##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---

FORM 10-Q



---



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

For the quarterly period ended June 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 333-133319



---

LIFECARE HOLDINGS, INC.

(Exact name of registrant as specified in its charter)



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 51-0372090                          
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification Number)



|                                         |  |           
|---------------------------------------- |  | ----------
|5560 Tennyson Parkway                    |  | 75024     
|(Address of Principal Executive Offices) |  | (Zip Code)

(469) 241-2100

(Registrants telephone number, including area code)

None

(Former name, former address and former fiscal year, if changes since last report)



---

Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days.    Yes ̈No  x

Indicate by check mark whether the registrant is a
large accelerated filer, an accelerated filer, or a non-accelerated filer. Please see definition of accelerated and large accelerated filer in Rule 12b-2 of the Exchange Act.



|                          |  |                     |  |                          
|------------------------- |  | ------------------- |  | -------------------------
|Large Accelerated Filer: ̈ |  | Accelerated Filer: ̈ |  | Non-Accelerated Filer:  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Act).    Yes ̈No  x

As of August 1, 2006, the registrant had 100 shares of Common Stock, par value $0.01 per share, outstanding.



---



---

##### Table of Contents

LIFECARE HOLDINGS, INC.

TABLE OF CONTENTS



|           |  |                                                                                       |  |   
|---------- |  | ------------------------------------------------------------------------------------- |  | --
|PART I     |  | FINANCIAL INFORMATION                                                                 |  |   
|           |  |                                                                                      
|ITEM 1.    |  | CONSOLIDATED FINANCIAL STATEMENTS                                                     |  | 3 
|           |  |                                                                                      
|           |  | CONDENSED CONSOLIDATED BALANCE SHEETS                                                 |  | 3 
|           |  |                                                                                      
|           |  | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                                       |  | 4 
|           |  |                                                                                      
|           |  | CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY                             |  | 5 
|           |  |                                                                                      
|           |  | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW                                        |  | 6 
|           |  |                                                                                      
|           |  | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                  |  | 7 
|           |  |                                                                                      
|ITEM 2.    |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 13
|           |  |                                                                                      
|ITEM 3.    |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 24
|           |  |                                                                                      
|ITEM 4.    |  | CONTROLS AND PROCEDURES                                                               |  | 24
|           |  |                                                                                      
|PART II    |  | OTHER INFORMATION                                                                     |  | 24
|           |  |                                                                                      
|ITEM 1.    |  | LEGAL PROCEEDINGS                                                                     |  | 24
|           |  |                                                                                      
|ITEM 6.    |  | EXHIBITS                                                                              |  | 24
|           | 
|SIGNATURES |  | 24                                                                                   



2



---

##### Table of Contents

PART 1: FINANCIAL INFORMATION

ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

June 30, 2006 (unaudited) and December 31, 2005

(In thousands)



|                                                                                                |  |               |         |   |                   |   |         |  
|----------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                |  | June 30, 2006 |         |   | December 31, 2005 |  
|Assets                                                                                          |  |               |         |   |                   |   |         |  
|Cash and cash equivalents                                                                       |  | $             | 31,858  |   |                   | $ | 19,843  |  
|Accounts receivable, net of allowance for doubtful accounts of $14,445 and $14,372 respectively |  |               | 60,647  |   |                   |   | 63,283  |  
|Estimated third-party payer settlements                                                         |  |               | 9,212   |   |                   |   | 8,267   |  
|Income taxes                                                                                    |  |               | 4,672   |   |                   |   | 17,380  |  
|Insurance proceeds receivable                                                                   |  |               | 5,333   |   |                   |   | 7,000   |  
|Deferred income taxes                                                                           |  |               | 8,259   |   |                   |   | 8,020   |  
|Other current assets                                                                            |  |               | 7,891   |   |                   |   | 6,034   |  
|                                                                                                |  |               |         |   |                   |   |         |  
|Total current assets                                                                            |  |               | 127,872 |   |                   |   | 129,827 |  
|Property and equipment, net                                                                     |  |               | 64,560  |   |                   |   | 61,100  |  
|Other assets                                                                                    |  |               | 14,722  |   |                   |   | 14,637  |  
|Identifiable intangibles, net                                                                   |  |               | 20,175  |   |                   |   | 20,932  |  
|Goodwill                                                                                        |  |               | 318,159 |   |                   |   | 317,618 |  
|                                                                                                |  |               |         |   |                   |   |         |  
|                                                                                                |  | $             | 545,488 |   |                   | $ | 544,114 |  
|                                                                                                |  |               |         |   |                   |   |         |  
|Liabilities and Stockholders Equity                                                            |  |               |         |   |                   |   |         |  
|Current installments of long-term debt                                                          |  | $             | 2,550   |   |                   | $ | 2,550   |  
|Current installments of obligations under capital leases                                        |  |               | 4,597   |   |                   |   | 5,364   |  
|Accounts payable                                                                                |  |               | 19,617  |   |                   |   | 18,464  |  
|Accrued payroll                                                                                 |  |               | 3,808   |   |                   |   | 5,709   |  
|Accrued vacation                                                                                |  |               | 3,829   |   |                   |   | 3,286   |  
|Accrued insurance                                                                               |  |               | 1,997   |   |                   |   | 2,119   |  
|Accrued interest                                                                                |  |               | 5,178   |   |                   |   | 6,594   |  
|Accrued other                                                                                   |  |               | 2,844   |   |                   |   | 3,212   |  
|                                                                                                |  |               |         |   |                   |   |         |  
|Total current liabilities                                                                       |  |               | 44,420  |   |                   |   | 47,298  |  
|Obligations under capital leases, excluding current installments                                |  |               | 2,643   |   |                   |   | 4,767   |  
|Long-term debt, excluding current installments                                                  |  |               | 397,538 |   |                   |   | 401,813 |  
|Accrued insurance                                                                               |  |               | 8,678   |   |                   |   | 7,194   |  
|Deferred income taxes                                                                           |  |               | 12,671  |   |                   |   | 14,539  |  
|Other noncurrent liabilities                                                                    |  |               | 6,483   |   |                   |   | 2,411   |  
|                                                                                                |  |               |         |   |                   |   |         |  
|Total liabilities                                                                               |  |               | 472,433 |   |                   |   | 478,022 |  
|                                                                                                |  |               |         |   |                   |   |         |  
|Commitments and contingencies                                                                   |  |               |         |   |                   |   |         |  
|                                                                                                |  |              
|Stockholders equity:                                                                           |  |               |         |   |                   |   |         |  
|Common stock, $0.01 par value. 100 shares authorized, issued and outstanding in 2006 and 2005   |  |               |        |   |                   |   |        |  
|Additional paid-in capital                                                                      |  |               | 160,709 |   |                   |   | 135,928 |  
|Accumulated deficit                                                                             |  |               | (87,654 | ) |                   |   | (69,836 | )
|                                                                                                |  |               |         |   |                   |   |         |  
|Total stockholders equity                                                                      |  |               | 73,055  |   |                   |   | 66,092  |  
|                                                                                                |  |               |         |   |                   |   |         |  
|                                                                                                |  | $             | 545,488 |   |                   | $ | 544,114 |  
|                                                                                                |  |               |         |   |                   |   |         |  

See accompanying notes to condensed consolidated financial statements.



3



---

##### Table of Contents

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

For the three and six months ended June 30, 2006 and 2005

(In thousands)

(Unaudited)



|                                     |  |              |         |            |             |   |           |  |   |             |   |  |   |        
|------------------------------------ |  | ------------ | ------- | ---------- | ----------- | - | --------- |  | - | ----------- | - |  | - | -------
|                                     |  | Three Months |         | Six Months
|                                     |  | Successor    |         |            | Predecessor |   | Successor |  |   | Predecessor
|                                     |  | 2006         |         |            | 2005        |   | 2006      |  |   | 2005       
|Net patient service revenue          |  | $            | 81,258  |            |             | $ | 91,538    |  | $ | 168,577     |   |  | $ | 181,575
|                                     |  |              |         |            |             |   |           |  |   |             |   |  |   |        
|Salaries, wages, and benefits        |  |              | 36,283  |            |             |   | 37,526    |  |   | 72,351      |   |  |   | 73,359 
|Supplies                             |  |              | 8,400   |            |             |   | 8,445     |  |   | 16,836      |   |  |   | 16,433 
|Rent                                 |  |              | 4,265   |            |             |   | 4,630     |  |   | 8,825       |   |  |   | 9,023  
|Other operating expenses             |  |              | 19,945  |            |             |   | 21,993    |  |   | 40,822      |   |  |   | 41,577 
|Provision for doubtful accounts      |  |              | 1,447   |            |             |   | 1,484     |  |   | 2,962       |   |  |   | 2,981  
|Depreciation and amortization        |  |              | 2,876   |            |             |   | 1,494     |  |   | 5,854       |   |  |   | 2,847  
|Goodwill impairment charge           |  |              | 24,600  |            |             |   |          |  |   | 24,600      |   |  |   |       
|Insurance recovery                   |  |              | (5,333  | )          |             |   |          |  |   | (5,333      | ) |  |   |       
|Interest expense, net                |  |              | 8,203   |            |             |   | 608       |  |   | 16,083      |   |  |   | 1,256  
|Gain on early extinguishment of debt |  |              |        |            |             |   |          |  |   | (1,329      | ) |  |   |       
|                                     |  |              |         |            |             |   |           |  |   |             |   |  |   |        
|Total expenses                       |  |              | 100,686 |            |             |   | 76,180    |  |   | 181,671     |   |  |   | 147,476
|                                     |  |              |         |            |             |   |           |  |   |             |   |  |   |        
|Income (loss) before income taxes    |  |              | (19,428 | )          |             |   | 15,358    |  |   | (13,094     | ) |  |   | 34,099 
|                                     |  |              |         |           
|Provision for income taxes           |  |              | 2,181   |            |             |   | 6,320     |  |   | 4,724       |   |  |   | 13,355 
|                                     |  |              |         |            |             |   |           |  |   |             |   |  |   |        
|Net income(loss)                     |  | $            | (21,609 | )          |             | $ | 9,038     |  | $ | (17,818     | ) |  | $ | 20,744 
|                                     |  |              |         |            |             |   |           |  |   |             |   |  |   |        

See accompanying notes to condensed consolidated financial statements



4



---

##### Table of Contents

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholders Equity

For the six months ended June 30, 2006

(In thousands)

(Unaudited)



|                                 |  |             |   |                          |   |                    |  |   |                          |   |  |   |         |  
|-------------------------------- |  | ----------- | - | ------------------------ | - | ------------------ |  | - | ------------------------ | - |  | - | ------- | -
|                                 |  | CommonStock |   | AdditionalPaid-inCapital |   | AccumulatedDeficit |  |   | TotalStockholdersEquity |  
|Balance, December 31, 2005       |  | $           |  |                          | $ | 135,928            |  | $ | (69,836                  | ) |  | $ | 66,092  |  
|Equity compensation amortization |  |             |  |                          |   | 181                |  |   |                         |   |  |   | 181     |  
|Settlement of purchase escrow    |  |             |  |                          |   | 24,600             |  |   |                         |   |  |   | 24,600  |  
|Net loss                         |  |             |  |                          |   |                   |  |   | (17,818                  | ) |  |   | (17,818 | )
|                                 |  |             |   |                          |   |                    |  |   |                          |   |  |   |         |  
|Balance, June 30, 2006           |  | $           |  |                          | $ | 160,709            |  | $ | (87,654                  | ) |  | $ | 73,055  |  
|                                 |  |             |   |                          |   |                    |  |   |                          |   |  |   |         |  

See accompanying notes to condensed consolidated financial statements.



