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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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 March 31, 2010

or

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

Commission File Number 001-16817

FIVE STAR QUALITY CARE, INC.

(Exact Name of Registrant as Specified in Its Charter)

400 Centre Street, Newton, Massachusetts 02458

(Address of Principal Executive Offices) (Zip Code)

(Registrant’s Telephone Number, Including Area Code): 617-796-8387

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filed”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

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

Number of registrant’s shares of common stock, $0.01 par value, outstanding as of May 3, 2010: 35,668,814.

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FIVE STAR QUALITY CARE, INC.

FORM 10-Q

MARCH 31, 2010

INDEX

As used herein the terms “we”, “us”, “our” and “Five Star” include Five Star Quality Care, Inc. and its consolidated subsidiaries unless otherwise expressly stated or the context otherwise requires.

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Part I.    Financial Information

Item 1.  Condensed Consolidated Financial Statements

FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(in thousands, except share data)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF INCOME

(in thousands, except per share data)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

Note 1.  Basis of Presentation and Organization

The accompanying condensed consolidated financial statements of Five Star Quality Care, Inc. and its subsidiaries, which we refer to as the Company, we, us and our, have been prepared without audit.  Certain information and disclosures required by U.S. generally accepted accounting principles, or GAAP, for complete financial statements have been condensed or omitted.  We believe the disclosures made are adequate to make the information presented not misleading.  However, the accompanying financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2009.  In the opinion of our management, all adjustments, which include only normal recurring adjustments, considered necessary for a fair presentation have been included.  All material intercompany transactions and balances have been eliminated.  Our operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.  For discussion of our liquidity and capital resources see Item 2 of this quarterly report. Reclassifications have been made to the prior year’s financial statements to conform to the current year’s presentation.  Material changes are limited to presenting accrued self insurance obligations separately from other current liabilities and presenting community fees separately from other long term liabilities.  These reclassifications had no effect on net income or shareholders’ equity.

We operate senior living communities, including independent communities, assisted living facilities and skilled nursing facilities, or SNFs.  As of March 31, 2010, we leased or owned and operated 217 senior living communities containing 22,878 living units, including 170 primarily independent and assisted living communities with 18,638 living units and 47 SNFs with 4,240 living units.

Of our 170 primarily independent and assisted living communities, we:

·                  leased 143 communities containing 16,466 living units from Senior Housing Properties Trust, or SNH, our former parent;

·                  leased four communities with 200 living units from Health Care Property Investors, or HCPI; and

·                  owned 23 communities with 1,972 living units.

Of our 47 SNFs, we:

·                  leased 45 facilities with 3,969 living units from SNH; and

·                  owned two facilities with 271 living units.

In aggregate, our 217 senior living communities included 6,315 independent living apartments, 10,374 assisted living suites and 6,189 skilled nursing units.  Excluded from the preceding data are two assisted living communities containing 173 living units leased from SNH that we have classified as discontinued operations.

We also operate two rehabilitation hospitals with 321 beds that we lease from SNH.  Our two rehabilitation hospitals provide inpatient services at the two hospitals and three satellite locations.  In addition, we operate 13 outpatient clinics affiliated with these rehabilitation hospitals.  We also own and operate six institutional pharmacies.

Note 2. Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board, or FASB, issued an accounting standards update requiring additional disclosures regarding fair value measurements. The update requires reporting entities to disclose additional information regarding assets and liabilities that are transferred between levels within the fair value hierarchy. The update also clarifies the level of disaggregation at which fair value disclosures should be made and the requirements to disclose information about the valuation techniques and inputs used in estimating Level 2 and

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

Level 3 fair values. The update is effective for interim and annual reporting periods beginning after December 15, 2009 except for the requirement to separately disclose purchases, sales, issuances and settlements in the Level 3 roll forward that becomes effective for fiscal periods beginning after December 15, 2010.

In February, the FASB issued an update to the disclosure requirements relating to subsequent events to exclude the requirement to disclose the date through which an entity has evaluated subsequent events and whether that date represents the date the financial statements were issued or available to be issued.

The adoption of these updates does not, and is not expected to, cause any material changes to the disclosures in our condensed consolidated financial statements.

Note 3. Property and Equipment

Property and equipment, at cost, consists of the following:

As of March 31, 2010 and December 31, 2009, we had assets of $7,371 and $6,944, respectively, included in our property and equipment that we intend to sell to SNH as permitted by our leases.

