Number) | 
| | ------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------- | ------------------------------------------------ | 

(610) 444-6350

(Registrants telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:



Title of each class

        Name of each exchange on which registeredCommon Stock, par value $.01 per sharePreferred Share Purchase Rights, no par value per share

        NASDAQ Stock Market LLC


Securities registered pursuant to Section 12(g) of the Act:

NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.



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YESNO

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

YESNO

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.

YESNO

Indicate
  by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation
  S-K is not contained herein, and will not be contained, to the best of registrants
  knowledge, in definitive proxy or reports incorporated by reference in Part
  III of this Form 10-K or any amendment to this Form 10-K.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Act. (Check one):

Large
  accelerated filerAccelerated
  filerNon-accelerated
  filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YESNO

The aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant is $867,073,381.(1)  As of December 1, 2006, 19,733,122 shares of the registrants common stock were outstanding, including 131,545 shares currently held in escrow to be issued in connection with the registrants joint plan of reorganization confirmed by the Bankruptcy Court on September 20, 2001.

APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

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.(2)

YESNO

DOCUMENTS INCORPORATED BY REFERENCE

NONE



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(1)

        The aggregate market value of the voting and non-voting common stock set forth above equals the number of shares of the registrants common stock outstanding, reduced by the number of shares of common stock held by officers, directors and shareholders owning in excess of 10% of the registrants common stock, multiplied by the last reported sale price for the registrants common stock on the most recently completed second fiscal quarter. The information provided shall in no way be construed as an admission that any officer, director or 10% shareholder of the registrant may or may not be deemed an affiliate of the registrant or that he/she/it is the beneficial owner of the shares reported as being held by him/her/it, and any such inference is hereby disclaimed. The information provided herein is included solely for record keeping purposes of the
Securities and Exchange Commission.


(2)

        In 2000, prior to the creation of the registrant, a substantial majority of the registrants subsidiaries filed for relief under Chapter 11 of the Bankruptcy Code and emerged from such proceeding in 2001.







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INDEX



Cautionary
          Statements Regarding Forward-Looking Statements
      1PART
          IITEM
          1:
      
      BUSINESS
      3ITEM
          1A:
      
      RISK
          FACTORS
      19ITEM
          1B:
      
      UNRESOLVED
          STAFF COMMENTS
      28ITEM
          2:
      
      PROPERTIES
      29ITEM
          3:
      
      LEGAL
          PROCEEDINGS
      30ITEM
          4:
      
      SUBMISSION
          OF MATTERS TO A VOTE OF SECURITY HOLDERS
      30ITEM
          4A:
      
      EXECUTIVE
          OFFICERS OF THE REGISTRANT
      30PART
          IIITEM
          5:
      
      MARKET
          FOR THE REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS
          AND ISSUER PURCHASES OF EQUITY SECURITIES
      32ITEM
          6:
      
      SELECTED
          FINANCIAL DATA
      33ITEM
          7:
      
      MANAGEMENTS
          DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
      34ITEM
          7A:
      
      QUANTITATIVE
          AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
      58ITEM
          8:
      
      FINANCIAL
          STATEMENTS AND SUPPLEMENTARY DATA
      59ITEM
          9:
      
      CHANGES
          IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
      104ITEM
          9A:
      
      CONTROLS
          AND PROCEDURES
      104ITEM
          9B:
      
      OTHER
          INFORMATION
      106PART
          IIIITEM
          10:
      
      DIRECTORS
          AND EXECUTIVE OFFICERS OF THE REGISTRANT
      106ITEM
          11:
      
      EXECUTIVE
          COMPENSATION
      106ITEM
          12:
      
      SECURITY
          OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
          MATTERS
      107ITEM
          13:
      
      CERTAIN
          RELATIONSHIPS AND RELATED TRANSACTIONS
      107ITEM
          14:
      
      PRINCIPAL
          ACCOUNTANT FEES AND SERVICES
      107PART
          IVITEM
          15:
      
      EXHIBITS AND FINANCIAL STATEMENT SCHEDULE
      108




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Cautionary Statements Regarding Forward-Looking Statements

As used herein, unless the context otherwise requires, all references to GHC, the Company, we, our, us, and similar terms in this report refer to Genesis HealthCare Corporation together with its subsidiaries. All references to NCI in this report refer to NeighborCare, Inc. together with its subsidiaries, our parent prior to December 1, 2003.

Statements made in this report, and in our other public filings and releases, which are not historical facts, contain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) that involve risks and uncertainties and are subject to change at any time. These forward-looking statements may include, but are not limited to:



        statements contained in Risk Factors;




        statements contained in Business concerning contract renewals, government regulations and the Medicare and Medicaid programs, reimbursement for services provided, demographic trends, strategy, competitive strengths, corporate integrity programs, insurance coverage and insurance reserves, environmental matters and legal proceedings;




        Statements contained in Properties concerning our anticipated level of capital expenditures in fiscal 2007;




        statements
          contained in Managements Discussion and Analysis of Financial
          Condition and Results of Operations, and the notes to our consolidated
          financial statements, such as demographic trends and our ability to
          take advantage of such demographic trends; the expected impact to our
          effective tax rate if certain credits are reinstated; our ability to
          meet our working capital requirements, debt service, and future cash
          needs; capital sources; estimated levels in fiscal 2007 of capital expenditures,
          stock-based compensation and expenses for asset retirement obligations;
          debt and lease requirements; our potential extension of credit to our
          joint venture partners; the expected changes in and effects of government
          legislation, regulation and funding on our business; estimates in our
          pro forma financial data and critical accounting policies, including
          the adequacy of our allowance for doubtful accounts, any anticipated
          impact of long-lived asset impairments and our ability to provide for
          outstanding losses and loss expenses for self-insured programs and legal
          proceedings; and the estimated impact of new accounting pronouncements
          upon their adoption;




        statements contained in Quantitative and Qualitative Disclosures About Market Risk; and




        statements contained in Legal Proceedings regarding the effects of litigation.


The forward-looking statements involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond our control. You are cautioned that these statements are not guarantees of future performance and that actual results and trends in the future may differ materially.

Factors that could cause actual results to differ materially include, but are not limited to, the following:



        changes in the reimbursement rates or methods of payment from Medicare and Medicaid, including those described herein, or the implementation of other measures to reduce the reimbursement for our services;




        the expiration of enactments providing for additional governmental funding;




        the impact of federal and state regulations;




        changes in case mix, payor mix and payment methodologies;




        competition in our businesses;




        the capital intensive nature of our inpatient services segment and the need for extensive capital expenditures in order to modernize and improve our physical infrastructure;




        an increase in insurance costs and potential liability for losses not covered by, or in excess of, our insurance;


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

        competition for, and availability of, qualified staff in the healthcare industry, and risks of potential labor strikes;




        our ability to control operating costs and generate sufficient cash flow to meet operational and financial requirements;




        our ability, and the ability of our subsidiary guarantors, to fulfill debt obligations;




        our
          covenants and restrictions contained in financing agreements which limit
          our discretion in the operation of our business and financing activities;




        the economic condition of, or changes in the laws affecting, our business in those markets in which we operate;




        our ability to realize tax benefits relating to our estimated net operating loss carryforwards;




        the increasing cost of being a publicly owned company and our ability to provide reasonable assurance of the effectiveness of our internal controls over financial reporting;




        the impact of new accounting pronouncements;




        the impact of implementing new information systems;




        the impact of acquisitions, and our ability to integrate acquired businesses, on our operations and finances;




        our charter documents and the Pennsylvania Business Corporation Law of 1988, as amended, which could delay or prevent a change of control;



      the
          ability to implement and achieve certain performance improvement objectives
          in our rehabilitation therapy services segment;




        the difficulty in evaluating certain of our financial information due to the spin-off;




        federal income tax liabilities and indemnification obligations related to the spin-off; and




        acts of God or public authorities, war, civil unrest, terrorism, fire, floods, earthquakes and other matters beyond our control.


In addition to these factors and any risks and uncertainties specifically identified in the text surrounding forward-looking statements, any statements in this report or the reports and other documents filed by us with the SEC that warn of risks or uncertainties associated with future results, events or circumstances also identify factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements.

We do not undertake any obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as may be required under applicable securities law.

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PART I

ITEM 1:BUSINESS

Description of Our Business

Genesis HealthCare Corporation was incorporated in May 2003 as a Pennsylvania corporation. On December 1, 2003, NCI completed the distribution (the spin-off) of our common stock. Our common stock began trading publicly on the NASDAQ Global Market System on December 2, 2003 under the symbol GHCI.

We are one of the largest providers of healthcare and support services to the elderly in the United States. Within our network of geographically concentrated facilities, we offer services focusing on the primary medical, physical and behavioral issues facing the medically complex elderly population.

Our business is comprised of two primary business segments: inpatient services and rehabilitation therapy services. These segments are supported by complementary service capabilities.

Approximately 90% of our net revenues are generated through inpatient services. Our inpatient services are offered through a network of skilled nursing and assisted living centers primarily located in the eastern United States. We currently own, lease, manage or jointly own 210 eldercare facilities, consisting of 176 skilled nursing facilities, 26 assisted living facilities and 8 transitional care units collectively having 25,800 beds.

Our rehabilitation therapy services business, which represents approximately 8% of our net revenues, provides an extensive range of rehabilitation therapy services to the elderly, including speech pathology, physical therapy and occupational therapy principally in our inpatient market concentrations.

We also provide other complementary healthcare services, the revenues for which are included in all other services revenues in our segment financial information.

Inpatient Services Segment

Our
  eldercare centers are located in the following 12 states: Connecticut, Delaware,
  Maryland, Massachusetts, New Hampshire, New Jersey, North Carolina, Pennsylvania,
  Rhode Island, Vermont, Virginia and West Virginia. Approximately 80% of our
  beds are concentrated in the states of Pennsylvania, New Jersey, Maryland, Massachusetts
  and West Virginia.

Through our physicians, nurses, therapists and other members of our interdisciplinary medical care team, we apply a comprehensive approach to the complex needs facing the elderly, which we believe has resulted in above industry average occupancy levels and an enhanced level of Medicare, insurance and private paying patients. We receive higher rates of reimbursement from Medicare and private paying patients. For the twelve months ended September 30, 2006, the average occupancy level in our inpatient facilities was approximately 91%, and approximately 48% of our net revenues were from Medicare, insurance and private paying patients.

We employ physicians, physician assistants and nurse practitioners who are primarily involved in providing medical direction and/or direct patient care at each center. The emphasis on physician leadership is a strength that differentiates us from many other long-term care companies. In addition to physician executives, nursing center medical directors are administratively and clinically accountable for clinical care and quality improvement. The nursing center medical directors are dually accountable to the administrator and the physician executive. This medical staff structure allows for significant involvement of physicians at all levels of the organization thus ensuring that an emphasis on quality care is maintained. Directed by a senior nurse executive, we maintain a corporate quality improvement program to enhance and improve continuously the care provided in each center. In addition to
clinical care, our centers provide our customers with dietary, housekeeping and laundry services, as well as social and recreational services.

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Our assisted living centers staff provides assistance with general activities of living such as medication management, bathing, dressing and meal preparation. Our assisted living centers offer a variety of daily social and therapeutic activities.

We
  have established and actively market programs for the elderly and other patients
  who require more complex levels of medical care. We focus on clinically complex
  elderly patients who need extensive therapies and treatments to stabilize health
  problems before returning home or transitioning into a permanent long-term care
  setting. Over 89% of patients come to our centers directly from an acute care
  hospital stay and have five or more health problems that affect their ability
  to carry out everyday activities. Half of the patients who enter our centers
  for post-acute care are discharged within 24 days while the average stay for
  a long-term care patient is 158 days. Private insurance companies and other
  third-party payors, including certain state Medicaid programs, have recognized
  that treating patients requiring complex medical care in centers such as those
  we operate is a cost-effective alternative to treatment in an acute care or
  rehabilitation hospital. We provide high acuity care at rates that we believe
  are substantially below the rates typically charged by acute care hospitals
  for comparable services.

The following table reflects our average number of beds in service and our average occupancy levels for the periods presented:



Year Ended September 30,2006

        

        2005

        

        2004Average Beds in Service:Owned and leased facilities, including consolidated VIEs

        

        20,895

        

        21,167

        

        21,621Managed and jointly-owned facilities, excluding consolidated VIEs

        

        4,983

        

        5,482

        

        4,870Occupancy Based on Average Beds in Service:Owned and leased facilities, including consolidated VIEs

        

        91

        %

        90

        %

        91

        %


The following table reflects the payor mix of inpatient services revenues for the periods presented, and has been adjusted to exclude discontinued operations:



Year
          Ended September 30,2006
      
      2005
      
      2004Medicaid
      
      52
      %
      54
      %
      51
      %Medicare
      
      29
      %
      27
      %
      29
      %Private
          pay and other
      
      19
      %
      19
      %
      20
      %100
      %
      100
      %
      100
      %


See  Revenue Sources and  Government Regulation.

Rehabilitation Therapy Services Segment

We provide an extensive range of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy in all of our inpatient market concentrations. These services are provided by

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approximately 4,900 licensed rehabilitation therapists and assistants employed or contracted by us at substantially all of the eldercare centers we operate, as well as by contract to healthcare facilities operated by others and through our 13 certified outpatient rehabilitation agencies. For the fiscal year ended September 30, 2006, approximately 61% of our rehabilitation therapy services revenue was generated under contracts with unrelated third parties.

Other Services

We
  provide management services to 34 independently and jointly owned eldercare
  centers and 8 transitional care units, which are the eldercare centers jointly
  owned and/or managed referred to in   Inpatient Services Segment
  above, pursuant to management agreements that provide generally for the day-to-day
  responsibility for the operation and management of the centers. In turn, we
  receive management fees, depending on the agreement, computed as an overall
  fixed fee, a fixed fee per customer, a percentage of net revenues of the center
  plus an incentive fee, or a percentage of gross revenues of the center with
  some incentive clauses. The management agreements, including renewal option
  periods, are scheduled to terminate between 2006 and 2024, 23 of which are scheduled
  to terminate within the next twelve months. We expect to be able to renew a
  majority of the terminating contracts.

We also provide an array of other specialty medical services in certain parts of our eldercare network, including respiratory health services, physician services, hospitality services, staffing services and other related services.

Our Industry

The aging of the population and increased life expectancies are the primary driving forces behind the growth of the nursing and assisted living facilities market in the United States. According to the United States Census Bureau, in 2000, there were approximately 35 million Americans aged 65 or older, comprising approximately 13% of the total United States population. The number of Americans aged 65 or older is expected to climb to approximately 40 million by 2010 and to approximately 54 million by 2020. There are approximately 16,500 nursing homes with approximately 1.8 million total beds certified to provide Medicare and/or Medicaid services in the United States. On average, approximately 3.5 million people live in nursing homes during the course of a year. We believe that these demographic trends will support a growing demand for the services provided by nursing and assisted living facility
operators that deliver the most efficient, responsive, cost-effective and highest quality eldercare services to support a full range of needs and acuity levels. We also believe that these demographic considerations will place increased pressure on healthcare providers to find innovative, efficient means of delivering healthcare services.

See  Revenue Sources.

Our Strategy

Our
  industry continues to experience significant change, as patients and payors
  seek higher quality health care while at the same time containing the overall
  costs of the healthcare system. We are an active participant in this evolutionary
  change in healthcare delivery, as we continue to provide more complex care to
  a higher acuity patient population at a lower cost setting. Our service model
  continues to increase our capabilities for meeting both the healthcare and personal
  needs of the short-stay patient requiring rehabilitation and recovery under
  skilled nursing care after an acute care episode. Additionally, we continue
  to improve both the appearance and amenities of our facilities which, coupled
  with our strength in clinical care, allows us to compete more effectively with
  market alternatives for residential services.

Implementation of our strategy requires us to:

Focus
  on quality care.We
  are focused on qualitative and quantitative clinical performance measures in
  order to enhance and improve continuously the care provided in our facilities.
  We continually seek to enhance our reputation for providing clinical capabilities
  and outcomes in patient care and rehabilitation. Among other things, we are
  increasing our professional nursing mix and are integrating nurse practitioners
  into our clinical model, we have incentivized our management team to improve
  clinical performance, and we employ physician executives who are administratively
  and clinically accountable for the quality of care.

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Focus on developing clinical specialties.We continue to develop our strong relationships with hospitals and physicians in our local markets, who increasingly seek skilled nursing facilities with demonstrated capabilities to accept and care for complex patients following an acute hospital stay. The market has also sought qualified and experienced providers of care for individuals with Alzheimers disease and other forms of dementia. We have developed and effectively implemented branded programs in certain markets and facilities to provide rehabilitation to expedite recovery and return to home for orthopedic and other disciplines after surgery, to care for those on dialysis or ventilator, and those who suffer from dementia, while assuring that core clinical services are provided at every facility.

Focus on developing our resources.We are focused on the improvement and development of both our physical plant as well as the implementation of information systems to grow revenue and better monitor and manage our business. These efforts include facility modernization to improve occupancy and quality mix, the development of an integrated clinical, operational and financial system to improve administrative efficiency and operational performance, and the implementation of tools for more effective management of purchasing and nursing staff scheduling to reduce the use of premium staffing, including temporary agency services and overtime.

Strengthen our presence in existing markets.Our significant presence in most of our markets has enhanced our specialty development capabilities, as facilities develop complementary capabilities and enhance our overall marketplace presence and reputation. Additionally, we seek to expand our presence in certain of our core markets through selective acquisitions of newer facilities which present growth opportunities through strategic as well as operational improvement. Expansion of existing facility clusters and creation of new clusters in local markets will allow us to leverage existing operations and to achieve greater operating efficiencies.

Our Competitive Strengths

We believe the following competitive strengths will enable us to continue to improve our profitability and cash flows:

Geographically
  focused network.We are regionally
  focused, and within our markets, we have developed strong referral networks
  with hospitals, physicians and discharge planners. Through these relationships,
  we have demonstrated the flexibility to design and customize our systems and
  services to meet the specific needs within our local markets. By concentrating
  our operations in specific and contiguous markets, with strong demographic trends
  for growth in our service population, we have achieved lower operating costs
  through greater purchasing power and operating efficiencies.

High acuity capabilities.We focus on clinically complex elderly patients who require extensive therapies and treatments to stabilize health problems before returning home or transitioning into a permanent long-term care setting. Over 89% of our patients come to our facilities directly from an acute care hospital and require assistance to perform daily activities. Private insurance companies and other third-party payors have recognized that treating patients requiring complex care in eldercare facilities, such as those we operate, is a cost-effective alternative to treatment in an acute care or rehabilitation hospital.

High quality eldercare services.We believe we have a reputation as a leading provider of high quality eldercare services. As a result, we believe we have excellent relationships with hospitals and discharge planners, our primary referral sources. We maintain a corporate compliance program to monitor and collect regulatory compliance data and to enhance and improve continuously the care provided in our facilities. We believe we have good relations with the state and federal agencies who regulate and provide oversight of our industry, and work effectively with them on both operational and strategic issues.

Significant facility ownership.We own rather than lease a majority of our eldercare facilities, unlike a number of our competitors. Excluding facilities held for sale, we own 137 facilities with 16,665 beds, which represents approximately 80% of the total number of beds we own or lease. We believe that owning properties increases our operating and financial flexibility by enabling us to control more directly our occupancy costs, divest facilities and exit markets at our discretion and refurbish or remodel facilities in order to satisfy market demand.

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Admissions
  and discharge planning.We believe
  we have developed a successful model to process admissions through the automated
  tracking of bed availability and specialty care capacity at each of our facilities.
  Our model utilizes a multifaceted approach including clinical care coordinators
  and toll-free phone lines to assist our marketing staff and direct referral
  sources. These efforts, we believe, have contributed to our achieving higher
  occupancy levels as compared to industry averages. For the twelve month period
  ended September 30, 2006, our occupancy level was approximately 91% compared
  to the industry median occupancy level of approximately 89%, as reported in
  the June 2006 Nursing Facility State Occupancy Rate and Median Facility Occupancy
  Rate for Certified Beds CMS OSCAR Data Current Surveys issued by the American
  Health Care Association.

Stable and experienced management team.While we operate in a healthcare sector which has historically experienced significant volatility due to a constantly changing reimbursement environment and varying ownership structures, our management team has remained substantially intact, with many years of operating experience working together. Our management teams collective experience allows us to address effectively the continuing challenges facing the industry while providing the stability necessary to achieve meaningful operational and financial improvements.

Revenue Sources

We receive revenues from Medicare, Medicaid, private insurance, self-pay residents and other third-party payors. Our rehabilitation therapy services and other service related businesses also receive revenues from independent long-term care facilities that utilize our services.

The sources and amounts of our patient revenues will be determined by a number of factors, including licensed bed capacity and occupancy rates of our centers, the mix of patients and the rates of reimbursement among payors. Likewise, therapy services provided by our rehabilitation therapy services business will vary based upon payor and payment methodologies. Changes in the case mix of the patients as well as payor mix among private pay, Medicare and Medicaid will significantly affect our profitability.

Medicare and Medicaid

The Health Insurance for Aged and Disabled Act (Title XVIII of the Social Security Act), known as Medicare, has made available to nearly every United States citizen 65 years of age and older a broad program of health insurance designed to help the nations elderly meet hospital and other healthcare costs. The Medicare program consists of four parts: (i) Medicare Part A, which covers, among other things, inpatient hospital, skilled long-term care, home healthcare and certain other types of healthcare services; (ii) Medicare Part B, which covers physicians services, outpatient services, certain prescription drugs, and certain items and services provided by medical suppliers; (iii) a managed care option for beneficiaries who are entitled to Medicare Part A and enrolled in Medicare Part B, known as Medicare Advantage or Medicare Part C and (iv) a Medicare Part D
benefit that became effective January 1, 2006 covering prescription drugs. The Medicare program is administered by the Centers for Medicare and Medicaid Services (CMS).

Medicaid (Title XIX of the Social Security Act) is a federal-state matching program, whereby the federal government, under a need based formula, matches funds provided by the participating states for medical assistance to medically indigent persons. The programs are administered by the applicable state welfare or social service agencies under federal rules. Although Medicaid programs vary from state to state, traditionally they have provided for the payment of certain expenses, up to established limits, at rates determined in accordance with each states regulations. For skilled nursing centers, most states pay prospective rates, and have some form of acuity adjustment. In addition to facility based services, most states cover an array of medical ancillary services. Payment methodologies for these services vary based upon state preferences and practices permitted
under federal rules.

State Medicaid programs generally have long-established programs for reimbursement which have been revised and refined over time. Any future changes in such reimbursement programs or in regulations relating thereto, such as reductions in the allowable reimbursement levels or the timing of processing of payments, could adversely affect our business, results of operations, financial position and cash flows. The annual increase in the federally matched

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funds could vary from state to state based on a variety of factors. Additionally, any shift from Medicaid to state designated managed care plans could adversely affect our business, results of operations, financial position and cash flows.

Medicare and Medicaid are subject to statutory and regulatory changes, retroactive rate adjustments, administrative rulings and government funding restrictions, all of which may materially affect the timing and/or levels of payments to us for our services.

We are subject to periodic audits by the Medicare and Medicaid programs, which have various rights and remedies against us if they assert that we have overcharged the programs or failed to comply with program requirements. These rights and remedies may include requiring the repayment of any amounts alleged to be overpayments or in violation of program requirements, or making deductions from future amounts due to us. Such programs may also impose fines, criminal penalties or program exclusions. Other third-party payor sources also reserve rights to conduct audits and make monetary adjustments in connection with or inclusive of auditing activities.

Laws Affecting Medicare Revenues

Participating skilled nursing facilities are reimbursed under a prospective payment system for inpatient Medicare covered services. The prospective payment system commenced with a facilitys first cost reporting period beginning on or after July 1, 1998 and phased in over a three-year period following passage of the Balanced Budget Act in 1997. Under the prospective payment system, or PPS, skilled nursing facilities are paid a predetermined amount per patient, per day or per diem based on the anticipated costs of treating patients. The per diem rate is determined by classifying each patient into one of 53 Resource Utilization Groups (RUGs) based on the nature of the patients condition and care needs. Prior to January 1, 2006, there were 44 RUGs categories. There is a separate per diem rate for each of the RUG classifications. The per diem rate also covers
rehabilitation and certain ancillary services.

As implemented by CMS, the prospective payment system initially had an adverse impact on the Medicare revenues of many skilled nursing facilities. In 1999 and 2000, refinements were made to the Balanced Budget Act that restored substantial Medicare funding to skilled nursing facilities that was originally eliminated in the initial implementation of the prospective payment system.

A number of refinements made in 1999 and 2000 providing additional funding for Medicare participating skilled nursing facilities expired on September 30, 2002, resulting in an approximate 10% reduction in the rates paid to us for providing services to Medicare patients. We refer to the expiration of the additional funding as the skilled nursing facility Medicare cliff.  Effective October 1, 2002, Medicare rates adjusted for the skilled nursing facility Medicare cliff were increased by a 2.6% annual inflation update factor. For us, the net impact of the 10% rate reduction, offset by the annual inflation update factor, adversely impacted fiscal 2003 revenue and EBITDA approximately $24.8 million and net income approximately $15.1 million.

On July 28, 2005, CMS released the final fiscal 2006 skilled nursing facility prospective payment rules, including refinement to the RUG classification system (RUGs refinement). Effective January 1, 2006, the rules established nine new payment classifications, altered the case-mix weights for the remaining 44 RUG payment categories and adjusted upward the nursing component of most RUG payment categories. Excluding an additional 3.1% annual inflation factor, and after considering the distribution of our Medicare patient population under the new system, we previously expected RUGs refinement to reduce our Medicare payment rates approximately $9 per patient day beginning January 1, 2006. However, as a result of continuing shifts in the mix of our Medicare admissions toward higher acuity cases, and a higher percentage of patients qualifying for the new nine RUG categories than
initially projected, our average Medicare payment rate increased approximately $5 per patient following the January 1, 2006 implementation of RUGs refinement.

On
  July 31, 2006, CMS released the final fiscal 2007 skilled nursing facility prospective
  payment rules effective October 1, 2006. The rate notice confirmed that the
  underlying fiscal 2007 rate methodology would not change, that per patient day
  payments would increase by a 3.1% annual inflation update factor and that a
  phased

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transition to revised labor market areas would occur. This latter change, a revision from standard metropolitan statistical areas to core-based statistical areas, is estimated to have a 0.4% negative impact on our fiscal 2007 Medicare payment rates, yielding net Medicare payment rate growth of approximately 2.7% effective October 1, 2006.

In February 2006, the Deficit Reduction Act of 2005 (DRA) was signed into law. Under the DRA, effective for cost report years beginning on or after October 1, 2005, the amount that Medicare reimburses skilled nursing facilities and other non-hospital providers for bad debts arising from uncollectible accounts receivable with non-government payors was reduced by 30%. The Congressional decision to differentiate between governmental and non-governmental bad debts minimizes the impact to us of this component of the DRA because most of our uncollectible Medicare coinsurance and deductibles are billed to state Medicaid programs. The impact of the final rule on our fiscal year 2006 EBITDA and net income was not material.

Included
  in the DRA is a provision that directed CMS to develop an exceptions process
  for medically necessary physical, speech and occupational therapy services for
  beneficiaries that exceed a $1,740 annual reimbursement cap. The provision establishes
  a 10-day exceptions request process. In connection with the DRA, on February
  13, 2006 CMS issued three program transmittals instructing its contractors on
  implementing the exceptions process. Under the instructions, a two-tier process
  is established providing for automatic exceptions based upon diagnoses and patient
  condition, and a manual exceptions process for other claims that are not automatically
  exempt. These changes were retroactive to January 1, 2006. While initially there
  were delays in processing claims, most of the implementation issues were resolved.
  Generally, most nursing home therapy claims fell within the automatic exceptions
  group, and, therefore, we did not experience a disruption of services. However,
  the delayed communication and implementation of the exceptions process negatively
  impacted Medicare Part B therapy utilization during the three months ended March
  31, 2006. There continues to be uncertainty regarding how the Medicare Part
  B therapy cap will be addressed in future reimbursement policy. CMS recently
  announced the proposed physician fee schedules and the implementation of the
  therapy caps effective January 1, 2007. The proposed rules suggest the therapy
  caps will increase from the current level of $1,740 to $1,780. On December 9,
  2006, Congress passed legislation extending the existing exceptions process
  through December 31, 2007, removing a significant financial threat to our rehabilitation
  therapy business for the short term. No assurances can be made or given that
  Congress will extend the exceptions process beyond calendar year 2007, or enact
  other revisions.

By
  law, Medicare reimbursement for physician and non-physician professional services
  (including Medicare Part B physical therapy, speech pathology and occupational
  therapy services) is based on fee schedules. On August 22, 2006, CMS published
  in theFederal Registerthe proposed calendar year 2007 physician and non-physician fee schedule rules.
  In an accompanying press statement, CMS indicated that it anticipated calendar
  year 2007 physician fee schedules would be reduced by 5.1% effective January
  1, 2007. On December 9, 2006, Congress passed legislation that negated the rate
  reduction and established a 1.5% bonus incentive to providers who report on
  quality measures in 2007.

Effective
  January 1, 2006, under the Medicare Modernization Act (MMA), Medicaid coverage
  of prescription drugs for Medicare beneficiaries who are also eligible for Medicaid
  have been shifted to the Medicare program (Medicare Part D). These residents
  are referred to as dual eligibles. This change has affected a significant
  percentage of residents in our nursing facilities. The final regulations and
  subsequent sub-regulatory guidance specifically require the new prescription
  drug plans and Medicare Advantage Plans that offer prescription drug coverage
  to provide convenient access to long-term care pharmacies and to offer standard
  contracts to all long-term care pharmacies within the plans service areas
  that meet performance standards specified by CMS. Currently, under contract,
  Omnicare, Inc., through its wholly owned subsidiary, provides services required
  for our residents. Under Medicare Part D, reimbursement for such services is
  provided through such plans as the primary payor for prescription drugs. Effective
  January 1, 2006, all dual eligible participants were automatically assigned
  to private prescription drug plans (PDPs). Our long-term care pharmacy provider,
  Omnicare, Inc. (Omnicare) negotiates its payment terms directly with the PDPs.
  It is important to note that, in its 2007 Work Plan, the Office of Inspector
  General stated that it will focus on whether skilled nursing facilities are
  properly passing through any benefits they receive through contracts with PDPs
  to their beneficiaries.

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Implementation
  of the new prescription drug benefit has been challenging; however, our residents
  have not experienced a significant disruption in receiving their necessary medication.
  Given the scale of the conversion, and the voluntary nature of Medicare Part
  D enrollment for other than dually eligible residents, there were complex implementation
  issues. CMS has been responsive to issues as they have been identified and transmitted.
  Additionally, in a number of states, special provisions are being considered
  or implemented under the state Medicaid plans to safeguard individuals automatically
  enrolled in the new Medicare Part D. Because of concerns that the MMA shifts
  prescription drug coverage from Medicaid to Medicare through private plans,
  CMS extended its initial 30-day transition period for those persons transitioning
  to the Part D program to 90 days. This transition period expired on April 1,
  2006. Identifying nursing home residents and communicating formulary and coverage
  decisions continues to be challenging.

The second open enrollment for the Medicare Part D benefit began in mid-November, 2006 and will run through the end of the calendar year. Automatic plan selection changes may be required for some dual eligibles and low-income subsidized beneficiaries. There continues to be a risk that these changes and related issues with the implementation of Medicare Part D may disrupt pharmacy services to our facilities. Any such change or reduction in long-term care pharmacy services could create additional cost for us, reduce our ability to meet quality standards and disrupt service delivery to our residents.

The MMA covers most prescription drugs, insulin and certain insulin supplies, and approved vaccines. However, certain drugs are excluded from coverage under the new Medicare benefit in Part D, including several drugs that are commonly prescribed for nursing home and other long-term care residents. A number of states announced that they will continue to cover these excluded drugs under their Medicaid plans, however, there remains the possibility that certain physician ordered medications may fall outside of the PDPs and/or Medicaids formularies thereby requiring us to bear the cost of these drugs.

We have described only certain provisions of the MMA applicable to our business. There may be other provisions of the legislation that may impact our business by decreasing revenues or increasing operational expenses. The impact of this legislation depends upon a variety of factors, including patient mix and the implementing regulations. CMS continues to issue new regulations to implement the MMA, which we are in the process of reviewing. However, because of the broad scope and phased-implementation of key provisions in the MMA, we are not in a position to assess fully its impact on our business.

Laws Affecting Medicaid Revenues

Jointly
  financed by the federal and state governments, Medicaid is an essential part
  of the health coverage and financing system nationally and in every state. Combined
  federal and states Medicaid outlays are projected to approximate $347.0
  billion in calendar year 2007 and account for nearly 15% of total national healthcare
  expenditures. Medicaid is the principal purchaser for approximately 45% of nursing
  home services purchased in the United States. Rapidly increasing Medicaid spending
  combined with slow state revenue growth and competing budgetary requirements
  has led many states to institute measures aimed at controlling spending growth.
  Historically, these budget pressures have translated into reductions in the
  rate of growth of state Medicaid spending. Budget constraints and other factors
  have caused some states to curb Medicaid reimbursement to nursing facilities
  and states may continue to curb or delay payments to nursing facilities in the
  future. The Balanced Budget Act of 1997 granted the states greater flexibility
  in establishing Medicaid managed care programs without the need to obtain a
  federal waiver. Although these waiver programs generally exempted institutional
  care, including nursing facility services, these programs could ultimately change
  the Medicaid reimbursement system for long-term care. These changes could include
  changing reimbursement for pharmacy services from fee-for-service, or payment
  per procedure or service rendered, to a fixed amount per person utilizing managed
  care negotiated or capitated rates. In each of the major states where we provide
  services, we are working with trade groups, consultants and government officials
  to address responsibly the particular funding issues.

The
  Benefits Improvement and Protection Act of 2000 enacted a phase out of intergovernmental
  transfer transactions by states whereby states would artificially inflate the
  payments to certain public facilities to increase federal matching funds. This
  action may have had the effect of reducing federal support for a number of state
  Medicaid programs. The reduced federal payments may impact aggregate available
  funds requiring states to further contain payments to providers. We operate
  in several of the states that have experienced or will experience a contraction
  of federal matching funds.

Medicaid
  funding is set annually. Most states have completed legislative actions on their
  fiscal year 2007 state budgets. In light of the changes to Medicaid payment
  rates, we expect our average Medicaid rate per patient day to increase between
  approximately 2.5% to 3.5% in our fiscal 2007. As part of the state budget process,
  a number of states have indicated a desire to divert individuals from placement
  in nursing homes through an expansion of home and community based services.
  Most of these efforts are being established under demonstration and waiver authority.
  To date, these alternative care programs have not significantly impacted nursing
  home admissions. The DRA also provided states greater flexibility to pursue
  alternative programs for the delivery of Medicaid services. During recent months,
  CMS has transmitted guidance letters to state Medicaid directors explaining
  how states can take advantage of the permissive authority

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provided under the new law to expand coverage for individuals with disabilities, increase access to home and community based services and re-design benefits. Many states are examining these options, weighing the full costs and benefits and the impact on vulnerable populations. We are unable to predict the outcome of these potential changes and their impact on resources necessary to sustain both facility-based and community-based services.

Among the alternative Medicaid funding approaches that states have explored, and in many states implemented, are nursing home provider assessments as tools for leveraging increased Medicaid matching funds. Such initiatives are authorized under the law. Provider assessment plans generate additional federal matching funds to the states for Medicaid reimbursement purposes, and implementation of a provider assessment plan requires approval by CMS in order to qualify for federal matching funds. These plans usually take the form of a bed tax or a quality assessment fee, which is imposed uniformly across classes of providers within the state. In turn, the state generally utilizes the additional federal matching funds generated by the tax to pay increased reimbursement rates to the providers, which often include a repayment of a portion of the provider tax based on the providers
percentage of Medicaid patients. Nursing home provider assessments have been implemented in nine states where we operate (Massachusetts, West Virginia, Rhode Island, North Carolina, New Hampshire, Vermont, Pennsylvania, New Jersey and Connecticut). Of these nine states, all but one has provider assessment taxes of 6%. See Item 7  Managements Discussion and Analysis of Financial Condition and Results of Operations  Certain Transactions and Events for a description of certain of the more material provider assessment programs recently implemented.

The
  Presidents proposed fiscal 2007 federal budget recommended spending reductions
  for both Medicare and Medicaid. One of the specific changes advanced by the
  President is a request to phase-down the level of federal matching under Medicaid
  for provider assessments. Current regulations permit states to receive federally
  matched funds for up to 6% of aggregate outlays for state Medicaid nursing home
  services. On December 9, 2006, Congress passed legislation reducing the maximum
  federal matching under Medicaid provider assessments to 5.5% of aggregate Medicaid
  outlays. This reduction in funding, which will become effective January 1, 2008,
  is expected to have an adverse effect on our business, results of operations,
  financial position and cash flows.

The
  DRA reduced projected Medicaid outlays by $6.9 billion over 5 years. The President
  signed this legislation into law on February 8, 2006. Among the provisions of
  the final legislation were requirements that extend the Medicaid look-back period
  for asset transfers from three years to five years, a change in the manner that
  annuities are considered and a change in the date for calculating the look-back
  penalty from the date of transfer to the date that Medicaid nursing home services
  are delivered. It is our understanding that CMS will be issuing specific guidance
  regarding the changes in the asset transfer rules. The DRA also implemented
  new penalties and rule changes to deter asset transfers individuals make to
  become Medicaid eligible. These changes may affect the number of people potentially
  eligible for Medicaid funding. We are unable to predict what impact this provision
  of the DRA will have on our financial condition, results of operations and cash
  flows, if any.

Under the DRA, states may be allowed to reduce the benefits provided to certain Medicaid enrollees, which could affect the services that states contract for with us. On July 12, 2006, CMS issued interim final regulations implementing the requirement that Medicaid recipients must be able to show proof of citizenship. We are unable to predict the outcome of these potential changes and their impact on our financial condition, results of operations and cash flows, if any.

Congress,
  during its fiscal year 2006, scaled back proposed Medicaid reductions through
  2006. The final enactment is a compromise establishing a National Medicaid Commission
  authorized to make specific policy recommendations, while agreeing to defer
  Medicaid cuts during fiscal year 2006, and providing reconciliation instructions
  to Congress to make $10.0 billion in aggregate Medicaid reductions during fiscal
  years 2007 to 2011. Some of the ideas generated by the National Medicaid Commission
  were incorporated into the DRA. The National Medicaid Commission is mandated
  to deliver to the Congress a second report by the end of 2006 making specific
  recommendations for a comprehensive reform of the Medicaid program. These proposals
  may be considered in the coming 110th Congress. No predictions can
  be made as to the ultimate outcome of these reform proposals. We cannot predict
  the extent of the impact that

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such decrease, if any, in spending by the federal government will have on our business, financial condition, results of operations and cash flows.

The
  federal government and state governments continue to focus on efforts to curb
  spending on healthcare programs such as Medicare and Medicaid. Among the ideas
  receiving active consideration in the Congress are revisions to the federal
  budget process that would establish an Entitlement Commission empowered to alter
  future outlays for all entitlement programs including Medicare and Medicaid.
  It is impossible to predict the outcome of the legislative and regulatory processes.
  We cannot at this time predict the extent to which these proposals will be adopted
  or, if adopted and implemented, what effect, if any, such proposals and existing
  new legislation and regulation will have on us. It is not possible to quantify
  fully the effect of legislative changes, the interpretation or administration
  of such legislation or other governmental initiatives on our business and the
  business of the customers served by our rehabilitation services business. Accordingly,
  there can be no assurance that the impact of any future healthcare legislation
  or regulation will not adversely affect our business. There can be no assurance
  that payments under governmental and private third-party payor programs will
  be timely, will remain at levels similar to present levels or will, in the future,
  be sufficient to cover the costs allocable to patients eligible for reimbursement
  pursuant to such programs. Our financial condition and results of operations
  will be affected by the reimbursement process, which in the healthcare industry
  is complex and can involve lengthy delays between the time that revenue is recognized
  and the time that reimbursement amounts are settled.

Government Regulation

General

Our
  business is subject to extensive federal, state and, in some cases, local regulation
  with respect to, among other things, participation in the Medicare and Medicaid
  programs, licensure, certification and government reimbursement. For our eldercare
  centers, these regulations relate, among other things, to the adequacy of physical
  plant and equipment, qualifications of personnel, standards of care, government
  reimbursement and operational requirements. Compliance with such regulatory
  requirements, as interpreted and amended from time to time, can increase operating
  costs and thereby adversely affect the financial viability of our business.
  Failure to comply with current or future regulatory requirements could also
  result in the imposition of various remedies including fines, restrictions on
  admission, denial of payment for all or new admissions, the revocation of licensure,
  decertification, imposition of temporary management or the closure of the facility
  or site of service.

Licensure, Certification and Regulation

Our
  eldercare centers and healthcare services, to the extent required, are currently
  licensed under applicable law. Our skilled nursing centers and healthcare services,
  or practitioners providing the services therein, are certified or approved as
  providers under one or more of the Medicaid and Medicare programs. Generally,
  assisted living centers are not eligible to be certified under Medicare or Medicaid.
  Licensing, certification and other applicable standards vary from jurisdiction
  to jurisdiction and are revised periodically. State and local agencies survey
  all skilled nursing centers on a regular basis to determine whether such centers
  are in compliance with governmental operating and health standards and conditions
  for participation in government sponsored third-party payor programs. We believe
  that our eldercare centers and other sites of service are in substantial compliance
  with the various Medicare, Medicaid and state regulatory requirements applicable
  to them. However, in the ordinary course of our business, we periodically receive
  notices of deficiencies for failure to comply with conditions of participation
  in the Medicare and Medicaid programs. We review such notices and take appropriate
  corrective action. In these cases, we submit our plan to bring the center into
  compliance with regulations which must be accepted by the reviewing agency prior
  to its implementation. In some cases, the reviewing federal or state agency
  may take various adverse actions against a provider, including but not limited
  to:



        the imposition of fines;




        suspension of payments for new or all admissions to the center; and


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

        in
          extreme circumstances, exclusion from participation in the Medicare
          or Medicaid programs and revocation of a centers or service sites
          license.


These actions may adversely affect a providers ability to continue to operate, ability to provide certain services, and/or eligibility to participate in the Medicare or Medicaid programs or to receive payments from other payors. Certain of our centers have received notices that, as a result of certain alleged deficiencies, federal and/or state agencies were taking steps to impose remedies. Additionally, actions taken by one center or service site may subject other centers or service sites under common control or ownership to adverse remedies.

All of our skilled nursing centers participate in the Medicare and Medicaid programs. Both initial and continuing qualifications of a skilled nursing center to participate in such programs depend upon many factors including accommodations, equipment, services, patient care, safety, personnel, physical environment, and adequate policies, procedures and controls.

Several
  states in which we operate, as well as states in which we may wish to operate
  in the future, have adopted certificate of need or similar laws which generally
  require that a state agency approve certain acquisitions and determine the need
  for certain bed additions, new services, and capital expenditures. State approvals
  are generally issued for a specified maximum expenditure and require implementation
  of the proposal within a specified period of time. Failure to obtain the necessary
  state approval can result in:



        the inability to provide the service;




        the inability to operate the centers;




        the inability to complete the acquisition, addition or other change; and




        the imposition of sanctions or adverse action on the centers license and adverse reimbursement action.