5



---

##### Table of Contents

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

For the six months ended June 30, 2006 and 2005

(In thousands)

(Unaudited)



|                                                                                         |  |           |         |   |             |   |        |  
|---------------------------------------------------------------------------------------- |  | --------- | ------- | - | ----------- | - | ------ | -
|                                                                                         |  | Successor |         |   | Predecessor |  
|                                                                                         |  | 2006      |         |   | 2005        |  
|Cash flows from operating activities:                                                    |  |           |         |   |             |   |        |  
|Net income (loss)                                                                        |  | $         | (17,818 | ) |             | $ | 20,744 |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |           |         |   |             |   |        |  
|Depreciation and amortization                                                            |  |           | 6,274   |   |             |   | 3,053  |  
|Provision for doubtful accounts                                                          |  |           | 2,962   |   |             |   | 2,981  |  
|Impairment charges                                                                       |  |           | 24,600  |   |             |   |       |  
|Gain on early extinguishment of debt                                                     |  |           | (1,329  | ) |             |   |       |  
|Accrued interest on shares subject to mandatory redemption                               |  |           |        |   |             |   | 595    |  
|Deferred income taxes                                                                    |  |           | (2,107  | ) |             |   | (1,009 | )
|Equity compensation amortization                                                         |  |           | 181     |   |             |   |       |  
|Changes in operating assets and liabilities:                                             |  |           |         |   |             |   |        |  
|Patient accounts receivable                                                              |  |           | (326    | ) |             |   | (8,687 | )
|Current income taxes                                                                     |  |           | 12,708  |   |             |   | 914    |  
|Insurance proceeds receivable                                                            |  |           | 1,667   |   |             |   |       |  
|Prepaid expenses and other current assets                                                |  |           | (1,857  | ) |             |   | (891   | )
|Other assets                                                                             |  |           | (644    | ) |             |   | (653   | )
|Estimated third-party payer settlements                                                  |  |           | (945    | ) |             |   | 2      |  
|Accounts payable and accrued expenses                                                    |  |           | (2,110  | ) |             |   | 8,783  |  
|Other liabilities                                                                        |  |           | 5,556   |   |             |   | (357   | )
|                                                                                         |  |           |         |   |             |   |        |  
|Net cash provided by operating activities                                                |  |           | 26,812  |   |             |   | 25,475 |  
|                                                                                         |  |           |         |   |             |   |        |  
|Cash used in investing activities:                                                       |  |           |         |   |             |   |        |  
|Purchases of property and equipment                                                      |  |           | (9,100  | ) |             |   | (1,253 | )
|                                                                                         |  |           |         |   |             |   |        |  
|Net cash used in investing activities                                                    |  |           | (9,100  | ) |             |   | (1,253 | )
|                                                                                         |  |           |         |   |             |   |        |  
|Cash flows used in financing activities:                                                 |  |           |         |   |             |   |        |  
|Payments of notes payable and long-term debt                                             |  |           | (2,806  | ) |             |   | (949   | )
|Payments on obligations under capital leases                                             |  |           | (2,891  | ) |             |   | (2,030 | )
|                                                                                         |  |           |         |   |             |   |        |  
|Net cash used in financing activities                                                    |  |           | (5,697  | ) |             |   | (2,979 | )
|                                                                                         |  |           |         |   |             |   |        |  
|Net increase in cash and cash equivalents                                                |  |           | 12,015  |   |             |   | 21,243 |  
|Cash and cash equivalents, beginning of period                                           |  |           | 19,843  |   |             |   | 6,678  |  
|                                                                                         |  |           |         |   |             |   |        |  
|Cash and cash equivalents, end of period                                                 |  | $         | 31,858  |   |             | $ | 27,921 |  
|                                                                                         |  |           |         |   |             |   |        |  
|Supplemental disclosure of cash flow information:                                        |  |           |         |   |             |   |        |  
|Cash:                                                                                    |  |           |         |   |             |   |        |  
|Interest paid                                                                            |  | $         | 17,658  |   |             | $ | 706    |  
|Net income taxes paid (received)                                                         |  |           | (5,877  | ) |             |   | 13,458 |  
|Noncash:                                                                                 |  |           |         |   |             |   |        |  
|Equipment purchased through capital lease financing                                      |  |           |        |   |             |   | 4,736  |  

See accompanying notes to condensed consolidated financial statements.



6



---

##### Table of Contents

LifeCare Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In thousands, except share and per share data)



|(1) | Basis of Presentation
|--- | ---------------------

On July 19, 2005,
LifeCare Holdings, Inc. (the Company) entered into a merger agreement with Rainier Acquisition Corporation and LCI Holdco, LLC (Holdco), resulting in the Company becoming a wholly owned subsidiary of Holdco. Holdco is a
wholly owned subsidiary of LCI Holding Company, Inc. (Holdings), which is owned by an investor group that includes affiliates of The Carlyle Group and members of the Companys senior management and board of directors. The Merger and
related transaction are referred to as the Merger.

The Companys financial position and results of operations prior to the
Merger are presented separately in the unaudited condensed consolidated financial statements as Predecessor financial statements, while the Companys financial position and results of operations following the Merger are presented as
Successor financial statements. Due to the revaluation of assets as a result of purchase accounting associated with the Merger, the pre-merger financial statements are not comparable with those after the Merger in certain respects.

The accompanying unaudited condensed consolidated financial statements and financial information have been prepared in accordance with
generally accepted accounting principles, and reflect all adjustments that are, in the opinion of management, necessary for a fair presentation of the results of the interim periods. The accompanying financial statements for the three and six month
periods ended June 30, 2006 and 2005 are not necessarily indicative of annualized financial results.

The accompanying unaudited
condensed consolidated financial statements should be read in conjunction with the consolidated audited financial statements and notes thereto for the year ended December 31, 2005 included in the Form S-4 filed by the Company on April 14,
2006, as amended, with the Securities and Exchange Commission. Certain information and disclosures normally included in the notes to consolidated financial statements have been condensed or omitted as permitted by the rules and regulations of the
Securities and Exchange Commission, although the Company believes the disclosure is adequate to make the information presented not misleading.



|(2) | Summary of Significant Accounting Policies
|--- | ------------------------------------------

Stock Compensation

All stock options related to the Predecessor stock incentive plans were redeemed
and canceled in connection with the Merger. The Predecessor Company applied the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations, in accounting for its fixed plan stock options. As such, compensation expense was recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. For fixed awards with pro
rata vesting, the Company recognized the related expense on the straight-line basis.

Effective January 1, 2006, the Company adopted
FASB Statement No. 123(R), Share-Based Payment, (FAS 123(R)) using the prospective application transition method. Prior to 2006, the Company accounted for its equity compensation using the intrinsic value-based method of
accounting prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations (and as allowed by FASB Statement No. 123, Accounting for Stock-Based Compensation). The Company had
previously only adopted the disclosure requirements of FASB Statement No. 123. The pro forma disclosures were presented utilizing the minimum value methodology as permitted for non-public companies. As permitted by FAS 123(R), the Company will
continue to account for equity compensation based shares granted prior to the adoption of FAS 123(R) pursuant to APB Opinion No. 25, until such time as the shares are modified, canceled or repurchased.

For grants of stock options subsequent to the adoption of FAS 123(R), the Company estimates the fair value of awards on the date of grant using the
Black-Scholes option pricing model. The fair value of options granted in the six months ended June 30, 2006 was $2.16 per share and was calculated as of the grant date using the Black-Scholes option pricing model with the following assumptions:
expected volatility of 45%, expected dividend yield of 0%, expected life of 6.25 years, expected forfeiture rate of 10% and a risk-free interest rate of 4.82%. Expected volatility was derived using data drawn from similar public companies for five
to seven years prior to the date of grant. The expected life was computed utilizing the simplified method as permitted by the Securities and Exchange Commissions Staff Accounting Bulletin No. 107, Share-Based Payment. The expected
forfeiture rate was based upon the Companys expectations. The risk-free interest rate is based on the approximate yield on seven-year United States Treasury Bonds as of the date of grant. There were no options granted during the three months
ended June 30, 2006.



7



---

##### Table of Contents

|(3) | Merger Transaction
|--- | ------------------

As more fully discussed in note
2 to the Companys audited financial statements for the year ended December 31, 2005, the Merger agreement provided for additional purchase price consideration of $35.5 million as of December 31, 2005 that was contingent upon the
resolution of certain specific issues. The remaining contingent consideration had previously been deposited in separate escrow accounts. On June 29, 2006, $24.6 million that had been placed into one of the specific escrows for general
indemnification matters was made available for distribution to the prior shareholders of the Company since no general indemnification claims had been made against the escrow prior to its expiration date. This resulted in an increase in the purchase
price to be allocated of $24.6 million with a corresponding increase in goodwill.

The original amount deposited into the contingent escrow
accounts was $40.5 million. Through June 30, 2006, $29.6 million of the original amount had been settled and disbursed accordingly. It is anticipated that the remaining contingent issues will be resolved through June 2007.



|(4) | Net Patient Service Revenue
|--- | ---------------------------

The Company recognizes
in its consolidated financial statements the impact of adjustments, if any, to Medicare reimbursement when the amounts can be reasonably determined. Net revenues for the three months ended June 30, 2006 and 2005, included (decreases)/increases
of $(3,400) and $1,640, respectively, and (decreases)/increases of $(3,400) and $1,340 for the six months ended June 30, 2006 and 2005, respectively, related to changes in estimates and settlements on prior year cost reports filed with the
Medicare program.



|(5) | Goodwill and Impairment Charges
|--- | -------------------------------



|                                                                   |  |   |         |  
|------------------------------------------------------------------ |  | - | ------- | -
|Goodwill at December 31, 2005                                      |  | $ | 317,618 |  
|Additional purchase price allocation                               |  |   | 24,600  |  
|Impairment charge                                                  |  |   | (24,600 | )
|Adjustment in fair market value assigned to property and equipment |  |   | 541     |  
|                                                                   |  |   |         |  
|Goodwill at June 30, 2006                                          |  | $ | 318,159 |  
|                                                                   |  |   |         |  

The adjustment of $541 was recorded in connection with the Companys continuing review of the
allocation of purchase cost related to the Companys Merger on August 11, 2005, as more fully discussed in note 2 to the Companys audited financial statements for the year ending December 31, 2005. See note 3 for discussion
regarding the additional purchase price allocation of $24.6 million.