Note 4. Comprehensive Income

Comprehensive income for the three months ended March 31, 2010 and 2009 is summarized below:

Note 5.  Financial Data by Segment

Our reportable segments consist of our senior living community business and our rehabilitation hospital business.   In the senior living community segment, we operate independent communities, assisted living facilities and SNFs, which are subject to centralized oversight functions and provide housing and services generally to elderly customers.  Our rehabilitation hospital segment provides inpatient rehabilitation services at two hospital locations and three satellite locations and outpatient rehabilitation services at 13 affiliated outpatient clinics.  We do not consider our institutional pharmacy operations to be a material, separately reportable segment of our business, but we report our institutional pharmacy revenues and expenses as separate items within our corporate and other activities.  All of our

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

operations and assets are located in the United States, except for our captive insurance company, which participates in our workers’ compensation and liability insurance programs and is located in the Cayman Islands.

We use segment operating profit as a means to evaluate our performance and for our business decision making purposes.  Segment operating profit excludes interest and other income, interest and other expense, and certain corporate expenses.

Our revenues by segments and a reconciliation of segment operating profit (loss) to income (loss) from continuing operations for the three months ended March 31, 2010 and 2009 are as follows:

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

(1)            Corporate and Other includes operations that we do not consider significant, separately reportable segments of our business, as well as income and expenses that are not attributable to a specific segment.

(2)            General and administrative expenses are not attributable to a specific segment and include items such as corporate payroll and benefits and contractual service expenses affecting home office activities.

Note 6. Goodwill, Other Intangible and Long Lived Assets

The changes in the carrying amount of goodwill and other intangible assets as of March 31, 2010 and 2009 are as follows:

(1)          Goodwill and other intangible assets in our senior living communities relate to management agreements and                           trademarks we acquired in connection with one of the leases we initiated with SNH in 2009 and goodwill we recorded with our senior living community acquisitions in previous years.

(2)          Intangible assets in our corporate and other segment relate to the cost of customer agreements we acquired with our pharmacy acquisitions.

Note 7.  Income Taxes

Because we have historically reported losses, we do not currently recognize the benefit of all of our deferred tax assets, including tax loss carry forwards that may be used to offset future taxable income.  We will, however, continue to assess our ability to generate sufficient taxable income during future periods in which our deferred tax assets may be realized.  When we believe that we will more likely than not realize the benefit of our deferred tax assets, we will record deferred tax assets as an income tax benefit in our consolidated statement of income, which will affect our results of operations.  As of December 31, 2009, our federal net operating loss carry forward was approximately $117,602.  Our net operating loss carry forwards, which begin to expire in 2024 if unused, are subject to audit and adjustment by the Internal Revenue Service.

For the three months ended March 31, 2010, we recognized tax expenses of $493, which primarily represents tax expense for state taxes that are payable without regard to our tax loss carry forwards.

Note 8.  Earnings Per Share

We computed basic earnings per share, or EPS, for the three months ended March 31, 2010 and 2009 using the weighted average number of shares outstanding during the periods.  Diluted EPS for the periods ended March 31, 2010 and 2009, reflects additional common shares, related to our convertible senior notes, that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income applicable to common shareholders that would result from their assumed issuance.  The weighted average shares outstanding used to calculate basic and diluted EPS include approximately 436,010 and 398,020 unvested shares as of March 31,

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

2010 and 2009, respectively, issued to our officers and others under our 2001 Stock Option and Stock Incentive Plan.

The following table provides a reconciliation of income (loss) from continuing and discontinued operations and the number of common shares used in the computations of diluted EPS:

Note 9.  Fair Values of Assets and Liabilities

The table below presents the assets and liabilities measured at fair value at March 31, 2010, categorized by the level of inputs used in the valuation of each asset.