In recent years it has become more difficult for nursing facilities to maintain licensure and certification. We have experienced and expect to continue to experience increased costs in connection with maintaining our licenses and certifications as well as increased enforcement actions. Failure to provide quality resident care may result in civil and/or criminal fines and penalties.

The operation of our eldercare centers is subject to federal and state laws prohibiting fraud by healthcare providers, including criminal provisions, which prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid, or failing to refund overpayments or improper payments. Violation of these criminal provisions is a felony punishable by imprisonment and/or fines. We may be subject to fines and treble damage claims if we violate the civil provisions that prohibit the knowing filing of a false claim or the knowing use of false statements to obtain payment.

State and federal governments are devoting increased attention and resources to anti-fraud initiatives against healthcare providers. HIPAA and the Balanced Budget Act expanded the penalties for healthcare fraud, including broader provisions for the exclusion of providers from the Medicaid program.

The
  DRA requires providers who make or receive over $5 million in payments from
  state health plans to establish policies and procedures detailing the Federal
  False Claims Act, state false claims acts (if applicable), state Whistleblower
  Protection Acts, and other state laws related to the reduction of fraud and
  abuse. This provision may require us to implement state-specific employee training
  based on these laws. Further, as a result of the DRA, certain states are contemplating
  the need for their own false claims acts which, if implemented, may impose stricter
  penalties than the federal statute and regulations.

While
  we believe that our business practices are consistent with Medicare and Medicaid
  criteria, those criteria are often vague and subject to change and interpretation.
  Determinations of alleged fraud could have an adverse effect on our business,
  results of operations, financial condition and cash flows.

Laws Affecting Billing and Business Practices

We are also subject to federal and state laws that govern financial and other arrangements between healthcare providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between healthcare providers that are designed to induce the referral of patients to, or the recommendation of, a particular provider for medical products and services. These laws include:



        the
          anti-kickback provisions of the federal Medicare and Medicaid
          programs, which prohibit, among other things, knowingly and willfully
          soliciting, receiving, offering or paying any remuneration (including
          any kickback, bribe or rebate) directly or indirectly in return for
          or to induce the referral of an individual to a person for the furnishing
          or arranging for the furnishing of any item or service for which payment
          may be made in whole or in part under Medicare or Medicaid. Penalties
          may include imprisonment, fines, exclusion from participation in the
          Medicare and Medicaid programs and loss of license;



      the
          Stark laws which prohibit, with limited exceptions, the
          referral of patients by physicians for certain services, including home
          health services, physical therapy and occupational therapy, to an entity
          in which the physician has a financial interest. Penalties may include
          denial of payment, mandatory refund of prior payment, civil monetary
          penalties and exclusion from participation in the Medicare and Medicaid
          programs; and
      parallel state laws containing similar prohibitions and additional penalties.


In
  addition, some states restrict certain business relationships between physicians
  and other providers of healthcare services. Possible sanctions for violation
  of any of these restrictions or prohibitions include loss of licensure or eligibility
  to participate in reimbursement programs and/or civil and criminal penalties.
  These laws vary from state to state, are often complex and have seldom been
  interpreted by the courts or regulatory agencies. From time to time, we have
  sought guidance as to the interpretation of these laws; however, there can be
  no assurance that such laws will ultimately be interpreted in a manner consistent
  with our practices.

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There have also been a number of recent federal and state legislative and regulatory initiatives concerning reimbursement under the Medicare and Medicaid programs. During the past few years, DHHS has issued a series of voluntary compliance guidelines. These compliance guidelines provide guidance on acceptable practices. Skilled nursing facility services and durable medical equipment, prosthetics, orthotics, supplies, and supplier performance practices have been among the services addressed in these publications. Our Corporate Integrity Program is working to assure that our practices conform to regulatory requirements. DHHS also issues fraud alerts and advisory opinions. For example, directives concerning double billing, home health services, the provision of medical supplies to nursing facilities, and contractual joint venture relationships have been released. It is anticipated
that areas addressed by these advisories may come under closer scrutiny by the government. While we have reviewed government guidance, we cannot predict accurately the impact of any such initiatives.

Laws Governing Health Information

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) requires us to comply with standards for the internal use of identifiable health information and the sharing of such information with third parties, such as payors, business associates, residents and patients. Among the standards that DHHS may adopt pursuant to HIPAA are standards for the following: electronic transactions and code sets, unique identifiers for providers, employers, health plans and individuals, security and electronic signatures, privacy, and enforcement.

DHHS
  has released three rules to date mandating the use and disclosure of new standards
  with respect to certain healthcare transactions and health information. The
  first rule establishes uniform standards for common healthcare transactions,
  including: healthcare claims information; plan eligibility, referral certification
  and authorization; claims status; plan enrollment and disenrollment; payment
  and remittance advice; plan premium payments; and coordination of benefits.
  Second, DHHS has released standards relating to the privacy of individually
  identifiable health information. These standards not only require our compliance
  with rules governing the use and disclosure of protected health information,
  but they also require us to impose those rules, by contract, on any business
  associate to whom we disclose information. Third, DHHS has released rules governing
  the security of health information maintained or transmitted in electronic form.

At this time, we believe we are in substantial compliance with the HIPAA requirements that are currently in effect, and we continue to make good faith efforts to carry out compliance. As part of our Corporate Integrity Program, we monitor our compliance with HIPAA. Our compliance and privacy officer is responsible for administering the Corporate Integrity Program which includes HIPAA related compliance. Although HIPAA was ultimately intended to reduce administrative expenses and burdens faced within the healthcare industry, we believe that implementation of this law has resulted in additional costs. Sanctions for failing to comply with HIPAA health information practices provisions include criminal penalties and civil sanctions.

Corporate Integrity Program

Our Corporate Integrity Program was developed to assure that we strive to achieve our goal of providing a high level of care and service in a manner consistent with all applicable state and federal laws and regulations and our internal standard of conduct. This program is intended to allow personnel to prevent, detect and resolve any conduct or action that fails to satisfy all applicable laws and our standard of conduct.

We have a corporate compliance officer responsible for administering the Corporate Integrity Program. The corporate compliance officer, with the approval of the chief executive officer or the board of directors, may use any of our resources to evaluate and resolve compliance issues. The corporate compliance officer reports significant compliance issues to the board of directors.

We established the Corporate Integrity Program hotline, which offers a toll-free number available to all of our employees to report compliance issues, including any alleged privacy violations under HIPAA. All calls reporting alleged non-compliance are logged, investigated, addressed and remedied by appropriate company officials.

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The corporate integrity subcommittee was established to ensure a mechanism exists for us to monitor compliance issues. The corporate integrity subcommittee members are senior members of the finance, human resources, information systems, legal, clinical practices, internal audit and operations departments.

Periodically, we receive information from DHHS regarding individuals and providers that are excluded from participation in Medicare, Medicaid and other federal healthcare programs. Providers may include medical directors, attending physicians, vendors, consultants, therapists and other clinical staff. On a monthly basis, management compares the information provided by DHHS to databases containing providers and individuals doing business with us. Any potential matches are investigated and any necessary corrective action is taken to ensure we cease doing business with that provider and/or individual.

Personnel

We and our industry continue to experience shortages in qualified professional clinical staff. We compete with other healthcare providers and with non-healthcare providers for both professional and non-professional employees. As the demand for these services continually exceeds the supply of available and qualified staff, we and our competitors have been forced to offer more attractive wage and benefit packages to these professionals and to utilize outside contractors for these services at premium rates. Furthermore, the competitive arena for this shrinking labor market has created high turnover among clinical professional staff as many seek to take advantage of the supply of available positions, offering new and more attractive wage and benefit packages. In addition to the wage pressures inherent in this environment, the cost of training new employees amid the high turnover rates
has created added pressure on our operating margins. Lastly, increased attention to the quality of care provided in skilled nursing facilities has caused several states to mandate and other states to consider mandating minimum staffing laws that further increase the gap between demand for and supply of qualified individuals and lead to higher labor costs. While we have been able to retain the services of an adequate number of qualified personnel to staff our facilities and sites of service appropriately and maintain our standards of quality care, there can be no assurance that continued shortages will not affect our ability to attract and maintain an adequate staff of qualified healthcare personnel in the future. A lack of qualified personnel at a facility could result in significant increases in labor costs and an increased reliance on expensive temporary agencies at such facility or otherwise adversely affect operations at such facility. Any of these developments could adversely
affect our operating results or expansion plans.

In recognition of the competitive nature of clinical staff recruitment and retention, we have implemented the following reward, recognition and professional development programs:



        An enhanced recruitment department focused on the recruitment of licensed nurses and therapists;




        A new orientation process which includes extended training and mentoring for clinical employees; and




        TAP (Tuition Assistance Program), a program designed to provide eligible employees with financial assistance to pursue education and training through defined degree and certified programs of study related to professional career growth. In 2006 and 2007, the majority of the expenditures for this program are for clinical education courses.


Our
  focus on recruitment and retention led us to consolidate our company-wide recruitment
  functions in fiscal 2006.

We
  employ approximately 35,500 people. We have 60 centers that have certified unions
  that have entered into collective bargaining agreements. The agreements expire
  at various dates through 2011 and cover approximately 5,300 employees. We believe
  that our relationship with our employees is generally good.

In fiscal 2004, we entered into an agreement with the Service Employees International Union (SEIU) to provide for one collective bargaining agreement which covers the six centers that were unionized SEIU buildings at that time and under which the SEIU was afforded the opportunity to organize 10 of our non-unionized centers in the State of New Jersey starting in September 2004. Consequently, seven of these non-unionized centers have elected to be

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represented
  by the SEIU, and one has elected not to be represented by the SEIU. To date,
  the two remaining centers have not held elections. The agreement emphasizes
  our positive relationship and common goals shared with the SEIU in the State
  of New Jersey. The agreement contains a formula which ties increases in employee
  wages and benefits to increases in the combined per patient day rates of the
  covered centers and protects us and our employees from lock-outs and/or strikes.
  The initial term of the agreement will expire in September 2008, with a successor
  agreement expiring in September 2011.

Marketing

Marketing for eldercare centers is focused at the local level and is conducted primarily by a dedicated regional marketing staff that calls on referral sources such as hospitals, hospital discharge planners, doctors and various community organizations. In addition to those efforts, our marketing objective is to maintain public awareness of our eldercare centers and their capabilities. We take advantage of our regional concentrations in our marketing efforts, where appropriate, through consolidated marketing programs, which benefit more than one center. Toll-free regional phone lines assist the marketing staff and direct referral sources, which speeds admissions by automated tracking of bed availability and specialty care capabilities for each of our centers and all of our affiliated centers.

We market our rehabilitation therapy services and other services through a direct sales force which primarily calls on eldercare centers, hospitals, clinics and home health agencies.

Historically, we operated our core business under the name Genesis ElderCare. Our logos, trademarks and service marks are featured in print advertisements in publications serving the regional markets in which we operate. We are using advertising, including our toll free Care Lines, to promote our brand names in trade, professional and business publications and to promote services directly to consumers.

Competition

We
  compete with a variety of other companies in providing healthcare services.
  Certain competing organizations have greater financial and other resources and
  may be more established in their respective communities than we are. Competing
  organizations may offer newer or different centers or services than us, including
  a variety of community based services, and may thereby attract our patients
  who are either presently residents of our eldercare centers or are otherwise
  receiving our healthcare services.

We operate eldercare centers in 12 states. In each market, our eldercare centers may compete for patients with rehabilitation hospitals, subacute units of hospitals, skilled or intermediate nursing centers, and personal care or residential centers. Certain of these providers are operated by not-for-profit organizations and similar businesses that can finance capital expenditures on a tax-exempt basis or receive charitable contributions unavailable to us. In competing for patients, a centers local reputation is of paramount importance. Referrals typically come from acute care hospitals, physicians, religious groups, health maintenance organizations, the patients families and friends, and other community organizations.

Members of a patients family generally actively participate in the selection of an eldercare center. Competition for medically complex patients is intense among acute care hospitals with long-term care capability, rehabilitation hospitals and other specialty providers and is expected to remain so in the future. Important competitive factors include the reputation in the community, services offered, the appearance of a center, and the cost of services.

We compete in providing rehabilitation therapy services and other healthcare services with a variety of different companies. Generally, this competition is regional and local in nature. The primary competitive factors in these businesses are similar to those in the inpatient services business and include reputation, the cost of services, the quality of clinical services, responsiveness to patient needs, and the ability to provide support in other areas such as third-party reimbursement, information management and patient record-keeping.

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Insurance

The vast majority of our exposure to general and professional liability claims is insured by commercial insurers subject to per claim and aggregate retention limits. The retentions are insured by our wholly owned captive insurance company, Liberty Health Corporation, Ltd. (LHC). Growth in general and professional liability insurance premiums for coverage above our retention has risen in recent years. We have managed this increase by assuming additional retention through LHC and by more proactively managing claims. The vast majority of our exposure to workers compensation liability claims prior to May 1, 2006 is fully insured by LHC. After May 1, 2006, we are insured through a loss deposit fund with a large deductible workers compensation policy subject to per claim and aggregate retention limits.

We provide several health insurance options to our employees, including self-insured health plans and several fully-insured health maintenance organizations. Growth in health insurance premiums in the market rose sharply in recent years. Our business is a labor intensive business, and therefore health insurance costs represent a significant expense for us. In recent years, we have partially managed this increase with changes in program offerings. Continuing increases substantially in excess of inflation could have a negative impact on our profitability, as further shifts in responsibility for these cost increases to the employee may not be possible.

We believe that adequate reserves are in place to cover the ultimate liability related to general and professional liability, workers compensation and health insurance claims exposure. However, there can be no assurance that any current or future claims will not exceed applicable insurance reserves or that in the future such insurance will be available at a reasonable price or that we will be able to maintain adequate coverage.

Other

Environmental Matters

We
  are subject to various federal, state and local statutes and ordinances regulating
  the discharge of materials into the environment. Certain of our real estate
  assets contain asbestos. The asbestos is believed to be appropriately contained
  in accordance with environmental regulations. If these properties were demolished
  or subject to renovation activities that disturb the asbestos, certain environmental
  regulations are in place which specify the manner in which the asbestos must
  be handled and disposed. At September 30, 2006, we recognized a liability for
  the fair value of the related asset retirement obligation aggregating approximately
  $5.3 million, which amount is included in other long-term liabilities on our
  consolidated balance sheet. Management does not believe that we will be required
  to otherwise expend any material amounts in order to comply with environmental
  laws and regulations or that compliance will materially affect our capital expenditures,
  results of operations, financial condition and cash flows.

Reorganization

On June 22, 2000, NCI and certain of its direct and indirect subsidiaries filed for voluntary relief under Chapter 11 of the United States Code, referred to as the Bankruptcy Code, with the United States Bankruptcy Court for the District of Delaware, referred to as the Bankruptcy Court.  On the same date, NCIs 43.6% owned affiliate, The Multicare Companies, Inc., and certain of its direct and indirect subsidiaries and certain of its affiliates, referred to as Multicare, also filed for relief under Chapter 11 of the Bankruptcy Code with the Bankruptcy Court. A substantial majority of NCI and Multicare subsidiaries that became our subsidiaries following the spin-off filed for bankruptcy.

See Item 1A Risk Factors.

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Available Information

Our internet address is www.GenesisHCC.com. We make available free of charge on www.GenesisHCC.com our registration statement on Form 10, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to such registration statement or reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

In addition, you may request a copy of these filings (excluding exhibits) at no cost by writing or telephoning us at the following address or telephone number:

Genesis HealthCare Corporation

101 East State Street

Kennett Square, PA  19348

Attention: Investor Relations

Telephone: (610) 925-2000

Information contained on our website is not part of this annual report on Form 10-K and is not incorporated by reference in this document. Our website is, and is only intended to be, an inactive textual reference.

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ITEM 1A:

        RISK FACTORS


If any of the following risks and uncertainties develop into actual events, this could have a material adverse effect on our business, financial condition, results of operations and cash flows. In that case, the trading price of our common stock could decline.

Healthcare-related legislation has significantly impacted our business, and future legislation and regulations may negatively affect our financial condition, results of operations and cash flows.

Our inpatient services business currently receives approximately 81% of its revenues from Medicare and Medicaid. The healthcare industry is experiencing a strong trend toward cost containment, as the government seeks to impose lower reimbursement and RUGs rates, limit the scope of covered services and negotiate reduced payment schedules with providers. These cost containment measures generally have resulted in a reduced rate of growth in the reimbursement for the services that we provide relative to the increase in our cost to provide such services. Prior reductions in governmental reimbursement rates contributed to our predecessor companys subsidiaries bankruptcy filings under Chapter 11 of the United States Code on June 22, 2000. Additional reductions in reimbursement rates for our services may further negatively impact our business, results of operations, financial
condition and cash flows.

Changes to Medicare and Medicaid reimbursement programs have limited, and are expected to continue to limit, payment increases under these programs. Also, the timing of payments made under the Medicare and Medicaid programs is subject to regulatory action and governmental budgetary constraints resulting in a risk that the time period between submission of claims and payment could increase. Further, within the statutory framework of the Medicare and Medicaid programs, a substantial number of areas are subject to administrative rulings and interpretations that may further affect payments.

It
  is not possible to quantify fully the effect of legislative changes, the interpretation
  or administration of such legislation or other governmental initiatives on our
  business and the business of the customers served by our rehabilitation services
  business. Accordingly, there can be no assurance that the impact of any future
  healthcare legislation or regulation will not adversely affect our business.
  There can be no assurance that payments under governmental and private third-party
  payor programs will be timely, will remain at levels similar to present levels
  or will, in the future, be sufficient to cover the costs allocable to patients
  eligible for reimbursement pursuant to such programs. Our financial condition,
  results of operations and cash flows will be affected by the reimbursement process,
  which in the healthcare industry is complex and can involve lengthy delays between
  the time that revenue is recognized and the time that reimbursement amounts
  are settled. Any adverse impact of skilled nursing facility rate changes to
  the liquidity of our inpatient services segment, could require us to borrow
  in order to fund our working capital needs, and in turn, cause us to become
  more highly leveraged and further impact our results of operations and cash
  flows from increased interest expense.

Our revenues could be affected by changes to the Medicare program.

In
  February 2006, the DRA was signed into law. Included in the DRA is a provision
  that directed CMS to develop an exceptions process for medically necessary physical,
  speech and occupational therapy services for beneficiaries that exceed a $1,740
  annual reimbursement cap. The provision establishes a 10-day exceptions request
  process. In connection with the DRA, on February 13, 2006 CMS issued three program
  transmittals instructing its contractors on implementing the exceptions process.
  Under the instructions, a two-tier process is established providing for automatic
  exceptions based upon diagnoses and patient condition, and a manual exceptions
  process for other claims that are not automatically exempt. These changes were
  retroactive to January 1, 2006. While initially there were delays in processing
  claims, most of the implementation issues were resolved. Generally, most nursing
  home therapy claims fell within the automatic exceptions group, and, therefore,
  we did not experience a disruption of services. However, the delayed communication
  and implementation of the exceptions process negatively impacted Medicare Part
  B therapy utilization during the three months ended March 31, 2006. There continues
  to be uncertainty regarding how the Medicare Part B therapy cap will be addressed
  in future reimbursement policy. CMS recently announced the proposed physician
  fee schedules and the implementation of the therapy caps effective January 1,
  2007. The proposed rules suggest the therapy caps will increase from the current
  level of $1,740 to $1,780. On December 9, 2006, Congress passed legislation
  extending the existing exceptions process through December 31, 2007, removing
  a significant threat to our rehabilitation therapy business for the short term.
  No assurances can be made or given that Congress will extend the exceptions
  process beyond calendar year 2007, or enact other revisions.

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By
  law, Medicare reimbursement for physician and non-physician professional services
  (including Medicare Part B physical therapy, speech pathology and occupational
  therapy services) is based on fee schedules. On August 22, 2006, CMS published
  in theFederal Registerthe proposed calendar year 2007 physician and non-physician fee schedule rules.
  In an accompanying press statement, CMS indicated that it anticipated calendar
  year 2007 physician fee schedules would be reduced by 5.1% effective January
  1, 2007. On December 9, 2006, Congress passed legislation that negated the rate
  reduction and established a 1.5% bonus incentive to providers who report on
  quality measures in 2007.

Effective
  January 1, 2006, under the MMA, Medicaid coverage of prescription drugs for
  Medicare beneficiaries who are also eligible for Medicaid have been shifted
  to the Medicare program (Medicare Part D). These residents are referred to as
  dual eligibles. This change has affected a significant percentage
  of residents in our nursing facilities. The final regulations and subsequent
  specific sub-regulatory guidance specifically require the new prescription drug
  plans and Medicare Advantage Plans that offer prescription drug coverage to
  provide convenient access to long-term care pharmacies and to offer standard
  contracts to all long-term care pharmacies within the plans service areas
  that meet performance standards specified by CMS. Currently, under contract,
  Omnicare, Inc., through its wholly owned subsidiary, provides services required
  for our residents. Under Medicare Part D, reimbursement for such services is
  provided through such plans as the primary payor for prescription drugs. Effective
  January 1, 2006, all dual eligible participants were automatically assigned
  to PDPs. Our long-term care pharmacy provider, Omnicare, negotiates its payment
  terms directly with the PDPs. It is important to note that, in its 2007 Work
  Plan, the Office of Inspector General stated that it will focus on whether skilled
  nursing facilities are properly passing through any benefits they receive through
  contracts with PDPs to their beneficiaries.

Implementation
  of the new prescription drug benefit has been challenging; however, our residents
  have not experienced a significant disruption in receiving their necessary medication.
  Given the scale of the conversion, and the voluntary nature of Medicare Part
  D enrollment for other than dually eligible residents, there were complex implementation
  issues. CMS has been responsive to issues as they have been identified and transmitted.
  Additionally, in a number of states, special provisions are being considered or implemented
  under the state Medicaid plans to safeguard individuals automatically enrolled
  in the new Medicare Part D. Because of concerns that the MMA shifts prescription
  drug coverage from Medicaid to Medicare through private plans, CMS extended
  its initial 30-day transition period for those persons transitioning to the
  Part D program to 90-days. This transition period expired on April 1, 2006.
  Identifying nursing home residents and communicating formulary and coverage
  decisions continues to be challenging.

The second open enrollment for the Medicare Part D benefit began in mid-November, 2006 and will run through the end of the calendar year. Automatic plan selection changes may be required for some dual eligibles and low-income subsidized beneficiaries. There continues to be a risk that these changes and related issues with the implementation of Medicare Part D may disrupt pharmacy services to our facilities. Any such change or reduction in long-term care pharmacy services could create additional cost for us, reduce our ability to meet quality standards and disrupt service delivery to our residents.

The MMA covers most prescription drugs, insulin and certain insulin supplies, and approved vaccines. However, certain drugs are excluded from coverage under the new Medicare benefit in Part D, including several drugs that are commonly prescribed for nursing home and other long-term care residents. A number of states announced that they will continue to cover these excluded drugs under their Medicaid plans, however, there remains the possibility that certain physician ordered medications may fall outside of the PDPs and/or Medicaids formularies thereby requiring us to bear the cost of these drugs.

We have described only certain provisions of the MMA applicable to our business. There may be other provisions of the legislation that may impact our business by decreasing revenues or increasing operational expenses. The impact of this legislation depends upon a variety of factors, including patient mix and the implementing regulations. CMS continues to issue new regulations to implement the MMA, which we are in the process of reviewing. However, because of the broad scope and phased-implementation of key provisions in the MMA, we are not in a position to assess fully its impact on our business.

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Our revenues could be impacted by federal and state changes to Medicaid.

Jointly financed by the federal and state governments, Medicaid is an essential part of the health coverage and financing system nationally and in every state. Combined federal and states Medicaid outlays are projected to approximate $347.0 billion in calendar year 2007 and account for nearly 15% of total national healthcare expenditures. Medicaid is the principal purchaser for approximately 45% of nursing home services purchased in the United States. Rapidly increasing Medicaid spending combined with slow state revenue growth and competing budgetary requirements has led many states to institute measures aimed at controlling spending growth. Historically, these budget pressures have translated into reductions in the rate of growth of state Medicaid spending. Budget constraints and other factors have caused some states to curb Medicaid reimbursement to nursing facilities, and
states may continue to curb or delay payments to nursing facilities in the future. The Balanced Budget Act of 1997 granted the states greater flexibility in establishing Medicaid managed care programs without the need to obtain a federal waiver. Although these waiver programs generally exempted institutional care, including nursing facility services, these programs could ultimately change the Medicaid reimbursement system for long-term care. These changes could include changing reimbursement for pharmacy services from fee-for-service, or payment per procedure or service rendered, to a fixed amount per person utilizing managed care negotiated or capitated rates. In each of the major states where we provide services, we are working with trade groups, consultants and government officials to address responsibly the particular funding issues. Given that Medicaid outlays are a significant component of state budgets, we expect continuing cost containment pressures on Medicaid outlays for
skilled nursing facilities in the states in which we operate, which could result in Medicaid rate adjustments that are below the average inflationary increase in our operating costs. States may be unable to continue to support financially growing Medicaid programs as currently structured and there is no assurance that federal assistance with the funding of these programs will continue.

The
  Benefits Improvement and Protection Act of 2000 enacted a phase out of intergovernmental
  transfer transactions by states whereby states would artificially inflate the
  payments to certain public facilities to increase federal matching funds. This
  action may have had the effect of reducing federal support for a number of state
  Medicaid programs. The reduced federal payments may impact aggregate available
  funds requiring states to further contain payments to providers. We operate
  in several of the states that have experienced or will experience a contraction
  of federal matching funds.

The
  Presidents proposed fiscal 2007 federal budget recommended spending reductions
  for both Medicare and Medicaid. One of the specific changes advanced by the
  President is a request to phase-down the level of federal matching under Medicaid
  for provider assessments. Current regulations permit states to receive federally
  matched funds for up to 6% of aggregate outlays for state Medicaid nursing home
  services. On December 9, 2006, Congress passed legislation reducing the maximum
  federal matching to 5.5% of aggregate Medicaid outlays. This reduction in funding,
  which will become effective January 1, 2008, is expected to have an adverse
  effect on our business, results of operations, financial position and cash flows.

The
  DRA reduced projected Medicaid outlays by $6.9 billion over five years. The
  President signed this legislation into law on February 8, 2006. Among the provisions
  of the final legislation were requirements that extend the Medicaid look-back
  period for asset transfers from three years to five years, a change in the manner
  that annuities are considered and a change in the date for calculating the look-back
  penalty from the date of transfer to the date that Medicaid nursing home services
  are delivered. It is our understanding that CMS will be issuing specific guidance
  regarding the changes in the asset transfer rules. The DRA also implemented
  new penalties and rule changes to deter asset transfers individuals make to
  become Medicaid eligible. These changes may affect the number of people potentially
  eligible for Medicaid funding. We are unable to predict what impact this provision
  of the DRA will have on our financial condition, results of operations and cash
  flows, if any.

Under the DRA, states may be allowed to reduce the benefits provided to certain Medicaid enrollees, which could affect the services that states contract for with us. On July 12, 2006, CMS issued interim final regulations implementing the requirement that Medicaid recipients must be able to show proof of citizenship. We are unable to predict the outcome of these potential changes and their impact on our financial condition, results of operations and cash flows, if any.

Congress,
  during its fiscal year 2006, scaled back proposed Medicaid reductions through
  2006. The final enactment is a compromise establishing a National Medicaid Commission
  authorized to make specific policy recommendations, while agreeing to defer
  Medicaid cuts during fiscal year 2006, and providing reconciliation instructions
  to Congress to make $10.0 billion in aggregate Medicaid reductions during fiscal
  years 2007 to 2011. Some of the ideas generated by the National Medicaid Commission
  were incorporated into the DRA. The National Medicaid Commission is mandated

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to deliver to the Congress a second report by the end of 2006 making specific recommendations for a comprehensive reform of the Medicaid program. These proposals may be considered in the coming 110th Congress. No predictions can be made as to the ultimate outcome of these reform proposals. We cannot predict the extent of the impact that such decrease, if any, in spending by the federal government will have on our business, financial condition, results of operations and cash flows.

We conduct business in a heavily regulated industry, and changes in regulations and violations of regulations may result in increased costs or sanctions, including loss of licensure and decertification.

Our
  business is subject to extensive federal, state and, in some cases, local regulation
  with respect to, among other things, participation in the Medicare and Medicaid
  programs, licensure, certification and government reimbursement. For our eldercare
  centers, these regulations relate, among other things, to the adequacy of physical
  plant and equipment, qualifications of personnel, standards of care, government
  reimbursement and operational requirements. Compliance with these regulatory
  requirements, as interpreted and amended from time to time, can increase operating
  costs and thereby adversely affect the financial viability of our business.
  Because these regulations are amended from time to time and are subject to interpretation,
  we cannot predict when and to what extent liability may arise. Failure to comply
  with current or future regulatory requirements could also result in the imposition
  of various remedies including  fines, restrictions on admission, denial of payment
  for all or new admissions, the revocation of licensure, decertification, imposition
  of temporary management or the closure of a facility or site of service.

We
  are subject to periodic audits by the Medicare and Medicaid programs, which
  have various rights and remedies against us if they assert that we have overcharged
  the programs or failed to comply with program requirements. These rights and
  remedies may include requiring the repayment of any amounts alleged to be overpayments
  or in violation of program requirements, or making deductions from future amounts
  due to us. These programs may also impose fines, criminal penalties or program
  exclusions. Other third-party payor sources also reserve rights to conduct audits
  and make monetary adjustments in connection with or exclusive of audit activities.

In
  the ordinary course of our business, we periodically receive notices of deficiencies
  for failure to comply with conditions of participation in the Medicare and Medicaid
  programs. We review such notices and take appropriate corrective action. In
  these cases, we submit our plan to bring the center into compliance with regulations
  which must be accepted by the reviewing agency prior to its implementation.
  In some cases, the reviewing federal or state agency may take various adverse
  actions against a provider, including but not limited to:



        the imposition of fines;




        suspension of payments for new or all admissions to the center; and 

        in
          extreme circumstances, exclusion from participation in the Medicare
          or Medicaid programs and revocation of a centers or service sites
          license.


These actions may adversely affect a providers ability to continue to operate, the ability to provide certain services and/or eligibility to participate in the Medicare or Medicaid programs or to receive payments from other payors. Certain of our centers have received notices that, as a result of alleged deficiencies, federal and/or state agencies were taking steps to impose remedies. Additionally, actions taken against one center or service site may subject other centers or service sites under common control or ownership to adverse remedies.

We are also subject to federal and state laws that govern financial and other arrangements between healthcare providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between healthcare providers that are designed to induce the referral of patients to a particular provider for medical products and services. Possible sanctions for violation of any of these restrictions or prohibitions include loss of eligibility to participate in reimbursement programs and/or civil and criminal penalties. Furthermore, some states restrict certain business relationships between physicians and other providers of healthcare services. Many states prohibit business corporations from providing, or holding themselves out as providers of, medical care. From time to time, we may seek guidance as to the interpretation of these laws; however, there can be no
assurance that such laws will ultimately be interpreted in a manner consistent with our practices.

In recent years it has become more difficult for nursing facilities to maintain licensure and certification. We have experienced and expect to continue to experience increased costs in connection with maintaining our licenses and certifications as well as increased enforcement actions. Failure to provide quality resident care may result in civil and/or criminal fines and penalties.

The operation of our eldercare centers is subject to federal and state laws prohibiting fraud by healthcare providers, including criminal provisions, which prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid, or failing to refund overpayments or improper payments. Violation of these criminal provisions is a felony punishable by imprisonment and/or fines. We may be subject to

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fines and treble damage claims if we violate the civil provisions that prohibit the knowing filing of a false claim or the knowing use of false statements to obtain payment.

State and federal governments are devoting increased attention and resources to anti-fraud initiatives against healthcare providers. HIPAA and the Balanced Budget Act expanded the penalties for healthcare fraud, including broader provisions for the exclusion of providers from the Medicaid program.

The
  DRA requires providers who make or receive over $5 million in payments from
  state health plans to establish policies and procedures detailing the Federal
  False Claims Act, state false claims acts (if applicable), state Whistleblower
  Protection Acts, and other state laws related to the reduction of fraud and
  abuse. This provision may require us to implement state-specific employee training
  based on these laws. Further, as a result of the DRA, certain states are contemplating
  the need for their own false claims acts which, if implemented, may impose stricter
  penalties than the federal statute and regulations.

While
  we believe that our business practices are consistent with Medicare and Medicaid
  criteria, those criteria are often vague and subject to change and interpretation.
  Determinations of alleged fraud could have an adverse effect on our business,
  results of operations, financial condition and cash flows.

HIPAA requires us to comply with standards for the internal use of identifiable health information and the sharing of such information with third parties, such as payors, business associates, residents and patients. The standards promulgated under HIPAA regulate the exchange of information in common healthcare transactions, the use of electronic signatures, the development of unique identifiers for providers, employers, health plans and individuals, the security and privacy of identifiable health information, and enforcement.

Sanctions for failing to comply with the HIPAA health information practices provisions include criminal penalties and civil sanctions that could have a material adverse effect on us.

State laws and regulations could affect our ability to grow.

Several
  states in which we operate our business, as well as states in which we may wish
  to operate in the future, have adopted certificate of need or similar laws that
  generally require that a state agency approve certain acquisitions and determine
  the need for certain bed additions, new services and capital expenditures. State
  approvals are generally issued for a specified maximum expenditure and require
  implementation of the proposal within a specified period of time. Failure to
  obtain the necessary state approval can result in the inability to provide the
  service, to operate the centers, to complete the acquisition, addition or other
  change, and can also result in the imposition of sanctions or adverse action
  on the centers license and adverse reimbursement action. There can be
  no assurance that we will be able to obtain state approval for all future projects
  requiring such approval or that such approvals will be timely.

Possible changes in the case mix of patients as well as payor mix and payment methodologies may significantly affect our profitability.

The sources and amounts of our patient revenues will be determined by a number of factors, including licensed bed capacity and occupancy rates of our centers, the mix of patients and the rates of reimbursement among payors. Likewise, therapy services provided by our rehabilitation therapy services business will vary based upon payor and payment methodologies. Changes in the case mix of the patients as well as payor mix among private pay, Medicare and Medicaid will significantly affect our profitability. Particularly, any significant increase in our Medicaid population could have an adverse effect on our business, results of operations, financial condition and cash flows, especially if states operating these programs continue to limit, or more aggressively seek limits on, reimbursement rates.

We face intense competition in our business.

The
  healthcare industry is highly competitive. We compete with a variety of other
  organizations in providing healthcare services. Certain competing organizations
  have greater financial and other resources and may be more established in their
  respective communities than we are. Competing organizations may offer newer
  or different centers or services than us, including a variety of community based
  services, and may thereby attract patients or customers who are presently patients,
  customers or are otherwise receiving our services.

Our
  inpatient services segment is capital intensive, requiring us to direct continually
  financial resources to the maintenance and enhancement of our physical plant
  and equipment.

As of September 30, 2006, we wholly owned or leased 161 skilled nursing and assisted living centers. Our ability to maintain and enhance our physical plant and equipment in a suitable condition to meet regulatory standards, operate efficiently and remain competitive in our markets requires us to commit a substantial portion of our free cash flow to continued investment in our physical plant and equipment. Certain of our competitors may operate centers that are not as old as our centers, or may appear more modernized than our centers, and therefore may be more attractive to prospective customers. In addition, the cost to replace our existing centers through

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acquisition or construction is substantially higher than the carrying value of our centers. We are undertaking a process to allocate more aggressively capital spending within our owned and leased centers in an effort to address issues that arise in connection with an aging physical plant.

If factors, including factors indicated in these Risk Factors and other factors beyond our control, render us unable to direct the necessary financial and human resources to the maintenance, upgrade and modernization of our physical plant and equipment, our business, results of operations, financial condition and cash flows could be adversely impacted.

An increase in insurance costs may adversely affect us, and we may be liable for losses not covered by or in excess of our insurance.

We carry property, workers compensation insurance, general and professional liability coverage on our behalf and on behalf of our subsidiaries in amounts deemed adequate by management. However, there can be no assurance that any current or future claims will not exceed applicable insurance coverage.

Health insurance premiums in the market rose sharply in recent years. Our business is labor intensive, and therefore health insurance costs represent a significant expense for us. In recent years, we have partially managed the increase in insurance premiums with changes in program offerings. Continuing increases substantially in excess of inflation could have a negative impact on our profitability, as further shifts in responsibility for these cost increases to the employee may not be possible.

In
  addition, we are self-insured for a significant portion of our exposure for
  workers compensation insurance, general and professional liability claims
  and health insurance provided to our employees. Accordingly, we are liable for
  payments to be made. To the extent claims are greater than estimated, they could
  adversely affect our business, results of operations, financial condition and
  cash flows.

We could experience significant increases in our operating costs due to continued intense competition for qualified staff, minimum staffing laws in the healthcare industry and potential labor strikes.

We
  and our industry continue to experience shortages in qualified professional
  clinical staff. We compete with other healthcare providers and with non-healthcare
  providers for both professional and non-professional employees. As the demand
  for these services continually exceeds the supply of available and qualified
  staff, we and our competitors have been forced to offer more attractive wage
  and benefit packages to these professionals and to utilize outside contractors
  for these services at premium rates. Furthermore, the competitive arena for
  this shrinking labor market has created high turnover among clinical professional
  staff as many seek to take advantage of the supply of available positions offering
  new and more attractive wage and benefit packages. In addition to the wage pressures
  inherent in this environment, the cost of training new employees amid the high
  turnover rates has increased pressure on our operating margins. Lastly, increased
  attention to the quality of care provided in skilled nursing facilities has
  caused several states to mandate and other states to consider mandating minimum
  staffing laws that further increase the gap between demand for and supply of
  qualified individuals and lead to higher labor costs. While we have been able
  to retain the services of an adequate number of qualified personnel to staff
  our facilities appropriately and maintain our standards of quality care, there
  can be no assurance that continued shortages will not affect our ability to
  attract and maintain an adequate staff of qualified healthcare personnel in
  the future. A lack of qualified personnel at a facility could result in significant
  increases in labor costs and an increased reliance on expensive temporary professional
  staffing agencies at such facility or otherwise adversely affect operations
  at such facility. Any of these developments could adversely affect our business,
  results of operations, financial condition and cash flows.

In addition, certain of our centers have certified unions that have entered into collective bargaining agreements. If one or more of these centers experience a lock-out or strike it could create a disruption in our business and increase our operating costs.

If we are unable to control operating costs and generate sufficient cash flow to meet operational and financial requirements, including servicing our indebtedness, our business operations may be adversely affected.

Cost containment and lower reimbursement levels relative to inflationary increases in cost by third-party payors, including federal and state governments, have had a significant impact on the healthcare industry as a whole and on our cash flows. Our operating margins continue to be under pressure because of continuing regulatory requirements and scrutiny and growth in operating expenses, such as labor costs and insurance premiums. In

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addition, as a result of competitive pressures, our ability to maintain operating margins through price increases to private patients is limited.

Our ability to make payments on our existing and future debt and to pay our expenses will depend on our ability to generate cash in the future. Our ability to generate cash is subject to various risks and uncertainties, including those disclosed in this section and prevailing economic, regulatory and other conditions beyond our control.

The agreements that govern our financing agreements contain various covenants that limit our discretion in the operation of our business.

The agreements and instruments that govern our financing arrangements contain various restrictive covenants that, among other things, require us to comply with or maintain certain financial tests and ratios and restrict our ability to:



        incur more debt;




        pay dividends, purchase company stock or make other distributions;




        make
          payments in respect of subordinated debt;




        make certain investments;




        create liens;




        enter into transactions with affiliates;




        make acquisitions;




        merge or consolidate; and




        transfer or sell assets.


Our ability to comply with these covenants is subject to various risks and uncertainties. In addition, events beyond our control could affect our ability to comply with and maintain the financial tests and ratios. Any failure by us to comply with and maintain all applicable financial tests and ratios and to comply with all applicable covenants could result in an event of default with respect to, and the acceleration of the maturity of, and the termination of the commitments to make further extension of credit under, a substantial portion of our debt. If we were unable to repay debt to our senior lenders, these lenders could proceed against the collateral securing that debt. Even if we are able to comply with all applicable covenants, the restrictions on our ability to operate our business in our sole discretion could harm our business by, among other things, limiting our ability to
take advantage of financing, mergers, acquisitions and other corporate opportunities.

A significant portion of our business is concentrated in certain markets and the respective economic conditions or changes in the laws affecting our business in those markets could have a material adverse effect on our operating results.

As of September 30, 2006, we receive approximately 80% of our inpatient services revenue from operations in Pennsylvania, New Jersey, Maryland, Massachusetts and West Virginia. The economic condition of these markets could affect the ability of our patients and third-party payors to reimburse us for our services through a reduction of disposable household income or the ultimate reduction of the tax base used to generate state funding of their respective Medicaid programs. An economic downturn, or changes in the laws affecting our business in these markets and in surrounding markets, could have an adverse effect on our business, results of operations, financial condition and cash flows.

Realization of the tax benefit relating to our net operating loss carryforward is subject to numerous risks.

We estimate our net operating loss carryforward is approximately $83.2 million at September 30, 2006 after giving effect to NCIs consolidated federal tax return completed for the period ended September 30, 2004. However, such net operating loss carryforward may further need to be adjusted pending settlement of any federal tax audit of tax years ending on or before that date which could materially reduce, or even eliminate, our estimated net operating loss carryforward. The amount and timing of any realized tax benefit resulting from the utilization of the net operating loss carryforward is a function of future taxable income, multiple change of ownership limitations

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imposed by Section 382 of the Internal Revenue Code of 1986, as amended, contractual limitations imposed by the tax sharing agreement with NCI, and the term of the carryforward period.

Recent
  legislation and the increasing costs of being publicly owned are likely to impact
  our future financial position and results of operations.

In
     connection with the Sarbanes-Oxley Act of 2002, we are subject to rules
    requiring
  our management to report on the effectiveness of our internal controls over
     financial reporting, and further requiring our independent registered public

  accounting firm to attest similarly to such effectiveness. If we fail to have
     effective internal controls and procedures for financial reporting in place,

  we could be unable to provide timely and reliable financial information which
     could, in turn, have an adverse effect on our business, results of operations,

  financial condition and cash flows.

Significant regulatory changes, including the Sarbanes-Oxley Act and rules and regulations promulgated as a result of the Sarbanes-Oxley Act, have increased, and in the future are likely to further increase, general and administrative costs. In order to comply with the Sarbanes-Oxley Act of 2002, the listing standards of the NASDAQ Global Market, and rules implemented by the Securities and Exchange Commission (SEC), we have had to hire additional personnel and utilize additional outside legal, accounting and advisory services, and may continue to require such additional resources. Moreover, in the rapidly changing regulatory environment in which we now operate, there is significant uncertainty as to what will be required to comply with many of the new rules and regulations. As a result, we may be required to spend substantially more than we currently estimate, and may need to
divert resources from other activities, as we develop our compliance plans.

New
  accounting pronouncements or new interpretations of existing standards could
  require us to make adjustments in our accounting policies that could affect
  our consolidated financial statements.

The
  Financial Accounting Standards Board (FASB), the SEC, or other accounting organizations
  or governmental entities issue new pronouncements or new interpretations of
  existing accounting standards that sometimes require us to change our accounting
  policies and procedures. Future pronouncements or interpretations could require
  us to change our policies or procedures and have a significant impact on our
 consolidated financial statements.

Implementation of new information systems could negatively affect us.

We are in the process of implementing certain new information systems to enhance operating efficiencies and provide more effective management of our business. Implementation of new systems carries risks such as project cost overruns and business interruptions. If we experience a material business interruption as a result of the implementation of new information systems or are unable to obtain the projected benefits of new systems, it could have an adverse effect on our business, results of operations, financial condition and cash flows.

We may make acquisitions that could subject us to a number of operating risks.

We have made and may make additional acquisitions of, investments in, and strategic alliances with complementary businesses utilizing cash or debt financing to enable us to capitalize on our position in the geographic markets in which we operate and to expand our businesses geographically. Implementation of this strategy entails a number of risks, including:



        inaccurate assessment of undisclosed liabilities;




        diversion of managements attention from our existing operations;




        difficulties in assimilating the operations of an acquired business or in realizing projected revenue synergies, efficiencies and cost savings; and




        increase in our indebtedness and a limitation on our ability to access additional capital when needed.


Certain changes may be necessary to integrate the acquired businesses into our operations, to assimilate new employees and to implement reporting, monitoring, compliance and forecasting policies and procedures.

Provisions in Pennsylvania law and our corporate documents could delay or prevent a change in control.

As a Pennsylvania corporation, we are governed by the Pennsylvania Business Corporation Law of 1988, as amended, referred to as Pennsylvania corporation law. Pennsylvania corporation law provides that the board of directors of a corporation in discharging its duties, including its response to a potential merger or takeover, may consider the effect of any action upon employees, shareholders, suppliers, patients, customers and creditors of the

26

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corporation, as well as upon communities in which offices or other establishments of the corporation are located and all other pertinent factors. In addition, under Pennsylvania corporation law, subject to certain exceptions, a business combination between us and a beneficial owner of more than 20% of our common stock may be accomplished only if certain conditions are met.

Our articles of incorporation contain certain provisions that may affect a persons decision to initiate a takeover of us, including the following provisions:



        a classified board of directors;




        a provision confirming that we are subject to the restrictions in the Pennsylvania corporation law on certain business combinations involving us that are not approved by the board or directors; and




        the authority to issue preferred stock with rights to be designated by the board of directors.


Our articles of incorporation also confirm that we are subject to the provisions of Pennsylvania corporation law that deny our shareholders the right to act by partial written consent without a meeting.

Additionally, our board of directors adopted a shareholder rights plan, which makes it difficult for any person or group to acquire a significant interest in our common stock without advance approval of our board of directors.

The overall effect of the foregoing provisions may be to deter a future tender offer or other offers to acquire us or our shares. Shareholders might view such an offer to be in their best interest if the offer includes a substantial premium over the market price of the common stock at that time. In addition, these provisions may assist our management in retaining its position and place it in a better position to resist changes that the shareholders may want to make if dissatisfied with the conduct of our business.

Our future profitability could be impacted by our ability to achieve certain performance improvement objectives in our rehabilitation therapy services segment.

Beginning in fiscal 2004 and throughout fiscal 2006, we and the rehabilitation therapy services sector have experienced a shortage of qualified rehabilitation therapists. As the demand for these services continues to exceed the supply of available therapists, we and our competitors have been forced to offer more attractive wage and benefit packages to these professionals while utilizing outside contractors for these services at premium rates. We have undertaken a series of actions intended to improve the operating performance of our rehabilitation therapy services segment. If we are unsuccessful in achieving our performance improvement objectives, it could have an adverse effect on our business, results of operations, financial condition and cash flows.

Portions of our historical financial information and our pro forma financial information may not be representative of our results as a separate company.

Prior to our spin-off on December 1, 2003, our operations were conducted as part of the consolidated NCI entity and not as a stand-alone entity. Accordingly, the financial information included or incorporated by reference in this annual report as of dates prior to the spin-off may not reflect the results of operations, financial condition and cash flows that would have been achieved had our company been operated independently during such periods and as of such dates presented.

Prior to December 1, 2003, costs related to our corporate functions, including legal support, treasury administration, insurance administration, human resource management, internal audit, corporate accounting and income tax administration, which are not directly and solely related to our operations, were allocated to us prior to the spin-off based upon various methodologies deemed reasonable by management. Prior to December 1, 2003, certain assets and liabilities relating to our business were managed and controlled by NCI on a centralized basis. Such assets and liabilities reflected in our financial statements as of dates prior to December 1, 2003 were also allocated to us based upon various methodologies deemed reasonable by management. Although our management believes that the methods used to allocate and estimate such assets, liabilities and expenses are reasonable, there can be
no assurance that such financial information is comparable to financial information for periods after the December 1, 2003 spin-off.

27

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We may be required to satisfy certain indemnification obligations to NCI, or may not be able to collect on indemnification rights from NCI.

Under the terms of a separation and distribution agreement, we and NCI each agreed to indemnify each other from and after the distribution with respect to the indebtedness, liabilities and obligations that are retained by our respective companies. These indemnification obligations could be significant, and we cannot presently determine the amount of indemnification obligations for which we will be liable or for which we will seek payment from NCI. Our ability to satisfy these indemnities, if we are called upon to do so, will depend upon our future financial performance. Similarly, NCIs ability to satisfy any such obligations to us will depend on NCIs future financial performance. We cannot assure you that we will have the ability to satisfy any substantial indemnification obligations to NCI. We also cannot assure you that if NCI is required to indemnify us for any substantial
obligations, NCI will have the ability to satisfy those obligations.

ITEM 1B:UNRESOLVED STAFF COMMENTS

None.

28

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ITEM
  2:   PROPERTIES

Inpatient Sites of Service

The following table provides information by state as of December 1, 2006 regarding the eldercare centers we own, lease and manage. Included in the center count are 26 stand-alone assisted living facilities with 2,325 units and 15 skilled nursing facilities with 425 assisted living units.



Wholly
          Owned Centers
      
      Leased
          Centers
      
      Managed
          Centers (1)
      
      TotalState
      
      Facilities
      
      Beds
      
      Facilities
      
      Beds
      
      Facilities
      
      Beds
      
      Facilities
      
      BedsPennsylvania
      
      32
      
      4,218
      
      8
      
      941
      
      5
      
      863
      
      45
      
      6,022New Jersey
      
      20
      
      2,850
      
      7
      
      1,356
      
      5
      
      577
      
      32
      
      4,783Maryland
      
      14
      
      1,756
      
      6
      
      831
      
      13
      
      1,881
      
      33
      
      4,468Massachusetts
      
      16
      
      2,170
      
      2
      
      250
      
      11
      
      639
      
      29
      
      3,059West Virginia
      
      23
      
      1,890
      
      5
      
      394
      
      1
      
      62
      
      29
      
      2,346New Hampshire
      
      10
      
      972
      
      2
      
      208
      
      2
      
      246
      
      14
      
      1,426Connecticut
      
      9
      
      1,330
      
      -
      
      -
      
      1
      
      70
      
      10
      
      1,400Delaware
      
      5
      
      582
      
      -
      
      -
      
      2
      
      237
      
      7
      
      819Virginia
      
      2
      
      210
      
      1
      
      240
      
      -
      
      -
      
      3
      
      450Rhode Island
      
      3
      
      373
      
      -
      
      -
      
      -
      
      -
      
      3
      
      373North Carolina
      
      -
      
      -
      
      -
      
      -
      
      2
      
      340
      
      2
      
      340Vermont
      
      3
      
      314
      
      -
      
      -
      
      -
      
      -
      
      3
      
      314Total
      
      137
      
      16,665
      
      31
      
      4,220
      
      42
      
      4,915
      
      210
      
      25,800


(1)

        Managed centers include 9 properties with 1,331 beds that are jointly owned by us and independent third-parties. Also included in managed centers are 8 transitional care units with 206 beds located in hospitals principally in the Commonwealth of Massachusetts.


We believe that our physical properties are well maintained and are in a suitable condition for the conduct of our business. In fiscal 2006, we significantly increased our level of capital spending in an effort to upgrade and modernize our physical plant. Our capital spending plan for fiscal 2007 contemplates spending levels in the range of $75 million to $85 million.

29

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ITEM 3:LEGAL PROCEEDINGS

Haskell et al. v. Goldman Sachs & Co. et al.

NeighborCare, Inc., our former parent, is the defendant in an action brought by former investors in NeighborCare, Inc. on January 27, 2004 in the Supreme Court of New York, County of New York. The plaintiffs collectively held over $205.0 million in subordinated debentures prior to the filing by NeighborCare, Inc. and substantially all of our subsidiaries of a Chapter 11 bankruptcy petition in 2000. The claim alleges fraud and grossly negligent misrepresentation by defendants NeighborCare, Inc., Goldman Sachs & Co., Mellon Bank, N.A., Highland Capital Management, LP, and George V. Hager, Jr., our Chief Executive Officer (and former Chief Financial Officer of NeighborCare, Inc. prior to the spin-off), in connection with the Bankruptcy Courts approval of the plan of reorganization confirmed by the Bankruptcy Court in 2001 which canceled the subordinated debentures. The
plaintiffs seek to recover $200.0 million plus interest costs and fees. The action was removed to the United States Bankruptcy Court for the District of Delaware. In July 2004, we received notice from NeighborCare, Inc. indicating that it believes we are responsible for 50% of the legal fees related to this matter. In addition, Mellon Bank, N.A. has asserted a claim against NeighborCare, Inc. for indemnification for expenses and damages related to the former investors claim. On March 28, 2005, the Bankruptcy Court ruled that NeighborCare, Inc. would be obligated to reimburse Mellon Bank, N.A. for expenses and damages relating to the claim, other than any expenses or damages determined by the Bankruptcy Court to have resulted from Mellon Banks gross negligence or willful misconduct. On April 27, 2005 the Bankruptcy Court dismissed the plaintiffs complaint against all named defendants. Plaintiff has appealed the Bankruptcy Courts decision. While we have advanced
NeighborCare, Inc. 50% of the deductible under the insurance policy related to the former investors claim, we have not made a determination with respect to our ultimate liability, if any, relative to this case.

ITEM 4:SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of shareholders during the fourth quarter of fiscal 2006.

ITEM 4A:EXECUTIVE OFFICERS OF THE REGISTRANT

The following table and biographies set forth information with respect to persons who serve as our executive officers:



Name


      


      Age


      


      PositionGeorge V. Hager, Jr.


      

        50


      

        Chief Executive Officer and Class I Director (Chairman of the Board of Directors)James V. McKeon

        

        42

        

        Executive Vice President and Chief Financial OfficerRobert A. Reitz

        

        56

        

        Executive Vice President and Chief Operating OfficerDavid C. Almquist

        

        52

        

        Executive Vice PresidentRichard P. Blinn

        

        52

        

        Executive Vice PresidentEileen M. Coggins

        

        42

        

        Senior Vice President, General Counsel and Corporate SecretaryBarbara J. Hauswald

        

        47

        

        Senior Vice President, Planning and DevelopmentRichard Pell, Jr.

        

        58

        

        Senior Vice President, AdministrationA. T. Locilento, Jr.

        

        63

        

        Senior Vice President, Human DevelopmentThomas DiVittorio

        

        38

        

        Vice President, Corporate Controller and Chief Accounting Officer


George V. Hager, Jr.has served as our chief executive officer and chairman of the board of directors since our inception in May 2003. Mr. Hager joined NCI in 1992. From 1992 to December 2003, he served as NCIs chief financial officer and was responsible for corporate finance, treasury, investor relations, information services, third-party reimbursement and risk management. Mr. Hager serves on the board of directors of Adolor Corporation.

James V. McKeonhas served as our executive vice president and chief financial officer since December 2003. Mr. McKeon served as NCIs senior vice president and corporate controller from April 2000 to December 2003.

30

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From April 1997 to April 2000, Mr. McKeon served as NCIs vice president and corporate controller.  Mr. McKeon joined NCI in June 1994 as director of financial reporting and investor relations and served as NCIs vice president of finance and investor relations from November 1995 to April 1997.

Robert A. Mike Reitzhas served as our executive vice president and chief operating officer since December 2003.  Mr. Reitz served as president of NCIs Mid-Atlantic ElderCare region from September 1997 until December 2003.  He served in various management positions with Meridian Healthcare for nineteen years prior to its acquisition by NCI in 1993.

David C. Almquisthas served as our executive vice president since December 2003.  Mr. Almquist served as president of NCIs Chesapeake ElderCare region from 1996 until December 2003.  Mr. Almquist has over 29 years of experience in the healthcare industry.

Richard P. Blinnhas served as our executive vice president since December 2003.  Mr. Blinn served as president of NCIs New England ElderCare region from 1998 until December 2003.  Mr. Blinn has over 27 years of experience in the healthcare industry.

Eileen M. Coggins, Esquire,has served as our senior vice president, general counsel and corporate secretary since December 2003.  Ms. Coggins served as NCIs corporate compliance and privacy officer from December 2002 until December 2003.  Prior to that appointment, from April 1998 to December 2002, she was NCIs vice president of compliance, and prior to that was NCIs deputy general counsel.

Barbara J. Hauswaldhas served as our senior vice president, planning and development since December 2003.  Ms. Hauswald served as NCIs senior vice president and treasurer from April 2000 until December 2003, and joined NCI as vice president and treasurer in April 1998. Prior to joining NCI, Ms. Hauswald served as first vice president in the healthcare banking department of Mellon Bank N.A.

Richard Pell, Jr.has served as our senior vice president, administration since December 2003. Mr. Pell served as NCIs senior vice president, administration and chief compliance officer from April 1998 until December 2003, with responsibility for the following areas: human resources, law, government relations, public relations, staff development and corporate communications. Prior to joining NCI, Mr. Pell was the director of the Veterans Affairs Medical Center in Martinsburg, West Virginia.

Arthur T. Bud Locilento, Jr.has served as our senior vice president of human development since August 2006, and is responsible for determining and implementing our human capital strategy. Prior to joining us, he founded and operated Human Capital Partners from April 2003 through August 2006, a retained executive search firm that provided recruitment services principally to clients in the healthcare and financial services industries. From April 1998 through April 2003, he served as managing director of the Diversified Search Companies, with responsibility for conducting senior-level retained searches in a variety of industry sectors with emphasis on the healthcare and financial services sector.

Thomas DiVittoriohas served as our vice president, corporate controller and chief accounting officer since December 2004, and vice president and corporate controller since December 2003. From January 2003 to December 2003, Mr. DiVittorio served as NCIs vice president and assistant controller. From April 1999 to January 2003, Mr. DiVittorio served as NCIs director of financial reporting and from November 1996 to April 1999 he served as NCIs manager of financial reporting.

31

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PART II

ITEM
          5:

        MARKET FOR THE REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES


The following table indicates, for each of the quarters in the fiscal years ended September 30, 2006 and 2005, the range of high and low closing prices of our common stock reported on the NASDAQ Global Market System.



Quarter
          Ended
      
      High
      
      LowDecember
          31, 2005
      
      $
      43.98
      
      $
      36.14March
          31, 2006
      
      
      44.85
      
      
      36.10June
          30, 2006
      
      
      48.11
      
      
      42.86September
          30, 2006
      
      
      48.57
      
      
      43.90Quarter
          Ended
      
      High
      
      LowDecember
          31, 2004
      
      $
      36.70
      
      $
      29.24March
          31, 2005
      
      
      43.27
      
      
      33.11June
          30, 2005
      
      
      46.62
      
      
      35.39September
          30, 2005
      
      
      47.96
      
      
      39.16


As of December 1, 2006, there were 3,808 shareholders of record of our common stock. We have never declared or paid cash dividends on our common stock. Our ability to pay dividends on our common stock is restricted by our senior credit agreement and senior subordinated notes agreement. See Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations  Liquidity and Capital Resources.  Management does not anticipate the payment of cash dividends on our common stock in the foreseeable future.

The equity compensation plan table and related footnotes included under Item 12  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters of this report is incorporated herein by reference.

32

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ITEM
          6:

        SELECTED FINANCIAL DATA




Year ended September 30,

        

        2006

        

        2005

        

        2004

        

        2003

        

        2002Statement of Operations Data (1)(in thousands, except per share and ratio data)Net revenues

        

        $

        1,770,298

        

        $

        1,711,433

        

        $

        1,558,197

        

        $

        1,409,425

        

        $

        1,322,789Income from continuing operations

        

        

        37,943

        

        

        46,228

        

        

        30,449

        

        

        27,563

        

        

        41,362Net income

        

        $

        35,877

        

        $

        46,068

        

        $

        28,242

        

        $

        10,036

        

        $

        35,911Diluted earnings per share from continuing operations(2)

        

        $

        1.93

        

        $

        2.31

        

        $

        1.51Diluted earnings per share from net income(2)

        

        $

        1.83

        

        $

        2.30

        

        $

        1.40Ratio of earnings to fixed charges

        

        

        2.84x

        

        

        2.95x

        

        

        2.21x

        

        

        2.22x

        

        

        3.43xOperating Data of Inpatient Services Segment:Payor Mix:Medicaid

        

        


      52%

        

        


      54%

        

        


      51%

        

        


      50%

        

        


      48%Medicare

        

        


      29%

        

        


      27%

        

        


      29%

        

        


      28%

        

        


      29%Private pay and other

        

        


      19%

        

        


      19%

        

        


      20%

        

        


      22%

        

        


      23%Average owned/leased eldercare center beds, including consolidated VIEs

        

        

        20,895

        

        

        21,167

        

        

        21,621

        

        

        23,463

        

        

        24,139Occupancy percentage

        

        


      91%

        

        


      90%

        

        


      91%

        

        


      91%

        

        


      92%Average managed eldercare center beds, excluding consolidated VIEs

        

        

        4,983

        

        

        5,482

        

        

        4,870

        

        

        5,615

        

        

        7,898At September 30,

        

        

        2006

        

        

        2005

        

        

        2004

        

        

        2003

        

        

        2002Balance Sheet Data (in thousands)Working capital

        

        $

        222,195

        

        $

        214,864

        

        $

        199,144

        

        $

        94,130

        

        $

        69,263Total assets

        

        

        1,472,530

        

        

        1,412,700

        

        

        1,372,848

        

        

        1,150,525

        

        

        1,161,216Long-term debt, including current installments

        

        

        444,834

        

        

        451,096

        

        

        484,514

        

        

        318,774

        

        

        326,476Shareholders equity

        

        $

        700,474

        

        $

        650,813

        

        $

        555,076

        

        $

        563,447

        

        $

        589,966


(1)

        For a discussion of operating results from fiscal 2004 through fiscal 2006, and factors affecting comparability of financial information, see  Item 7  Managements Discussion and Analysis of Financial Condition and Results of Operations  Results of Operations.  The net revenues and income from continuing operations data for all periods presented have been adjusted to exclude discontinued operations. The payor mix and occupancy data have also been adjusted to exclude discontinued operations.


(2)

        The computation of diluted earnings per share assumes that the number of our common shares distributed by NCI on December 1, 2003 in connection with the spin-off was outstanding on October 1, 2003, and is therefore presented on a pro forma basis for the year ended September 30, 2004.


Please refer to Item 7  Managements Discussion and Analysis of Financial Condition and Results of Operations  Certain Transactions and Events and  Managements Discussion and Analysis of Financial Condition and Results of Operations  Revenue Sources for a discussion of significant transactions and material uncertainties.

33

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|ITEM
        7: | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|--------------- | -------------------------------------------------------------------------------------

Overview

We
  are one of the largest providers of healthcare and support services to the elderly
  in the United States. Within our network of geographically concentrated facilities,
  we offer services focusing on the primary medical, physical and behavioral issues
  facing the medically complex elderly population. We are focused on qualitative
  and quantitative clinical performance measures in order to enhance and improve
  continuously the care provided in our facilities. Through our physicians, nurses,
  therapists and other members of our interdisciplinary medical care team, we
  apply a comprehensive approach to the complex needs facing the elderly, which
  we believe has resulted in our above-industry average occupancy levels and an
  enhanced level of Medicare and private paying patients. We receive higher rates
  of reimbursement from Medicare and private paying and other patients. For the
  twelve months ended September 30, 2006, the average occupancy level in our inpatient
  facilities was approximately 91% and approximately 48% of our net revenues were
  from Medicare and private paying and other patients.

Approximately
  90% of our net revenues are generated through our inpatient services segment.
  Our inpatient services business is offered through a network of skilled nursing
  and assisted living centers primarily located in the eastern United States.
  Our eldercare centers are concentrated in the states of Pennsylvania, New Jersey,
  Maryland Massachusetts and West Virginia. We currently own, lease, manage or
  jointly own 210 eldercare facilities, consisting of 176 skilled nursing facilities,
  26 assisted living facilities and 8 transitional care units together totaling
  25,800 beds.

Our rehabilitation therapy segment, which represents approximately 8% of our net revenues, provides an extensive range of rehabilitation therapy services to the elderly, including speech pathology, physical therapy and occupational therapy in our eldercare regional market concentrations. These services are provided by approximately 4,900 licensed rehabilitation therapists and assistants employed or contracted by us at substantially all of the eldercare facilities we operate, as well as by contract to third-party healthcare facilities operated by other providers and through our 13 outpatient rehabilitation agencies. We also provide other complementary healthcare services, the revenues for which are included in all other services revenues in our segment financial information.

The aging of the population and increased life expectancies are the primary driving forces behind the growth of our businesses. We believe that positive demographic trends imply that there will be a growing demand for the services offered by healthcare providers that deliver the most efficient, responsive, cost effective and high quality eldercare services. We are continually engaged in various efforts to improve our profitability by focusing on key operational initiatives, including: modernizing our physical plant and information systems, improving the level of Medicare and private paying patients, increasing our rate of occupancy, improving nursing staff scheduling and retention, reducing reliance on overtime compensation and temporary agency services, and capitalizing on best demonstrated practices in various areas of cost control. As a result, we believe we will be well
positioned to take advantage of the favorable demographic and growth trends in our industry.

Government funded programs, principally Medicaid and Medicare, provide approximately 74% of our revenue. Over the past five years, changes in funding from these government sources has had a significant impact on our cash flows and profitability. Through trade and other organizations, we actively participate in partnership with other healthcare providers to pursue strategies to minimize any potentially adverse impact of government funding proposals. We believe the continuation of government funding at levels sufficient to operate our business profitably is our greatest financial risk.

Labor costs, including salaries, wages and benefits, account for approximately 73% of our total operating expenses. We compete with other healthcare providers and with non-healthcare providers for both professional and non-professional employees. In recent years, we and our industry have experienced shortages in qualified professional clinical staff. While in our inpatient services segment we have been able to retain the services of an adequate number of qualified personnel to staff our facilities and sites of services, we have used expensive temporary nursing agency services to supplement staffing. If a shortage of nurses or other health care workers

34

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occurred in the geographic areas in which we operate, it could adversely affect our ability to attract and retain qualified personnel and could further increase our operating costs, without a corresponding increase in the level of government funded reimbursement.

Beginning in fiscal 2004 and continuing through fiscal 2006, we and the rehabilitation therapy services sector have experienced a shortage of qualified rehabilitation therapists. As the demand for these services continues to exceed the supply of available therapists, we and our competitors have been forced to offer more attractive wage and benefit packages to these professionals while utilizing outside contractors for these services at premium rates. Although we have been able to retain adequate levels of qualified therapists to maintain our standards of quality care in the services we provide, the shortage of qualified therapists has impacted negatively our profitability and our ability to generate new therapy business. We implemented certain initiatives in fiscal 2006 intended to improve our therapist recruitment and retention capabilities while also being more aggressive in
pricing our services and more selective in our external customer base. These initiatives, along with the implementation of a more efficient and integrated time collection system to improve the productivity of our therapist workforce are intended to improve the profitability of this business.

For
  a description of our material challenges and risks, including an analysis of
  industry trends and the effect of recent legislation on our operations, see
  Item 1A  Risk Factors.

Certain Transactions and Events

Acquisition of ElderCare Centers

Subsequent to September 30, 2006, we completed two transactions to acquire eldercare center assets.

Effective
  November 1, 2006, we purchased a 115 bed skilled nursing facility in the State
  of Maryland. The net purchase price of $8.1 million has been financed with $6.0
  million of debt from our revolving credit facility and $2.1 million of cash.
  This facility generates annual revenues of approximately $7.0 million.

Effective
  December 1, 2006, we completed the purchase of two skilled nursing facilities
  and four assisted living facilities in the State of West Virginia for a net
  purchase price of $41.1 million. The purchase has been financed with $33.0 million
  of debt from our revolving credit facility and $8.1 million of cash. The combined
  facilities generate annual revenues of approximately $20.0 million.

Amendments to NCI Agreements

On
  August 18, 2006, we and Omnicare, Inc. (Omnicare) entered into (i) an Amended
  and Restated Master Agreement for Pharmacy, Pharmacy Consulting and Related
  Products and Services, dated as of July 1, 2006, which agreement amends and
  restates the Master Agreement for Pharmacy, Pharmacy Consulting and Related
  Products and Services, dated as of December 1, 2003, by and between us and NeighborCare
  Pharmacy Services, Inc. (NPS), as first amended on May 7, 2004 and second amended
  on June 9, 2005 (the Pharmacy Services
  Agreement), and (ii) an Amended
  and Restated Master Agreement for Specialty Beds and Oxygen Concentrators, dated
  as of July 1, 2006, which agreement amends and restates the Master Agreement
  for Specialty Beds and Oxygen Concentrators, dated as of December 1, 2003, by
  and between us and NPS (the Durable
  Medical Equipment Agreement).
  On July 28, 2005, Omnicare acquired NPS in a merger transaction pursuant to
  which NPS became a wholly owned subsidiary of Omnicare. Pursuant to the above-referenced
  merger transaction, Omnicare succeeded to all of NPSs rights and obligations
  under the Pharmacy Services Agreement and Durable Medical Equipment Agreement.

35

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Pharmacy Services Agreement

We and Omnicare amended the Pharmacy Services Agreement in order to, among other things: (i) extend the initial term for an additional five years to November 30, 2018; (ii) provide for annual price reviews and potential price adjustments based on the number of skilled nursing facility beds served by Omnicare under the Pharmacy Services Agreement; and (iii) reduce the prices paid by us for certain medications, including modifying the discounts available to us for our prompt payment of Omnicare invoices.

Durable Medical Equipment Agreement

We and Omnicare amended the Durable Medical Equipment Agreement in order to, among other things: (i) permit us to purchase or rent certain equipment directly from a certain manufacturer or its affiliates or successors; (ii) increase price discounts available to us for our prompt payment of Omnicare invoices; and (iii) reduce the cost to us for certain products.

Purchase of Joint Venture Interests

In
  June 2006, we acquired a 49% limited partnership interest in a joint venture
  with capital contributions amounting to $2.1 million as of September 30, 2006.
  The joint venture is engaged in the construction of an office building. The
  total cost of the project is estimated to be between $17 million and $19 million
  and will be financed with capital contributions from the partners and a line
  of credit of up to $14 million. The building is expected to be completed by
  the end of our fiscal year-ended September 30, 2007. We, as the primary tenant
  of the building under construction, consolidate and capitalize the construction
  costs and borrowings under the line of credit through the construction phase
  of the project. At September 30, 2006, we included in our consolidated balance
  sheet $4.1 million classified as property and equipment for the construction
  in progress to date and a $2.0 million obligation classified as other long-term
  liabilities representing the other parties contributions less the partnerships
  cash balance at the end of the period. Once the project is complete, we will
  re-evaluate our accounting.

In
  December 2005, we deposited into escrow $4.1 million to acquire all of our joint
  venture partners interests in three skilled nursing facilities located
  in the State of West Virginia having a combined 208 beds. We owned a 50% interest
  in and managed the operations of each of the three facilities, but upon completion
  of the transaction on June 1, 2006 owned 100% of each facility and consolidated
  the related revenues, expenses and net assets. We had already consolidated the
  financial statements of one of the facilities and recorded minority interest
  to reflect its joint venture partners interests.

Effective January 1, 2005, we acquired our joint venture partners interest in a Commonwealth of Massachusetts skilled nursing facility having 123 beds. Prior to that acquisition, we owned a 50% interest in the facility and consolidated its operations upon adoption of FIN 46 effective January 1, 2003 as we determined we were the primary beneficiary of the partnership. Upon completion of the transaction, we owned 100% of the facility and adjusted the carrying value of the acquired interest in the assets and liabilities to fair value as of January 1, 2005. The aggregate consideration consisted of cash of $0.5 million to acquire the remaining partnership interests and the assumption of approximately $6.0 million of partnership debt, all of which was repaid at the closing of the transaction.

On January 5, 2004, we acquired our joint venture partners interest in two Massachusetts skilled nursing facilities we previously managed. We previously owned a 50% interest in one facility and a 20% interest in the other. Upon completion of the transaction, we owned 100% of both facilities and acquired approximately $6.0 million of working capital along with the property and equipment of the two skilled nursing facilities, having a total of 318 beds. The aggregate consideration consisted of $6.0 million in cash and the assumption of debt in the amount of approximately $20.0 million, of which $12.5 million was repaid following completion of the transactions.

36

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Lease and Purchase Option Agreements

In
  May 2006, we announced that we signed an agreement to enter into lease and purchase
  option agreements with an unrelated provider of long-term care that operates
  11 facilities with a combined total of 970 skilled nursing and assisted living
  facility beds located in the State of Maine. The transaction contemplates that
  we will enter into 11 separate agreements to lease the facilities over a 10-year
  term, with two five-year renewal options. We will also obtain an option to purchase
  all 11 properties in 2026 for $53.0 million. We expect to account for the transaction
  as a capital lease. Upon closing, we would expect to pay approximately $16.0
  million of cash and the related capital lease obligation is expected to approximate
  $40.0 million. The 11 facilities currently generate approximately $65.0 million
  of annual revenue. The closing of the transaction, which is expected to occur
  in early calendar year 2007, is subject to receipt of regulatory approvals and
  various other customary conditions. Accordingly, no assurances can be given
  that the transaction will be consummated or, if it is, what the final terms
  will be or what its ultimate impact will be on our financial condition, results
  of operations and cash flows.

Share Repurchase

In April 2006, our board of directors authorized the repurchase of up to $150.0 million of our common stock, with such repurchases to take place at our managements discretion and/or under pre-established, non-discretionary programs from time to time, depending on market conditions, in the open market and in privately negotiated transactions, subject to any covenants or restrictions contained in agreements governing our indebtedness. Repurchases of common stock are restricted by our debt agreements, the most restrictive of which is our 8% senior subordinated notes. Such restrictions preclude repurchases of common stock above 50% of our net income since July 1, 2003. After considering common stock repurchases made to date and other repurchase provisions, our maximum common stock repurchasing capacity at September 30, 2006 was $22.7 million. In total, 1,075,745 shares of common
stock have been repurchased under current and past common stock repurchase programs at a cost of $42.8 million, of which 288,408 shares at a cost of $10.7 million were repurchased during fiscal 2006.

Debt Repurchase

In February 2005, our board of directors authorized the repurchase of a portion of our 8% senior subordinated notes due 2013 from time to time in the open market commencing in March 2005 until December 31, 2006. There were $79.1 million of 8% senior subordinated notes repurchased through September 30, 2006, of which $8.2 million were repurchased in fiscal 2006. The total debt repurchases made to date resulted in prepayment premium charges of $7.9 million and the write-off of unamortized deferred financing fees and other fees of $3.0 million. These charges, along with the write-off of unamortized deferred financing fees, are collectively included in loss on early extinguishment of debt in the consolidated statements of operations, of $0.8 million, $11.8 million and $1.7 million for the years ended September 30, 2006, 2005 and 2004, respectively.

Issuance and Registration of Convertible Senior Subordinated Debentures

In March 2005, we completed a private placement of $180.0 million aggregate principal amount of our 2.5% convertible senior subordinated debentures due 2025 to qualified institutional buyers under Rule 144A of the Securities Act of 1933, as amended. After paying financing fees of approximately $5.5 million, we used (i) approximately $20.1 million of the net proceeds of the offering to repurchase shares of our common stock from the initial purchasers of the debentures in negotiated transactions concurrently with the offering, (ii) approximately $119.7 million of the net proceeds to repay the remaining outstanding borrowings under the term loan portion of our senior credit facility, and (iii) the balance for general corporate purposes, including debt repurchases described above. In July 2005, we registered with the Securities and Exchange Commission the resale of the convertible
senior subordinated debentures and the relating guarantees and underlying common stock.

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Senior Credit Facility Amendment

In March 2005, in connection with the offering of the convertible senior subordinated debentures, we entered into an amended and restated senior credit agreement pursuant to which we refinanced the indebtedness under our existing senior credit agreement. We repaid all outstanding borrowings under the term loan portion of the senior credit facility and expanded the borrowing capacity of the revolving credit portion.

Prior to the amendment, the existing senior credit agreement provided for a revolving credit facility of $75.0 million, with sub limits for swing line loans, letters of credit and term loans. The amended and restated senior credit agreement provides for a $125.0 million revolving credit facility, with sub limits for the issuance of letters of credit and for swing line loans.

Recognition of Pennsylvania and New Jersey Provider Assessments

Provider assessments generate additional federal matching funds to the states for Medicaid reimbursement purposes, and implementation of a provider assessment plan requires approval by the Centers for Medicare and Medicaid (CMS) in order to qualify for federal matching funds. These plans usually take the form of a bed tax or a quality assessment fee, which is imposed uniformly across classes of providers within the state. In turn, the state generally utilizes the additional federal matching funds generated by the tax to pay increased reimbursement rates to the providers, which often include a repayment of a portion of the provider tax based on the providers percentage of Medicaid patients.

In January 2005, CMS approved the Pennsylvania provider assessment. The Pennsylvania provider assessment, which was retroactive to July 1, 2003 and will expire on June 30, 2007, was recognized cumulatively in the quarter ended March 31, 2005. Recognition of the Pennsylvania provider assessment resulted in increased revenue and net income of $50.9 million and $4.0 million, respectively, in fiscal 2005, of which $30.9 million of revenue and $3.3 million of net income relates to periods prior to fiscal 2005.

In February 2005, CMS approved the New Jersey provider assessment. The New Jersey provider assessment, which was retroactive to July 1, 2004 and will expire on June 30, 2007, was recognized cumulatively in the quarter ended March 31, 2005. Recognition of the New Jersey provider assessment resulted in increased revenue and net income of $22.1 million and $3.7 million, respectively, in fiscal 2005, of which $4.3 million of revenue and $0.6 million of net income relates to periods prior to fiscal 2005.

Acquisition of Previously Leased ElderCare Center and Lease Termination

In January 2005, we acquired the land and building of a State of New Jersey skilled nursing facility having 136 beds that we previously leased. The purchase price of approximately $15.8 million includes the assumption of a $9.5 million, 6% fixed rate mortgage that matures in October 2007. The transaction results in an annual reduction to lease expense of approximately $1.5 million and an increase to depreciation expense and interest expense of approximately $0.5 million and $0.6 million, respectively.

In January 2005, we terminated the lease of a State of New Jersey skilled nursing facility having 186 beds. Upon termination, the center was classified as a discontinued operation; consequently, its results of operations in the current and prior year periods have been classified as discontinued operations in the consolidated statements of operations. The annual revenues and pretax income of this center were approximately $12.3 million and $1.4 million, respectively.

The Spin-Off

Prior to December 1, 2003, our operations were owned by NCI. On December 1, 2003, NCI completed the distribution (the spin-off) of our common stock and our common stock began trading publicly on the NASDAQ Global Market System on December 2, 2003 under the symbol GHCI. Prior to the spin-off, NCI was named Genesis Health Ventures, Inc.

NCI consummated the spin-off by distributing, on a pro rata basis, all of our shares to holders of record of NCI common stock at the close of business on October 15, 2003, the record date for the spin-off. Based on the total

38

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number of shares of NCI common stock at the close of business on the record date for the spin-off, each record holder of NCI common stock received 0.5 shares of our common stock (an aggregate of 19,898,104 shares), or cash in lieu of a fractional share of our common stock.

Additionally, immediately after the spin-off, we issued 130,246 shares of our common stock into an escrow account for future delivery to former unsecured claimants of NCI and its subsidiaries that were entitled to receive common equity securities under the terms of the 2001 joint plan of reorganization.

We
  and NCI agreed contractually to continue certain transitional arrangements and
  practices for a limited time after the spin-off. In addition, we and NCI agreed
  to certain mutually beneficial commercial arrangements intended to reflect terms
  similar to those that would be agreed to by parties bargaining at arms
  length.

Adoption of New Accounting Pronouncement for Share-Based Payments

Effective
  October 1, 2005, we adopted the provisions of Statement of Financial Accounting
  Standards (SFAS) No. 123(R), Share-Based
  Payment (SFAS 123R). SFAS 123R
  establishes accounting for stock-based awards exchanged for employee services.
  Accordingly, stock-based compensation cost is measured at the grant date, based
  on the fair value of the award, and is recognized as expense over the requisite
  employees service period. We previously applied Accounting Principles
  Board (APB) Opinion No. 25, Accounting
  for Stock Issued to Employees,
  and related interpretations and provided the required pro forma disclosures
  of SFAS No. 123, Accounting for
  Stock-Based Compensation (SFAS 123).

Generally, the approach in SFAS 123R to stock-based payment accounting is similar to SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation cost in the statement of operations at their fair values. Pro forma disclosure is no longer an alternative under SFAS 123R.

We elected to adopt SFAS 123R using the modified prospective application method in which compensation cost is recognized beginning with the effective date (a) based upon the requirements of SFAS 123R for all share-based payments granted after the effective date, and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date.

We recorded stock-based compensation expense for the years ended September 30, 2006, 2005 and 2004 and as follows (in thousands):



2006

        

        2005

        

        2004Stock options

        

        $

        4,523

        

        $

        -

        

        $

        -Stock incentive plan

        

        

        5,130

        

        

        4,120

        

        

        2,636Stock held in deferred compensation plan

        

        

        1,440

        

        

        1,665

        

        

        1,024Total stock-based compensation before income taxes

        

        

        11,093

        

        

        5,785

        

        

        3,660Income tax benefit

        

        

        (4,492

        )

        

        (2,314

        )

        

        (1,449

        )Total stock-based compensation after income taxes

        

        $

        6,601

        

        $

        3,471

        

        $

        2,211


As
  of September 30, 2006, there was $7.0 million of total unrecognized compensation
  cost related to non-vested stock options granted under our stock option plan,
  which is expected to be recognized over the remaining vesting periods as follows:
  $3.4 million in fiscal 2007, $3.3 million in fiscal 2008 and $0.3 million in
  fiscal 2009. The expected recognition of compensation expense could differ from
  these estimates as better information becomes available regarding the turnover
  trends of our plan participants and forfeiture assumptions are revised accordingly.
  As of September 30, 2006, there was $12.9 million of total unrecognized compensation
  cost related to future service periods for non-vested restricted stock granted
  under the stock incentive plan, which is expected to be

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recognized over the remaining vesting periods as follows: $4.4 million in fiscal 2007, $4.4 million in fiscal 2008, $2.2 million in fiscal 2009, $1.2 million in fiscal 2010, and $0.7 million in fiscal 2011.

A
  detailed description of the components of stock-based compensation and the assumptions
  and methodologies used to determine fair value are described in note 15Stock-Based Benefit Plans
  to the consolidated financial statements.

Adoption of New Accounting Pronouncement for Conditional Asset Retirement Obligations

In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations  an Interpretation of SFAS No. 143, (FIN 47). FIN 47 clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated, even though uncertainty exists about the timing and / or method of settlement. Certain of our real estate assets contain asbestos. The asbestos is believed to be appropriately contained in accordance with environmental regulations. If these properties were demolished or subject to renovation activities that disturb the asbestos, certain environmental regulations are in place, which specify the manner in which the asbestos must be handled and disposed.

At September 30, 2006, we recognized a liability for the fair value of the asset retirement obligation aggregating approximately $5.3 million, which is included in other long-term liabilities and an asset aggregating approximately $2.3 million, which is included in property and equipment on the consolidated balance sheet. In addition, we recognized the cumulative effect of adopting FIN 47, totaling approximately $1.7 million, net of taxes, $1.5 million of which is included in cumulative effect of an accounting change and $0.2 million of which is included in loss from discontinued operations on the consolidated statements of operations for the year ended September 30, 2006.

Annual accretion of the liability and depreciation expense will be recorded each year for the impacted assets until the obligation year is reached, either by sale of the property, demolition or some other future event such as a government action. The estimated accretion of the liability and depreciation expense will approximate $0.5 million in fiscal 2007.

Revenue Sources

We receive revenues from Medicare, Medicaid, private insurance, self-pay residents and other third-party payors. Our rehabilitation therapy services and other service related businesses also receive revenues from long-term care facilities that utilize our services.

The following table reflects the payor mix of inpatient service revenues for the periods presented, and has been adjusted to exclude discontinued operations:



Year Ended September 30,2006

        

        2005

        

        2004Medicaid

        

        52

        %

        54

        %

        51

        %Medicare

        

        29

        %

        27

        %

        29

        %Private pay and other

        

        19

        %

        19

        %

        20

        %100

        %

        100

        %

        100

        %


The sources and amounts of our revenues are determined by a number of factors, including licensed bed capacity and occupancy rates of our eldercare centers, the mix of patients and the rates of reimbursement among payors. Likewise, payment for ancillary medical services, including services provided by our rehabilitation therapy

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services business, vary based upon the type of payor and payment methodologies. Changes in these and other factors can significantly affect our profitability.

See Item 1  Business  Revenue Sources for more information regarding laws affecting Medicare and Medicaid revenues.

Results of Operations

Factors Affecting Comparability of Financial Information

Our consolidated statements of operations for the first two months (through November 30, 2003) of the twelve months ended September 30, 2004 have been prepared on a basis which reflects our historical financial statements assuming that the operations of NCI contributed in the spin-off were organized as a separate legal entity which owned certain net assets of NCI.

The allocation methodology followed in preparing the financial statements prior to the December 1, 2003 spin-off may not necessarily reflect what the results of operations, financial position and cash flows would have been had we been a separate stand-alone public entity for such periods.

Reasons for Non-GAAP Financial Information

The
  following discussion includes EBITDA which is a non-GAAP financial measure.
  For purposes of SEC Regulation G, a non-GAAP financial measure is a numerical
  measure of a registrants historical or future financial performance, financial
  position and 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, 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.
  In this regard, GAAP refers to U.S. generally accepted accounting principles.
  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 this financial measure is useful for trending, analyzing and benchmarking the performance and value of our business. By excluding certain expenses and other items that may not be indicative of our core business operating results, this non-GAAP financial measure:



        allows investors to evaluate our performance from managements perspective, resulting in greater transparency with respect to supplemental information used by us in our financial and operational decision making;




        facilitates comparisons with prior periods and reflect the principal basis on which management monitors financial performance; and




        facilitates comparisons with the performance of others in the long-term care services industry.


We use EBITDA primarily as a performance measure and believe that the GAAP financial measure most directly comparable to EBITDA is net income. We use EBITDA as a measure to assess the relative performance of our eldercare properties and other of our operating businesses, as well as the employees responsible for operating such businesses. EBITDA is useful in this regard because it does not include such costs as interest expense, income taxes and depreciation and amortization expense which may vary from business unit to business unit depending upon such factors as the method used to finance the original purchase of the business unit or the tax law in the state that a business unit operates in. By excluding such factors when measuring financial performance, many of which are outside of the control of the employees responsible for operating our business units, management is better able
to evaluate the operating performance of the business unit and the employees responsible for business unit

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performance. Consequently, management uses EBITDA to determine the extent to which our employees have met performance goals, and therefore may or may not be eligible for incentive compensation awards.