As a result of the recent Medicare reimbursement changes as more fully
discussed in note 11 that were effective on July 1, 2006, and our estimate of the impact of the changes on future cash flows, the Company reviewed the carrying value of its goodwill as of June 30, 2006. As a result of this review, an
impairment charge of $24.6 million was recorded during the three months ended June 30, 2006. The present value of future cash flows was the method used to determine fair value for purposes of these impairment charges. The Company performs its
annual valuation of goodwill and identifiable intangibles annually as of December 31. Based upon the review to be performed as of December 31, 2006 and the actual impact of the Medicare reimbursement changes, additional goodwill impairment
charges may be recorded.

Specific assets and liabilities, including certain identified intangibles, certain properties and leasehold
improvements, as well as unresolved contingencies remain outstanding that require the Company to obtain additional information in order to properly assess and finalize the potential impact, if any, to the consolidated financial statements. The
Company does not expect the impact of such additional adjustments to be material. Any additional valuation adjustments that would need to be recorded will be offset with a corresponding adjustment to goodwill.



|(6) | Long-Term Debt
|--- | --------------

Long-term debt at June 30,
2006 consists of the following:



|                                               |  |   |         |  
|---------------------------------------------- |  | - | ------- | -
|Senior secured credit facility - term loan     |  | $ | 253,088 |  
|91/4%
senior subordinated notes (Notes)      |  |   | 147,000 |  
|                                               |  |   |         |  
|Total long-term debt                           |  |   | 400,088 |  
|Current installments of long-term debt         |  |   | (2,550  | )
|                                               |  |   |         |  
|Long-term debt, excluding current installments |  | $ | 397,538 |  
|                                               |  |   |         |  



8



---

##### Table of Contents

During the six months ended June 30, 2006, the Company repurchased $3 million of its outstanding
Notes for $1.53 million. This resulted in the Company recording a $1.33 million gain, net of the write-off of $0.14 million of capitalized financing cost, on the early extinguishment of this indebtedness.

Registration Rights Agreement

In
connection with the offering of the Notes, the Company entered into a registration rights agreement with the initial purchasers. Under the terms of that agreement, the Company agreed to:



| |  |  | File by April 15, 2006 a registration statement with respect to an offer to exchange the Notes for new registered notes of the Company having substantially identical terms,
other than with respect to transfer restriction and registration rights, referred to as subordinated exchange notes.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Use commercially reasonable efforts to cause such registration statement to be declared effective prior to 120 days after the day it is filed with the SEC; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Consummate such exchange offer within 30 business days after the day the registration statement is declared effective.
| | - |  | ----------------------------------------------------------------------------------------------------------------------

On April 14, 2006, the Company filed a Form S-4 registration statement with the SEC as required by the Registration Rights Agreement. This filing was
declared effective by the SEC on May 12, 2006. The Company completed the exchange offer for all outstanding Notes as of June 21, 2006, which satisfied the requirements of the Registration Rights Agreement.

Other

Capitalized costs incurred in
obtaining financing under the credit facility, including the revolving line of credit and the Notes, of $12,473 as of June 30, 2006, is being amortized over the terms of the related debt using the interest method. Amortization expense for
capitalized financing costs were $342 and $103 for the three months ended June 30, 2006 and 2005, respectively, and $675 and $206 for the six months ended June 30, 2006 and 2005, respectively.



|(7) | Stock Options
|--- | -------------

Successor Stock Option Plan

At June 30, 2006, there were 2,860,000 million shares of common stock of Holdings available under the 2005 Equity Incentive
Plan (Plan) for stock option grants and other incentive awards, including restricted stock units. Options granted generally have an exercise price equal to the fair market value of the shares on the date of grant and expire 10 years from
the date of grant. A restricted stock unit is a contractual right to receive one share of Holdings common stock in the future. Options typically vest one-quarter on each of the first four anniversary dates of the grant and restricted stock units
vest one-quarter upon grant and one-third each year thereafter.

Income from the three months ended June 30, 2006 and 2005 and the six
months ended June 30, 2006 and 2005 includes $90, $173, $181 and $289, respectively, of pre-tax compensation costs related to our or our Predecessors stock-based compensation arrangements.

The following table summarizes stock option activity during the six months ended June 30, 2006:



|                             |  |                 |   |  |                              |      
|---------------------------- |  | --------------- | - |  | ---------------------------- | -----
|                             |  | Number ofShares |   |  | Weightedaverageexerciseprice
|Successor:                   |  |                 |   |  |                              |      
|Balance at December 31, 2005 |  | 695,000         |   |  | $                            | 10.00
|Granted                      |  | 80,000          |   |  |                              | 10.00
|Exercised                    |  |                |   |  |                              |     
|Forfeited                    |  | (168,000        | ) |  |                              | 10.00
|Expired                      |  |                |   |  |                              |     
|                             |  |                 |   |  |                              |      
|Balance at June 30, 2006     |  | 607,000         |   |  | $                            | 10.00
|                             |  |                 |   |  |                              |      



9



---

##### Table of Contents

At June 30, 2006, the weighted average remaining contractual life of outstanding options was 9.18
years. There were no stock options exercisable at June 30, 2006.

As of June 30, 2006, there was approximately $139 of total
unrecognized compensation costs related to stock options. These costs are expected to be recognized over a period of approximately four years.

Restricted Stock Awards

The following table summaries restricted stock award activity during the six
months ended June 30, 2006:



|                             |  |                 |  
|---------------------------- |  | --------------- | -
|                             |  | Number ofShares |  
|Successor:                   |  |                 |  
|Balance at December 31, 2005 |  | 160,000         |  
|Granted                      |  |                |  
|Exercised                    |  |                |  
|Forfeited                    |  | (15,000         | )
|Repurchased                  |  | (5,000          | )
|                             |  |                 |  
|Balance at June 30, 2006     |  | 140,000         |  
|                             |  |                 |  

During the three months ended June 30, 2006, a restricted stock award holder resigned from the
Company resulting in the forfeiture of 15,000 shares of restricted stock awards that were not vested. Holdings purchased the 5,000 shares that had previously vested for $10 pursuant to the restricted stock award agreement

As of June 30, 2006, there was approximately $539 of total unrecognized compensation costs related to restricted stock awards. These costs are
expected to be recognized over a remaining period of approximately two years.



|(8) | Insurance Recovery
|--- | ------------------

We have recorded $13.2 million
of insurance recoveries, including $7.9 million during the year ended December 31, 2005 and $5.3 million during the six months ended June 30, 2006, related to the loss of our New Orleans operations during 2005. The $5.3 million was
received in July 2006. We currently believe that all available amounts have been received pursuant to the policy limits in connection with our Hurricane Katrina losses.



|(9) | Regulatory Matters
|--- | ------------------

All healthcare providers are
required to comply with a significant number of laws and regulations at the federal and state government levels. These laws are extremely complex, and in many instances, providers do not have the benefit of significant regulatory or judicial
interpretation as to how to interpret and/or apply these laws and regulations in the normal course of conducting their business. The U.S. Department of Justice and other federal agencies are increasing resources dedicated to regulatory
investigations and compliance audits of healthcare providers. As a healthcare provider, the Company is subject to these regulatory efforts. Healthcare providers that do not comply with these laws and regulations may be subject to civil or criminal
penalties, the loss of their licenses, or restriction in their ability to participate in various federal and state healthcare programs. The Company endeavors to conduct its business in compliance with applicable laws and regulations, including
healthcare fraud and abuse laws.

The Company undertakes various procedures to assure that its annual cost reports are correctly prepared
and filed in accordance with applicable Medicare regulations governing provider reimbursement. During 2004 and 2003, the Company conducted an internal review of its previously filed cost reports. As a result of this review, which covered the years
1997 through 2001, the Company made certain adjustments in 2003 to its previously reported allowable home office expenses. The findings of this review and proposed amendments to the home office cost reports were submitted to the Office of Inspector
General of the Department of Health and Human Services (OIG), who reviewed the Companys findings. On June 12, 2006, the Company entered into a Settlement Agreement and a Certification of Compliance Agreement (CCA) with the OIG that
settled these matters. The amount paid in connection with this settlement was approximately $2.6 million, which was funded out of a specific escrow account established as part of the Merger that occurred on August 11, 2005. The CCA is effective
for three years from the date of the CCA, and requires, among other things, that the Company continue to maintain our corporate compliance program, report certain events if they occur to the OIG and file an annual report with the OIG regarding
certain specified items, including corporate compliance and internal audit activities.

As part of its internal review, the Company
identified certain federal election contribution issues relevant to the Federal Election Commission and federal election law. On June 3, 2005, the Company reached an agreement with the Federal



10



---

##### Table of Contents

Election Commission that resolved this matter. The agreement resulted in a settlement amount that approximated the Companys recorded estimate. These
federal election contribution issues were also reported to the Department of Justice (DOJ). The DOJ review of the reported issues is still ongoing. Any settlement resulting from the findings of this review will be paid out of $7.5
million that is held in one of the specific escrow funds established upon the Merger.



|(10) | Commitments and Contingencies
|---- | -----------------------------

On
September 28, 2005, the Louisiana Attorney Generals office announced that it was conducting an investigation of 13 nursing homes and six hospitals in the New Orleans area relating to patient deaths that occurred at these facilities during
and in the aftermath of Hurricane Katrina. One of these facilities is Memorial Medical Center within which the Company operated an 82-bed licensed hospital. The Company has been fully cooperating with this investigation since its inception and will
continue to do so until the investigation is complete. On July 18, 2006, the Attorney Generals office presented certain findings related to this investigation that resulted in the arrest of one physician and two nurses, who were not
employees of the Company. Neither the Company nor its employees have been named to date in any illegal or criminal activities under investigation by the Attorney General. The Attorney Generals office has indicated, however, that the
investigation will be ongoing. We have received no indication of how long the Attorney Generals office will take to complete its investigation. At this time we cannot determine what, if any, impact this investigation ultimately may have on the
Company. If we become a target of the investigation, it could have a materially adverse effect on our business, operating results and financial condition.

