UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended March 31, 2008.

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

For the transition period from                    to                         

THE ENSIGN GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware (State or Other Jurisdiction of Incorporation or Organization)		33-0861263 (I.R.S. Employer Identification No.)

27101 Puerta Real, Suite 450
Mission Viejo, CA 92691
(Address of Principal Executive Offices and Zip Code)

(949) 487-9500
(Registrants Telephone Number, Including Area Code)

N/A
(Former Name, Former Address and Former Fiscal Year, If Changed 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. þ Yes o No

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

Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ		Smaller reporting company o
				(Do not check if a smaller reporting company)

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

As of April 30, 2008, 20,537,280 shares of the registrant’s common stock were outstanding.

 

 

THE ENSIGN GROUP, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED MARCH 31, 2008

TABLE OF CONTENTS

Part I. Financial Information
Item 1. Financial Statements (unaudited):			1
Condensed Consolidated Balance Sheets as of March 31, 2008 and December 31, 2007			1
Condensed Consolidated Statements of Income for the three months ended March 31, 2008 and 2007			2
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2008 and 2007			3
Notes to Condensed Consolidated Financial Statements			4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
Item 3. Quantitative and Qualitative Disclosures About Market Risk			35
Item 4T. Controls and Procedures			36
Part II. Other Information
Item 1. Legal Proceedings			36
Item 1A. Risk Factors			37
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			64
Item 3. Defaults Upon Senior Securities			64
Item 4. Submission of Matters to a Vote of Security Holders			64
Item 5. Other Information			65
Item 6. Exhibits			66
Signatures			67
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

Part I. Financial Information

Item 1. Financial Statements

THE ENSIGN GROUP, INC.

		March 31,				December 31,
		2008				2007
Assets
Current assets:
Cash and cash equivalents		$	54,446			$	51,732
Accounts receivable—less allowance for doubtful accounts of $7,856 and $7,454 at March 31, 2008 and December 31, 2007, respectively			50,350				50,615
Prepaid income taxes			1,495				5,835
Prepaid expenses and other current assets			5,423				5,319
Deferred tax asset—current			6,558				6,862
Total current assets			118,272				120,363
Property and equipment, net			128,356				124,861
Insurance subsidiary deposits			9,396				8,810
Deferred tax asset			5,396				4,865
Restricted and other assets			3,453				3,273
Intangible assets, net			2,692				2,335
Goodwill			2,882				2,882
Total assets		$	270,447			$	267,389
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	12,199			$	14,699
Accrued wages and related liabilities			20,026				21,141
Accrued self-insurance liabilities—current			7,148				7,424
Other accrued liabilities			10,916				11,137
Current maturities of long-term debt			3,017				2,993
Total current liabilities			53,306				57,394
Long-term debt—less current maturities			60,290				60,577
Accrued self-insurance liability			18,381				17,236
Deferred rent and other long-term liabilities			2,462				2,505
Commitments and contingencies (Note 12)
Stockholders’ equity:
Common stock; $0.001 par value; 75,000 shares authorized; 21,217 and 20,535 issued and outstanding at March 31, 2008, respectively, and 21,196 and 20,480 shares issued and outstanding at December 31, 2007, respectively			21				21
Additional paid-in capital			62,766				62,142
Retained earnings			77,632				72,119
Common stock in treasury, at cost, 682 and 716 shares at March 31, 2008 and December 31, 2007, respectively			(4,411	)			(4,605	)
Total stockholders’ equity			136,008				129,677
Total liabilities and stockholders’ equity		$	270,447			$	267,389

See accompanying notes to condensed consolidated financial statements.

THE ENSIGN GROUP, INC.

		Three Months Ended
		March 31,
		2008				2007
Revenue		$	113,779			$	97,978
Expense:
Cost of services (exclusive of facility rent and depreciation and amortization shown separately below)			91,434				80,847
Facility rent—cost of services			3,999				4,155
General and administrative expense			5,092				3,746
Depreciation and amortization			1,990				1,532
Total expenses			102,515				90,280
Income from operations			11,264				7,698
Other income (expense):
Interest expense			(1,201	)			(1,169	)
Interest income			483				392
Other expense, net			(718	)			(777	)
Income before provision for income taxes			10,546				6,921
Provision for income taxes			4,212				2,784
Net income		$	6,334			$	4,137
Net income per share:
Basic		$	0.31			$	0.30
Diluted		$	0.31			$	0.24
Weighted average common shares outstanding:
Basic			20,498				13,420
Diluted			20,647				16,904

See accompanying notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

		Three Months Ended
		March 31,
		2008				2007
Cash flows from operating activities:
Net income		$	6,334			$	4,137
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			1,993				1,532
Amortization of deferred financing fees			7				—
Deferred income taxes			(227	)			(760	)
Provision for doubtful accounts			1,051				1,127
Stock-based compensation			462				249
Excess tax benefit from share based compensation			(106	)			—
Loss on disposition of property and equipment			152				14
Change in operating assets and liabilities
Accounts receivable			(786	)			(289	)
Prepaid income taxes			4,428				—
Prepaid expenses and other current assets			(104	)			(753	)
Insurance subsidiary deposits			(586	)			(1,240	)
Accounts payable			(2,500	)			776
Accrued wages and related liabilities			(1,115	)			(3,074	)
Other accrued liabilities			(350	)			250
Accrued self-insurance			869				2,140
Deferred rent liability			(46	)			111
Net cash provided by operating activities			9,476				4,220
Cash flows from investing activities:
Purchase of property and equipment			(5,578	)			(2,796	)
Restricted and other assets			(180	)			(242	)
Cash payment for acquisitions			—				(9,436	)
Net cash used in investing activities			(5,758	)			(12,474	)
Cash flows from financing activities:
Proceeds from issuance of debt			—				11
Payments on long term debt			(263	)			(270	)
Issuance of treasury stock upon exercise of options			194				—
Issuance of common stock upon exercise of options			74				89
Dividends paid			(819	)			(657	)
Excess tax benefit from share based compensation			106				—
Payments of deferred financing costs			(296	)			—
Net cash used in financing activities			(1,004	)			(828	)
Net increase (decrease) in cash and cash equivalents			2,174				(9,082	)
Cash and cash equivalents beginning of period			51,732				25,491
Cash and cash equivalents end of period		$	54,446			$	16,409
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest		$	1,239			$	1,169
Income taxes		$	106			$	2,500
Non-cash investing and financing activities:
Conditional asset retirement obligations under FIN 47		$	—			$	48

See accompanying notes to condensed consolidated financial statements

THE ENSIGN GROUP, INC.

1. DESCRIPTION OF BUSINESS

The Company —The Ensign Group, Inc., through its subsidiaries (collectively, Ensign or the Company), provides skilled nursing and rehabilitative care services through the operation of 61 facilities as of March 31, 2008, located in California, Arizona, Texas, Washington, Utah and Idaho. All of these facilities are skilled nursing facilities, other than three stand-alone assisted living facilities in Arizona and Texas and four campuses that offer both skilled nursing and assisted living services located in California, Arizona and Utah. The Company’s facilities, each of which strives to be the facility of choice in the community it serves, provide a broad spectrum of skilled nursing and assisted living services, physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. The Company’s facilities have a collective capacity of over 7,400 skilled nursing, assisted living and independent living beds. As of March 31, 2008, the Company owned 26 of its 61 facilities and operated an additional 35 facilities through long-term lease arrangements, and had options to purchase or purchase agreements for 10 of those 35 facilities.

The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenue. All of the Company’s facilities are operated by separate, wholly-owned, independent subsidiaries, each of which has its own management, employees and assets. One of the Company’s wholly-owned subsidiaries, sometimes referred to as the Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other centralized services to the other operating subsidiaries through contractual relationships with such subsidiaries. The Company also has a wholly-owned captive insurance subsidiary (the Captive) that provides some claims-made coverage to the Company’s operating subsidiaries for general and professional liability, as well as coverage for certain workers’ compensation insurance liabilities.

Like the Company’s facilities, the Service Center and the captive insurance subsidiary are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that the Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the captive insurance subsidiary are operated by the same entity.

Other Information—The accompanying condensed consolidated financial statements as of March 31, 2008 and for the three month periods ended March 31, 2008 and 2007 (collectively, the Interim Financial Statements), are unaudited. Certain information and footnote disclosures normally included in annual consolidated financial statements have been condensed or omitted, as permitted under applicable rules and regulations. Readers of the Interim Financial Statements should refer to the Company’s audited consolidated statements and notes thereto for the year ended December 31, 2007 which are included in the Company’s annual report on Form 10-K, File No. 001-33757 (the Annual Report) filed with the Securities and Exchange Commission (the SEC). Management believes that the Interim Financial Statements reflect all adjustments which are of a normal and recurring nature necessary to present fairly the Company’s financial position and results of operations in all material respects. The results of operations presented in the Interim Financial Statements are not necessarily representative of operations for the entire year.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation—The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The Company is the sole member or shareholder of various consolidated limited liability companies and corporations; each established to operate various acquired skilled nursing and assisted living facilities. All intercompany transactions and balances have been eliminated in consolidation.

Estimates and Assumptions—The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The most significant estimates in the Company’s consolidated financial statements relate to revenue, allowance for doubtful accounts, intangible assets and goodwill, impairment of long-lived assets, patient liability, general and professional liability, worker’s compensation, and healthcare claims included in accrued self-insurance liabilities, stock-based compensation and income taxes. Actual results could differ from those estimates.

Business Segments—The Company has a single reporting segment—long-term care services, which includes the operation of skilled nursing and assisted living facilities, and related ancillary services at the facilities. The Company’s single reporting segment is made up of several individual operating segments grouped together principally based on their geographical locations within the United States. Based on the similar economic and other characteristics of each of the operating segments, management believes the Company meets the criteria for aggregating its operations into a single reporting segment.

Fair Value of Financial Instruments — The Company’s financial instruments consist principally of cash and cash equivalents, accounts receivable, insurance subsidiary deposits, accounts payable and borrowings. The Company believes all of the financial instruments’ recorded values approximate fair values because of their nature and respective durations. The Company’s fixed-rate debt instruments do not actively trade in an established market. The fair values of this debt are estimated by discounting the principal and interest payments at rates available to the Company for debt with similar terms and maturities.

Revenue Recognition—The Company follows the provisions of Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition in Financial Statements (SAB 104), for revenue recognition. Under SAB 104, four conditions must be met before revenue can be recognized: (i) there is persuasive evidence that an arrangement exists; (ii) delivery has occurred or service has been rendered; (iii) the price is fixed or determinable; and (iv) collection is reasonably assured.