We also use EBITDA in our annual budget process. We believe EBITDA facilitates internal comparisons to historical operating performance of prior periods and external comparisons to competitors historical operating performance. The presentation of this non-GAAP financial measure is consistent with our past practice and we believe this measure further enables investors and analysts to compare current non-GAAP measures with non-GAAP measures presented in prior periods.

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, the cost of our federal and state tax obligations, our share of the
  earnings or losses of our less than 100% owned operations, the operating results
  of our discontinued businesses and the cumulative effect of accounting changes.
  Because EBITDA does not consider these important elements of our cost structure,
  a user of our financial information who relies on EBITDA as the only measure
  of our performance could draw an incomplete or misleading conclusion regarding
  our financial performance. Consequently, a user of our financial information
  should consider net income an important measure of our financial performance
  because it provides the most complete measure of our performance.

We define EBITDA as earnings from continuing operations before equity in net income of unconsolidated affiliates, minority interests, interest expense, income taxes, depreciation and amortization. Other companies may define EBITDA differently and, as a result, our measure of EBITDA may not be directly comparable to EBITDA of other companies. EBITDA does not represent net income, as defined by GAAP.

EBITDA should be considered in addition to, not a substitute for, or superior to, GAAP financial measures.

Reconciliation of Net Income to EBITDA



Year ended September 30,(in thousands)


      

        2006


      

        2005


      

        2004Net income

        

        $

        35,877

        

        $

        46,068

        

        $

        28,242Add back:Cumulative effect of an accounting change, net of taxes

        

        

        1,539

        

        

        -

        

        

        -Loss from discontinued operations, net of taxes

        

        

        527

        

        

        160

        

        

        2,207Equity in net income of unconsolidated affiliates

        

        

        (1,977

        )

        

        (2,600

        )

        

        (1,202

        )Minority interests

        

        

        1,601

        

        

        1,494

        

        

        1,871Income tax expense

        

        

        25,839

        

        

        28,644

        

        

        19,897Interest expense

        

        

        25,242

        

        

        28,809

        

        

        32,592Depreciation and amortization expense

        

        

        62,519

        

        

        53,704

        

        

        51,310EBITDA

        

        $

        151,167

        

        $

        156,279

        

        $

        134,917


Fiscal 2006 Compared to Fiscal 2005

In the current year, revenues were $1,770.3 million, an increase of $58.9 million, or 3.4%, over the prior year. Of this growth, inpatient services revenue increased by $48.3 million, external rehabilitation therapy services revenue increased by $14.6 million and other businesses revenue decreased by $4.0 million.

The $48.3 million of revenue growth in our inpatient services segment is net of $36.7 million of New Jersey, Pennsylvania and New Hampshire provider tax assessments recognized in the prior year that pertained to prior periods. Exclusive of the retroactive provider assessments, revenues increased by $85.0 million primarily due to increased payor rates. In the aggregate, payor rates increased by $66.9 million versus the prior year with $30.5

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million
  of such increase occurring in the Medicare payor category. Medicare rates increased
  by 7.7% due to the October 1, 2005 upward Medicare rate adjustment of 3.1%,
  higher Medicare patient acuity levels and the positive impact of the Medicare
  programs RUGs refinement reimbursement regulations that took effect on
  January 1, 2006. Approximately $25.1 million of payor rate increases occurred
  in the Medicaid payor category of which $5.7 million was due to provider tax
  assessments in Connecticut, which became effective in the fourth quarter of
  fiscal 2005. The prior year contained one quarter of provider tax assessments
  in Connecticut. Medicaid revenue settlements and adjustments decreased by $6.0
  million versus the prior year principally due to a $4.3 million Maryland cost
  report settlement in the prior year. The $25.4 million balance of Medicaid rate
  increases, which equate to a 3.2% increase, resulted from both increased acuity
  levels and legislative increases. Increases in private and insurance rates of
  4.8% and 3.9%, respectively, were the primary reasons for the $11.3 million
  remainder of the overall rate increase. Approximately $3.6 million of the overall
  revenue increase is due to the step acquisition of two previously unconsolidated
  eldercare centers, which we previously jointly owned and managed. We purchased
  our joint venture partners ownership interest in the centers and, beginning
  in June 2006, we own and consolidate 100% of the operations. Overall occupancy
  increased to 91.5% in the current year from 90.2% in the prior year resulting
  in a $10.4 million revenue increase, including a 0.8% increase in occupancy
  resulting from 206 licensed beds being taken out of service over the past 12
  months. Total patient days increased 52,659 to 6,961,676 in the current year
  compared to 6,909,017 in the prior year. Of the total increase in patient days,
  15,125 days is attributed to the step acquisitions of two eldercare centers
  with the 37,534 patient day balance of the increase attributed to occupancy
  growth at our same facility centers which were included in both reporting periods.
  Remaining net revenue increases of $4.1 million were primarily due to increased
  Medicare Part B volume and other revenues.

The $14.6 million increase in external rehabilitation therapy services revenue resulted from net increased business volume of $16.3 million from new and existing contracts partially offset by a net $1.7 million revenue reduction primarily resulting from a decline in revenue mix caused by Medicare Part B revenues representing a lower percentage of overall revenues in the current year versus the prior year.

The $4.0 million decrease in other business revenue was the net result of $2.5 million of revenue decreases primarily resulting from decreased external business volume in our non-core hospitality and staffing services businesses, a $1.1 million decrease due to non-recurring management fees recorded in the fourth quarter of 2005 and a $1.4 million decrease resulting from decreased billing for certain shared services to our former parent company prior to our spin-off, with the remaining net $1.0 million increase primarily resulting from increased external business volume in our respiratory health services business.

Fiscal 2006 net income decreased to $35.9 million from $46.1 million in the prior year. Revenue increases of $58.9 million, as previously discussed, were offset by $59.6 million of increased salaries, wages and benefits and $1.8 million of higher other operating expenses. Of the $59.6 million of increased salaries, wages and benefits, $1.9 million is attributed to the step acquisitions of two eldercare centers and approximately $1.4 million is attributed to the replacement of higher cost temporary agency nurses with internally employed nurses with the balance of the increase due to normal inflationary growth in wage and benefits in both our inpatient services segment and rehabilitation therapy services segment, increased occupancy within our inpatient segment, increased inpatient nursing hours per patient day and nursing mix (i.e. a
higher percentage of total nursing hours being represented by registered and licensed practical nurses versus nursing assistants) resulting from servicing higher acuity patients and increased rehabilitation therapy services business volume. The $1.8 million of increased other operating expenses was net of the $28.8 million retroactive portion of New Jersey and Pennsylvania provider assessment taxes recognized in the prior year that pertained to prior periods. Exclusive of retroactive provider taxes, other operating expenses increased by $30.6 million. Of the $30.6 million increase, $5.5 million was attributed to the write-down of the carrying value of two underperforming centers, $3.7 million was due to the recognition of newly implemented provider assessment taxes in Connecticut which became effective in the fourth quarter of fiscal 2005, $4.1 million was due to provider assessment tax increases in other states, $3.2 million was attributed to an increase in pharmacy and
medical/nursing supply costs incurred to treat a higher acuity patient population, $4.6 million was due to increased natural gas and electricity costs and $1.0 million was due to the step acquisition of two previously unconsolidated eldercare centers. These increases were offset by approximately $2.1 million of reduced costs attributed to the replacement of higher cost temporary agency nurses with internally employed nurses and $1.7 million of reduced costs as the result ofan impairment charge in the prior year to write-off the investment related to an abandoned rehabilitation services application system. The balance of the increase in other operating expenses of

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approximately
  $12.3 million was largely attributed to normal inflationary increases in costs.
  The provision for losses on accounts receivable and notes receivable increased
  by $1.4 million as compared with the prior year primarily due to a slight deterioration
  in our accounts receivable aging. General and administrative costs increased
  by $12.5 million primarily due to increased payroll costs resulting from both
  wage inflation and additional resources to support multiple operational improvement
  and system initiatives as well as $5.3 million of incremental stock-based compensation
  primarily due to the October 1, 2005 adoption of SFAS 123R. Net income was further
  reduced from increases in depreciation and amortization expense, lower earnings
  of less than 100% owned subsidiaries, increased after-tax losses from discontinued
  operations and the cumulative effect of an accounting change net of taxes, each
  of which is further discussed below. Net income increased due to higher investment
  income, lower early extinguishment of debt costs, interest expense and income
  tax expense, each of which is further discussed below.

In
  the current year, EBITDA decreased by $5.1 million to $151.2 million compared
  with $156.3 million in the prior year. Inpatient services EBITDA decreased $9.6
  million, of which $8.3 million was due tothe
  retroactive New Jersey, Pennsylvania and New Hampshire provider tax assessments
  recognized in the prior year that pertained to prior periods, $5.5 million was
  attributed to the write-down of the carrying value of two underperforming centers,
  $4.6 million was due to increased natural gas and electricity costs and $6.0
  million was due to decreased Medicaid revenue settlements and adjustments, partially
  offset by $0.6 million due to the step acquisition of two previously unconsolidated
  eldercare centers and $1.9 million of provider tax assessments in Connecticut.
  The prior year contained one quarter of tax assessments in Connecticut.The
  remaining $12.3 million increase resulted from the previously discussed other
  increases in payor rates, increased occupancy levels, increased Medicare Part
  B volume, and reduced utilization of agency labor offset by the impact of increased
  nursing hours per patient day and nursing mix, provider assessment tax expense
  increases in other states, increased provision for losses on accounts and notes
  receivable and inflationary increases in cost as well as increased pharmacy
  and medical/nursing supply costs. The rehabilitation services segment combined
  external and intersegment revenues increased by $24.8 million, while EBITDA
  increased by $3.8 million. Approximately $1.7 million of the EBITDA increase
  resulted froman impairment charge in the
  prior year to write-off the investment related to an abandoned rehabilitation
  services application system. Exclusive of such impairment charge, EBITDA increased
  by $2.1 million while EBITDA as a percentage of combined external and intersegment
  revenues (EBITDA margin) increased to 5.7% of revenues in the current year from
  5.4% in the prior year. Of the aforementioned $2.1 million increase, $1.4 million
  was generated by increased revenues with the remaining $0.7 million increase
  resulting from EBITDA margin expansion. The margin expansion of $0.7 million
  primarily resulted from an increase in therapist productivity in the current
  year versus the prior year gained through newly implemented technology and pricing
  increases to customers, partially offset by the decline in revenue mix as discussed
  above and increased rates for both internal wages and temporary agencies. The
  increase in rates for both internal wages and temporary agencies was primarily
  being driven by high market demand for a limited pool of qualified therapists.Decreased loss on early extinguishment of
  debt in the current year increased EBITDA by $11.0 million. The $0.8 million
  loss on early extinguishment of debt recognized in the current year resulted
  from the write-off of deferred financing fees and other costs related to the
  repayment of $8.2 million of 8% subordinated debt. Of the $11.8 million loss
  on early extinguishment of debt recognized in the prior year, $0.4 million is
  due to the write-off of unamortized financing fees for several repaid mortgages,
  $1.3 million is due to the full write-off of unamortized financing fees for
  the term loan component of our senior credit facility and $2.7 million is due
  to the write-off of unamortized financing fees from the repurchase of our 8%
  senior subordinated notes. In addition, prepayment premiums on the repurchased
  8% senior subordinated notes resulted in $7.4 million of debt extinguishment
  charges. The remaining decrease in EBITDA of $10.3 million in the current year
  versus the prior year in all other services and corporate costs resulted principally
  from $4.8 million of increased payroll costs resulting from both wage inflation
  and additional costs to support our operational improvement and system initiatives
  and $5.3 million of incremental stock based compensation primarily associated
  with the October 1, 2005 adoption of SFAS 123R.

Capital Costs and Other

Depreciation and amortization expense increased by $8.8 million to $62.5 million in the current year compared to $53.7 million for the same period in the prior year. The increase is primarily attributed to additional depreciation expense on incremental capital additions.

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Interest expense decreased $3.6 million in the current year to $25.2 million, compared to $28.8 million for the same period in the prior year, due to repurchases of our 8% senior subordinated notes and the restructuring of our debt portfolio in the quarter ended March 31, 2005 resulting in a decline in our overall weighted average interest rate.

Investment income increased $0.5 million to $9.3 million in the current year compared to $8.8 million for the same period in the prior year. Investment income was reduced by $1.1 million from lower investment earnings on assets of our deferred compensation plan in our rabbi trust, offset by $1.6 million of higher interest income on cash and short-term investments.

Our
  effective tax rate approximated 40.5% for the current year. Our effective tax
  rate was adversely impacted in the current year by the lapsing of certain jobs-related
  tax credit provisions at December 31, 2005. Income tax expense in the prior
  year was recorded using an effective tax rate of approximately 40.0%, offset
  by the recognition of $0.5 million of tax credits, a $0.7 million tax refund
  and a $0.3 million adjustment to our income tax liability following the filing
  of our fiscal 2004 tax return. Income tax expense includes the provision of
  taxes on both equity in net income of unconsolidated affiliates and minority
  interests.

Operating results of our less than 100% owned subsidiaries in the current year declined compared to the prior year, resulting in a combined decrease of $0.7 million in equity in net income of unconsolidated affiliates and minority interests.

Loss from discontinued operations, net of taxes, was $0.5 million in the current year versus $0.2 million in the prior year. The increased loss is primarily due to an after-tax charge of $0.2 million recognized in the current year for the adoption of FIN 47.

Cumulative effect of an accounting change, net of taxes, of $1.5 million in the current year is due to the adoption of FIN 47 for continuing operations.

Fiscal 2005 Compared to Fiscal 2004

Fiscal 2005 revenues were $1,711.4 million, an increase of $153.2 million, or 9.8%, over the prior year. Of this growth, inpatient services revenue increased by $141.1 million, external rehabilitation therapy services revenue increased by $10.4 million and external other businesses revenue increased by $1.7 million.

The $141.1 million of revenue growth in our inpatient services segment is primarily attributed to increased payor rates and acquisitions. In aggregate, payor rates increased by $142.1 million versus the prior year with $116.1 million of such increase occurring in the Medicaid payor category, of which $74.4 million was due to provider tax assessments in New Jersey, Pennsylvania, New Hampshire and Connecticut, with $36.7 million of such provider tax assessments pertaining to prior years. The prior year period contained no provider tax assessments in New Jersey, Pennsylvania or Connecticut. Medicaid revenue settlements and adjustments increased by $2.0 million versus the prior year period. The $39.7 million balance of Medicaid rate increases, which equate to a 5.6% increase, resulted from both increased acuity levels and legislative increases. A 5.1% increase in our average Medicare
rate, attributed to the October 1, 2004 upward Medicare rate adjustments of 2.8% and higher Medicare patient acuity, was the primary reason for the remainder of the overall rate increase. Approximately $6.4 million of the overall revenue increase is due to the step acquisition of two eldercare centers, which we previously jointly owned and managed. We purchased our joint venture partners ownership interests in the centers and currently we own and consolidate 100% of the operations. Higher Medicare Part B volume resulted in $4.6 million of increased revenues. Remaining net revenue increases of $3.4 million were primarily due to increased quality mix resulting from combined insurance and Medicare census comprising 0.4% more of our skilled nursing facility census in the current year to date period versus the prior year to date period. The preceding were partially offset by a $5.8 million revenue decline as the result of the deconsolidation of one eldercare center effective May 31,
2004 pursuant to FIN 46, a $3.8 million revenue decline as the result of the current year period having one less day than the same period in the prior leap year and a $5.8 million revenue decline resulting from a decline in overall occupancy. Overall occupancy declined

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to 90.2% in the current year period from 90.8% in the same period in the prior year. Total patient days decreased 52,230 patient days to 6,909,017 in the current year period compared to 6,961,247 in the same period of the prior year. A 27,896 patient day increase attributed to the step acquisitions of two eldercare centers was offset by a decline of 23,530 patient days as the result of the deconsolidation of one eldercare center effective May 31, 2004 pursuant to FIN 46, a decline of 19,020 patient days as the result of the current year having one less day than the prior year and a 37,576 patient day decline in our same facility centers which were included in both reporting periods.

Increased revenue volume generated by ongoing customer contracts was the primary reason for the $10.4 million (or 8.7%) increase in external rehabilitation therapy services revenue.

The $1.7 million increase in external other business revenue primarily resulted from $2.6 million of increased volume in our respiratory therapy business and $0.8 million of net increases primarily due to increased management fee revenues. The preceding was partially offset by $1.7 million of decreased external business volume in our non-core hospitality, physician services and staffing services businesses.

Fiscal 2005 net income increased to $46.1 million from $28.2 million in the same period in the prior year. Revenue increases of $153.2 million, as previously discussed, were partially offset by $51.2 million of increased salaries, wages and benefits and $73.9 million of higher other operating expenses. Of the $51.2 million of increased salaries, wages and benefits, $3.4 million is attributed to the step acquisitions of two eldercare centers, approximately $6.4 million is attributed to the replacement of higher cost temporary agency nurses with internally employed nurses, offset by a decline of $2.9 million as the result of the deconsolidation of one eldercare center effective May 31, 2004 pursuant to FIN 46. The balance of the remaining increase in salaries, wages and benefits is due to normal inflationary growth in wage and benefits in both our inpatient services segment and
rehabilitation therapy services segment, increased inpatient nursing hours per patient day resulting from servicing higher acuity patients and increased rehabilitation therapy services business volume. Of the $73.9 million of increased other operating expenses, $61.2 million is attributed to increased provider assessments primarily in New Jersey, Pennsylvania and Connecticut, with $28.8 million of such provider assessments pertaining to periods prior to fiscal 2005, $5.9 million is attributed to increased utilization of temporary agencies within our rehabilitation services business as a result of an industry-wide shortage of therapists, $3.0 million is attributed to an increase in pharmacy, medical supply and other ancillary costs incurred to treat a higher acuity patient population, $1.4 million is attributed to step acquisitions of two eldercare centers and $1.7 million is attributed to increased training costs associated with employee safety programs. These increases in other
operating expenses were offset by approximately  $3.4 million of decreased general and professional liability insurance, $6.9 million of reduced costs attributed to the replacement of higher cost temporary agency nurses with internally employed nurses and $1.7 million of reduced costs as the result of the deconsolidation of one eldercare center effective May 31, 2004 pursuant to FIN 46. The balance of the increase in other operating expenses of approximately $12.7 million is largely attributed to normal inflationary increases in cost. General and administrative costs increased by $10.7 million with $2.0 million attributed to increased strategic consulting costs, $1.5 million attributed to consulting costs incurred relative to matters associated with the Sarbanes-Oxley Act, $1.6 million attributed to support costs relative to the implementation of new inpatient data systems with the balance of the increase primarily resulting from inflationary increases in payroll costs and increased
support staff. The $9.3 million decrease in the provision for losses on accounts receivable and notes receivable is primarily due to improvement in the collection of older accounts receivable. Net income was further reduced from increases in early extinguishment of debt costs, depreciation and amortization expense and income tax expense as further discussed below. Net income increased due to lower lease expense, lower interest expense, higher investment income, lower after-tax losses of discontinued operations and higher earnings of less than 100% owned subsidiaries, each of which is further discussed below.

For fiscal 2005, EBITDA increased $21.4 million to $156.3 million compared with $134.9 million in the same period of the prior year. Inpatient services EBITDA increased $41.3 million, of which $14.2 million is due to provider tax assessments for New Jersey, Pennsylvania, Connecticut and New Hampshire, with $8.3 million of such provider tax assessments pertaining to periods prior to fiscal 2005. Increased Medicaid revenue settlements and adjustments are responsible for $2.0 million of the increase. Approximately $1.3 million of the increase is due to step acquisitions of two eldercare centers and $2.2 million is due to decreased lease expense, which is further described below, offset by reduced EBITDA of $1.1 million as the result of the deconsolidation of one eldercare

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center effective May 31, 2004 pursuant to FIN 46. The remaining $22.7 million increase in EBITDA resulted from the previously discussed other increases in payor rates, increased quality mix, reduced utilization of external nursing agencies and reduced bad debt expense offset by the impact of decreased occupancy and inflationary increases in cost. EBITDA of our rehabilitation therapy services segment declined $6.8 million with $14.6 million of combined external and intersegment revenue increases being offset by $14.1 million of higher labor related costs, $5.6 million of increased utilization of temporary agencies and a $1.7 million impairment charge to write-off the investment related to an abandoned rehabilitation services application system. The increase in rehabilitation therapy labor and temporary agency costs is primarily being driven by high market demand for a limited pool of qualified
therapists. Increased loss on early extinguishment of debt in the current year decreased EBITDA by $10.1 million. Of the $11.8 million loss on early extinguishment of debt recognized in fiscal 2005, $0.4 million is due to the write-off of unamortized financing fees for several repaid mortgages, $1.3 million is due to the full write-off of unamortized financing fees for the term loan component of our senior credit facility and $2.7 million is due to the write-off of unamortized financing fees from the repurchase of our 8% senior subordinated notes. In addition, prepayment premiums on the repurchased 8% senior subordinated notes resulted in $7.4 million of debt extinguishment charges. The remaining decrease in EBITDA of $3.0 million in fiscal 2005 in all other services and corporate costs resulted principally from $2.0 million of increased strategic consulting costs, $1.5 million of consulting costs incurred relative to compliance with the Sarbanes-Oxley Act and $1.6 million of support
costs relative to the implementation of new inpatient data systems, partially offset by $2.1 million of net cost reductions primarily resulting from a decrease in estimate of self-insurance liability claims.

Capital Costs and Other

Lease expense decreased by $2.2 million to $22.1 million in fiscal 2005, compared to $24.3 million for the same period in the prior year, primarily due to the purchase of six previously leased facilities.

Depreciation and amortization expense increased by $2.4 million to $53.7 million in fiscal 2005 compared to $51.3 million for the same period in the prior year. The increase is principally attributed to additional depreciation expense on incremental capital additions.

Interest expense decreased by $3.8 million to $28.8 million in fiscal 2005 compared to $32.6 million for the same period in the prior year, primarily due to repurchases of our 8% senior subordinated notes and the restructuring of our debt portfolio in the March 2005 quarter resulting in a decline in our overall weighted average interest rate.

Investment income increased by $2.6 million to $8.8 million in fiscal 2005 from $6.2 million for the same period in the prior year, primarily due to higher levels of interest bearing assets and higher investment yields.

Income tax expense in fiscal 2005 was estimated using an effective tax rate of approximately 40.0%, offset by the recognition of $0.5 million of tax credits, a $0.7 million tax refund and a $0.3 million adjustment to our income tax liability following the filing of our fiscal 2004 tax return. Income tax in the prior year was estimated using an effective tax rate of 39.6%. The increase in the effective tax rate is attributed to higher permanent deductions principally in the area of lobbying expenses. Income tax expense includes the provision of taxes on both equity in net income of unconsolidated affiliates and minority interests.

Loss from discontinued operations, net of taxes, was $0.2 million in fiscal 2005 and $2.2 million in the prior year to date period. The change is primarily due to the relative results of operations of those businesses identified as discontinued operations.

Operating results of our less than 100% owned subsidiaries in fiscal 2005 improved compared to the same period in the prior year, resulting in a combined increase of $1.8 million in equity in net income of unconsolidated affiliates and minority interests.

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Liquidity and Capital Resources

Working Capital and Cash Flows

Reference to our consolidated balance sheets and consolidated statements of cash flows will facilitate understanding of the discussion that follows.

Our
  primary source of cash inflows comes from government funded programs, principally
  Medicaid and Medicare. Our operating cash flow has been used to finance trade
  accounts receivable, fund capital expenditures, service and repurchase our indebtedness
  and repurchase our common stock, and make selective acquisitions. Financing
  trade accounts receivable is necessary because, on average, the customers and
  payors for our services do not pay us as quickly as we pay our vendors and employees
  for their services. Our cash flow from operations for fiscal 2006 and 2005 were
  $81.3 million and $128.4 million, respectively. The $47.1 million decline in
  cash flow from operations in fiscal 2006 primarily resulted from $17.6 million
  in decreased cash flows from the timing of payments to vendors and employees
  and decreased cash flows of $22.6 million in accounts receivable. Approximately
  $12.0 million of the accounts receivable fluctuation is attributed to a permenant
  change in the Pennsylvania Medicaid payment schedule and $5.0 million is attributed
  to temporary Medicare payment delays. The remaining decline in operating cash
  flow is attributed to lower net income.

Our investing activities principally consist of capital expenditures and asset acquisitions and dispositions. Capital expenditures consist primarily of betterments and expansion of eldercare centers and investments in computer hardware and software. Capital expenditures were $102.1 million and $56.1 million for fiscal 2006 and fiscal 2005, respectively. For fiscal 2007, capital expenditures are anticipated to be within the range of $75.0 million to $85.0 million. Investing activities for fiscal 2006 include $2.4 million of net cash used to purchase our joint venture partners interests in three skilled nursing facilities, $0.7 million to purchase a tract of land, $1.0 million for the purchase of a building and $0.6 million for deposits on upcoming center acquisitions further described below, as well as a $2.1 million investment in a joint venture. Investing activities for
fiscal 2006 also included $1.2 million of net sales of restricted cash and marketable securities held by our wholly owned insurance captive compared to $2.0 million of net purchases of restricted marketable securities in fiscal 2005. In fiscal 2005, $7.2 million of net cash was used principally to purchase two previously leased skilled nursing facilities. Investing activities in fiscal 2005 included proceeds received from the sale of eldercare centers of $6.7 million, principally from the sale of eldercare centers located in the state of Wisconsin.

Cash flows from financing activities were a net use of cash of $15.8 million and $86.0 million for fiscal 2006 and fiscal 2005, respectively. Cash flows from financing activities for fiscal 2005 are reflective of several financing transactions that occurred in the second fiscal quarter of 2005. In March 2005, we issued $180.0 million of 2.5% convertible senior subordinated debentures due 2025. After paying financing fees of approximately $5.5 million, we used (i) approximately $20.1 million of the net proceeds of the offering to repurchase shares of our common stock from the initial purchasers of the debentures in negotiated transactions concurrently with the offering, (ii) approximately $119.7 million of the net proceeds to repay the remaining outstanding borrowings under the term loan portion of our senior credit facility, and (iii) the balance for general corporate purposes,
including repurchases of our 8% senior subordinated notes due 2013. Through September 30, 2005, we repurchased $70.9 million of our 8% senior subordinated notes due 2013. The debt repurchases resulted in a prepayment premium of $7.4 million, which is included in loss on early extinguishment of debt. Also impacting cash from net financing activities, in November 2004, we repaid approximately $14.0 million under the mandatory payment provisions of our then existing term loan under our senior credit facility. In November 2004, we prepaid an $11.0 million, 11% fixed rate mortgage and paid the lender a $0.3 million prepayment penalty. In January 2005, we repaid a $6.0 million mortgage that was assumed in the same period upon the step acquisition of a skilled nursing facility joint venture partnership.

We continually evaluate the most efficient use of our capital, including investments in our property and equipment, information systems, potential asset acquisitions or dispositions, purchasing, refinancing, exchanging or retiring certain of our outstanding debt securities to the extent permitted by our existing covenant restrictions. As part of such ongoing evaluation, our board of directors has authorized the repurchase of up to $150.0 million of our common stock, as well as certain principal amounts of our 8% senior subordinated notes in accordance with the restrictions of our amended and restated senior credit agreement. The authorization of debt repurchases expires



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December
  31, 2006. Share and debt repurchases may take place at managements discretion
  and/or under pre-established, nondiscretionary programs from time to time, depending
  on market conditions, in the open market, and in privately negotiated transactions.
  Repurchases of common stock are restricted by our debt agreements, the most
  restrictive of which is our 8% senior subordinated notes. Such restrictions
  preclude repurchases of common stock above 50% of our net income since July
  1, 2003. After considering common stock repurchases made to date and other repurchase
  provisions, our maximum common stock repurchasing capacity at September 30,
  2006 was $22.7 million. In fiscal 2006, 288,408 shares of common stock were
  repurchased at a cost of $10.7 million, and $8.2 million principal amount of
  our 8% senior subordinated notes were repurchased. Cumulatively through September
  30, 2006, 1,075,745 shares of common stock were repurchased at a cost of $42.8
  million and $79.1 million principal amount of our 8% senior subordinated notes
  were repurchased. The debt repurchases resulted in a prepayment premium charge
  of $7.9 million and the write-off of unamortized deferred financing fees and
  other fees of $3.0 million. These charges are recorded as loss on early extinguishment
  of debt in the consolidated statements of operations in the period in which
  the repurchases were made.

In June 2006, we acquired a 49% limited partnership interest in a joint venture with capital contributions amounting to $2.1 million as of September 30, 2006. The joint venture is engaged in the construction of an office building. Upon completion of construction, we intend to lease office space from the joint venture to house certain of our corporate support functions. See Certain Transactions and Events  Purchase of Joint Venture Interests.

In
  May 2006, we announced that we signed an agreement to enter into lease and purchase
  option agreements with an unrelated provider of long-term care that operates
  11 facilities with a combined total of 970 skilled nursing and assisted living
  facility beds located in the state of Maine. The transaction contemplates that
  we will enter into 11 separate agreements to lease the facilities over a 10
  year term, with two five year renewal options. We will also obtain an option
  to purchase all 11 properties in 2026 for $53.0 million. We expect to account
  for the transaction as a capital lease. Upon closing, we would expect to pay
  approximately $16.0 million of cash and the related capital lease debt balance
  is expected to approximate $40.0 million. The 11 facilities generate approximately
  $65.0 million of annual revenue. The closing of the transaction, which is expected
  to occur in early calendar year 2007, is subject to receipt of regulatory approvals
  and various other customary conditions. Accordingly, no assurances can be given
  that the transaction will be consummated or, if it is, what the final terms
  will be or what its ultimate impact will be on our financial condition or results
  of operations.

We have entered into a series of non-binding letters of intent with unrelated third parties to acquire the real estate and operations of two skilled nursing and assisted living facilities and to purchase additional equity interests in one of our currently managed joint venture assisted living properties. The aggregate purchase price of these transactions of approximately $17.7 million is expected to be financed by us with cash on hand or available borrowings under our revolving credit facility. In the case of the managed joint venture, the additional equity interest would cause us to consolidate the entitys financial statements with ours, less minority interests.

We
  believe that the net cash provided by our operating activities, supplemented
  as necessary with unrestricted cash reserves and borrowings available under our revolving
  credit facility, will provide sufficient resources to meet our working capital
  requirements, debt service and other liquidity needs over the next 12 months.
  At September 30, 2006, $112.2 million was available under our $125.0 million
  revolving credit facility after giving effect to $6.8 million in outstanding
  letters of credit issued under the revolving credit facility and $6.0 million
  borrowed to finance a subsequent facility acquisition.

At September 30, 2006, we had restricted cash equivalents and restricted investments in marketable securities of $100.0 million, which are held by Liberty Health Corporation (LHC), our wholly owned captive insurance subsidiary incorporated under the laws of Bermuda. The cash equivalents and investments held by LHC are restricted by statutory capital requirements in Bermuda. As a result of such restrictions and encumbrances, we and LHC are precluded from freely transferring funds through intercompany loans, advances or cash dividends.

Financing Arrangements

Convertible senior subordinated debentures. In March 2005, we completed a private placement of $180.0 million aggregate principal amount of our 2.5% convertible senior subordinated debentures due 2025 to qualified institutional buyers under Rule 144A of the Securities Act. Interest is payable semi-annually in March and



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September. Each of our subsidiaries that guarantee the indebtedness under the senior subordinated notes also guarantees the convertible senior subordinated debentures. The guarantees will be released at such time that such subsidiary ceases to be a guarantor under the senior subordinated notes, all of the senior subordinated notes are no longer outstanding, or on March 20, 2012. In July 2005, we registered with the SEC the resale of the convertible senior subordinated debentures and the relating guarantees and underlying common stock.

The debentures may be converted into cash and, depending on the circumstances at the time of conversion, shares of our common stock. The initial conversion rate for the debentures will be equivalent to 18.4493 shares of common stock per $1,000 principal amount of the debentures (which is based upon an initial conversion price equivalent to approximately $54.20 per share), subject to adjustment under certain circumstances. The holders of the convertible senior subordinated debentures may convert their debentures into shares of our common stock prior to the stated maturity at their option only under the following circumstances: (1) if, after June 30, 2005, the closing price of our common stock exceeds 130% of the conversion price then in effect for at least 20 trading days in the 30 consecutive trading day period ending on the last trading day of the immediately preceding fiscal
quarter; (2) during the five business days immediately following any five consecutive trading day period in which the trading price per $1,000 principal amount of debentures for each day of such period was less than 95% of the product of the closing price of our common stock and the applicable conversion rate then in effect, subject to certain exceptions; (3) the debentures have been called for redemption; (4) upon the occurrence of specified corporate transactions; or (5) upon the occurrence of certain designated events.

Subject to certain exceptions, once debentures are tendered for conversion, the value, or conversion value, of the cash and shares of our common stock, if any, to be received by a holder converting $1,000 principal amount of the debentures will be determined by multiplying the applicable conversion rate by the ten trading day average closing price of our common stock. We will deliver the conversion value to holders as follows: (i) an amount in cash, referred to as the principal return, equal to the lesser of (x) the aggregate conversion value of the debentures to be converted and (y) the aggregate principal amount of the debentures to be converted, (ii) if the aggregate conversion value of the debentures to be converted is greater than the principal return, an amount in whole shares, referred to as the net shares, equal to such aggregate conversion value less the principal return,
referred to as the net share amount, and (iii) an amount in cash in lieu of any fractional shares of our common stock. The number of net shares to be paid will be determined by dividing the net share amount by the ten trading day average closing price of our common stock.

We may not redeem the convertible senior subordinated debentures before March 20, 2010. The holders of the convertible senior subordinated debentures may require us to purchase all or a portion of their debentures at any of three specified dates during the life of the debentures, with the first such date being March 15, 2012, or upon the occurrence of certain designated events for cash at a repurchase price equal to the principal amount plus accrued and unpaid interest plus, in the case of certain designated events that occur on or prior to March 20, 2010, a make whole premium, if any, payable solely in shares of our common stock.

The dilutive effect of the common shares that would be issued if the convertible debentures were converted is not included in our diluted weighted average common share balance unless the weighted average market price of our common stock during a reporting period exceeds $54.20 per share.

In
  connection with the issuance of the convertible senior subordinated debentures,
  we have agreed with The NASDAQ Global Market LLC not to take certain actions
  without prior shareholder approval if, as a result of such actions, greater
  than 19.99% of our common stock outstanding immediately prior to the issuance
  of the debentures would be issued.

Senior
  Credit Facility.In connection with
  the offering of the convertible senior subordinated debentures, we entered into
  an amended and restated senior credit agreement pursuant to which we refinanced
  the indebtedness under our existing senior credit agreement. We repaid all outstanding
  borrowings under the term loan portion of the senior credit facility and expanded
  the borrowing capacity of the revolving credit portion. The repayment of the
  term loan portion of the senior credit facility resulted in the write-off of
  unamortized deferred financing fees of $1.3 million in fiscal 2005, which is
  included in loss on early extinguishment of debt in the consolidated statements
  of operations.



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Prior to the amendment, the senior credit agreement provided for a revolving credit facility of $75.0 million, with sub limits for swing line loans, letters of credit and term loans. The amended and restated senior credit agreement provides for a $125.0 million revolving credit facility, with sub limits for the issuance of letters of credit and for swing line loans. However, so long as we are not in default and if we find lenders that are willing to commit, the amended and restated senior credit agreement allows us to add up to $50.0 million of additional available credit under the revolver, subject to the approval of our board of directors. Each of our material U.S. subsidiaries provided guarantees of the indebtedness under the amended and restated senior credit agreement. We and the guarantors pledged substantially all of our personal property to secure the obligations under the
amended and restated senior credit agreement, subject to certain exceptions agreed upon with the lenders. In addition, the mortgages that we and our subsidiaries provided under the prior credit agreement continue to secure the amended and restated senior credit agreement, but we are not required to provide additional mortgages except under certain limited circumstances. The amended and restated senior credit agreement has a five year term, expiring in March 2010.

We
  pay interest on the outstanding loans under the amended and restated senior
  credit agreement at either a base rate plus a margin or at the London Interbank
  Offered Rate (LIBOR) plus a margin. The margin is adjusted from time to time,
  depending on our leverage ratio, as defined. For base rate loans, the margin
  range is from 0.00% to 1.00%. For LIBOR loans, the margin range is from 1.00%
  to 2.00%. At September 30, 2006, the margin on base rate loans was 0.50% and
  the margin on LIBOR loans was 1.50%. At September 30, 2005, the margin on base
  rate loans was 0.25% and the margin on LIBOR loans was 1.25%. We currently pay
  a commitment fee to the lenders on the unused portion of the revolving credit
  facility equal to 0.50% of the unused amount, which is an increase from the
  prior year when we paid 0.375%. The increases are due to our total leverage
  ratio rising above 2.25:1.00, as defined.

Senior
  Subordinated Notes.In October 2003,
  we issued 8% senior subordinated notes in an aggregate principal amount of $225.0
  million due in 2013. In July 2004, upon the expiration of the exchange offer,
  $224.0 million aggregate principal amount of senior subordinated notes registered
  under the Securities Act were exchanged for the unregistered notes issued in
  October 2003. The aggregate principal amount of $1.0 million of unregistered
  notes was not exchanged and remains outstanding. Under the terms of our senior
  subordinated notes, the notes are not redeemable until after October 15, 2008.
  In February 2005, our board of directors authorized the repurchase of a portion
  of the 8% senior subordinated notes due 2013 from time to time in the open market
  commencing in March 2005. Through September 30, 2006, we repurchased $79.1
  million of our 8% senior subordinated notes. The debt repurchases resulted in
  a prepayment premium charge of $7.9 million and the write-off of unamortized
  deferred financing fees and other fees of $3.0 million, which are included in
  loss on early extinguishment of debt in the consolidated statements of operations.

The agreements and instruments governing our financing arrangements contain various restrictive covenants that, among other things, require us to comply with or maintain certain financial tests and ratios and restrict our ability to:



        incur more debt;




        pay dividends, purchase company stock or make other distributions;




        make payments in respect of subordinated debt;




        make certain investments;




        create liens;




        enter into transactions with affiliates;




        make acquisitions;




51



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

        merge or consolidate; and




        transfer or sell assets.


Our financing arrangements require us to maintain compliance with certain financial covenants as defined in the agreement, including a senior leverage ratio, a total leverage ratio and a fixed charge coverage ratio. There is also a limitation on the amount of capital expenditures that we may make.

Contractual Obligations, Off-Balance Sheet Commitments and Commitments to Consolidated VIEs

We have future obligations for debt repayments and future minimum rentals under operating and capital leases. The obligations as of September 30, 2006 are summarized as follows (in thousands):



Payments
          Due by PeriodContractual
          Obligations
      
      Total
      
      Less
          than 1year
      
      1-3
          years
      
      4-5
          years
      
      ThereafterLong-term
          debt (including interest and interest rate swap)
      
      $
      639,958
      
      $
      26,887
      
      $
      58,767
      
      $
      59,880
      
      $
      494,424Operating
          leases
      
      
      163,502
      
      
      21,181
      
      
      41,125
      
      
      37,309
      
      
      63,887Capital
          leases (including interest)
      
      
      40,299
      
      
      4,996
      
      
      33,596
      
      
      1,076
      
      
      631$
      843,759
      
      $
      53,064
      
      $
      133,488
      
      $
      98,265
      
      $
      558,942


Long-term
  debt obligations include fixed and variable rate instruments, interest payments
  thereon, commitment fees payable to lenders for the unused portion of our revolving
  credit facility and payments under an interest rate swap agreement relative
  to one variable rate, non-recourse mortgage. Excluding rates fixed effectively
  by the aforementioned rate swap agreement, variable rate debt consists of two
  recourse mortgages having a combined principal balance of $7.8 million and one
  non-recourse mortgage having a principal balance of $6.1 million at September
  30, 2006. The estimated interest payment obligation thereon is calculated using
  the effective rate for each mortgage at September 30, 2006. The weighted average
  effective rate of these three variable interest rate mortgages is 4.7%. The
  basis for determining the periodic interest rates for each of these variable
  instruments differs and the actual rates paid in future periods could be significantly
  different than those estimated in the table above. For more information regarding
  the balances and terms of the components of our long-term debt obligations,
  see Item 8  Financial Statements and Supplementary Data under
  note 9  Long-Term Debt in the notes to consolidated financial
  statements.

In addition to the contractual obligations and commitments described above, we also have contingent obligations related to outstanding lines of credit and letters of credit, including those with our joint venture partnerships determined to be VIEs and consolidated pursuant to FIN 46. These commitments as of September 30, 2006 are summarized as follows (in thousands):



Amount
          of Commitment Expiration Per PeriodOff-Balance
          Sheet Commitments
      
      Total
      
      Less
          than 1year
      
      1-3
          years
      
      4-5
          years
      
      ThereafterLines
          of credit
      
      $
      2,109
      
      $
      -
      
      $
      -
      
      $
      -
      
      $
      2,109Letters
          of credit
      
      
      6,768
      
      
      6,768
      
      
      -
      
      
      -
      
      
      -$
      8,877
      
      $
      6,768
      
      $
      -
      
      $
      -
      
      $
      2,109


Requests for providing commitments to extend financial guarantees and extend credit are reviewed and approved by senior management subject to obligational authority limitations. Management regularly reviews all



52



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outstanding commitments, letters of credit and financial guarantees, and the results of these reviews are considered in assessing the need for any reserves for possible credit and guarantee loss.

We have extended $3.9 million in working capital lines of credit to certain jointly owned and managed companies, including certain consolidated VIEs, of which $2.1 million were unused at September 30, 2006. In addition, we have agreed to extend credit for working capital needs of a nursing center managed by us. Under that arrangement, the propertys owner is responsible for funding working capital needs up to $0.9 million and we would be required to cover deficits in excess of that limit. To date, we have not had to perform under that agreement. Credit risk represents the accounting loss that would be recognized at the reporting date if the affiliate companies were unable to repay any amounts utilized under the working capital lines of credit. Commitments to extend credit to third parties are conditional agreements generally having fixed expiration or termination dates and
specific interest rates and purposes.

We have posted $6.8 million of outstanding letters of credit. The letters of credit guarantee performance to third parties of various trade activities. The letters of credit are not recorded as liabilities on our consolidated balance sheet unless they are probable of being utilized by the third party. The financial risk approximates the amount of outstanding letters of credit.

