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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
ANNUAL REPORT
PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2006
or
o
  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: 0-8082
 
LHC GROUP, INC.
(Exact Name of Registrant as Specified in Charter)
 
     
Delaware   71-0918189
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)
420 West Pinhook Rd, Suite A
Lafayette, LA 70503
(Address of principal executive offices)
 
(337) 233-1307
(Registrant’s telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Exchange Act:
 
     
Common Stock, par value $.001 per share   Nasdaq Global Market
(Title of each class)
  (Name of each exchange on which registered)
 
Securities registered pursuant to Section 12(g) of the Exchange Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act.  Yes o     No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ
 
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 þ     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o     Accelerated filer þ      Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ
 
As of June 30, 2006, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $220,921,804 based on the closing sale price as reported on the Nasdaq Global Market. For purposes of this determination shares beneficially owned by officers, directors and ten percent shareholders have been excluded, which does not constitute a determination that such persons are affiliates.
 
There were 17,868,320 shares of common stock, $.01 par value, issued and outstanding as of March 8, 2007.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Registrant’s Annual Report to stockholders for the fiscal year ended December 31, 2006 are incorporated by reference in Part II of this Form 10-K. Portions of the Registrant’s Proxy Statement for its 2007 Annual Meeting of Stockholders are incorporated by reference in Part III of this annual report on Form 10-K.
 


 

 
LHC GROUP, INC.
 
TABLE OF CONTENTS
 
                 
        Page
 
  Business   5
  Risk Factors   27
  Unresolved Staff Comments   37
  Properties   38
  Legal Proceedings   38
  Submission of Matters to a Vote of Security Holders   38
 
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   38
  Selected Financial Data   40
  Management’s Discussion and Analysis of Financial Condition and Results of Operation   41
  Quantitative and Qualitative Disclosures About Market Risk   60
  Financial Statements and Supplementary Data   61
  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure   61
  Controls and Procedures   61
  Other Information   63
 
  Directors, Executive Officers and Corporate Governance   63
  Executive Compensation   63
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   63
  Certain Relationships and Related Transactions, and Director Independence   64
  Principal Accounting Fees and Services   64
 
  Exhibits, Financial Statement Schedules   65
  66
  67
 EX-21.1 SUBSIDIARIES OF THE REGISTRANT
 EX-23.1 CONSENT OF ERNST & YOUNG LLP
 EX-31.1 SECTION 302 CERTIFICATION OF CEO
 EX-31.2 SECTION 302 CERTIFICATION OF CFO
 EX-32.1 SECTION 906 CERTIFICATION OF CEO
 EX-32.2 SECTION 906 CERTIFICATION OF CFO


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This report contains “forward-looking statements.” Forward-looking statements relate to our expectations, beliefs, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts or that necessarily depend upon future events. In some cases, you can identify forward-looking statements by words like “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “predict,” “potential” and similar expressions. Specifically, this report contains, among others, forward-looking statements about:
 
  •  our expectations regarding financial condition or results of operations for periods after December 31, 2006;
 
  •  our critical accounting policies;
 
  •  our business strategies and our ability to grow our business;
 
  •  the reimbursement levels of Medicare and other third-party payors;
 
  •  our future sources of and needs for liquidity and capital resources;
 
  •  the outcomes of various routine and non-routine governmental reviews, audits, and investigations;
 
  •  our expansion strategy and the successful integration of recent acquisitions;
 
  •  the value of our propriety technology;
 
  •  the impact of legal proceedings;
 
  •  our insurance coverage;
 
  •  the costs of medical supplies;
 
  •  our competitors and our competitive advantages;
 
  •  the payment of dividends;
 
  •  our compliance with environmental laws and regulations;
 
  •  the impact of federal and state government regulation on our business; and
 
  •  the impact of changes in or future interpretations of fraud, anti-kickback or other laws.
 
The forward-looking statements included in this report reflect our current views about future events. They are based on assumptions and are subject to known and unknown risks and uncertainties. Many factors could cause actual results or achievements to differ materially from future results or achievements that may be expressed in or implied by our forward-looking statements. Many of the factors that will determine future events or achievements are beyond our ability to control or predict. Important factors that could cause actual results or achievements to differ materially from the results or achievements reflected in our forward-looking statements include, among other things, the factors discussed on pages 27 to 37 of this report under the heading “Risk Factors.”
 
You should read this report, the information incorporated by reference into this report and the documents filed as exhibits to this report completely and with the understanding that our actual future results or achievements may be materially different from what we expect or anticipate.


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The forward-looking statements contained in this report reflect our views and assumptions only as of the date this report is filed with the Securities and Exchange Commission. Except as required by law, we assume no responsibility to update any forward-looking statements.
 
Before you invest in our common stock, you should understand that the occurrence of any of the events described in the Risk Factors section, located in Part I, Item 1A in this annual report on Form 10-K or incorporated by reference into this annual report on Form 10-K and other events that we have not predicted or assessed could have a material adverse effect on our earnings, financial condition and business. If the events described in the Risk Factors or other unpredicted events occur, then the trading price of our common stock could decline, and you may lose all or part of your investment.
 
We qualify all of our forward-looking statements by these cautionary statements. In addition, with respect to all of our forward-looking statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.
 
Unless otherwise indicated, “LHC Group,” “we,” “us,” “our,” and “the Company” refer to LHC Group, Inc. and our consolidated subsidiaries.


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PART I
 
Item 1.   Business
 
Overview
 
We provide post-acute healthcare services primarily to Medicare beneficiaries in rural markets in the southern United States. We provide home-based services, primarily through home nursing agencies and hospices, and facility-based services, primarily through long-term acute care hospitals and outpatient rehabilitation clinics. Through our wholly and majority-owned subsidiaries, equity joint ventures, and controlled affiliates, we currently operate in Louisiana, Mississippi, Arkansas, Alabama, Texas, Kentucky, Florida, Tennessee, Georgia, and West Virginia. As of December 31, 2006, we owned and operated 106 home nursing locations, six hospices, a diabetes self management company, and a home health pharmacy. We also managed four home nursing agencies and one hospice as of December 31, 2006 in which we have no ownership interest. With respect to our facility-based services operations, as of December 31, 2006, we also owned and operated four long-term acute care hospitals with a total of seven locations, an outpatient rehabilitation clinic, a critical access hospital, a pharmacy, a medical equipment company, a health club, and provided contract rehabilitation services to third parties.
 
We provide home-based post-acute healthcare services through our home nursing agencies and hospices. Our home nursing locations offer a wide range of services, including skilled nursing, nursing, physical, occupational, and speech therapy and medically-oriented social services. The nurses, home health aides and therapists in our home nursing agencies work closely with patients and their families to design and implement individualized treatment responsive to a physician-prescribed plan of care. Our hospices provide palliative care to patients with terminal illnesses through interdisciplinary teams of physicians, nurses, home health aides, counselors and volunteers. Of our 114 home-based services locations in which we maintain an ownership interest, 78 are wholly-owned by us and 36 are majority-owned or controlled by us through joint ventures. For the years ended December 31, 2006, 2005, and 2004, our home-based services provided $164.7 million, $105.6 million and $81.6 million, respectively, of our net service revenue.
 
We provide facility-based post-acute healthcare services through our long-term acute care hospitals, outpatient rehabilitation clinic, and critical access hospital. As of December 31, 2006, we owned and operated four long-term acute care hospitals with seven locations, with a total of 156 licensed beds. Our long-term acute care hospitals, of which six locations are within host hospitals, provide services primarily to patients who have transitioned out of a hospital intensive care unit with complex medical conditions that remain too severe for treatment in a non-acute setting. We provide outpatient rehabilitation services through physical therapists, occupational therapists and speech pathologists at our outpatient rehabilitation clinic in which we maintain an ownership interest. We also provide outpatient rehabilitation services on a contract basis. Our critical access hospital provides much needed access to healthcare in a rural community. In addition, we manage the operations of one inpatient rehabilitation facility in which we have no ownership interest. Of our 12 facility-based services locations in which we maintain an ownership interest, six are wholly-owned by us and six are majority-owned or controlled by us through joint ventures. For the years ended December 31, 2006, 2005 and 2004, our facility-based services provided $50.5 million, $47.1 million and $34.5 million, respectively, of our net service revenue.
 
Our founders began operations in September 1994 as St. Landry Home Health, Inc. in Palmetto, Louisiana. After several years of expansion, in June 2000, our founders reorganized their business and began operating as Louisiana Healthcare Group, Inc. In March 2001, Louisiana Healthcare Group, Inc. reorganized and became a wholly owned subsidiary of The Healthcare Group, Inc., also a Louisiana business corporation. Effective December 2002, The Healthcare Group, Inc. merged into LHC Group, LLC, a Louisiana limited liability company, with LHC Group, LLC being the surviving entity. In January 2005, LHC Group, LLC established a wholly owned Delaware subsidiary, LHC Group, Inc. Effective February 9, 2005, LHC Group, LLC merged into LHC Group, Inc. LHC Group, Inc. is a Delaware corporation; our principal executive offices are located at 420 West Pinhook Road, Suite A, Lafayette, Louisiana, 70503; and our telephone number is (337) 233-1307. Our website is www.lhcgroup.com.


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Industry and Market Opportunity
 
According to the Medicare Payment Advisory Committee, or MedPAC, an independent federal body established in 1997 to advise Congress on issues affecting the Medicare program, approximately one-third of all general acute care hospital patients require additional care following their discharge from the hospital. Some of these patients receive less intensive care in settings such as skilled nursing facilities, outpatient rehabilitation clinics or the home, while others receive continuing care in more intensive care settings such as inpatient rehabilitation facilities or long-term acute care hospitals that are either freestanding or co-located within general acute care facilities. According to MedPAC estimates, Medicare spending totaled $17.1 billion in 2005 for the two primary post-acute sectors in which we operate: home nursing and long-term acute care hospitals.
 
MedPAC estimates Medicare spending on home nursing services totaled $12.6 billion in 2005. The Centers for Medicare & Medicaid, or CMS, estimates that there were approximately 8,802 Medicare-certified home nursing agencies in the United States in 2006, the majority of which are operated by small local or regional providers. CMS has estimated that approximately 32.0% of these agencies are hospital-based or not-for-profit, freestanding agencies, and MedPAC estimates that approximately 37.0% were located in rural markets in 2005. CMS predicts that Medicare spending on home nursing will increase at an average annual growth rate of 5.7% between 2006 and 2016. Growth is being driven by:
 
  •  a U.S. population that is getting older and living longer;
 
  •  patient preference for less restrictive care settings;
 
  •  incentives for general acute care hospitals to discharge patients into less intensive treatment settings as quickly as medically appropriate; and
 
  •  higher incidences of chronic conditions and disease.
 
Long-term acute care hospitals provide specialized medical and rehabilitative care to patients with complex medical conditions requiring higher intensity care and monitoring that cannot be provided effectively in other healthcare settings. These facilities typically serve as an intermediate step between the intensive care unit of a general acute care hospital and a less intensive treatment setting, such as a skilled nursing facility or the home. According to MedPAC estimates, Medicare spending for services provided by long-term acute care hospitals grew from $1.7 billion in 1997 to an estimated $4.5 billion in 2005.
 
According to the U.S. Census Bureau, rural areas have a higher percentage of residents over the age of 65, who account for 12.8% of the total population in rural markets compared to 12.3% in urban markets. Additionally, according to the American Public Health Association, or APHA, rural areas typically do not offer the range of post-acute healthcare services that are available in urban or suburban markets. As such, patients in rural markets face challenges in accessing healthcare in a convenient and appropriate setting. For example, APHA estimates that although 21.0% of Americans live in rural areas, only 9.0% of the nation’s physicians practice in rural areas. According to APHA, individuals in rural areas may also have difficulty reaching healthcare facilities due to greater travel time required or a lack of public transportation. The economic characteristics and population dispersion of rural markets also make these markets less attractive to health maintenance organizations and other managed care payors. Government studies cited by APHA have shown rural residents also tend to have more health complications than urban residents. Additionally, APHA has noted that residents in rural areas are less likely to use preventive screening services, and have a higher prevalence of disabilities, heart disease, cancer, diabetes, and other chronic conditions compared to urban residents. Therefore, we believe our post-acute service provides valuable alternatives to this underserved, rural patient population.
 
In our experience, because most rural areas have the population size to support only one or two general acute care hospitals, the local hospital often plays a significant role in rural market healthcare delivery systems. Rural patients who require home nursing frequently receive care from a small home care agency or an agency that, while owned and run by the hospital, is not an area of focus for that hospital. Similarly, patients in these markets who require services typically offered by long-term acute care hospitals are more


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likely to remain in the community hospital, as it is often the only local facility equipped to deal with severe, complex medical conditions. By entering these markets through affiliations with local hospitals, we usually face less competition for the services we provide. Therefore, we believe we are well positioned to foster community loyalty by building and maintaining long-term relationships with local hospitals, physicians and other healthcare providers and to become the highest quality post-acute provider in our markets.
 