We have been named as a defendant in three civil lawsuits brought by former patients at Memorial Medical Center who allege damages as a result of injuries sustained during Hurricane Katrina. Tenet Healthsystem
Memorial Medical Center, Inc., our former landlord, is also named as a defendant in these actions. In one of these cases, plaintiffs counsel is seeking class action certification to represent other individuals who were also patients at
Memorial Medical Center at the time of Hurricane Katrina. We intend to vigorously defend ourselves in these lawsuits; however, we cannot predict the ultimate resolution of these matters. There can be no guarantees that additional legal actions or
claims will not be brought against us related to the circumstances surrounding Hurricane Katrina.

Significant reductions in the patient
service revenues earned by a hospital may occur if the Company is unable to maintain the certification of the hospital as an LTACH in accordance with Medicare regulations. Additionally, the majority of the Companys hospitals operate in space
leased from general acute care hospitals (host hospitals); consequently, these HIH hospitals are subject to additional specific Medicare HIH regulations in addition to the general LTACH regulations. The HIH regulations are designed to ensure that
the hospitals are organizationally and functionally independent of their host hospital. If an LTACH located in a host hospital fails to meet the HIH regulations, it may also lose its status as an LTACH. These determinations are made on an annual
basis. The Company believes its providers are currently in compliance with the Medicare regulations regarding HIHs and LTACHs and are expected to maintain compliance under the current Medicare regulations.

Additionally, the Company has certain pending and threatened litigation and claims incurred in the ordinary course of business. The Company is unable to
predict the ultimate outcome of pending litigation and regulatory and other government investigations, nor can there be any assurance that the resolution of any litigation or investigation, either individually or in the aggregate, would not have a
material adverse effect on the Companys financial position, results of operations or liquidity.



|(11) | Regulatory Update
|---- | -----------------

On May 2, 2006, CMS issued
the final rules for the 2007 fiscal year starting July 1, 2006 regarding the prospective payment system for long-term acute care hospitals. The rules include changes in the methodology used to compute payments to long-term acute care hospitals
for patients that are classified as short-stay outliers and an increase of $4,386 in the high-cost outlier fixed loss threshold to $14,887 and freezing the 2007 federal fiscal year base rate at the 2006 fiscal year level, among other changes. CMS
estimates that the changes in this rule will reduce aggregate Medicare reimbursement paid to long-term acute care hospitals by approximately 3.7%. This percentage is based on the industry average for all facilities. The results for a particular
facility will vary based on a facilitys patient mix and geographic location.

Based upon our Medicare patient activity, we have
estimated that if these changes had been enacted on January 1, 2006, including updates to the wage indices for the geographic locations of our hospitals, our Medicare revenue for the six months ended June 30, 2006 would have been reduced
by approximately 4.2%, or $5.0 million. This estimate does not include the negative impact resulting from the elimination of the annual market basket adjustment as discussed previously. This is only an estimate of the effects of the final rule. The
actual impact of these reimbursement changes in subsequent periods could be materially different from our estimate.



11



---

##### Table of Contents

On August 1, 2006, CMS issued their annual updates to the Medicare hospital payment system,
including changes to the relative weights and lengths of stay for the diagnosis related groups treated by LTACHs. This final rule will be effective for all Medicare discharges on or after October 1, 2006. CMS estimates these changes will result
in reducing payments to LTAC providers by 1.3% based on the current reimbursement regulations that are in place. This reduction will be in addition to the reduction discussed previously as a result of the fiscal 2007 rule changes. We are in the
process of evaluating the impact that these recent changes will have on our Medicare net patient service revenue in future periods. Historically, however, the actual impact of regulation changes on our Medicare net patient service revenue has
closely approximated CMSs estimates. The actual impact of these reimbursement changes in subsequent periods could be materially different from CMSs estimate.

The final regulations also include (1) changes in the regulations applicable to grandfathered hospitals-within-hospitals and grandfathered satellite facilities, and (2) changes in the methodology for
determining cost-to-charge ratios for LTACHs and the reconciliation of high-cost and short-stay outlier payments under the Medicare payment system for such hospitals.

The Company is assessing the financial impact that the new regulations are expected to have on its operations. It is possible that the impact may result in the Company recording additional impairment charges in future
periods as it relates to the carrying value of goodwill and certain identifiable intangible assets.



12



---

##### Table of Contents

ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the
following discussion and analysis in conjunction with our condensed consolidated financial statements and the accompanying notes. This discussion and analysis covers periods prior to (Predecessor Periods) and following (Successor
Periods) August 12, 2005, the date of the Merger of Rainier Acquisition Corp. with and into LifeCare Holdings, Inc. (LifeCare or Company) and the financings related thereto (Transactions). Accordingly,
the discussion and analysis of Predecessor Periods does not reflect the significant impact that Transactions have had and will have on us, including without limitation, increased leverage and debt service requirements and the impact of purchase
accounting.

Company Overview

We are a leading
operator of long-term acute care hospitals (LTACHs) in the United States. As of June 30, 2006 we operated 18 hospitals located in nine states, consisting of 12 hospital within a hospital facilities (46% of beds) and six
freestanding facilities (54% of beds). Through these 18 long-term acute care hospitals, we operate a total of 893 licensed beds and employ approximately 2,800 people, the majority of whom are registered or licensed nurses and respiratory therapists.
As discussed in more detail below, our three New Orleans hospitals were closed during the last week of August and will not re-open in their current facilities. The licensed beds for these hospitals are not included in the total number of facilities
or licensed beds discussed above.

Our patients have serious medical conditions such as respiratory failure, chronic pulmonary disease, nervous system
disorders, infectious diseases and non-healing wounds. They generally require a high level of monitoring and specialized care yet may not require the continued services of an intensive care unit. Due to their serious medical conditions, our patients
are generally not clinically appropriate for admission to a skilled nursing facility or inpatient rehabilitation facility. By combining general acute care services with a focus on long-term treatment, we believe that our hospitals provide medically
complex patients with better and more cost-effective outcomes.

Recent Trends and Events

Impact of Hurricane Katrina

During the last week of August
2005 operations at our three New Orleans hospitals ceased as a result of Hurricane Katrina. The Chalmette campus, a hospital within a hospital, contained 37 licensed beds and was substantially damaged as a result of Hurricane Katrina. We will not be
able to resume operations within the existing building. Our other two New Orleans locations were located within hospitals operated by Tenet Healthcare Corporation (Tenet). These facilities contain a combined 113 licensed beds. In
November 2005, Tenet terminated the leases for these facilities effective December 15, 2005 due to the extensive physical damages sustained at these hospitals. We are evaluating whether our Medicare provider numbers and licenses for these three
facilities can be used for alternative sites. To the extent we are able to relocate these facilities, we will have capital expenditure needs and will incur start-up costs associated with the relocation. At this time we do not yet know the amount of
the capital expenditure requirements or start-up costs that we would incur if and when these operations are relocated. However, we expect that such costs would result in the new facilities sustaining losses at least in the short-term. We cannot
determine the likelihood of being able to re-open hospitals in the New Orleans market.

For the three month and six month periods ended June 30, 2005,
these three hospitals contributed $10.6 and $22.4 million, respectively, of our net revenues. As a result of the losses incurred in connection with Hurricane Katrina, we recorded impairment charges on long-lived assets and goodwill for the twelve
months ended December 31, 2005 of $74.2 million. To date, we have received $13.2 million in insurance proceeds pursuant to the policies that in force at the time of the hurricane. This amount includes the $5.3 million in insurance proceeds
receivable recorded as of June 30, 2006, which was received during July 2006. We currently believe that all available amounts have been received pursuant to the policy limits in connection with our Hurricane Katrina related losses.

On September 28, 2005, the Louisiana Attorney Generals office announced that it is conducting an investigation of 13 nursing homes and six hospitals in the
New Orleans area relating to patient deaths that occurred at these facilities during and in the aftermath of Hurricane Katrina. One of these facilities is Memorial Medical Center within which we operated an 82-bed facility. We have been fully
cooperating with this investigation since its inception. On July 18, 2006, the Attorney Generals office presented certain findings related to this investigation that resulted in the arrest of one physician and two nurses, who were not
employees of the Company. Neither the Company nor its employees have been named to date in any illegal or criminal activities under investigation by the Attorney General. The Attorney Generals office has indicated, however, that the
investigation will be ongoing. We have received no indication of how long the Attorney Generals office will take to complete its investigation. At this time we cannot determine what, if any, impact this investigation ultimately may have on the
Company. If we become a target of the investigation, it could have a materially adverse effect on our business, operating results and financial condition.



13



---

##### Table of Contents

We have been named as a defendant in three civil lawsuits brought by former patients at Memorial Medical Center who
allege damages as a result of injuries sustained during Hurricane Katrina. Tenet Healthsystem Memorial Medical Center, Inc., our former landlord, is also named as a defendant in these actions. In one of these cases plaintiffs counsel is
seeking class action certification to represent other individuals who were also patients at Memorial Medical Center at the time of Hurricane Katrina. We intend to vigorously defend ourselves in these lawsuits; however, we cannot predict the ultimate
resolution of these matters. There can be no guarantees that additional legal actions or claims will not be brought against us related to the circumstances surrounding Hurricane Katrina.

Hospital Openings and Milwaukee Lease Termination

During the last week of September 2005 we opened a new
39-bed hospital in West Chester, Pennsylvania. The hospital admitted its first patient in September 2005 and became certified by CMS as a LTAC hospital on April 1, 2006. We also opened a 62-bed satellite expansion hospital in McAllen, Texas
during March 2005 and closed a 17-bed hospital in Milwaukee, Wisconsin at the end of November 2005. The assets located in our Milwaukee hospital are being used at other locations.

The Transactions

On August 11, 2005, we consummated an acquisition pursuant to which Rainier Acquisition
Corp., a Delaware corporation formed by investment funds associated with The Carlyle Group and certain members of our current management and board of directors, merged with and into our Company, with our Company continuing as the surviving
corporation. The funds necessary to consummate the Transactions were approximately $552.0 million, including approximately $512.2 million to pay the then current stockholders and option holders, approximately $10.7 million to repay existing
indebtedness and approximately $29.1 million to pay related fees and expenses. The effective date of the merger was August 11, 2005.

In connection
with the Transactions, we borrowed $255.0 million under a senior credit facility and issued $150.0 million principal amount of senior subordinated notes. We also entered into a revolving working capital loan agreement (Revolver) that
provides up to $75.0 million of borrowing capacity. To date, we have made no borrowings pursuant to the Revolver.

As a result of the Transactions, our
assets and liabilities were adjusted to their fair value as of the consummation of the Merger. The excess of the total purchase price over the fair value of our tangible assets and liabilities has been allocated to goodwill and other identifiable
intangible assets, which are subject to an annual impairment test, or more frequent tests if circumstances warrant such a test. We have also increased our aggregate outstanding indebtedness. Accordingly, interest expense is higher in periods
following the Transactions.