We
  are a party to joint venture partnerships whereby our ownership interests are
  50% or less of the total capital of the partnerships. We account for certain
  of these partnerships using the equity method of accounting and, therefore,
  the assets, liabilities and operating results of these partnerships are not
  consolidated with ours. Certain other of our joint venture partnerships qualifying
  as VIEs, and where we are determined to be the primary beneficiary of such arrangements,
  are consolidated. The carrying value of our investment in unconsolidated joint
  venture partnerships is $4.9 million at September 30, 2006. Although we are
  not contractually obligated to fund operating losses of these partnerships in
  all cases, in certain cases, we have extended credit to such joint venture partnerships
  in the past and may decide to do so in the future in order to realize economic
  benefits from our joint venture relationship. Management assesses the creditworthiness
  of such partnerships in the same manner it does other third-parties. The underlying
  loan commitments of our consolidated VIEs are non-recourse to us. Credit risk
  represents the accounting loss that would be recognized at the reporting date
  if counter-parties failed to perform completely as contracted. The credit risk
  amounts are equal to the contractual amounts, assuming that the amounts are
  fully advanced and that no amounts could be recovered from other parties.

Critical Accounting Policies

We consider an accounting policy to be critical if it is important to our financial condition and results of operations, and requires significant judgment and estimates on the part of management in its application. Our critical accounting estimates and the related assumptions are evaluated periodically as conditions warrant, and changes to such estimates are recorded as new information or changed conditions require revision. Application of the critical accounting policies requires managements significant judgments, often as the result of the need to make estimates of matters that are inherently uncertain. If actual results were to differ materially from the estimates made, the reported results could be materially affected. Our senior management has reviewed these critical accounting policies and estimates with our audit committee. We believe that the following represents our
critical accounting policies. For a summary of all of our significant accounting policies, including critical accounting policies, see Item 8  Financial Statements and Supplementary Data, under note 2  Summary of Significant Accounting Policies, in the notes to the consolidated financial statements.

Allowance for Doubtful Accounts

We utilize the aging method to evaluate the adequacy of our allowance for doubtful accounts. This method is based upon applying estimated standard allowance requirement percentages to each accounts receivable aging category for each type of payor. We have developed estimated standard allowance requirement percentages by utilizing historical collection trends and our understanding of the nature and collectibility of receivables in the various aging categories and the various segments of our business. The standard allowance percentages are developed by payor type as the accounts receivable from each payor type have unique characteristics. The allowance for doubtful accounts is determined utilizing the aging method described above while also considering



53



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accounts specifically identified as uncollectible. Accounts receivable that we specifically estimate to be uncollectible, based upon the age of the receivables, the results of collection efforts, or other circumstances, are fully reserved for in the allowance for doubtful accounts until they are written-off.

We continue to refine our assumptions and methodologies underlying the aging method. We believe the assumptions used in the aging method, coupled with continued improvements in our collection patterns, suggest that our allowance for doubtful accounts is provided for adequately. However, because the assumptions underlying the aging method are based upon historical collection data, there is a risk that our current assumptions are not reflective of more recent collection patterns. Changes in overall collection patterns can be caused by market conditions and/or budgetary constraints of government funded programs such as Medicare and Medicaid. See Item 1A  Risk Factors.  Such changes can adversely impact the collectibility of receivables, but not be addressed in a timely fashion when using the aging method, until updates to our periodic historical collection studies are
completed and implemented.

At
  least annually, we update our historical collection studies in order to evaluate
  the propriety of the assumptions underlying the aging method. Any changes to
  the underlying assumptions are implemented immediately. Changes to these assumptions
  can have a material impact on our bad debt expense, which is reported in the
  consolidated statements of operations as a component of the provision for losses
  on accounts receivable and notes receivable. For the years ended September 30,
  2006, 2005 and 2004, the provision for losses on accounts receivable and notes
  receivable was $12.5 million, $11.1 million and $20.3 million, respectively.

Loss Reserves For Certain Self-Insured Programs

General
  and Professional Liability and Workers Compensation

Prior to June 1, 2000, we had first dollar coverage for general and professional liability costs with third party insurers; accordingly, we have no exposure for claims prior to that date. Effective June 1, 2000, we began insuring a substantial portion of our professional liability risks through LHC. Specifically, we are responsible for the first dollar of each claim (on a claims-made basis), up to a self-insurance retention limit determined by the individual policies, subject to aggregate limits for each policy year. The self-insured retention limits amount to $24.0 million, $21.0 million and $19.0 million for the policy years ended May 31, 2007, 2006 and 2005, respectively, with a per incident limit of $1.0 million for each of those years. Any costs above the retention and per incident limits are covered by third-party insurance carriers. Since the June 1, 2000 inception of the
self-insurance program through September 30, 2006, our cumulative self-insurance retention levels are $122.0 million and our provision for these losses is $98.6 million. Assuming our actual losses were to reach the retention limits in each of the policy years, our additional exposure is approximately $23.4 million which, if incurred, would be recognized as an increase to our other operating expenses in the consolidated statements of operations in the period such exposure became known. In addition, we have provided $4.7 million for the estimated costs of claims incurred but not reported as of September 30, 2006.

We
  are insured through a loss deposit fund with a large deductible workers
  compensation policy beginning May 1, 2006 up to the first $1.0 million per incident.
  We have an annual aggregate self-insured retention of $67.9 million for this
  policy year ended April 30, 2007. All claims above the aggregate and per incident
  limits are insured through a third-party insurer. Our provision for losses in
  this policy year is $10.6 million as of September 30, 2006, with an estimated
  $10.0 million reserve for unpaid losses as of that date.

Prior
  to May 1, 2006, we are self-insured against workers compensation losses
  through LHC. Beginning May 1, 2005 through April 30, 2006, we have per incident
  retention limits up to the first $1.0 million and $0.5 million prior to May
  1, 2005. All claims above these per incident limits, in their respective periods,
  are insured through a third-party insurer. We have annual aggregate self-insured
  retentions of $61.8 million and $56.0 million in policy years ended April 30,
  2006 and 2005, respectively. Claims above these aggregate limits are insured
  through a third-party insurer as of September 30, 2006. Our provision for losses
  in these policy years is $46.4 million as of September 30, 2006. We evaluate
  our reserve levels on a quarterly basis. Any necessary adjustments are recognized
  as an adjustment to salaries, wages and benefits in the consolidated statements
  of operations.

We record outstanding losses and loss expenses for both general and professional liability and workers compensation liability based on the estimates of the amount of reported losses together with a provision for losses incurred but not reported, based on the recommendations of an independent actuary, and managements judgment

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using
  our past experience and industry experience. As of September 30, 2006, our estimated
  range of outstanding losses for these liabilities is $103.9 million to $129.0
  million ($95.6 million to $111.8 million net of amounts recoverable from third-party
  insurance carriers). Our recorded reserves for these liabilities were $102.0
  million as of September 30, 2006, net of $9.1 million recoverable from third-party
  insurance carriers, and are included in self-insurance liability reserves in
  the consolidated balance sheets. Through LHC, we have restricted cash and investments
  in marketable securities of $100.0 million at September 30, 2006, which
  are substantially restricted to securing the outstanding claim losses of LHC.

We believe, based upon our valuation and discussions with an independent actuary, that the provision for outstanding losses and loss expenses will be adequate to cover the ultimate cost of losses incurred as of September 30, 2006, but the provision is necessarily an estimate and may ultimately be settled for a significantly greater or lesser amount. It is at least reasonably possible that we will revise our estimates significantly in the near term. Any subsequent differences arising are recorded in the period in which they are determined.

Health
  Insurance

We offer our employees an option to participate in a self-insured health plan. Health claims under this plan are self-insured with a stop-loss umbrella policy in place to reduce the maximum potential liability for individual claims for a plan year. Health insurance claims are paid as they are submitted to the plan administrator. We maintain an accrual for claims that have been incurred but not yet reported to the plan administrator and therefore have not been paid. The incurred but not reported reserve is based on the historical claim lag period and current payment trends of health insurance claims (generally 1-2 months). The liability for the self-insured health plan is recorded in accrued compensation in the consolidated balance sheets.

We charge our employees a portion of the cost of our self-insured and non self-insured health plans, and determine this charge at the beginning of each plan year based upon historical and projected medical utilization data, along with projected inflationary increases in medical costs. Any differences between our projections and our actual experience are borne by us. A one percent variance between our projections and the actual medical utilization or inflationary increases in cost would result in a $0.3 million change in our expense, which would be reflected in salaries, wages and benefits in the consolidated statements of operations.

Revenue Recognition/Contractual Allowances

We receive payments through reimbursement from Medicaid and Medicare programs and directly from individual residents (private pay), third party insurers and long-term care facilities.

Within our inpatient services segment, revenue and related receivables are recorded in the accounting records at our established billing rates in the period the related services are rendered. The provision for contractual adjustments, which represents the difference between the established billing rates and the predetermined reimbursement rates, is deducted from gross revenue to determine net revenue. Retroactive adjustments that are likely to result from future examinations by third party payors are accrued on an estimated basis in the period the related services are rendered and adjusted as necessary in future periods based upon new information or final settlements.

Within our rehabilitation therapy services segment and ancillary service businesses, we record revenues at the time services or products are provided or delivered to the customer. Upon delivery of services or products, we have no additional performance obligation to the customer.

We
  recorded contractual adjustments from continuing operations of $336.2 million,
  $330.8 million and $329.8 million in fiscal year 2006, 2005 and 2004,
  respectively.

Long-Lived Asset Impairments

We account for long-lived assets, other than goodwill with an indefinite useful life, in accordance with the provisions of SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets.This statement



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requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by comparison of the carrying amount of an asset to the future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized to the extent the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or the fair value less costs to sell. Asset impairment charges totaling $5.5 million were recognized in fiscal year 2006 associated with the write-down of two under performing properties. The impairment charges are reflected in other operating expenses in the consolidated statements of operations.

We account for goodwill with an indefinite useful life in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, (SFAS 142). This statement requires us to perform an impairment test for goodwill at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. We perform our annual impairment test at the end of each fiscal year. No goodwill impairment charge was recorded in any of the fiscal years presented herein in connection with the annual impairment test.

Income Taxes

As of September 30, 2006, we have net operating loss (NOL) carryforwards available of $83.2 million, which can be utilized to offset future taxable income subject to an annual limitation of $33.1 million. We regularly assess our ability to realize the tax benefit from our NOL. Our balance sheet reflects a $34.4 million deferred tax asset representing the tax benefit of the NOL carryforwards.

New Accounting Pronouncements

Hybrid
  Financial Instruments

In February 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140 (SFAS 155), to simplify and make more consistent the accounting for certain financial instruments. Specifically, SFAS 155 amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities,to permit fair value re-measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. SFAS 155 amends SFAS 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities (as amended),to allow a qualifying special-purpose entity (SPE) to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 applies to all financial instruments acquired or issued after the beginning of an entitys first fiscal year that begins after September 15, 2006, or October 1, 2006 for us, with early adoption permitted. The adoption of SFAS 155 is not expected to have a material effect on our financial condition, results of operations and cash flows.

General Partner Control of Limited Partnerships

In June 2005, the Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (EITF 04-5). This consensus applies to voting right entities not within the scope of FIN 46(R) in which the investor is the general partner(s) in a limited partnership or functional equivalent. The EITF consensus is that the general partner(s) in a limited partnership is presumed to control that limited partnership and therefore should include the limited partnership in its consolidated financial statements. The general partner(s) may overcome this presumption of control and not consolidate the entity if the limited partners have: (a) the substantive ability to dissolve (liquidate) the limited partnership or
otherwise remove the general partner through substantive kick-out rights that can be exercised without having to show cause; or (b) substantive participating rights in managing the partnership. This guidance became immediately effective upon ratification by the FASB on June 29, 2005 for all newly formed limited partnerships and for existing limited partnerships for which the partnership agreements have been modified. For general partners in all other limited partnerships, the guidance is effective no later than the beginning of the first reporting period in fiscal years



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beginning after December 15, 2005, or October 1, 2006 for us. We expect that, upon adoption, we will begin consolidating two partnerships. One of the partnerships is a jointly owned and managed skilled nursing facility having 112 beds. The second partnership owns the real estate of a skilled nursing facility that is leased to us. Upon consolidation, the two partnerships are estimated to add $10.7 million of total assets, $4.4 million of non-recourse debt, $12.6 million of annual revenue, $2.9 million of annual EBITDA and no net income.

Accounting Changes and Error Corrections

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Correctionsa replacement of APB Opinion No.20 and FASB Statement No.3.  This statement changes the requirements for the accounting for and reporting of a change in accounting principle. This statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. APB 20 previously
required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement does not change the guidance for reporting the correction of an error in previously issued financial statements or the change in an accounting estimate. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, or October 1, 2006 for us.

Income Tax Uncertainties

In
  June 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes,
  (FIN 48), which prescribes detailed guidance for the financial statement
  recognition, measurement and disclosure of uncertain tax positions recognized
  in an enterprises financial statements in accordance with FASB Statement
  No. 109,Accounting for Income
  Taxes.Tax positions must meet
  a more-likely-than-not recognition threshold at the effective date to be recognized
  upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective
  for fiscal years beginning after December 15, 2006, or October 1, 2007 for us,
  and the provisions of FIN 48 will be applied to all tax positions accounted
  for under Statement No. 109 upon initial adoption. The cumulative effect of
  applying the provisions of this interpretation will be reported as an adjustment
  to the opening balance of retained earnings for that fiscal year. We are currently
  evaluating the potential impact of FIN 48 on our consolidated financial
  statements.

Accounting for Misstatements

In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108 (SAB 108) which addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires companies to quantify misstatements using both the balance-sheet and income-statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. Upon initial adoption, if the effect of the misstatement is determined to be material, SAB 108 allows companies to record that effect as a cumulative effect adjustment to beginning of year retained earnings. SAB 108 is effective for the first fiscal year ending after November 15, 2006. We will adopt the provisions of SAB 108 during our fourth quarter ending September 30, 2007 and are
currently assessing the impact of SAB 108 on our consolidated financial statements.

Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 applies where other accounting pronouncements require or permit fair value measurements. We are required to adopt SFAS 157 effective at the beginning of our

57

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fiscal
  year 2009, or October 1, 2008 for us. We are evaluating the impact this statement
  will have on our consolidated financial statements.

Other

We manage the operations of 34 independently and jointly owned eldercare centers, including consolidated VIEs, and 8 transitional care units. Under a majority of these arrangements, we employ the operational staff of the managed center for ease of benefit administration and bill the related wage and benefit costs on a dollar-for-dollar basis to the owner of the managed property. In this capacity, we operate as an agent on behalf of the managed property owner and are not the primary obligor in the context of a traditional employee/employer relationship. Historically, we have treated these transactions on a net basis thereby not reflecting the billed labor and benefit costs as a component of our net revenue or expenses. For the fiscal years 2006, 2005 and 2004, we billed our managed clients $119.5 million, $114.7 million, and $110.4 million, respectively, for such labor related costs.

Seasonality

Our earnings generally fluctuate from quarter to quarter. This seasonality is related to a combination of factors, which include the timing of Medicaid rate increases and payroll tax obligations, inclement weather, seasonal census cycles, and the number of calendar days in a given quarter.

Impact of Inflation

The healthcare industry is labor intensive. Wages and other labor costs are especially sensitive to inflation and marketplace labor shortages. We have implemented cost control measures to limit increases in operating costs and expenses but cannot predict our ability to control such operating cost increases in the future. See Cautionary Statements Regarding Forward-Looking Statements, Item 1A   Risk Factors and Item 7  Managements Discussion and Analysis of Financial Condition and Results of Operations.

ITEM 7A:

        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK At September 30, 2006, our overall debt mix is approximately
  94% fixed and 6% variable, significantly reducing any exposure to rising rates
  of interest. We consolidate one VIE pursuant to FIN 46 that entered into an
  interest rate swap agreement. The VIEs obligation under the interest rate
  swap agreement is non-recourse to us. The interest rate swap agreement effectively
  converts approximately $6.9 million of variable-rate debt (one month LIBOR)
  into fixed-rate debt (4.38%). The interest rate swap agreement matures on July
  29, 2010.


At September 30, 2006, we have $85.9 million of cash and equivalents, including restricted cash and equivalents, that are affected by market rates of interest. A one percent change in the rate of interest would result in a change to interest income of $0.9 million annually.

Our wholly owned subsidiary, Liberty Health Corporation, Ltd., holds restricted investments in marketable securities. Securities that are affected by market rates of interest at September 30, 2006 amounted to $11.5 million. A one percent change in the rate of interest would result in a change to interest income of $0.1 million annually.

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ITEM
  8:    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



PageReport
          of Independent Registered Public Accounting Firm

        60Consolidated
          Balance Sheets as of September 30, 2006 and 2005

        61Consolidated
          Statements of Operations for the years ended September 30, 2006, 2005
          and 2004

        62Consolidated
          Statements of Shareholders Equity for the years ended September
          30, 2006, 2005 and 2004

        63Consolidated
          Statements of Cash Flows for the years ended September 30, 2006, 2005,
          and 2004

        64Notes
          to Consolidated Financial Statements

        65Schedule
          II  Valuation and Qualifying Accounts

        103


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Report
  of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Genesis HealthCare Corporation:

We have audited the accompanying consolidated balance sheets of Genesis HealthCare Corporation and subsidiaries (the Company) as of September 30, 2006 and 2005, and the related consolidated statements of operations, shareholders equity and cash flows for each of the years in the three-year period ended September 30, 2006. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedule II. These consolidated financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Genesis HealthCare Corporation and subsidiaries as of September 30, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As
  discussed in note 2 to the consolidated financial statements, the Company adopted
  Statement of Financial Accounting Standards No. 123(R),Share-Based
  Payment, and related interpretations
  on October 1, 2005; the Company also adopted Financial Accounting Standards
  Board Interpretation No. 47,Accounting
  for Conditional Asset Retirement Obligations,
  and recognized the impact of the adoption as a cumulative effect of an accounting
  change in the accompanying consolidated statement of operations for the year
  ended September 30, 2006.

We
  also have audited, in accordance with the standards of the Public Company Accounting
  Oversight Board (United States), the effectiveness of Genesis HealthCare Corporations
  internal control over financial reporting as of September 30, 2006, based on
  criteria established inInternal ControlIntegrated
  Frameworkissued by the Committee of
  Sponsoring Organizations of the Treadway Commission (COSO), and our report dated
  December 13, 2006 expressed an unqualified opinion on managements assessment
  of, and the effective operation of, internal control over financial reporting.

/s/ KPMG LLP

Philadelphia, Pennsylvania

December
  13, 2006

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GENESIS
  HEALTHCARE CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

SEPTEMBER 30, 2006 AND 2005

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)



September 30, 2006
      
      September 30, 2005Assets:Current
          assets:Cash
          and equivalents
      
      $
      74,819
      
      $
      107,350Current
          portion of restricted cash and investments in marketable securities
      
      
      35,160
      
      
      39,875Accounts
          receivable, net of allowances for doubtful accounts of $25,685 and $22,982,
          at September 30, 2006 and 2005, respectively
      
      
      226,689
      
      
      186,296Prepaid
          expenses and other current assets
      
      
      48,583
      
      
      41,746Current
          portion of deferred income taxes
      
      
      45,206
      
      
      43,148Total
          current assets
      
      
      430,457
      
      
      418,415Property
          and equipment, net of accumulated depreciation of $234,928 and $173,714,
          at September 30, 2006 and 2005, respectively
      
      
      873,164
      
      
      818,138Assets
          held for sale
      
      
      3,911
      
      
      3,911Restricted
          cash and investments in marketable securities
      
      
      64,819
      
      
      63,639Other
          long-term assets
      
      
      85,133
      
      
      85,094Deferred
          income taxes
      
      
      5,830
      
      
      13,789Identifiable
          intangible assets, net of accumulated amortization of $2,157 and $1,633,
          at September 30, 2006 and 2005, respectively
      
      
      571
      
      
      1,095Goodwill
      
      
      8,645
      
      
      8,619Total
          assets
      
      $
      1,472,530
      
      $
      1,412,700Liabilities
          and Shareholders Equity:Current
          liabilities:Current
          installments of long-term debt
      
      $
      4,829
      
      $
      5,419Accounts
          payable
      
      
      54,034
      
      
      56,266Accrued
          expenses
      
      
      30,498
      
      
      25,123Accrued
          compensation
      
      
      68,441
      
      
      68,032Accrued
          interest
      
      
      7,682
      
      
      7,794Current
          portion of self-insurance liability reserves
      
      
      40,455
      
      
      39,875Income
          taxes payable
      
      
      2,323
      
      
      1,042Total
          current liabilities
      
      
      208,262
      
      
      203,551Long-term
          debt
      
      
      440,005
      
      
      445,677Self-insurance
          liability reserves
      
      
      70,682
      
      
      73,952Other
          long-term liabilities
      
      
      53,107
      
      
      38,707Commitments
          and contingenciesShareholders
          equity:Common
          stock - par $0.01, 45,000,000 shares authorized at September 30, 2006
          and 2005, 20,736,223 and 20,429,110 shares issued at September 30, 2006
          and 2005, respectively
      
      
      207
      
      
      204Additional
          paid-in capital
      
      
      645,278
      
      
      623,326Retained
          earnings
      
      
      101,546
      
      
      65,669Accumulated
          other comprehensive loss
      
      
      (65
      )
      
      (562
      )Treasury
          stock at cost, 1,075,745 and 787,337 shares at September 30, 2006 and
          2005, respectively
      
      
      (42,787
      )
      
      (32,096
      )Common
          stock held in deferred compensation plan at cost, 236,227 and 163,135
          shares at September 30, 2006 and 2005, respectively
      
      
      (9,714
      )
      
      (5,728
      )Deferred
          compensation liability
      
      
      6,009
      
      
      -Total
          shareholders equity
      
      
      700,474
      
      
      650,813Total
          liabilities and shareholders equity
      
      $
      1,472,530
      
      $
      1,412,700


See accompanying notes to the consolidated financial statements.





61

---





GENESIS
  HEALTHCARE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE YEARS ENDED SEPTEMBER 30, 2006, 2005 AND 2004

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)



Year ended September 30,2006


      

        2005


      

        2004Net revenues

        


      $

        1,770,298

        


      $

        1,711,433

        


      $

        1,558,197Salaries, wages and benefits

        

        

        1,089,904

        

        

        1,030,282

        

        

        979,082Other operating expenses

        

        

        390,301

        

        

        388,551

        

        

        314,626General and administrative costs

        

        

        112,705

        

        

        100,215

        

        

        89,505Provision for losses on accounts receivable and notes receivable

        

        

        12,486

        

        

        11,054

        

        

        20,346Loss on early extinguishment of debt

        

        

        793

        

        

        11,765

        

        

        1,692Lease expense

        

        

        22,225

        

        

        22,102

        

        

        24,267Depreciation and amortization expense

        

        

        62,519

        

        

        53,704

        

        

        51,310Interest expense

        

        

        25,242

        

        

        28,809

        

        

        32,592Investment income

        

        

        (9,283

        )

        

        (8,815

        )

        

        (6,238

        )Income before income tax expense, equity in net income of unconsolidated affiliates and minority interests

        

        

        63,406

        

        

        73,766

        

        

        51,015Income tax expense

        

        

        25,839

        

        

        28,644

        

        

        19,897Income before equity in net income of unconsolidated affiliates and minority interests

        

        

        37,567

        

        

        45,122

        

        

        31,118Equity in net income of unconsolidated affiliates

        

        

        1,977

        

        

        2,600

        

        

        1,202Minority interests

        

        

        (1,601

        )

        

        (1,494

        )

        

        (1,871

        )Income from continuing operations

        

        

        37,943

        

        

        46,228

        

        

        30,449Loss from discontinued operations, net of taxes

        

        

        (527

        )

        

        (160

        )

        

        (2,207

        )Cumulative effect of an accounting change, net of taxes

        

        

        (1,539

        )

        

        

        

        

        Net income

        

        $

        35,877

        

        $

        46,068

        

        $

        28,242Per
          common share data in 2006 and 2005 and pro forma per common share data
          in 2004 (see note 2  Summary of Significant Accounting
          Policies - Earnings Per Share):Basic:Income from continuing operations

        

        $

        1.96

        

        $

        2.34

        

        $

        1.53Loss from discontinued operations

        

        

        (0.03

        )

        

        (0.01

        )

        

        (0.11

        )Cumulative effect of an accounting change

        

        

        (0.08

        )

        

        

        

        

        Net income

        

        $

        1.85

        

        $

        2.34

        

        $

        1.42Weighted average shares

        

        

        19,359,076

        

        

        19,713,478

        

        

        19,947,177Diluted:Income from continuing operations

        

        $

        1.93

        

        $

        2.31

        

        $

        1.51Loss from discontinued operations

        

        

        (0.03

        )

        

        (0.01

        )

        

        (0.11

        )Cumulative effect of an accounting change

        

        

        (0.08

        )

        

        

        

        

        Net income

        

        $

        1.83

        

        $

        2.30

        

        $

        1.40Weighted average shares

        

        

        19,634,284

        

        

        20,021,811

        

        

        20,118,292


See accompanying notes to the consolidated financial statements.





62

---





GENESIS
  HEALTHCARE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

FOR THE YEARS ENDED SEPTEMBER 30, 2006, 2005 AND 2004

(IN THOUSANDS)



NCI's equityin GHC


      

        Commonstock


      

        Additionalpaid-in capital


      

        Retainedearnings


      

        Accumulatedothercomprehensiveincome (loss)


      

        Treasurystock


      

        Common stockheld indeferredcompensationplan


      

        Deferredcompensationliability


      

        Totalshareholders'equityBalance at September 30, 2003


      


      $


      562,685


      


      $


      -


      


      $


      -


      


      $


      -


      


      $


      763


      


      $


      -


      


      $


      -


      


      $


      -


      


      $


      563,448Comprehensive incomeNet income prior to the spin-off

        

        

        8,641

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -Net income subsequent to the spin-off

        

        

        -

        

        

        -

        

        

        -

        

        

        19,601

        

        

        -

        

        

        -

        

        

        -

        

        

        -Net unrealized loss on marketable securities

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        (880

        )

        

        -

        

        

        -

        

        

        -Unrealized gain on interest rate swap agreement

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        130

        

        

        -

        

        

        -

        

        

        -Total comprehensive income

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        27,492Issuance of common stock in connection with the spin-off

        

        

        -

        

        

        199

        

        

        (199

        )

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -Dividend and distributions to NCI, net of advances

        

        

        (571,326

        )

        

        -

        

        

        530,139

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        (41,187

        )Utilization of tax benefits under SOP 90-7

        

        

        -

        

        

        -

        

        

        6,593

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        6,593Issuance of common stock under stock option plan and stock incentive plan

        

        

        -

        

        

        1

        

        

        2,522

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        2,523Purchases of common stock in deferred compensation plan

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        (3,793

        )

        

        -

        

        

        (3,793

        )Balance at September 30, 2004

        

        $

        -

        

        $

        200

        

        $

        539,055

        

        $

        19,601

        

        $

        13

        

        $

        -

        

        $

        (3,793

        )

        $

        -

        

        $

        555,076Comprehensive incomeNet income

        

        

        -

        

        

        -

        

        

        -

        

        

        46,068

        

        

        -

        

        

        -

        

        

        -

        

        

        -Net unrealized loss on marketable securities

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        (667

        )

        

        -

        

        

        -

        

        

        -Net increase to minimum pension liability

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        (157

        )

        

        -

        

        

        -

        

        

        -Unrealized gain on interest rate swap agreement

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        249

        

        

        -

        

        

        -

        

        

        -Total comprehensive income

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        45,493Utilization of tax benefits under SOP 90-7

        

        

        -

        

        

        -

        

        

        20,893

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        20,893Pre emergence deferred tax valuation allowance adjustment

        

        

        -

        

        

        -

        

        

        50,979

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        50,979Issuance of common stock under stock option plan and stock incentive plan

        

        

        -

        

        

        4

        

        

        10,489

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        10,493Purchases of common stock for treasury

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        (32,096

        )

        

        -

        

        

        -

        

        

        (32,096

        )Purchases and sales, net, of common stock in deferred compensation plan

        

        

        -

        

        

        -

        

        

        1,910

        

        

        -

        

        

        -

        

        

        -

        

        

        (1,935

        )

        

        -

        

        

        (25

        )Balance at September 30, 2005

        

        $

        -

        

        $

        204

        

        $

        623,326

        

        $

        65,669

        

        $

        (562

        )

        $

        (32,096

        )

        $

        (5,728

        )

        $

        -

        

        $

        650,813Comprehensive incomeNet income

        

        

        -

        

        

        -

        

        

        -

        

        

        35,877

        

        

        -

        

        

        -

        

        

        -

        

        

        -Net unrealized gain on marketable securities

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        357

        

        

        -

        

        

        -

        

        

        -Net decrease to minimum pension liability

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        46

        

        

        -

        

        

        -

        

        

        -Unrealized gain on interest rate swap agreement

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        94

        

        

        -

        

        

        -

        

        

        -Total comprehensive income

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        

        36,374Utilization of tax benefits under SOP 90-7

        

        

        -

        

        

        -

        

        


      7,572

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        


      7,572Issuance of common stock under stock option plan and stock incentive plan

        

        

        -

        

        

        3

        

        

        8,867

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        


      8,870Stock-based compensation expense for stock options

        

        

        -

        

        

        -

        

        

        4,523

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        4,523Purchases of common stock for treasury

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        -

        

        

        (10,691

        )

        

        -

        

        

        -

        

        

        (10,691

        )Purchases and sales, net, of common stock in deferred compensation plan

        

        

        -

        

        

        -

        

        

        990

        

        

        -

        

        

        -

        

        

        -

        

        

        (3,986

        )

        

        6,009

        

        

        3,013Balance at September 30, 2006

        

        $

        -

        

        $

        207

        

        $

        645,278

        

        $

        101,546

        

        $

        (65

        )

        $

        (42,787

        )

        $

        (9,714

        )

        $

        6,009

        

        $

        700,474


See accompanying notes to the consolidated financial statements.



63



---



GENESIS
  HEALTHCARE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED SEPTEMBER 30, 2006, 2005 AND 2004

(IN THOUSANDS)



Year ended September 30,2006


      

        2005


      

        2004Cash flows from operating activities:Net income

        

        $

        35,877

        

        $

        46,068

        

        $

        28,242Net charges included in operations not requiring funds:Non-cash compensation expenses

        

        

        11,093

        

        

        5,785

        

        

        3,660Loss on impairment of assets and other charges

        

        

        6,646

        

        

        13,153

        

        

        2,275Depreciation and amortization

        

        

        62,519

        

        

        53,704

        

        

        51,550Provision for losses on accounts receivable and notes receivable

        

        

        14,590

        

        

        11,054

        

        

        21,248Equity in net income of unconsolidated affiliates and minority interests

        

        

        (376

        )

        

        (1,106

        )

        

        669Provision for deferred taxes

        

        

        14,944

        

        

        24,944

        

        

        15,307Excess tax benefits from share-based payment arrangements

        

        

        (1,267

        )

        

        -

        

        

        -Amortization of deferred rents

        

        

        1,742

        

        

        943

        

        

        555Cumulative effect of an accounting change

        

        

        2,965

        

        

        -

        

        

        -Advanced rent payments on operating leases

        

        

        -

        

        

        -

        

        

        (9,774

        )Changes in assets and liabilities:Accounts receivable

        

        

        (47,210

        )

        

        (24,591

        )

        

        5,928Accounts payable and other accrued expenses

        

        

        (19,316

        )

        

        (1,708

        )

        

        29,930Other, net

        

        

        (879

        )

        

        199

        

        

        (5,308

        )Total adjustments

        

        

        45,451

        

        

        82,377

        

        

        116,040Net cash provided by operating activities

        

        

        81,328

        

        

        128,445

        

        

        144,282Cash flows from investing activities:Capital expenditures

        

        

        (102,066

        )

        

        (56,100

        )

        

        (32,137

        )Purchases of restricted marketable securities

        

        

        (92,081

        )

        

        (148,863

        )

        

        (209,769

        )Proceeds on maturity or sale of restricted marketable securities

        

        

        93,299

        

        

        146,893

        

        

        204,472Net change in restricted cash and equivalents

        

        

        2,673

        

        

        (3,310

        )

        

        548Purchases of eldercare centers and lease amendments

        

        

        (4,728

        )

        

        (7,208

        )

        

        (38,867

        )Investment in joint venture

        

        

        (2,109

        )

        

        -

        

        

        -Proceeds from sales of eldercare assets

        

        

        -

        

        

        6,664

        

        

        17,956Consolidation of variable interest entities

        

        

        -

        

        

        (1,690

        )

        

        (2,940

        )Other, net

        

        

        6,909

        

        

        607

        

        

        (2,535

        )Net cash used in investing activities

        

        

        (98,103

        )

        

        (63,007

        )

        

        (63,272

        )Cash flows from financing activities:Proceeds from issuance of long-term debt

        

        

        6,000

        

        

        180,000

        

        

        410,000Repayment of long-term debt

        

        

        (15,452

        )

        

        (226,615

        )

        

        (307,129

        )Debt issuance costs and debt prepayment premium

        

        

        (534

        )

        

        (14,303

        )

        

        (9,337

        )Purchase of common stock for treasury

        

        

        (10,691

        )

        

        (32,096

        )

        

        -Proceeds from exercise of stock options

        

        

        3,654

        

        

        7,239

        

        

        -Net transactions with NCI, prior to the spin-off

        

        

        -

        

        

        -

        

        

        (55,548

        )Excess tax benefits from share-based payment arrangements

        

        

        1,267

        

        

        -

        

        

        -Other, net

        

        

        -

        

        

        (263

        )

        

        -Net cash (used in) provided by financing activities

        

        

        (15,756

        )

        

        (86,038

        )

        

        37,986Net (decrease) increase in cash and equivalents

        

        $

        (32,531

        )

        $

        (20,600

        )

        $

        118,996Cash and equivalents:Beginning of period

        

        

        107,350

        

        

        127,950

        

        

        8,954End of period

        

        $

        74,819

        

        $

        107,350

        

        $

        127,950Supplemental disclosure of cash flow information:Interest paid

        

        $

        25,354

        

        $

        28,457

        

        $

        22,413Taxes paid

        

        

        9,104

        

        

        4,562

        

        

        3,272Non-cash financing activities:Capital leases

        

        $

        -

        

        $

        3,951

        

        $

        33,905Assumption of long-term debt

        

        

        3,190

        

        

        15,533

        

        

        34,014


See accompanying notes to the consolidated financial statements.



64



---



Genesis HealthCare Corporation and Subsidiaries

Notes
  to Consolidated Financial Statements

(1)

        Organization and Basis of Presentation


Description of Business

Genesis HealthCare Corporation and subsidiaries (GHC or the Company) is comprised of two primary business segments, inpatient services and rehabilitation therapy services. These segments are supported by complementary service capabilities and a general and administrative function.

GHC provides inpatient services through skilled nursing and assisted living centers primarily located in the eastern United States. The Company has 206 owned, leased, managed and jointly owned eldercare centers with 25,373 beds as of September 30, 2006. Revenues of GHCs owned, leased and otherwise consolidated centers constitute approximately 90% of its revenues in fiscal 2006, and are presented in GHCs segment information as inpatient services revenues. Management fees earned from unconsolidated centers that are managed and/or jointly owned by GHC are included in all other services revenues presented in GHCs segment information. See note 20  Segment Information.

GHC provides an extensive range of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy. These services are provided by approximately 4,900 licensed rehabilitation therapists and assistants employed or contracted at substantially all of the centers operated by GHC, as well as by contract to healthcare facilities operated by others and through GHCs 13 certified outpatient rehabilitation agencies. After the elimination of intercompany revenues, the rehabilitation therapy services segment constitutes approximately 8% of GHCs revenues in fiscal 2006.

GHC also provides an array of other specialty medical services, including respiratory health services, physician services, hospitality services, staffing services and other healthcare related services.

Spin-off

On December 1, 2003, NeighborCare, Inc. (NCI) completed the distribution (the spin-off) of the common stock of GHC. The spin-off was effected by way of a pro-rata tax free distribution of GHCs common stock to holders of NCIs common stock on December 1, 2003 at a rate of 0.5 shares of GHC stock for each share of NCI stock owned as of October 15, 2003. NCI received a private letter ruling from the Internal Revenue Service to the effect that, for United States federal income tax purposes, the distribution of GHCs common stock qualified as tax free for its and NCIs shareholders, with the exception of cash received for fractional shares. GHCs common stock began trading publicly on the NASDAQ National Market System on December 2, 2003 under the symbol GHCI.  Prior to the spin-off, NCI was named Genesis Health Ventures, Inc. In July 2005, NCI was
acquired by Omnicare, Inc. (Omnicare).

In connection with the spin-off, NCI and GHC agreed contractually to continue certain transitional arrangements and practices for a limited time after the spin-off. In addition, NCI and GHC entered into certain mutually beneficial commercial arrangements. Specifically, NCI and GHC entered into a separation and distribution agreement, a tax sharing agreement, as amended, a transition services agreement, as amended, a group purchasing agreement, an employee benefits agreement, a pharmacy services agreement, as amended, a pharmacy benefit management agreement, as amended, and a durable medical equipment agreement. In connection with the spin-off, GHC entered into new financing arrangements. See note 9  Long-Term Debt.

The following unaudited pro forma financial information gives effect to the spin-off as if it occurred on October 1, 2003. The unaudited pro forma data is for informational purposes only and does not purport to represent the results of future periods. The unaudited pro forma data reflects adjustments based upon available information and certain assumptions that management of GHC considers reasonable. No changes in operating revenues and expenses have been made to reflect the results of any modifications to operations that might have been made had the

65

---



spin-off been completed on the aforesaid effective date for purposes of the pro forma results. The following unaudited pro forma information is presented in thousands, except per share information:



Year ended September 30, 2004As reported

        

        

        Pro formaNet revenues

        $

        1,558,197

        

        $

        1,558,197Income from continuing operations

        

        30,449

        

        

        29,270Diluted earnings per share  from continuing operations

        

        1.51

        

        

        1.45


Basis of Presentation

The accompanying financial statements through November 30, 2003 have been prepared on a basis which reflects the historical financial statements of GHC assuming that the operations of NCI contributed in the spin-off were organized as a separate legal entity, owning certain net assets of NCI. Beginning December 1, 2003, the accompanying consolidated financial statements have been prepared on a basis which reflects the operations of GHC as a stand-alone entity, including the consolidation of its subsidiaries.

Prior to the spin-off, substantially all of GHCs cash accounts were linked to NCIs centralized cash management system. Accordingly, substantially all cash generated from or used in GHCs operations had been transferred to and from NCI. For instance, NCI funded nearly all routine and capital cash disbursements on behalf of GHC. Likewise, on a daily basis, GHC transferred its cash receipts directly to the concentrated bank account of NCI. The net effect of these cash transfers has been reflected in the NCIs Equity in GHC account as shown in the consolidated statements of shareholders equity. Cash and equivalents not specifically owned by legal entities which comprise GHC were not allocated to GHC in the pre spin-off financial statements. The net transactions with NCI as reflected in the consolidated statements of cash flows represent pre
spin-off cash activities between NCI and GHC as previously described. The advances and distributions to and from NCI as reflected in the consolidated statement of shareholders equity include the cash activities as reflected in the statements of cash flows as well as certain non-cash adjustments to NCIs equity in GHC. Such non-cash adjustments to NCIs equity in GHC principally relate to non-cash income tax provisions. The financing activities between NCI and GHC had been in the form of equity capital advances and there were no formal repayment or interest arrangements.

The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. In the opinion of management, the consolidated financial statements for the periods presented include all necessary adjustments for a fair presentation of the financial position and results of operations for the periods presented. Certain prior year amounts have been reclassified to conform with current period presentation, the effect of which was not material.

Principles of Consolidation and Variable Interest Entities

The accompanying consolidated financial statements include the accounts of GHC, its wholly owned subsidiaries and its consolidated variable interest entities (VIEs), as discussed further below. All significant intercompany accounts and transactions have been eliminated in consolidation for all periods presented.

GHCs investments in VIEs in which it is the primary beneficiary are consolidated, while investments in VIEs in which it is not the primary beneficiary are accounted for under other accounting principles. Investments in and the operating results of 20% to 50% owned companies, which are not VIEs, are included in the consolidated financial statements using the equity method of accounting.

In total, at September 30, 2006 and 2005, GHC has consolidated five and six VIEs, respectively. At September 30, 2006, total assets and non-recourse debt of the consolidated VIEs are $47.4 million and $40.0 million, respectively; and at September 30, 2005, total assets and non-recourse debt of the consolidated VIEs are $50.8 million and $40.9 million, respectively. The total assets of the VIEs principally consist of property and equipment that serves as collateral for the VIEs non-recourse debt and is not available to satisfy any of GHCs other obligations. Creditors of the VIEs, including senior lenders, have no recourse against the general credit of GHC. The consolidated VIEs own and operate skilled nursing and assisted living facilities having 615 beds. GHCs ownership interests in the consolidated VIEs range from 25% to 50% and GHC manages the day-to-day
operations of the consolidated VIEs under management agreements. GHCs involvement with the VIEs began in years prior to 2000.

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In the case of one VIE, at September 30, 2006, GHC is not the primary beneficiary and, therefore, the VIE is not consolidated into its financial statements. At September 30, 2006, total assets and debt of the unconsolidated VIE are $14.9 million and $13.3 million, respectively. The unconsolidated VIE owns and operates a skilled nursing facility having 224 beds. GHCs ownership interests in the unconsolidated VIE is 33.3% and GHC manages the day-to-day operations of the unconsolidated VIE under a management agreement. GHCs involvement with the unconsolidated VIE began in 1990. At September 30, 2006, GHCs maximum exposure to loss associated with this unconsolidated VIE approximates the aggregate carrying-value of its equity method investments of $0.1 million. In addition to the unconsolidated VIE previously described, GHC was not the primary beneficiary and,
therefore, did not consolidate a second skilled nursing facility VIE at September 30, 2005. Total assets and debt of this unconsolidated VIE were $2.8 million and $1.5 million, respectively, at September 30, 2005. In June 2006, GHC acquired its joint venture partners remaining 50% interest in this VIE, after which the financial statements of the VIE are consolidated.

Factors Affecting Comparability of Financial Information

The Companys statements of operations for the first two months (through November 30, 2003) of the fiscal year ended September 30, 2004 have been prepared on a basis which reflects the Companys historical financial statements assuming that the operations of NCI contributed in the spin-off were organized as a separate legal entity which owned certain net assets of NCI.

The allocation methodology followed in preparing the financial statements prior to the December 1, 2003 spin-off may not necessarily reflect what the results of operations, cash flows or financial position would have been had it been a separate stand-alone public entity for such period.

(2)

        Summary of Significant Accounting Policies


Revenue Recognition/Contractual Allowances

The Company receives payments through reimbursement from Medicaid and Medicare programs and directly from individual residents (private pay), third-party insurers and long-term care facilities.

Within the Companys inpatient services segment, revenue and the related receivables are recorded in the accounting records at the Companys established billing rates in the period the related services are rendered. The provision for contractual adjustments, which represents the differences between the established billing rates and predetermined reimbursement rates, is deducted from gross revenue to determine net revenue. Retroactive adjustments that are likely to result from future examinations by third party payors are accrued on an estimated basis in the period the related services are rendered and adjusted as necessary in future periods based upon new information or final settlements.

Within the Companys rehabilitation therapy services business and other ancillary service businesses, the Company records revenues at the time services or products are provided or delivered to the customer. Upon delivery of products or services, the Company has no additional performance obligation to the customer.

The
  Company recorded contractual allowances from continuing operations of $336.2
  million, $330.8 million and $329.8 million in fiscal years 2006, 2005 and 2004,
  respectively.