Business Strategy
 
Our objective is to become the leading provider of post-acute services to Medicare beneficiaries in rural markets in the southern United States. To achieve this objective, we intend to:
 
Drive internal growth in existing markets.  We intend to drive internal growth in our current markets by increasing the number of healthcare providers in each market from whom we receive referrals and by expanding the breadth of our services. We intend to achieve this growth by: (1) continuing to educate healthcare providers about the benefits of our services; (2) reinforcing the position of our agencies and facilities as community assets; (3) maintaining our emphasis on high-quality medical care for our patients; and (4) providing a superior work environment for our employees.
 
Achieve margin improvement through the active management of costs.  The majority of our net service revenue is generated under Medicare prospective payment systems through which we are paid pre-determined rates based upon the clinical condition and severity of the patients in our care. Because our profitability in a fixed payment system depends upon our ability to manage the costs of providing care, we continue to pursue initiatives to improve our margins and net income.
 
Expand into new rural markets.  We will continue expanding into new markets by developing new and acquiring existing Medicare-certified home nursing agencies in attractive markets. We currently plan to pursue expansion opportunities in 15 contiguous states, and we have identified over 700 potential non-profit hospital partners located in rural markets within these states.
 
Pursue strategic acquisitions.  We will continue to identify and evaluate opportunities for strategic acquisitions in new and existing markets that will enhance our market position, increase our referral base and expand the breadth of services we offer.
 
Services
 
We provide post-acute healthcare services primarily to Medicare beneficiaries in rural markets in the southern United States. Our services can be broadly classified into two principal categories: (1) home-based services offered through our home nursing agencies and hospices; and (2) facility-based services offered through our long-term acute care hospitals, outpatient rehabilitation clinic, and critical access hospital.
 
Home-Based Services
 
Home Nursing.  Our registered and licensed practical nurses provide a variety of medically necessary services to homebound patients who are suffering from acute or chronic illness, recovering from injury or surgery, or who otherwise require care or monitoring. These services include wound care and dressing changes, cardiac rehabilitation, infusion therapy, pain management, pharmaceutical administration, skilled observation and assessment, and patient education. We have also designed guidelines to treat chronic diseases and conditions including diabetes, hypertension, arthritis, Alzheimer’s disease, low vision, spinal stenosis, Parkinson’s disease, osteoporosis, complex wound care and chronic pain. Our home health aides provide assistance with daily activities such as housekeeping, meal preparation, medication management, bathing, and walking. Through our medical social workers we counsel patients and their families with regard to financial, personal, and social concerns that arise from a patient’s health-related problems. We also provide skilled nursing, ventilator and tracheotomy services, extended care specialties, medication administration and management, and patient and family assistance and education. We also provide management services to third party home nursing agencies, often as an interim solution until proper state and regulatory approvals for an acquisition can be obtained.


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Our physical, occupational and speech therapists provide therapy services to patients in their home. Our therapists coordinate multi-disciplinary treatment plans with physicians, nurses and social workers to restore basic mobility skills such as getting out of bed, walking safely with crutches or a walker, and restoring range of motion to specific joints. As part of the treatment and rehabilitation process, a therapist will stretch and strengthen muscles, test balance and coordination abilities, and teach home exercise programs. Our therapists assist patients and their families with improving and maintaining a patient’s ability to perform functional activities of daily living, such as the ability to dress, cook, clean, and manage other activities safely in the home environment. Our speech and language therapists provide corrective and rehabilitative treatment to patients who suffer from physical or cognitive deficits or disorders that create difficulty with verbal communication or swallowing.
 
All of our home nursing agencies offer 24 hour personal emergency response and support services through LifeLine Systems, Inc. for patients who require close medical monitoring but who want to maintain an independent lifestyle. These services consist principally of a communicator that connects to the telephone line in the subscriber’s home and a personal help button that is worn or carried by the individual subscriber and that, when activated, initiates a telephone call from the subscriber’s communicator to LifeLine’s central monitoring facilities. LifeLine’s trained personnel identify the nature and extent of the subscriber’s particular need and notify the subscriber’s family members, neighbors, and/or emergency personnel, as needed. Our use of the LifeLine system increases customer satisfaction and loyalty by providing our patients a point of contact between our scheduled nursing visits. As a result, we offer our patients a more complete regimen of care management than our competitors in the markets in which we operate, particularly in Mississippi and Louisiana where we have an exclusive contract for these services with LifeLine.
 
Hospice.  Our Medicare-certified hospice operations provide a full range of hospice services designed to meet the individual physical, spiritual, and psychosocial needs of terminally ill patients and their families. Our hospice services are primarily provided in a patient’s home but can also be provided in a nursing home, assisted living facility, or hospital. Key services provided include pain and symptom management accompanied by palliative medication; emotional and spiritual support; inpatient and respite care; homemaker services; dietary counseling; social worker visits; spiritual counseling; and bereavement counseling for up to 13 months after a patient’s death.
 
Facility-Based Services
 
Long-term Acute Care Hospitals.  Our long-term acute care hospitals treat patients with severe medical conditions who require high-level care along with frequent monitoring by physicians and other clinical personnel. Patients who receive our services in a long-term acute care hospital are too medically unstable to be treated in a non-acute setting. Examples of these medical conditions include respiratory failure, neuromuscular disorders, cardiac disorders, non-healing wounds, renal disorders, cancer, head and neck injuries, and mental disorders. These impairments often are associated with accidents, strokes, heart attacks and other serious medical conditions. We also treat patients diagnosed with musculoskeletal impairments that restrict their ability to perform normal activities of daily living. As part of our facility-based services, we operate an institutional pharmacy, which focuses on providing a full array of institutional pharmacy services to our long-term acute care hospitals and inpatient rehabilitation facility. We also own and operate one critical access hospital.
 
Rehabilitation Services.  We provide rehabilitation services in multiple settings, including both inpatient and outpatient settings. In our facilities and through our contractual relationships, we provide physical, occupational and speech rehabilitation services. We also provide certain specialized services such as hand therapy or sports performance enhancement that treat sports and work related injuries, musculoskeletal disorders, chronic or acute pain and orthopedic conditions. Our patients are typically diagnosed with musculoskeletal impairments that restrict their ability to perform normal activities of daily living. These impairments are often associated with accidents, sports injuries, strokes, heart attacks and other medical conditions. Our rehabilitation services are designed to help these patients minimize physical and cognitive impairments and maximize functional ability. We also design services to prevent short-term disabilities from becoming chronic conditions. Our rehabilitation services are provided by our physical, occupational and


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respiratory therapists, and speech-language pathologists. We also provide management services to one inpatient rehabilitation facility and operate one health and wellness center located adjacent to one of our outpatient rehabilitation clinics.
 
Operations
 
Financial information relating to the home- and facility- based segments is found in the consolidated financial statements of the Company which are included in this report. All of our operations are based in the United States; therefore 100% of our revenues from external customers for the years ended December 31, 2006, 2005 and 2004 and 100% of our long-lived assets were attributed to the United States.
 
Home-Based Services
 
Each of our home nursing agencies is staffed with experienced clinical home health professionals who provide a wide range of patient care services. Our home nursing agencies are managed by a Director of Nursing or Branch Manager who is also a licensed registered nurse. Our Directors of Nursing and Branch Managers are overseen by Regional Managers who report to Area Managers. Our Area Managers report to our Chief Operating Officer. Our patient care operating model for our home nursing agencies is structured on a base model that requires a Medicare patient minimum census of 50 patients. At the base model level, one registered nurse is responsible for all aspects of the management of each patient’s plan of care. A home nursing agency based on this model is also staffed with an office manager, a field-registered nurse, a field-licensed professional nurse and a home health aide. All field staff are paid on a per visit basis. If needed, we contract with local community therapists as independent contractors to provide additional therapy services. As the size and patient census of a particular home nursing agency grows, these staffing patterns are increased appropriately.
 
Our home nursing agencies use our Service Value Point system, a proprietary clinical resource allocation model and cost management system. The system is a quantitative tool that assigns a target level of resource units to a group of patients based upon their initial assessment and estimated skilled nursing and therapy needs. The Service Value Point system allows the Director of Nursing or Branch Manager to allocate adequate resources throughout the group of patients assigned to his/her care, rather than focusing on the profitability of an individual patient.
 
Patient care is handled at the home nursing agency level. Functions that are centralized into the home office include payroll, accounting, financial reporting, billing, collections, regulatory and legal compliance, risk management, pharmacy, and general clinical oversight accomplished by periodic on-site surveys. Each of our home nursing agencies is licensed and certified by the state and federal governments, and 34 of them also are accredited by the Joint Commission for Accreditation of Healthcare Organizations, or JCAHO. Those not yet accredited are working towards achieving this accreditation, which can take up to six months.
 
Facility-Based Services
 
Long-Term Acute Care Hospitals.  Each of our long-term acute care hospital locations is managed by a hospital administrator, while the clinical operations are directed by a Director of Nursing who is also a licensed registered nurse. The individual hospital administrators are responsible for managing the day-to-day operating activities of the hospital within appropriate budgetary constraints. Each hospital administrator reports to the Vice President of Facility-Based Services. Each Director of Nursing reports directly to his or her respective hospital administrator as well as indirectly to our Clinical Operations Officer responsible for the oversight of the quality of patient care services at the home office level. The medical management of each patient is overseen by a Medical Director who is responsible for ensuring the appropriateness of admissions, as well as leading weekly patient care conferences.
 
We follow a clinical approach under which each patient is discussed in weekly, multidisciplinary team meetings, at which patient progress is assessed, compared to goals, and future goals are set. Attendees at these meetings include a patient’s family and referring physician. We believe that this model results in higher quality care, predictable discharge patterns and the avoidance of unnecessary delays.


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All coding, medical records, human resources, case management, utilization review, and medical staff credentialing are provided at the hospital level. Centralized functions that are provided by the home office include payroll, accounting, financial reporting, billing, collections, regulatory and legal compliance, risk management, pharmacy, and general clinical oversight accomplished by periodic on-site surveys.
 
Rehabilitation Services.  Our rehabilitation services are overseen by an administrator, who is a licensed physical therapist. Each clinic also has an on-site therapist responsible for addressing staffing needs and concerns as well as managing the day-to-day operations of the outpatient rehabilitation clinic.
 
As with our long-term acute care hospitals, all coding, medical records, human resources, charge/data entry, front end collections, and marketing for our rehabilitation centers are provided at the individual center level. Centralized functions provided by the home office include payroll, accounting, financial reporting, billing, collections, regulatory and legal compliance, risk management, and general clinical oversight accomplished by periodic on-site surveys.
 
Joint Ventures
 
As of December 31, 2006, we have entered into 50 joint ventures with respect to the ownership and operation of 40 home nursing agency locations, three hospices, six long-term acute care hospital locations, and one home health pharmacy. Our joint ventures are structured either as equity joint ventures, cooperative endeavors or agency leasing arrangements, as permitted by applicable state laws and subject to business considerations. As of December 31, 2006, we had 40 equity joint ventures, two cooperative endeavors and eight agency leasing arrangements. Of these 50 joint ventures, 37 are with hospitals, four are with physicians, and nine are with other parties. With respect to our four joint ventures with physicians, three are for the ownership and operation of long-term acute care hospitals, and one is for the ownership of a home nursing agency.
 
Equity Joint Ventures
 
As of December 31, 2006, we have entered into 40 equity joint ventures for the ownership and operation of home nursing agencies, hospices, outpatient rehabilitation clinics and long-term acute care hospitals. Our equity joint ventures are structured as limited liability companies in which we own a majority equity interest and our partners own a minority equity interest ranging from 1.0% to 49.0%. At the time of formation, we and our partners each contribute capital to the equity joint venture in the form of cash or property. We believe that the amount contributed by each party to the equity joint venture represents their pro-rata portion of the fair market value of the equity joint venture. None of our partners are required to make or influence referrals to our equity joint ventures. In fact, each of our hospital joint venture partners must follow the same Medicare discharge planning regulations as they would if they owned 100.0% of the home health agency. For example, each of our hospital joint venture partners must offer each Medicare patient a list of available Medicare-certified home nursing agency options and must allow the patient to make their own choice of provider.
 
Generally, we serve as the manager of our equity joint ventures and oversee their day-to-day operations. In two of our equity joint ventures with parties other than hospitals or physicians, our partners provide business development services and, in one case, administrative services. The management of our equity joint ventures are typically governed by a management committee, which is comparable to a board of directors. We generally possess a majority of the total votes available to be cast by the members of the management committee. However, in three of these joint ventures where we have partnered with not-for-profit hospitals, the hospital controls a majority of the total management committee votes. In such instances we possess the right to withdraw from the equity joint venture at any time upon notice to our partner in exchange for the receipt of a payment in an amount calculated in accordance with a predetermined fair market value formula. Each member of all but one of our equity joint ventures participates in profits and losses in proportion to their equity interests. We have two equity joint ventures in which participation in the losses of the ventures are limited per quarter to three times the amount of rent paid monthly by the equity joint ventures to the parent companies of our joint venture partners for space used in the operation of the equity joint ventures. The


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amounts of these monthly rental payments are currently $4,200 and $2,867 respectively. Distributions from our equity joint ventures are not based on referrals made to the equity joint venture by any of the members.
 
The 40 equity joint ventures individually contribute between 0.1% and 11.4% of our total net service revenue, with only two of these equity joint ventures accounting for greater than 5.0% of our total net service revenue for the twelve months ended December 31, 2006. One of these is St. Landry Extended Care Hospital, a long-term acute care hospital equity joint venture in which we own 98.7% of the membership interests, with the remaining 1.3% ownership divided among four individual physicians. Any party may withdraw from this equity joint venture upon 90 days’ advance written notice. The second entity is Extended Care Hospital of Lafayette, a long-term acute care hospital in which we own 76.5% of the membership interests, with the remaining 23.5% ownership divided among 19 individual physicians. Any member may withdraw from this equity joint venture upon 90 days’ advance written notice.
 
In addition to these conversion rights, several of our equity joint ventures grant a buy/sell option that will require us to either purchase or our joint venture partner(s) to sell all of the exercising member’s membership interests in the equity joint venture within 30 days of the receipt of notice of the exercise of the buy/sell option. The purchase price under these buy/sell provisions is typically based on a multiple of the historical or future earnings before income taxes, depreciation and amortization of the equity joint venture at the time the buy/sell option is exercised.
 
Cooperative Endeavors
 
As of December 31, 2006, we have entered into two arrangements that involve the sharing of profits and losses, which we call cooperative endeavors. Unlike our equity joint venture relationships, our cooperative endeavor partners do not own an equity interest in the venture. Instead, our partners have only a contractual right to participate in the sharing of profits and losses. This right is part of the consideration we pay to acquire a home nursing agency from the entity that is a party to the cooperative endeavor. In these cooperative endeavors, we possess interests in the net profits and losses ranging from 67.0% to 80.0%. In one instance, there is a limit on the losses attributable to our cooperative endeavor partner equal to the amount of rent payments made to our cooperative endeavor partner during the preceding twelve months for the lease of space used in the operation of the cooperative endeavor. For the years ended December 31, 2006 and 2005, these payments totaled $27,252 and $26,747, respectively. As with the equity joint ventures, we oversee the day-to-day operations of the arrangement, but the management of our cooperative endeavors is governed by a management committee, where we possess a majority of the total votes available to be cast.
 
Agency Leasing Arrangements
 
As of December 31, 2006, we have entered into two agreements to lease, through our wholly owned subsidiaries, the right to hold the home health licenses necessary to operate seven of our home nursing agency locations and one hospice. These leases are entered into in instances where state law would otherwise prohibit the alienation and sale of home nursing agencies or the local hospital is reluctant to sell its home health agency due to state imposed limits on the number of certificates of need or permits of approval issued. The leasing fees for one of these agency leasing arrangements is fixed at $243,000 per year for the initial term and the other arrangement provides for fees equal to 33.33% of the net quarterly profits not to exceed $159,380. Of the initial five-year terms for our two agency leasing arrangements, one expires on October 1, 2008 and the other on July 1, 2010. These leasing arrangements provide for five-year terms with optional renewal periods. One of these leasing arrangements provides that if we choose not to renew, the lessor can require us to purchase the agency. In the other leasing arrangement, we have a right of first refusal in the event that the lessor intends to sell the leased agency to a third party.
 
One of our agency leasing arrangements, relating to the lease of the license for Mississippi Home Care of Jackson, LLC accounted for greater than 5.0% of our total net service revenue for the year ended December 31, 2006. This leasing arrangement with a Mississippi hospital is for the lease of the right to hold the provider number and home health license for the agency. The terms of this lease provide for fixed monthly payments over an initial five-year term. Upon the expiration of the second year of the initial term, either party may


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terminate this leasing arrangement upon 180 days’ written notice. The lease is automatically renewed for one consecutive five-year term unless we receive written notice of the lessor’s desire to terminate the lease at least 180 days prior to the expiration of the initial term.
 
Management Services Agreements
 
As of December 31, 2006, we have six management services agreements under which we manage the operations of four home nursing agencies, one hospice and one inpatient rehabilitation facility. We currently have no ownership interest in the agencies and facilities that are the subject of these management services agreements. In five of these arrangements, we are responsible for all direct and indirect costs associated with the operations and receive a management fee equal to the amount of our direct and indirect costs plus a percentage of the net income of those operations. Under the remaining agreement, we receive a flat fee for management. The term of these arrangements is typically five years, with an option to renew for an additional five-year term. The initial termination dates for our management services agreements range from June 1, 2008 to August 1, 2010.
 
Competition
 
The home healthcare market is highly fragmented. According to CMS, there are approximately 8,802 Medicare-certified home nursing agencies in the United States, of which approximately 32% are hospital-based or not-for-profit, freestanding agencies. MedPAC estimates that 37% of these home nursing agencies are located in non-urban markets. Although there are a small number of public home nursing companies with significant home nursing operations, they generally do not compete with us in the rural markets that we currently serve. As we expand into new markets, we may encounter public companies that have greater resources or greater access to capital. Competition in our markets comes primarily from small local and regional providers, many of which are undercapitalized. These providers include facility- and hospital-based providers, visiting nurse associations, and nurse registries. We are unaware of any competitor offering our breadth of services and focusing on the needs of rural markets.
 
Although several public and private national and regional companies own or manage long-term acute care hospitals, they generally do not operate in the rural markets that we serve. Generally, the competition in our markets comes from local healthcare providers. We believe our principal competitive advantages over these local providers are our diverse service offerings, our collaborative approach to working with healthcare providers, our focus on rural markets and our patient-oriented operating model.
 
Compliance and Quality Control
 
We have had a Compliance Committee since 1996. Our Compliance Committee oversees a comprehensive company-wide compliance program that provides for:
 
  •  the appointment of a compliance officer and committee;
 
  •  adoption of codes of business conduct and ethics;
 
  •  employee education and training;
 
  •  monitoring of an internal system, including a toll-free hotline, for reporting concerns on a confidential, anonymous basis;
 
  •  ongoing internal compliance auditing and monitoring programs;
 
  •  means for enforcing the compliance programs’ policies; and
 
  •  a system to respond to and correct detected problems.
 
As part of our ongoing quality control, internal auditing and monitoring programs, at least annually we conduct internal regulatory audits and mock surveys at each of our agencies and facilities. If an agency or facility does not achieve a satisfactory rating, we require it to prepare and implement a plan of correction. We


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then perform a follow-up audit and survey to verify that all deficiencies identified in the initial audit and survey have been corrected.
 
As required under the Medicare conditions of participation, we have a continuous quality improvement program, which involves:
 
  •  ongoing education of staff and quarterly continuous quality improvement meetings at each of our agencies and facilities and at our home office;
 
  •  quarterly comprehensive audits of patient charts performed by each of our agencies and facilities; and
 
  •  at least annually, a comprehensive audit of patient charts performed on each of our agencies and facilities by our home office staff.
 
If an agency or facility fails to achieve a satisfactory rating on a patient chart audit, we require it to prepare and implement a plan of correction. We then conduct a follow-up patient chart audit to verify that appropriate action has been taken to prevent future deficiencies.
 
The effectiveness of our compliance program is directly related to the legal and ethical training that we provide to our employees. Compliance education for new hires is initiated immediately upon employment with corporate video training and subsequently reinforced through corporate orientation at which the Chief Compliance Officer conducts a comprehensive compliance training seminar. In addition, all of our employees are required to receive continuing compliance education and training each year.
 
We continually expand and refine our compliance and quality improvement programs. Specific written policies, procedures, training and educational materials and programs, as well as auditing and monitoring activities, have been prepared and implemented to address the functional and operational aspects of our business. Our programs also address specific problem areas identified through regulatory interpretation and enforcement activities. Additionally, our policies, training, standardized documentation requirements, reviews and audits specifically address our financial arrangements with our referral sources, including fraud and abuse laws and physician self-referral laws. We believe our consistent focus on compliance and continuous quality improvement programs provide us with a competitive advantage in the market.
 
Technology and Intellectual Property
 
Our Service Value Point system is a proprietary information system that assists us in, among other things, monitoring use and other cost factors, supporting our healthcare management techniques, internal benchmarking, clinical analysis, outcomes monitoring and claims generation, revenue cycle management and revenue reporting. This proprietary home nursing clinical resource and cost management system is a quantitative tool that assigns a target level of resource units to each patient based upon their initial assessment and estimated skilled nursing and therapy needs. We designed this system to empower our direct care employees to make appropriate day-to-day clinical care decisions while also allowing us to manage the quality and delivery of care across our system and to monitor the cost of providing that care both on a patient-specific and agency-specific basis.
 
In addition to our Service Value Point system, our business is substantially dependent on other non-proprietary software. We utilize a third-party software information system for our long-term acute care hospitals. Our various home nursing agency databases were fully consolidated into an enterprise-wide system during the first half of 2005. These conversions have improved the accuracy, reliability, and efficiency of processing and management reporting.
 
Further, we have two major patient billing systems that we use across the enterprise: one system for our home-based services and one for our facility-based services. Both of these systems are fully automated and contain functionality that allows us to calculate net service revenue at both the payor and patient level.
 
The software we use is based on client-server technology and is highly scalable. We believe our software and systems are flexible, easy-to-use, and allow us to accommodate growth without difficulty through development and acquisitions. Technology plays a key role in our organization’s ability to expand operations


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and maintain effective managerial control. We believe that building and enhancing our information and software systems provides us with a competitive advantage that will allow us to grow our business in a more cost-efficient manner and will result in better patient care.
 
Reimbursement
 
Medicare
 
The federal government’s Medicare program, governed by the Social Security Act of 1965, reimburses healthcare providers for services furnished to Medicare beneficiaries. These beneficiaries generally include persons age 65 and older and those who are chronically disabled. The program is primarily administered by the Department of Health and Human Services, or HHS, and CMS. Medicare payments accounted for 81.6%, 85.6%, and 86.3%, respectively, of our net service revenue for the years ended December 31, 2006, 2005, and 2004. Medicare reimburses us based upon the setting in which we provide our services or the Medicare category in which those services fall.
 
Home Nursing.  The Medicare home nursing benefit is available to patients who need care following discharge from a hospital, as well as patients who suffer from chronic conditions that require ongoing but intermittent care. The services received need not be rehabilitative or of a finite duration; however, patients who require full-time skilled nursing for an extended period of time generally do not qualify for Medicare home nursing benefits. As a condition of coverage under Medicare, beneficiaries must: (1) be homebound in that they are unable to leave their home without considerable effort; (2) require intermittent skilled nursing, physical therapy, or speech therapy services that are covered by Medicare; and (3) receive treatment under a plan of care that is established and periodically reviewed by a physician. Qualifying patients also may receive reimbursement for occupational therapy, medical social services, and home health aide services if these additional services are part of a plan of care prescribed by a physician.
 
We receive a standard prospective Medicare payment for delivering care over a base 60-day period, or episode of care. There is no limit to the number of episodes a beneficiary may receive as long as he or she remains eligible. Most patients complete treatment within one payment episode. The base episode payment, established through federal legislation, is a flat rate that is adjusted upward or downward based upon differences in the expected resource needs of individual patients as indicated by clinical severity, functional severity, and service utilization. The magnitude of the adjustment is determined by each patient’s categorization into one of 80 payment groups, known as home health resource groups, and the costliness of care for patients in each group relative to the average patient. Our payment is also adjusted for differences in local prices using the hospital wage index. We bill and are reimbursed for services in two stages: an initial request for advance payment when the episode commences and a final claim when it is completed. We receive 60.0% of the estimated payment for a patient’s initial episode up-front (after the initial assessment is completed and upon initial billing) and the remaining 40.0% upon completion of the episode and after all final treatment orders are signed by the physician. In the event of subsequent episodes, reimbursement timing is 50.0% up-front and 50.0% upon completion of the episode. Final payments may reflect one of five retroactive adjustments to ensure the adequacy and effectiveness of the total reimbursement: (1) an outlier payment if the patient’s care was unusually costly; (2) a low utilization adjustment if the number of visits was fewer than five; (3) a partial payment if the patient transferred to another provider before completing the episode; (4) a change-in-condition adjustment if the patient’s medical status changes significantly, resulting in the need for more or less care; or (5) a payment adjustment based upon the level of therapy services required in the population base. Because the applicability of a change is dependent upon the completion date of the episode, changes in our reimbursement could impact our financial results up to 60 days in advance of the effective date and recognition of the change. We submit all Medicare claims through two fiscal intermediaries for the federal government.
 
We verify benefits at the time of admission and through this verification process are able to determine the payor source and eligibility for reimbursement for each patient. Accordingly, we do not have any material reimbursement amounts that are pending approval based on the eligibility of a patient to receive reimbursement from the applicable payor program. Further, we only provide limited services to patients who are


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ineligible for reimbursement from a third party payor; therefore, do not have any material reimbursement from patients who are self pay.
 
The current base payment rate for Medicare home nursing is $2,339. Since the inception of the prospective payment system in October 2000, the base episode rate payment has varied due to both the impact of annual market basket based increases and Medicare-related legislation. Home health payment rates are updated annually by either the full home health market basket percentage, or by the home health market basket percentage as adjusted by Congress. CMS establishes the home health market basket index, which measures inflation in the prices of an appropriate mix of goods and services included in home health services. Section 5201(c) of the Deficit Reduction Act (DRA) of 2005 provided for an adjustment to the home health market basket percentage update for 2007 and subsequent years depending on the submission of quality data by home health agencies, or HHAs. HHAs that submit the required quality data using the Outcome and Assessment Information Set (OASIS) will receive payments based on the full home health market basket update of 3.3 percent for 2007. If an HHA does not submit quality data, the home health market basket update will be reduced by 2 percentage points to 1.3 percent for 2007. Rural home health agencies that participate in the ongoing quality reporting effort will receive an average estimated 3.6 percent increase in payment, while urban agencies who continue to provide quality data will experience an estimated 3.1 percent increase in payment. We intend to participate in quality reporting programs.
 
CMS is currently developing a proposal that would update and refine the basic case mix adjustment system. We are unable to predict the timing or outcome of such action.
 
On November 1, 2006, CMS released the final rule updating the home health perspective payment systems for calendar year 2007. The rule finalizes the market basket increase of 3.3%, a 0.2% increase over the proposed rule. This equates to a 3.1% update for urban HHAs and a 3.6% update for rural HHAs after accounting for changes in the wage index. The update increases the national 60-day episode payment rate for urban home health agencies from the current level of $2,264.38 to $2,339.00. Under the final rule, HHAs will get the full home health market basket as long as they submit required quality data using OASIS. With some limited exceptions, if an HHA does not provide this data, then its home health market basket update of 3.3% will be reduced by two percentage points. The final rule discontinues the temporary 5% add-on payment for rural HHAs in 2007, except for episodes that begin before January 1, 2007. The final rule does not modify the current case-mix methodology for 2007.
 
The Office of Inspector General of Health and Human Services, or OIG, has a responsibility to report both to the Secretary of HHS and to Congress any program and management problems related to programs such as Medicare. The OIG’s duties are carried out through a nationwide network of audits, investigations and inspections. The OIG has recently undertaken a study with respect to Medicare reimbursement rates. No estimate can be made at this time regarding the impact, if any, of the OIG’s findings.
 
Hospice.  In order for a Medicare beneficiary to qualify for the Medicare hospice benefit, two physicians must certify that, in the best judgment of the physician or medical director, the beneficiary has less than six months to live, assuming the beneficiary’s disease runs its normal course. In addition, the Medicare beneficiary must affirmatively elect hospice care and waive any rights to other Medicare benefits related to his or her terminal illness. Each benefit period, a physician must recertify that the Medicare beneficiary’s life expectancy is six months or less in order for the beneficiary to continue to qualify for and to receive the Medicare hospice benefit. The first two benefit periods are measured at 90-day intervals and subsequent benefit periods are measured at 60-day intervals. There is no limit on the number of periods that a Medicare beneficiary may be recertified. A Medicare beneficiary may revoke his or her election at any time and begin receiving traditional Medicare benefits. There is no limit on how long a Medicare beneficiary can receive hospice benefits and services, provided that the beneficiary continues to meet Medicare hospice eligibility criteria.
 
Medicare reimburses for hospice care using a prospective payment system. Under that system, we receive one of four predetermined daily or hourly rates based upon the level of care we furnish to the beneficiary.


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These rates are subject to annual adjustments based on inflation and geographic wage considerations. Our base Medicare rates effective October 1, 2006 depend upon which of the following four levels of care we provide:
 
  •  Routine Home Care.  We receive between $109.11 and $140.95 per day for routine home care, depending on the geographic location. We are paid the routine home care rate for each day a patient is under our care and not receiving one of the other categories of hospice care. This rate is not adjusted for the volume or intensity of care provided on a given day. This rate is also paid when a patient is receiving hospital care for a condition unrelated to the terminal condition.
 
  •  General Inpatient Care.  We receive between $490.65 and $622.62 per day for general inpatient care, depending on the geographic location.
 
  •  Continuous Home Care.  We receive between $636.81 and $822.67 per day for continuous home care, depending on the geographic location. This daily continuous home care rate is divided by 24 in order to arrive at an hourly rate. The hourly rate is paid for every hour that continuous home care is furnished, up to 24 hours in a single day. A minimum of eight hours must be provided in a single day to qualify for this rate.
 
  •  Respite Care.  We receive between $116.68 and $142.64 per day for respite care, depending on the geographic location. Respite care is provided when the family or caregiver of a patient requires temporary relief from his or her care giving responsibilities for certain reasons. We can receive payment for respite care provided to a given patient for up to five consecutive days. Our payment for any additional days of respite care provided to the patient is limited to the routine home care rate.
 
Medicare limits the reimbursement we may receive for inpatient care services. Under the so-called “80-20 rule,” if the number of inpatient care days furnished by us to Medicare beneficiaries exceeds 20.0% of the total days of hospice care furnished by us to Medicare beneficiaries, Medicare payments to us for inpatient care days exceeding the inpatient cap will be reduced to the routine home care rate. This determination is made annually based on the twelve-month period beginning on November 1st of each year. This limit is computed on a program-by-program basis. None of our hospices have exceeded the cap on inpatient care services during 2005 or 2004. We have not received notification that any of our hospices have exceeded the cap on inpatient care services during 2006.
 
Our Medicare hospice reimbursement is also subject to a cap amount calculated by the Medicare fiscal intermediary at the end of the hospice cap period, which runs from November 1st of each year through October 31st of the following year. Total Medicare payments to us during this period are compared to the “cap amount” for this period. Payments in excess of the cap amount must be returned by us to Medicare. The cap amount is calculated by multiplying the number of beneficiaries electing hospice care during the period by a statutory amount that is indexed for inflation annually. The cap amount for the twelve-month period ending October 31, 2006 was $20,585. The hospice cap amount is computed on a program-by-program basis. None of our hospices have exceeded the cap on per beneficiary limits during 2005 or 2004. We have not received notification that any of our hospices have exceeded the cap on per beneficiary limits during 2006.
 
We are required to file annual cost reports with HHS on each of our hospices for informational purposes and to submit claims on the basis of the location where we actually furnish the hospice services. These requirements permit Medicare to adjust payment rates for regional differences in wage costs.
 
Long-term Acute Care Hospitals.  We are reimbursed by Medicare for services provided by our long-term acute care hospitals under the long-term acute care hospital prospective payment system, which was implemented on October 1, 2002. Although CMS regulations allowed for a phase-in period, we have elected to be paid solely on the basis of the long-term care diagnosis-related groups established by the new system. All of our eligible long-term acute care hospitals have implemented the prospective payment system.
 
Under the prospective payment system, each patient discharged from our long-term acute care hospitals is assigned a long-term care diagnosis-related group. CMS establishes these long-term care diagnosis-related groups by grouping diseases by diagnosis, which group reflects the amount of resources needed to treat a given diseases. We are paid a pre-determined fixed amount applicable to the particular long-term care


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diagnosis-related group to which that patient is assigned. This payment is intended to reflect the average cost of treating a Medicare patient classified in that particular long-term care diagnosis-related group. For select patients, the amount may be further adjusted based on length of stay and facility-specific costs, as well as in instances where a patient is discharged and subsequently readmitted, among other factors. Similar to other Medicare prospective payment systems, the rate is also adjusted for geographic wage differences. Effective for discharges on or after October 1, 2005, CMS has published the new relative weights applicable to the long-term care diagnosis-related group system. CMS has stated its intention to develop long-term acute care hospital patient-specific criteria to refine the definition of such facilities.
 
To this end, CMS awarded a contract to Research Triangle Institute (RTI) for the purpose of evaluating patient and facility level characteristics for long-term care hospitals in order to differentiate the role of long-term acute care hospitals from general acute care hospitals. RTI recently released its study results, many of which are similar to MedPAC’s findings released in a 2004 report. Like MedPAC, RTI recommended the development and use of facility and patient criteria as a method of ensuring that patients admitted to long-term acute care hospitals, LTACHs, are medically complex and have a good chance of improvement. Also, while MedPAC recommended that quality improvement organizations (QIOs) review LTACH admissions for medical necessity and monitor whether facilities comply with the criteria, RTI recommended that CMS clarify QIO roles in overseeing the appropriateness of LTACH admissions. Additionally, RTI examined several key issues that MedPAC had not yet researched. The RTI report is advisory in nature, and it is uncertain which, if any, of its recommendations will be enacted, many of which require Congressional approval.
 
In order to qualify for payment under the long-term acute care prospective payment system, a facility must be certified as a hospital by Medicare and have an average Medicare inpatient length of stay of greater than 25 days. Prior to qualifying under the long-term acute care hospital prospective payment system, facilities are classified as short-term acute care hospitals and therefore receive lower payments under the acute or inpatient rehabilitation facility prospective payments systems. New long-term acute care hospitals continue to be paid under these systems for a minimum of six months while they establish the required average length of stay and meet certain additional Medicare long-term acute care hospital requirements. All of our LTACHs are currently qualified to receive full payment under the long-term acute care prospective payment.
 
On May 12, 2006, CMS published a final rule maintaining the Medicare payment rates for long-term acute care hospitals at $38,086.04 for patient discharges taking place on or after July 1, 2006 through June 30, 2007. In this rule, the agency declined to apply its one-time budget neutrality adjustment, set the cost outlier fixed loss threshold at $14,877, and made an addition to the reimbursement calculation for discharges defined as “short stay outliers”.
 
Long-term acute care hospitals are typically operated either as stand-alone facilities or as separate provider units within traditional acute care hospitals. All but one of our long-term acute care hospitals are located within host hospitals. These hospitals within a hospital must satisfy additional standards. A hospital within a hospital must establish itself as a hospital separate from its host by, among other things, obtaining separate licensure and certification, not having common control with its host hospital or a common parent organization, and having a separate chief executive officer, chief medical officer and medical staff. Further, there are financial penalties associated with the failure to limit the number of total Medicare patients discharged to the host hospital and subsequently readmitted to the long-term acute care hospital to no greater than 5.0%. None of our long-term acute care hospitals exceeded this 5.0% limitation through the year ended December 31, 2006.
 
In August 2004, CMS announced final regulatory changes applicable to long-term acute care facilities operated as hospitals within hospitals (HwHs). Effective for cost reporting periods beginning on or after October 1, 2004, long-term acute care HwHs would have to limit the number of Medicare admissions from their co-located host hospital according to specified thresholds. Medicare discharges over the specified threshold would be paid at a reduced payment rate, specifically, the inpatient prospective payment system rate.
 
This new policy was subject to a four year phase-in period for existing LTACH HwHs, satellites and LTACHs under formation. All of our LTACHs met the requirements for the four year phase-in period. The first year of the phase-in period (cost reporting periods beginning on or after October 1, 2004 and before October 1,


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2005) was a “hold harmless” year with no admission percentage threshold followed by a percentage transition over the three years beginning in FY 2006 (October 1, 2005 to September 30, 2006) as set forth in the table below:
 
                 
    Allowable Admissions
 
    from Host Hospital
 
    Before Payment
 
    Reduction  
Cost Report Period Beginning
  MSAs     Non-MSAs  
 
Until September 30, 2005
    100.0%       100.0%  
October 1, 2005 — September 30, 2006
    75.0%       75.0%  
October 1, 2006 — September 30, 2007
    50.0%       50.0%  
October 1, 2007 — and thereafter
    25.0%       50.0%  
 
The HwH rule specified that for HwHs located in rural or non-MSA locations, the final year phase in percentage would be 50%. For HwHs located in an MSA the final phase-in percentage would be 25%.
 
We currently have a total of seven long-term acute care hospitals. Six of our hospitals are classified as hospitals within a hospital (HwH) and one as freestanding. Of the six HwH facilities, four are located in rural or non-MSAs and are therefore subject to a final admission percentage of 50% at the end of the phase in period. Two of our six HwH facilities are located in MSA or urban areas and will be subject to a final admission percentage of 25% at the end of the phase-in period. Of these six locations classified as HwHs, two facilities are satellite locations of a parent hospital located in an MSA and one is a satellite location of a parent hospital located in an non-MSA. Based on our discussions with CMS, we believe these satellite locations will be viewed as being located in a non-MSA regardless of the location of its parent hospital and will be treated independently from its parent for purposes of calculating its compliance with the admissions limitations.
 
For the twelve months ended December 31, 2006, on an individual basis, all of our long-term acute care hospital locations admitted between 50.0% and 75.0% of their patients from their host hospitals. We currently anticipate that these hospitals will be under the proper threshold as of September 30, 2007. Our remaining long-term acute care hospital is not a hospital within a hospital; therefore, it is not subject to these limits on host hospital referrals.
 
In February 2007, CMS proposed to subject freestanding LTAC hospitals to the same admission restrictions as HwH facilities. Freestanding facilities would be prevented from admitting more than 25% of its Medicare admissions from a single referring hospital. Our current freestanding facility would not be affected by this proposed rule change because we currently do not receive more than 25% of our Medicare admissions from any single referring hospital.
 
Outpatient Rehabilitation Services.  Medicare requires that outpatient therapy services be reimbursed on a fee schedule, subject to annual limitations. Outpatient therapy providers receive a fixed fee for each procedure performed, adjusted by the geographical area in which the facility is located. Medicare also imposes annual per Medicare beneficiary caps. For 2006, these annual caps limited Medicare coverage to $1,740 for outpatient rehabilitation services (including both physical therapy and speech-language pathology services) and $1,740 for outpatient occupational health services, including deductible and co-insurance amounts. These caps were replaced for 2007 by annual cap amounts of $1,780. Historically, Congress has acted to bypass the cap and impose a moratorium on its operation. The Deficit Reduction Act of 2005 and the Tax Relief and Health Care Act of 2006 provided for an “exceptions” process that effectively prevents application of the caps. The exceptions process ends January 1, 2008. We are unable to predict whether Congress will extend the exceptions process for 2008. We cannot be assured that one or more of our outpatient rehabilitation clinics will not exceed the caps in the future.
 
Historically, outpatient rehabilitation services have been subject to scrutiny by the Medicare program for, among other things, medical necessity, appropriate documentation, supervision of therapy aides and students, and billing for group therapy. CMS has issued guidance to clarify that services performed by a student are not


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reimbursable even if provided under “line of sight” supervision of the therapist. Likewise, CMS has reiterated that Medicare does not pay for services provided by aides regardless of the level of supervision. CMS also has issued instructions that outpatient physical and occupational therapy services provided simultaneously to two or more individuals by a practitioner should be billed as group therapy services.
 
Inpatient Rehabilitation Facilities.  Inpatient rehabilitation facilities are paid under a prospective payment system. Under this system, each patient discharged from an inpatient rehabilitation facility is assigned to a case mix group containing patients with similar clinical problems that are expected to require comparable resources. An inpatient rehabilitation facility is generally paid a predetermined, fixed amount applicable to the assigned case mix group (subject to certain case and facility level adjustments). The prospective payment system for inpatient rehabilitation facilities also includes special payment policies that adjust the payments for some patients based on length of stay, facility costs, whether the patient was discharged and subsequently readmitted, and other factors.
 
Medicaid
 
Medicaid is a joint federal and state funded health insurance program for certain low-income individuals. Medicaid reimburses healthcare providers using a number of different systems, including cost-based, prospective payment, and negotiated rate systems. Rates are also subject to adjustment based on statutory and regulatory changes, administrative rulings, interpretations of policy by individual state agencies, and certain government funding limitations. Medicaid payments accounted for 6.1%, 6.0%, and 4.8%, respectively, of our net service revenue for the years ended December 31, 2006, 2005, and 2004.
 
Non-Governmental Payors
 
A portion of our net service revenue comes from private payor sources. These sources include insurance companies, workers’ compensation programs, health maintenance organizations, preferred provider organizations, other managed care companies, and employers, as well as patients directly. Patients are generally not responsible for any difference between customary charges for our services and amounts paid by Medicare and Medicaid programs and the non-governmental payors, but are responsible for services not covered by these programs or plans, as well as for deductibles and co-insurance obligations of their coverage. The amount of these deductibles and co-insurance obligations on patients has increased in recent years. Collection of amounts due from individuals is typically more difficult than collection of amounts due from government or business payors. However, the majority of our billed services are paid in full by Medicare, Medicaid or private insurance. Accordingly, co-payments from patients do not represent a material portion of our billed revenue and corresponding accounts receivable. To further reduce their healthcare costs, most insurance companies, health maintenance organizations, preferred provider organizations, and other managed care companies have negotiated discounted fee structures or fixed amounts for services performed, rather than paying healthcare providers the amounts billed. Our results of operations may be negatively affected if these organizations are successful in negotiating further discounts. Payments from non-governmental payors accounted for 12.3%, 8.4%, and 8.9%, respectively, of our net service revenue for the years ended December 31, 2006, 2005, and 2004.
 
Government Regulations
 
General
 
The healthcare industry is highly regulated, and we are required to comply with federal, state and local laws, which significantly affect our business. These laws and regulations are extremely complex and, in many instances, the industry does not have the benefit of significant regulatory or judicial interpretation. Regulations and policies frequently change, and we monitor these changes through trade and governmental publications and associations. The significant areas of federal and state regulatory laws that could affect our ability to conduct our business include the following:
 
  •  Medicare and Medicaid participation and reimbursement;


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  •  the federal Anti-Kickback Statute and similar state laws;
 
  •  the federal Stark Law and similar state laws;
 
  •  false and other improper claims;
 
  •  the Health Insurance Portability and Accountability Act of 1996, or HIPAA;
 
  •  civil monetary penalties;
 
  •  environmental health and safety laws;
 
  •  licensing; and
 
  •  certificates of need and permits of approval.
 
If we fail to comply with these applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate and our ability to participate in federal and state healthcare programs. Although we believe we are in material compliance with all applicable laws, these laws are complex and a review of our practices by a court or law enforcement or regulatory authority could result in an adverse determination that could harm our business. Furthermore, the laws applicable to us are subject to change, interpretation and amendment, which could adversely affect our ability to conduct our business.
 
Medicare Participation
 
During the year ended December 31, 2006, 2005, and 2004, 81.6%, 85.6% and 86.3%, respectively, of our net service revenue was received from Medicare. We expect to continue to receive the majority of our net service revenue from serving Medicare beneficiaries. Medicare is a federally funded and administered health insurance program, primarily for individuals entitled to social security benefits who are 65 or older or who are disabled. To participate in the Medicare program and receive Medicare payments, our agencies and facilities must comply with regulations promulgated by CMS. Among other things, these requirements, known as “conditions of participation,” relate to the type of facility, its personnel and its standards of medical care. Although we intend to continue to participate in the Medicare reimbursement programs, we cannot assure you that our agencies and programs will continue to qualify for participation.
 
Under Medicare rules, the designation “provider-based” refers to circumstances in which a subordinate facility (e.g., a separately-certified Medicare provider, a department of a provider or a satellite facility) is treated as part of a provider for Medicare payment purposes. In these cases, the services of the subordinate facility are included in the “main” provider’s cost report and overhead costs of the main provider can be allocated to the subordinate facility, to the extent that they are shared. We operate three long-term acute care hospitals that are treated as provider-based satellites of certain of our other facilities. We also provide contract rehabilitation and management services to hospital rehabilitation departments that may be treated as provider-based. These facilities are required to satisfy certain operational standards in order to retain their provider-based status.
 
Anti-Kickback Statute
 
Provisions of the Social Security Act of 1965, commonly referred to as the Anti-Kickback Statute, prohibit the payment or receipt of anything of value in return for the referral of patients or arranging for the referral of patients, or in return for the recommendation, arrangement, purchase, lease or order of items or services that are covered by a federal healthcare program such as Medicare and Medicaid. Violation of the Anti-Kickback Statute is a felony, and sanctions include imprisonment of up to five years, criminal fines of up to $25,000, civil monetary penalties of up to $50,000 per act plus three times the amount claimed or three times the remuneration offered, and exclusion from federal healthcare programs (including the Medicare and Medicaid programs). Many states have adopted similar prohibitions against payments that are intended to induce referrals of Medicaid and other third-party payor patients.
 
The OIG has published numerous “safe harbors” that exempt some practices from enforcement action under the federal Anti-Kickback Statute. These safe harbors exempt specified activities, including bona-fide


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employment relationships, contracts for the rental of space or equipment, and personal service arrangements and management contracts, so long as all of the requirements of the safe harbor are met. The OIG has recognized that the failure of an arrangement to satisfy all of the requirements of a particular safe harbor does not necessarily mean that the arrangement violates the Anti-Kickback statute. Nonetheless, we cannot assure you that arrangements that do not satisfy a safe harbor are not in violation of the Anti-Kickback Statute.
 
We are required under the Medicare conditions of participation and some state licensing laws to contract with numerous healthcare providers and practitioners, including physicians, hospitals and nursing homes, and to arrange for these individuals or entities to provide services to our patients. In addition, we have contracts with other suppliers, including pharmacies, ambulance services and medical equipment companies. We have also entered into various joint ventures with hospitals and physicians for the ownership and management of home nursing agencies and long-term acute care hospitals. Some of these individuals or entities may refer, or be in a position to refer, patients to us, and we may refer, or be in a position to refer, patients to these individuals or entities. We attempt to structure these arrangements in a manner which meets a safe harbor. However, some of these arrangements may not meet all of the requirements of a safe harbor. We believe that our contracts and arrangements with providers, practitioners and suppliers do not violate the Anti-Kickback Statute or similar state laws. We cannot assure you, however, that these laws will ultimately be interpreted in a manner consistent with our practices.
 
From time to time, various federal and state agencies, such as HHS, issue pronouncements, including fraud alerts, that identify practices that may be subject to heightened scrutiny. For example, the OIG’s 2007 Work Plan describes, among other things, the government’s intention to examine outlier payments to home health agencies, accuracy of claims coding for Medicare home health resources groups, payments to long-term acute care hospitals and average lengths of stay at long-term acute care hospitals.
 
In June 1995, the OIG issued a special fraud alert that focused on the home nursing industry and identified some of the illegal practices the OIG has uncovered. In March 1998, the OIG issued a special fraud alert titled, Fraud and Abuse in Nursing Home Arrangements with Hospices. This special fraud alert focused on payments received by nursing homes from hospices. We believe, but cannot assure you, that our operations comply with the principles expressed by the OIG in these special fraud alerts.
 
We endeavor to conduct our operations in compliance with federal and state healthcare fraud and abuse laws, including the Anti-Kickback Statute. However, our practices may be challenged in the future, and the fraud and abuse laws may be interpreted in a way that finds us in violation of these laws. If we are found to be in violation of the Anti-Kickback Statute, we could be subject to civil and criminal penalties, and we could be excluded from participating in federal healthcare programs such as Medicare and Medicaid. The occurrence of any of these events could significantly harm our business and financial condition.
 
Stark Law
 
Congress also passed significant prohibitions against certain physician referrals of patients for healthcare services. These prohibitions are commonly known as the Stark Law. The Stark Law prohibits a physician from making referrals for particular healthcare services (called designated health services) to entities with which the physician, or an immediate family member of the physician, has a financial relationship.
 
The term “financial relationship” is defined very broadly to include most types of ownership or compensation relationships. The Stark Law also prohibits the entity receiving the referral from seeking payment under the Medicare and Medicaid programs for services rendered pursuant to a prohibited referral. If an entity is paid for services rendered pursuant to a prohibited referral, it may incur civil penalties and could be excluded from participating in the Medicare or Medicaid programs. If an arrangement is covered by the Stark Law, the requirements of a Stark Law exception must be met for the physician to be able to make referrals to the entity for designated health services and for the entity to be able to bill for these services.
 
“Designated health services” under the Stark Law are defined to include clinical laboratory services; physical therapy services; occupational therapy services; radiology services, including magnetic resonance imaging, computerized axial tomography scans, and ultrasound services; radiation therapy services and


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supplies; durable medical equipment and supplies; parenteral and enteral nutrients, equipment, and supplies; prosthetics, orthotics, and prosthetic devices and supplies; home health services; outpatient prescription drugs; and inpatient and outpatient hospital services. The Stark Law defines a financial relationship to include: (1) a physician’s ownership or investment interest in an entity and (2) a compensation relationship between a physician and an entity. Under the Stark Law, financial relationships include both direct and indirect relationships.
 
Physicians refer patients to us for several Stark Law designated health services, including home health services, inpatient and outpatient hospital services, and physical therapy services. We have compensation arrangements with some of these physicians or their professional practices in the form of medical director and consulting agreements. We also have operations owned by joint ventures in which physicians have an investment interest. In addition, other physicians who refer patients to our agencies and facilities may own our stock. As a result of these relationships, we could be deemed to have a financial relationship with physicians who refer patients to our facilities and agencies for designated health services. If so, the Stark Law would prohibit the physicians from making those referrals and would prohibit us from billing for the services unless a Stark Law exception applies.
 
The Stark Law contains exceptions for certain physician ownership or investment interests in and certain physician compensation arrangements with entities. If a compensation arrangement or investment relationship between a physician, or a physician’s immediate family member, and an entity satisfies all requirements for a Stark Law exception, the Stark Law will not prohibit the physician from referring patients to the entity for designated health services. The exceptions for compensation arrangements cover employment relationships, personal services contracts, and space and equipment leases, among others. The exceptions for a physician investment relationship include ownership in an entire hospital and ownership in rural providers. We believe our compensation arrangements with referring physicians and our physician investment relationships meet the requirements for an exception under the Stark Law and that our operations comply with the Stark Law.
 
The Stark Law also includes an exception for a physician’s ownership or investment interest in certain entities through the ownership of stock. If a physician owns stock in an entity, and the stock is listed on a national exchange or is quoted on Nasdaq and the ownership meets certain other requirements, the Stark Law will not apply to prohibit the physician from referring to the entity for designated health services. The requirements for this Stark Law exception include a requirement that the entity issuing the stock have at least $75.0 million in stockholders’ equity at the end of its most recent fiscal year or on average during the previous three fiscal years. As of December 31, 2006, we have exceeded $75.0 million in stockholders’ equity.
 