Regulatory Changes

Approximately 71.3% and 76.4% of our total net patient service revenue for the six months ended June 30, 2006 and 2005, respectively, came from Medicare reimbursement. Our industry is subject to extensive government regulation,
including regulation of the Medicare reimbursement process. Changes in these regulations can have a material impact on the way we operate our business and on our results of operations. In recent years, several material changes in reimbursement
regulations have been implemented including the 25% limit on admissions from a host hospital to an HIH, and the re-weighting of LTACH diagnosis related groupings, or DRGs. On May 2, 2006, CMS issued the final rules for LTACHs for fiscal 2007
that will result in a reduction of our Medicare reimbursement. Additionally, on August 1, 2006, CMS issued updates to the weighting of LTACH DRGs that will result in a further reduction of our Medicare reimbursement for all discharges on or
after October 1, 2006. CMS is also considering establishing new patient and facility criteria for long-term acute care hospital providers.

HIH
Facility Admission Regulations

Based upon our historical host admission levels, the new HIH facility admission regulations would require transition
plans for three of our twelve HIH facilities, excluding our three New Orleans facilities. As a result of these new facility admission regulations, we are developing transition plans for the three impacted HIH facilities that include consolidating
HIH facilities or relocating certain of these facilities to alternative settings, building new hospitals or buying freestanding facilities. One of the other nine HIH facilities is our new 39-bed hospital in Chester, Pennsylvania that we expect will
operate below the 25% host hospital admission threshold. With respect to our other eight HIH facilities, four currently operate below the 25% host hospital admission threshold, one qualifies for the Metropolitan Statistical Area-dominant
(MSA-dominant) exemption and we believe that three qualify for grandfather treatment and are therefore currently exempt from this payment limitation. Two



14



---

##### Table of Contents

of the three facilities located in the New Orleans market were also grandfathered facilities and the third operated near the 25% host hospital admission
threshold. We are uncertain at this time as to whether these two New Orleans facilities would retain their grandfather status if they were relocated to new sites. As a result of the phase-in of these rules, the HIH facility regulations had no effect
on our 2005 financial results, and will have only a minimal impact on our 2006 financial results. In the second quarter of 2007, one of our HIH facilities will become subject to the 50% admission threshold. We believe that we will be able to adapt
to the HIH facility regulations with minimal disruption to our business.

Medicare Reimbursement Change in Payment Rates and DRG-Weighting for Fiscal
2006

On May 6, 2005, CMS issued a final rule to update LTACH PPS payment rates for the 2006 rate year. CMS estimates that this rule, together with
other factors, including wage index adjustments, will lead to a combined effective increase in Medicare reimbursement paid to LTACHs of 5.7%. On August 1, 2005, CMS issued a rule to, among other things, revise the classifications, relative
weights and lengths of stay for the DRGs treated by LTACHs, effective October 1, 2005. CMS estimates that the changes will reduce aggregate Medicare reimbursement to LTACHs by approximately 4.2%. These percentages are based on the industry
average for all facilities. The results for a particular facility will vary based on a facilitys patient mix and geographic location.

Based upon our
assessment of the impact of the above changes taken together using our actual patient population, we have estimated that had these updates been in effect during the six months ended June 30, 2005, the net impact would have been a reduction of
our Medicare net patient service revenue by approximately 1.3%, or $1.9 million less, for the six months then ended. This is only an estimate of these effects, and the actual impact of these reimbursement changes in subsequent periods could have
been materially different from our estimates.

Medicare Reimbursement Change in Payment Rate for Fiscal 2007

On May 2, 2006 CMS issued the final regulations for the 2007 fiscal year starting on July 1, 2006 regarding the prospective payment system for LTACHs. The final
rules included, among other things, (i) a change in the payment provisions related to short-stay outliers; (ii) an increase in the outlier fixed-loss amount from $10,501 to $14,887; (iii) an increase in the labor-related share of the
prospective payment system federal rate from 72.855% to 75.665%; (iv) eliminating the surgical case exception to the three-day or less interruption of stay policy; and (v) a freeze on the fiscal 2007 federal rate at the 2006 level.

The current payment methodology for short-stay outliers reimburses long-term acute care hospital providers at the lowest of (i) 120% of patient cost;
(ii) 120% of the per diem amount based on the diagnosis related group; or (iii) the full diagnosis related group payment. The final rule introduced a fourth payment alternative: (iv) a blend of an amount comparable to what would
otherwise be paid under the short-term acute care inpatient payment system (IPPS DRG) computed as a per diem, capped at the full IPPS DRG comparable payment amount, and 120% of the LTACH DRG per diem payment. An additional CMS change
will lower the reimbursement under the patient cost payment alternative from 120% of patient cost to 100%.

CMS has estimated that exclusive of the freeze
of the federal rate for fiscal 2007, these changes will result in a decrease in Medicare reimbursement of 3.7% for LTACH providers. Based upon our Medicare patient activity, we have estimated that if these changes had been enacted on January 1,
2006, including updates to the wage indices for the geographic locations of our hospitals, our Medicare revenue for the six months ended June 30, 2006 would have been reduced by approximately 4.2%, or $5.0 million. These are only estimates of
the impact of the final regulations. The actual impact in subsequent periods could be materially different from our estimates. Furthermore, our estimated impact does not include the effect of CMS proposed freeze of the 2007 federal rate at the
2006 level.

Medicare Reimbursement Changes to DRG Weighting for Fiscal 2007

On August 1, 2006 CMS issued changes to the Medicare hospital payment system, including changes to the relative weights and lengths of stay for the diagnosis related groups treated by LTACHs. This final rule will
be effective for Medicare discharges on or after October 1, 2006. CMS estimates these changes will result in reducing payments to LTAC providers by 1.3% based on the current reimbursement regulations that are in place. This reduction will be in
addition to the reduction discussed previously as a result of the fiscal 2007 rule changes. We are in the process of evaluating the impact that these recent changes will have on our Medicare net patient service revenue in future periods.
Historically, however, the actual impact of regulation changes on our Medicare net patient service revenue has closely approximated CMSs estimates. The actual impact of these reimbursement changes in subsequent periods could be materially
different from CMSs estimate.

The final regulations also includes (1) changes in the regulations applicable to grandfathered
hospitals-within-hospitals and grandfathered satellite facilities, and (2) changes in the methodology for determining cost-to-charge ratios for LTACHs and the reconciliation of high-cost and short-stay outlier payments under the Medicare
payment system for such hospitals.



15



---

##### Table of Contents

CMS Study on Patient and Facility Criteria

Based upon a June 2004 report prepared by the MedPAC, it was recommended that CMS study and consider new patient and facility criteria for long-term acute care hospital providers. The contractor commissioned by CMS to
conduct aspects of this analysis is expected to submit its report to CMS in 2006. At this time we are not certain as to when this study will be finalized nor of the impact any such proposed changes, if adopted, could have on our operations and
financial performance in future periods.

Regulatory Matters

As discussed in note 16 to our December 31, 2005 consolidated financial statements included in our Form S-4 filed with the SEC on April 11, 2005, as amended, we had reached an agreement in principle on
March 6, 2006 with the Office of Inspector General of the Department of Health and Human Services (OIG) to settle certain matters that had been previously self-reported by us to the OIG. On June 12, 2006, we entered into a Settlement
Agreement and a Certification of Compliance Agreement (CCA) with the OIG that settled these matters. The amount paid in connection with this settlement was approximately $2.6 million, which was funded out of a specific escrow account established as
part of the Transactions that occurred on August 11, 2005. The CCA is effective for three years from the date of the CCA, and requires, among other things, that we continue to maintain our corporate compliance program, report certain events if
they occur to the OIG and that we file an annual report with the OIG regarding certain specified items, including corporate compliance and internal audit activities. We believe that the annual incremental costs to comply with the CCA will not be
significant since we currently maintain corporate compliance and internal audit functions.

Sources of Revenue

We are reimbursed for our services provided to patients by a number of sources, including the federal Medicare program and commercial payors. Payment arrangements include
prospectively determined rates per discharge, reimbursed costs, discounted charges and per diem rates. Our net patient service revenue consists of the amounts that we estimate to be reimbursable from each of the applicable non-governmental payors
and the Medicare and Medicaid programs. We account for the differences between the estimated reimbursement rates and our standard billing rates as contractual adjustments, which are deducted from gross revenues to arrive at net revenues. We record
accounts receivable resulting from such payment arrangements net of contractual allowances. Net patient service revenues generated directly from the Medicare program approximated 71.3% and 76.4% of total net patient service revenue for the six
months ended June 30, 2006 and 2005, respectively. Net patient service revenues generated from non-Medicare payors were substantially from commercial payors.

Laws and regulations governing provider reimbursement pursuant to the Medicare program are complex and subject to interpretation. The Medicare reimbursement amounts reported in our financial statements are based upon estimates and, as such,
are subject to adjustment until such time as our billings and cost reports are filed and settled with the appropriate regulatory authorities. Federal regulations require that providers participating in the Medicare program submit annual cost reports
associated with services provided to program beneficiaries. In addition, payments under LTACH PPS are subject to review by the regulatory authorities. These reviews primarily focus on the accuracy of the DRG assigned to each discharged patient and
normally occur after the completion of the billing process.

The annual cost reports are also subject to review and adjustment by CMS through its fiscal
intermediaries. These reviews may not occur until several years after a provider files its cost reports and often results in adjustments to amounts reported by providers in their cost reports as a result of the complexity of the regulations and the
inherent judgment that is required in the application of certain provisions of provider reimbursement regulations. Since these reviews of filed cost reports occur periodically, there is a possibility that recorded estimated Medicare reimbursement
reflected in our consolidated financial statements and previously filed cost reports may change by a material amount in future periods. We recognize in our consolidated financial statements the impact of adjustments, if any, to estimated Medicare
reimbursement when the amounts can be reasonably determined. Net revenues for the three months ended June 30, 2006 and 2005 included (decreases)/increases of $(3,400) and $1,640, respectively, and (decreases)/increases of $(3,400) and $1,340
for the six months ended June 30, 2006 and 2005, respectively, related to changes in estimates and settlements on prior year cost reports filed with the Medicare program. The most significant cost report valuation adjustment recognized during
the three and six month periods ended June 30, 2006 relates to two of the Companys hospitals. In these cases, the actual cost to charge ratio, which is used to determine the reimbursement for short stay and high cost outliers, was outside the
10% limit of the cost to charge ratio amount used by CMS to process interim claims such that it resulted in a reconciliation of payments to the actual cost to charge ratio for these cost report periods.