Use of Estimates

The Company has made a number of estimates relating to the reporting of assets and liabilities, revenues and expenses and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with U.S. generally accepted accounting principles. Some of the more significant estimates impact accounts receivable, long-lived assets and loss reserves for self-insurance programs. It is reasonable to assume that a change in estimate will occur in the near nerm and that change would be material if a different estimate were used

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in
  preparing the consolidated financial statements. Actual results could differ
  significantly from estimates. Additionally, the preparation of the financial
  statements prior to the December 1, 2003 spin-off required an extensive use
  of estimates to allocate assets, liabilities, revenues and expenses to GHC.
  See note 1  Organization and Basis of Presentation  Spin-off.

Cash and Equivalents

Short-term investments that have a maturity of ninety days or less at acquisition are considered cash equivalents. Investments in cash equivalents are carried at cost, which approximates fair value.

Restricted Cash and Investments in Marketable Securities

Restricted cash includes cash and money market funds held by the Companys wholly owned captive insurance subsidiary, Liberty Health Corporation, Ltd. (LHC), which is substantially restricted to securing the outstanding claims losses of LHC. The restricted cash balances at September 30, 2006 and 2005 were $11.1 million and $11.9 million, respectively.

Restricted investments in marketable securities, comprised of fixed interest rate securities and equity securities, are considered to be available-for-sale and accordingly are reported at fair value with unrealized gains and losses, net of related tax effects, included within accumulated other comprehensive income (loss), a separate component of shareholders equity. Fair values for fixed interest rate securities and equity securities are based on quoted market prices. Premiums and discounts on fixed interest rate securities are amortized or accreted over the life of the related security as an adjustment to yield.

A decline in the market value of any security below cost that is deemed other-than-temporary is charged to earnings, resulting in the establishment of a new cost basis for the security. Realized gains and losses for securities classified as available for sale are derived using the specific identification method for determining the cost of securities sold.

Marketable securities are held by LHC and are substantially restricted to securing the outstanding claims losses of LHC.

Allowance for Doubtful Accounts

The Company utilizes the aging method to evaluate the adequacy of its allowance for doubtful accounts. This method is based upon applying estimated standard allowance requirement percentages to each accounts receivable aging category for each type of payor. The Company has developed estimated standard allowance requirement percentages by utilizing historical collection trends and its understanding of the nature and collectibility of receivables in the various aging categories and the various segments of the Companys business. The standard allowance percentages are developed by payor type as the accounts receivable from each payor type have unique characteristics. The allowance for doubtful accounts is determined utilizing the aging method described above while also considering accounts specifically identified as uncollectible. Accounts receivable that Company
management specifically estimates to be uncollectible, based upon the age of the receivables, the results of collection efforts, or other circumstances, are reserved for in the allowance for doubtful accounts until they are written-off.

Property and Equipment

Property and equipment are recorded at cost. Depreciation is calculated using the straight-line method over estimated useful lives of 20-35 years for building improvements, land improvements and buildings, and 3-15 years for equipment, furniture and fixtures and information systems. Depreciation expense on leasehold improvements and assets held under capital leases is calculated using the straight-line method over the lesser of the lease term or the estimated useful life of the asset. Expenditures for maintenance and repairs necessary to maintain property and equipment in efficient operating condition are charged to operations as incurred. Costs of additions and betterments

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are capitalized. Interest costs associated with major construction projects are capitalized in the period in which they are incurred.

Total depreciation expense from continuing operations for the years ended September 30, 2006, 2005 and 2004 was $60.1 million, $51.3 million and $48.5 million, respectively.

Allowance for Notes Receivable

GHC classifies its notes receivable balances, net of allowances, in other long-term assets in its consolidated balance sheets. See note 7  Other Long-Term Assets.  These long-term receivables represent the net realizable value of GHCs loans receivable resulting principally from the conversion of trade accounts and consideration received for certain enterprise sales transactions. The notes include varying payment terms, rates of interest and maturity dates based upon circumstances specific to each agreement. At least annually, the Company reviews the collectibility of its notes receivable on an individual basis to determine possible impairments and/or non-accrual status for interest terms. Impairments or write-downs to net realizable value are recorded in the consolidated statements of operations as a component of the provision for losses on accounts
receivable and notes receivable. Subsequent recoveries of reserved notes receivable are recorded as a reduction to the provision for losses on accounts receivable and notes receivable in the period of such recovery.

Long-Lived Assets

The
  Company accounts for long-lived assets, other than goodwill with an indefinite
  useful life, in accordance with the provisions of SFAS No. 144, Accounting
  for the Impairment or Disposal of Long-Lived Assets.
  This statement requires that long-lived assets be reviewed for impairment whenever
  events or changes in circumstances indicate the carrying amount of an asset
  may not be recoverable. Recoverability of assets to be held and used is measured
  by comparison of the carrying amount of an asset to the future cash flows expected
  to be generated by the asset. If the carrying amount of an asset exceeds its
  estimated future cash flows, an impairment charge is recognized to the extent
  the carrying amount of the asset exceeds the fair value of the asset. Assets
  to be disposed of are reported at the lower of the carrying amount or the fair
  value less costs to sell. Asset impairment charges totaling $5.5 million were
  recognized in fiscal year 2006 associated with the write-down of two under performing
  properties. The impairment charges are reflected in other operating expenses
  in the consolidated statements of operations and reduced EBITDA of the impatient
  services segment. See note 20  Segment Information.

The Company accounts for goodwill with an indefinite useful life in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets.  This statement requires the Company to perform an impairment test for goodwill at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company performs its annual impairment test at the end of each fiscal year. No goodwill impairment charge was recorded in any of the fiscal years presented herein in connection with the annual impairment test.

Self-Insurance Risks

GHC records outstanding losses and loss expenses for both general and professional liability and workers compensation liability based on the estimates of the amount of reported self-insured losses together with a provision for losses incurred but not reported, based upon the recommendations of an independent actuary, and managements judgment using its past experience and industry experience. GHC believes, based upon the recommendations of an independent actuary, that the provision for outstanding losses and loss expenses will be adequate to cover the ultimate cost of losses incurred as of September 30, 2006, but the provision is necessarily an estimate and may be settled for a significantly greater or lesser amount. It is at least reasonably possible that GHC will revise its estimates significantly in the near term. Any subsequent changes in estimates are recorded in
the period in which they are determined. See note 12  Loss Reserves for Certain Self-Insured Programs.

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Income Taxes

The
  provision for current income taxes is based upon managements estimate
  of taxable income or loss for each respective accounting period. Deferred income
  taxes arise from the recognition of the tax consequences of temporary differences
  between the tax bases of assets and liabilities and their reported amounts in
  the consolidated financial statements. These temporary differences will result
  in taxable or deductible amounts in future years when the reported amounts of
  the assets are recovered or liabilities are settled. The Company also recognizes
  as deferred tax assets the future tax benefits from net operating loss (NOL)
  carryforwards. A valuation allowance is provided for these deferred tax assets
  if it is more likely than not that some portion or all of the net deferred tax
  assets will not be realized. See note 11  Income Taxes.

Comprehensive Income

Comprehensive income includes all changes to shareholders equity during a period, except those resulting from investments by and distributions to shareholders. The components of comprehensive income are shown in the consolidated statements of shareholders equity. Also, see note 21  Comprehensive Income.

Leases

Lease arrangements are capitalized when such leases convey substantially all the risks and benefits incidental to ownership. Capital leases are amortized over either the lease term or the life of the related assets, depending upon available purchase options and lease renewal features. Amortization related to capital leases is included in the consolidated statements of operations within depreciation and amortization expense.

Deferred lease balances carried in the consolidated balance sheet represent future differences between lease expense recognized on an accrual basis and the amount of cash disbursed for lease obligations under operating leases. Deferred lease balances are amortized on a straight-line basis over the lease term and are more fully described in note 10  Leases and Lease Commitments.

Reimbursement of Managed Property Labor Costs

The
  Company manages the operations of 35 independently and jointly owned eldercare
  centers, including consolidated VIEs, and 10 transitional care units as of September
  30, 2006. Under a majority of these arrangements, the Company employs the operational
  staff of the managed center for ease of benefit administration and bills the
  related wage and benefit costs on a dollar-for-dollar basis to the owner of
  the managed property. In this capacity, the Company operates as an agent on
  behalf of the managed property owner and is not the primary obligor in the context
  of a traditional employee/employer relationship. Historically, the Company has
  treated these transactions on a net basis, thereby not reflecting
  the billed labor and benefit costs as a component of its net revenue or expenses.
  For the years ended September 30, 2006, 2005 and 2004, the Company billed its
  managed clients $119.5 million, $114.7 million, and $110.4 million, respectively,
  for such labor related costs.

Earnings Per Share

The computation of basic net income per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the reporting period. The computation of basic weighted average common shares for the fiscal year ended September 30, 2004 is based upon the number of GHC shares distributed by NCI on December 1, 2003 in connection with the spin-off, assuming such distribution took place on October 1, 2003. Therefore, the basic weighted average common shares presented for the fiscal year ended September 30, 2004 are labeled pro forma.  The computation of diluted net income per common share is calculated by dividing net income by the sum of the weighted average basic common shares and potentially dilutive securities. GHC applies the treasury stock method in calculating potentially dilutive securities which assumes that

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the proceeds from the exercise of all GHC stock options are used to repurchase GHC common stock at the average market price for the period. GHCs outstanding stock options yielded 162,332, 169,777 and 60,326 potentially dilutive securities for the fiscal years ended September 30, 2006, 2005 and 2004, respectively. GHCs unvested restricted stock yielded an additional 112,876, 138,556 and 110,789 potentially dilutive securities under the treasury stock method for the fiscal years ended September 30, 2006, 2005 and 2004, respectively.

Derivative Financial Instruments

The
  Company consolidates one VIE that entered into an interest rate swap agreement.
  The VIE is exposed to the impact of interest rate changes because its long-term
  debt bears interest at a variable rate. The VIEs objective in managing
  exposure to interest rate changes is to limit the impact of such changes on
  its earnings and cash flows and to lower its overall borrowing costs. The VIEs
  debt and obligation under the interest rate swap agreement are non-recourse
  to GHC. The Company and the VIE do not enter into such arrangements for trading
  purposes. Such instruments are recognized on the consolidated balance sheet
  at fair value. Changes in the fair value of a derivative that is designated
  as and meets all of the required criteria for a cash flow hedge are recorded
  in accumulated other comprehensive income (loss) and reclassified as an adjustment
  to interest expense as the underlying hedged item affects earnings.

Adoption of New Accounting Pronouncements

Share-Based Payments

Effective
     October 1, 2005, the Company adopted the provisions of Statement of Financial

  Accounting Standard (SFAS) No. 123(R), Share-Based
   Payment (SFAS 123R). SFAS 123R
    establishes accounting for stock-based awards exchanged for employee services.

  Accordingly, stock-based compensation cost is measured at the grant date, based
    on the fair value of the award, which the Company recognizes as expense on
   a straight-line basis over the requisite employees service period.

The
  Company elected to adopt SFAS 123R using the modified prospective application
  method in which compensation cost is recognized beginning with the effective
  date (a) based upon the requirements of SFAS 123R for all share-based payments
  granted after the effective date, and (b) based on the requirements of SFAS
  123 for all awards granted to employees prior to the effective date of SFAS
  123R that remain unvested on the effective date. See note 15  Stock-Based
  Benefit Plans.

GHC
     previously applied Accounting Principles Board (APB) Opinion No. 25, Accounting
      for Stock Issued to Employees,
  and related interpretations and provided the required pro forma disclosures
   of SFAS No. 123, Accounting for
   Stock-Based  Compensation (SFAS
   123). Under  this method, compensation expense was recorded on the date of
   grant only if
  the current market price of the underlying stock exceeded the exercise price.
    Generally, the approach in SFAS 123R to stock-based payment accounting is
   similar
  to SFAS 123. However, SFAS 123R requires all share-based payments to employees,
    including grants of employee stock options, to be recognized as compensation

  cost in the statement of operations at their fair values. Pro forma disclosure
    is no longer an alternative under SFAS 123R.

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The following table illustrates the effect on net income (in thousands, except per share data) if the fair-value-based method had been applied to all outstanding and unvested awards in each period.



Year
          Ended September 30,2005


      

        2004Net income, as reported


      


      $


      46,068


      


      $


      28,242Adjustments:Stock-based compensation included in net income, net of tax effects

        

        

        3,471

        

        

        2,211Stock-based compensation determined under fair value based method, net of tax effects

        

        

        (5,654

        )

        

        (5,789

        )Pro forma net income

        

        $

        43,885

        

        $

        24,664Per common share data in 2005 and pro forma per common share data in 2004:Basic:Net income as reported

        

        $

        2.34

        

        $

        1.42Net income as adjusted

        

        

        2.23

        

        

        1.24Diluted:Net income as reported

        

        $

        2.30

        

        $

        1.40Net income as adjusted

        

        

        2.19

        

        

        1.23


The fair value of stock options granted in fiscal 2004 were estimated at the grant date using the Black-Scholes option pricing model with the following assumptions:  volatility (51%), expected life (6.6 years), risk free rate of return (4.04%), dividend yield (0.00%) and weighted average fair value ($12.01). There were no stock options granted in fiscal 2005.

Conditional Asset Retirement Obligations

In
  March 2005, the Financial Accounting Standards Board (FASB) issued Interpretation
  No. 47, Accounting for Conditional
  Asset Retirement Obligations  an Interpretation of SFAS No. 143,
  (FIN 47). FIN 47 clarifies that an entity is required to recognize a liability
  for the fair value of a conditional asset retirement obligation if the fair
  value can be reasonably estimated, even though uncertainty exists about the
  timing and / or method of settlement. Certain of GHCs real estate assets
  contain asbestos. The asbestos is believed to be appropriately contained in
  accordance with environmental regulations. If these properties were demolished
  or subject to renovation activities that disturb the asbestos, certain environmental
  regulations are in place, which specify the manner in which the asbestos must
  be handled and disposed.

At September 30, 2006, GHC recognized a liability for the fair value of the asset retirement obligation aggregating approximately $5.3 million, which is included in other long-term liabilities and an asset aggregating approximately $2.3 million, which is included in property and equipment on the consolidated balance sheet. In addition, GHC recognized the cumulative effect of adopting FIN 47, totaling approximately $1.7 million, net of taxes, $1.5 million of which is included in cumulative effect of an accounting change and $0.2 million of which is included in loss from discontinued operations on the consolidated statements of operations for the year ended September 30, 2006.

Annual
    accretion of the liability and depreciation expense will be recorded each
    year
  for the impacted assets until the obligation year is reached, either by sale
    of the property, demolition or some other future event such as a government
    action. The estimated accretion of the liability and depreciation expense
    will
  approximate $0.5 million in fiscal 2007. Pro forma disclosures of balance sheet
    information, income from continuing operations and net income have not been
    provided as the impact to the previously reported balance sheets and statements
  of operations is not material.

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New Accounting Pronouncements

Hybrid Financial Instruments

In
  February 2006, the FASB issued SFAS No. 155, Accounting
  for Certain Hybrid Financial Instruments - an amendment of FASB Statements No.
  133 and 140 (SFAS 155), to simplify
  and make more consistent the accounting for certain financial instruments. Specifically,
  SFAS 155 amends SFAS No. 133, Accounting
  for Derivative Instruments and Hedging Activities,to permit fair value re-measurement for any hybrid financial instrument with
  an embedded derivative that otherwise would require bifurcation, provided that
  the whole instrument is accounted for on a fair value basis. SFAS 155 amends
  SFAS 140, Accounting for Transfers
  and Servicing of Financial Assets and Extinguishments of Liabilities (as amended),to allow a qualifying special-purpose entity (SPE) to hold a derivative financial
  instrument that pertains to a beneficial interest other than another derivative
  financial instrument. SFAS 155 applies to all financial instruments acquired
  or issued after the beginning of an entitys first fiscal year that begins
  after September 15, 2006, or October 1, 2006 for GHC, with early adoption permitted.
  The adoption of SFAS 155 is not expected to have a material effect on GHCs
  financial condition, results of operations and cash flows.

General Partner Control of Limited Partnerships

In June 2005, the Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 04-5,Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights(EITF 04-5). This consensus applies to voting right entities not within the scope of FIN 46(R) in which the investor is the general partner(s) in a limited partnership or functional equivalent. The EITF consensus is that the general partner(s) in a limited partnership is presumed to control that limited partnership and therefore should include the limited partnership in its consolidated financial statements. The general partner(s) may overcome this presumption of control and not consolidate the entity if the limited partners have:
(a) the substantive ability to dissolve (liquidate) the limited partnership or otherwise remove the general partner through substantive kick-out rights that can be exercised without having to show cause; or (b) substantive participating rights in managing the partnership. This guidance became immediately effective upon ratification by the FASB on June 29, 2005 for all newly formed limited partnerships and for existing limited partnerships for which the partnership agreements have been modified. For general partners in all other limited partnerships, the guidance is effective no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005, or October 1, 2006 for GHC. GHC expects that, upon adoption, it will begin consolidating two partnerships. One of the partnerships is a jointly owned and managed skilled nursing facility having 112 beds. The second partnership owns the real estate of a skilled nursing facility that is leased to GHC. Upon
consolidation, the two partnerships are estimated to add $10.7 million of total assets, $4.4 million of non-recourse debt, $12.6 million of annual revenue, $2.9 million of annual EBITDA and no net income.

Accounting Changes and Error Corrections

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Correctionsa replacement of APB Opinion No.20 and FASB Statement No.3.  This statement changes the requirements for the accounting for and reporting of a change in accounting principle. This statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. APB 20 previously
required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement does not change the guidance for reporting the correction of an error in previously issued financial statements or the change in an accounting estimate. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, or October 1, 2006 for GHC.

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Income Tax Uncertainties

In June 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes, (FIN 48), which prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprises financial statements in accordance with FASB Statement No. 109,Accounting for Income Taxes.Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006, or October 1, 2007 for GHC, and the provisions of FIN 48 will be applied to all tax positions
accounted for under Statement No. 109 upon initial adoption. The cumulative effect of applying the provisions of this interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. GHC is currently evaluating the potential impact of FIN 48 on its consolidated financial statements.

Accounting for Misstatements

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 108 (SAB 108) which addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires companies to quantify misstatements using both the balance-sheet and income-statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. Upon initial adoption, if the effect of the misstatement is determined to be material, SAB 108 allows companies to record that effect as a cumulative effect adjustment to beginning of year retained earnings. SAB 108 is effective for the first fiscal year ending after November 15, 2006. GHC will adopt the provisions of SAB 108 during its fourth
quarter ending September 30, 2007 and is currently assessing the impact of SAB 108 on its consolidated financial statements.

Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 applies where other accounting pronouncements require or permit fair value measurements. GHC is required to adopt SFAS 157 effective at the beginning of its fiscal year 2009, or October 1, 2008. GHC is evaluating the impact this statement will have on its consolidated financial statements.

|(3) | Certain
        Significant Risks and Uncertainties
|--- | ---------------------------------------------------

Revenue Sources

GHC receives revenues from Medicare, Medicaid, private insurance, self-pay residents, other third-party payors and long-term care facilities that utilize its rehabilitation therapy and other services.

The sources and amounts of GHCs revenues are determined by a number of factors, including licensed bed capacity and occupancy rates of its eldercare centers, the mix of patients and the rates of reimbursement among payors. Likewise, payment for ancillary medical services, including services provided by GHCs rehabilitation therapy services business, vary based upon the type of payor and payment methodologies. Changes in the case mix of the patients as well as payor mix among Medicare, Medicaid and private pay can significantly affect GHCs profitability.

It
  is not possible to quantify fully the effect of legislative changes, the interpretation
  or administration of such legislation or other governmental initiatives on GHCs
  business and the business of the customers served by GHCs rehabilitation
  therapy business. Accordingly, there can be no assurance that the impact of
  any future healthcare legislation or regulation will not adversely affect GHCs
  business. There can be no assurance that payments under governmental and private
  third-party payor programs will be timely, will remain at levels similar to
  present

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levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for reimbursement pursuant to such programs. GHCs financial condition and results of operations will be affected by the reimbursement process, which in the healthcare industry is complex and can involve lengthy delays between the time that revenue is recognized and the time that reimbursement amounts are settled.

GHCs inpatient services segment earned revenues from the following payor sources for the periods presented:



Year
          Ended September 30,2006
      
      2005
      
      2004Medicaid
      
      52
      %
      54
      %
      51
      %Medicare
      
      29
      %
      27
      %
      29
      %Private
          pay and other
      
      19
      %
      19
      %
      20
      %100
      %
      100
      %
      100
      % (4)
      Significant
          Transactions and Events


Amendments to NCI Agreements

On
  August 18, 2006, GHC and Omnicare entered into (i) an Amended and Restated Master
  Agreement for Pharmacy, Pharmacy Consulting and Related Products and Services,
  dated as of July 1, 2006, which agreement amends and restates the Master Agreement
  for Pharmacy, Pharmacy Consulting and Related Products and Services, dated as
  of December 1, 2003, by and between the Company and NeighborCare Pharmacy Services,
  Inc. (NPS), as first amended on May 7, 2004 and second amended on June 9, 2005
  (the Pharmacy Services
  Agreement), and (ii)
  an Amended and Restated Master Agreement for Specialty Beds and Oxygen Concentrators,
  dated as of July 1, 2006, which agreement amends and restates the Master Agreement
  for Specialty Beds and Oxygen Concentrators, dated as of December 1, 2003, by
  and between the Company and NPS (the Durable
  Medical Equipment Agreement).
  On July 28, 2005, Omnicare acquired NPS in a merger transaction pursuant to
  which NPS became a wholly owned subsidiary of Omnicare. Pursuant to the above-referenced
  merger transaction, Omnicare succeeded to all of NPSs rights and obligations
  under the Pharmacy Services Agreement and Durable Medical Equipment Agreement.

Pharmacy Services Agreement

The Company and Omnicare amended the Pharmacy Services Agreement in order to, among other things: (i) extend the initial term for an additional five years to November 30, 2018; (ii) provide for annual price reviews and potential price adjustments based on the number of skilled nursing facility beds served by Omnicare under the Pharmacy Services Agreement; and (iii) reduce the prices paid by the Company for certain medications, including modifying the discounts available to the Company for its prompt payment of Omnicare invoices.

Durable Medical Equipment Agreement

The Company and Omnicare amended the Durable Medical Equipment Agreement in order to, among other things: (i) permit the Company to purchase or rent certain equipment directly from a certain manufacturer or its affiliates or successors; (ii) increase price discounts available to the Company for its prompt payment of Omnicare invoices; and (iii) reduce the cost to the Company for certain products.

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Purchase of Joint Venture Interests

In
  June 2006, GHC acquired a 49% limited partnership interest in a joint venture
  with capital contributions amounting to $2.1 million as of September 30, 2006.
  The joint venture is engaged in the construction of an office building. The
  total cost of the project is estimated to be between $17 million and $19 million
  and will be financed with capital contributions from the partners and a line
  of credit of up to $14 million. The building is expected to be completed by
  the end of GHCs fiscal year ended September 30, 2007. GHC, as the primary
  tenant of the building under construction consolidates and capitalizes the construction
  costs and borrowings under the line of credit through the construction phase
  of the project. At September 30, 2006, GHC included in its consolidated balance
  sheet $4.1 million classified as property and equipment for the construction
  in progress to date and a $2.0 million obligation classified as other long-term
  liabilities representing the other parties contributions less the partnerships
  cash balance at the end of the period. Once the project is complete GHC will
  re-evaluate its accounting.

In
  December 2005, GHC deposited into escrow $4.1 million to acquire all of its
  joint venture partners interests in three skilled nursing facilities located
  in the State of West Virginia having a combined 208 beds. GHC owned a 50% interest
  in and managed the operations of each of the three facilities, but upon completion
  of the transaction on June 1, 2006 owned 100% of each facility and consolidated
  the related revenues, expenses and net assets. GHC had already consolidated
  the financial statements of one of the facilities and recorded minority interest
  to reflect its joint venture partners interests.

Effective January 1, 2005, GHC acquired its joint venture partners interest in a Commonwealth of Massachusetts skilled nursing facility having 123 beds. Prior to that acquisition, the Company owned a 50% interest in the facility and consolidated its operations upon adoption of FIN 46 effective January 1, 2003 as GHC determined it was the primary beneficiary of the partnership. Upon completion of the transaction, GHC owned 100% of the facility and adjusted the carrying value of the acquired interest in the assets and liabilities to fair value as of January 1, 2005. The aggregate consideration consisted of cash of $0.5 million to acquire the remaining partnership interests and the assumption of approximately $6.0 million of partnership debt, all of which was repaid at the closing of the transaction.

On January 5, 2004, GHC acquired its joint venture partners interest in two Massachusetts skilled nursing facilities it previously managed. GHC previously owned a 50% interest in one facility and a 20% interest in the other. Upon completion of the transaction, GHC owned 100% of both facilities and acquired approximately $6.0 million of working capital along with the property and equipment of the two skilled nursing facilities, having a total of 318 beds. The aggregate consideration consisted of $6.0 million in cash and the assumption of debt in the amount of approximately $20.0 million, of which $12.5 million was repaid following completion of the transactions.

Share Repurchase

In April 2006, GHCs board of directors authorized the repurchase of up to $150.0 million of GHCs common stock, with such repurchases to take place at GHC managements discretion and/or under pre-established, non-discretionary programs from time to time, depending on market conditions, in the open market and in privately negotiated transactions, subject to any covenants or restrictions contained in agreements governing GHCs indebtedness. Repurchases of common stock are restricted by GHCs debt agreements, the most restrictive of which is its 8% senior subordinated notes. Such restrictions preclude repurchases of common stock above 50% of GHCs net income since July 1, 2003. After considering common stock repurchases made to date and other repurchase provisions, GHCs maximum common stock repurchasing capacity at September 30, 2006 was $22.7
million. In total, 1,075,745 shares of common stock have been repurchased under current and past common stock repurchase programs at a cost of $42.8 million, of which 288,408 shares at a cost of $10.7 million were repurchased during fiscal 2006.

Debt Repurchase

In February 2005, GHCs board of directors authorized the repurchase of a portion of GHCs 8% senior subordinated notes due 2013 from time to time in the open market commencing in March 2005 until December 31,

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2006. There were $79.1 million of 8% senior subordinated notes repurchased through September 30, 2006, of which $8.2 million were repurchased in fiscal 2006. The total debt repurchases made to date resulted in prepayment premium charges of $7.9 million and the write-off of unamortized deferred financing fees and other fees of $3.0 million. These charges, along with the write-off of unamortized deferred financing fees, are collectively included in loss on early extinguishment of debt in the consolidated statements of operations, of $0.8 million, $11.8 million and $1.7 million for the years ended September 30, 2006, 2005 and 2004, respectively.

Issuance and Registration of Convertible Senior Subordinated Debentures

In March 2005, GHC completed a private placement of $180.0 million aggregate principal amount of its 2.5% convertible senior subordinated debentures due 2025 to qualified institutional buyers under Rule 144A of the Securities Act of 1933, as amended (Securities Act). After paying financing fees of approximately $5.5 million, GHC used (i) approximately $20.1 million of the net proceeds of the offering to repurchase shares of its common stock from the initial purchasers of the debentures in negotiated transactions concurrently with the offering, (ii) approximately $119.7 million of the net proceeds to repay the remaining outstanding borrowings under the term loan portion of its senior credit facility, and (iii) the balance for general corporate purposes, including debt repurchases described above. In July 2005, the Company registered with the SEC the resale of the convertible senior
subordinated debentures and the relating guarantees and underlying common stock.

Senior Credit Facility Amendment

In March 2005, in connection with the offering of the convertible senior subordinated debentures, GHC entered into an amended and restated senior credit agreement pursuant to which the Company refinanced the indebtedness under its existing senior credit agreement. The Company repaid all outstanding borrowings under the term loan portion of the senior credit facility and expanded the borrowing capacity of the revolving credit portion.

Prior to the amendment, the existing senior credit agreement provided for a revolving credit facility of $75.0 million, with sub limits for swing line loans, letters of credit and term loans. The amended and restated senior credit agreement provides for a $125.0 million revolving credit facility, with sub limits for the issuance of letters of credit and for swing line loans.

Recognition of Pennsylvania and New Jersey Provider Assessments

Provider assessments generate additional federal matching funds to the states for Medicaid reimbursement purposes, and implementation of a provider assessment plan requires approval by the Centers for Medicare and Medicaid Services (CMS) in order to qualify for federal matching funds. These plans usually take the form of a bed tax or a quality assessment fee, which is imposed uniformly across classes of providers within the state. In turn, the state generally utilizes the additional federal matching funds generated by the tax to pay increased reimbursement rates to the providers, which often include a repayment of a portion of the provider tax based on the providers percentage of Medicaid patients.

In January 2005, CMS approved the Pennsylvania provider assessment. The Pennsylvania provider assessment, which was retroactive to July 1, 2003 and will expire on June 30, 2007, was recognized cumulatively in the quarter ended March 31, 2005. Recognition of the Pennsylvania provider assessment resulted in increased revenue and net income of $50.9 million and $4.0 million, respectively, in fiscal 2005, of which $30.9 million of revenue and $3.3 million of net income relates to periods prior to fiscal 2005.

In February 2005, CMS approved the New Jersey provider assessment. The New Jersey provider assessment, which was retroactive to July 1, 2004 and will expire on June 30, 2007, was recognized cumulatively in the quarter ended March 31, 2005. Recognition of the New Jersey provider assessment resulted in increased revenue and net income of $22.1 million and $3.7 million, respectively, in fiscal 2005, of which $4.3 million of revenue and $0.6 million of net income relates to periods prior to fiscal 2005.

Acquisition of Previously Leased ElderCare Center and Lease Termination

On January 31, 2005, GHC acquired the land and building of a State of New Jersey skilled nursing facility having 136 beds that it previously leased. The purchase price of approximately $15.8 million includes the assumption of a $9.5 million, 6% fixed rate mortgage that matures in October 2007. The transaction results in an annual reduction to lease expense of approximately $1.5 million and an increase to depreciation expense and interest expense of approximately $0.5 million and $0.6 million, respectively.

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On January 31, 2005, GHC terminated the lease of a State of New Jersey skilled nursing facility having 186 beds. Upon termination, the center was classified as a discontinued operation; consequently, its results of operations in the current and prior year periods have been classified as discontinued operations in the consolidated statements of operations. The annual revenues and pretax income of this center were approximately $12.3 million and $1.4 million, respectively.

(5)

        Restricted Cash and Investments in Marketable Securities


Marketable securities (classified as available for sale) are held by the Companys wholly owned subsidiary, Liberty Health Corporation, Ltd. (LHC), incorporated under the laws of Bermuda. LHC provides various insurance coverages to the Company and to unrelated entities, most of which are managed by the Company.

The current portion of restricted cash and investments in marketable securities represents an estimate of the level of outstanding self-insured losses the Company expects to pay in the succeeding year.

Restricted cash and equivalents and investments in marketable securities at September 30, 2006 consist of the following (in thousands):



Amortizedcost
      
      Unrealizedgains
      
      Unrealizedlosses
      
      Fair
          valueRestricted
          cash and equivalents:Cash
      
      $
      4,769
      
      $
      -
      
      $
      -
      
      $
      4,769Money
          market funds
      
      
      6,350
      
      
      -
      
      
      -
      
      
      6,350Restricted
          investments in marketable securities:U.S.
          mortgage backed securities
      
      
      31,076
      
      
      86
      
      
      (219
      )
      
      30,943Corporate
          bonds
      
      
      36,574
      
      
      142
      
      
      (429
      )
      
      36,287Government
          bonds
      
      
      21,348
      
      
      426
      
      
      (144
      )
      
      21,630$
      100,117
      
      $
      654
      
      $
      (792
      )
      $
      99,979Less:
          Current portion of restricted investments
      
      
      
      
      
      
      
      
      
      
      
      (35,160
      )Long-term
          restricted investments
      
      
      
      
      
      
      
      
      
      
      $
      64,819


Restricted cash and equivalents and investments in marketable securities at September 30, 2005 consist of the following (in thousands):



Amortizedcost
      
      Unrealizedgains
      
      Unrealizedlosses
      
      Fair
          valueRestricted
          cash and equivalents:Cash
      
      $
      7,442
      
      $
      -
      
      $
      -
      
      $
      7,442Money
          market funds
      
      
      4,482
      
      
      -
      
      
      -
      
      
      4,482Restricted
          investments in marketable securities:U.S.
          mortgage backed securities
      
      
      24,006
      
      
      59
      
      
      (299
      )
      
      23,766Corporate
          bonds
      
      
      48,739
      
      
      47
      
      
      (643
      )
      
      48,143Government
          bonds
      
      
      19,531
      
      
      351
      
      
      (201
      )
      
      19,681$
      104,200
      
      $
      457
      
      $
      (1,143
      )
      $
      103,514Less:
          Current portion of restricted investments
      
      
      
      
      
      
      
      
      
      
      
      (39,875
      )Long-term
          restricted investments
      
      
      
      
      
      
      
      
      
      
      $
      63,639


Maturities of restricted investments yielded proceeds of less than $0.1 million, $0.5 million and $3.1 million for the years ended September 30, 2006, 2005 and 2004, respectively. Sales of investments yielded proceeds of $93.3 million, $146.4 million and $201.4 million for the years ended September 30, 2006, 2005 and 2004, respectively, with associated gross realized gains of less than $0.1 million, $0.1 million and $1.3 million and gross realized losses



78



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of
  $0.7 million, $0.6 million and $0.1 million for the years ended September 30,
  2006, 2005 and 2004, respectively.

There are restricted investments held continuously for less than 12 months having less than $0.1 million and $0.7 million of unrealized losses at September 30, 2006 and 2005, respectively. There are restricted investments held continuously for greater than 12 months having $0.8 million and $0.5 million of unrealized losses at September 30, 2006 and 2005, respectively. As the majority of GHCs investments are investment grade government and corporate debt securities that have maturities of five years or less, and GHC has both the ability and intent to hold the investments until maturity, it does not expect to realize any significant losses on such investments.

Restricted investments in marketable securities held at September 30, 2006 mature as follows (in thousands):



Amortizedcost

        


      Fair
          valueDue in one year or less

        

        $

        15,043

        

        $

        14,951Due after 1 year through 5 years

        

        

        62,284

        

        

        62,011Due after 5 years through 10 years

        

        

        6,560

        

        

        6,692Due after 10 years

        

        

        5,111

        

        

        5,206$

        88,998

        

        $

        88,860


Actual maturities may differ from stated maturities because borrowers have the right to call or prepay certain obligations with or without prepayment penalties.

LHC
    has issued letters of credit totaling $74.4 million at September 30, 2006
    and $90.1 million at September 30, 2005 to its third party administrators
    and GHCs excess insurance carriers. Restricted cash of $4.7 million
    and restricted investments with an amortized cost of $89.0 million and a
    market value of $88.9 million
    are
    pledged
    as
    security
    for these letters of credit as of September 30, 2006.

(6)

        Property and Equipment


Property and equipment at September 30, 2006 and 2005 consist of the following (in thousands):



2006

        

        2005Land
          and improvements

        

        $

        88,988

        

        $

        84,645Buildings and improvements

        

        

        809,924

        

        

        746,321Equipment, furniture and fixtures

        

        

        204,234

        

        

        159,369Construction in progress

        

        

        4,946

        

        

        1,517Gross property and equipment

        

        

        1,108,092

        

        

        991,852Less:
          accumulated depreciation

        

        

        (234,928

        )

        

        (173,714

        )Net property and equipment

        

        $

        873,164

        

        $

        818,138


Assets held under capital leases, which are principally carried in building and improvements above, were $48.0 million and $51.4 million at September 30, 2006 and 2005, respectively. Accumulated depreciation on assets held under capital leases was $7.1 million and $4.9 million at September 30, 2006 and 2005, respectively.

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(7)

        Other Long-Term Assets


Other long-term assets at September 30, 2006 and 2005 consist of the following (in thousands):



2006
      
      2005Notes
          receivable, net
      
      $
      9,978
      
      $
      16,493Assets
          held in Rabbi Trust
      
      
      18,840
      
      
      14,119Insurance
          claims recoverable
      
      
      11,187
      
      
      14,938Deferred
          financing fees, net
      
      
      11,514
      
      
      13,473Deposits
          and funds held in escrow
      
      
      19,497
      
      
      10,008Advanced
          rents
      
      
      7,253
      
      
      9,608Investments
          in unconsolidated affiliates
      
      
      4,873
      
      
      6,062Other,
          net
      
      
      1,991
      
      
      393Other
          long-term assets
      
      $
      85,133
      
      $
      85,094


Notes
  receivable are recorded net of allowances of $22.6 million and $25.6 million
  at September 30, 2006 and 2005, respectively. The net decline of notes receivable
  in the year ended September, 30, 2006 is principally due to the repayment of
  a $6.0 million note.

Growth
  of assets held in Rabbi Trust is due to employee contributions to the deferred
  compensation plan and the relative performance of the investments held. The
  investments are accounted for as trading securities and therefore adjusted to
  fair value with a corresponding adjustment to investment income.

Deferred
  financing fees are recorded net of accumulated amortization of $5.1 million
  and $3.2 million at September 30, 2006 and 2005, respectively.

Growth
  in deposits and funds held in escrow is principally due to $7.2 million of net
  funding at September 30, 2006 for a loss deposit fund in connection with workers
  compensation insurance. See note 12 - Loss Reserves for Certain Self Insured
  Programs.



(8)

        Goodwill and Identifiable Intangible Assets


The changes in the carrying value of goodwill for the years ended September 30, 2006 and 2005 are as follows (in thousands):



2006
      
      2005Balance
          at beginning of period
      
      $
      8,619
      
      $
      10,293Goodwill
          related to contingent consideration adjustments
      
      
      26
      
      
      643Goodwill
          adjustment due to step-acquisition
      
      
      -
      
      
      (2,317
      )Balance
          at end of period
      
      $
      8,645
      
      $
      8,619


Identifiable intangible assets at September 30, 2006 and 2005 consist of the following (in thousands):



Classification

        

        2006

        

        2005

        

        Estimated Life(Years)Customer Contracts

        

        $

        1,605

        

        $

        1,605

        

        4-5Non-Competition agreements

        

        

        1,123

        

        

        1,123

        

        4-5Indentifiable intangible assets


      


      


      2,728


      


      


      2,728Accumulated amortization

        

        

        (2,157

        )

        

        (1,633

        )Indentifiable intangible assets, net

        

        $

        571

        

        $

        1,095


Aggregate amortization expense for identifiable intangible assets for the years ended September 30, 2006 and 2005 was $0.5 million and $0.6 million, respectively. Amortization expense for the next two fiscal years is $0.5 million in fiscal 2007 and $0.1 million in fiscal 2008.

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(9)

        Long-Term Debt


Long-term debt at September 30, 2006 and 2005 consists of the following (in thousands):



2006
      
      2005Senior
          credit facility - revolving credit
      
      $
      6,000
      
      
      -Senior
          subordinated notes
      
      
      145,935
      
      
      154,150Convertible
          senior subordinated debentures
      
      
      180,000
      
      
      180,000Mortgages
          and other secured debt (recourse)
      
      
      37,909
      
      
      39,600Capital
          lease obligations
      
      
      34,950
      
      
      36,420Mortgages
          and other secured debt (non recourse)
      
      
      40,040
      
      
      40,926444,834
      
      
      451,096Less:Current
          installments of long-term debt
      
      
      (4,829
      )
      
      (5,419
      )Long-term
          debt
      
      $
      440,005
      
      $
      445,677


Senior credit facility.On December 1, 2003, GHC entered into a senior credit facility that provided for a fully drawn $185.0 million term loan and a revolving credit facility of $75.0 million. In March 2005, in connection with the offering of the convertible senior subordinated debentures, GHC entered into an amended and restated senior credit agreement pursuant to which the Company refinanced the indebtedness under its existing senior credit agreement. The Company repaid all outstanding borrowings under the term loan portion of the senior credit facility and expanded the borrowing capacity of the $75.0 million revolving credit portion of the senior credit facility.

The amended and restated senior credit agreement provides for a $125.0 million revolving credit facility, with sub limits for the issuance of letters of credit and for swing line loans. However, so long as GHC is not in default and if it finds lenders that are willing to commit, the amended and restated senior credit agreement allows GHC to add up to $50.0 million of additional available credit under the revolver, subject to the approval of GHCs board of directors. Each of GHCs material U.S. subsidiaries provided guarantees of the indebtedness under the amended and restated senior credit agreement. GHC and the guarantors pledged substantially all of their personal property to secure the obligations under the amended and restated senior credit agreement, subject to certain exceptions agreed upon with the lenders. In addition, the mortgages that GHC and its subsidiaries provided under
the prior credit agreement continue to secure the amended and restated senior credit agreement, but GHC is not required to provide additional mortgages except under certain limited circumstances. The amended and restated senior credit agreement has a five year term, expiring in March 2010.

At
  September 30, 2006, $112.2 million was available under the revolving credit
  facility after giving effect to $6.8 million in outstanding letters of credit
  issued and $6.0 million borrowed to finance a subsequent facility acquisition.
  GHC pays interest monthly on the outstanding loans under the amended and restated
  senior credit agreement at either a base rate plus a margin or at the London
  Interbank Offered Rate (LIBOR) plus a margin. The margin is adjusted from time
  to time, depending on GHCs leverage ratio. For base rate loans, the margin
  range is from 0.00% to 1.00%. For LIBOR loans, the margin range is from 1.00%
  to 2.00%. At September 30, 2006, the margin on base rate loans was 0.50% and
  the margin on LIBOR loans was 1.50%. At September 30, 2005, the margin on base
  rate loans was 0.25% and the margin on LIBOR loans was 1.25%. GHC currently
  pays a commitment fee to the lenders on the unused portion of the revolving
  credit facility equal to 0.50% of the unused amount, which is an increase from
  the prior year when GHC paid 0.375%. The increases are due to GHCs total
  leverage ratio rising above 2.25:1.00, as defined.

The agreements and instruments governing the amended and restated senior credit agreement contain various restrictive covenants that, among other things, restrict the ability of GHC and its subsidiaries that guarantee the

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indebtedness under the amended and restated senior credit agreement to:  incur more debt; pay dividends; purchase GHC common stock or make other distributions; make payments in respect of subordinated debt; make certain investments; create liens; enter into transactions with affiliates; make acquisitions, merge or consolidate; and transfer or sell assets.

The amended and restated senior credit agreement requires that GHC maintain compliance with certain financial covenants as defined in the agreement, including a senior leverage ratio, a total leverage ratio and a fixed charge coverage ratio. There is also a limitation on the amount of capital expenditures that GHC may make.

Senior
  subordinated notes. In October 2003, GHC issued 8% senior
  subordinated notes in an aggregate principal amount of $225.0 million due in
  2013. Interest is payable semi-annually in April and October. In July 2004,
  upon the expiration of an exchange offer, $224.0 million aggregate principal
  amount of senior subordinated notes registered under the Securities Act were
  exchanged for the unregistered notes issued in October 2003. The aggregate principal
  amount of $1.0 million of unregistered notes was not exchanged and remains outstanding.
  Under the terms of GHCs senior subordinated notes, the notes are not redemable
  until after October 15, 2008. Each of GHCs subsidiaries that guarantees
  the indebtedness under the amended and restated senior credit agreement also
  guarantees the senior subordinated notes. The guarantees will be released at
  such time that such subsidiary ceases to be a guarantor under the amended and
  restated senior credit agreement or all of the senior subordinated notes are
  no longer outstanding. See note 4 - Significant Transaction and Events
  regarding the repayment of a portion of these notes.