If an entity violates the Stark Law, it could be subject to civil penalties of up to $15,000 per prohibited claim and up to $100,000 for knowingly entering into certain prohibited referral schemes. The entity also may be excluded from participating in federal healthcare programs (including Medicare and Medicaid). If the Stark Law was found to apply to our relationships with referring physicians and no exceptions under the Stark Law were available, we would be required to restructure these relationships or refuse to accept referrals for designated health services from these physicians. If we were found to have submitted claims to Medicare or Medicaid for services provided pursuant to a referral prohibited by the Stark Law, we would be required to repay any amounts we received from Medicare for those services and could be subject to civil monetary penalties. Further, we could be excluded from participating in Medicare and Medicaid. If we were required to repay any amounts to Medicare, subjected to fines, or excluded from the Medicare and Medicaid Programs, our business and financial condition would be harmed significantly.
 
Many states have physician relationship and referral statutes that are similar to the Stark Law. These laws generally apply regardless of payor. We believe that our operations are structured to comply with applicable state laws with respect to physician relationships and referrals. However, any finding that we are not in compliance with these state laws could require us to change our operations or could subject us to penalties. This, in turn, could have a negative impact on our operations.


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False and Improper Claims
 
The submission of claims to a federal or state healthcare program for items and services that are “not provided as claimed” may lead to the imposition of civil monetary penalties, criminal fines and imprisonment, and/or exclusion from participation in state and federally funded healthcare programs, including the Medicare and Medicaid programs. These false claims statutes include the Federal False Claims Act. Under the Federal False Claims Act, actions against a provider can be initiated by the federal government or by a private party on behalf of the federal government. These private parties are often referred to as qui tam relators, and relators are entitled to share in any amounts recovered by the government. Both direct enforcement activity by the government and qui tam actions have increased significantly in recent years. This development has increased the risk that a healthcare company like us will have to defend a false claims action, pay fines or be excluded from the Medicare and Medicaid programs as a result of an investigation arising out of false claims laws. Many states have enacted similar laws providing for the imposition of civil and criminal penalties for the filing of fraudulent claims. Because of the complexity of the government regulations applicable to our industry, we cannot assure that we will not be the subject of an action under the Federal False Claims Act or similar state law.
 
Anti-fraud Provisions of the Health Insurance Portability and Accountability Act of 1996
 
In an effort to combat healthcare fraud, Congress included several anti-fraud measures in HIPAA. Among other things, HIPAA broadened the scope of certain fraud and abuse laws, extended criminal penalties for Medicare and Medicaid fraud to other federal healthcare programs, and expanded the authority of the OIG to exclude persons and entities from participating in the Medicare and Medicaid programs. HIPAA also extended the Medicare and Medicaid civil monetary penalty provisions to other federal healthcare programs, increased the amounts of civil monetary penalties, and established a criminal healthcare fraud statute.
 
Federal healthcare offenses under HIPAA include healthcare fraud and making false statements relating to healthcare matters. Under HIPAA, among other things, any person or entity that knowingly and willfully defrauds or attempts to defraud a healthcare benefit program is subject to a fine, imprisonment or both. Also under HIPAA, any person or entity that knowingly and willfully falsifies or conceals or covers up a material fact or makes any materially false or fraudulent statements in connection with the delivery of or payment of healthcare services by a healthcare benefit plan is subject to a fine, imprisonment or both. HIPAA applies not only to governmental plans but also to private payors.
 
Administrative Simplification Provisions of HIPAA
 
HHS’s final regulations governing electronic transactions involving health information are part of the administrative simplification provisions of HIPAA. These regulations are commonly referred to as the Transaction Standards rule. The rule establishes standards for eight of the most common healthcare transactions by reference to technical standards promulgated by recognized standards publishing organizations. Under the new standards, any party transmitting or receiving health transactions electronically must send and receive data in a single format, rather than the large number of different data formats currently used. This rule will apply to us in connection with submitting and processing health claims. The Transaction Standards rule also applies to many of our payors and to our relationships with those payors. Since many of our payors might not have been able to accept transactions in the format required by the Transaction Standards rule by the original compliance date, we filed a timely compliance extension plan with HHS. We believe that our operations materially comply with the Transaction Standards rule.
 
HHS also has final regulations implementing HIPAA that set forth standards for the privacy of individually-identifiable health information, referred to as protected health information. The regulations cover healthcare providers, healthcare clearinghouses and health plans. The privacy regulations require companies covered by the regulations to use and disclose protected health information only as allowed by the privacy regulations. Specifically, the privacy regulations require companies such as us to do the following, among other things:
 
  •  obtain patient authorization prior to certain uses or disclosures of protected health information;


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  •  provide notice of privacy practices to patients and obtain an acknowledgement that the patient has received the notice;
 
  •  respond to requests from patients for access to or to obtain a copy of their protected health information;
 
  •  respond to patient requests for amendments of their protected health information;
 
  •  provide an accounting to patients of certain disclosure of their protected health information;
 
  •  enter into agreements with the companies’ business associates through which the business associates agree to use and disclose protected health information only as permitted by the agreement and the requirements of the privacy regulations;
 
  •  train the companies’ workforce in privacy compliance;
 
  •  designate a privacy officer;
 
  •  use and disclose only the minimum necessary information to accomplish a particular purpose; and
 
  •  establish policies and procedures with respect to uses and disclosures of protected health information.
 
These regulatory requirements impose significant administrative and financial obligations on companies that use or disclose individually identifiable health information relating to the health of a patient. We have implemented new policies and procedures to maintain patient privacy and comply with HIPAA’s privacy regulations. The privacy regulations are extensive, and we may need to change some of our practices to comply with them as they are interpreted and as we deal with issues that arise.
 
In February 2003, HHS published the final security regulations implementing HIPAA that govern the security of health information. The compliance date for the security regulations was April 21, 2005. The security regulations require the implementation of policies and procedures that establish administrative, physical, and technical safeguards for electronic protected health information. Companies covered by the security regulations are required to ensure the confidentiality, integrity, and availability of electronic protected health information. Specifically, among others things, companies are required to:
 
  •  conduct a thorough assessment of the potential risks and vulnerabilities to confidentiality, integrity, and availability of electronic protected health information and to reduce the risks and vulnerabilities to a reasonable and appropriate level as required by the security regulations;
 
  •  designate a security officer;
 
  •  establish policies relating to access by the companies’ workforce to electronic protected health information;
 
  •  enter into agreements with the companies’ business associates whereby business associates agree to establish administrative, physical, and technical safeguards for electronic protected health information received from or on behalf of the companies;
 
  •  create a disaster and contingency plan to ensure the availability of electronic protected health information;
 
  •  train the companies’ workforce in security compliance;
 
  •  establish physical controls for electronic devices and media containing or transmitting electronic protected health information;
 
  •  establish policies and procedures regarding the use of workstations with access to electronic protected health information; and
 
  •  establish technical controls for the information systems maintaining or transmitting electronic protected health information.


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These regulatory requirements impose significant administrative and financial obligations on companies like us that use or disclose electronic health information. Our operations are in compliance with the security regulations.
 
Civil Monetary Penalties
 
The Secretary of HHS may impose civil monetary penalties on any person or entity that presents, or causes to be presented, certain ineligible claims for medical items or services. The amount of penalties varies depending on the offense, from $2,000 to $50,000 per violation, plus treble damages for the amount at issue and exclusion from federal healthcare programs (including Medicare and Medicaid).
 
HHS also can impose penalties on a person or entity who offers inducements to beneficiaries for program services, who violates rules regarding the assignment of payments or who knowingly gives false or misleading information that could reasonably influence the discharge of patients from a hospital. Persons who have been excluded from a federal healthcare program and who retain ownership in a participating entity and persons who contract with excluded persons may be penalized.
 
HHS also can impose penalties for false or fraudulent claims and those that include services not provided as claimed. In addition, HHS may impose penalties on claims:
 
  •  for physician services that the person or entity knew or should have known were rendered by a person who was unlicensed, or misrepresented either (1) his or her qualifications in obtaining his or her license or (2) his or her certification in a medical specialty;
 
  •  for services furnished by a person who was, at the time the claim was made, excluded from the program to which the claim was made; or
 
  •  that show a pattern of medically unnecessary items or services.
 
Penalties also are applicable in certain other cases, including violations of the federal Anti-Kickback Statute, payments to limit certain patient services and improper execution of statements of medical necessity.
 
Environmental Health and Safety Laws
 
We are subject to federal, state and local regulations governing the storage, use and disposal of materials and waste products. Although we believe that our safety procedures for storing, handling and disposing of these hazardous materials comply with the standards prescribed by law and regulation, we cannot completely eliminate the risk of accidental contamination or injury from those hazardous materials. In the event of an accident, we could be held liable for any damages that result, and any liability could exceed the limits or fall outside the coverage of our insurance. We may not be able to maintain insurance on acceptable terms, or at all. We could incur significant costs and the diversion of our management’s attention in order to comply with current or future environmental laws and regulations. We do not have any material estimated capital expenditures related to compliance with environmental, health and safety laws through calendar year 2007.
 
Licensing
 
Our agencies and facilities are subject to state and local licensing regulations ranging from the adequacy of medical care to compliance with building codes and environmental protection laws. In order to assure continued compliance with these various regulations, governmental and other authorities periodically inspect our agencies and facilities. Additionally, healthcare professionals at our agencies and facilities are required to be individually licensed or certified under applicable state law. We take steps to ensure that our employees and agents possess all necessary licenses and certifications.
 
The institutional pharmacy operations within our facility-based services segment are subject to regulation by the various states in which business is conducted as well as by the federal government. The pharmacies are regulated under the Food, Drug and Cosmetic Act and the Prescription Drug Marketing Act, which are administered by the United States Food and Drug Administration. Under the Comprehensive Drug Abuse Prevention and Control Act of 1970, which is administered by the United States Drug Enforcement


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Administration, dispensers of controlled substances must register with the Drug Enforcement Administration, file reports of inventories and transactions and provide adequate security measures. Failure to comply with such requirements could result in civil or criminal penalties.
 
JCAHO is a nationwide commission that establishes standards relating to the physical plant, administration, quality of patient care and operation of medical staffs of hospitals. Currently, JCAHO accreditation of home nursing agencies is voluntary. However, managed care organizations use JCAHO accreditation as a minimum standard for regional and state contracts. As of December 31, 2006, JCAHO had accredited 34 of our home nursing agencies. Those not yet accredited are working towards achieving this accreditation, which can take up to six months.
 
Certificate of Need and Permit of Approval Laws
 
In addition to state licensing laws, some states require a provider to obtain a certificate of need or permit of approval prior to establishing or expanding certain health services or facilities. States with certificate of need or permit of approval laws place limits on both the construction and acquisition of healthcare facilities and operations and the expansion of existing facilities and services. In these states, approvals are required for capital expenditures exceeding certain amounts that involve certain facilities or services, including home nursing agencies. In addition, the state of Louisiana has imposed a moratorium on the issuance of new licenses for home nursing agencies that is effective until July 1, 2008. Of the 15 states in which we intend to pursue expansion opportunities, ten have certificate of need or permit of approval laws: Alabama, Arkansas, Georgia, Kentucky, Mississippi, North Carolina, South Carolina, Tennessee, Virginia and West Virginia. The certificate of need or permit of approval issued by the state determines the service areas for the applicable agency or program.
 
State certificate of need and permit of approval laws generally provide that, prior to the addition of new capacity, the construction of new facilities or the introduction of new services, a designated state health planning agency must determine that a need exists for those beds, facilities or services. The process is intended to promote comprehensive healthcare planning, assist in providing high quality healthcare at the lowest possible cost and avoid unnecessary duplication by ensuring that only those healthcare facilities and operations that are needed will be built and opened.
 
Employees
 
As of December 31, 2006 we had 3,959 employees, of which 2,478 were full-time and 1,481 were part-time employees, and approximately 775 independent contractors. None of our employees are subject to a collective bargaining agreement. We consider our relationships with our employees and independent contractors to be good.
 
Insurance
 
We are subject to claims and legal actions in the ordinary course of our business. To cover claims that may arise, we maintain professional malpractice liability insurance, general liability insurance, automobile liability insurance, and workers’ compensation/employer’s liability in amounts that we believe are appropriate and sufficient for our operations. We maintain professional malpractice and general liability insurance that provide primary coverage on a claims-made basis of $1.0 million per incident and $3.0 million in annual aggregate amounts. We maintain workers’ compensation insurance that meets state statutory requirements with a primary employer liability limit of $1.0 million for Louisiana, Mississippi Alabama, Arkansas, Texas, Tennessee, Georgia, Florida, and Kentucky and $500,000 in West Virginia. We maintain Automobile Liability for all owned, hired, and non-owned autos with a primary limit of $2.0 million. In addition, we currently maintain multiple layers of umbrella coverage in the aggregate amount of $25.0 million that provides excess coverage for professional malpractice, general liability, automobile liability and employer’s liability. We also currently maintain Directors and Officers liability insurance in the aggregate amount of $15.0 million. The cost and availability of such coverage has varied widely in recent years. While we believe that our insurance policies and coverage are adequate for a business enterprise of our type, we cannot assure you that our


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insurance coverage is sufficient to cover all future claims or that it will continue to be available in adequate amounts or at a reasonable cost.
 
Available Information
 
Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements and amendments to those reports, are available free of charge on our internet website at www.lhcgroup.com as soon as reasonably practicable after such reports are electronically filed with or furnished to the Securities and Exchange Commission, or SEC. The SEC also maintains an internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.
 
Item 1A.   Risk Factors
 
You should carefully consider the risks described below before investing in the Company. The risks and uncertainties described below are not the only ones we face. Other risks and uncertainties that we have not predicted or assessed may also adversely affect us.
 
If any of the following risks occurs, our earnings, financial condition or business could be materially harmed, and the trading price of our common stock could decline, resulting in the loss of all or part of your investment.
 
More than 80% of our net service revenue is derived from Medicare. If there are changes in Medicare rates or methods governing Medicare payments for our services, or if we are unable to control our costs, our net service revenue and net income could decline materially.
 
For the years ended December 31, 2006, 2005 and 2004, we received 81.6%, 85.6% and 86.3%, respectively, of our net service revenue from Medicare. Reductions in Medicare rates or changes in the way Medicare pays for services could cause our net service revenue and net income to decline, perhaps materially. Reductions in Medicare reimbursement could be caused by many factors, including:
 
  •  administrative or legislative changes to the base rates under the applicable prospective payment systems;
 
  •  the reduction or elimination of annual rate increases;
 
  •  the imposition or increase by Medicare of mechanisms, such as co-payments, shifting more responsibility for a portion of payment to beneficiaries;
 
  •  adjustments to the relative components of the wage index used in determining reimbursement rates;
 
  •  changes to case mix or therapy thresholds;
 
  •  the reclassification of home health resource groups or long-term care diagnosis-related groups; or
 
  •  further limitations on referrals to long-term acute care hospitals from host hospitals.
 
We generally receive fixed payments from Medicare for our services based on the level of care provided to our patients. Consequently, our profitability largely depends upon our ability to manage the cost of providing these services. Medicare currently provides for an annual adjustment of the various payment rates, such as the base episode rate for our home nursing services, based upon the increase or decrease of the medical care expenditure category of the Consumer Price Index, which may be less than actual inflation. This adjustment could be eliminated or reduced in any given year. Our base episode rate for home nursing services is also subject to an annual market basket adjustment. For 2007, the home health market basket percentage increase is 3.3%. Further, Medicare routinely reclassifies home health resource groups and long-term care diagnosis-related groups. As a result of those reclassifications, we could receive lower reimbursement rates depending on the case mix of the patients we service. If our cost of providing services increases by more than the annual Medicare price adjustment, or if these reclassifications result in lower reimbursement rates, our net income could be adversely impacted.


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We are subject to extensive government regulation. Any changes in the laws governing our business, or the interpretation and enforcement of those laws or regulations, could cause us to modify our operations and could negatively impact our operating results.
 
As a provider of healthcare services, we are subject to extensive regulation on the federal, state and local levels, including with regard to:
 
  •  agency, facility and professional licensure, certificates of need and permits of approval;
 
  •  conduct of operations, including financial relationships among healthcare providers, Medicare fraud and abuse, and physician self-referral;
 
  •  maintenance and protection of records, including the Health Insurance Portability and Accountability Act of 1996, or HIPAA;
 
  •  environmental protection, health and safety;
 
  •  certification of additional agencies or facilities by the Medicare program; and
 
  •  payment for services.
 
The laws and regulations governing our operations, along with the terms of participation in various government programs, regulate how we do business, the services we offer, and our interactions with patients and other providers. These laws and regulations, and their interpretations, are subject to frequent change. Changes in existing laws or regulations, their interpretations, or the enactment of new laws or regulations could increase our costs of doing business and cause our net income to decline. If we fail to comply with these applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate and our ability to participate in federal and state reimbursement programs.
 
We are subject to various routine and non-routine governmental reviews, audits, and investigations. In recent years federal and state civil and criminal enforcement agencies have heightened and coordinated their oversight efforts related to the healthcare industry, including with respect to referral practices, cost reporting, billing practices, joint ventures and other financial relationships among healthcare providers. A violation or change in the interpretation of the laws governing our operations, or changes in the interpretation of those laws, could result in the imposition of fines, civil or criminal penalties, the termination of our rights to participate in federal and state-sponsored programs, or the suspension or revocation of our licenses to operate. If we become subject to material fines or if other sanctions or other corrective actions are imposed upon us, we may suffer a substantial reduction in net income.
 
If any of our agencies or facilities fail to comply with the conditions of participation in the Medicare program, that agency or facility could be terminated from Medicare, which would adversely affect our net service revenue and net income.
 
Our agencies and facilities must comply with the extensive conditions of participation in the Medicare program. These conditions of participation vary depending on the type of agency or facility, but in general require our agencies and facilities to meet specified standards relating to personnel, patient rights, patient care, patient records, administrative reporting and legal compliance. If an agency or facility fails to meet any of the Medicare conditions of participation, that agency or facility may receive a notice of deficiency from the applicable state surveyor. If that agency or facility then fails to institute and comply with a plan of correction to correct the deficiency within the time period provided by the state surveyor, that agency or facility could be terminated from the Medicare program. We respond in the ordinary course to deficiency notices issued by state surveyors, and none of our facilities or agencies have ever been terminated from the Medicare program for failure to comply with the conditions of participation. Any termination of one or more of our agencies or facilities from the Medicare program for failure to satisfy the Medicare conditions of participation would adversely affect our net service revenue and net income.
 
In addition, if our long-term acute care hospitals fail to meet or maintain the standards for Medicare certification as long-term acute care hospitals, such as for average minimum length of patient stay, they will


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receive reimbursement under the prospective payment system applicable to general acute care hospitals rather than the system applicable to long-term acute care hospitals. Payments at rates applicable to general acute care hospitals would likely result in our long-term acute care hospitals receiving less Medicare reimbursement than they currently receive for their patient services. Moreover, all of our long-term acute care hospitals are subject to additional Medicare criteria because they operate as separate hospitals located in space leased from, and located in, a general acute care hospital, known as a host hospital. This is known as a “hospital within a hospital” model. These additional criteria include requirements concerning financial and operational separateness from the host hospital. If several of our long-term acute care hospitals were subject to payment as general acute care hospitals or fail to comply with the separateness requirements, our net service revenue and net income would decline.
 
CMS has adopted regulations that could materially and adversely impact the revenue and net income of our long-term acute care hospitals.
 
In August 2004, CMS announced final regulatory changes applicable to long-term acute care facilities operated as hospitals within hospitals (HwHs). Effective for cost reporting periods beginning on or after October 1, 2004, long-term acute care HwHs would have to limit the number of Medicare admissions from their co-located host hospital according to specified thresholds. Medicare discharges over the specified threshold would be paid at a reduced payment rate, specifically, the inpatient prospective payment system rate.
 
This new policy was subject to a four year phase-in period for existing LTACH HwHs, satellites and LTACHs under formation. All of our LTACHs met the requirements for the four year phase-in period. The first year of the phase-in period (cost reporting periods beginning on or after October 1, 2004 and before October 1, 2005) was a “hold harmless” year with no admission percentage threshold followed by a percentage transition over the three years beginning in FY 2006 (October 1, 2005 to September 30, 2006) as set forth in the table below:
 
                 
    Allowable Admissions
 
    from Host Hospital
 
    Before Payment Reduction  
Cost Report Period Beginning
  MSAs     Non-MSAs  
 
Until September 30, 2005
    100.0%       100.0%  
October 1, 2005 — September 30, 2006
    75.0%       75.0%  
October 1, 2006 — September 30, 2007
    50.0%       50.0%  
October 1, 2007 — and thereafter
    25.0%       50.0%  
 
We currently have a total of seven long-term acute care hospitals. Six of our hospitals are classified as hospitals within a hospital (HwH) and one as freestanding. Of the six HwH facilities, four are located in rural or non-MSAs and are therefore subject to a final admission percentage of 50% at the end of the phase in period. Two of our six HwH facilities are located in MSA or urban areas and will be subject to a final admission percentage of 25% at the end of the phase-in period. Of these six locations classified as HwHs, two facilities are satellite locations of a parent hospital located in an MSA and one is a satellite location of a parent hospital located in an non-MSA. Based on our discussions with CMS, we believe these satellite locations will be viewed as being located in a non-MSA regardless of the location of its parent hospital and will be treated independently from its parent for purposes of calculating its compliance with the admissions limitations.
 
In February 2007, CMS proposed to subject freestanding LTAC hospitals to the same admission restrictions as HwH facilities. Freestanding facilities would be prevented from admitting more than 25% of its Medicare admissions from a single referring hospital. Our current freestanding facility would not be affected by this proposed rule change because we currently do not receive more than 25% of our Medicare admissions from any single referring hospital.


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Our ability to quantify the potential reduction in our reimbursement rates resulting from the implementation of these new regulations is contingent upon a variety of factors, such as our ability to reduce the percentage of admissions that are derived from our host hospitals and, if necessary, our ability to relocate our existing long-term acute care hospitals to freestanding locations. We may not be able to successfully restructure or relocate these operations without incurring significant expense or in a manner that avoids reimbursement reductions. If these new regulations result in lower reimbursement rates, our net service revenue and net income could decline. As a result of these new rules, we do not intend to expand the number of hospital within a hospital long-term acute care hospitals that we operate.
 
We are reimbursed by Medicare for services we provide in our long-term acute care hospitals based on the long-term care diagnosis-related group assigned to each patient. CMS establishes these long-term care diagnosis-related groups by grouping diseases by diagnosis, which group reflects the amount of resources needed to treat a given disease. These new rules reclassify certain long-term care diagnosis-related groups, which could result in a decrease in reimbursement rates. Further, the new rules kept in place the financial penalties associated with the failure to limit the total number of Medicare patients discharged to a host hospital and subsequently readmitted to a long-term acute care hospital located within the host hospital to no greater than 5.0%. If we fail to comply with these readmission rates or if our reimbursement rates decline due to the reclassification of certain long-term care diagnosis-related groups, our net service revenue and net income could decline.
 
Legislative initiatives could negatively impact our operations and financial results.
 
In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would result in major changes in the healthcare system, either at the national or state level. Many of these proposals have been introduced in an effort to reduce costs. For example, the Medicare Modernization Act of 2003, MMA allocated significant additional funds to Medicare managed care providers in order to promote greater participation in those plans by Medicare beneficiaries. If these increased funding levels achieve their intended result, the rate of growth in the Medicare fee-for-service market could decline. For the years ended December 31, 2006, 2005 and 2004, we received 81.6%, 85.6%, and 86.3%, respectively, of our net service revenue from the Medicare fee-for-service market. Among other proposals that have been introduced are insurance market reforms to increase the availability of group health insurance to small businesses, requirements that all businesses offer health insurance coverage to their employees and the creation of government health insurance or plans that would cover all citizens and increase payments by beneficiaries. We cannot predict whether any of the above proposals, or any other future proposals, will be adopted. If adopted, we could be forced to expend considerable resources to comply with and implement such reforms.
 
More than 60% of our net service revenue is currently generated in Louisiana, making us particularly sensitive to economic and other conditions in that state.
 
Our Louisiana agencies and facilities accounted for approximately 63.5%, 78.8%, and 82.8% of net service revenue during the years ended December 31, 2006, 2005 and 2004, respectively. Any material change in the current economic or competitive conditions in Louisiana, which could result from events such as the implementation of certificate of need regulations or changes in state tax laws, could have a disproportionate effect on our overall business results.
 
Hurricanes or other adverse weather events could negatively affect our local economies or disrupt our operations, which could have an adverse effect on our business or results of operations.
 
Our market areas in the southern United States are particularly susceptible to hurricanes. Such weather events can disrupt our operations, result in damage to our properties and negatively affect the local economies in which we operate. In late summer 2005, Hurricane Katrina and Hurricane Rita struck the Gulf Coast region of the United States and caused extensive and catastrophic physical damage to those areas. While we believe we have recovered from the effects of Hurricane Katrina and Hurricane Rita, future hurricanes could affect our operations or the economies in those market areas and result in damage to certain of our facilities and the


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equipment located at such facilities, or equipment on rent with customers in those areas. Our business or results of operations may be adversely affected by these and other negative effects of future hurricanes.
 
If we are unable to maintain relationships with existing referral sources or establish new referral sources, our growth and net income could be adversely affected.
 
Our success depends significantly on referrals from physicians, hospitals, and other healthcare providers in the communities in which we deliver our services. Our referral sources are not obligated to refer business to us and may refer business to other healthcare providers. We believe many of our referral sources refer business to us as a result of the quality of patient service provided by our local employees in the communities in which our agencies and facilities are located. If we are unable to retain these employees, our referral sources may refer business to other healthcare providers. Our loss of, or failure to maintain, existing relationships or our failure to develop new relationships could affect adversely our ability to expand our operations and operate profitably.
 