Total Expenses

Total expenses consists of salaries, wages and
benefits, supplies, which includes expenses related to drug and medical supplies, rent, other operating expenses, provision for doubtful accounts, depreciation and amortization and interest expense. Other operating expenses include expenses such as
contract labor, legal and accounting fees, insurance and contracted services purchased from host hospitals.



16



---

##### Table of Contents

Other Operating Metrics

We use certain operating metrics in the management of our facility operations. These include:

Licensed beds. Licensed beds represent beds
for which a facility has been granted approval to operate from the applicable state licensing agency. These licensed beds are used in the determination of average licensed beds and occupancy rates.

Average licensed beds. We compute average licensed beds by computing a weighted average based upon the number of licensed beds in place for each month within the
reporting period.

Admissions. Admissions are the total number of patients admitted to our facilities during the
reporting period.

Patient days. Patient days are the cumulative number of days that licensed beds are occupied in our facilities for the entire
reporting period. We also refer to patient days as our census.

Average length of stay (days). We compute average length of stay in days by dividing
patient days for discharged patients by discharges.

Occupancy rates. We compute our occupancy rate by determining the percentage of average
licensed beds that are occupied for a 24-hour period during a reporting period. The occupancy rate provides a measure of the utilization of inpatient rooms.

Net patient service revenue per patient day. This measure is determined by dividing our total net patient service revenue by the number of patient days in a reporting period. We use this metric to provide a measure of the net patient
service revenue generated for each patient day.

Critical Accounting Matters

This discussion and analysis of our financial condition and results of operation is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of those financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures. We rely on historical experience and other assumptions that we believe are
reasonable at the time in forming the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts may differ from these estimates.

We believe that the following critical accounting policies as more fully described in our annual financial statements as of December 31, 2005 as filed in the Form
S-4, affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.



| |  |  | Revenue recognition
| | - |  | -------------------



| |  |  | Accounts receivable and allowance for doubtful accounts
| | - |  | -------------------------------------------------------



| |  |  | Insurance Risks
| | - |  | ---------------



| |  |  | Impairment of Long-Lived Assets
| | - |  | -------------------------------



| |  |  | Accounting for income taxes
| | - |  | ---------------------------



| |  |  | Accounting for stock-based compensation
| | - |  | ---------------------------------------

Goodwill

We review our goodwill annually, or more frequently if circumstances warrant a more timely review, to determine if there has been an impairment. We
review goodwill based upon one reporting unit. In calculating the fair value of the reporting unit, we use various assumptions including projected cash flows and discount rates. If projected future cash flows decline from the current amounts
projected by management, impairments may be required.

During the three months ended June 30, 2006, we reviewed goodwill for impairment as the result
of the finalization of the Medicare regulations issued on May 2, 2006, along with a $24.6 million increase in goodwill recorded in June 2006 related to the release of one of the Merger transaction escrows to the prior shareholders. Based upon
the present value of projected future cash flows, we recorded an impairment charge of $24.6 million related to goodwill during the three months ended June 30, 2006.

We are assessing the financial impact that the final regulations issued on May 2, 2006 and August 1, 2006 will have on our operations. It is possible that the actual impact may result in recording impairment
charges in future periods as it relates to the carrying value of goodwill and identifiable intangible assets.



17



---

##### Table of Contents

Stock-based Compensation

Effective January 1, 2006, the Company adopted FASB Statement No. 123(R), Share-Based Payment, (FAS 123(R)) using the prospective application transition method. Prior to 2006, the Company
accounted for its equity compensation using the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations (and as
allowed by FASB Statement No. 123, Accounting for Stock-Based Compensation). The Company had previously only adopted the disclosure requirements of FASB Statement No. 123. The pro forma disclosures were presented utilizing
the minimum value methodology as permitted for non-public companies. As permitted by FAS 123(R), the Company will continue to account for equity compensation based shares granted prior to the adoption of FAS 123(R) pursuant to APB Opinion
No. 25, until such time as the shares are modified, canceled or repurchased.

Results of Operations

We have reported our operating results and financial position for all periods subsequent to August 12, 2005, as Successor Periods and all periods prior to
August 12, 2005, as Predecessor Periods.



|                                     |  |                           |         |                         |                  |   |                |  |   |                  |   |  |   |        
|------------------------------------ |  | ------------------------- | ------- | ----------------------- | ---------------- | - | -------------- |  | - | ---------------- | - |  | - | -------
|                                     |  | Three Months EndedJune 30 |         | Six Months EndedJune 30
|                                     |  | Successor 2006            |         |                         | Predecessor 2005 |   | Successor 2006 |  |   | Predecessor 2005
|Net patient service revenue          |  | $                         | 81,258  |                         |                  | $ | 91,538         |  | $ | 168,577          |   |  | $ | 181,575
|Salaries, wages and benefits         |  |                           | 36,283  |                         |                  |   | 37,526         |  |   | 72,351           |   |  |   | 73,359 
|Supplies                             |  |                           | 8,400   |                         |                  |   | 8,445          |  |   | 16,836           |   |  |   | 16,433 
|Rent                                 |  |                           | 4,265   |                         |                  |   | 4,630          |  |   | 8,825            |   |  |   | 9,023  
|Other operating expenses             |  |                           | 19,945  |                         |                  |   | 21,993         |  |   | 40,822           |   |  |   | 41,577 
|Provision for doubtful accounts      |  |                           | 1,447   |                         |                  |   | 1,484          |  |   | 2,962            |   |  |   | 2,981  
|Depreciation and amortization        |  |                           | 2,876   |                         |                  |   | 1,494          |  |   | 5,854            |   |  |   | 2,847  
|Impairment charges                   |  |                           | 24,600  |                         |                  |   |               |  |   | 24,600           |   |  |   |       
|Insurance recovery                   |  |                           | (5,333  | )                       |                  |   |               |  |   | (5,333           | ) |  |   |       
|Interest expense, net                |  |                           | 8,203   |                         |                  |   | 608            |  |   | 16,083           |   |  |   | 1,256  
|Gain on early extinguishment of debt |  |                           |        |                         |                  |   |               |  |   | (1,329           | ) |  |   |       
|                                     |  |                           |         |                         |                  |   |                |  |   |                  |   |  |   |        
|Total expenses                       |  |                           | 100,686 |                         |                  |   | 76,180         |  |   | 181,671          |   |  |   | 147,476
|                                     |  |                           |         |                         |                  |   |                |  |   |                  |   |  |   |        
|Income (loss) before income taxes    |  |                           | (19,428 | )                       |                  |   | 15,358         |  |   | (13,094          | ) |  |   | 34,099 
|                                     |  |                           |         |                        
|Provision for income taxes           |  |                           | 2,181   |                         |                  |   | 6,320          |  |   | 4,724            |   |  |   | 13,355 
|                                     |  |                           |         |                         |                  |   |                |  |   |                  |   |  |   |        
|Net income (loss)                    |  | $                         | (21,609 | )                       |                  | $ | 9,038          |  | $ | (17,818          | ) |  | $ | 20,744 
|                                     |  |                           |         |                         |                  |   |                |  |   |                  |   |  |   |        

Operating Statistics

The following table sets forth operating statistics for each of the periods presented.



|                                                                           |  |                           |        |   |                         |   |        |                |  |   |                  |   |  |   |         |  
|-------------------------------------------------------------------------- |  | ------------------------- | ------ | - | ----------------------- | - | ------ | -------------- |  | - | ---------------- | - |  | - | ------- | -
|                                                                           |  | Three Months EndedJune 30 |        |   | Six Months EndedJune 30 |  
|                                                                           |  | Successor 2006            |        |   | Predecessor 2005        |   |        | Successor 2006 |  |   | Predecessor 2005 |  
|Number of hospitals within hospitals (end of period)                       |  |                           | 12     |   |                         |   | 15     |                |  |   | 12               |   |  |   | 15      |  
|Number of freestanding hospitals (end of period)                           |  |                           | 6      |   |                         |   | 6      |                |  |   | 6                |   |  |   | 6       |  
|Number of total hospitals (end of period)                                  |  |                           | 18     |   |                         |   | 21     |                |  |   | 18               |   |  |   | 21      |  
|Licensed beds (end of period)(1)                                           |  |                           | 893    |   |                         |   | 1,021  |                |  |   | 893              |   |  |   | 1,021   |  
|Average licensed beds(1)                                                   |  |                           | 893    |   |                         |   | 1,021  |                |  |   | 893              |   |  |   | 1,000   |  
|Admissions                                                                 |  |                           | 2,105  |   |                         |   | 2,343  |                |  |   | 4,186            |   |  |   | 4,799   |  
|Patient days                                                               |  |                           | 57,311 |   |                         |   | 62,387 |                |  |   | 115,126          |   |  |   | 125,587 |  
|Occupancy rate                                                             |  |                           | 70.5   | % |                         |   | 67.1   | %              |  |   | 71.2             | % |  |   | 69.4    | %
|Percent net patient service revenue from Medicare                          |  |                           | 71.3   | % |                         |   | 76.5   | %              |  |   | 71.3             | % |  |   | 76.4    | %
|Percent net patient service revenue from commercial payors and Medicaid(2) |  |                           | 28.7   | % |                         |   | 23.5   | %              |  |   | 28.7             | % |  |   | 23.6    | %
|Net patient service revenue per patient day                                |  | $                         | 1,418  |   |                         | $ | 1,467  |                |  | $ | 1,464            |   |  | $ | 1,446   |  

---

|(1) | The licensed beds and end of period and average licensed beds above include the three New Orleans hospitals and 17-bed facility in Milwaukee that were closed during 2005 for the
period of time prior to closure.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The percentage of net patient service revenue from Medicaid is less than one percent for each of the periods presented.
|--- | -----------------------------------------------------------------------------------------------------------------------



18



---

##### Table of Contents

Overview

In
March 2005, we expanded our licensed beds in McAllen, Texas through the addition of a 62-bed freestanding site. In September 2005, we opened a new 39-bed hospital in West Chester, Pennsylvania. This facility became certified by CMS as a LTAC
hospital on April 1, 2006. Additionally, we elected not to renew our lease related to a 17-bed HIH in Milwaukee, Wisconsin effective November 2005.

On August 11, 2005, we consummated the Transactions, including the related financing. We have allocated the purchase price based upon the fair values of the assets acquired and the liabilities assumed.

During the last week of August 2005 we evacuated our three hospitals in New Orleans as a result of Hurricane Katrina. We have not resumed patient service operations
since the evacuation, and will not re-open these hospitals at their previous locations. For the three and six month periods ended June 30, 2006, our New Orleans operations resulted in income before taxes of $4.8 million and $4.1 million,
respectively, as the result of expenses incurred, which were primarily related to salaries and benefits for remaining employees, legal expenses, and asset and record recovery expenses offset by insurance recoveries of $5.3 million. For the same
three and six month periods in 2005, our three New Orleans hospitals had combined net revenues of $10.6 million and $22.4 million, respectively, and earnings before taxes of $2.7 million and $6.1 million, respectively.

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

Net Revenues

Our net patient service revenue decreased by
$10.2 million, or 11.2%, for the three months ended June 30, 2006, to $81.3 million from $91.5 million for the comparable period in 2005. Our net patient service revenues for the three New Orleans hospitals decreased by $10.6 million in 2006 as
compared to 2005 as a result of the closure of these locations. Patient days in 2006 were 5,076 less, or 8.1% less, than the same period in 2005. Our New Orleans hospitals had 7,458 patient days during the three month period ended June 30,
2005.

Exclusive of the decrease in net patient service revenue attributable to the New Orleans market, our net patient service revenue at our other
hospitals increased by $0.4 million in the 2006 period to $81.3 million from $80.9 million during the same period in 2005. This increase was comprised of a $3.4 million favorable benefit from an increase in patient days and a $2.0 million favorable
benefit from an increase in the rate per patient day, offset by a net decrease of $5.0 million for adjustments related to previously filed cost reports. Patient days at our facilities exclusive of New Orleans were 2,382 greater for the three months
ended June 30, 2006 as compared to the same period in 2005. This increase in patient days was partially attributable to the expansion of our operations in the McAllen, Texas and West Chester, Pennsylvania markets as discussed previously.

During the three months ended June 30, 2006, we recorded a reduction in net patient service revenue of $3.4 million whereas during the three months
ended June 30, 2005, we recorded an increase in net patient service revenue of $1.6 million related to changes in estimates and settlements on cost reports filed with the Medicare program. Taken together, these adjustments represent the $5.0
million component of the overall net $0.4 million increase discussed herein. The most significant cost report valuation adjustment recognized during the three months ended June 30, 2006 relates to two of the Companys hospitals. In these cases,
the actual cost to charge ratio, which is used to determine the reimbursement for short stay and high cost outliers, was outside the 10% limit of the cost to charge ratio amount used by CMS to process interim claims such that it resulted in a
reconciliation of payments to the actual cost to charge ratio for these cost report periods.

During the three months ended June 30, 2006, our net
patient service revenue per patient day as reported was $1,418. However, exclusive of the cost report reimbursement adjustment discussed previously, the net patient service revenue per patient day was $1,479, which represented an increase of 2.7%
compared to the same period in 2005, exclusive of the New Orleans operations and the prior year cost report reimbursement adjustment. This increase on a per patient day basis was primarily the result of an increase in the percentage of our revenues
generated from commercial payors and our continued focus on treating higher acuity patients. Net patient service revenues on a per patient day basis from commercial payors are generally higher than those realized from Medicare as a result of the
higher case mix indexes of the commercial patients as compared to our overall Medicare patient population.

Total Expenses

Total expenses increased by $24.5 million to $100.7 million for the three months ended June 30, 2006 as compared to $76.2 million for the comparable period in 2005.
Included in the expenses for the 2006 period is an impairment charge of $24.6 million related to goodwill as discussed previously. For the three months ended June 30, 2006 our New Orleans operations had total expenses of $(4.8) million as
compared to $7.9 million during the same period in 2005. Included in the New Orleans expenses for the three months ended June 30, 2006 is a credit of $5.3 million related to the recording of additional insurance proceeds during this period.
Exclusive of the goodwill impairment charge and net expenses attributable to our New Orleans operations, total expenses increased by $12.5 million to $80.8 million for the three months ended June 30, 2006 from $68.3 million for the three months
ended June 30, 2005.



19



---

##### Table of Contents

Of this $12.5 million increase in total expenses, approximately $7.6 million was attributable to an increase in net
interest expense and $1.4 million was attributable to an increase in depreciation and amortization expense. The increase in net interest expense was the result of the additional borrowings that occurred in connection with the Transactions during
2005. Depreciation and amortization expense increased during the three month period ended June 30, 2006 primarily due to an increase in depreciation expense as a result of adjusting property and equipment to fair market value as of the date of
the Transactions and amortization expense recorded on the identifiable intangible assets established as a result of the Transactions.

The remaining $3.5
million of the total $12.5 million increase was the result of a combination of the increase in patient days of 2,382 discussed previously, and increases in salaries, wages and benefits, supplies, outside services and contract labor expenses incurred
as the result of inflationary increases and the overall increase in patient acuity during the 2006 period as compared to the same period in 2005.

Income Tax Expense

For the three months ended June 30, 2006, the income tax expense recorded represented an effective rate of
42.2%, excluding the $24.6 million impairment charge, as compared to an effective rate of 41.2% for the same period in 2005. The effective rate in 2006 was higher primarily as a result of an increase in effective state income tax rates as increased
interest expense is generally considered a parent company expense resulting in losses in certain states that do not benefit other states with income.

Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Net Revenues

Our net patient service revenue decreased by $13.0 million, or 7.2%, for the six months ended June 30, 2006, to $168.6 million from $181.6
million for the comparable period in 2005. Our net patient service revenues for the three New Orleans hospitals decreased by $22.4 million in 2006 as compared to 2005 as a result of the closure of these locations. Patient days in 2006 were 10,461
less, or 8.3% less, than the same period in 2005. Our New Orleans hospitals had 16,025 patient days during the six month period ended June 30, 2005.

Exclusive of the decrease in net patient service revenue attributable to the New Orleans market, our net patient service revenue at our other hospitals increased by $9.4 million in the 2006 period to $168.6 million from $159.2 million
during the same period in 2005. This increase was comprised of a $8.0 million favorable benefit from an increase in patient days and a $6.1 million favorable benefit from increased rate per patient day, offset by a net decrease of $4.7 million for
adjustments related to previously filed cost reports. Patient days at our facilities exclusive of New Orleans were 5,564 greater for the six months ended June 30, 2006 as compared to the same period in 2005. This increase in patient days was
partially attributable to the expansion of our operations in the McAllen, Texas and West Chester, Pennsylvania markets as discussed previously.

During the
six months ended June 30, 2006, we recorded a reduction in net patient service revenue of $3.4 million whereas during the six months ended June 30, 2005, we recorded an increase in net patient service revenue of $1.3 million related to
changes in estimates and settlements on cost reports filed with the Medicare program. Taken together, these adjustments represent the $4.7 million component of the overall net $9.4 million increase discussed herein. The most significant cost report
valuation adjustment recognized during the six months ended June 30, 2006 relates to two of the Companys hospitals. In these cases, the actual cost to charge ratio, which is used to determine the reimbursement for short stay and high cost
outliers, was outside the 10% limit of the cost to charge ratio amount used by CMS to process interim claims such that it resulted in a reconciliation of payments to the actual cost to charge ratio for these cost report periods.

During the six months ended June 30, 2006, our net patient service revenue per patient day as reported was $1,464. However, exclusive of the cost report
reimbursement adjustment discussed previously, the net patient service revenue per patient day was $1,495, which represented an increase of 4.0% compared to the same period in 2005, exclusive of the New Orleans operations and the prior year cost
report reimbursement adjustment. This increase on a per patient day basis was primarily the result of an increase in the percentage of our revenues generated from commercial payors and our continued focus on treating higher acuity patients.

Total Expenses

Total expenses increased by
$34.2 million to $181.7 million for the six months ended June 30, 2006 as compared to $147.5 million for the comparable period in 2005. Included in the expenses for the 2006 period is an impairment charge of $24.6 million related to goodwill as
discussed previously and a gain of $1.3 million related to the early extinguishment of debt. For the six months ended June 30, 2006 our New Orleans operations had total expenses of $(4.1) million as compared to $16.3 million during the same
period in 2005. Included in the New Orleans expenses for the six months ended June 30, 2006 is a credit of $5.3 million related to the recording of additional insurance proceeds during this period. Exclusive of the goodwill impairment charge,
the gain on early extinguishment of debt and net expenses attributable to our New Orleans operations, total expenses increased by $31.3 million to $162.5 million for the six months ended June 30, 2006 from $131.2 million for the six months
ended June 30, 2005.



20



---

##### Table of Contents

Of this $31.3 million increase in total expenses, approximately $14.8 million was attributable to an increase in net
interest expense and $3.0 million was attributable to an increase in depreciation and amortization expense. The increase in net interest expense was the result of the additional borrowings that occurred in connection with the Transactions during
2005. Depreciation and amortization expense increased during the three month period ended June 30, 2006 primarily due to an increase in depreciation expense as a result of adjusting property and equipment to fair market value as of the date of
the Transactions and amortization expense recorded on the identifiable intangible assets established as a result of the Transactions.

The remaining $13.5
million of the total $31.3 million increase was the result of a combination of the increase in patient days of 5,564 discussed previously, and increases in salaries, wages and benefits, supplies, outside services and contract labor expenses incurred
as the result of inflationary increases and the overall increase in patient acuity during the 2006 period as compared to the same period in 2005.

Gain on
early extinguishment of debt for the six months ended June 30, 2006 was the result of our repurchasing $3 million in face of our senior subordinated notes for an amount approximating $1.5 million. Partially offsetting the gain was the write-off
of capitalized financing cost of $0.1 million recorded in connection with the retirement of these senior subordinated notes.

Income Tax Expense

For the six months ended June 30, 2006, the income tax expense recorded represented an annual effective rate of 41.1%, excluding the impact of
the $24.6 million impairment charge, as compared to an effective rate of 39.2% for the same period in 2005. As discussed previously, the effective rate in 2006 was higher primarily as a result of an increase in effective state income tax rates as
increased interest expense is generally considered a parent company expense resulting in losses in certain states that do not benefit other states with income.

Liquidity and Capital Resources

Historically our primary sources of liquidity have been cash flows generated by operations and borrowings
under a revolving credit facility. Following the Transactions, we expect that our primary sources of liquidity will continue to be cash flow generated from operations and the availability under our revolving credit facility. Our primary liquidity
requirements will be for debt service on our senior secured credit facilities and the notes, capital expenditures and working capital.

At June 30,
2006, our debt structure consisted of $147.0 million aggregate principal amount of senior subordinated notes, a senior secured credit facility, consisting of (i) a $253.1 million term loan facility with a maturity of seven years,
(ii) capital lease obligations of $7.2 million with varying maturities, and (iii) a $75.0 million revolving credit facility, including sub-facilities for letters of credit and swingline loans, with a maturity of six years. The full amount
available under the term loan facility was used in connection with the Transactions. During the six months ended June 30, 2006 we repurchased $3 million face value of our senior subordinated notes for approximately $1.5 million. Accordingly, we
recorded a gain on early extinguishment of debt, net of write-off of capitalized financing costs, of approximately $1.3 million during this period.