(1) Long lived assets held for sale consist of property and equipment we expect to sell to SNH as permitted by our leases.  We determined that these asset costs approximate fair value since we have either recently acquired the assets or the assets are part of ongoing construction projects and we expect to sell these assets to SNH at their recorded value.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

(2) Our investments in trading securities consist of auction rate securities, or ARS, which are primarily bonds issued by various entities to fund student loans pursuant to the Federal Family Education Loan Program.  Due to events in the credit markets, auctions for our ARS failed starting in the first quarter of 2008 and there is currently no market, or a very illiquid market, in which we might sell these securities.  We measured the fair value of these securities by reference to a statement provided by UBS AG, or UBS, that was calculated with the assistance of a valuation model.  This model considered, among other items, the collateral underlying the investments, the creditworthiness of the counterparty, the timing of expected future cash flows including possible refinancing of the securities and a determination of the appropriate discount rate.  The analysis also included a comparison, when possible, to observable market data of securities with characteristics similar to our ARS.  We reviewed the components of, and calculations made under, UBS’s model.  Due to the changes in fair value for our ARS for the three months ended March 31, 2010 and 2009, we have recorded an unrealized gain of $669 and $3,516, respectively. We have entered a settlement agreement with UBS related to our investment in ARS.  Pursuant to this agreement we have the right to require UBS to acquire our ARS at par value on or about June 30, 2010, or the UBS Put Right.  We expect to exercise the UBS Put Right on or about June 30, 2010.

(3) We valued the UBS Put Right by taking into consideration the fair value of our ARS, the amounts outstanding on our loan with UBS and a factor representing our credit party risk with UBS.  The largest risk associated with the UBS Put Right is the continued financial solvency of UBS. The value of the UBS Put Right typically fluctuates inversely with the value of the ARS that we hold.  The increase in value of our ARS for the three months ended March 31, 2010 caused an unrealized loss of $670 in the value of the UBS Put Right.  We elected the fair value option since we expect that, other than changes in UBS’s credit default swap rate and our borrowings on the UBS non-recourse credit facility, the changes in fair value of the UBS Put Right will be offset by the fair value change in the ARS.  We include the UBS Put Right in current assets because we expect to exercise the UBS Put Right on or about June 30, 2010.

(4) Investments in available for sale securities are carried at fair value utilizing quoted market prices with changes in fair value recorded in other comprehensive income and have an amortized cost of $12,518 as of March 31, 2010 and December 31, 2009.

When a change in fair value of available for sale securities is deemed temporary, we record a corresponding credit or charge to other comprehensive income for any unrealized gains or losses.  As of March 31, 2010 and 2009, these securities had unrealized gains of $5,596 and $227 and unrealized losses of $13 and $741, respectively.  If we determine that a valuation adjustment results in an “other than temporary impairment”, we would record a charge to earnings.  We determine the estimated fair value of our available for sale investments by reviewing the current market price, the ratings of the security, the financial condition of the obligor and our intent and ability to retain the investment during temporary market price fluctuations or until maturity.  In evaluating the factors described above, we presume a decline in value to be an “other than temporary impairment” if the quoted market price of the security is below the investment’s cost basis for an extended period.  However, the presumption may be overcome if there is persuasive evidence indicating the decline is temporary in nature, such as if the operating performance of the obligor is strong or the market price of the security is historically volatile.  During the three months ended March 31, 2009, we recorded an “other than temporary impairment” of $2,947, due to economic conditions at that time involving the companies that issued the securities we held.  Unrealized gains earned on our available for sale investments are recorded in other comprehensive income for the current period and will be recorded in the statement of income when the investments are sold.  At March 31, 2010, four of the securities we hold are in a loss position that has ranged from one to 39 months and have accumulated losses of $13.  We consider these investments temporarily impaired since we believe we have the ability, and maintain our intent, to hold these investments until recovery of their market value occurs.

The table below presents the change in fair value measurements that used Level 3 inputs for the three months ended March 31, 2010:

There were no transfers into or out of securities valued using Level 3 inputs during the periods.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

Our financial instruments are limited to cash and cash equivalents, accounts receivable, trading and available for sale securities, accounts payable, mortgage notes payable, the UBS Put Right and our convertible senior notes due in 2026, or the Notes.  As of March 31, 2010 we believe that the fair values of our current financial instruments approximate their reported carrying amounts.

The carrying values and fair values of non-current financial instruments are shown in the following table.

(1) The carrying value of our restricted cash and investments and our mortgage notes payable approximate fair value.

(2) We measured the fair value of our equity investment in Affiliates Insurance Company, or Affiliates Insurance, by considering, among other things, the individual assets and liabilities held by Affiliates Insurance, Affiliates Insurance’s overall financial condition and earning trends, and the financial condition and prospects for the insurance industry generally.