The Company’s revenue is derived primarily from providing long-term healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis.

Revenue from the Medicare and Medicaid programs accounted for approximately 75% and 74% of the Company’s revenue for the three months ended March 31, 2008 and 2007, respectively. The Company records revenue from these governmental and managed care programs as services are performed at their expected net realizable amounts under these programs. The Company’s revenue from governmental and managed care programs is subject to audit and retroactive adjustment by governmental and third-party agencies. Consistent with healthcare industry accounting practices, any changes to these governmental revenue estimates are recorded in the period the change or adjustment becomes known based on final settlements. The Company recorded retroactive adjustments that increased revenue by $325 and $709 for the three months ended March 31, 2008 and 2007, respectively. The Company records revenue from private pay patients as services are performed.

Accounts Receivable—Accounts receivable consist primarily of amounts due from Medicare and Medicaid programs, other government programs, managed care health plans and private payor sources. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.

In evaluating the collectibility of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type and the status of ongoing disputes with third-party payors. The percentages applied to the aged receivable balances are based on the Company’s historical experience and time limits, if any, for managed care, Medicare and Medicaid. The Company periodically refines its procedures for estimating the allowance for doubtful accounts based on experience with the estimation process and changes in circumstances.

Impairment of Long-Lived Assets—The Company reviews the carrying value of long-lived assets that are held and used in the Company’s operations for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined based upon expected undiscounted future net cash flows from the operations to which the assets relate, utilizing management’s best estimate, appropriate assumptions, and projections at the time. If the carrying value is determined to be unrecoverable from future operating cash flows, the asset is deemed impaired and an impairment loss would be recognized to the extent the carrying value exceeded the estimated fair value of the asset. The Company estimates the fair value of assets based on the estimated future discounted cash flows of the asset. The Company’s management has evaluated its long-lived assets and has not identified any impairment as of March 31, 2008 and December 31, 2007.

Intangible Assets and Goodwill—Intangible assets consist primarily of deferred financing costs, lease acquisition costs and trade names. Deferred financing costs are amortized over the term of the related debt, ranging from five to 26 years. Lease acquisition costs are amortized over the life of the lease of the facility, ranging from ten to 20 years. Trade names are amortized over 30 years.

Goodwill is accounted for under Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations (SFAS 141) and represents the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), goodwill is subject to annual testing for impairment. In addition, goodwill is tested for impairment if events occur or circumstances change that would reduce the fair value of a reporting unit below its carrying amount. The Company defines reporting units as the individual facilities. The Company performs its annual test for impairment during the fourth quarter of each year. The Company did not record any impairment charges during the three months ended March 31, 2008 or in 2007.

Self-Insurance—The Company is partially self-insured for general and professional liability up to a base amount per claim (the self-insured retention) with an aggregate, one time deductible above this limit. Losses beyond these amounts are insured through third-party policies with coverage limits per occurrence, per location and on an aggregate basis for the Company. For claims made in the first quarter of 2008, the self-insured retention was $350 per claim with a $900 deductible. The third-party coverage above these limits for all periods presented was $1,000 per occurrence, $3,000 per facility with a $6,000 blanket aggregate.

The self-insured retention and deductible limits for general and professional liability and worker’s compensation are self-insured through the Captive, the related assets and liabilities of which are included in the accompanying consolidated financial statements. The Captive is subject to certain statutory requirements as an insurance provider. These requirements include, but are not limited to, maintaining statutory capital. The Company’s policy is to accrue amounts equal to the estimated costs to settle open claims of insureds, as well as an estimate of the cost of insured claims that have been incurred but not reported. The Company develops information about the size of the ultimate claims based on historical experience, current industry information and actuarial analysis, and evaluates the estimates for claim loss exposure on a quarterly basis. Accrued general liability and professional malpractice liabilities recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets were $19,215 and $18,596 as of March 31, 2008 and December 31, 2007, respectively.

The Company’s operating subsidiaries are self-insured for workers’ compensation liability in California. To protect itself against loss exposure in California, with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $600 for each claim. In Texas, the operating subsidiaries have elected non-subscriber status for workers’ compensation claims. The Company’s operating subsidiaries in other states have third party guaranteed cost coverage. In California and Texas, the Company accrues amounts equal to the estimated costs to settle open claims, as well as an estimate of the cost of claims that have been incurred but not reported. The Company uses actuarial valuations to estimate the liability based on historical experience and industry information. Accrued workers’ compensation liabilities are recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets and were $4,343 and $4,145 as of March 31, 2008 and December 31, 2007, respectively.

During 2003 and 2004, the Company’s California and Arizona operating subsidiaries were insured for workers’ compensation liability by a third-party carrier under a policy where the retrospective premium was adjusted annually based on incurred developed losses and allocated expenses. Based on a comparison of the computed retrospective premium to the actual payments funded, amounts will be due to the insurer or insured. The funded accrual in excess of the estimated liabilities is included in prepaid expenses and other current assets in the accompanying condensed consolidated balance sheets and was $446 and $431 as of March 31, 2008 and December 31, 2007, respectively.

Effective May 1, 2006, the Company began to provide self-insured medical (including prescription drugs) and dental healthcare benefits to the majority of its employees. Prior to this, the Company had multiple third-party HMO and PPO plans, of which certain HMO plans are still active. The Company is not aware of any run-off claim liabilities from the prior plans. The Company is fully liable for all financial and legal aspects of these benefit plans. To protect itself against loss exposure with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $200 for each covered person which resets every plan year or a maximum of $6,000 per each covered person’s lifetime on the PPO plan and unlimited on the HMO plan. The Company has also purchased aggregate stop-loss coverage that reimburses the plan up to $5,000 to the extent that paid claims exceed $7,225. The aforementioned coverage only applies to claims paid during the plan year. The Company’s accrued liability under these plans recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets was $1,971 and $1,919 at March 31, 2008 and December 31, 2007, respectively.

The Company believes that adequate provision has been made in the consolidated financial statements for liabilities that may arise out of patient care, workers’ compensation, healthcare benefits and related services provided to date. The amount of the Company’s reserves was determined based on an estimation process that uses information obtained from both company-specific and industry data. This estimation process requires the Company to continuously monitor and evaluate the life cycle of the claims. Using data obtained from this monitoring and the Company’s assumptions about emerging trends, the Company, with the assistance of an independent actuary, develops information about the size of ultimate claims based on the Company’s historical experience and other available industry information. The most significant assumptions used in the estimation process include determining the trend in costs, the expected cost of claims incurred but not reported and the expected costs to settle or pay damage awards with respect to unpaid claims. It is possible, however, that the actual liabilities may exceed the Company’s estimate of loss.

The self-insured liabilities are based upon estimates, and while management believes that the estimates of loss are reasonable, the ultimate liability may be in excess of or less than the recorded amounts. Due to the inherent volatility of actuarially determined loss estimates, it is reasonably possible that the Company could experience changes in estimated losses that could be material to net income. If the Company’s actual liability exceeds its estimate of loss, its future earnings and financial condition would be adversely affected.

Income Taxes — Income taxes are accounted for in accordance with SFAS No. 109, Accounting for Income Taxes (SFAS 109). Under this method, deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities at tax rates expected to be in effect when such temporary differences are expected to reverse. The temporary differences are primarily attributable to compensation accruals, straight line rent adjustments and reserves for doubtful accounts and insurance liabilities. When necessary, the Company records a valuation allowance to reduce its net deferred tax assets to the amount that is more likely than not to be realized. In considering the need for a valuation allowance against some portion or all of its deferred tax assets, the Company must make certain estimates and assumptions regarding future taxable income, the feasibility of tax planning strategies and other factors.

Estimates and judgments regarding deferred tax assets and the associated valuation allowance, if any, are based on, among other things, knowledge of operations, markets, historical trends and likely future changes and, when appropriate, the opinions of advisors with knowledge and expertise in certain fields. However, due to the nature of certain assets and liabilities, there are risks and uncertainties associated with some of the Company’s estimates and judgments. Actual results could differ from these estimates under different assumptions or conditions. The net deferred tax assets as of March 31, 2008 and December 31, 2007 were $11,954 and $11,727, respectively. The Company expects to fully utilize these deferred tax assets; however, their ultimate realization is dependent upon the amount of future taxable income during the periods in which the temporary differences become deductible.

As of January 1, 2007, the Company adopted Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 requires the Company to maintain a liability for underpayment of income taxes and related interest and penalties, if any, for uncertain income tax positions. In considering the need for and magnitude of a liability for uncertain income tax positions, the Company must make certain estimates and assumptions regarding the amount of income tax benefit that will ultimately be realized. The ultimate resolution of an uncertain tax position may not be known for a number of years, during which time the Company may be required to adjust these reserves, in light of changing facts and circumstances.

The Company used an estimate of its annual income tax rate to recognize a provision for income taxes in financial statements for interim periods. However, changes in facts and circumstances could result in adjustments to the Company’s effective tax rate in future quarterly or annual periods.

Stock-Based Compensation—As of January 1, 2006, the Company adopted SFAS No. 123(R), Share-Based Payment (SFAS 123(R)), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options based on estimated fair values, ratably over the requisite service period of the award. Net income will be reduced as a result of the recognition of the fair value of all stock options issued on and subsequent to January 1, 2006, the amount of which is contingent upon the number of future options granted and other variables. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) as allowed under SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123).

The Company adopted SFAS 123(R) using the prospective transition method. The Company’s consolidated financial statements as of and for the periods ended March 31, 2008 and 2007 reflect the impact of SFAS 123(R). In accordance with the prospective transition method, the Company’s consolidated financial statements for periods prior to January 1, 2006 have not been restated to reflect, and do not include, the impact of SFAS 123(R).

Historically, no compensation expense was recognized by the Company in its financial statements in connection with the awarding of stock option grants to employees provided that, as of the grant date, all terms associated with the award were fixed and the fair value of its stock, as of the grant date, was equal to or less than the amount an employee must pay to acquire the stock. The Company would have recognized compensation expense in situations where the fair value of its common stock on the grant date was greater than the amount an employee must pay to acquire the stock. Stock-based compensation expense recognized in the Company’s consolidated statements of income for the three months ended March 31, 2008 does not include compensation expense for share-based payment awards granted prior to, but not yet vested as of January 1, 2006, in accordance with the pro forma provisions of SFAS 123, but does include compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the fair value on the grant date estimated in accordance with the provisions of SFAS 123(R). Existing options at January 1, 2006 will continue to be accounted for in accordance with APB 25 unless such options are modified, repurchased or canceled after the effective date of SFAS 123(R).