After
the Transactions, we are significantly more leveraged than we were prior to the Transactions. The interest rates per annum applicable to loans, other than swingline loans, under our senior secured credit facility are, at our option, equal to either
an alternate base rate or an adjusted LIBOR rate for a one-, two-, three- or six-month interest period, or a nine- or twelve-month period if available, in each case, plus an applicable margin. The applicable margins on the loans are currently
(1) 1.25% for alternate base rate revolving loans, (2) 2.25% for adjusted LIBOR revolving loans, (3) 1.25% for alternate base rate term loans and (4) 2.25% for adjusted LIBOR term loans. These margins are subject to reduction
beginning after delivery of financial statements for the first full fiscal quarter completed after closing based upon the ratio of our total indebtedness to our consolidated adjusted EBITDA (as defined in the credit agreement governing our senior
secured credit facility). At June 30, 2006, the interest rate applicable to the $253.1 million under our term loan facility was 7.34%.

We believe
that our cash on hand, internally generated cash flows and borrowings under the revolving portion of our senior secured credit facilities will be sufficient to finance our operations, capital expenditure needs and meet our debt service requirements
for at least the next twelve months.

Capital Expenditures

We anticipate that we may incur capital expenditures of approximately $25 million during the remainder of 2006 based on our current plans. These expenditures will relate to the transition plans for facilities affected
by the new 25% host hospital admission threshold regulations, market expansion opportunities, investment in information technology enhancements, and facility maintenance requirements.



21



---

##### Table of Contents

Historical Cash Flow

Six Months Ended June 30, 2006 and 2005



|                                          |  |                         |        |   |                  |   |        |  
|----------------------------------------- |  | ----------------------- | ------ | - | ---------------- | - | ------ | -
|                                          |  | Six Months EndedJune 30 |       
|                                          |  | Successor 2006          |        |   | Predecessor 2005 |  
|Net cash provided by operating activities |  | $                       | 26,812 |   |                  | $ | 25,475 |  
|Net cash used in investing activities     |  |                         | (9,100 | ) |                  |   | (1,253 | )
|Net cash used in financing activities     |  |                         | (5,697 | ) |                  |   | (2,979 | )

For the six months ended June 30, 2006, operating activities provided $26.8 million of cash as compared to
providing $25.5 million in cash for the comparable period in 2005. For the six-months ended June 30, 2006, we had a net loss of $(17.8) million as compared to net income of $20.7 million for the same period in 2005. Excluding the $24.6 million
impairment charge recorded in the six months ended June 30, 2006, net income would have been approximately $6.8 million for the period then ended. Offsetting the lower net income amount for the six months ended June 30, 2006 was the
receipt of $12.4 million related to a refund of 2005 federal income payments. This tax benefit was the result of expenses recorded related to the Transactions during the year ended December 31, 2005. Additionally, during the six months ended
June 30, 2006, we received $7.0 million in business interruption proceeds that were recorded as a receivable at December 31, 2005 as a result of the impact of Hurricane Katrina on our New Orleans operations. Also, net income is lower in
the 2006 period due to an increase in net interest expense of $14.8 million related to indebtedness incurred to finance the Transactions and an increase of $3.0 million in depreciation and amortization expense primarily due to the write-up of
property and equipment and the recording of identifiable intangibles in connection with the Transactions and debt issue costs.

Accounts receivable
increased by $0.3 million for the six months ended June 30, 2006 as compared to an increase of $8.7 million for same period during 2005. Days of net patient service revenue in accounts receivable at June 30, 2006 had decreased to 67.2 as
compared to 73.6 at December 31, 2005. This decrease is the result of continued increased collections during the six months ended June 30, 2006, subsequent to the relocation of our central business office operations to Texas.

A decrease in accounts payable and accrued expense resulted in a net use of cash of $2.1 million for the six months ended June 30, 2006 as compared to providing
$8.8 million in the comparable period in 2005. This decrease is primarily the result of the timing of interest payments on the senior subordinated notes, which approximated $7 million during the six months ended June 30, 2006. Interest payments
on the senior subordinated notes are paid semi-annually on the 15thof February and August.

Cash used in investing activities was $9.1 million for the six months ended June 30, 2006 as compared to $1.3 million in 2005. During the six months ended
June 30, 2005, equipment purchased through capital lease financing was $4.7 million. During the six months ended June 30, 2006, we funded all equipment purchases using our available cash on hand and we used $4.5 million to purchase the
land for the location of our new free-standing facility in the Milwaukee, WI market.

Cash used by financing activities for the three months ended
June 30, 2006 was $5.7 million as compared to cash used of $3.0 million for the same period in 2005. Included in the $5.7 million for the 2006 period was $1.5 million that was used to repurchase $3 million in face value of our senior
subordinated notes.

Seasonality

Our business
experiences seasonality resulting in variation in census levels, with the highest census historically occurring in the first quarter of the year and the lowest census occurring in the third quarter of the year.

Inflation

We derive a substantial portion of our revenue from the
Medicare program. LTACH PPS payments are subject to fixed payments that generally are adjusted annually for inflation. However, there can be no assurance that these adjustments, if received, will reflect the actual increase in our costs for
providing healthcare services. As discussed previously, the final rules issued by CMS for LTACHs for the 2007 fiscal year did not provide for an inflation update.



22



---

##### Table of Contents

Labor and supply expenses make up a substantial portion of our operating expense structure. The expenses can be subject
to increase in periods of rising inflation. To date, we have been able to offset such increases with corresponding increases in reimbursement and the implementation of cost control measures. There can, however, be no assurance that we will be
successful in offsetting future cost increases.

Forward Looking Statements

This quarterly report contains forward-looking statements regarding, among other things, our financial condition, results of operations, plans, objectives, future performance and business. All statements contained in
this document other than historical information are forward-looking statements. Forward-looking statements include, but are not limited to, statements that represent our beliefs concerning future operations, strategies, financial results or other
developments, and contain words and phrases such as may, expects, believes, anticipates, estimates, should, or similar expressions. Because these forward-looking statements are
based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different. Although we believe
that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, we cannot assure you that we will achieve or realize these plans, intentions or expectations. Forward-looking statements are
inherently subject to risks, uncertainties and assumptions. Important factors that could cause actual results to differ materially from the forward-looking statements include, but are not limited to:



| |  |  | changes in government reimbursement for our services or new restrictive criteria regarding the types of patients that may be admitted to our facilities may have an adverse effect on
our future revenues and profitability;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in applicable regulations or a government investigation or assertion that we have violated applicable regulations may result in increased costs or sanctions that reduce our
revenues and profitability;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | actions that may be brought by individuals on the governments behalf under the False Claims Acts qui tam or whistleblower provisions may expose us to
unforeseen liabilities;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | compliance with the Medicare hospital within a hospital regulation changes that will require increased capital expenditures and may have an adverse effect on our future
revenues and profitability;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the failure of our long-term acute care hospitals to maintain their qualification as such may cause our revenues and profitability to decline;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the failure of our facilities operated as hospitals within hospitals to qualify as hospitals separate from their host hospitals may cause our revenues and profitability
to decline;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the adoption by Medicare of new payment methods for long-term acute care hospitals may cause our revenues and profitability to decline;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the failure of our satellite facilities to qualify for provider-based status with the applicable main facilities may adversely affect our results of
operations;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | implementation of new information systems to comply with federal and state initiatives relating to patient privacy, security of medical information and electronic transactions may
result in increased costs;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | implementing accounting and other management systems and resources in response to financial reporting and other requirements may result in increased costs;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | integration of recently acquired operations and future acquisitions may prove difficult or unsuccessful, use significant resources or expose us to unforeseen liabilities;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | private third-party payors for our services may undertake future cost containment initiatives that limit our future revenues and profitability;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the failure to maintain established relationships with the physicians in our markets could reduce our revenues and profitability;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | shortages in qualified nurses or therapists could increase our operating costs significantly;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | competition may limit our ability to grow and result in a decrease in our revenues and profitability;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | the loss of key members of our management team could significantly disrupt our operations;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | the geographic concentration of our facilities in Texas may make us sensitive to economic, regulatory, environmental and other developments in this state;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the effect of legal actions asserted against us or lack of adequate available insurance could subject us to substantial uninsured liabilities; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | protecting current and former employees from the effects of misappropriated data may use significant resources or subject us to liabilities.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



23



---

##### Table of Contents

Consequently, such forward-looking statements should be regarded solely as our current plans, estimates and beliefs. We
do not intend, and do not undertake, any obligation to update any forward-looking statements to reflect future events or circumstances after the date of this report.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At June 30, 2006, we had $253.1 million in senior
term loans outstanding and borrowing availability of $75.0 million under our revolving credit facility, each bearing interest at variable rates. Each 0.125% point change in interest rates would result in a $0.4 million annual change in interest
expense on our term loans and revolving credit facility loans, assuming that our revolving credit facility is fully drawn. Pursuant to our senior term loan credit agreement we were required to enter into an interest rate Swap Agreement that would
provide protection against fluctuations in interest rates on a notional amount of $12 million. On November 9, 2005, we entered into such an agreement for a three year period. This agreement will cap the LIBOR rate used to compute interest on
the notional amount of our senior term loan at six percent per annum. In the future, we may enter into additional interest rate swaps, involving exchange of floating for fixed rate interest payments, to reduce interest rate volatility.

ITEM 4: CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our
principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of the end of the period
covered in this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures provide reasonable assurance that material information required to be included in
our periodic SEC reports is recorded, processed, summarized and reported within the time periods specified in the relevant SEC rules and forms.

In
addition, we reviewed our internal controls, and there have been no significant changes in our internal controls or in other factors that could significantly affect those controls in the first quarter.

PART II: OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

The Company is a party to various legal actions that arise in the ordinary course of business,
as well as other litigation described elsewhere in this report. These actions are primarily related to malpractice claims covered under insurance policies; however, there may be some legal actions which are not insured. The Company is unable to
predict the ultimate outcome of pending litigation and regulatory and other government investigations, nor can there be any assurance that the resolution of any litigation or investigation, either individually or in the aggregate, would not have a
material adverse effect on the Companys financial position, results of operations or liquidity.

ITEM 6: EXHIBITS

The exhibits to this report are listed in the Exhibit Index appearing on page 31 hereof.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.



LifeCare Holdings, Inc.By:

/s/ W. EARL REED, IIIW. Earl Reed, IIIChief Executive OfficerBy:

/s/ PHILLIP B. DOUGLASPhillip B. DouglasChief Financial Officer


Dated: August 14, 2006



24



---

##### Table of Contents

EXHIBIT INDEX



|        |  |                                                                                                                                                                               
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                                                                                   
|        | 
|31.1    |  | Certification of Chief Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|        | 
|31.2    |  | Certification of Chief Financial Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|        | 
|32.1    |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                            
|        | 
|32.2    |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                            



25