The indenture governing the senior subordinated notes contains various restrictive covenants that, among other things, restrict the ability of GHC and its subsidiaries that guarantee the senior subordinated notes to:  incur more debt; pay dividends; purchase GHC common stock or make other distributions; make payments in respect of subordinated debt; make certain investments; create liens; enter into transactions with affiliates; make acquisitions, merge or consolidate; and transfer or sell assets.

Convertible senior subordinated debentures.In March 2005, GHC completed a private placement of $180.0 million aggregate principal amount of its 2.5% convertible senior subordinated debentures due 2025 to qualified institutional buyers under Rule 144A of the Securities Act. Interest is payable semi-annually in March and September. Each of GHCs subsidiaries that guarantee the indebtedness under the senior subordinated notes also guarantee the convertible senior subordinated debentures. The guarantees will be released at such time that such subsidiary ceases to be a guarantor under the senior subordinated notes, all of the senior subordinated notes are no longer outstanding, or on March 20, 2012. In July 2005, the Company registered with the SEC the resale of the convertible senior subordinated debentures and the relating guarantees and underlying common stock.

The debentures may be converted into cash and, depending on the circumstances at the time of conversion, shares of GHC common stock. The initial conversion rate for the debentures will be equivalent to 18.4493 shares of common stock per $1,000 principal amount of the debentures (which is based upon an initial conversion price equivalent to approximately $54.20 per share), subject to adjustment under certain circumstances. The holders of the convertible senior subordinated debentures may convert their debentures into shares of GHC common stock prior to the stated maturity at their option only under the following circumstances:  (1) if, after June 30, 2005, the closing price of GHC common stock exceeds 130% of the conversion price then in effect for at least 20 trading days in the 30 consecutive trading day period ending on the last trading day of the immediately preceding fiscal quarter; (2) during
the five business days immediately following any five consecutive trading day period in which the trading price per $1,000 principal amount of debentures for each day of such period was less than 95% of the product of the closing price of GHC common stock and the applicable conversion rate then in effect, subject to certain exceptions; (3) the debentures have been called for redemption; (4) upon the occurrence of specified corporate transactions; or (5) upon the occurrence of certain designated events.

Subject to certain exceptions, once debentures are tendered for conversion, the value, or conversion value, of the cash and shares of GHC common stock, if any, to be received by a holder converting $1,000 principal amount of the debentures will be determined by multiplying the applicable conversion rate by the ten trading day average closing price of GHC common stock. GHC will deliver the conversion value to holders as follows: (i) an amount in cash, referred to as the principal return, equal to the lesser of (x) the aggregate conversion value of the debentures to be converted and (y) the aggregate principal amount of the debentures to be converted, (ii) if the aggregate conversion value of the debentures to be converted is greater than the principal return, an amount in whole shares,

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referred to as the net shares, equal to such aggregate conversion value less the principal return, referred to as the net share amount, and (iii) an amount in cash in lieu of any fractional shares of GHC common stock. The number of net shares to be paid will be determined by dividing the net share amount by the ten trading day average closing price of GHC common stock.

GHC may not redeem the convertible senior subordinated debentures before March 20, 2010. The holders of the convertible senior subordinated debentures may require GHC to purchase all or a portion of their debentures at any of three specified dates during the life of the debentures, with the first such date being March 15, 2012, or upon the occurrence of certain designated events for cash at a repurchase price equal to the principal amount plus accrued and unpaid interest plus, in the case of certain designated events that occur on or prior to March 20, 2010, a make whole premium, if any, payable solely in shares of GHC common stock.

The dilutive effect of the common shares that would be issued if the convertible debentures were converted is not included in GHCs diluted weighted average common share balance unless the weighted average market price of GHCs common stock during a reporting period exceeds $54.20 per share.

Mortgages and other secured debt (recourse).At September 30, 2006 and 2005, GHC had $37.9 million and $39.6 million, respectively, of other secured debt consisting principally of revenue bonds and secured bank loans, including loans insured by the Department of Housing and Urban Development. These loans are secured by the underlying real and personal property of individual eldercare centers and have fixed or variable rates of interest ranging from 3.0% to 11.0%, with a weighted average interest rate of 6.6% at September 30, 2006 and 2005.

Capital lease obligations.The capital lease obligations represent the present value of minimum lease payments under such capital lease arrangements and bear imputed interest at rates ranging from 5.00% to 7.75% and mature at dates ranging primarily from 2007 to 2009. See note 10  Leases and Lease Commitments.

Mortgages and other secured debt (non-recourse).These loans are carried by certain of GHCs less than 51% owned joint ventures consolidated pursuant to FIN 46. The loans consist principally of revenue bonds and secured bank loans. These loans are secured by the underlying real and personal property of individual eldercare centers and have fixed or variable rates of interest ranging from 3.8% to 8.7% at September 30, 2006, with maturity dates ranging from 2010 to 2038. These loans are labelednon-recourse because neither GHC nor a wholly owned subsidiary is obligated to perform under the respective loan agreements.

The Company consolidates one VIE pursuant to FIN 46 that entered into an interest rate swap agreement. The VIEs obligation under the interest rate swap agreement is non-recourse to GHC. The interest rate swap agreement effectively converts approximately $6.9 million and $7.0 million at September 30, 2006 and 2005, respectively, of variable-rate debt (one month LIBOR) into fixed-rate debt (4.38%). The interest rate swap agreement matures on July 29, 2010. The counterparty to the interest rate swap agreement is a major institutional bank.

The maturity of total debt, excluding capital lease obligations, of $409.9 million at September 30, 2006 is as follows: $4.3 million in fiscal 2007, $13.4 million in fiscal 2008, $2.2 million in fiscal 2009, $17.6 million in fiscal 2010, $2.0 million in fiscal 2011 and $370.4 million thereafter.

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|(10) | Leases and Lease Commitments
|---- | ----------------------------

The
  Company leases certain facilities under capital and operating leases. Future
  minimum payments for the next five years and thereafter under such leases at
  September 30, 2006 are as follows (in thousands):



Year ending September 30,


      


      Capital
          Leases


      


      Operating
          Leases2007

        

        $

        4,996

        

        $

        21,1812008

        

        

        3,210

        

        

        21,0432009

        

        

        30,386

        

        

        20,0822010

        

        

        534

        

        

        18,8492011

        

        

        542

        

        

        18,460Thereafter

        

        

        631

        

        

        63,887Total future minimum lease payments

        

        $

        40,299

        

        $

        163,502Less amount representing interest

        

        

        (5,349

        )Present value of net minimum lease payments

        

        

        34,950Less current portion

        

        

        (501

        )Long-term capital lease obligation

        

        $

        34,449


GHC holds fixed price purchase options to acquire the land and buildings of eight centers for $70.5 million with expirations ranging from 2007 to 2009. Three of these options are deemed to be bargain purchases and, consequently, these leases have been classified as capital leases contributing $29.4 million in capital lease obligations of the total $35.0 million at September 30, 2006. The large capital lease obligation in fiscal 2009 is caused by the three bargain purchase options which become exercisable in that year. GHC also classifies two other center leases as capital leases contributing $3.6 million to the capital lease obligation at September 30, 2006.

Deferred lease balances carried on the consolidated balance sheets represent future differences between accrual basis and cash basis lease costs. Differences between lease expense on an accrual basis and the amount of cash dispersed for lease obligations is caused by:



        Unfavorable or favorable lease balances established in GHCs September 30, 2001 adoption of fresh-start reporting and deferred gains on sale leaseback transactions which are amortized on a straight-line basis over the lease term;




        Lease balances established to account for operating lease costs on a straight-line basis; and




        Advanced rent payments made to lessors in order to reduce future lease payments which are amortized on a straight-line basis over the lease term.


The net balance of unfavorable/favorable leases and deferred gain on sale lease back at September 30, 2006 of ($1.9) million is included in other long-term liabilities on the consolidated balance sheets and will be amortized to lease expense over the remaining lease terms, which have a weighted average term of 5.7 years. The net balance of the straight-line lease adjustment at September 30, 2006 of $1.4 million is included in other long-term liabilities on the consolidated balance sheets. The balance of advanced rent payments at September 30, 2006 of $7.3 million is included in other long-term assets in the consolidated balance sheets and will be amortized as an increase to lease expense over the remaining lease terms, which have a weighted average term of 4.2 years.

In
  June 2006, GHC acquired a 49% limited partnership interest in a joint venture
  with capital contributions amounting to $2.1 million as of September 30, 2006.
  The joint venture is engaged in the construction of an office building. Upon
  completion of construction, GHC intends to lease office space from the joint
  venture to house certain of its corporate support functions. See note 4 
  Significant Transactions and Events.

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|(11) | Income Taxes
|---- | ------------

Total income tax expense (benefit) for the years ended September 30, 2006, 2005 and 2004 was as follows (in thousands):



2006


      

        2005


      

        2004From continuing operations

        

        $

        25,839

        

        $

        28,644

        

        $

        19,897From cumulative effect of an accounting change

        

        

        (1,054

        )

        

        -

        

        

        -From discontinued operations

        

        

        (361

        )

        

        (109

        )

        

        (1,484

        )Total

        

        $

        24,424

        

        $

        28,535

        

        $

        18,413


The components of the provision for income taxes on income from continuing operations for the years ended September 30, 2006, 2005 and 2004 were as follows (in thousands):



2006


      

        2005


      

        2004Current:Federal

        

        $

        4,994

        

        $

        2,839

        

        $

        274State

        

        

        4,486

        

        

        690

        

        

        2,8319,480

        

        

        3,529

        

        

        3,105Deferred:Federal

        

        

        15,191

        

        

        19,610

        

        

        15,707State

        

        

        1,168

        

        

        5,505

        

        

        1,08516,359

        

        

        25,115

        

        

        16,792Total

        

        $

        25,839

        

        $

        28,644

        

        $

        19,897


Total income tax expense for the years ended September 30, 2006, 2005 and 2004 differed from the amounts computed by applying the U.S. federal income tax rate of 35% to income from continuing operations before income taxes, equity in net income of unconsolidated affiliates and minority interests as illustrated below (in thousands):



2006


      

        2005


      

        2004Computed expected tax

        

        $

        22,192

        

        $

        25,818

        

        $

        17,855Increase (reduction) in income taxes resulting from: State and local income taxes, net of federal tax benefits

        

        

        3,675

        

        

        4,026

        

        

        2,544Targeted jobs tax credit

        

        

        (629

        )

        

        (1,247

        )

        

        (560

        )Carryback of losses allowed under Job Creation and Worker Assistance Act of 2002

        

        

        -

        

        

        (669

        )

        

        -Other, net

        

        

        601

        

        

        716

        

        

        58Total income tax expense

        

        $

        25,839

        

        $

        28,644

        

        $

        19,897


85

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The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at September 30, 2006 and 2005 are presented below (in thousands):



2006

        

        2005Deferred Tax Assets:Accounts receivable

        

        $

        19,539

        

        $

        20,877Accrued liabilities and reserves

        

        

        37,290

        

        

        38,737Net operating loss carryforwards (NOL)

        

        

        34,352

        

        

        50,786Net unfavorable leases

        

        

        2,216

        

        

        2,844Other

        

        

        10,767

        

        

        6,990Total deferred tax assets

        

        

        104,164

        

        

        120,234Deferred Tax Liabilities:Accrued liabilities and reserves

        

        

        (811

        )

        

        (3,441

        )Depreciation

        

        

        (52,317

        )

        

        (59,856

        )Total deferred tax liabilities

        

        

        (53,128

        )

        

        (63,297

        )Net deferred tax assets

        

        $

        51,036

        

        $

        56,937


Prior to the spin-off, GHC did not file a separate federal tax return. It was included in the consolidated federal tax return filed by NCI. GHC files its own federal tax returns for periods subsequent to the spin-off. The first such tax period was comprised of the ten months ended September 30, 2004. Under terms of the Tax Sharing Agreement, as amended, between NCI and GHC, NCI bears responsibility for all consolidated, combined or unitary tax returns through the date of the spin-off.

Current and deferred taxes calculated under the separate company approach to intercorporate tax allocation followed in preparing the consolidated financial statements for the pre-spin-off period may not necessarily reflect the impact of income taxes on the results of operations, cash flows or financial position of GHC in the future.

Management
  believes the net deferred tax assets at September 30, 2006 and 2005 were more
  likely than not to be realized. As of September 30, 2006, GHC expects it will
  have sufficient taxable income in future periods such that the remaining NOL
  would be utilized within the carryforward period. During the year ended September
  30, 2006, GHC utilized $33.1 million in NOL carryforwards, adjusted prior
  year utilization by $4.6 million, and had NOL carryforwards remaining of $83.2 million
  at September 30, 2006. The NOL arose in fiscal 2000 and 2001 and has a carryforward
  period of 20 years. Pursuant to the American Institute of Certified Public Accountants
  Statement of Position No. 90-7, Financial
  Reporting By Entities in Reorganization Under the Bankruptcy Code (SOP 90-7), utilization of deferred tax assets existing
  at the October 2, 2001 bankruptcy emergence date must be applied first as a
  reduction of identifiable intangible assets and, then, as an increase to shareholders
  equity. The Company recorded an increase to shareholders equity in fiscal
  2006 and fiscal 2005 of $7.6 million and $71.9 million, respectively, pursuant
  to SOP 90-7. Included in the fiscal 2005 increase to shareholders equity
  is the reversal of the then remaining NOL valuation allowance of $51.0 million.Prior to September 2005, the tax benefit
  of the NOL carryforwards was fully reserved due to the uncertainty caused by
  utilization limitations based on taxable income, tax statutes, and contractual
  provisions between NCI and GHC, and filing positions to be determined by NCI.
  This uncertainty was largely resolved with the filing of NCIs fiscal 2004
  federal and state income tax returns in June and July 2005, prompting GHC to
  remove the valuation allowance.

|(12) | Loss Reserves For Certain Self-Insured Programs
|---- | -----------------------------------------------

General and Professional Liability and Workers Compensation

Prior to June 1, 2000, GHC had first dollar coverage for general and professional liability costs with third party insurers; accordingly, it has no exposure for claims prior to that date. Effective June 1, 2000, GHC began insuring a substantial portion of its professional liability risks through LHC. Specifically, it is responsible for the first dollar of each claim (on a claims-made basis), up to a self-insurance retention limit determined by the individual policies, subject to aggregate limits for each policy year. The self-insured retention limits amount to $24.0 million, $21.0 million and $19.0 million for the policy years ended May 31, 2007, 2006 and 2005, respectively, with a per incident limit of $1.0 million for each of those years. Any costs above these retention limits are covered by third-party insurance carriers. Since the June 1, 2000 inception of the self-insurance
program through September 30, 2006,

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GHCs cumulative self-insurance retention levels are $122.0 million and its provision for these losses is $98.6 million. Assuming GHCs actual losses were to reach its retention limits in each of the policy years, its additional exposure is approximately $23.4 million which, if incurred, would be recognized as an increase to its other operating expenses in its consolidated statements of operations in the period such exposure became known. In addition, GHC has provided $4.7 million for the estimated costs of claims incurred but not reported as of September 30, 2006.

GHC
  is insured through a loss deposit fund with a large deductible workers
  compensation policy beginning May 1, 2006 up to the first $1.0 million per incident.
  GHC has an annual aggregate self-insured retention of $67.9 million for this
  policy year ended April 30, 2007. All claims above the aggregate and per incident
  limits are insured through a third-party insurer. GHCs provision for losses
  in this policy year is $10.6 million as of September 30, 2006, with an estimated
  $10.0 million reserve for unpaid losses as of that date.

Prior
  to May 1, 2006, GHC is self-insured against workers compensation losses
  through LHC. Beginning May 1, 2005 through April 30, 2006, GHC has per incident
  retention limits up to the first $1.0 million and $0.5 million prior to May
  1, 2005. All claims above these per incident limits, in their respective periods,
  are insured through a third-party insurer. GHC has annual aggregate self-insured
  retentions of $61.8 million and $56.0 million in policy years ended April 30,
  2006 and 2005, respectively. Claims above these aggregate limits are insured
  through a third-party insurer as of September 30, 2006. GHCs provision
  for losses in these policy years is $46.4 million as of September 30, 2006.
  GHCs reserve levels are evaluated on a quarterly basis. Any necessary
  adjustments are recognized as an adjustment to salaries, wages and benefits
  in its consolidated statements of operations.

GHC
  records outstanding losses and loss expenses for both general and professional
  liability and workers compensation liability based on the estimates of
  the amount of reported losses together with a provision for losses incurred
  but not reported, based on the recommendations of an independent actuary, and
  managements judgment using its past experience and industry experience.
  As of September 30, 2006, GHCs estimated range of outstanding losses for
  these liabilities is $103.9 million to $129.0 million ($95.6 million to $111.8
  million net of amounts recoverable from third-party insurance carriers). GHC
  recorded reserves for these liabilities were $102.0 million as of September
  30, 2006, net of $9.1 million recoverable from third-party insurance carriers,
  and are included in self-insurance liability reserves in its consolidated balance
  sheet. GHC (through LHC) has restricted cash and investments in marketable securities
  of $100.0 million at September 30, 2006, which are substantially restricted
  to securing the outstanding claim losses of LHC.

GHC believes, based upon its valuation and discussions with an independent actuary, that the provision for outstanding losses and loss expenses will be adequate to cover the ultimate cost of losses incurred as of September 30, 2006, but the provision is necessarily an estimate and may ultimately be settled for a significantly greater or lesser amount. It is at least reasonably possible that GHC will revise its estimates significantly in the near term. Any subsequent differences arising are recorded in the period in which they are determined.

Health Insurance

GHC offers employees an option to participate in a self-insured health plan. Health claims under this plan are self-insured with a stop-loss umbrella policy in place to limit maximum potential liability for both individual claims and total claims for a plan year. Health insurance claims are paid as they are submitted to the plan administrator. GHC maintains an accrual for claims that have been incurred but not yet reported to the plan administrator and therefore have not been paid. The incurred but not reported reserve is based on the historical claim lag period and current payment trends of health insurance claims (generally 1-2 months). The liability for the self-insured health plan is recorded in accrued compensation in the consolidated balance sheets.

GHC charges its employees a portion of the cost of its self-insured and non self-insured health plans, and it determines this charge at the beginning of each plan year based upon historical and projected medical utilization data, along with projected inflationary increases in medical costs. Any differences between GHCs projections and its actual experience are borne by it. A one percent variance between GHCs projections and the actual medical utilization or inflationary increases in cost would result in a $0.3 million change in its expense, which would be reflected in salaries, wages and benefits in its consolidated statements of operations.

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|(13) | Related
        Party Transactions
|---- | ----------------------------------

GHC has a continuing relationship with NCI as a result of the agreements it entered into in connection with the spin-off. GHC believes the charges for services under the transition services agreement, as amended, the Tidewater agreement and the pharmacy services agreement, as amended, are no less favorable to GHC than those that could have been obtained by negotiating those agreements with an independent third party.

In October 2003, GHC purchased for $0.2 million the 10% general partnership interest in a partnership which leased four eldercare centers. GHC owned the 90% limited partnership interest in the partnership. The principal of the seller of the general partnership became a director of GHC subsequent to the transaction. Simultaneously with the purchase of the general partnership interest, GHC made a lease termination payment and sold the leasehold rights to an unrelated third party.

|(14) | Shareholders Equity
|---- | --------------------

The Companys authorized capital stock consists of 50,000,000 shares, including 45,000,000 shares of common stock, $0.01 par value, and 5,000,000 shares of preferred stock, $0.01 par value. The Companys board of directors may from time to time authorize the issuance of one or more classes or series of preferred stock without shareholder approval.

Common Stock

Authorized common stock consists of 45,000,000 shares, $0.01 par value, of which 20,736,223 shares were issued at September 30, 2006, including 131,680 common shares held in an escrow account for future delivery to former unsecured claimants of NCI and its subsidiaries, including subsidiaries of GHC, that were entitled to receive common equity securities under the terms of the 2001 joint plan of reorganization.

Treasury Stock

In April 2006, GHCs board of directors authorized the repurchase of up to $150.0 million of GHCs common stock, with such repurchases to take place at GHC managements discretion and/or under pre-established, non-discretionary programs from time to time, depending on market conditions, in the open market and in privately negotiated transactions, subject to any covenants or restrictions contained in agreements governing GHCs indebtedness. Repurchases of common stock are restricted by GHCs debt agreements, the most restrictive of which is its 8% senior subordinated notes. Such restrictions preclude repurchases of common stock above 50% of GHCs net income since July 1, 2003. After considering common stock repurchases made to date and other repurchase provisions, GHCs maximum common stock repurchasing capacity at September 30, 2006 was $22.7
million. In total, 1,075,745 shares of common stock have been repurchased under current and past common stock repurchase programs at a cost of $42.8 million, of which 288,408 shares at a cost of $10.7 million were repurchased during fiscal 2006. The Company accounted for the repurchases under the cost method.

Common Stock Held in Deferred Compensation Plan

In 2004, GHC established a non-qualified deferred compensation plan for certain of its employees. Plan participants are able to defer cash and stock based compensation until some future point in time. Under the provisions of the plan, a rabbi trust was established to maintain the amounts deferred by the participants. A rabbi trust is a funding vehicle used to protect deferred compensation benefits from various events, excluding bankruptcy

88

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or insolvency. Certain of the plan participants have elected to invest their deferred compensation in GHC stock units, which effectively mirror the performance of GHCs common stock. To satisfy a portion of the Companys obligation under the plan, GHC held 236,227 and 163,135 shares of its common stock in the rabbi trust at September 30, 2006 and 2005, respectively. GHC funds the rabbi trust with an amount of shares of GHC common stock that approximates the number of stock units invested by plan participants. The Company has recorded the $9.7 million and $5.7 million cost of the shares of common stock as a reduction of shareholders equity as of September 30, 2006 and 2005, respectively. The Company is required to recognize future changes in the fair value of the common stock held in the rabbi trust that is not required to be settled by the delivery of shares of employer stock as
periodic charges or credits to compensation cost. During fiscal 2006 and 2005, respectively, the Company sold 58,510 and 82,267 shares of GHC common stock held in the rabbi trust at a net realized gain of $1.0 million and $1.9 million, which was recorded as an increase to additional paid-in capital.

Deferred Compensation Liability

Effective June 30, 2006, GHC placed certain restrictions on the compensation deferrals of certain members of executive management. For these individuals, the restrictions require that deferrals designated in GHC common stock units are irrevocable, meaning that such holdings cannot be diversified within the rabbi trust of the deferred compensation plan and all future distributions of such designations must be settled in shares of GHC common stock. Accordingly, the portion of the deferred compensation obligation that is required to be settled by the delivery of shares of employer stock is classified in shareholders equity. At September 30, 2006, there were 127,611 shares of GHC stock, carried at $6.0 million, held by the rabbi trust and presented in the accompanying consolidated balance sheet as an equity account. Changes in the fair value of both the employer stock held in the
rabbi trust and the deferred compensation obligation for those shares restricted from diversification and distribution are not recognized through earnings.

Preferred Stock

Authorized preferred stock consists of 5,000,000 shares, $0.01 par value, including 1,000,000 shares that have been designated Series A Junior Participating Preferred Shares, none of which are issued or outstanding at September 30, 2006.

Preferred Share Purchase Rights

On November 13, 2003, the Companys board of directors declared a dividend of one preferred share purchase right (a Right) for each outstanding share of common stock, par value $0.01 per share, payable on December 1, 2003 to the shareholders of record on that date. The board of directors declared these rights to protect shareholders from coercive or otherwise unfair takeover tactics. The Rights should not interfere with any merger or other business combination approved by the board of directors.

Each Right will allow its holder to purchase from the Company one one-hundredth of a share of Series B Junior Participating Preferred Stock (a Preferred B Share) for $75.00, once the Rights become exercisable. This portion of a Preferred B Share will give the shareholders approximately the same dividend and liquidation rights as would one share of common stock. Prior to exercise, the Right does not give its holder any dividend, voting, or liquidation rights.

The Rights will not be exercisable until ten days after the public announcement of the acquisition by any person or group of beneficial ownership of 20% or more of GHCs outstanding common stock (or ten days after a person or group begins a tender or exchange offer that, if consummated, would bestow upon them beneficial ownership of 20% or more of GHCs outstanding common stock). The Rights expire December 1, 2013.

NCIs Equity in GHC

Prior to the spin-off, substantially all of the Companys cash accounts were linked to NCIs centralized cash management system. Accordingly, substantially all cash generated from or used in GHCs operations was

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transferred to and from NCI. For instance, NCI funded nearly all routine and capital cash disbursements on behalf of GHC. Likewise, on a daily basis, GHC transferred its cash receipts directly to the concentrated bank account of NCI. The net transactions with NCI as reflected in GHCs statements of cash flows represent cash activities between NCI and GHC. The advances and distributions to and from NCI as reflected in the consolidated statements of shareholders equity include the cash activities as reflected in the consolidated statements of cash flows as well as certain non-cash adjustments to NCIs equity in GHC. Such non-cash adjustments to NCIs equity in GHC principally relate to non-cash income tax provisions. The financing activities between NCI and GHC were in the form of equity capital advances and there were no formal repayment or interest arrangements.

|(15) | Stock-Based Benefit Plans
|---- | -------------------------

As
  more fully discussed in note 2  Summary of Significant Accounting
  Policies  Adoption of New Accounting Pronoucements, effective October 1,
  2005, GHC adopted the provisions of SFAS No. 123(R).

Stock-Based Compensation Expenses

GHC recorded stock-based compensation expense for the years ended September 30, 2006, 2005 and 2004 as follows (in thousands):



2006


      

        2005


      

        2004Stock options

        


      $

        4,523

        


      $

        -

        


      $

        -Stock incentive plan

        

        

        5,130

        

        

        4,120

        

        

        2,636Stock held in deferred compensation plan

        

        

        1,440

        

        

        1,665

        

        

        1,024Total stock-based compensation before income taxes


      


      


      11,093


      


      


      5,785


      


      


      3,660Income tax benefit

        

        

        (4,492

        )

        

        (2,314

        )

        

        (1,449

        )Total stock-based compensation after income taxes

        

        $

        6,601

        

        $

        3,471

        

        $

        2,211


Stock Option Plan

GHC has a stock option plan that provides for the grant of incentive stock options and non-qualified stock options for officers, key employees and non-employee directors. A total of 1,500,000 shares of GHC common stock were reserved for issuance under the stock option plan, of which 500 were available for grant at September 30, 2006. The exercise price of each stock option equals 100% of the market price of GHCs common stock on the date of grant and generally each stock option has a maximum term of 10 years. Stock options are generally subject to vesting, which means the optionee earns the right to exercise an increasing number of the shares underlying the option over a specific period of time only if he or she continues to provide services to GHC over that period. Options generally vest quarterly over three years and provide for accelerated vesting if there is a change in
control of GHC, as defined in the option grant. GHC distributes newly issued common shares to satisfy its obligations under the stock option plan.

The fair value of each option award granted prior to October 1, 2005 was estimated on the date of grant using a Black-Scholes-Merton option valuation model. The fair value of each option award granted after the October 1, 2005 adoption of SFAS 123R is estimated on the grant date using a lattice-based binomial option pricing model. Because GHC was a newly formed public company effective December 1, 2003, expected volatility is based on the historical volatility of similar companies and also on the implied volatility from traded options on the stocks of similar companies. The risk free rate for the expected life of each option award is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term of each option award used as an input to the Black-Scholes-Merton option valuation model is derived from the output of a lattice-based option valuation model, in
which option exercise and employee termination rates are based on published research studies regarding executive behavior in these areas. A range of expected terms results from certain groups of employees exhibiting different behavior and from the graded vesting nature of the awards.

90

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The weighted average fair value of stock options of $18.31 per share for options granted during the year ended September 30, 2006, was determined using the lattice-based binomial option pricing model with the following assumptions:  expected volatility (46%), weighted average expected life (6.6 years), weighted average risk free rate of return (4.46%) and dividend yield (0.00%). Estimates of fair value are not intended to predict actual future events or the value ultimately realized by employees who receive equity awards, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by GHC under SFAS 123R.

Changes to the stock option plan for the year ended September 30, 2006 were as follows:



StockOptions
      
      WeightedAverageExercisePrice
      
      IntrinsicValue (inthousands)
      
      WeightedAverageRemainingContractualLifeOutstanding
          at October 1, 2005
      
      576,976
      
      $
      23.72Granted
      
      599,500
      
      
      38.19Exercised
      
      (153,847
      )
      
      23.91
      
      $
      3,200Outstanding
          at September 30, 2006
      
      1,022,629
      
      $
      32.17
      
      $
      15,810
      
      8.45Exercisable
          at September 30, 2006
      
      463,000
      
      $
      28.26
      
      $
      8,969
      
      7.93Vested
          and expected to vest at September 30, 2006
      
      972,026
      
      $
      31.86
      
      $
      15,332
      
      8.41


No
     stock options were forfeited or expired during the year ended September
    30,
  2006. Cash received from stock option exercises totaled $3.7 million and $7.2
     million in the years ended September 30, 2006 and 2005, respectively. The
    intrinsic
  value of stock options exercised were $3.2 million, $5.2 million and $0.1 million
     in the years ended September 30, 2006, 2005 and 2004, respectively.

The following table summarizes information about stock options outstanding at September 30, 2006:



Stock
          Options Outstanding
      
      Stock
          Options ExercisableRange
          of Exercise Prices
      
      Number
      
      WeightedAverageRemainingContractualLife
      
      WeightedAverageExercisePrice
      
      Number
      
      WeightedAverageRemainingContractualLife
      
      WeightedAverageExercisePrice$20.00
          - $29.99
      
      425,213
      
      7.37
      
      $
      23.70
      
      313,330
      
      7.37
      
      $
      23.79$30.00
          - $39.99
      
      474,916
      
      9.21
      
      
      36.40
      
      117,166
      
      9.21
      
      
      36.40$40.00
          - $49.99
      
      122,500
      
      9.29
      
      $
      45.16
      
      32,504
      
      9.93
      
      $
      42.02




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The following table presents information regarding non-vested option activity during the year ended September 30, 2006:



Non-VestedNumber ofStock Options
      
      WeightedAverageGrant-DateFair ValueNon-vested
          at October 1, 2005
      
      381,263
      
      $
      13.53Granted
      
      599,500
      
      
      18.31Vested
      
      (421,134
      )
      
      14.98Non-vested
          at September 30, 2006
      
      559,629
      
      $
      17.20


The
  weighted average grant-date fair value of stock options which vested in fiscal
  years 2005 and 2004 were $13.23 and $12.73, respectively.

As
  of September 30, 2006, there was $7.0 million of total unrecognized compensation
  cost related to non-vested stock options granted under the plan. That cost is
  expected to be recognized over the remaining vesting periods as follows: $3.4
  million in fiscal 2007, $3.3 million in fiscal 2008 and $0.3 million in fiscal
  2009. The expected recognition of compensation expense could differ from these
  estimates as better information becomes available regarding the turnover trends
  of GHCs plan participants and forfeiture assumptions are revised accordingly.

Stock Incentive Plan

GHC has a stock incentive plan that provides for the grant of restricted stock to certain GHC officers, directors and employees. The number of shares of common stock available for issuance under the 2003 stock incentive plan is 1,000,000, of which 80,724 shares were available for grant at September 30, 2006. Restrictions on the awards to GHC employees typically vest quarterly over a five year period from the date of grant such that the employee cannot sell or trade the restricted stock until it becomes vested. In fiscal 2004 and fiscal 2005, GHC made annual restricted stock grants of $95,000 worth of shares of its common stock to each of its seven non-employee directors. In fiscal 2006, GHC made a grant of restricted shares to its seven non-employee directors each having a market value of $105,000. In April 2006, GHC made a grant of restricted shares to its lead director having a
market value of $160,000 as consideration for the assumption of certain expanded responsibilities. All restricted stock grants made to non-employee directors vest on the earlier of three years from the date of grant or the date the director no longer serves as a member of the board. During the year ended September 30, 2006, GHC granted 177,051 restricted shares to employees with a weighted average grant date fair value of $41.23 per share. GHC distributes newly issued common shares to satisfy its obligations under the stock incentive plan.

GHC recognizes compensation expense ratably over each quarterly service period at the market value of GHCs common stock on the grant date. GHC recorded compensation expense of $5.1 million, $4.1 million and $2.6 million for the years ended September 30, 2006, 2005 and 2004, respectively, for employee and director restricted stock grants.

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The following table presents non-vested restricted stock activity during the year ended September 30, 2006:



Non-VestedNumber of RestrictedShares
      
      WeightedAverageGrant-DateFair ValueNon-vested
          at October 1, 2005
      
      492,253
      
      $
      22.32Granted
      
      197,886
      
      
      41.41Vested
          and Distributed
      
      (153,266
      )
      
      24.79Forfeited
      
      (4,174
      )
      
      29.31Non-vested
          at September 30, 2006
      
      532,699
      
      $
      25.72


As of September 30, 2006, there was $12.9 million of total unrecognized compensation cost related to future service periods for non-vested restricted stock granted. This unrecognized compensation cost is expected to be recognized over the remaining vesting periods as follows: $4.4 million in fiscal 2007, $4.4 million in fiscal 2008, $2.2 million in fiscal 2009, $1.2 million in fiscal 2010, and $0.7 million in fiscal 2011.

(16)

        Commitments and Contingencies


Financial Commitments

Requests for providing commitments to extend financial guarantees and extend credit are reviewed and approved by senior management subject to obligational authority limitations. Management regularly reviews all outstanding commitments, letters of credit and financial guarantees, and the results of these reviews are considered in assessing the need for any reserves for possible credit and guarantee loss.

The Company has extended $3.9 million in working capital lines of credit to certain jointly owned and managed companies, including certain consolidated VIEs, of which $2.1 million was unused at September 30, 2006. In addition, the Company has agreed to extend credit for working capital needs of one managed nursing center. Under that arrangement, the propertys owner is responsible for funding working capital needs up to $0.9 million and the Company would be required to cover deficits in excess of that limit. To date, the Company has not had to perform under that agreement. Credit risk represents the accounting loss that would be recognized at the reporting date if the affiliate companies were unable to repay any amounts utilized under the working capital lines of credit. Commitments to extend credit to third parties are conditional agreements generally having fixed expiration
or termination dates and specific interest rates and purposes.

The Company has posted $6.8 million of outstanding letters of credit. The letters of credit guarantee performance to third parties of various trade activities. The letters of credit are not recorded as liabilities on the Companys consolidated balance sheet unless they are probable of being utilized by the third party. The financial risk approximates the amount of outstanding letters of credit.

The Company is a party to joint venture partnerships whereby its ownership interests are 50% or less of the total capital of the partnerships. The Company accounts for certain of these partnerships using either the cost or equity method of accounting depending on the percentage of ownership interest, and therefore, the assets, liabilities and operating results of these partnerships are not consolidated with the Companys. Certain other of the Companys joint venture partnerships qualifying as VIEs, and where the Company is determined to be the primary beneficiary of such arrangements, are consolidated. The carrying value of the Companys investment in unconsolidated joint venture partnerships is $4.9 million and $6.1 million at September 30, 2006 and 2005, respectively. Although the Company is not contractually obligated to fund operating losses of these
partnerships, in certain cases it has extended credit to such joint venture partnerships in the past and may decide to do so in the future in order to realize economic benefits from its joint venture relationship. Management assesses the creditworthiness of such

93

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partnerships in the same manner it does other third-parties. The underlying debt obligations of the Companys consolidated VIEs are non-recourse to it. Guarantees are not recorded as liabilities on the Companys consolidated balance sheet unless it is required to perform under the guarantee. Credit risk represents the accounting loss that would be recognized at the reporting date if the counter-parties failed to perform completely as contracted. The credit risk amounts are equal to the contractual amounts, assuming that the amounts are fully advanced and that no amounts could be recovered from other parties.

Legal Proceedings

GHC is a party to litigation and regulatory investigations arising in the ordinary course of business. Management does not believe the results of such litigation and regulatory investigations, even if the outcome is unfavorable, would have a material adverse effect on the results of operations, financial position or cash flows of GHC.

Conditional Asset Retirement Obligations

See note 2  Summary of Significant Accounting Policies  Adoption of New Accounting Pronouncements.

At September 30, 2006, GHC recognized a liability for the fair value of the asset retirement obligation associated primarily with the cost of asbestos removal aggregating approximately $5.3 million, which amount is included in other long-term liabilities. The liability for each facility will be accreted to its present value each period, which is estimated to approximate $15.7 million through the estimated settlement dates extending from 2007 through 2037. Due to the time over which these obligations could be settled and the significant judgment used to determine the liability, the ultimate obligation may differ significantly from the estimate. Upon settlement any difference between actual cost and the estimate is recognized as a gain or loss in that period.

Spin-off Contingencies

The separation and distribution agreement generally provides for a full and complete release and discharge as of the date of the consummation of the spin-off of all liabilities existing or arising from all acts and events occurring or failing to occur or alleged to have occurred or to have failed to occur and all conditions existing or alleged to have existed on or before the date of the consummation of the spin-off between or among NCI and its affiliates, on the one hand, and GHC and its affiliates, on the other hand, including any contractual agreements or arrangements existing or alleged to exist between or among those parties on or before that date.

GHC has agreed to indemnify, defend and hold harmless NCI and its affiliates, and each of its directors, officers and employees, from and against all liabilities relating to, arising out of or resulting from:



        the failure of GHC, or its affiliates, or any other person to pay, perform or otherwise promptly discharge any of the liabilities of the eldercare businesses;




        any liabilities of the eldercare businesses and the operation of the eldercare businesses at any time before or after the spin-off;




        any breach by GHC or its affiliates of the separation and distribution agreement or any of the ancillary agreements entered into in connection with the separation and distribution agreement;




        one-half of any liabilities arising out of the 2001 joint plan of reorganization (other than certain liabilities specifically allocated in the separation and distribution agreement); and




        specified disclosure liabilities.


NCI has agreed to indemnify, defend and hold harmless GHC and its affiliates, and each of its directors, officers and employees, from and against all liabilities relating to, arising out of or resulting from:



        the failure of NCI, or its affiliates, or any other person to pay, perform or otherwise promptly discharge any of its liabilities, other than liabilities of the eldercare businesses;




        any of NCI liabilities, other than liabilities of the eldercare businesses, and the operation of its business other than the eldercare businesses at any time before or after the spin-off;




        any breach by NCI or its affiliates of the separation and distribution agreement or any of the ancillary agreements entered into in connection with the separation and distribution agreement;


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

        one-half of any liabilities arising out of the 2001 joint plan of reorganization (other than certain liabilities specifically allocated in the separation and distribution agreement); and




        specified disclosure liabilities.


(17)

        Fair Value of Financial Instruments


The carrying amount and fair value of financial instruments at September 30, 2006 and 2005 consist of the following (in thousands):



2006

        

        2005Carrying Amount

        

        Fair Value

        

        Carrying Amount

        

        Fair ValueCash and equivalents

        

        $

        74,819

        

        $

        74,819

        

        $

        107,350

        

        $

        107,350Restricted cash and investments in marketable securities

        

        

        99,979

        

        

        99,979

        

        

        103,514

        

        

        103,514Accounts receivable, net

        

        

        226,689

        

        

        226,689

        

        

        186,296

        

        

        186,296Accounts payable

        

        

        54,034

        

        

        54,034

        

        

        56,266

        

        

        56,266Debt, excluding capital leases

        

        

        409,884

        

        

        430,725

        

        

        414,676

        

        

        428,497Pay fixed/receive variable interest rate swap

        

        

        135

        

        

        135

        

        

        41

        

        

        41


The carrying value of cash and equivalents, net accounts receivable and accounts payable is equal to its fair value due to their short maturity. The Companys restricted investments in marketable securities are carried at fair value. The fair value of debt is based upon quoted market prices or is computed using discounted cash flow analysis, based on the Companys estimated borrowing rate at the end of each fiscal period presented. The fair value of the interest rate swap agreement was determined using confirmations from a third-party financial institution.

The Company places its cash and equivalents and restricted investments in marketable securities in quality financial instruments and limits the amount invested in any one institution or in any one type of instrument. The Company has not experienced any significant losses on its cash or restricted investments in marketable securities.

(18)

        Investment Income


Investment
  income isearned
  principally on short-term investments of cash on hand, restricted cash and investments
  of marketable securities held by LHC and assets held in a rabbi trust of GHCs
  deferred compensation plan. GHC includes investment income in the EBITDA, as
  defined herein, of its other services and corporate costs segment category.
  See note 20  Segment Information.

The following table sets forth the components of investment income (in thousands):



2006
      
      2005
      
      2004Income
          on cash and short-term investments
      
      $
      3,994
      
      $
      2,888
      
      $
      1,249Income
          on restricted cash and investments
      
      
      3,332
      
      
      2,808
      
      
      3,564Income
          on assets held in rabbi trust
      
      
      1,511
      
      
      2,615
      
      
      882Interest
          income on notes receivable
      
      
      446
      
      
      504
      
      
      543Total
          investment income
      
      $
      9,283
      
      $
      8,815
      
      $
      6,238




95

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|(19) | Assets Held for Sale and Discontinued Operations
|---- | ------------------------------------------------

In the normal course of business, GHC continually evaluates the performance of its operating units, with an emphasis on selling or closing under-performing or non-strategic assets. Discontinued businesses, including assets held for sale, are removed from the results of continuing operations. The results of operations in the current and prior year periods, along with any cost to exit such businesses in the year of discontinuation, are classified as discontinued operations in the consolidated statements of operations.

Consolidated interest expense has been allocated to discontinued operations for all periods presented based on allocated debt that could be repaid in connection with the sale of the assets. The amount of after-tax interest expense allocated to discontinued operations in fiscal 2006, fiscal 2005 and fiscal 2004 was $0.2 million, $0.3 million, and $0.7 million, respectively.

GHC has separately classified $3.9 million of carrying value associated with its assets held for sale in its consolidated balance sheets at September 30, 2006 and 2005.

The following table sets forth net revenues and the components of loss from discontinued operations for the years ended September 30, 2006, 2005 and 2004 (in thousands):



2006

        

        2005

        

        2004Net revenues

        

        $

        153

        

        $

        10,817

        

        $

        43,496Net operating loss of discontinued businesses

        

        $

        (516

        )

        $

        (183

        )

        $

        (3,442

        )Loss on discontinuation of businesses

        

        

        -

        

        

        (86

        )

        

        (249

        )Cumulative effect of an accounting change

        

        

        (372

        )

        

        -

        

        

        -Income tax benefit

        

        

        361

        

        

        109

        

        

        1,484Loss from discontinued operations, net of taxes

        

        $

        (527

        )

        $

        (160

        )

        $

        (2,207

        )


The
  loss on discontinuation of businesses includes the write-down of assets to estimated
  net realizable value. The cumulative effect of an accounting change represents
  a charge recognized upon adoption of FIN 47.

|(20) | Segment Information
|---- | -------------------

The Companys principal operating segments are identified by the types of products and services from which revenues are derived and are consistent with the reporting structure of the Companys internal organization. The Company includes in inpatient services revenues all room and board charges and ancillary service revenue for its customers at the centers which the Company owns or leases. The Company includes in rehabilitation therapy services all revenue earned from the provisions of speech pathology, physical therapy and occupational therapy. The accounting policies of the segments are the same as those of the consolidated organization. All intersegment sales prices are market based.