(3) We estimate the fair value of our Notes using quoted market data for these securities.

Note 10.  Indebtedness

On March 18, 2010, we entered into a $35,000 revolving line of credit and security agreement, or our Credit Agreement, to replace our prior $40,000 revolving line of credit that was scheduled to expire in May 2010.  Our Credit Agreement terminates on March 18, 2013, when all amounts outstanding thereunder are due. Borrowings under our Credit Agreement are available for acquisitions, working capital and general business purposes.  Funds available under our Credit Agreement may be drawn, repaid and redrawn until maturity and no principal payment is due until maturity.  We borrow in U.S. dollars and borrowings under our Credit Agreement bear interest at LIBOR (with a floor of 2% per annum) plus 400 basis points.  We are the borrower under our Credit Agreement and certain of our subsidiaries guarantee our obligations under our Credit Agreement, which is secured by our and our guarantor subsidiaries’ accounts receivable and related collateral. Our Credit Agreement contains covenants requiring us to maintain certain financial ratios, places limits on our ability to incur or assume debt or create liens with respect to certain of our properties and has other customary provisions. Our Credit Agreement also provides for acceleration of payment of all amounts payable under our Credit Agreement upon the occurrence and continuation of certain events of default.  As of March 31, 2010 and May 3, 2010, no amounts were outstanding and $35,000 was available to be borrowed under our Credit Agreement. As of March 31, 2010 and May 3, 2010, we believe we are in compliance with all applicable covenants under our Credit Agreement. Interest expense and other associated costs related to our Credit Agreement and our prior revolving line of credit were $63 and $39 for the three months ended March 31, 2010 and 2009, respectively.

Pursuant to our settlement agreement with UBS, we have a non-recourse credit facility with UBS which is available for acquisitions, working capital and general business purposes. The amount we are able to borrow at any time is 75% of the market value of the ARS which are collateral for the facility; accordingly, the amount available to be

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

borrowed may vary over time. The interest rate under this credit facility also varies depending on the interest payable to us on the ARS, but will not exceed LIBOR plus 125 basis points.  As of March 31, 2010 and May 3, 2010, we had $36,348 and $33,253 outstanding under this credit facility, respectively, and approximately $9,087 and $12,145 available to be borrowed as of March 31, 2010 and May 3, 2010, respectively.  As of March 31, 2010 and May 3, 2010, we believe we are in compliance with all applicable covenants under this revolving credit facility. Interest expense and other associated costs related to this facility were $56 and $69 for the three months ended March 31, 2010 and 2009, respectively.

At March 31, 2010, we had $49,707 principal amount of the Notes outstanding, that were issued pursuant to an indenture in October 2006.  These Notes bear interest at a rate of 3.75% per annum, payable semi-annually in arrears on April 15 and October 15 of each year.  These Notes are convertible into our common shares at any time.  The initial conversion rate, which is subject to adjustment, is 76.9231 common shares per $1 principal amount of the Notes, which represents an initial conversion price of $13.00 per share.  The Notes are guaranteed by certain of our wholly owned subsidiaries.  These Notes mature on October 15, 2026.  We may prepay the Notes at any time after October 20, 2011 and the Note holders may require that we purchase some or all of these Notes on October 15 of each of 2013, 2016 and 2021.  If a “fundamental change”, as defined in the indenture governing the Notes, occurs, holders of the Notes may require us to repurchase all or a portion of their Notes for cash at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus any accrued and unpaid interest and, in certain circumstances, plus a make whole premium as defined in the indenture governing the Notes.  Interest expense and other associated costs on the outstanding Notes were $454 and $871 for the three months ended March 31, 2010 and 2009, respectively.  As of March 31, 2010 and May 3, 2010, we believe we are in compliance with all applicable covenants of this indenture.

During the three months ended March 31, 2009, we purchased and retired $46,500 par value of our outstanding Notes that we had purchased for $20,000, plus accrued interest.  As a result of these purchases we recorded a gain on extinguishment of debt of $25,125, net of related unamortized costs.