New Accounting Pronouncements—In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (SFAS 141(R)), which replaces SFAS 141. The provisions of SFAS 141(R) are similar to those of SFAS 141; however, SFAS 141(R) requires companies to record most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination at “full fair value.” SFAS 141(R) also requires companies to record fair value estimates of contingent consideration and certain other potential liabilities during the original purchase price allocation and to expense acquisition costs as incurred. This statement applies to all business combinations, including combinations by contract alone. Further, under SFAS 141(R), all business combinations will be accounted for by applying the acquisition method. SFAS 141(R) is effective for fiscal years beginning on or after December 15, 2008. Accordingly, any business combinations the Company engages in will be recorded and disclosed according to SFAS 141, Business Combinations, until January 1, 2009. The Company expects SFAS No. 141(R) will have an impact on its consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions, if any, that the Company consummates after the effective date.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (SFAS 160), which will require noncontrolling interests (previously referred to as minority interests) to be treated as a separate component of equity, not as a liability or other item outside of permanent equity. This Statement applies to the accounting for noncontrolling interests and transactions with non-controlling interest holders in consolidated financial statements. SFAS 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date except that comparative period information must be recast to classify noncontrolling interests in equity, attribute net income and other comprehensive income to noncontrolling interests, and provide other disclosures required by Statement 160. SFAS 160 is effective for periods beginning on or after December 15, 2008. The Company is currently evaluating the impact that SFAS 160 will have on its consolidated financial statements.

Adoption of New Accounting Pronouncements—In September 2006, the FASB issued SFAS 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and requires enhanced disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. In February 2008 the FASB issued FSP 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS 157 for non-financial assets and liabilities, other than those that are recognized or disclosed at fair value on a recurring basis, to fiscal years beginning after November 15, 2008. The adoption of SFAS 157 related to financial assets and liabilities had no impact on the Company’s consolidated financial statements. The Company is currently evaluating the impact, if any, that SFAS 157 may have on its future consolidated financial statements related to non-financial assets and liabilities.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 permits all entities to choose, at specified election dates, to measure certain financial instruments and other items at fair value (fair value option). A business entity must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Upfront costs and fees related to items for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company’s adoption of SFAS 159 at the beginning of fiscal 2008 had no impact on its consolidated financial position or results of operations.

In June 2007, the FASB ratified EITF Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (EITF 06-11). This EITF prescribes that the tax benefit received on dividends associated with non-vested share-based awards that are charged to retained earnings should be recorded in additional paid-in capital and included in the pool of excess tax benefits available to absorb potential future tax deficiencies of share based payment awards. EITF 06-11 is effective for the tax benefits of dividends declared in fiscal years beginning after December 15, 2007. The Company’s adoption of EITF 06-11 at the beginning of fiscal 2008 did not have a material impact on its consolidated financial position or results of operations.

3. COMPUTATION OF NET INCOME PER COMMON SHARE

Basic net income per share is computed by dividing net income attributable to common shares by the weighted average number of outstanding common shares for the period. The computation of diluted net income per share is similar to the computation of basic net income per share except that the denominator is increased to include contingently returnable shares and the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. In addition, in computing the dilutive effect of convertible securities, the numerator is adjusted to add back (a) any convertible preferred dividends and (b) the after-tax amount of interest, if any, recognized in the period associated with any convertible debt.

A reconciliation of the numerator and denominator used in the calculation of basic net income per common share follows:

		Three Months Ended
		March 31,
		2008				2007
Numerator:
Net income		$	6,334			$	4,137
Preferred stock dividends			—				(110	)
Net income available to common stockholders for basic net income per share		$	6,334			$	4,027
Denominator:
Weighted average shares outstanding for basic net income per share(1)			20,498				13,420
Basic net income per common share		$	0.31			$	0.30

A reconciliation of the numerator and denominator used in the calculation of diluted net income per common share follows:

		Three Months Ended
		March 31,
		2008				2007
Numerator:
Net income		$	6,334			$	4,137
Denominator:
Weighted average common shares outstanding			20,498				13,420
Plus: incremental shares from assumed conversions(1)			149				3,484
Adjusted weighted average common shares outstanding			20,647				16,904
Diluted net income per common share		$	0.31			$	0.24

4. REVENUE AND ACCOUNTS RECEIVABLE

Revenue for the three months ended March 31, 2008 and 2007, respectively, is summarized in the following tables:

		Three Months Ended March 31,
		2008								2007
		Revenue				% of Revenue				Revenue				% of Revenue
Medicaid		$	47,526				41.8	%		$	42,641				43.5	%
Medicare			37,918				33.3				30,130				30.8
Total Medicaid and Medicare			85,444				75.1				72,771				74.3
Managed care			15,256				13.4				12,705				13.0
Private and other payors			13,079				11.5				12,502				12.7
Revenue		$	113,779				100.0	%		$	97,978				100.0	%

Accounts receivable consisted of the following:

		March 31,				December 31,
		2008				2007
Medicaid		$	21,307			$	20,842
Managed care			15,224				14,821
Medicare			14,381				14,521
Private and other payors			7,294				7,885
			58,206				58,069
Less allowance for doubtful accounts			(7,856	)			(7,454	)
Accounts receivable		$	50,350			$	50,615

5. PROPERTY AND EQUIPMENT

Property and equipment are initially recorded at their original historical cost. Repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the depreciable assets (ranging from 3 to 30 years). Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the remaining lease term.

Property and equipment consist of the following:

		March 31,				December 31,
		2008				2007
Land		$	26,296			$	26,107
Buildings and improvements			76,463				76,262
Equipment			18,659				17,801
Furniture and fixtures			7,067				6,414
Leasehold improvements			11,746				10,771
Construction in progress			6,569				4,050
Less accumulated depreciation			(18,444	)			(16,544	)
Property and equipment, net		$	128,356			$	124,861

6. INTANGIBLE ASSETS—Net

		March 31, 2008																December 31, 2007
		Weighted
		Average				Gross												Gross
		Life				Carrying				Accumulated								Carrying				Accumulated
Intangible Assets		(Years)				Amount				Amortization				Net				Amount				Amortization				Net
Debt issuance costs			9.3			$	2,231			$	(730	)		$	1,501			$	1,808			$	(687	)		$	1,121
Lease acquisition costs			15.5				1,071				(558	)			513				1,071				(541	)			530
Customer base			0.3				213				(213	)			—				213				(213	)			—
Tradename			30.0				733				(55	)			678				733				(49	)			684
Total						$	4,248			$	(1,556	)		$	2,692			$	3,825			$	(1,490	)		$	2,335

The Company paid $423 in debt issuance costs in connection with the amendment to the Amended and Restated Loan and Security Agreement, as amended (the Revolver) to increase available borrowings. See additional discussion at Note 10. Amortization expense was $66 and $63 for the three months ended March 31, 2008 and 2007, respectively.

Goodwill

Pursuant to SFAS No. 142, the Company performed its annual goodwill impairment analysis on December 31, 2007 for each reporting unit that constitutes a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment. The Company determines impairment by comparing the net assets of each reporting unit to their respective fair values. The Company determines the estimated fair value of each reporting unit using a discounted cash flow analysis. In the event a unit’s net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit’s fair value to each asset and liability of the unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value. The Company recorded no goodwill impairment for the three months ended March 31, 2008 or the year ended December 31, 2007.

7. RESTRICTED AND OTHER ASSETS

Restricted and other assets consist primarily of capital reserves and deposits. Capital reserves are maintained as part of the mortgage agreements of the Company and certain of its landlords with the U.S. Department of Housing and Urban Development. These capital reserves are restricted for capital improvements and repairs to the related facilities.

Restricted and other assets consist of the following:

		March 31,				December 31,
		2008				2007
Deposits with landlords		$	1,001			$	1,001
Capital improvement reserves with landlords and lenders			2,425				2,244
Other			27				28
		$	3,453			$	3,273

8. OTHER ACCRUED LIABILITIES

Other accrued liabilities consist of the following:

		March 31,				December 31,
		2008				2007
Quality assurance fee		$	1,891			$	1,853
Resident refunds payable			1,663				1,767
Deferred resident revenue			1,682				1,745
Cash held in trust for residents			1,012				1,152
Dividends payable			821				819
Property taxes			731				838
Other			3,116				2,963
Other accrued liabilities		$	10,916			$	11,137

Quality assurance fee represents amounts payable to the State of California in respect of a mandated fee based on resident days. Resident refunds payable includes amounts due to residents for overpayments and duplicate payments. Deferred resident revenue occurs when the Company receives payments in advance of services provided. Cash held in trust for residents reflects monies received from, or on behalf of, residents. Maintaining a trust account for residents is a regulatory requirement and, while the trust assets offset the liability, the Company assumes a fiduciary responsibility for these funds. The cash balance related to this liability is included in other current assets in the accompanying condensed consolidated balance sheets.

9. INCOME TAXES

The provision for income taxes for the three months ended March 31, 2008 and 2007 is summarized as follows:

		Three Months Ended
		March 31,
		2008				2007
Current:
Federal		$	3,611			$	2,814
State			723				706
			4,334				3,520
Deferred:
Federal			(182	)			(515	)
State			(44	)			(260	)
			(226	)			(775	)
Tax benefit from exercise of stock options			89				—
Interest income, gross of related tax effects			(20	)			(18	)
Interest expense, gross of related tax effects			35				57
Total		$	4,212			$	2,784

The Company’s deferred tax assets and liabilities as of March 31, 2008 and December 31, 2007 are summarized as follows:

		March 31,				December 31,
		2008				2007
Deferred tax assets (liabilities):
Accrued expenses		$	9,745			$	9,243
Allowance for doubtful accounts			3,331				3,161
Tax credits			1,139				1,103
Total deferred tax assets			14,215				13,507
State taxes			(588	)			(199	)
Depreciation and amortization			(607	)			(563	)
Prepaid expenses			(1,066	)			(1,018	)
Total deferred tax liabilities			(2,261	)			(1,780	)
Net deferred tax assets		$	11,954			$	11,727

The Company adopted FIN 48 effective January 1, 2007 and, as of the date of adoption, had a net amount of unrecognized tax detriments of $36, exclusive of accrued interest. This total consisted of $234 of unrecognized tax benefits for permanent differences (as defined by SFAS 109) and other items, net of $270 of unrecognized tax detriments from temporary differences (as defined by SFAS 109), which resulted in additional deferred tax liability. The ending unrecognized tax benefit as of December 31, 2007 was $120.

As of January 1, 2007, the Company recorded $340 as an adjustment, net of the associated tax impact on interest amounts, to opening retained earnings as a result of the adoption of FIN 48. Of this total, $188 related to unrecognized tax benefits and $152 related to accrued interest.

As of March 31, 2008 and December 31, 2007, the unrecognized tax benefits, net of their state tax benefits that would affect the Company’s effective tax rate were $44.

The Company closed examinations by the Internal Revenue Service (IRS) for the 2004 and 2005 income tax years and by a major state tax jurisdiction for the 2003, 2004, and 2005 income tax years. As of December 31, 2007, the Company had settled with both the IRS and the major tax jurisdiction on all outstanding requests for a net refund of tax. Because the Company contemplated certain of the favorable examination adjustments in its beginning unrecognized tax detriment, the settlement of these items resulted in the recognition of the tax detriments and an increase to the Company’s unrecognized tax benefits.

The Federal statute of limitations on the Company’s 2003 income tax year lapsed in the third quarter of 2007, which resulted in a reduction in unrecognized tax benefits of $38 for uncertain tax positions. In 2008, the statute of limitations will lapse on the Company’s 2003 and 2004 income tax years for state and Federal purposes in the third quarter, respectively; however, the Company does not believe this lapse will significantly impact unrecognized tax benefits for any uncertain tax position. The Company is not aware of any other event that might significantly impact the balance of unrecognized tax benefits.

The Company has historically classified interest and/or penalties on income tax liabilities or refunds as additional income tax expense or income and will continue to do so with the adoption of FIN 48. As of the adoption date of FIN 48, the Company recorded total accrued interest and penalties, gross of related tax benefit, of $253. For 2007, the Company reported $123 of interest income and $150 of interest expense, gross of related tax benefit, in the statement of income. As of December 31, 2007, the total amount of accrued interest and penalties in the Company’s consolidated balance sheet was $298. As of March 31, 2008, the total amount of accrued interest and penalties in the Company’s consolidated balance sheet was $314.

10. Debt

The Company has an Amended and Restated Loan and Security Agreement, as amended (the Revolver) with General Electric Capital Corporation (the Lender) under which the Company may borrow up to the lesser of $50,000 or 85% of the eligible accounts receivable. The Company may elect from time to time to change the interest rate for all or any portion of the outstanding indebtedness thereunder to any of three options: (i) the one, two, three or six month LIBOR (at the Company’s option) plus 2.5%, or (ii) the greater of (a) prime plus 1.0% or (b) the federal funds rate plus 1.5% or (iii) a floating LIBOR rate. The Revolver will expire on February 21, 2013. The Revolver contains typical representations and financial and non-financial covenants for a loan of this type, a violation of which could result in a default under the Revolver and could possibly cause the entire amount outstanding, under the Revolver and all amounts owed by the Company, including amounts due under the Third Amended and Restated Loan Agreement (the Term Loan), to be declared immediately due and payable. The Company was in compliance with all covenants as of March 31, 2008. At March 31, 2008 and December 31, 2007, there were no outstanding borrowings under the Revolver and $8,449 of borrowing capacity was pledged to secure outstanding letters of credit in the same periods.

Long-term debt consists of the following:

		March 31,				December 31,
		2008				2007
Term Loan with the Lender, multiple-advance term loan, principal and interest payable monthly; interest is fixed at time of draw at 10-year Treasury Note rate plus 2.25% (rates in effect at December 31, 2007 range from 6.95% to 7.50%), balance due June 2016, collateralized by deeds of trust on real property, assignments of rents, security agreements and fixture financing statements		$	54,722			$	54,929
Mortgage note, principal, and interest of $54 payable monthly and continuing through February 2027, interest at fixed rate of 7.5%, collateralized by deed of trust on real property, assignment of rents and security agreement			6,572				6,612
Mortgage note, principal, and interest of $18 payable monthly and continuing through September 2008, interest at fixed rate of 7.49%, collateralized by a deed of trust and security agreement and an assignment of rents			2,013				2,029
			63,307				63,570
Less current maturities			(3,017	)			(2,993	)
		$	60,290			$	60,577

Under the Term Loan, the Company is subject to standard reporting requirements and other typical covenants for a loan of this type. On a quarterly basis, the Company is subject to restrictive financial covenants, including average occupancy, Debt Service (as defined in the agreement) and Project Yield (as defined in the agreement). As of March 31, 2008 and December 31, 2007, the Company was in compliance with such loan covenants.

The carrying value of the Company’s long-term debt is considered to approximate the fair value of such debt for all periods presented based upon the interest rates that the Company believes it can currently obtain for similar debt.

11. OPTIONS AND WARRANTS

Stock-based compensation expense recognized under SFAS 123(R) consists of share-based payment awards made to employees and directors including employee stock options based on estimated fair values. Stock-based compensation expense recognized in the Company’s condensed consolidated statements of income for the three months ended March 31, 2008 and 2007 does not include compensation expense for share-based payment awards granted prior to, but not yet vested as of January 1, 2006, in accordance with the provisions of SFAS 123 but does include compensation expense for the share-based payment awards granted on or subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the adoption provisions of SFAS 123(R). As stock-based compensation expense recognized in the Company’s condensed consolidated statements of income for the three month periods ended March 31, 2008 and 2007 was based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The Company has three option plans, all of which have been approved by the stockholders. In the 2001 Stock Option, Deferred Stock and Restricted Stock Plan (2001Plan) and the 2005 Stock Incentive Plan (2005 Plan), options may be exercised for unvested shares of common stock, which have full stockholder rights including voting, dividend and liquidation rights. The Company retains the right to repurchase any or all unvested shares at the exercise price paid per share of any or all unvested shares should the optionee cease to remain in service while holding such unvested shares.

2001 Stock Option, Deferred Stock and Restricted Stock Plan—The 2001 Stock Option, Deferred Stock and Restricted Stock Plan (2001 Plan) authorizes the sale of up to 1,980 shares of common stock to officers, employees, directors, and consultants of the Company. Granted non-employee director options vest and become exercisable immediately. Generally, all other granted options and restricted stock vest over five years at 20% per year on the anniversary of the grant date. Options expire ten years from the date of grant. The exercise price of the stock is determined by the Board of Directors, but shall not be less than 100% of the fair value on the date of grant. Shares issued upon early exercise of options granted prior to 2006 vested in full upon the consummation of the Company’s initial public offering (IPO) or if such options had not been exercised before the consummation of the Company’s IPO, such shares will vest in full upon exercise. At March 31, 2008 and December 31, 2007, there were 257 and 247, respectively, unissued shares of common stock available for issuance under this plan, including shares that have been forfeited and are available for reissue.

2005 Stock Incentive Plan—The 2005 Stock Incentive Plan (2005 Plan) authorizes the sale of up to 1,000 shares of treasury stock of which only 800 shares were repurchased and therefore eligible for reissuance as of March 31, 2008 and December 31, 2007, to officers, employees, directors, and consultants of the Company. Options granted to non-employee directors vest and become exercisable immediately. All other granted options vest over five years at 20% per year on the anniversary of the grant date. Options expire ten years from the date of grant. At March 31, 2008 and December 31, 2007, there were 114 and 112, respectively, unissued shares of common stock available for issuance under this plan, including shares that have been forfeited and are available for reissue.

2007 Omnibus Incentive Plan — The 2007 Omnibus Incentive Plan (2007 Plan) authorizes the sale of up to 1,000 shares of common stock to officers, employees, directors and consultants of the Company. In addition, the number of shares of common stock reserved under the 2007 Plan will automatically increase on the first day of each fiscal year, beginning on January 1, 2008, in an amount equal to the lesser of (i) 1,000 shares of common stock, or (ii) 2% of the number of shares outstanding as of the last day of the immediately preceding fiscal year, or (iii) such lesser number as determined by the Company’s board of directors. Granted non-employee director options vest and become exercisable in three equal annual installments, or the length of the term if less than three years, on the completion of each year of service measured from the grant date. All other granted options vest over five years at 20% per year on the anniversary of the grant date. Options expire ten years from the date of grant. At March 31, 2008, there were 1,035 unissued shares of common stock available for issuance under this plan.

The Company uses the Black-Scholes option-pricing model to recognize the value of stock-based compensation expense for all share-based payment awards. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. The Company develops estimates based on historical data and market information, which can change significantly over time. The Black-Scholes model required the Company to make several key judgments including:

	•		The expected option term reflects the application of the simplified method set out in SAB No. 107 Share-Based Payment (SAB 107), which was issued in March 2006. In December 2007, the SEC released SAB No. 110 (SAB 110), which extends the use of the “simplified” method, under certain circumstances, in developing an estimate of expected term of “plain vanilla” share options. Accordingly, the Company has utilized the average of the contractual term of the options and the weighted average vesting period for all options to calculate the expected option term.
	•		Estimated volatility also reflects the application of SAB 107 interpretive guidance and, accordingly, incorporates historical volatility of similar public entities until sufficient information regarding the volatility of the Company’s share price becomes available.
	•		The dividend yield is based on the Company’s historical pattern of dividends as well as expected dividend patterns.
	•		The risk-free rate is based on the implied yield of U.S. Treasury notes as of the grant date with a remaining term approximately equal to the expected term.
	•		Estimated forfeiture rate of approximately 8% per year is based on its historical forfeiture activity of unvested stock options.

Approximately 375 options were granted during the three month period ended March 31, 2008. The Company used the following assumptions for stock options granted during the three months ended March 31, 2008:

Weighted

Weighted

Average

Weighted

Average

Options

Risk-Free

Expected

Average

Dividend

Plan

Granted

Rate

Life

Volatility

Yield

2007

375

2.9

%

6.5 years

45

%

1.45

%

For the three months ended March 31, 2008, the following represents the Company’s weighted average exercise price, grant date intrinsic value and fair value displayed at grant date:

Weighted

Weighted

Weighted

Weighted

Average

Average

Average

Average

Options

Exercise

Grant Date

Fair Value

Fair Value of

Plan

Grant Date

Granted

Price

Intrinsic Value

of Options

Common Stock

2007

1/22/2008

375

$

11.03

$

0.00

$

4.62

$

11.03

As of December 31, 2004, 2005 and 2006, the Company valued its common stock using a combination of weighted income and market valuation approaches. The income approach was based on discounted cash flows. The market approach employed both a guideline company method and merger and acquisition method.

The following table represents the employee stock option activity during the three months ended March 31, 2008:

						Weighted								Weighted
		Number of				Average				Number of				Average
		Options				Exercise				Options				Exercise
		Outstanding				Price				Vested				Price
December 31, 2007			1,023			$	6.19				316			$	5.25
Granted			375			$	11.03
Forfeitures			(7	)		$	5.09
Exercised			(56	)		$	4.82
March 31, 2008			1,335			$	7.61				256			$	5.37

The following summary information reflects stock options outstanding, vesting and related details as of March 31, 2008:

		Options Outstanding																Options Vested
										Black-				Remaining				Number
		Number				Exercise				Scholes Fair				Contractual				Vested and				Exercise
Year of Grant		Outstanding				Price				Value				Life (Years)				Exercisable				Price
2003			43			$	0.67-0.81			$	34				6				30			$	0.67-0.81
2004			72			$	1.96-2.46				165				7				37			$	1.96-2.46
2005			273			$	4.99-5.75				1,552				8				78			$	4.99-5.75
2006			572			$	7.05-7.50				5,440				8				111			$	7.05-7.50
2008			375			$	11.03				1,731				10				—			$	11.03
Total			1,335								8,922								256

The Company recognized $462 and $249 in compensation expense during the three months ended March 31, 2008 and 2007, respectively. In future periods, the Company expects to recognize approximately $5,521 in stock-based compensation expense over the next 3.0 weighted average years for unvested options that were outstanding as of March 31, 2008. There were 1,079 unvested and outstanding options at March 31, 2008, of which 919 are expected to vest. The weighted average contractual life for options vested at March 31, 2008 was 7.8 years.

The aggregate intrinsic value of options outstanding, vested, expected to vest and exercised as of March 31, 2008 was approximately $2,871, $839, $1,827 and $279, respectively. The aggregate intrinsic value of options outstanding, vested, expected to vest and exercised as of December 31, 2007 was approximately $8,392, $2,890, $4,509 and $404, respectively. The intrinsic value is calculated as the difference between the market value and the exercise price of the options.

12. COMMITMENTS AND CONTINGENCIES

Leases—The Company leases certain facilities and its Service Center offices under non-cancelable operating leases, most of which have initial lease terms ranging from 5 to 20 years. The Company also leases certain of its equipment under non-cancelable operating leases with initial terms ranging from three to five years. Most of these leases contain renewal options, certain of which involve rent increases. Total rent expense, inclusive of straight-line rent adjustments, was $4,087 and $4,229 for the three months ended March 31, 2008 and 2007, respectively.

Six of the Company’s facilities are operated under master lease arrangements and a breach at a single facility could subject multiple facilities covered by the same master lease to the same default risk. Under a master lease, the Company may lease a large number of geographically dispersed properties through an indivisible lease. Failure to comply with Medicare or Medicaid provider requirements is a default under several of the Company’s master lease and debt financing instruments. In addition, other potential defaults related to an individual facility may cause a default of an entire master lease portfolio and could trigger cross-default provisions in the Company’s outstanding debt arrangements and other leases. With an indivisible lease, it is difficult to restructure the composition of the portfolio or economic terms of the lease without the consent of the landlord. In addition, a number of the Company’s individual facility leases are held by the same or related landlords, and some of these leases include cross-default provisions that could cause a default at one facility to trigger a technical default with respect to others, potentially subjecting certain leases and facilities to the various remedies available to the landlords under separate but cross-defaulted leases.

Regulatory Matters—Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. Compliance with such laws and regulations can be subject to future governmental review and interpretation, as well as significant regulatory action including fines, penalties, and exclusion from certain governmental programs. The Company believes that it is in material compliance with all applicable laws and regulations.

A significant portion of the Company’s revenue is derived from Medicaid and Medicare, for which reimbursement rates are subject to regulatory changes and government funding restrictions. Although the Company is not aware of any significant future rate changes currently passed into law, significant changes to the reimbursement rates could have a material effect on the Company’s operations.

Cost-Containment Measures—Both government and private payor sources have instituted cost-containment measures designed to limit payments made to providers of healthcare services, and there can be no assurance that future measures designed to limit payments made to providers will not adversely affect the Company.

Indemnities—From time to time, the Company enters into certain types of contracts that contingently require the Company to indemnify parties against third-party claims. These contracts primarily include (i) certain real estate leases, under which the Company may be required to indemnify property owners or prior facility operators for post-transfer environmental or other liabilities and other claims arising from the Company’s use of the applicable premises, (ii) operations transfer agreements, in which the Company agrees to indemnify past operators of facilities the Company acquires against certain liabilities arising from the transfer of the operation and/or the operation thereof after the transfer, (iii) certain lending agreements, under which the Company may be required to indemnify the lender against various claims and liabilities, (iv) agreements with certain lenders under which the Company may be required to indemnify such lenders against various claims and liabilities, and (v) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising in the course of their duties for the Company. The terms of such obligations vary by contract and, in most instances, a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, because no claims have been asserted, no liabilities have been recorded for these obligations on the Company’s balance sheets for any of the periods presented.

Litigation—The skilled nursing business involves a significant risk of liability given the age and health of the Company’s patients and residents and the services the Company provides. The Company and others in the industry are subject to an increasing number of claims and lawsuits, including professional liability claims, alleging that services have resulted in personal injury, elder abuse, wrongful death or other related claims. The defense of these lawsuits may result in significant legal costs, regardless of the outcome, and can result in large settlement amounts or damage awards.

In addition to the lawsuits and claims described above, the Company is also subject to potential lawsuits under the Federal False Claims Act and comparable state laws alleging submission of fraudulent claims for services to any healthcare program (such as Medicare) or payor. A violation may provide the basis for exclusion from federally-funded healthcare programs. Such exclusions could have a correlative negative impact on the Company’s financial performance. Some states, including California, Arizona and Texas, have enacted similar whistleblower and false claims laws and regulations. In addition, the Deficit Reduction Act of 2005 created incentives for states to enact anti-fraud legislation modeled on the Federal False Claims Act. As such, the Company could face increased scrutiny, potential liability and legal expenses and costs based on claims under state false claims acts in the markets in which it does business.

On June 5, 2006, a complaint was filed against the Company in the Superior Court of the State of California for the County of Los Angeles, purportedly on behalf of the United States, claiming that the Company violated the Medicare Secondary Payer Act. In the complaint, the plaintiff alleged that the Company inappropriately received and retained reimbursement from Medicare for treatment given to certain unidentified patients and residents of its facilities whose injuries were caused by the Company as a result of unidentified and unadjudicated incidents of medical malpractice. The plaintiff in this action is seeking damages of twice the amount that the Company was allegedly obligated to pay or reimburse to Medicare in connection with the treatment in question under the Medicare Secondary Payer Act, plus interest, together with plaintiff’s costs and fees, including attorneys’ fees. The plaintiff’s case was dismissed in the Company’s favor by the trial court, and the dismissal is currently on appeal. At this time the loss or possible range of loss is not estimable or probable; accordingly, we have not recorded an accrual for this matter.

The Company has been, and continues to be, subject to claims and legal actions that arise in the ordinary course of business including potential claims related to care and treatment provided at its facilities, as well as employment related claims. The Company does not believe that the ultimate resolution of these actions will have a material adverse effect on the Company’s financial business, financial condition or results of operations. A significant increase in the number of these claims or an increase in amounts owing under successful claims could materially adversely affect the Company’s business, financial condition, results of operations and cash flows.

Medicare Revenue Recoupments—We are subject to reviews relating to Medicare services, billings and potential overpayments. One facility was subject to probe review during the three months ended March 31, 2008, which was subsequently concluded with a Medicare revenue recoupment, net of appeal recoveries, to the federal government and related resident copayments of approximately $4, which was paid subsequent to quarter end. We anticipate that these probe reviews will increase in frequency in the future. In addition, two of our facilities are currently on prepayment review, and others may be placed on prepayment review in the future. If a facility fails prepayment review, the facility could then be subject to undergo targeted review, which is a review that targets perceived claims deficiencies. We have no facilities that are currently undergoing targeted review.

Other Matters—In March 2007, the Company and certain of its officers received a series of notices from the Company’s bank indicating that the United States Attorney (U.S. Attorney) for the Central District of California had issued an authorized investigative demand, a request for records similar to a subpoena, to the Company’s bank and then rescinded that demand. This rescinded demand originally requested documents from the Company’s bank related to financial transactions involving the Company, ten of its operating subsidiaries, an outside investor group, and certain of its current and former officers. Subsequently, in June 2007, the U.S. Attorney sent a letter to one of the Company’s current employees requesting a meeting. The letter indicated that the U.S. Attorney and the U.S. Department of Health and Human Services Office of Inspector General were conducting an investigation of claims submitted to the Medicare program for rehabilitation services provided at the Company’s facilities. Although both the Company and the employee offered to cooperate, the U.S. Attorney later withdrew its meeting request. From these contacts, the Company believes that an investigation was underway, but to date the Company has been unable to determine the exact cause or nature of the U.S. Attorney’s interest in the Company or its subsidiaries.

On December 17, 2007, the Company was informed by Deloitte & Touche LLP, the Company’s independent registered public accounting firm that the U.S. Attorney served a grand jury subpoena on Deloitte & Touche LLP, relating to the Company and several of its operating subsidiaries. The subpoena confirmed the Company’s previously reported belief that the U.S. Attorney is conducting an investigation involving certain of the Company’s operating subsidiaries. Based on these most recent events, the Company believes that the United States Government may be conducting parallel criminal, civil and administrative investigations involving The Ensign Group and one or more of its skilled nursing facilities. To the Company’s knowledge, however, neither The Ensign Group, Inc. nor any of its operating subsidiaries or employees has been formally charged with any wrongdoing, served with any related subpoenas or requests, or been directly notified of any concerns or related investigations by the U.S. Attorney or any government agency. Subsequently, in February 2008, the U.S. Attorney contacted two additional current employees. Both the Company and all three of the employees contacted have offered to cooperate and meet with the U.S. Attorney. While the Company has no reason to believe that the assertion of criminal charges, civil claims, administrative sanctions or whistleblower actions would be warranted, to date the U.S. Attorney’s office has declined to provide the Company with any specific information with respect to this matter, other than to confirm that an investigation is ongoing. The Company continued to request a meeting with the U.S. Attorney to discuss the grand jury subpoena, the Company’s completed internal investigation and any specific allegations or concerns they may have. The Company cannot predict or provide any assurance as to the possible outcome of the investigation or any possible related proceedings, or as to the possible outcome of any qui tam litigation that may follow, nor can the Company estimate the possible loss or range of loss that may result from any such proceedings and, therefore, the Company has not recorded any related accruals. To the extent the U.S. Attorney’s office elects to pursue this matter, or if the investigation has been instigated by a qui tam relator who elects to pursue the matter, the Company’s business, financial condition and results of operations could be materially and adversely affected.

In November 2006, the Company became aware of an allegation of possible reimbursement irregularities at one or more of its facilities. That same month, the Company retained outside counsel and initiated an internal investigation into these matters. The Company and its outside counsel concluded this investigation without identifying any systemic patterns or practices of fraudulent or intentional misconduct. The Company made observations at certain facilities regarding areas of potential improvement in some of its recordkeeping and billing practices and has implemented measures, some of which were already underway before the investigation began, that it believes will strengthen recordkeeping and billing processes. None of these additional findings or observations appears to be rooted in fraudulent or intentional misconduct. The Company continues to evaluate the measures implemented for effectiveness, and is continuing to seek ways to improve these processes.

As a byproduct of its investigation, the Company identified a limited number of selected Medicare claims for which adequate back-up documentation could not be located or for which other billing deficiencies existed. The Company, with the assistance of independent consultants experienced in Medicare billing, completed a billing review on these claims. To the extent missing documentation was not located, the Company treated these claims as overpayments. Consistent with healthcare industry accounting practices, the Company records any charge for refunded payments against revenue in the period in which the claim adjustment becomes known. During the year ended December 31, 2007, the Company accrued a liability of approximately $224, plus interest, for selected Medicare claims for which documentation had not been located or for other billing deficiencies identified to date. The remittance of these claims started with the Company’s filing of its regular January 2008 Quarterly Credit Balance Reports, which were submitted to the Medicare Fiscal Intermediary on or before January 31, 2008, and were completed with the regular April 2008 Quarterly Credit Balance Reports which were submitted on or before April 30, 2008. If additional reviews result in identification and quantification of additional amounts to be refunded, the Company would accrue additional liabilities for claim costs and interest and repay any amounts due in normal course. If future investigations ultimately result in findings of significant billing and reimbursement noncompliance which could require the Company to record significant additional provisions or remit payments, the Company’s business, financial condition and results of operations could be materially and adversely affected.

Concentrations

Credit Risk—The Company has significant accounts receivable balances, the collectibility of which is dependent on the availability of funds from certain governmental programs, primarily Medicare and Medicaid. These receivables represent the only significant concentration of credit risk for the Company. The Company does not believe there is significant credit risks associated with these governmental programs. The Company believes that an adequate allowance has been recorded for the possibility of these receivables proving uncollectible, and continually monitors and adjusts these allowances as necessary. The Company’s receivables from Medicare and Medicaid payor programs accounted for approximately 61% of its total accounts receivable as of March 31, 2008 and December 31, 2007, respectively. Revenue from reimbursements under the Medicare and Medicaid programs accounted for approximately 75% and 74% of the Company’s revenue for the three months ended March 31, 2008 and 2007.

Cash in Excess of FDIC Limits—The Company currently has bank deposits with a financial institution that exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $100.

13. DEFINED CONTRIBUTION PLAN

The Company has a 401(k) defined contribution plan (the 401(k) Plan), whereby eligible employees may contribute up to 15% of their annual basic earnings. Additionally, the 401(k) Plan provides for discretionary matching contributions (as defined in the 401(k) Plan) by the Company. The Company contributed $77 and $63 to the 401(k) Plan during the three months ended March 31, 2008 and 2007, respectively. Beginning in 2007, the Company’s 401(k) plan allowed eligible employees to contribute up to 90% of their eligible compensation, subject to applicable annual Internal Revenue Code limits.

14. SUBSEQUENT EVENTS

On May 1, 2008, the Company assumed an existing lease for a 120-bed skilled nursing facility in Orem, Utah.  The Company purchased the tenant’s rights under the lease agreement from the prior tenant and operator for approximately $2.0 million.  The Company did not acquire any material assets or assume any liabilities other than the prior tenant’s post-assumption rights and obligations under the lease. The Company also entered into a separate operations transfer agreement with the prior tenant as a part of this transaction, which is common. The Company paid for the prior tenant’s lease rights in cash from its IPO proceeds.

Also on May 1, 2008, under the terms of a purchase option contained in the original lease agreement, the Company purchased the underlying assets of one of its leased long-term care facilities in Scottsdale, Arizona.  This facility was purchased for approximately $5.2 million, which was paid in cash from the Company’s IPO proceeds.

As of May 1, 2008, the Company owns 27 of its facilities and operates 35 under long-term lease arrangements with options to purchase or purchase agreements for nine of those 35 facilities.

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 unaudited condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission (SEC), including our Annual Report on Form 10-K (Annual Report), which discusses our business and related risks in greater detail, as well as subsequent reports we may file from time to time on Forms 10-Q and 8-K, for additional information. The section entitled “Risk Factors” contained in Part II, Item 1A of this Report, and similar discussions in our other SEC filings, also describe some of the important risk factors that may affect our business, financial condition, results of operations and/or liquidity. You should carefully consider those risks, in addition to the other information in this Report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.

This Report contains forward-looking statements, which include, but are not limited to the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities and plans and objectives of management. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions, and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are listed under the section “Risk Factors” contained in Part II, Item 1A of this Report. These forward-looking statements speak only as of the date of this Report, and are based on our current expectations, estimates and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law. As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our” and “us” refer to The Ensign Group, Inc. and its consolidated subsidiaries. All of our facilities, the Service Center and the Captive are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. The use of “we”, “us”, “our” and similar verbiage in this quarterly report is not meant to imply that any of our facilities or the Service Center are operated by the same entity. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes included in the Annual Report.

Overview

We are a provider of skilled nursing and rehabilitative care services through the operation of 61 facilities located in California, Arizona, Texas, Washington, Utah and Idaho. All of these facilities are skilled nursing facilities, other than three stand-alone assisted living facilities in Arizona and Texas and four campuses that offer both skilled nursing and assisted living services in California, Arizona and Utah. Our facilities provide a broad spectrum of skilled nursing and assisted living services, physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. We encourage and empower our facility leaders and staff to make their facility the “facility of choice” in the community it serves. This means that our facility leaders and staff are generally free to discern and address the unique needs and priorities of healthcare professionals, customers and other stakeholders in the local community or market, and then work to create a superior service offering and reputation for that particular community or market to encourage prospective customers and referral sources to choose or recommend the facility. As of March 31, 2008, we owned 26 of our facilities and operated an additional 35 facilities under long-term lease arrangements, and had options to purchase, or purchase agreements in place, for 10 of those 35 facilities. The following table summarizes our facilities and licensed and independent living beds by ownership status as of March 31, 2008:

						Leased (with a				Leased (without a
		Owned				Purchase Option)				Purchase Option)				Total
Number of facilities			26				10				25				61
Percent of total			42.6	%			16.4	%			41.0	%			100	%
Skilled nursing, assisted living and independent living beds(1)			3,251				1,227				2,970				7,448
Percent of total			43.6	%			16.5	%			39.9	%			100	%

The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenues. All of our facilities are operated by separate, wholly-owned, independent subsidiaries, which have their own management, employees and assets. In addition, one of our wholly-owned independent subsidiaries, which we call our Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other services to each operating subsidiary through contractual relationships between such subsidiaries. In addition, we have a wholly-owned captive insurance subsidiary that provides some claims-made coverage to our operating subsidiaries for general and professional liability, as well as for certain workers’ compensation insurance liabilities. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that the Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the captive insurance subsidiary are operated by the same entity.

Recent Developments

On November 15, 2007, in connection with our IPO, we sold 4.0 million shares of common stock, and on November 20, 2007, certain selling stockholders sold 0.6 million shares of common stock upon exercise in full of the over-allotment option, each at the IPO price of $16.00 per share. The proceeds to us from the IPO, net of underlying discounts and commissions and estimated offering expenses payable by us (Net Proceeds), were approximately $56.5 million. Concurrently with the closing of our IPO, all previously outstanding shares of preferred stock converted into 2.7 million shares of our common stock.

On February 21, 2008, we amended our Revolver by extending the term to 2013, increasing the available credit thereunder up to the lesser of $50.0 million or 85% of the eligible accounts receivable, and changing the interest rate for all or any portion of the outstanding indebtedness thereunder to any of three options, as we may elect from time to time, (i) the 1, 2, 3 or 6 month LIBOR (at our option) plus 2.5%, or (ii) the greater of (a) prime plus 1.0% or (b) the federal funds rate plus 1.5% or (iii) a floating LIBOR rate. The Revolver contains typical representations and financial and non-financial covenants for a loan of this type, a violation of which could result in a default under the Revolver and could possibly cause all amounts owed by us, including amounts due under the Term Loan, to be declared immediately due and payable.

On May 1, 2008, we assumed an existing lease for a 120-bed skilled nursing facility in Orem, Utah.  We purchased the tenant’s rights under the lease agreement from the prior tenant and operator for approximately $2.0 million.  We did not acquire any material assets or assume any liabilities other than the prior tenant’s post-assumption rights and obligations under the lease. We also entered into a separate operations transfer agreement with the prior tenant as a part of this transaction, which is common. We paid for the prior tenant’s lease rights in cash from our IPO proceeds. Also on May 1, 2008, under the terms of a purchase option contained in the original lease agreement, we purchased the underlying assets of one of our leased long-term care facilities in Scottsdale, Arizona.  This facility was purchased for approximately $5.2 million, which was paid in cash from our IPO proceeds.

Facility Acquisition History

		As of December 31,																																				As of March 31,
		1999				2000				2001				2002				2003				2004				2005				2006				2007				2008
Cumulative number of facilities			5				13				19				24				41				43				46				57				61				61
Cumulative number of skilled nursing, assisted living and independent living beds(1)			710				1,645				2,244				2,919				5,147				5,401				5,780				6,940				7,448				7,448

(1)		Includes 671 beds in our 460 assisted living units and 84 independent living units as of March 31, 2008. The cumulative number of skilled nursing, assisted living and independent living beds is calculated using the current number of licensed beds at each facility and may differ from the number of beds at the time of acquisition. We may also permanently expand or reduce the number of licensed beds in connection with renovations or expansions of specific facilities. All bed counts are licensed beds except independent living beds, and may not reflect the number of beds actually available for patient use.

The following table sets forth the location of our facilities and the number of licensed and independent living beds located at our facilities as of March 31, 2008:

		CA				AZ				TX				UT				WA				ID				Total
Number of facilities			31				12				10				4				3				1				61
Skilled nursing, assisted living and independent living beds(1)			3,529				1,952				1,154				442				283				88				7,448

(1)		Includes 671 beds in our 460 assisted living units and 84 independent living units as of March 31, 2008. All bed counts are licensed beds except for independent living beds, and may not reflect the number of beds actually available for patient use.

Key Performance Indicators

We manage our skilled nursing business by monitoring key performance indicators that affect our financial performance. These indicators and their definitions include the following:

	•		Routine revenue: Routine revenue is generated by the contracted daily rate charged for all contractually inclusive services. The inclusion of therapy and other ancillary treatments varies by payor source and by contract. Services provided outside of the routine contractual agreement are recorded separately as ancillary revenue, including Medicare Part B therapy services, and are not included in the routine revenue definition.
	•		Skilled revenue: The amount of routine revenue generated from patients in our skilled nursing facilities who are receiving care under Medicare or managed care reimbursement, referred to as “Medicare and managed care patients.” Skilled revenue excludes any revenue generated from our assisted living services.

	•		Skilled mix: The amount of our skilled revenue as a percentage of our total routine revenue. Skilled mix (in days) represents the number of days our Medicare and managed care patients are receiving services at our skilled nursing facilities divided by the total number of days patients from all payor sources are receiving services at our skilled nursing facilities for any given period.
	•		Quality mix: The amount of routine non-Medicaid revenue as a percentage of our total routine revenue. Quality mix (in days) represents the number of days our non-Medicaid patients are receiving services at our skilled nursing facilities divided by the total number of days patients from all payor sources are receiving services at our skilled nursing facilities for any given period.
	•		Average daily rates: The routine revenue by payor source for a period at our skilled nursing facilities divided by actual patient days for that revenue source for that given period.
	•		Occupancy percentage (Licensed beds): The total number of residents occupying a bed in a skilled nursing, assisted living or independent living facility as a percentage of the number of total licensed and independent living beds in a facility.
	•		Occupancy percentage (Operational beds): The total number of residents occupying a bed in a skilled nursing, assisted living or independent living facility as a percentage of the beds in a facility which are available for occupancy during the measurement period.
	•		Number of facilities and licensed beds: The total number of skilled nursing, assisted living and independent living facilities that we own or operate and the total number of licensed and independent living beds associated with these facilities. Independent living beds do not have a licensing requirement.

Skilled and Quality Mix. Like most skilled nursing providers, we measure both patient days and revenue by payor. Medicare and managed care patients, whom we refer to as high acuity patients, typically require a higher level of skilled nursing and rehabilitative care. Accordingly, Medicare and managed care reimbursement rates are typically higher than from other payors. In most states, Medicaid reimbursement rates are generally the lowest of all payor types. Changes in the payor mix can significantly affect our revenue and profitability.

The following table summarizes our skilled mix and quality mix for the periods indicated as a percentage of our total routine revenue (less revenue from assisted living services) and as a percentage of total patient days:

		Three Months Ended
		March 31,
		2008				2007
Skilled Mix:
Days			24.5	%			23.7	%
Revenue			47.0	%			44.2	%
Quality Mix:
Days			37.2	%			36.7	%
Revenue			56.4	%			54.3	%

Occupancy. We have historically defined occupancy as the ratio of actual patient days (one patient day equals one patient or resident occupying one bed for one day) during any measurement period to the number of licensed patient days for that period. Licensed patient days are determined by multiplying the total of officially licensed beds by the number of calendar days in the measurement period.

However, the number of licensed and independent living beds in a skilled nursing, assisted living or independent living facility that are actually operational and available for occupancy may be less than the total official licensed bed capacity. This sometimes occurs due to the permanent dedication of bed space to alternative purposes, such as enhanced therapy treatment space or other desirable uses calculated to improve service offerings and/or operational efficiencies in a facility. In some cases, three- and four-bed wards have been reduced to two-bed rooms for resident comfort. These beds are seldom expected to be placed back into service. In addition, we occasionally acquire facilities with “banked” beds, for which valuable licensing rights have been retained, but have been voluntarily suspended under state regulations until the beds can be economically placed into service again. We define occupancy in operational beds as the ratio of actual patient days during any measurement period to the number of available patient days for that period. Available patient days are determined by subtracting unavailable licensed beds from total licensed beds, and multiplying the difference by the number of calendar days in the measurement period. Although we believe that reporting occupancy based on operational beds is consistent with industry practices and provides a more useful measure of actual occupancy performance from period to period, we intend to also continue reporting occupancy based on all licensed beds, whether they are in service or not, through at least fiscal year 2008.

The following table summarizes our occupancy statistics for the periods indicated:

		Three Months Ended
		March 31,
		2008				2007
Occupancy:
Licensed and independent living beds at end of period(1)			7,448				7,342
Operational beds at end of period(2)			7,105				7,020
Available patient days(2)			646,555				617,168
Licensed patient days			677,768				639,342
Actual patient days			530,395				497,887
Occupancy percentage (based on operational beds)			82.0	%			81.1	%
Occupancy percentage (based on licensed beds)			78.3	%			77.9	%

Revenue Sources

Our total revenue represents revenue derived primarily from providing services to patients and residents of skilled nursing facilities, and to a lesser extent from assisted living facilities and ancillary services. We receive service revenue from Medicaid, Medicare, private payors and other third-party payors, and managed care sources. The sources and amounts of our revenue are determined by a number of factors, including bed capacity and occupancy rates of our healthcare facilities, the mix of patients at our facilities and the rates of reimbursement among payors. Payment for ancillary services varies based upon the service provided and the type of payor. The following table sets forth our total revenue by payor source and as a percentage of total revenue for the periods indicated:

		Three Months Ended March 31,
		2008								2007
		(in thousands)
Revenue:
Medicare		$	37,918				33.3	%		$	30,130				30.8	%
Managed care			15,256				13.4				12,705				13.0
Private and other payors(1)			13,079				11.5				12,502				12.7
Medicaid			47,526				41.8				42,641				43.5
Total revenue		$	113,779				100.0	%		$	97,978				100.0	%

Critical Accounting Policies Update

There have been no significant changes during the three month period ended March 31, 2008 to the items that we disclosed as our critical accounting policies and estimates in our discussion and analysis of financial condition and results of operations in our Annual Report on Form 10-K filed with the SEC.

Industry Trends

The skilled nursing industry has evolved to meet the growing demand for post-acute and custodial healthcare services generated by an aging population, increasing life expectancies and the trend toward shifting of patient care to lower cost settings. The skilled nursing industry has evolved in recent years, which we believe has led to a number of favorable improvements in the industry, as described below:

	•		Shift of Patient Care to Lower Cost Alternatives. The growth of the senior population in the United States continues to increase healthcare costs, often faster than the available funding from government-sponsored healthcare programs. In response, federal and state governments have adopted cost-containment measures that encourage the treatment of patients in more cost-effective settings such as skilled nursing facilities, for which the staffing requirements and associated costs are often significantly lower than acute care hospitals, inpatient rehabilitation facilities and other post-acute care settings. As a result, skilled nursing facilities are generally serving a larger population of higher-acuity patients than in the past.
	•		Significant Acquisition and Consolidation Opportunities. The skilled nursing industry is large and highly fragmented, characterized predominantly by numerous local and regional providers. We believe this fragmentation provides significant acquisition and consolidation opportunities for us.
	•		Improving Supply and Demand Balance. The number of skilled nursing facilities has declined modestly over the past several years. We expect that the supply and demand balance in the skilled nursing industry will continue to improve due to the shift of patient care to lower cost settings, an aging population and increasing life expectancies.
	•		Increased Demand Driven by Aging Populations and Increased Life Expectancy. As life expectancy continues to increase in the United States and seniors account for a higher percentage of the total U.S. population, we believe the overall demand for skilled nursing services will increase. At present, the primary market demographic for skilled nursing services is individuals age 75 and older. According to U.S. Census Bureau Interim Projections, there were 38 million people in the United States in 2007 that were over 65 years old. The U.S. Census Bureau estimates this group is one of the fastest growing segments of the United States population and is expected to more than double between 2000 and 2030.

We believe the skilled nursing industry has been and will continue to be impacted by several other trends. The use of long-term care insurance is increasing among seniors as a means of planning for the costs of skilled nursing services. In addition, as a result of increased mobility in society, reduction of average family size, and the increased number of two-wage earner couples, more seniors are looking for alternatives outside the family for their care.

Effects of Changing Prices. Medicare reimbursement rates and procedures are subject to change from time to time, which could materially impact our revenue. Medicare reimburses our skilled nursing facilities under a prospective payment system (PPS) for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group (RUG) category that is based upon each patient’s acuity level. As of January 1, 2006, the RUG categories were expanded from 44 to 53, with increased reimbursement rates for treating higher acuity patients. The new rules also implemented a market basket increase that increased rates by 3.1% for fiscal year 2006. At the same time, Congress terminated certain temporary add-on payments that were added in 1999 and 2000 as the nursing home industry came under financial pressure from prior Medicare cuts. While the 2006 Medicare skilled nursing facility payment rates will not decrease payments to skilled nursing facilities, the loss of revenue associated with future changes in skilled nursing facility payments could, in the future, have an adverse impact on our financial condition or results of operation.

The Deficit Reduction Act of 2005 (DRA) was expected to significantly reduce net Medicare and Medicaid spending. Prior to the DRA, caps on annual reimbursements for rehabilitation therapy became effective on January 1, 2006. The DRA provides for exceptions to those caps for patients with certain conditions or multiple complexities whose therapy is reimbursed under Medicare Part B and provided in 2006. The Tax Relief and Health Care Act of 2006 extended the exceptions through the end of 2007. The Medicare, Medicaid and SCHIP Extension Act of 2007 extended these exceptions until June 30, 2008.

On February 4, 2008, the Bush Administration released its fiscal year 2009 budget proposal, which, if enacted, would significantly reduce Medicare spending by $182 billion over five years. Approximately 62% of the proposed five-year reduction total results from reductions in provider update factors, including a three-year freeze for skilled nursing facilities followed by annual updates of the inflation adjustment (or market basket) minus 0.65 percentage points indefinitely thereafter. Additional proposals would reduce provider payments by phasing out bad debt payments to skilled nursing facilities and imposing payment adjustments for five conditions commonly treated in skilled nursing facilities. Further, the proposed budget reiterates a proposal offered in past years by establishing an automatic annual 0.4 percent payment reduction that would take effect absent other Congressional action if general fund expenditures for Medicare exceed 45 percent. The budget also includes a series of proposals having an effect on Medicaid. For example, the budget proposes $18.2 billion in five-year savings from Medicaid, more than half of which, $10.1 billion, is expected to come from reducing matching rates for administrative costs, case management, family planning services, and qualifying individuals.

On May 2, 2008, CMS released its fiscal year 2009 budget proposal, which if enacted, would update PPS reimbursement rates to include a market basket increase of 3.1% for fiscal 2009. In addition, the proposal would recalibrate the resource utilization group (RUG) case-mix adjustment by a reduced 3.3%, which would reduce the net aggregate reimbursement to U.S. skilled nursing facilities by an estimated $60.0 million for the annual period from October 1, 2008 to September 30, 2009. If the proposal is adopted and the RUG recalibration results in a reduction of Medicare rates for patients in RUG categories where we provide a larger percentage of our Medicare services, without a corresponding increase or offset in rates in other RUG categories where we also provide significant services, our financial performance could be negatively impacted.

Historically, adjustments to reimbursement rates under Medicare have had a significant effect on our revenue. For a discussion of historic adjustments and recent changes to the Medicare program and related reimbursement rates see Risk Factors—Risks Related to Our Business and Industry—“Our revenue could be impacted by federal and state changes to reimbursement and other aspects of Medicaid and Medicare,” “Our future revenue, financial condition and results of operations could be impacted by continued cost containment pressures on Medicaid spending,” and “If Medicare reimbursement rates decline, our revenue, financial condition and results of operations could be adversely affected.” The federal government and state governments continue to focus on efforts to curb spending on healthcare programs such as Medicare and Medicaid. We are not able to predict the outcome of the legislative process. We also cannot predict the extent to which proposals will be adopted or, if adopted and implemented, what effect, if any, such proposals and existing new legislation will have on us. Efforts to impose reduced allowances, greater discounts and more stringent cost controls by government and other payors are expected to continue and could adversely affect our business, financial condition and results of operations.

Results of Operations

The following table sets forth details of our revenue, expenses and earnings as a percentage of total revenue for the periods indicated:

		Three Months Ended
		March 31,
		2008				2007
Revenue			100.0	%			100.0	%
Expenses:
Cost of services (exclusive of facility rent and depreciation and amortization shown separately below)			80.4				82.5
Facility rent—cost of services			3.5				4.2
General and administrative expense			4.5				3.8
Depreciation and amortization			1.7				1.6
Total expenses			90.1				92.1
Income from operations			9.9				7.9
Other income (expense):
Interest expense			(1.1	)			(1.2	)
Interest income			0.4				0.4
Other expense, net			(0.7	)			(0.8	)
Income before provision for income taxes			9.2				7.1
Provision for income taxes			3.7				2.9
Net income			5.5	%			4.2	%

The table below reconciles net income to EBITDA and EBITDAR for the periods presented:

		Three Months Ended
		March 31,
		2008				2007
Consolidated Statement of Income Data:
Net income		$	6,334			$	4,137
Interest expense, net			718				777
Provision for income taxes			4,212				2,784
Depreciation and amortization			1,990				1,532
EBITDA(1)		$	13,254				9,230
Facility rent—cost of services			3,999				4,155
EBITDAR(1)		$	17,253			$	13,385

We believe EBITDA and EBITDAR are useful to investors and other external users of our financial statements in evaluating our operating performance because:

	•		they are widely used by investors and analysts in our industry as a supplemental measure to evaluate the overall operating performance of companies in our industry without regard to items such as interest expense, net and depreciation and amortization, which can vary substantially from company to company depending on the book value of assets, capital structure and the method by which assets were acquired; and
	•		they help investors evaluate and compare the results of our operations from period to period by removing the impact of our capital structure and asset base from our operating results.

We use EBITDA and EBITDAR:

	•		as measurements of our operating performance to assist us in comparing our operating performance on a consistent basis;
	•		to design incentive compensation and goal setting;
	•		to allocate resources to enhance the financial performance of our business;
	•		to evaluate the effectiveness of our operational strategies; and
	•		to compare our operating performance to that of our competitors.

We typically use EBITDA and EBITDAR to compare the operating performance of each skilled nursing and assisted living facility. EBITDA and EBITDAR are useful in this regard because they do not include such costs as net interest expense, income taxes, depreciation and amortization expense, and, with respect to EBITDAR, facility rent—cost of services, which may vary from period-to-period depending upon various factors, including the method used to finance facilities, the amount of debt that we have incurred, whether a facility is owned or leased, the date of acquisition of a facility or business, or the tax law of the state in which a business unit operates. As a result, we believe that the use of EBITDA and EBITDAR provide a meaningful and consistent comparison of our business between periods by eliminating certain items required by GAAP.

We also establish compensation programs and bonuses for our facility level employees that are partially based upon the achievement of EBITDAR targets.

Despite the importance of these measures in analyzing our underlying business, designing incentive compensation and for our goal setting, EBITDA and EBITDAR are non-GAAP financial measures that have no standardized meaning defined by GAAP. Therefore, our EBITDA and EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported in accordance with GAAP. Some of these limitations are:

	•		they do not reflect our current or future cash requirements for capital expenditures or contractual commitments;
	•		they do not reflect changes in, or cash requirements for, our working capital needs;
	•		they do not reflect the net interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;
	•		they do not reflect any income tax payments we may be required to make;
	•		although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and EBITDAR do not reflect any cash requirements for such replacements; and
	•		other companies in our industry may calculate these measures differently than we do, which may limit their usefulness as comparative measures.

We compensate for these limitations by using them only to supplement net income on a basis prepared in accordance with GAAP in order to provide a more complete understanding of the factors and trends affecting our business.

Management strongly encourages investors to review our consolidated financial statements in their entirety and to not rely on any single financial measure. Because these non-GAAP financial measures are not standardized, it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. For information about our financial results as reported in accordance with GAAP, see our condensed consolidated financial statements and related notes included elsewhere in this document.

Three Months Ended March 31, 2008 Compared to Three Months Ended March 31, 2007

		Three Months Ended
		March 31,
		2008				2007				Change
		(dollars in thousands)
Same Facility Results(1):
Revenue		$	109,009			$	96,421				13.1	%
Number of facilities at period end			57				57				0.0	%
Actual patient days			503,654				488,061				3.2	%
Occupancy percentage — Operational beds			83.0	%			81.4	%			1.6	%
Occupancy percentage — Licensed beds			79.8	%			78.3	%			1.5	%
Skilled mix by nursing days			25.2	%			24.0	%			1.2	%
Recently Acquired Facility Results(2):
Revenue		$	4,770			$	1,557				206.3	%
Number of facilities at period end			4				3				33.3	%
Actual patient days			26,741				9,826				172.2	%
Occupancy percentage — Operational beds			67.1	%			70.8	%			(3.7	)%
Occupancy percentage — Licensed beds			57.9	%			62.1	%			(4.2	)%
Skilled mix by nursing days			12.9	%			11.0	%			1.9	%
Total Facility Results:
Revenue		$	113,779			$	97,978				16.1	%
Number of facilities at period end			61				60				1.7	%
Actual patient days			530,395				497,887				6.5	%
Occupancy percentage — Operational beds			82.0	%			81.1	%			0.9	%
Occupancy percentage — Licensed beds			78.3	%			77.9	%			0.4	%
Skilled mix by nursing days			24.5	%			23.7	%			0.8	%

Revenue. Revenue increased $15.8 million, or 16.1%, to $113.8 million for the three months ended March 31, 2008 compared to $98.0 million for the three months ended March 31, 2007. Of the $15.8 million increase, skilled revenue (Medicare and managed care) increased $9.9 million, or 24.1%, Medicaid revenue increased $4.9 million, or 11.5%, and private and other revenue increased $0.6 million, or 4.6%.

Revenue generated by Same Facilities increased $12.6 million, or 13.1%, for the three months ended March 31, 2008 as compared to the three months ended March 31, 2007. This increase was primarily due to increases in skilled mix and occupancy rates of 1.2% and 1.6%, respectively, combined with higher reimbursement rates relative to the three months ended March 31, 2007. The increase in skilled mix was primarily due to an increase in Medicare days of 13.4% as compared to the three months ended March 31, 2007. Same Facility skilled mix and occupancy rate increases were primarily attributable to three facilities, where revenues increased by an aggregate of approximately $3.5 million, of which $1.6 million were attributable to Medicare revenue.

Approximately $3.2 million of the total revenue increase was due to revenue generated by Recently Acquired Facilities, which was primarily attributable to the increase in actual patient days due to the effect of having a full three months of operations in 2008 at the facilities acquired in 2007, combined with generally higher skilled mix and quality mix at such facilities. Historically, we have generally experienced lower occupancy rates, lower skilled mix and quality mix in Recently Acquired Facilities, and in the future, if we acquire additional facilities into our overall portfolio, we expect this trend to resume.

The following table reflects the change in the skilled nursing average daily revenue rates by payor source, excluding therapy and other ancillary services that are not covered by the daily rate:

		Three Months Ended March 31,
		Total								Acquisitions								Same Facility
		2008				2007				2008				2007				2008				2007
Skilled Nursing Average Daily Revenue Rates:
Medicare		$	493.36			$	444.04			$	433.34			$	391.00			$	495.98			$	444.74
Managed care			315.70				286.54				430.88				311.84				314.78				286.40
Total skilled revenue			424.29				381.22				433.08				373.85				424.03				381.30
Medicaid			154.72				148.44				131.47				123.07				156.07				149.09
Private and other payors			164.19				158.54				131.83				126.04				168.05				159.46
Total skilled nursing revenue		$	222.44			$	205.35			$	170.46			$	151.13			$	225.46			$	206.55

The average Medicare daily rate increased by approximately 11.1% in the three months ended March 31, 2008 as compared to the three months ended March 31, 2007, as a result of higher acuity patient mix and an increase in the average Medicare rate of approximately 3.0%. The average Managed care rate increased 10.2% in the three months ended March 31, 2008 as compared to the same period in the prior year as a result of higher patient acuity mix and higher reimbursement rates. The average Medicaid rate increase of 4.2% in the three months ended March 31, 2008 relative to the same period in the prior year primarily resulted from increases in reimbursement rates. The change in the daily rate in the private and other payors category was primarily due to net rate changes based on local market dynamics.

Payor Sources as a Percentage of Skilled Nursing Services. We use both our skilled mix and quality mix as measures of the quality of reimbursements we receive at our skilled nursing facilities over various periods. The following table sets forth our percentage of skilled nursing patient revenue and days by payor source:

		Three Months Ended March 31,
		Total								Acquisitions								Same Facility
		2008				2007				2008				2007				2008				2007
Percentage of Skilled Nursing Revenue:
Medicare			33.4	%			30.9	%			29.3	%			22.3	%			33.6	%			31.1	%
Managed care			13.6				13.3				3.5				4.9				14.0				13.4
Skilled mix			47.0				44.2				32.8				27.2				47.6				44.5
Private and other payors			9.3				10.1				19.1				13.8				8.9				10.0
Quality mix			56.3				54.3				51.9				41.0				56.5				54.5
Medicaid			43.7				45.7				48.1				59.0				43.5				45.5
Total skilled nursing			100.0	%			100.0	%			100.0	%			100.0	%			100.0	%			100.0	%