Summarized financial information concerning the Companys reportable segments is shown in the following table. The All other services and corporate costs category of revenues and EBITDA represents operating information of business units below the prescribed quantitative thresholds that trigger segment reporting requirements, and the Companys corporate support functions. The operating business units in this category derive revenues from the following services: management services, respiratory health services, physician services, hospitality services, staffing services and other healthcare related services. This approach to segment reporting is

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consistent with the Companys internal financial reporting and the information used by the chief operating decision maker regarding the performance of the Companys reportable and non-reportable segments.



Year ended September 30,(in thousands)

        

        2006

        

        2005

        

        2004Revenues:Inpatient services - external

        

        $

        1,591,900

        

        $

        1,543,628

        

        $

        1,402,479Rehabilitation services:External

        

        

        143,872

        

        

        129,256

        

        

        118,868Intersegment

        

        

        92,619

        

        

        82,469

        

        

        78,210All other services:External

        

        

        34,526

        

        

        38,549

        

        

        36,850Intersegment

        

        

        49,404

        

        

        59,333

        

        

        72,480Elimination of intersegment revenues

        

        

        (142,023

        )

        

        (141,802

        )

        

        (150,690

        )Total net revenues

        

        

        1,770,298

        

        

        1,711,433

        

        

        1,558,197EBITDA (1):Inpatient services

        

        

        208,785

        

        

        218,376

        

        

        177,092Rehabilitation services

        

        

        13,416

        

        

        9,662

        

        

        16,493All other services and corporate costs

        

        

        (70,241

        )

        

        (59,994

        )

        

        (56,976

        )Loss on early extinguishment of debt

        

        

        (793

        )

        

        (11,765

        )

        

        (1,692

        )Total EBITDA

        

        

        151,167

        

        

        156,279

        

        

        134,917Capital and other:Depreciation and amortization expense

        

        

        (62,519

        )

        

        (53,704

        )

        

        (51,310

        )Interest expense

        

        

        (25,242

        )

        

        (28,809

        )

        

        (32,592

        )Income tax expense

        

        

        (25,839

        )

        

        (28,644

        )

        

        (19,897

        )Equity in net income of unconsolidated affiliates

        

        

        1,977

        

        

        2,600

        

        

        1,202Minority interests

        

        

        (1,601

        )

        

        (1,494

        )

        

        (1,871

        )Income from continuing operations

        

        

        37,943

        

        

        46,228

        

        

        30,449Loss from discontinued operations, net of taxes

        

        

        (527

        )

        

        (160

        )

        

        (2,207

        )Cumulative effect of an accounting change, net of taxes

        

        

        (1,539

        )

        

        -

        

        

        -Net income

        

        $

        35,877

        

        $

        46,068

        

        $

        28,242


(1)

        EBITDA is defined by GHC as earnings before interest expense, income taxes, depreciation and amortization expense of continuing operations. EBITDA can be calculated through GHCs consolidated statements of operations by adding back interest expense, income taxes, depreciation and amortization, equity in net income of unconsolidated affiliates and minority interests to GHCs income from continuing operations.


97

---



Total assets by segment at September 30, 2006 and 2005 were as follows (in thousands):



2006

        

        2005Inpatient services

        

        $


      1,071,635

        

        $

        996,263Rehabilitation therapy services

        

        

        43,189

        

        

        38,689All other

        

        


      357,706

        

        

        377,748Total assets

        

        $

        1,472,530

        

        $

        1,412,700


Capital expenditures as reflected in the consolidated statements of cash flows in all periods presented are principally concentrated in the inpatient services segment. The inpatient services segment and the rehabilitation therapy services segment, respectively, carry $4.9 million and $3.7 million of the $8.6 million consolidated goodwill balance at September 30, 2006. The rehabilitation therapy segment carries all of the $0.6 million consolidated net identifiable intangible balance at September 30, 2006.

|(21) | Comprehensive Income
|---- | --------------------

The following table sets forth the computation of comprehensive income for the years ended September 30, 2006, 2005 and 2004 (in thousands):



2006

        

        2005

        

        2004Net income

        

        $

        35,877

        

        $

        46,068

        

        $

        28,242Net unrealized gain (loss) on restricted investments in marketable securities

        

        

        357

        

        

        (667

        )

        

        (880

        )Net decrease (increase) to minimum pension liability

        

        

        46

        

        

        (157

        )

        

        -Unrealized gain on interest rate swap agreement

        

        

        94

        

        

        249

        

        

        130Total comprehensive income

        

        $

        36,374

        

        $

        45,493

        

        $

        27,492


The unrealized gain (loss) on restricted investments in marketable securities is net of income tax expenses (benefits) of $0.2 million, ($0.4) million and ($0.5) million for the years ended September 30, 2006, 2005 and 2004, respectively. The minimum pension liability is net of income tax expenses (benefits) of less than $0.1 million and ($0.1) million for the years ended September 30, 2006 and 2005, respectively.

The unrealized gain on the interest rate swap agreement represents the change in the fair value of the underlying variable to fixed interest rate swap agreement held by a VIE consolidated by GHC. The VIE is a limited liability corporation and does not record income taxes at the limited liability corporation level. Therefore, the net unrealized gain on the interest rate swap agreement has not been tax effected. Obligations under the interest rate swap agreement are non-recourse to GHC.

|(22) | Condensed Consolidating Financial Statements of Genesis HealthCare Corporation
  and Subsidiaries
|---- | -------------------------------------------------------------------------------------------------

The following condensed consolidating financial statements of GHC and subsidiaries have been prepared pursuant to Rule 3-10 of Regulation S-X.

These condensed consolidating financial statements have been prepared on the same basis of accounting as the consolidated financial statements. GHC is the borrower under the senior credit facility and certain other senior debt described in note 9  Long-Term Debt, that is registered under the Securities Act. The senior subordinated notes and the convertible senior subordinated debentures are fully and unconditionally guaranteed on a joint and several

98

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basis by certain 100% owned subsidiaries of GHC (Guarantors). Non-guarantor subsidiaries do not guarantee the registered senior subordinated notes and the convertible senior subordinated debentures and principally consist of LHC, GHCs wholly owned insurance captive, certain separately mortgaged centers and VIEs consolidated by GHC (Non-guarantors). The following tables present the condensed consolidating financial statements of GHC (Parent), the Guarantors and the Non-guarantors.

GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING BALANCE SHEETS

SEPTEMBER 30, 2006

(IN THOUSANDS)



Parent
      
      Guarantors
      
      Non-guarantors
      
      Eliminations
      
      ConsolidatedAssets:Current
          assets
      
      $
      125,595
      
      $
      252,830
      
      $
      52,571
      
      $
      (539
      )
      $
      430,457Property
          and equipment, net
      
      
      31,933
      
      
      799,232
      
      
      41,999
      
      
      -
      
      
      873,164Other
          long-term assets
      
      
      117,893
      
      
      21,928
      
      
      81,944
      
      
      (52,856
      )
      
      168,909Investments
          in subsidiaries
      
      
      493,115
      
      
      -
      
      
      -
      
      
      (493,115
      )
      
      -Intercompany
          receivables
      
      
      397,566
      
      
      -
      
      
      -
      
      
      (397,566
      )
      
      -Total
          assets
      
      $
      1,166,102
      
      $
      1,073,990
      
      $
      176,514
      
      $
      (944,076
      )
      $
      1,472,530Liabilities
          and shareholders equity:Current
          liabilities
      
      $
      71,684
      
      $
      101,228
      
      $
      38,610
      
      $
      (3,260
      )
      $
      208,262Intercompany
          payables
      
      
      -
      
      
      393,177
      
      
      4,389
      
      
      (397,566
      )
      
      -Long-term
          debt
      
      
      334,255
      
      
      59,074
      
      
      49,404
      
      
      (2,728
      )
      
      440,005Other
          long-term liabilities
      
      
      59,689
      
      
      8,509
      
      
      58,374
      
      
      (2,783
      )
      
      123,789Shareholders
          equity
      
      
      700,474
      
      
      512,002
      
      
      25,737
      
      
      (537,739
      )
      
      700,474Total
          liabilities and shareholders equity
      
      $
      1,166,102
      
      $
      1,073,990
      
      $
      176,514
      
      $
      (944,076
      )
      $
      1,472,530


GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING BALANCE SHEETS

SEPTEMBER 30, 2005

(IN THOUSANDS)



Parent
      
      Guarantors
      
      Non-guarantors
      
      Eliminations
      
      ConsolidatedAssets:Current
          assets
      
      $
      150,087
      
      $
      211,737
      
      $
      57,154
      
      $
      (563
      )
      $
      418,415Property
          and equipment, net
      
      
      25,048
      
      
      749,615
      
      
      43,475
      
      
      -
      
      
      818,138Other
          long-term assets
      
      
      111,869
      
      
      25,741
      
      
      76,275
      
      
      (37,738
      )
      
      176,147Investments
          in subsidiaries
      
      
      423,262
      
      
      -
      
      
      -
      
      
      (423,262
      )
      
      -Intercompany
          receivables
      
      
      388,093
      
      
      -
      
      
      -
      
      
      (388,093
      )
      
      -Total
          assets
      
      $
      1,098,359
      
      $
      987,093
      
      $
      176,904
      
      $
      (849,656
      )
      $
      1,412,700Liabilities
          and shareholders equity:Current
          liabilities
      
      $
      56,057
      
      $
      98,202
      
      $
      54,565
      
      $
      (5,273
      )
      $
      203,551Intercompany
          payables
      
      
      -
      
      
      387,771
      
      
      322
      
      
      (388,093
      )
      
      -Long-term
          debt
      
      
      338,780
      
      
      59,185
      
      
      54,883
      
      
      (7,171
      )
      
      445,677Other
          long-term liabilities
      
      
      52,709
      
      
      177
      
      
      61,546
      
      
      (1,773
      )
      
      112,659Shareholders
          equity
      
      
      650,813
      
      
      441,758
      
      
      5,588
      
      
      (447,346
      )
      
      650,813Total
          liabilities and shareholders equity
      
      $
      1,098,359
      
      $
      987,093
      
      $
      176,904
      
      $
      (849,656
      )
      $
      1,412,700






99



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GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

YEAR ENDED SEPTEMBER 30, 2006

(IN THOUSANDS)



Parent

        

        Guarantors

        

        Non-guarantors

        

        Eliminations

        

        ConsolidatedNet revenues

        

        $


      1,819

        

        $


      1,824,502

        

        $


      85,612

        

        $


      (141,635

        )

        $


      1,770,298Equity in net income of subsidiaries

        

        

        124,447

        

        

        -

        

        

        -

        

        

        (124,447

        )

        

        -Operating expenses

        

        

        129,735

        

        

        1,540,182

        

        

        74,964

        

        

        (138,692

        )

        

        1,606,189Lease expense

        

        

        1,859

        

        

        20,252

        

        

        114

        

        

        -

        

        

        22,225Depreciation and amortization expense

        

        

        12,205

        

        

        47,999

        

        

        2,315

        

        

        -

        

        

        62,519Interest expense

        

        

        17,312

        

        

        4,313

        

        

        4,474

        

        

        (857

        )

        

        25,242Investment income

        

        

        (4,281

        )

        

        (1,510

        )

        

        (3,492

        )

        

        -

        

        

        (9,283

        )Income (loss) before income tax (benefit) expense, equity in net income of unconsolidated affiliates and minority interests

        

        

        (30,564

        )

        

        213,266

        

        

        7,237

        

        

        (126,533

        )

        

        63,406Income tax (benefit) expense

        

        

        (63,164

        )

        

        86,397

        

        

        2,237

        

        

        369

        

        

        25,839Income before equity in net income of unconsolidated affiliates and minority interests

        

        

        32,600

        

        

        126,869

        

        

        5,000

        

        

        (126,902

        )

        

        37,567Equity in net income of unconsolidated affiliates

        

        

        3,277

        

        

        -

        

        

        -

        

        

        (1,300

        )

        

        1,977Minority interests

        

        

        -

        

        

        -

        

        

        -

        

        

        (1,601

        )

        

        (1,601

        )Income from continuing operations

        

        

        35,877

        

        

        126,869

        

        

        5,000

        

        


      (129,803

        )

        

        37,943Income (loss) from discontinued operations, net of taxes

        

        


      -

        

        

        (532

        )

        

        5

        

        

        -

        

        

        (527

        )Cumulative effect of an accounting change, net of taxes

        

        

        -

        

        

        (1,539

        )

        

        -

        

        

        -

        

        

        (1,539

        )Net income

        

        $

        35,877

        

        $

        124,798

        

        $

        5,005

        

        $

        (129,803

        )

        $

        35,877


GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

YEAR ENDED SEPTEMBER 30, 2005

(IN THOUSANDS)



Parent
      
      Guarantors
      
      Non-guarantors
      
      Eliminations
      
      ConsolidatedNet
          revenues
      
      $
      4,203
      
      $
      1,763,287
      
      $
      86,783
      
      $
      (142,840
      )
      $
      1,711,433Equity
          in net income of subsidiaries
      
      
      133,453
      
      
      -
      
      
      -
      
      
      (133,453
      )
      
      -Operating
          expenses
      
      
      116,484
      
      
      1,478,202
      
      
      91,079
      
      
      (143,898
      )
      
      1,541,867Lease
          expense
      
      
      1,550
      
      
      20,428
      
      
      124
      
      
      -
      
      
      22,102Depreciation
          and amortization expense
      
      
      9,194
      
      
      42,167
      
      
      2,343
      
      
      -
      
      
      53,704Interest
          expense
      
      
      20,920
      
      
      4,098
      
      
      4,660
      
      
      (869
      )
      
      28,809Investment
          income
      
      
      (3,318
      )
      
      (2,615
      )
      
      (2,882
      )
      
      -
      
      
      (8,815
      )Income
          (loss) before income tax (benefit) expense, equity in net income of
          unconsolidated affiliates and minority interests
      
      
      (7,174
      )
      
      221,007
      
      
      (8,541
      )
      
      (131,526
      )
      
      73,766Income
          tax (benefit) expense
      
      
      (49,331
      )
      
      80,746
      
      
      (4,160
      )
      
      1,389
      
      
      28,644Income
          (loss) before equity in net income of unconsolidated affiliates and
          minority interests
      
      
      42,157
      
      
      140,261
      
      
      (4,381
      )
      
      (132,915
      )
      
      45,122Equity
          in net income of unconsolidated affiliates
      
      
      3,911
      
      
      -
      
      
      -
      
      
      (1,311
      )
      
      2,600Minority
          interests
      
      
      -
      
      
      -
      
      
      -
      
      
      (1,494
      )
      
      (1,494
      )Income
          (loss) from continuing operations
      
      
      46,068
      
      
      140,261
      
      
      (4,381
      )
      
      (135,720
      )
      
      46,228Income
          (loss) from discontinued operations, net of taxes
      
      
      -
      
      
      630
      
      
      (790
      )
      
      -
      
      
      (160
      )Net
          income (loss)
      
      $
      46,068
      
      $
      140,891
      
      $
      (5,171
      )
      $
      (135,720
      )
      $
      46,068






100



---





GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

YEAR ENDED SEPTEMBER 30, 2004

(IN THOUSANDS)



Parent
      
      Guarantors
      
      Non-guarantors
      
      Eliminations
      
      ConsolidatedNet
          revenues
      
      $
      15,309
      
      $
      1,586,762
      
      $
      108,042
      
      $
      (151,916
      )
      $
      1,558,197Equity
          in net income of subsidiaries
      
      
      94,941
      
      
      -
      
      
      -
      
      
      (94,941
      )
      
      -Operating
          expenses
      
      
      96,843
      
      
      1,360,094
      
      
      100,068
      
      
      (151,754
      )
      
      1,405,251Lease
          expense
      
      
      2,123
      
      
      22,101
      
      
      43
      
      
      -
      
      
      24,267Depreciation
          and amortization expense
      
      
      7,689
      
      
      38,655
      
      
      4,966
      
      
      -
      
      
      51,310Interest
          expense
      
      
      23,680
      
      
      4,771
      
      
      4,844
      
      
      (703
      )
      
      32,592Investment
          income
      
      
      (1,682
      )
      
      (882
      )
      
      (3,674
      )
      
      -
      
      
      (6,238
      )Income
          (loss) before income tax (benefit) expense, equity in net income of
          unconsolidated affiliates and minority interests
      
      
      (18,403
      )
      
      162,023
      
      
      1,795
      
      
      (94,400
      )
      
      51,015Income
          tax (benefit) expense
      
      
      (43,727
      )
      
      64,229
      
      
      (194
      )
      
      (411
      )
      
      19,897Income
          before equity in net income of unconsolidated affiliates and minority
          interests
      
      
      25,324
      
      
      97,794
      
      
      1,989
      
      
      (93,989
      )
      
      31,118Equity
          in net income of unconsolidated affiliates
      
      
      2,918
      
      
      -
      
      
      -
      
      
      (1,716
      )
      
      1,202Minority
          interests
      
      
      -
      
      
      -
      
      
      -
      
      
      (1,871
      )
      
      (1,871
      )Income
          from continuing operations
      
      
      28,242
      
      
      97,794
      
      
      1,989
      
      
      (97,576
      )
      
      30,449Loss
          from discontinued operations, net of taxes
      
      
      -
      
      
      (2,103
      )
      
      (104
      )
      
      -
      
      
      (2,207
      )Net
          income
      
      $
      28,242
      
      $
      95,691
      
      $
      1,885
      
      $
      (97,576
      )
      $
      28,242


GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

YEAR ENDED SEPTEMBER 30, 2006

(IN THOUSANDS)



Parent

        

        Guarantors

        

        Non-guarantors

        

        ConsolidatedNet cash (used in) provided by operating activities


      

        $


      (136,937


      )

        $


      226,820


      

        $


      (8,555


      )

        $


      81,328Net
          cash (used in) provided by investing activities

        

        

        (16,969

        )

        

        (85,701

        )

        

        4,567

        

        

        (98,103

        )Net cash (used in) provided by financing activities

        

        

        (16,372

        )

        

        (2,336

        )

        

        2,952

        

        

        (15,756

        )Net (decrease) increase in cash and equivalents

        

        $

        (170,278

        )

        $

        138,783

        

        $

        (1,036


      )

        $

        (32,531

        )


GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

YEAR ENDED SEPTEMBER 30, 2005

(IN THOUSANDS)



Parent

        

        Guarantors

        

        Non-guarantors

        

        ConsolidatedNet cash (used in) provided by operating activities


      

        $


      (127,314


      )

        $


      250,143


      

        $


      5,616


      

        $


      128,445Net cash used in investing activities

        

        

        (4,287

        )

        

        (55,666

        )

        

        (3,054

        )

        

        (63,007

        )Net cash provided by (used in) financing activities

        

        

        83,749

        

        

        (158,497

        )

        

        (11,290

        )

        

        (86,038

        )Net (decrease) increase in cash and equivalents

        

        $

        (47,852

        )

        $

        35,980

        

        $

        (8,728

        )

        $

        (20,600

        )


GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

YEAR ENDED SEPTEMBER 30, 2004

(IN THOUSANDS)



Parent

        

        Guarantors

        

        Non-guarantors

        

        ConsolidatedNet cash (used in) provided by operating activities


      

        $


      (85,812


      )

        $


      221,832


      

        $


      8,262


      

        $


      144,282Net cash used in investing activities

        

        

        (24,755

        )

        

        (35,352

        )

        

        (3,165

        )

        

        (63,272

        )Net cash provided by (used in) financing activities

        

        

        231,500

        

        

        (188,549

        )

        

        (4,965

        )

        

        37,986Net increase (decrease) in cash and equivalents

        

        $

        120,933

        

        $

        (2,069

        )

        $

        132

        

        $

        118,996




101



---





|(23) | Subsequent Events
|---- | -----------------

Effective November 1, 2006, GHC purchased a 115 bed skilled nursing facility in the State of Maryland. The purchase price of $8.1 million has been financed with $6.0 million of debt from the revolving credit facility and $2.1 million of cash. This facility generates annual revenue of approximately $7.0 million.

Effective
  December 1, 2006, GHC completed a purchase of two skilled nursing facilities
  and four assisted living facilities in the State of West Virginia for a net
  purchase price of $41.1 million. The purchase has been financed with $33.0 million
  of debt from the revolving credit facility and $8.1 million of cash. The combined
  facilities generate annual revenues of approximately $20.0 million.

Subsequent to September 30, 2006, GHC paid off two secured mortgage obligations with a combined outstanding principal balance of $9.1 million. In connection with those payments, GHC paid $0.4 million of prepayment penalties to settle the obligations in advance of the contractual maturity.

|(24) | Quarterly Financial Data (Unaudited)
|---- | ------------------------------------

GHCs unaudited quarterly financial information is as follows (in thousands, except per share data):



Total
          NetRevenue
      
      IncomefromContinuingOperations
      
      Net
          Income
      
      Net
          Income Per ShareBasic
      
      DilutedQuarter
          ended:December
          31, 2005
      
      $
      436,982
      
      $
      11,322
      
      $
      11,437
      
      $
      0.59
      
      $
      0.58March
          31, 2006
      
      
      437,448
      
      
      8,195
      
      
      8,068
      
      
      0.42
      
      
      0.42June
          30, 2006
      
      
      442,230
      
      
      9,557
      
      
      9,686
      
      
      0.50
      
      
      0.49September
          30, 2006
      
      
      453,638
      
      
      8,869
      
      
      6,686
      
      
      0.34
      
      
      0.34Quarter
          ended:December
          31, 2004
      
      $
      407,491
      
      $
      12,544
      
      $
      13,151
      
      $
      0.66
      
      $
      0.65March
          31, 2005
      
      
      459,271
      
      
      13,285
      
      
      13,189
      
      
      0.66
      
      
      0.65June
          30, 2005
      
      
      417,494
      
      
      10,045
      
      
      8,776
      
      
      0.45
      
      
      0.44September
          30, 2005
      
      
      427,177
      
      
      10,354
      
      
      10,952
      
      
      0.56
      
      
      0.55




102



---



Schedule
  II

GENESIS HEALTHCARE CORPORATION AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS

FOR THE YEARS ENDED SEPTEMBER 30, 2006, 2005 AND 2004

(IN THOUSANDS)



Description
      
      Balance
          atBeginning ofPeriod
      
      Charged
          toOperations
      
      Deductions
          (1) (2)
      
      Balance
          atEnd ofPeriodYear
          Ended September 30, 2006Allowance
          for Doubtful Accounts
      
      $
      22,982
      
      12,740
      
      10,037
      
      $
      25,685Year
          Ended September 30, 2005Allowance
          for Doubtful Accounts
      
      $
      29,632
      
      12,909
      
      19,559
      
      $
      22,982Deferred
          Tax Asset Valuation Allowance
      
      
      77,748
      
      -
      
      77,748
      
      
      -Year
          Ended September 30, 2004Allowance
          for Doubtful Accounts
      
      $
      32,562
      
      18,859
      
      21,789
      
      $
      29,632Deferred
          Tax Asset Valuation Allowance
      
      
      127,573
      
      -
      
      49,825
      
      
      77,748


(1)

        Allowance for Doubtful Accounts deductions represent amounts written off as uncollectible.


(2)

        Deferred
          Tax Asset Valuation Allowance deductions in the year ended September
          30, 2004 result from a change in presentation of GHCs historical
          financial statements from that of a group determining income and loss
          separate and apart from NCI and its subsidiaries, to one reflecting
          the post spin-off allocation of loss carryforwards after utilization
          by NCI during their period of affiliation. Deductions in the year ended
          September 30, 2005 represent the utilization of NOLs and also include
          the reversal of the remaining $51.0 million of Deferred Tax Asset Valuation
          Allowance. Prior to September 2005, the tax benefit of the NOL carryforwards
          was fully reserved due to the uncertainty caused by utilization limitations
          based on taxable income, tax statutes, and contractual provisions between
          NCI and GHC, and filing positions to be determined by NCI. This uncertainty
          was largely resolved with the filing of NCIs fiscal 2004 federal
          and state income tax returns in June and July 2005, prompting GHC to
          remove the valuation allowance. Because these NOLs were generated during
          the period predating the emergence from bankruptcy, the realization
          of these NOLs is credited, pursuant to SOP 90-7, to shareholders
          equity and not to operations.


103

---



ITEM 9:

        CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE


None.

ITEM 9A:

        CONTROLS AND PROCEDURES


(a)Effectiveness of Disclosure Controls and Procedures

As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended (the Exchange Act), our management, including our chief executive officer and chief financial officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of September 30, 2006. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Form 10-K, is properly recorded, processed, summarized and reported within the time periods required by the Securities and Exchange Commissions rules and forms. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures that, by their nature, can provide only
reasonable assurance regarding managements control objectives. Management does not expect that its disclosure controls and procedures will prevent all errors and fraud. A control system, irrespective of how well it is designed and operated, can only provide reasonable assurance, and cannot guarantee that it will succeed in its stated objectives.

Based on an evaluation of the effectiveness of the design and operation of disclosure controls and procedures, our chief executive officer and chief financial officer concluded that, as of September 30, 2006, our disclosure controls and procedures were effective in reaching a reasonable level of assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commissions rules and forms.

(b)Managements Annual Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of September 30, 2006 based on the framework in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

Based on managements evaluation under the COSO framework of our internal control over financial reporting, management concluded that our internal control over financial reporting was effective as of September 30, 2006.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP.

KPMG LLP, our independent registered public accounting firm, audited our managements assessment of the effectiveness of our internal control over financial reporting as of September 30, 2006, as stated in their report, which appears below.

104

---



Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Genesis HealthCare Corporation:

We have audited managements assessment, included in the accompanying Managements Annual Report on Internal Control over Financial Reporting, that Genesis HealthCare Corporation (the Company) maintained effective internal control over financial reporting as of September 30, 2006, based on criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).Genesis HealthCare Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment
and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, managements assessment that Genesis HealthCare Corporation maintained effective internal control over financial reporting as of September 30, 2006, is fairly stated, in all material respects, based on criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).Also, in our opinion, Genesis HealthCare Corporation maintained, in all material respects, effective internal control over financial reporting as of September 30, 2006, based on criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO).

We
  also have audited, in accordance with the standards of the Public Company Accounting
  Oversight Board (United States), the consolidated balance sheets of Genesis
  HealthCare Corporation and subsidiaries as of September 30, 2006 and 2005, and
  the related consolidated statements of operations, shareholders equity
  and cash flows for each of the years in the three-year period ended September
  30, 2006 and the related financial statement schedule, and our report dated
  December 13, 2006 expressed an unqualified opinion on those consolidated financial
  statements and the related financial statement schedule.



/s/ KPMG LLPPhiladelphia, PennsylvaniaDecember
          13, 2006


105

---



(c)

        Changes in Internal Control Over Financial Reporting


As has been previously disclosed, in the course of performing our evaluation under Section 404 of the Sarbanes-Oxley Act of 2002, we determined that material weaknesses in internal control over financial reporting existed as of September 30, 2005. The material weaknesses related to ineffective controls over the selection and application of generally accepted accounting principles affecting self-insurance reserves and insufficient policies and procedures and technical expertise to identify and account for the consolidation of variable interest entities in accordance with FIN 46, Consolidation of Variable Interest Entities.  During fiscal 2006, we implemented a plan which resulted in the successful remediation of the material weaknesses in internal control over financial reporting
previously disclosed in the Form 10-K/A for fiscal year ended September 30, 2005.

Beginning in the third quarter and through the fourth quarter of fiscal 2006, we took the following steps in order to remediate the material weaknesses: (1) changed our procedures to ensure proper accounting for self-insured reserves on an undiscounted basis, (2) provided training for personnel responsible for the accounting and consolidation of variable interest entities and (3) designed and implemented enhanced control processes to ensure the proper identification of variable interest entities and the overall application of FIN 46.

Except for changes related to the remediated material weaknesses described above, there have been no changes during our fourth quarter ended September 30, 2006 in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

ITEM 9B:

        OTHER INFORMATION


None.

PART III

ITEM 10:

        DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT


The
  information required under Item 10 is incorporated herein by reference to our
  Proxy Statement, to be filed pursuant to Exchange Act Regulation 14A within
  120 days after the end of fiscal 2006.

ITEM 11:

        EXECUTIVE COMPENSATION


The
  information required under Item 11 is incorporated herein by reference to our
  Proxy Statement, to be filed pursuant to Exchange Act Regulation 14A within
  120 days after the end of fiscal 2006.

106

---



ITEM 12:

        SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS


The
  information required under Item 12 is incorporated herein by reference to our
  Proxy Statement, to be filed pursuant to Exchange Act Regulation 14A within
  120 days after the end of fiscal 2006.

EQUITY COMPENSATION PLAN INFORMATION

The following table details information regarding our existing equity compensation plans as of September 30, 2006:



(a)
      
      (b)
      
      (c)Plan
          Category
      
      Number
          of securitiesto be issued uponexercise ofoutstanding options,warrants and rights
      
      Weighted-averageexercise price ofoutstandingoptions, warrantsand rights
      
      Number
          of securitiesremaining available forfuture issuance under equitycompensation plans(excluding securitiesreflected in column (a))Equity
          compensation plans approved by security holders (1)
      
      1,022,629
      
      $
      32.17
      
      81,224Equity
          compensation plans not approved by security holders
      
      -
      
      
      -
      
      -Total
      
      1,022,629
      
      $
      32.17
      
      81,224




---

(1)

        At
          September 30, 2006, under the 2003 Stock Option Plan there were options
          currently exercisable to purchase 463,000 shares of common stock, options
          granted but not yet exercisable to purchase 559,629 shares of common
          stock and 500 stock options eligible for future grant. At September
          30, 2006, under the 2003 Stock Incentive Plan there were 80,724 shares
          of restricted common stock eligible for future grant.


ITEM 13:

        CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS


The
  information required under Item 13 is incorporated herein by reference to our
  Proxy Statement, to be filed pursuant to Exchange Act Regulation 14A within
  120 days after the end of fiscal 2006.

ITEM 14:

        PRINCIPAL ACCOUNTANT FEES AND SERVICES


The
  information required under Item 14 is incorporated herein by reference to our
  Proxy Statement, to be filed pursuant to Exchange Act Regulation 14A within
  120 days after the end of fiscal 2006.

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PART IV



ITEM
          15: EXHIBITS
          AND FINANCIAL STATEMENT SCHEDULE(a)(1)
      
      The
          following consolidated financial statements of GHC are filed as part
          of this Form 10-K in Part II Item 8:Report
          of Independent Registered Public Accounting FirmConsolidated
          Balance Sheets as of September 30, 2006 and 2005Consolidated
          Statements of Operations for the years ended September 30, 2006, 2005,
          and 2004Consolidated
          Statements of Shareholders Equity for the years ended September
          30, 2006, 2005, and 2004Consolidated
          Statements of Cash Flows for the years ended September 30, 2006, 2005,
          and 2004Notes
          to Consolidated Financial Statements(a)(2)
      
      ScheduleSchedule
          II - Valuation and Qualifying Accounts for the years ended September
          30, 2006, 2005 and 2004. Schedule II is included herein. All other schedules
          not listed have been omitted since the required information is included
          in the consolidated financial statements or the notes thereto, or is
          not applicable or required.(a)(3)
      
      Exhibits


The following documents are filed as exhibits hereto:



ExhibitNumber


      


      Description2.1(1)


      

        Separation and Distribution Agreement by and between NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Genesis HealthCare Corporation, dated as of October 27, 2003. (Schedules and Exhibits are omitted pursuant to Regulation S-K, Item 601(b)(2); Genesis HealthCare Corporation agrees to furnish supplementally a copy of such schedules and/or exhibits to the Securities and Exchange Commission upon request).3.1(2)

        

        Amended and Restated Articles of Incorporation of Genesis HealthCare Corporation.3.2(2)

        

        Articles of Amendment to Genesis HealthCare Corporations Amended and Restated Articles of Incorporation, effective as of December 1, 2003, designating the Companys Series A Junior Participating Preferred Shares, par value $0.01 per share.3.3(3)

        

        Amended and Restated Bylaws of Genesis HealthCare Corporation, as amended.4.1(4)

        

        Form of Genesis HealthCare Corporation Common Stock certificate.4.2(5)

        

        Rights Agreement, dated as of November 18, 2003, between Genesis HealthCare Corporation and StockTrans, Inc., which includes the form of Rights Certificate as Exhibit B and the Summary of Rights to Purchase Preferred Shares as Exhibit C.4.3(1)


      


      Indenture with respect to the 8% Senior Subordinated Notes due 2013 among Genesis HealthCare Corporation, NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.), the subsidiary guarantors named therein and The Bank of New York, as trustee, dated as of October 28, 2003.


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4.4(2)


      


      Articles of Amendment to Genesis HealthCare Corporations Amended and Restated Articles of Incorporation, effective as of December 1, 2003, designating the Companys Series A Junior Participating Preferred Shares, par value $0.01 per share (included in Exhibit 3.2).4.5(6)

        

        Supplemental Indenture with respect to the 8% Senior Subordinated Notes due 2013 of Genesis HealthCare Corporation by and among Genesis HealthCare Corporation, the subsidiary guarantors named there in and the Bank of New York, as trustee, dated as of January 20, 2004.4.6(7)

        

        Supplemental Indenture with respect to the 8% Senior Subordinated Notes due 2013 of Genesis HealthCare Corporation by and among Genesis HealthCare Corporation, the subsidiary guarantors named therein and The Bank of New York, as trustee, dated March 16, 2005.4.7(7)

        

        Indenture with respect to the 2.5% Convertible Senior Subordinated Debentures due 2025 of Genesis HealthCare Corporation by and among Genesis HealthCare Corporation, the subsidiary guarantors named therein and The Bank of New York, as trustee, dated as of March 2, 2005.10.1(2)

        

        Tax Sharing Agreement by and between NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Genesis HealthCare Corporation, dated as of December 1, 2003.10.2(2)

        

        Transition Services Agreement by and between NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Genesis HealthCare Corporation, dated as of December 1, 2003.10.3(2)

        

        Tidewater Membership Agreement by and between Tidewater Healthcare Shared Services Group, Inc. and Genesis HealthCare Corporation, dated as of December 1, 2003.10.4(2)+

        

        Employee Benefits Agreement by and between NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Genesis HealthCare Corporation, dated as of December 1, 2003.10.5(2)

        

        Master Agreement for Pharmacy, Pharmacy Consulting and Related Products and Services by and between NeighborCare Pharmacy Services, Inc. and Genesis HealthCare Corporation, dated as of December 1, 2003.10.6(2)

        

        Pharmacy Benefit Management Agreement by and between Genesis HealthCare Corporation and CareCard, Inc., dated as of December 1, 2003.10.7(2)

        

        Master Agreement for Specialty Beds and Oxygen Concentrators by and between Genesis HealthCare Corporation and NeighborCare Pharmacy Services, Inc., dated as of December 1, 2003.10.8(8)+

        

        Employment Agreement by and between Genesis HealthCare Corporation and George V. Hager, Jr., dated as of November 25, 2003.10.9(1)+

        

        2003 Stock Option Plan.10.10(9)+

        

        Amended and Restated 2003 Stock Incentive Plan.10.11(4)+

        

        Deferred Compensation Plan.


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10.12(1)


      


      Registration Rights Agreement regarding the 8% Senior Subordinated Notes due 2013 of Genesis HealthCare Corporation by and among Genesis HealthCare Corporation, NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.), the subsidiary guarantors named therein and the initial purchasers named therein, dated as of October 28, 2003.10.13(1)+

        

        First Amended and Restated Letter Agreement between Genesis HealthCare Corporation and NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and David C. Almquist, dated as of July 15, 2003.10.14(1)+

        

        First Amended and Restated Letter Agreement between Genesis HealthCare Corporation and NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Richard P. Blinn, dated as of July 15, 2003.10.15(1)+

        

        First Amended and Restated Letter Agreement between Genesis HealthCare Corporation and NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and James McKeon, dated as of July 15, 2003.10.16(1)+

        

        First Amended and Restated Letter Agreement between Genesis HealthCare Corporation and NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Robert A. Reitz, dated as of July 15, 2003.10.17(8)+

        

        Employment Agreement by and between Genesis HealthCare Corporation and David C. Almquist dated as of December 1, 2003.10.18(8)+

        

        Employment Agreement by and between Genesis HealthCare Corporation and Richard P. Blinn dated as of December 1, 2003.10.19(8)+

        

        Employment Agreement by and between Genesis HealthCare Corporation and James McKeon dated as of December 1, 2003.10.20(8)+

        

        Employment Agreement by and between Genesis HealthCare Corporation and Robert A. Reitz dated as of December 1, 2003.10.21(7)

        

        Amended and Restated Credit, Security, Guaranty and Pledge Agreement, dated as of March 2, 2005, by and among Genesis HealthCare Corporation, as Borrower, the Guarantors referred to therein, and the Lenders referred to therein, and Wachovia Capital Markets LLC as co-lead arranger and bookrunner, Wachovia Bank, National Association as administrative agent, General Electric Capital Corporation as co-lead arranger and documentation agent, Citicorp North America, Inc. as syndication agent and Merrill Lynch Capital, a Division of Merrill Lynch Business Financial Services, Inc. as syndication agent (Schedules and exhibits are omitted; Genesis HealthCare Corporation agrees to furnish supplementally a copy of such schedules and/or exhibits to the Securities and Exchange Commission upon request).10.22(10)

        

        Amendment No. 1, dated as of May 7, 2004, to Master Agreement for Pharmacy, Pharmacy Consulting and Related Products and Services by and between NeighborCare Pharmacy Services, Inc. and Genesis HealthCare Corporation dated as of December 1, 2003.10.23(11)+

        

        Form of Restricted Stock Agreement.10.24(7)


      


      Purchase Agreement relating to the 2.5% Convertible Senior Subordinated Debentures due 2025 of Genesis HealthCare Corporation by and among Genesis HealthCare Corporation, the subsidiary guarantors named therein and the Initial Purchasers named therein, dated as of February 24, 2005.


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10.25(7)


      


      Registration Rights Agreement relating to the 2.5% Convertible Senior Subordinated Debentures due 2025 of Genesis HealthCare Corporation by and among Genesis HealthCare Corporation, the subsidiary guarantors named therein and Wachovia Capital Markets LLC, on behalf of the Initial Purchasers, dated as of March 2, 2005.10.26(12)

        

        Amendment No. 1, dated as of June 9, 2005, to the Tax Sharing Agreement, dated as of December 1, 2003, by and between NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Genesis HealthCare Corporation.10.27(12)

        

        Amendment No. 1, dated as of June 9, 2005, to the Transition Services Agreement, dated as of December 1, 2003, by and between NeighborCare, Inc. (formerly Genesis Health Ventures, Inc.) and Genesis HealthCare Corporation.10.28(12)

        

        Amendment No. 2, dated as of June 9, 2005, to the Master Agreement for Pharmacy, Pharmacy Consulting and Related Products and Services, dated as of December 1, 2003 and as amended on May 7, 2004, by and between NeighborCare Pharmacy Services, Inc. and Genesis HealthCare Corporation.10.29

        

        Amended and Restated Master Agreement for Pharmacy, Pharmacy Consulting and Related Products and Services, dated as of July 1, 2006, between Genesis HealthCare Corporation and Omnicare, Inc.10.30

        

        Amended and Restated Master Agreement for Specialty Beds and Oxygen Concentrators, dated as of July 1, 2006, between Genesis HealthCare Corporation and Omnicare, Inc.10.31+

        

        Summary Sheet regarding Director and Executive Officer Compensation.12.1

        

        Statement Re: Computation of Earnings to Fixed Charges Ratio.14.1(13)

        

        Code of Business Conduct and Ethics of Genesis HealthCare Corporation.21.1

        

        Subsidiaries of Genesis HealthCare Corporation.23.1

        

        Consent of KPMG LLP.31.1

        

        Certification of George V. Hager, Jr., Chief Executive Officer of Genesis HealthCare Corporation, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.31.2

        

        Certification of James V. McKeon, Chief Financial Officer of Genesis HealthCare Corporation, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.32.1

        

        Certification of George V. Hager, Jr., Chief Executive Officer of Genesis HealthCare Corporation, pursuant to 18 U.S.C. Section 1350.32.2

        

        Certification of James V. McKeon, Chief Financial Officer of Genesis HealthCare Corporation, pursuant to 18 U.S.C. Section 1350.


---

+ Management contract or compensatory plan.

(1)
      Incorporated
          by reference to Genesis HealthCare Corporations Registration Statement
          on Form 10 filed on November 6, 2003 (as amended).(2)
      Incorporated
          by reference to Genesis HealthCare Corporations Current Report
          on Form 8-K filed on December 9, 2003.


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(3)

        Incorporated by reference to Genesis HealthCare Corporations Annual Report on Form 10-K for the annual period ended September 30, 2004 filed on December 14, 2004.


(4)

        Incorporated by reference to Genesis HealthCare Corporations Registration Statement on Form 10 filed on October 10, 2003.


(5)

        Incorporated by reference to Genesis HealthCare Corporations Registration Statement on Form 8-A filed on November 18, 2003.


(6)

        Incorporated by reference to Genesis HealthCare Corporations Registration Statement on Form S-4 filed April 5, 2004 (as amended).


(7)

        Incorporated by reference to Genesis HealthCare Corporations Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2005 filed on May 10, 2005.


(8)

        Incorporated by reference to Genesis HealthCare Corporations Annual Report on Form 10-K for the annual period ended September 30, 2003 filed on February 4, 2004.


(9)

        Incorporated by reference to Genesis HealthCare Corporations Annual Report on Form 10-K for the annual period ended September 30, 2005 filed on December 14, 2005.


(10)

        Incorporated by reference to Genesis HealthCare Corporations Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2004 filed on May 14, 2004.


(11)

        Incorporated by reference to Genesis HealthCare Corporations Current Report on Form 8-K filed on November 22, 2004.


(12)


      Incorporated
          by reference to Genesis HealthCare Corporations Current Report
          on Form 8-K filed on June 14, 2005.


(13)

        Incorporated by reference to Genesis HealthCare Corporations Current Report on Form 8-K filed on June 30, 2004.


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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 on December 14, 2006 by the undersigned thereunto duly authorized.



Genesis
          HealthCare CorporationBy:
      /s/ James
          V. McKeonJames
          V. McKeonChief Financial Officer


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 indicated on December 14, 2006.



Signature

        

        Capacity/s/ George
          V. Hager, Jr.George V. Hager, Jr.

        

        Chief Executive Officer (principal executive officer) and Chairman of the Board/s/ John
          F. DePodestaJohn F. DePodesta

        

        Director/s/ Robert
          H. FishRobert H. Fish

        

        Director/s/ J.
          Michael GallagherJ. Michael Gallagher

        

        Director/s/
          Kevin M. KelleyKevin M. Kelley

        

        Director/s/ Charles
          W. McQuearyCharles W. McQueary

        

        Director/s/ Charlene
          Connolly QuinnCharlene Connolly Quinn

        

        Director/s/ Terry
          Allison RappuhnTerry Allison Rappuhn

        

        Director/s/
          James V. McKeonJames V. McKeon

        

        Chief Financial Officer (principal financial officer)/s/ Thomas
          DiVittorioThomas DiVittorio

        

        Vice President and Corporate Controller (principal accounting officer)


113

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