At March 31, 2010, three of our communities were encumbered by United States Department of Housing and Urban Development, or HUD, insured mortgage debts totaling $12,403 that contain standard HUD mortgage covenants.  The weighted average interest rate on these loans was 6.23%.  Payments of principal and interest are due monthly until maturities at varying dates ranging from June 2035 to July 2043.  Mortgage interest expense, including premium amortization, under these debts was $199 and $202 for the three months ended March 31, 2010 and 2009, respectively.

Note 11. Off Balance Sheet Arrangements

As of March 31, 2010, we had no off balance sheet arrangements, commercial paper, derivatives, swaps, hedges, third party guarantees, material joint ventures or partnerships, except for the pledge of certain of our assets (e.g., accounts receivable) with a carrying value of $11,434 arising from our operation of 28 properties owned by SNH and leased to us to secure SNH’s borrowings from the Federal National Mortgage Association pursuant to a lease realignment agreement we entered into with SNH in August 2009.

Note 12. Related Person Transactions

During the three months ended March 31, 2010 and 2009 we recorded rent expense of $46,896 and $43,747, respectively, under our leases with SNH.  During the three months ended March 31, 2010, pursuant to the terms of our leases with SNH, SNH purchased $6,179 of improvements made to our properties leased from SNH, and, as a result, our annual rent payable to SNH increased by approximately $495.

As of March 31, 2010, we have invested $5,154 in Affiliates Insurance, concurrently with RMR and other companies to which RMR provides management services.  All of our directors are currently serving on the board of directors of Affiliates Insurance.  At March 31, 2010, we owned approximately 14.29% of Affiliates Insurance.  Although we own less than 20% of Affiliates Insurance, we use the equity method to account for this investment

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

because we believe that we have significant influence over Affiliates Insurance because each of our directors is a director of Affiliates Insurance.  This investment had a carrying value of $4,992 and $5,000 as of March 31, 2010 and December 31, 2009, respectively.  During the first quarter of 2010, we recognized a loss of $28 related to this investment.

We were formerly a 100% owned subsidiary of SNH.  RMR provides management services to both us and SNH.  One of our Managing Directors is also a Managing Trustee of SNH and the majority owner of RMR.  For more information about our dealings with our Managing Directors, SNH, RMR, and their affiliates, including Affiliates Insurance, and about the risks which may arise as a result of these related person transactions, please see our Annual Report on Form 10-K for the year ended December 31, 2009.

Note 13.  Discontinued Operations

In March 2007, we agreed with SNH that it should sell two assisted living communities in Pennsylvania, which we lease from SNH.  We and SNH are in the process of selling these assisted living communities and, if they are sold, our annual minimum rent payable to SNH will decrease by 9.0% of the net proceeds of the sale to SNH, in accordance with the terms of our lease with SNH.

In December 2007, we decided to sell one institutional pharmacy located in California and our mail order pharmacy located in Nebraska.  We sold the institutional pharmacy in two separate transactions in the six months ended June 30, 2009, which resulted in a gain on sale of $1,226.  We were unable to sell the mail order pharmacy on acceptable terms and we ceased its operations on March 31, 2009.

We have reclassified the consolidated statement of income for all periods presented to show the results of operations of the communities and pharmacies which have been sold or are expected to be sold as discontinued.  Below is a summary of the operating results of these discontinued operations included in the financial statements for the three months ended March 31, 2010 and 2009:

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Item 2. Management’s Discussion and Analysis of Financial Conditions and Results of Operation

RESULTS OF OPERATIONS

Our reportable segments consist of our senior living community business and our rehabilitation hospital business.   In the senior living community segment, we operate independent communities, assisted living facilities and SNFs.  Our rehabilitation hospital segment provides inpatient rehabilitation services at two hospital locations and three satellite locations and outpatient rehabilitation services at 13 outpatient clinics.  We do not consider our institutional pharmacy operations to be a material, separately reportable segment of our business, but we report our institutional pharmacy revenues and expense as separate items within our corporate and other activities.  All of our operations and assets are located in the United States, except for our captive insurance company, which participates in our workers’ compensation and liability insurance programs and is located in the Cayman Islands.

We use segment operating profit as an important measure to evaluate our performance and for business decision making purposes.  Segment operating profit excludes interest, dividend and other income, interest and other expense and certain corporate expenses.

Key Statistical Data For the Three Months Ended March 31, 2010 and 2009:

The following tables present a summary of our operations for the three months ended March 31, 2010 and 2009:

Senior living communities: