American Retirement 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

 X
  
 Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
     
     For the quarterly period ended June 30, 2005
   
 or
 
    Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
     
     For the transition period from ________ to ________
     
     Commission file number 01-13031
 
American Retirement Corporation
(Exact Name of Registrant as Specified in its Charter)

 Tennessee  62-1674303 
 (State or Other Jurisdiction of  (I.R.S. Employer
 Incorporation or Organization)  Identification No.) 
   
   
111 Westwood Place, Suite 200, Brentwood, TN
(Address of Principal Executive Offices)
37027 
(Zip Code)
 
Registrant’s Telephone Number, Including Area Code: (615) 221-2250

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X . No__.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes   X   No  __

As of August 3, 2005, 31,197,775 shares of the registrant’s common stock, $0.01, were outstanding.


1

INDEX
PART I.  FINANCIAL INFORMATION


Item 1.
Financial Statements
Page
     
   
 
3
     
   
   
 
4
     
   
   
 
5
     
   
   
 
6
     
 
8
     
Item 2.
  
 
21
     
Item 3.
39
     
Item 4.
39
     
PART II.
OTHER INFORMATION
  
     
Item 4.
41
     
Item 5.   Other Information 41
     
Item 6.
41
     
 
44

 
2

 
         
Item 1. Financial Statements  
          
           
AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES       
  
CONDENSED CONSOLIDATED BALANCE SHEETS       
  
(UNAUDITED)       
  
(in thousands, except share data)   
  
June 30,
  
December 31,
  
   
2005
  
2004
  
ASSETS
              
Current assets:
              
Cash and cash equivalents
  
$
46,472
  
$
28,454
  
Restricted cash
    
18,709
   
25,270
 
Accounts receivable, net of allowance for doubtful accounts
    
16,117
   
16,175
 
Inventory
    
1,343
   
1,364
 
Prepaid expenses
    
3,355
   
2,667
 
Deferred income taxes
    
8,049
   
5,645
 
Other current assets
    
11,273
   
8,490
 
 Total current assets
    
105,318
   
88,065
 
               
Restricted cash, excluding amounts classified as current
    
20,345
   
24,864
 
Notes receivable
    
21,270
   
18,563
 
Deferred income taxes
    
51,646
   
-
 
Leasehold acquisition costs, net of accumulated amortization
    
23,175
   
29,362
 
Land, buildings and equipment, net
    
516,786
   
496,297
 
Goodwill
    
36,463
   
36,463
 
Other assets
    
54,434
   
55,636
 
 Total assets
  
$
829,437
  
$
749,250
  
               
LIABILITIES AND SHAREHOLDERS' EQUITY
              
Current liabilities:
              
Current portion of long-term debt
  
$
6,975
  
$
10,372
  
Current portion of capital lease and lease financing obligations
    
16,922
   
16,474
 
Accounts payable
    
4,096
   
5,937
 
Accrued payroll and benefits
    
12,407
   
10,125
 
Accrued property taxes
    
8,438
   
8,872
 
Other accrued expenses
    
9,923
   
9,023
 
Other current liabilities
    
9,716
   
8,505
 
Tenant deposits
    
4,733
   
4,804
 
Refundable portion of entrance fees
    
83,556
   
79,148
 
Deferred entrance fee income
    
35,732
   
33,800
 
 Total current liabilities
    
192,498
   
187,060
 
               
Long-term debt, less current portion
    
98,549
   
125,584
 
Capital lease and lease financing obligations, less current portion
    
174,212
   
182,652
 
Deferred entrance fee income
    
121,258
   
111,386
 
Deferred gains on sale-leaseback transactions
    
92,965
   
98,876
 
Deferred income taxes
    
-
   
6,027
 
Other long-term liabilities
    
21,938
   
17,751
 
 Total liabilities
    
701,420
   
729,336
 
               
Minority interest
    
7,739
   
14,213
 
               
Commitments and contingencies (See notes)
              
               
Shareholders' equity:
              
Preferred stock, no par value; 5,000,000 shares authorized, no
              
shares issued or outstanding 
    
-
   
-
 
Common stock, $.01 par value; 200,000,000 shares authorized,
              
31,205,588 and 25,636,429 shares issued and outstanding, respectively 
    
312
   
252
 
Additional paid-in capital
    
220,487
   
168,092
 
Accumulated deficit
    
(98,800
)
  
(160,425
)
Deferred compensation, restricted stock
    
(1,721
)
  
(2,218
)
 Total shareholders' equity
    
120,278
   
5,701
 
 Total liabilities and shareholders' equity
  
$
829,437
  
$
749,250
  
 
See accompanying notes to condensed consolidated financial statements.
 
3

 
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS       
  
(UNAUDITED)      
  
(in thousands, except per share data)      
  
           
   
Three months ended June 30,  
  
   
2005
  
2004
  
       
(restated)
  
Revenues:
              
Resident and health care
 
$
120,641
  
$
109,110
  
Management and development services
   
516
   
515
 
Reimbursed expenses
   
542
   
524
 
Total revenues  
    
121,699
   
110,149
 
               
Operating expenses:
              
Community operating expenses
   
79,896
   
74,065
 
General and administrative
   
6,765
   
6,114
 
Lease expense
   
15,445
   
14,872
 
Depreciation and amortization
   
8,773
   
6,547
 
Amortization of leasehold acquisition costs
   
689
   
728
 
Loss (gain) on disposal or sale of assets
   
344
   
(6
)
Reimbursed expenses
   
542
   
524
 
Total operating expenses  
    
112,454
   
102,844
 
               
Operating income  
    
9,245
   
7,305
 
               
Other income (expense):
              
Interest expense
   
(3,916
)
  
(8,932
)
Interest income
   
874
   
669
 
Other
   
5
   
(364
)
Other expense, net  
    
(3,037
)
  
(8,627
)
               
Income (loss) before income taxes and minority interest
    
6,208
   
(1,322
)
               
Income tax (benefit) expense
    
(53,392
)
  
75
 
               
Income (loss) before minority interest
    
59,600
     (1,397  )
               
Minority interest in earnings of consolidated subsidiaries, net of tax     (600  )   (863  )
               
Net income (loss)  
  
$
59,000
  
$
(2,260
)
               
Basic earnings (loss) per share
 
$
1.90
  
$
(0.09
)
Dilutive earnings (loss) per share
 
$
1.82
  
$
(0.09
)
               
               
               
               
Weighted average shares used for basic earnings (loss) per share data
    
31,053
   
24,290
 
Effect of dilutive common stock options
    
1,278
   
-
 
Weighted average shares used for dilutive earnings (loss) per share data
    
32,331
   
24,290
 
               
 
See accompanying notes to condensed consolidated financial statements.

 
4

 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS       
  
(UNAUDITED)      
  
(in thousands, except per share data)      
  
           
   
Six months ended June 30,  
  
   
2005
  
2004
  
       
(restated)
  
Revenues:
              
Resident and health care
 
$
238,330
  
$
217,061
  
Management and development services
   
1,016
   
939
 
Reimbursed expenses
   
1,344
   
1,292
 
Total revenues  
    
240,690
   
219,292
 
               
Operating expenses:
              
Community operating expenses
   
159,233
   
147,917
 
General and administrative
   
13,356
   
12,702
 
Lease expense
   
30,955
   
29,693
 
Depreciation and amortization
   
18,044
   
13,460
 
Amortization of leasehold acquisition costs
   
1,388
   
1,446
 
Loss (gain) on disposal or sale of assets
   
356
   
(111
)
Reimbursed expenses
   
1,344
   
1,292
 
Total operating expenses  
    
224,676
   
206,399
 
               
Operating income  
    
16,014
   
12,893
 
               
Other income (expense):
              
Interest expense
   
(7,473
)
  
(18,633
)
Interest income
   
1,594
   
1,271
 
Other
   
144
   
(253
)
Other expense, net  
    
(5,735
)
  
(17,615
)
               
Income (loss) before income taxes and minority interest
    
10,279
   
(4,722
)
               
Income tax (benefit) expense
    
(52,017
)
  
220
 
             
Income (loss) before minority interest 
    
62,296
    
(4,942
 )
               
Minority interest in earnings of consolidated subsidiaries, net of tax    
 (671
 )   (1,825  )
               
Net income (loss)  
  
$
61,625
  
$
(6,767
)
               
Basic earnings (loss) per share
 
$
2.06
  
$
(0.30
)
Dilutive earnings (loss) per share
 
$
1.96
  
$
(0.30
)
               
               
               
               
Weighted average shares used for basic earnings (loss) per share data
    
29,976
   
22,770
 
Effect of dilutive common stock options
    
1,540
   
-
 
Weighted average shares used for dilutive earnings (loss) per share data
    
31,516
   
22,770
 
 
See accompanying notes to condensed consolidated financial statements.
 
 
5
 

 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS        
  
(UNAUDITED)       
  
(in thousands)    
  
Six months ended June 30,   
  
   
2005
  
2004
  
       
(restated)
  
Cash flows from operating activities:
              
Net income (loss)
  
$
61,625
  
$
(6,767
)
Adjustments to reconcile net income (loss) to cash and cash
              
equivalents provided by operating activities:
             
Tax benefit from release of tax valuation allowance
    
(55,697
)
  
-
 
Depreciation and amortization
    
19,432
   
14,906
 
Loss on extinguishment of debt
    
794
       
Amortization of deferred financing costs
    
253
   
1,208
 
Deferred entrance fee items:
              
Amortization of deferred entrance fee income 
    
(8,894
)
  
(8,745
)
Proceeds from entrance fee sales - deferred income 
    
18,211
   
15,325
 
Accrual of deferred interest
    
-
   
4,074
 
Amortization of deferred gain on sale-leaseback transactions
    
(5,911
)
  
(5,078
)
Amortization of deferred compensation
    
412
   
-
 
Minority interest in earnings of consolidated subsidiaries
    
 671
    
1,825
 
Tax benefit from exercise of stock options
    
558
   
-
 
(Gains) losses from unconsolidated joint ventures
    
(160
)
  
220
 
Loss (gain) on disposal or sale of assets
   
356
   
(111
)
Changes in assets and liabilities, exclusive of acquisitions
             
and sale-leaseback transactions:
              
Accounts receivable
    
72
   
(651
)
Inventory
    
29
   
34
 
Prepaid expenses
    
(762
)
  
376
 
Deferred income taxes
    
(8,431
)
  
-
 
Other assets
    
3,861
   
3,973
 
Accounts payable
    
(1,846
)
  
(121
)
Other accrued expenses and other current liabilities
    
4,000
   
(2,029
)
Tenant deposits
    
(161
)
  
(66
)
Deferred lease liability
    
1,445
   
(624
)
Other liabilities
    
755
    
3,640
 
Net cash and cash equivalents provided by operating activities
    
30,612
   
21,389
 
               
Cash flows from investing activities:
              
Additions to land, buildings and equipment
    
(13,583
)
  
(9,572
)
Acquisition of community and property
    
(13,950
)
  
-
 
Proceeds from the sale of assets
    
6,073
   
-
 
Investment in restricted cash
    
(8,327
)
  
(7,578
)
Proceeds from release of restricted cash
    
19,343
   
4,144
 
Net change in other restricted cash accounts
    
(236
)
  
(364
)
Issuances of notes receivable
    
(3,000
)
  
-
 
Receipts from notes receivable
    
113
   
180
 
Other investing activities
    
466
   
366
 
Net cash and cash equivalents used by investing activities
    
(13,101
)
  
(12,824
)
               
Cash flows from financing activities:
              
Proceeds from the issuance of long-term debt
    
-
   
43,838
 
Principal payments on long-term debt
    
(45,569
)
  
(49,239
)
Principal reductions in master trust liability
    
(553
)
  
(634
)
Refundable entrance fee items:
              
Proceeds from entrance fee sales - refundable portion 
    
8,878
   
7,295
 
Refunds of entrance fee terminations 
    
(11,615
)
  
(5,872
)
Expenditures for financing costs
    
(238
)
  
(341
)
Distributions to minority interest holders
    
(2,378
)
  
(2,225
)
Proceeds from the issuance of common stock
    
49,934
   
142
 
Proceeds from the issuance of stock under the associate stock purchase plan
    
1,035
   
-
 
Proceeds from the exercise of stock options
    
1,013
   
204
 
Net cash and cash equivalents provided (used) by financing activities
    
507
   
(6,832
)
 
See accompanying notes to condensed consolidated financial statements.
 
6
 
AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES       
  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED       
  
(UNAUDITED)       
  
(in thousands)       
  
   
Six months ended June 30,  
  
   
2005
  
2004
  
       
(restated)
 
           
Net increase in cash and cash equivalents
  
$
18,018
  
$
1,733
  
               
Cash and cash equivalents at beginning of period
    
28,454
   
17,192
 
Cash and cash equivalents at end of period
  
$
46,472
  
$
18,925
  
               
Supplemental disclosure of cash flow information:
              
Cash paid during the period for interest (including capitalized interest)
  
$
7,919
  
$
12,844
  
Income taxes paid
  
$
2,613
  
$
494
  
               
 
During the six months ended June 30, 2005, the Company acquired the real assets of an assisted living community previously operated pursuant to an operating lease and an entrance-fee continuing care retirement community for approximately $14.0 million of cash plus the assumption of various liabilities, including existing entrance fee refund obligations. As a result of the transaction, assets and liabilities changed as follows:      
  
   
     Six months ended June 30,
  
     
2005
    
2004
  
               
Land, buildings and equipment acquired
  
$
26,139
  
$
-
  
Refundable portion of entrance fees
    
(631
)
  
-
 
Deferred entrance fee income
    
(9,779
)
  
-
 
Other
   
(1,779
)
  
-
 
Cash paid for acquisition of community and property
  
$
13,950
  
$
-
  
 
Supplemental disclosure of non-cash transactions:
              
During the six months ended June 30, 2005, the Company completed a transaction with a real estate investment trust ("REIT") pursuant to which the Company received $9.5 million in proceeds under its existing leases on two of its retirement center communities. This investment by the REIT is recorded by the Company as a refinancing of a previous $8.7 million note payable. In connection with this refinancing, the Company incurred a loss on debt extinguishment which is included as a non-cash charge in the Company's condensed consolidated statements of cash flows for the six months ended June 30, 2005.
 
During the six months ended June 30, 2004, the Company issued 4,808,898 shares of common stock, par value $0.01 per share, to certain holders of the Company's 10% Convertible Senior Subordinated Series B Notes. The holders elected to convert $10.9 million of the Series B Notes to common stock at the conversion price of $2.25 per share. On April 1, 2004, the Company elected to redeem the balance of the Series B Notes on April 30, 2004. As a result, debt and equity were changed as follows:      
  
   
     Six months ended June 30,
  
     
2005
    
2004
  
Long-term debt
  
$
-
  
$
(10,820
)
Common stock
    
-
   
48
 
Additional paid-in capital
    
-
   
10,772
 
 
See accompanying notes to condensed consolidated financial statements.
 
7
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of American Retirement Corporation (the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. These financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2004. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals and other adjustments) considered necessary for a fair presentation have been included. In addtion, certain prior period amounts have been reclassifed to conform to current year presentation. Operating results for the three and six months ended June 30, 2005 are not necessarily indicative of the results that may be expected for the entire year ending December 31, 2005.

The preparation of the consolidated financial statements requires management to make estimates and assumptions relating to the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.

2. Restatement

The Company filed an amendment on Form 10-K/A to its Annual Report on Form 10-K for the year ended December 31, 2004 to restate its consolidated statements of operations, statements of shareholders' equity and comprehensive loss and statements of cash flows for the years ended December 31, 2004, 2003 and 2002, and its balance sheets as of December 31, 2004 and 2003 and for the quarterly periods of the fiscal years ended December 31, 2004 and 2003. The information contained herein reflects such restatement.

The following is a summary of the impact of the restatement on the Company’s condensed consolidated statements of operations and cash flows for the three and six months ended June 30, 2004 (in thousands, except per share data):
 
8
 
 

Condensed Consolidated Statements of Operations
(In thousands, except per share data)
  
   
For the three months ended June 30, 2004
  
For the six months ended June 30, 2004
  
   
As previously
filed
 
Adjustments
 
Restated
 
As previously
filed
 
Adjustments
 
Restated
 
                           
Total revenues
 
$
110,149
  
$
-
  
$
110,149
  
$
219,292
  
$
-
  
$
219,292
  
                                       
Lease expense
   
15,158
   
(286
)
  
14,872
   
30,272
   
(579
)
  
29,693
 
(Gain) loss on sale of assets
   
-
   
(6
)
  
(6
)
  
-
   
(111
)
  
(111
)
Total operating expenses
   
103,136
   
(292
)
  
102,844
   
207,089
   
(690
)
  
206,399
 
Operating income
   
7,013
   
292
   
7,305
   
12,203
   
690
   
12,893
 
                                       
Loss (gain) on sale of assets
   
(6
)
  
6
   
-
   
(111
)
  
111
   
-
 
Other expense, net
   
(8,621
)
  
(6
)
  
(8,627
)
  
(17,504
)
  
(111
)
  
(17,615
)
Loss before income taxes and minority interest
   
(1,608
)
  
286
   
(1,322
)
  
(5,301
)
  
579
   
(4,722
)
Income tax expense
   
75
   
-
   
75
   
220
   
-
   
220
 
Net loss
   
(2,546
)
  
286
   
(2,260
)
  
(7,346
)
  
579
   
(6,767
)
                                       
Basic and diluted loss per share
   
(0.10
)
  
0.01
   
(0.09
)
  
(0.32
)
  
0.02
   
(0.30
)
                                       
 
 Condensed Consolidated Statement of Cash Flows
(In thousands)
    
                    
For the six months ended June 30, 2004
 
                      
As previously
filed 
    
Adjustments
   
Restated
 
                                       
Net loss
                     
(7,346
)
  
579
   
(6,767
)
Entrance fee items:
                                     
Amortization of deferred entrance fee income
                     
(8,745
)
  
-
   
(8,745
)
Proceeds from entrance fee sales - deferred income
                     
22,620
   
(7,295
)
  
15,325
 
Refunds of entrance fee terminations
                     
(5,872
)
  
5,872
   
-
 
Accrual of deferred interest
                     
-
   
4,074
   
4,074
 
Other assets
                     
3,928
   
45
   
3,973
 
Deferred lease liability
                     
-
   
(624
)
  
(624
)
Net cash and cash equivalents provided by operating activities
                     
18,738
   
2,651
   
21,389
 
                                       
Net cash and cash equivalents used by investing activities
                     
(12,824
)
  
-
   
(12,824
)
                                       
Accrual of deferred interest
                     
4,074
   
(4,074
)
  
-
 
Entrance fee items:
                                     
Proceeds from entrance fee sales - refundable portion
                     
-
   
7,295
   
7,295
 
Refunds of entrance fee terminations
                     
-
   
(5,872
)
  
(5,872
)
Net cash and cash equivalents used by financing activities
                     
(4,181
)
  
(2,651
)
  
(6,832
)
Net increase in cash and cash equivalents
                     
1,733
   
-
   
1,733
 

3. Principles of Consolidation

The accompanying condensed consolidated financial statements include the financial statements of American Retirement Corporation and its wholly owned and majority owned subsidiaries that manage, own and operate senior living communities. The Company maintains each of its subsidiaries as a separate and distinct legal entity. Absent express contractual provisions or agreements to the contrary, neither the Company nor any of its subsidiaries are liable for, nor are any of their respective assets available to satisfy, the obligations or liabilities of any other subsidiary of the Company. The accounts of limited liability companies, joint ventures and partnerships are consolidated when the Company maintains effective control over such entities' assets and operations, notwithstanding, in some cases, a lack of majority ownership. All significant intercompany balances and transactions are eliminated in consolidation.
 
9

4. Segment Information

The Company operates principally in three business segments: (1) retirement centers, (2) free-standing assisted living communities, and (3) management services. The Company currently operates 29 retirement centers, which provide a continuum of care services such as independent living, assisted living and skilled nursing care. Of the 29 retirement centers, the Company owns five, operates four pursuant to leases classified as lease financing obligations (which include purchase options), operates 19 pursuant to operating leases and consolidates one variable interest entity, a retirement center that the Company manages (Freedom Square). The Company operates seven retirement centers which are entrance fee communities for which the Company receives an upfront fee and provides housing and health care services under various types of entrance fee agreements with residents.

The Company currently operates 33 free-standing assisted living communities. Free-standing assisted living communities are generally comprised of stand-alone assisted living communities that are not located on a retirement center campus, most of which also provide some specialized care such as Alzheimer’s and memory enhancement programs. Free-standing assisted living communities are generally much smaller than retirement centers. Of the 33 free-standing assisted living communities operated by the Company, 12 are owned (two in joint ventures), six are operated pursuant to leases classified as lease financing obligations, and 15 are operated pursuant to operating leases.

The management services segment includes fees from management agreements for communities owned by others, and fees for other services including development services, and reimbursed expense revenues together with associated expenses. The management services segment does not include any managed communities that the Company consolidates. The Company has five management agreements for retirement centers with third parties. Of the managed communities, two are cooperatives that are owned by their residents and two are owned by not-for-profit sponsors. The remaining managed retirement center is owned by an unaffiliated third party. 

10


The Company manages and evaluates the performance of its business segments principally based upon segment operating contributions, which the Company defines as revenue from the segment less operating expenses associated with the segment. The following is a summary of total revenues and operating contributions by segment for the three and six months ended June 30, 2005 and 2004, and total assets by segment at June 30, 2005 and December 31, 2004 (in thousands).(1)(2)(3)
 

   
Three Months Ended June 30,
  
Six Months Ended June 30,
  
   
2005
 
2004
 
2005
 
2004
 
       
(restated)
     
(restated)
 
Revenues
                         
Retirement centers  
  
$
93,794
  
$
85,578
  
$
185,276
  
$
170,866
  
Free-standing assisted living communities  
    
26,847
   
23,532
   
53,054
   
46,195
 
Management services (2)  
    
1,058
   
1,039
   
2,360
   
2,231
 
 Total revenue
 
$
121,699
  
$
110,149
  
$
240,690
  
$
219,292
  
                           
Retirement centers
                         
Resident and healthcare revenues  
  
$
93,794
  
$
85,578
  
$
185,276
  
$
170,866
  
Community operating expense  
    
61,869
   
56,546
   
122,759
   
113,337
 
 Segment operating contribution (3)
   
31,925
   
29,032
   
62,517
   
57,529
 
                           
Free-standing assisted living communities
                         
Resident and healthcare revenues  
    
26,847
   
23,532
   
53,054
   
46,195
 
Community operating expense  
    
18,027
   
17,519
   
36,474
   
34,580
 
 Segment operating contribution (3)
   
8,820
   
6,013
   
16,580
   
11,615
 
                           
Management services operating contribution
   
516
   
515
   
1,016
   
939
 
                           
General and administrative expense
   
6,765
   
6,114
   
13,356
   
12,702
 
Lease expense
   
15,445
   
14,872
   
30,955
   
29,693
 
Depreciation and amortization (4)
   
9,462
   
7,275
   
19,432
   
14,906
 
Loss (gain) on sale of assets
   
344
   
(6
)
  
356
   
(111
)
 Operating income
 
$
9,245
  
$
7,305
  
$
16,014
  
$
12,893
  
 
                           
 
                
 
    
 
  
                 
June 30,
    
December 31,
  
                 
2005
    
2004
  
Total Assets
                         
Retirement centers  
              
$
507,626
  
$
498,132
  
Free-standing assisted living communities  
                
185,840
   
182,353
 
Management services  
                
135,971
   
68,765
 
 Total
             
$
829,437
  
$
749,250
  

 
(1)
Segment financial and operating data does not include any inter-segment transactions or allocated costs.
 
(2)
Management Services represent the Company’s management fee revenue and reimbursed expense revenue.
 
(3)
Segment operating contribution is defined as segment revenues less segment operating expenses.
 
(4)
The Company’s depreciation expense for the six months ended June 30, 2004 includes $0.5 million of depreciation expense which would have been recognized during 2003 while the assets were held-for-sale if the assets had been continuously classified as held-for-use.

11


5. Stock Based Compensation

 
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R, Accounting for Share Based Payment, an amendment to SFAS No. 148, Stock-Based Compensation - Transition and Disclosure and a revision to SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123R requires alternative methods of transition for the change to the fair value method of accounting for stock-based employee compensation and is effective as of the beginning of the first annual period that begins after June 15, 2005 (calendar 2006). The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123 established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. The following table illustrates the effect on net income (loss) if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands except per share data).
 

   
Three Months Ended June 30,
  
Six Months Ended June 30,
  
   
2005
  
2004
  
2005
  
2004
  
       
(restated)
      
(restated)
  
Net income (loss), as reported
 
$
59,000
  
$
(2,260
)
$
61,625
  
$
(6,767
)
Deduct total stock-based employee compensation
expense determined under fair-value-based method
   
(294
)
  
(255
)
  
(322
)
  
(421
)
Pro forma net income (loss)
  
$
58,706
  
$
(2,515
)
$
61,303
  
$
(7,188
)
                           
Earnings (loss) per share:
                         
Basic - as reported
 
$
1.90
  
$
(0.09
)
$
2.06
  
$
(0.30
)
Diluted - as reported
 
$
1.82
  
$
(0.09
)
$
1.96
  
$
(0.30
)
Basic - pro forma
 
$
1.89
  
$
(0.10
)
$
2.05
  
$
(0.32
)
Diluted - pro forma
 
$
1.82
  
$
(0.10
)
$
1.95
  
$
(0.32
)


As permitted by SFAS No. 123R, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of these statements. Beginning in calendar year 2006, the Company plans to expense stock options using the modified prospective transition method prescribed in SFAS 123 (Revised). The modified prospective transition method requires expense to be recognized for new grants or modifications issued in the period of adoption, plus the current period expense for non-vested awards issued prior to the adoption of this standard. No expense is recognized for awards vested in prior periods. The weighted average fair value of options granted during the three and six months ended June 30, 2005 was $6.50 and $6.40, respectively, as compared to $2.25 and $2.28, for the three and six months, respectively, ended June 30, 2004. Considering recent market trends, the Company expects this average to continue to increase. At June 30, 2005, the Company had 0.9 million unvested options outstanding, of which 0.2 million vest during the remainder of 2005. The Company is currently evaluating the use of various models, as well as the necessary assumptions for calculating the impact from adoption of this standard. Based on current guidance, the Company intends to adopt SFAS 123R and begin expensing share payments January 1, 2006.

On July 19, 2004, the Company granted certain members of management a total of 440,000 shares of restricted stock. This stock had a $5.95 market value at the date of grant. These grants vest ratably over a period of three years from the date of grant. Measured compensation related to these grants totaled $2.6 million which is being amortized as compensation expense over the period of vesting. For the three months and six months ended June 30, 2005, the Company expensed $0.3 million and $0.5 million, respectively, as compensation expense related to the amortization of the restricted stock.
 
12
 
6.  Earnings (Loss) per Share

Basic and diluted earnings per share for the three and six months ended June 30, 2005 have been computed on the basis of the weighted average number of shares outstanding. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. At June 30, 2005 and 2004, there were approximately 2.1 million and 1.5 million options to purchase shares of common stock outstanding which had an exercise price below the average market price of the common shares for the corresponding periods, respectively.

A computation of diluted earnings (loss) per share is as follows (in thousands):
 

   
Three Months Ended  
  
Six Months Ended  
  
   
June 30,  
  
June 30,  
  
   
2005
  
2004
  
2005
  
2004
  
       
(restated)
     
(restated)
 
Net income (loss)
 
$
59,000
  
$
(2,260
)
$
61,625
  
$
(6,767
)
                           
Weighted average shares used for basic earnings per share data
    
31,053
   
24,290
   
29,976
   
22,770
 
Effect of dilutive common securities:
                          
Employee stock options
   
1,278
   
-
   
1,540
   
-
 
Weighted average shares used for diluted earnings per share data
    
32,331
   
24,290
   
31,516
   
22,770
 
                           
Basic income (loss) per share
 
$
1.90
  
$
(0.09
)
$
2.06
  
$
(0.30
)
Effect of dilutive securities
   
(0.08
)
  
-
   
(0.10
)
  
-
 
Diluted income (loss) per share
 
$
1.82
  
$
(0.09
)
$
1.96
  
$
(0.30
)

The following options outstanding during the three and six months ended June 30, 2005 and 2004 were excluded from the computation of diluted earnings per share for the respective period because the options’ exercise price was greater than the average market price of the common shares and, therefore, the effect would be anti-dilutive. The options outstanding during the three and six months ended June 30, 2004 were excluded from the computation of diluted earnings per share for the respective period because of net losses during these periods.


   
Three Months   
  
Six Months   
  
   
Ended June 30,  
  
Ended June 30,  
  
   
2005
  
2004
  
2005
  
2004
  
Number of options (in thousands)
    
36
   
746
   
176
   
1,038
 
Weighted-average exercise price
  
$
14.48
  
$
4.90
  
$
13.60
  
$
4.84
  


On April 1, 2004, the Company elected to redeem the balance of its 10% Series B Convertible Senior Subordinated Notes due 2008 (Series B Notes). The notes were not included in the computation of diluted earnings per share for the three and six months ended June 30, 2004 as the effect would be anti-dilutive.

13
 
7.  Long-term Debt and Other Transactions

A summary of long-term debt is as follows (in thousands):
   
June 30,
 
December 31,
 
   
2005
  
2004
  
Various mortgage notes, interest at variable and fixed rates, generally payable
monthly with any unpaid principal and interest due between 2006 and 2037.
Interest rates at June 30, 2005 range from 5.81% to 9.5%. The loans are secured
by certain land, buildings and equipment.
 
$
89,782
  
$
109,401
  
               
Other long-term debt, interest generally payable monthly with any unpaid
principal due between 2005 and 2018. Fixed interest rates at June 30, 2005 range
from 4.6% to 9.0%.
   
15,742
   
26,555
 
Subtotal debt
    
105,524
    
135,956
  
               
Capital lease and lease financing obligations with principal and interest payable
monthly bearing interest at fixed rates ranging from 0.53% to 10.9%, with final
payments due between 2009 and 2017. The obligations are secured by certain
land, buildings and equipment.
    
191,134
    
199,126
  
Total debt including capital lease and lease financing obligations
    
296,658
   
335,082
  
Less current portion:
              
Debt
    
(6,975
)
  
(10,372
)
Capital lease and lease financing obligations
    
(16,922
)
  
(16,474
)
Total long-term debt, excluding current portion:
              
Debt
    
98,549
    
125,584
  
Capital lease and lease financing obligations
    
174,212
    
182,652
  
Total
  
$
272,761
  
$
308,236
  

At June 30, 2005, the aggregate scheduled maturities of long-term debt were as follows (in thousands):
 

   
Long-term
Debt
  
Capital Lease
and Lease
Financing
Obligations
  
Total Debt at
June 30, 2005
  
               
For the twelve months ended June 30, 2006
  
$
6,975
  
$
16,922
  
$
23,897
  
For the twelve months ended June 30, 2007
    
11,148
    
17,304
    
28,452
  
For the twelve months ended June 30, 2008
    
2,508
    
18,026
    
20,534
  
For the twelve months ended June 30, 2009
    
7,588
    
18,867
    
26,455
  
For the twelve months ended June 30, 2010
    
9,007
    
19,764
    
28,771
  
Thereafter
    
68,298
    
100,251
    
168,549
  
   
$
105,524
  
$
191,134
  
$
296,658
  

14
 
2005 Activity

The Company used the proceeds of its January 26, 2005 secondary offering to make certain debt repayments. During January 2005, the Company repaid in full the balance on a mortgage loan from Health Care Property Investors (HCPI) in the amount of $5.7 million, bearing interest at 9%. In addition, during January 2005, the Company repaid in full the $17.2 million of 9.625% fixed interest-only mortgage notes, issued in 2001, due October 1, 2008.

During May 2005, the Company repaid in full the balance on a 5.5%, $7.1 million floating rate mortgage loan, due April 2011, related to a free standing assisted living community.

The Company recently completed four transactions as part of its strategy to release portions of its restricted cash, and to increase capacity in its portfolio through certain community expansions and new development. These transactions in the aggregate released approximately $13 million of restricted cash and facilitated the Company’s expansion plans at certain communities.

On June 29, 2005, the Company obtained a letter of credit facility from a commercial bank. The facility provides for the issuance of up to $10.7 million of standby letters of credit and is collateralized by a mortgage on two of the Company’s free-standing assisted living communities. The Company presently has $8.4 million of letters of credit outstanding under this facility, which has an initial term of one year, and can be renewed for two additional one year periods in accordance with its terms. A fee of 1% per annum is payable for any letters of credit issued under the facility. In the event a standby letter of credit is drawn upon, the amount so drawn will bear interest at the prime rate. The letter of credit facility contains certain financial convenants and other restrictions related to certain communities. As a result of this letter of credit facility, the Company released approximately $8.4 million from its restricted cash balance, which was used to repay debt.

On June 29, 2005, the Company completed a transaction with a real estate investment trust (“REIT”)  from whom the Company leases two of its Alabama retirement center communities. Pursuant to this transaction, the Company received $9.5 million in proceeds which were then used to repay the balance of a $9.5 million loan related to its leasehold in the communities. The additional investment by the REIT is recorded by the Company as a refinancing and is included in the Company’s condensed consolidated balance sheet debt at June 30, 2005. In connection with this refinancing, the Company incurred a loss on debt extinguishment. This loss is included in the Company’s condensed consolidated statement of operations as interest expense for the three and six months ended June 30, 2005.

The Company has a master lease with another REIT for nine of its communities. On June 30, 2005, the Company amended the master lease as part of a transaction that involved the sale to the REIT of two of the Company’s owned free-standing assisted living communities for inclusion in the master lease, and the contemporaneous removal of two other free-standing assisted living communities from the master lease. In connection with this exchange, the Company also received $1.5 million of cash from the REIT, which correspondingly increased the Company’s lease basis under the master lease. The operating results of all four of these communities are included in the Company’s condensed consolidated financial statements before and after the exchange. This exchange will facilitate planned expansions for both of the communities that were repurchased and removed from the master lease. Additionally, as part of this transaction, the REIT established a program to reduce up to $7.0 million of security deposit requirements under the master lease based on the satisfaction of certain financial performance tests for the master lease portfolio. The Company currently has $7.0 million of restricted cash underlying these security deposits that will be released incrementally as these tests are met. The master lease was also amended to extend the timing of a purchase option for one community under the master lease. The option was initially exercisable in 2010, which date may be deferred for up to three years at the option of the REIT.

On June 30, 2005, the Company completed a transaction with a third REIT to repurchase the REIT’s minority interest in the lessor of two of its entrance fee communities. As a result of the repurchase of these two minority ownership positions, the Company now owns 100% of both entrance fee communities. In exchange for these minority interests, the Company issued to the REIT a $6.2 million note, due July 1, 2010, bearing interest at 9%. The transaction simplifies the ownership structure of the two communities and facilitates the current expansion of one of them. In a related transaction, the REIT amended a separate lease with the Company to eliminate a $5 million security deposit requirement. As a result, $5 million of the Company’s restricted cash was released to unrestricted cash.

15
Other Activity

Approximately $63.5 million of the Company’s $191.1 million in lease financing obligations include contingent earnout provisions under certain leases which expire between December 2005 and October 2006. The contingent earnout provisions relate to one retirement center and six free-standing assisted living communities. When these provisions expire, the Company’s continuing involvement related to the initial sale-leaseback transactions will be relieved and the subject leases will no longer be accounted for as lease financing obligations, but will be accounted for as operating leases. As a result, lease financing obligations, depreciation expense and interest expense will decrease and operating lease obligations and lease expense will increase. The expected reduction of lease financing obligations as a result of these expirations, unless further extended and assuming no modifications in payment terms, is:

During the three months ended December 31, 2005
  
$
5.5 million
  
During the three months ended March 31, 2006
    
7.2 million
  
During the three months ended December 31, 2006
    
46.7 million
  
 
   $
 59.4 million
  

The Company guarantees approximately $18.2 million of mortgage debt that is not reflected on the Company’s balance sheet, of which $9.8 million relates to a retirement center which the Company leases and $8.4 million relates to a joint venture which the Company manages. These guarantees require that the Company pay or perform the borrower’s obligation. Accordingly, the Company would be required to make any payments, and perform any obligations, if the relevant borrower fails to do so. To date, the Company has not been required to fund any debt guarantees, and at June 30, 2005, the Company does not believe that it will be required to make payments under its current outstanding guarantees. If it were required to fund a debt guarantee, the Company would be entitled to seek indemnity or contribution payments from the borrower and, if applicable, any co-guarantor.

Liquidity
 
The Company believes that its current cash and cash equivalents, expected cash flow from operations, and the proceeds from additional financing transactions will be sufficient to fund its operating requirements, ongoing capital expenditure requirements, periodic debt service requirements, lease and tax obligations during the next twelve months.
 
The Company has substantial debt and lease obligations. During the past twelve months, total debt decreased $38.4 million from $335.1 million at June 30, 2004 to $296.7 million at June 30, 2005. Approximately $247.1 million or 83.3% of the Company’s debt and lease financing obligations have fixed interest rates, which on a weighted average basis were 4.02% at June 30, 2005. The remaining $49.6 million, or 16.7%, of debt has variable interest rates, which on a weighted average basis were 6.04% at June 30, 2005. The Company has scheduled current debt and lease principal payments of $23.9 million and minimum rental obligations of $69.1 million under long-term operating leases due during the twelve months ended June 30, 2006.
 
As of June 30, 2005, the Company had approximately $46.5 million in unrestricted cash and cash equivalents and $39.1 million in restricted cash. For the six months ended June 30, 2005, the Company’s cash provided by operations was $30.6 million. At June 30, 2005, the Company had $87.2 million of negative working capital, which includes the classification of $119.3 million of entrance fees and $4.7 million of tenant deposits as current liabilities as required by applicable accounting pronouncements. During 2002, 2003 and 2004, the Company experienced that only 12%, 11%, and 9%, respectively, of these entrance fee liabilities actually became payable and were required to be settled in cash. During this same period, entrance fee liabilities paid were offset by proceeds generated by subsequent entrance fee sales. Entrance fee sales, net of refunds paid, provided $21.5 million, $26.7 million, and $31.2 million of cash during 2002, 2003, and 2004, respectively.
 
16

On January 26, 2005, the Company completed a public offering of 5,175,000 shares of common stock, including the underwriter’s over-allotment of 675,000 shares. The shares were priced at $10.25. The net proceeds of the offering, after deducting underwriting discounts, commissions and expenses, were approximately $49.9 million.
 
Substantially all of the Company's assets are pledged (including first priority mortgages) to secure its indebtedness. Certain of the Company’s indebtedness and lease agreements are cross-collateralized or cross-defaulted. Any default with respect to such obligations could cause the Company’s lenders or lessors to declare defaults, accelerate payment obligations or foreclose upon the communities securing such indebtedness or exercise their remedies with respect to such communities, which could have a material adverse effect on the Company. Certain of the Company’s debt instruments and leases contain financial and other covenants, typically related to the specific communities financed or leased. The Company believes that its current cash and cash equivalents and expected cash flow from operations will be sufficient to fund its operating requirements, ongoing capital expenditure requirements, periodic debt service requirements, and lease obligations during the next twelve months. Should the Company’s cash and cash flow from operations not be sufficient, there is no guarantee that the Company will be able to obtain alternative financing under acceptable terms.
 
8. Operating Leases

As of June 30, 2005, the Company operated 44 of its senior living communities under long-term leases (34 operating leases and ten capital lease or lease financing obligations). Of the 34 operating lease communities, 25 are operated under four master lease agreements, with the remaining communities leased under individual lease agreements. The Company also leases its corporate offices and is obligated under several ground leases for senior living communities. The remaining base lease terms vary from three to 19 years. Many of the leases provide for renewal, extension and purchase options. Many of the leases also provide for graduated lease payments, either based upon fixed rate increases or a specified formula. In addition, several leases have provisions for contingent lease payments based on revenue, occupancy levels or other measures. Contingent rent that depends on factors directly related to the future use of leased property is accrued when it is deemed probable such amounts will be due. In addition, a majority of the Company’s lease agreements impose certain restrictions or require pre-approval for certain changes such as expansions or significant modifications to the leased property.

Net lease expense for the three months ended June 30, 2005 was $15.4 million, which includes lease payments of $17.0 million, plus accruals for future lease escalators (straight-line lease expense) of $1.4 million, net of the amortization of the deferred gain from prior sale-leasebacks of $3.0 million. Net lease expense for the three months ended June 30, 2004 was $14.9 million, which includes lease payments of $15.9 million, plus accruals for future lease escalators of $1.5 million, net of the amortization of the deferred gain from prior sale-leasebacks of $2.5 million.

Net lease expense for the six months ended June 30, 2005 was $31.0 million, which includes lease payments of $34.0 million, plus accruals for future lease escalators (straight-line lease expense) of $2.9 million, net of the amortization of the deferred gain from prior sale-leasebacks of $5.9 million. Net lease expense for the six months ended June 30, 2004 was $29.7 million, which includes lease payments of $31.8 million, plus accruals for future lease escalators of $3.0 million, net of the amortization of the deferred gain from prior sale-leasebacks of $5.1 million.

17

Future minimum lease payments at June 30, 2005 are as follows (in thousands):

Twelve months ended June 30, 2006
  
$
69,109
  
Twelve months ended June 30, 2007
    
70,214
  
Twelve months ended June 30, 2008
    
70,086
  
Twelve months ended June 30, 2009
    
70,109
  
Twelve months ended June 30, 2010
    
71,115
  
Thereafter
    
397,979
  
 
  
$
748,612
  

The following table provides a summary of operating lease obligations at June 30, 2005 by lessor:

   
Future Minimum Lease Payments
  
   
Twelve Months
Ending
  
Total
Remaining
  
   
June 30, 2006
  
Lease Term
  
Master lease agreements for ten communities. Initial term ranging from 10 to 15
years, with renewal options for two additional ten year terms.
 
$
24,048
  
$
251,308
  
 
Operating lease agreements for three communities with an initial term of 15
years and renewal options for two additional five year terms or two
additional ten year terms.
   
9,194
    
142,418
  
 
Master lease agreement for nine communities. Initial 12 year term, with renewal
options for two additional five year terms.
   
11,022
    
103,297
 
 
Operating lease agreement for a community which has a 23 year term, with a
seven year renewal option. The Company also has an option to purchase the
community at the expiration of the lease term at fair market value.
    
4,345
    
52,285
  
 
Operating lease agreement for a community with an initial term of 15 years with
two five year renewal options and a right of first refusal to repurchase the
community. The Company recorded a deferred gain of $11.7 million on the sale,
which is being amortized over the base term of the lease.
   
3,893
    
46,185
  
 
Master lease agreement for six communities with an initial ten year term, with
renewal options for four additional ten year terms.
   
6,067
    
45,717
  
 
Other lease agreements for four communities, as well as a lease for the home office.
Initial terms ranging from eight to 17 years, with various renewal options.
   
10,540
   
107,402
  
 
Total operating lease obligations
  
$
69,109
  
$
748,612
  


9.  Income Taxes

As a result of reported losses and other factors, the Company had previously established a valuation allowance against certain deferred tax assets. The Company has determined it is more likely than not that it will realize the benefit of certain of these deferred tax assets, and therefore has reduced its valuation allowance by approximately $55.7 million during the three months ended June 30, 2005, resulting in a significant tax benefit during the period.


10.  Commitments and Contingencies
The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. In the opinion of management, the ultimate liability with respect to those proceedings and claims will not materially affect the financial position, operations, or liquidity of the Company. The Company maintains commercial insurance on a claims-made basis for medical malpractice and professional liabilities.

18
Insurance

The delivery of personal and health care services entails an inherent risk of liability. Participants in the senior living and health care services industry have become subject to an increasing number of lawsuits alleging negligence or related legal theories, many of which involve large claims and result in the incurrence of significant exposure and defense costs. The Company currently maintains general and professional medical malpractice insurance policies for the Company's owned, leased and certain of its managed communities under a master insurance program. Premiums and deductibles for this insurance coverage have risen dramatically in recent years, particularly during 2002 and 2003. In response to these conditions, the Company has significantly increased the staff and resources involved in quality assurance, compliance and risk management during the past several years, and has also modified its insurance programs.

The Company currently maintains single incident and aggregate liability protection in the amount of $25.0 million for general liability and $15.0 million for professional liability, with self-insured retention of $1.0 million and $5.0 million, respectively. The Company believes it has adequately accrued amounts to cover open claims not yet settled and incurred but not reported claims as of June 30, 2005.

The Company operates under a self-insured workers’ compensation program, with excess loss coverage provided by third party carriers. As of June 30, 2005, the Company’s coverage for workers’ compensation and related programs, excluding Texas, included excess loss coverage of $350,000 per individual claim and approximately $6.3 million in the aggregate. As of June 30, 2005, the Company provided cash collateralized letters of credit in the aggregate amount of $9.9 million related to this program, which are reflected as restricted cash on the Company’s consolidated balance sheet. For work-related injuries in Texas, the Company is a non-subscriber under Texas state law, meaning that work-related losses are covered under a defined benefit program outside of the Texas Workers' Compensation system. The Company carries excess loss coverage of $250,000 per individual under its non-subscriber program. Losses are paid as incurred and estimated losses are accrued on a monthly basis. The Company utilizes a third party administrator to process and pay filed claims.

The Company maintains a self-insurance program for employee medical coverage, with stop-loss insurance coverage of approximately $250,000 per associate. Estimated costs related to this self-insurance program are accrued based on known claims and projected settlements of unasserted claims incurred but not yet reported to the Company. Subsequent changes in actual experience (including claim costs, claim frequency, and other factors) could result in additional costs to the Company.

During the three and six months ended June 30, 2005, the Company expensed $4.3 million and $8.5 million, respectively, as compared to $3.7 million and $8.4 million for the three and six months ended June 30, 2004, respectively, related to premiums, claims and costs for general liability and professional medical malpractice, workers’ compensation, and employee medical insurance related to multiple insurance years.

Management Agreements

The Company’s management agreements are generally for terms of three to 20 years, but certain of the agreements may be canceled by the owner of the community, without cause, on three to six months notice. One management agreement provides the Company with two ten year renewal options. Pursuant to the management agreements, the Company is generally responsible for providing management personnel, marketing, nursing, resident care and dietary services, accounting and data processing services, and other services for these communities in exchange for a monthly fee for its services based on either a contractually fixed amount, a percentage of revenues or income, or cash flows in excess of operating expenses and certain cash flows of the community. The Company’s existing management agreements expire at various times through June 2018.

In connection with these management agreements, the Company has guaranteed mortgage debt of $8.4 million related to a joint venture which the Company manages.

19
Regulatory Requirements

Federal and state governments regulate various aspects of the Company's business. The development and operation of health care facilities and the provision of health care services are subject to federal, state, and local licensure, certification, and inspection laws that regulate, among other matters, the number of licensed beds, the provision of services, the distribution of pharmaceuticals, billing practices and policies, equipment, staffing (including professional licens-ing), operating policies and procedures, fire prevention measures, environmental matters, and compliance with building and safety codes. Failure to comply with these laws and regulations could result in the denial of reimbursement, the imposition of fines, temporary suspension of admission of new patients, suspension or decertification from the Medicare programs, restrictions on the ability to acquire new communities or expand existing communities, and, in extreme cases, the revocation of a community's license or closure of a community. Management believes the Company was in compliance with such federal and state regulations at June 30, 2005.

Other

A portion of the Company’s skilled nursing revenue is attributable to reimbursements under Medicare. Certain per person annual limits on therapy services, which were effective September through December 2003, have been placed on moratorium for two years. These caps will become effective for the first quarter of 2006, unless revised or extended.
 
11.  Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29.” The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of assets exchanged. The guidance in that opinion, however, included certain exceptions to that principle. This Statement amends APB No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005, while early application is permitted for nonmonetary asset exchanges occuring in fiscal periods beginning after December 2004. The Company adopted the provisions of SFAS 153 on April 1, 2005.

 
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections” (SFAS 154), a replacement to Accounting Principles Board Opinion No. 20, “Accounting Changes” (APB 20) and Financial Accounting Standards No. 3, “Reporting Accounting Changes in Interim Financial Statements.” This statement changes the requirements for the accounting for and reporting of a change in accounting principle. This statement requires retrospective application to prior periods financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. Additionally, this statement carries forward the guidance in APB 20 for reporting the correction of an error, a change in accounting estimate and requires justification of a change in accounting principle. This pronouncement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, and accordingly, the Company will adopt SFAS 154 in the first quarter of 2006.

12.  Subsequent Events

On July 7, 2005, the Company acquired all of the real property interests underlying Freedom Plaza Care Center (FPCC), a 128-bed skilled nursing and 44-unit assisted living center in Peoria, Arizona for $20.3 million. The Company previously operated FPCC pursuant to a long-term operating lease with Maybrook Realty, which was 50% owned by W.E. Sheriff, the Company’s chairman, chief executive officer and president. The Company consummated the acquisition pursuant to an option under the lease, which provided for a fixed purchase price of $20.3 million. The Company also contemporaneously acquired the third-party ground lessor’s interest in the property, including an adjacent parcel of land, for a purchase price of $3.1 million. The total purchase price for these two transactions was $23.4 million, which was supported by a fair market value appraisal. The purchase price was paid with $4.7 million of cash and with the proceeds of an $18.7 million mortgage loan obtained from Bank of America, N.A. The loan is evidenced by a loan agreement and two promissory notes and is secured by the community. The $18.7 million mortgage loan matures on July 1, 2010, and requires principal payments to be made on an 18-year amortization schedule. Half of the outstanding principal balance of the loan will bear interest at a fixed rate of 6.61% and the other half of the outstanding principal balance will bear interest at a variable rate calculated, at the Company’s election, at either the prime rate plus 1% or the eurodollar fixed rate plus 2.375% (or a combination thereof).

As a result of these transactions, the Company simultaneously acquired the real estate interests of both Maybrook and the ground lessor in FPCC and, consequently, owns 100% of the community. On July 7, 2005, the Company also entered into a $4.5 million construction loan administration agreement (and related promissory note) with Bank of America, N.A. in order to finance a 21 assisted living unit and 20 dementia bed expansion of the community. The $4.5 million loan matures on July 1, 2010, requires quarterly principal payments beginning April 1, 2008, and bears interest at a variable rate calculated, at the Company’s election, at either the prime rate plus 1% or the eurodollar fixed rate plus 2.375% (or a combination thereof).

20


     Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

The senior living industry is experiencing growth as a result of demographic changes and various other factors. According to census data, the over age 75 population in the United States is growing much faster than the general population. We have seen increasing demand for services at both our retirement centers and our free-standing assisted living communities during the past year, and expect that this demand will continue over the next several years. As a general rule, economic factors that affect seniors will have a corresponding impact on the senior living industry. For example, general concerns regarding lower interest rates on savings and uncertainty of investment returns have impacted seniors during the past several years, as well as uncertainties related to world events such as the Iraqi war. On the other hand, the continuing strength of the home resale market in most areas of the country has been beneficial to seniors, since the equity from the sale of a home is a significant source of funding for senior living care in many cases. In addition, overall economic conditions and general consumer confidence can impact the senior living industry, since many adult children subsidize the cost for care of elderly parents, and share in decisions regarding their care.

The assisted living industry is maturing and rapidly evolving. The demand for assisted living services increased significantly beginning with the emergence of the industry segment in the mid-1990s. However, the development of new assisted living communities across the country outstripped demand during this period, resulting in oversupply of unit capacity, longer fill up times, price pressures and deep discounting. The steadily increasing demand for assisted living services, coupled with minimal new development activity, reduced much of the oversupply in many of our markets in 2002 and 2003. As a result, we were able to increase occupancy, increase rates and reduce promotional discounting for our free-standing assisted living communities during 2003, 2004 and the first six months of 2005. Based on available industry data, we believe that new assisted living development in the near term will remain at sustainable levels and, accordingly, expect this trend to continue. The average length of stay in our free-standing assisted living community segment is approximately two years, which represents a challenge and an opportunity for us. We must find a number of new residents to maintain and build occupancy. However, we also have the opportunity to “mark-to-market” if we are able to attract new residents at higher current market rates, replacing prior residents with lower or discounted rates.

Our retirement center segment is a more mature segment of the industry, and has seen demand and price increases in recent years, with new unit capacity entering the market at sustainable levels. Management expects this growth in demand and selling rate increases to continue over the next several years. The average length of stay is much longer in our retirement centers, approximately five to seven years in the rental communities, and approximately ten to twelve years in the entrance fee communities. In addition, we believe that many of our retirement centers benefit from significant barriers to entry from competitors, including the significant cost and length of time to develop competitive communities, certificate of need requirements for nursing beds in certain states, the difficulty in finding acceptable development sites in the geographical areas in which our retirement centers are located, and the length of time and difficulty in developing strong competitive reputations.

We earn our revenues primarily by providing housing and services to our residents. Approximately 84% of our revenues come from private pay sources, meaning that residents or their families pay from their own funds (or from the proceeds of their privately funded long-term care policies). All private pay residents are billed in advance for the next month’s housing and care. In addition, we receive private pay revenues from the sale of entrance fee contracts at our entrance fee communities. While this cash is received at the time the resident moves in, the non-refundable portion of the entrance fee is primarily recognized as income for financial reporting purposes over the actuarial life of the resident.

21


Our most significant expenses are:

 
·
Community operating expenses - Labor and labor related expenses for community associates represent approximately 60% to 65% of this line item. Other significant items in this category are food costs, property taxes, utility costs, marketing costs and insurance.

 
·
General and administrative - Labor costs also represent the largest component for this category, comprising the home office and regional staff supporting community operations. Other significant items are travel and legal and professional service costs. In response to higher liability insurance costs and deductibles in recent years, and the inherent liability risk in providing personal and health-related services to seniors, we have significantly increased our staff and resources involved in quality assurance, compliance and risk management.

 
·
Lease expense - Our lease expense has grown significantly over the past several years, as a result of the large number of sale-leaseback transactions completed in connection with various financing transactions. Our lease expense includes the rent expense for all operating leases, including an accrual for known lease escalators in future years (the impact of these future escalators is spread evenly over the lease term for financial reporting purposes), and is reduced by the amortization of deferred gains on previous sale-leaseback transactions.

 
·
Depreciation and amortization expense - We incur significant depreciation expense on our fixed assets (primarily community buildings and equipment) and amortization expense related primarily to leasehold acquisition costs.

 
·
Interest expense - Our interest expense is comprised of interest on our outstanding debt, capital lease and lease financing obligations.

Results of Operations

We filed an amendment on Form 10-K/A to our Annual Report on Form 10-K for the year ended December 31, 2004 to restate our consolidated statements of operations, statements of shareholders' equity and comprehensive loss and statements of cash flows for the years ended December 31, 2004, 2003 and 2002, and our balance sheets as of December 31, 2004 and 2003 and for the quarterly periods of the fiscal years ended December 31, 2004 and 2003. The information herein reflects such restatement.

Recent Events

During January 2005, we completed a secondary equity offering of 5,175,000 common shares, resulting in approximately $49.9 million of net proceeds to us. We used $37.1 million of these proceeds to further reduce certain high cost debt, to acquire a retirement center, and to acquire the real assets of an assisted living community we previously operated pursuant to an operating lease. We will use the remaining proceeds to acquire certain leased real estate at our communities, and for upcoming expansion and development activity at our communities or for working capital.

During the second quarter of 2005, we completed four transactions as part of our strategy to release portions of our restricted cash, and to increase the capacity level of our portfolio through certain community expansions and new development. These transactions in the aggregate released approximately $13 million of restricted cash and facilitated our expansion plans for certain communities. See Note 7 to the condensed consolidated financial statements.

22
 
Highlights of Operating Results

Our statements of operations in recent years should be considered in light of the following factors, some of which are likely to influence our future operating results and financial outlook:
 
 
·
Our statements of operations for the three and six months ended June 30, 2005 show significant improvement versus the respective prior year periods. Net income for the three months ended June 30, 2005 was $59.0 million, including the $55.7 million impact of the reduction of our deferred tax valuation allowance, versus a net loss for the three months ended June 30, 2004 of $2.3 million. Net income for the six months ended June 30, 2005 was $61.6 million, including the $55.7 million impact of the reduction of our deferred tax valuation allowance, versus a net loss for the six months ended June 30, 2004 of $6.8 million. Cash provided by operating activities has increased $9.2 million, to $30.6 million from $21.4 million for the six months ended June 30, 2005 and 2004, respectively.
 
 
·
In order to continue to increase net income, we are focusing on improving results in our retirement centers and free-standing assisted living segments, while controlling our general and administrative costs and reducing our debt service costs. We are also focused on the growth of our ancillary service revenues, as well as the expansion of capacity at several communities.
 
 
·
We are focused on increasing the revenues and operating contribution of our retirement centers. Revenue per unit increases at our retirement centers resulted primarily from increases in selling rates, increased therapy and ancillary service revenues, as well as annual billing rate increases to existing residents (typically 2% to 4% under most resident agreements). In addition, a significant component of the average revenue per unit increase stems from the “mark-to-market” effect of resident turnover. Since monthly rates for new residents (current market selling rates) are generally higher than billing rates for current residents (since annual increases to billing rates are typically capped in resident agreements), turnover typically results in significantly increased monthly fees for the new resident. This “mark-to-market” increase is generally more significant in entrance fee communities due to much longer average length of stay (ten or more years).
 
 
·
For the three months ended June 30, 2005, retirement center revenues were up 9.6% versus prior year, and segment operating contribution was up 10% versus the same period last year. Operating contribution per unit per month increased 7.4% for the same period, from $1,155 to $1,241. For the six months ended June 30, 2005, retirement center revenues were up 8.4% and segment operating contribution was up 8.7% versus the six months ended June 30, 2004. Operating contribution per unit per month increased 6.6% from $1,144 to $1,219.
 
 
·
We are also focusing on increasing our free-standing assisted living segment operating contribution further primarily by increasing occupancy above the current 90% level, and by increasing revenue per unit through price increases, ancillary services, and the “mark-to-market” effect of turnover of units that are at lower rates, while maintaining control of our operating costs. Since monthly rates for new residents (current market selling rates) are generally higher than billing rates for current residents, turnover typically results in significantly increased monthly fees for the new resident. We believe that, absent unforeseen market or pricing pressures, occupancy increases above 90% should produce high incremental community operating contribution margins for this segment. The risks to improving occupancy in our free-standing assisted living community portfolio are unexpected increases in move outs in any period (due to health or other reasons) and the development of new unit capacity or renewed price discounting by competitors in our markets, which could make it more difficult to fill vacant units and which could result in lower revenue per unit.
 
 
·
Our free-standing assisted living communities have continued to increase revenue and segment operating contribution during 2005, primarily as a result of an 8.4% year over year increase in revenue per unit as of June 30, 2005, as well as an increase in ending occupancy from 86% as of June 30, 2004, to 90% as of June 30, 2005. The increased revenue per unit in our free-standing assisted living communities resulted primarily from selling rate increases, reduced discounting, and turnover of units resulting in new residents paying higher current market rates. In addition, our residency agreements provide for annual rate increases. The increased amount of ancillary services, including therapy services, also contributed to the increased revenue per unit.
 
23
 
·
Our free-standing assisted living community incremental increase in operating contribution as a percentage of revenue increase was 85% and 72% for the three and six months ended June 30, 2005, respectively, versus 75% and 85% for the three and six months ended June 30, 2004. Our free-standing assisted living community operating contribution per unit per month increased 39% during the three months ended June 30, 2005, versus the same period last year, to $1,150 per unit per month. For the six months ended June 30, 2005, our free-standing assisted living community operating contribution per unit per month increased 35% versus the same period last year to $1,086 per unit per month.


Segment Results

We operate in three business segments: retirement centers, free-standing assisted living communities, and management services.

The following table presents the number, total unit capacity and total ending and average occupancy percentages of our communities by operating segment at June 30, 2005 and 2004.



   
Number of Communities /
  
Ending Occupancy % /
  
Average Occupancy % /
  
   
Total Ending Capacity
  
Ending Occupied Units
  
Average Occupied Units
  
   
June 30,
  
June 30,
  
Six Months Ended June 30,
  
   
2005
  
2004
  
2005
  
2004
  
2005
  
2004
  
                           
Retirement Centers
   
29
   
28
   
95
%
  
95
%
  
95
%
  
94
%
     
9,037
   
8,871
   
8,567
   
8,424
   
8,547
   
8,380
 
                                       
Free-standing ALs
   
33
   
33
   
90
%
  
86
%
  
89
%
  
84
%
     
3,012
   
3,002
   
2,705
   
2,590
   
2,681
   
2,532
 
                                       
Management Services
   
5
   
5
   
95
%
  
93
%
  
95
%
  
93
%
     
1,188
   
1,188
   
1,129
   
1,111
   
1,127
   
1,072
 
                                       
Total
   
67
   
66
   
94
%
  
93
%
  
94
%
  
92
%
     
13,237
   
13,061
   
12,401
   
12,125
   
12,355
   
11,984
 
 
 
24
 
We measure the performance of our three business segments, in part, based upon the operating contribution produced by these business segments. We compute operating contribution by deducting the operating expenses associated with a segment from the revenues produced by that segment. The following table sets forth certain selected financial and operating data on an operating segment basis(1) (dollars in thousands, except for per unit amounts).
 



   
Three Months Ended June 30,
  
2005 vs. 2004
  
Six Months Ended June 30,
  
2005 vs. 2004
  
 
 
2005
 
2004
 
Change
 
%
 
2005
 
2004
 
Change
 
%
  
       
(restated)
              
(restated)
          
Revenues:
                                                 
Retirement Centers  
  
$
93,794
  
$
85,578
  
$
8,216
    
9.6
%
$
185,276
  
$
170,866
  
$
14,410
    
8.4
%
Free-standing Assisted Living Communities  
    
26,847
   
23,532
   
3,315
   
14.1
%
  
53,054
   
46,195
   
6,859
   
14.8
%
Management Services  
    
1,058
   
1,039
   
19
   
1.8
%
  
2,360
   
2,231
   
129
   
5.8
%
 Total revenue
 
$
121,699
  
$
110,149
  
$
11,550
    
10.5
%
$
240,690
  
$
219,292
  
$
21,398
    
9.8
%
                                                   
Retirement Centers
                                                 
Ending occupied units  
    
8,567
   
8,424
   
143
   
1.7
%
  
8,567
   
8,424
   
143
   
1.7
%
Ending occupancy %  
    
95
%
  
95
%
  
0
%
        
95
%
  
95
%
  
0
%
      
Average occupied units  
    
8,572
   
8,382
   
190
   
2.3
%
  
8,547
   
8,380
   
167
   
2.0
%
Average occupancy %  
    
95
%
  
94
%
  
1
%
        
95
%
  
94
%
  
1
%
      
Revenue per occupied unit (per month)  
  
$
3,647
  
$
3,403
  
$
244
    
7.2
%
$
3,613
  
$
3,398
  
$
215
    
6.3
%
Operating contribution per unit (per month)  
    
1,241
   
1,155
   
86
   
7.4
%
  
1,219
   
1,144
   
75
   
6.6
%
                                                   
Resident and healthcare revenue  
    
93,794
   
85,578
   
8,216
   
9.6
%
  
185,276
   
170,866
   
14,410
   
8.4
%
Community operating expense  
    
61,869
   
56,546
   
5,323
   
9.4
%
  
122,759
   
113,337
   
9,422
   
8.3
%
 Segment operating contribution (2)
 
 
31,925
   
29,032
   
2,893
   
10.0
%
  
62,517
   
57,529
   
4,988
   
8.7
%
 Operating contribution margin (3)
   
34.0
%
  
33.9
%
  
0.1
%
  
0.3
%
  
33.7
%
  
33.7
%
  
NM
    
NM
  
                                                   
Free-standing Assisted Living Communities
                                                 
Ending occupied units (4)  
    
2,561
   
2,456