Delays in reimbursement may cause liquidity problems.
 
Our business is characterized by delays in reimbursement from the time we request payment for our services to the time we receive reimbursement or payment. A portion of our estimated reimbursement (60.0% for an initial episode of care and 50.0% for subsequent episodes of care) for each Medicare episode is billed at the commencement of the episode and we typically receive payment within approximately 12 days. The remaining reimbursement is billed upon completion of the episode and is typically paid within 14-17 days from billing date. If we have information system problems or issues arise with Medicare or other payors, we may encounter further delays in our payment cycle. For example, in the past we have experienced delays resulting from problems arising out of the implementation by Medicare of new or modified reimbursement methodologies or as a result of natural disasters, such as hurricanes. We have also experienced delays in reimbursement resulting from our implementation of new information systems related to our accounts receivable and billing functions. Any future timing delay may cause working capital shortages. As a result, working capital management, including prompt and diligent billing and collection, is an important factor in our consolidated results of operations and liquidity. Our working capital management procedures may not successfully negate this risk. Significant delays in payment or reimbursement could have an adverse impact on our liquidity and financial condition.
 
Future cost containment initiatives undertaken by private third party payors may limit our future net service revenue and net income.
 
Initiatives undertaken by major insurers and managed care companies to contain healthcare costs may affect our net income. These payors attempt to control healthcare costs by contracting with hospitals and other healthcare providers to obtain services on a discounted basis. We believe that this trend may continue and may limit reimbursements for healthcare services. If insurers or managed care companies from whom we receive substantial payments were to reduce the amounts they pay for services, our profit margins may decline, or we may lose patients if we choose not to renew our contracts with these insurers at lower rates.
 
If the structures or operations of our joint ventures are found to violate the law, our financial condition and consolidated results of operations could be materially adversely impacted.
 
We have entered into 50 joint ventures with respect to the ownership and operation of 40 home nursing agency locations, three hospices, and six long-term acute care hospital locations, and one home health pharmacy. As of December 31, 2006, we had 40 equity joint ventures, two cooperative endeavors and eight license leasing arrangements. Of these 50 joint ventures, 37 are with hospitals, four are with physicians, and nine are with other parties. With respect to our four joint ventures with physicians, three are for the ownership and operation of long-term acute care hospitals, and one is for the ownership of a home nursing agency. Our joint venture relationships are structured as equity joint ventures, cooperative endeavors or license leasing arrangements. Our joint ventures with hospitals and physicians are governed by the federal anti-kickback statute and similar state laws. These anti-kickback statutes prohibit the payment or receipt of anything of value


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in return for referrals of patients or services covered by governmental healthcare programs, such as Medicare. The Office of Inspector General of the Department of Health and Human Services has published numerous safe harbors that exempt qualifying arrangements from enforcement under the federal anti-kickback statute. We have sought to satisfy as many safe harbor requirements as possible in structuring these joint ventures. For example, each of our equity joint ventures with hospitals and physicians is structured in accordance with the following principles:
 
  •  The investment interest offered is not based upon actual or expected referrals by the hospital or physician;
 
  •  Our joint venture partners are not required to make or influence referrals to the joint venture;
 
  •  At the time the joint venture is formed, each hospital or physician joint venture partner is required to make an actual capital contribution to the joint venture equal to the fair market value of its investment interest and is at risk to lose its investment;
 
  •  Neither we nor the joint venture entity lends funds to or guarantees a loan to acquire interests in the joint venture for a hospital or physician; and
 
  •  Distributions to our joint venture partners are based solely on their equity interests and not affected by referrals from the hospital or physician
 
Although we have sought to satisfy as many safe harbor requirements as possible, our joint ventures may not satisfy all elements of the safe harbor requirements.
 
Our four joint ventures with physicians are also governed by the federal Stark Law and similar state laws, which restrict physicians from making referrals for particular healthcare services to entities with which the physicians or their families have a financial relationship. We also believe we have structured our physician joint ventures in a way that meets applicable exceptions under the federal Stark Law and similar state physician referral laws. For example, we believe our one physician joint ventures for a home nursing agency comply with the rural provider exception to the Stark Law and that our three physician joint ventures for long-term acute care hospitals comply with the whole hospital exception to the Stark Law.
 
If any of our joint ventures were found to be in violation of federal or state anti-kickback or physician referral laws, we could be required to restructure them or refuse to accept referrals from the physicians or hospitals with which we have entered into a joint venture. We also could be required to repay to Medicare amounts we have received pursuant to any prohibited referrals, and we could suffer civil or criminal penalties, including the loss of our licenses to operate and our ability to participate in federal and state healthcare programs. If any of our joint ventures were subject to any of these penalties, our business could be damaged. In addition, our growth strategy is, in part, based on the continued development of new joint ventures with rural hospitals for the ownership and operation of home nursing agencies. If the structure of any of these joint ventures were found to violate federal or state anti-kickback statutes or physician referral laws, we may be unable to implement our growth strategy, which could have an adverse impact on our future net income and consolidated results of operations.
 
If we are required to either repurchase or sell a substantial portion of the equity interests in our joint ventures, our capital resources and financial condition could be materially, adversely impacted.
 
Upon the occurrence of fundamental changes to the laws and regulations applicable to our joint ventures, or if a substantial number of our joint venture partners were to exercise the buy/sell provisions contained in many of our joint venture agreements, we may be obligated to purchase or sell the equity interests held by us or our joint venture partners. The purchase price under these buy/sell provisions is typically based on a multiple of the historical or projected earnings before income taxes, depreciation and amortization of the joint venture at the time the buy/sell option is exercised. In the event the buy/sell provisions are exercised and we lack sufficient capital to purchase the interest of our joint venture partners, we may be obligated to sell our equity interest in these joint ventures. If we are forced to sell our equity interest, we will lose the benefit of those particular joint venture operations. If these buy/sell provisions are exercised and we choose to purchase


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the interest of our joint venture partners, we may be obligated to expend significant capital in order to complete such acquisitions. If either of these events occur, our net service revenue and net income could decline or we may not have sufficient capital necessary to implement our growth strategy.
 
Shortages in qualified nurses and other healthcare professionals could increase our operating costs significantly or constrain our ability to grow.
 
We rely on our ability to attract and retain qualified nurses and other healthcare professionals. The availability of qualified nurses nationwide has declined in recent years, and competition for these and other healthcare professionals has increased. Salary and benefit costs have risen accordingly. Our ability to attract and retain these nurses and other healthcare professionals depends on several factors, including our ability to provide desirable assignments and competitive benefits and salaries. We may not be able to attract and retain qualified nurses or other healthcare professionals in the future. In addition, the cost of attracting and retaining these professionals and providing them with attractive benefit packages may be higher than anticipated, which could cause our net income to decline. Moreover, if we are unable to attract and retain qualified professionals, the quality of services offered to our patients may decline or our ability to grow may be constrained.
 
The loss of certain senior management could have a material adverse effect on our operations and financial performance.
 
Our success depends upon the continued employment of certain members of our senior management, including our co-founder, President, Chief Executive Officer and Chairman, Keith G. Myers, our Executive Vice President, Chief Financial Officer and Treasurer, Barry E. Stewart and our Executive Vice President, Chief Operating Officer, Secretary and Director, John L. Indest. We have entered into an employment agreement with each of these officers in an effort to further secure their employment. The loss of service of any of these officers could have a material adverse effect on our operations if we were unable to find a suitable replacement.
 
If we are subject to substantial malpractice or other similar claims, our net income could be materially, adversely impacted.
 
The services we offer have an inherent risk of professional liability and related, substantial damage awards. We and the nurses and other healthcare professionals who provide services on our behalf may be the subject of medical malpractice claims. These nurses and other healthcare professionals could be considered our agents and, as a result, we could be held liable for their medical negligence. We cannot predict the effect that any claims of this nature, regardless of their ultimate outcome, could have on our business or reputation or on our ability to attract and retain patients and employees. We maintain malpractice liability insurance that provides primary coverage on a claims-made basis of $1.0 million per incident and $3.0 million in annual aggregate amounts. In addition, we maintain multiple layers of umbrella coverage in the aggregate amount of $10.0 million that provide excess coverage for professional malpractice and other liabilities. We are responsible for deductibles and amounts in excess of the limits of our coverage. Claims that could be made in the future in excess of the limits of such insurance, if successful, could materially, adversely affect our ability to conduct business or manage our assets. In addition, our insurance coverage may not continue to be available to us at commercially reasonable rates, in adequate amounts or on satisfactory terms.
 
The application of state certificate of need and permit of approval regulations and compliance with federal and state licensing requirements could substantially limit our ability to operate and grow our business.
 
Our ability to expand operations in a state will depend on our ability to obtain a state license to operate. States may have a limit on the number of licenses they issue. For example, as of December 31, 2005 we operated 48 home nursing agencies in Louisiana. Louisiana currently has a moratorium on the issuance of new home nursing agency licenses through July 1, 2008. We cannot predict whether this moratorium will be extended beyond this date or whether any other states in which we currently operate, or may wish to operate in the future, may adopt a similar moratorium.


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In addition to the moratorium imposed by the state of Louisiana, nine of the states in which we currently operate, or plan to operate in the future, require healthcare providers to obtain prior approval, known as a certificate of need or a permit of approval, for the purchase, construction or expansion of healthcare facilities, to make certain capital expenditures or to make changes in services or bed capacity. Of the states in which we currently operate, or intend to operate in the future, Alabama, Arkansas, Georgia, Kentucky, Mississippi, North Carolina, South Carolina, Tennessee and West Virginia have certificate of need or permit of approval laws. In granting approval, these states consider the need in the service area for additional or expanded healthcare facilities or services. The failure to obtain any requested certificate of need, permit of approval or other license could impair our ability to operate or expand our business.
 
We face competition, including from competitors with greater resources, which may make it difficult for us to compete effectively as a provider of post-acute healthcare services.
 
We compete with local and regional home nursing and hospice companies, hospitals, and other businesses that provide post-acute healthcare services, some of which are large established companies that have significantly greater resources than we do. Our primary competition comes from local operators in each of our markets. We expect our competitors to develop joint ventures with providers, referral sources, and payors, which could result in increased competition. The introduction by our competitors of new and enhanced service offerings, in combination with industry consolidation and the development of competitive joint ventures, could cause a decline in net service revenue, loss of market acceptance of our services, or make our services less attractive. Future increases in competition from existing competitors or new entrants may limit our ability to maintain or increase our market share. We may not be able to compete successfully against current or future competitors, and competitive pressures may have a material, adverse impact on our business, financial condition, or consolidated results of operations.
 
If we are unable to protect the proprietary nature of our software systems and methodologies, our business and financial condition could be harmed.
 
We have developed a proprietary software system, which we refer to as our Service Value Point system that allows us to collect assessment data, establish treatment plans, monitor patient treatment, and evaluate our clinical and financial performance. In addition, we rely on other proprietary methodologies or information to which others may obtain access or independently develop. To protect our proprietary information, we require certain employees, consultants, financial advisors and strategic partners to enter into confidentiality and non-disclosure agreements. These agreements may not ultimately provide meaningful protection for our proprietary information in the event of any unauthorized use, misappropriation or disclosure. If our competitors were able to replicate our Service Value Point system, it could allow them to improve their operations and thereby compete more effectively in the markets in which we provide our services. If we are unable to protect the proprietary nature of our Service Value Point system or our other proprietary information or methodologies, our business and financial performance could be harmed.
 
Failure of, or problems with, our critical software or information systems could harm our business and operating results.
 
In addition to our Service Value Point system, our business is substantially dependent on other non-proprietary software. We utilize a third-party software information system for our long-term acute care hospitals. Our various home nursing agency databases were fully consolidated into an enterprise-wide system during the first half of 2005. Problems with, or the failure of, these systems could negatively impact our clinical performance and our management and reporting capabilities. Any such problems or failure could materially and adversely affect our operations and reputation, result in significant costs to us, cause delays in our ability to bill Medicare or other payors for our services, or impair our ability to provide our services in the future. The costs incurred in correcting any errors or problems with regard to our proprietary and non-proprietary software may be substantial and could adversely affect our net income.
 
Our information systems are networked via public network infrastructure and standards based encryption tools that meet regulatory requirements for transmission of protected healthcare information over such


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networks. However, threats from computer viruses, instability of the public network on which our data transit relies, or other instances that might render those networks unstable or disabled would create operational difficulties for us, including the ability to effectively transmit claims and maintain efficient clinical oversight of our patients as well as the disruption of revenue reporting and billing and collections management, which could adversely affect our business or operations.
 
Future acquisitions may be unsuccessful and could expose us to unforeseen liabilities.
 
Our growth strategy involves the acquisition of home nursing agencies in rural markets. These acquisitions involve significant risks and uncertainties, including difficulties integrating acquired personnel and other corporate cultures into our business, the potential loss of key employees or patients of acquired agencies, and the assumption of liabilities and exposure to unforeseen liabilities of acquired agencies. We may not be able to fully integrate the operations of the acquired businesses with our current business structure in an efficient and cost-effective manner. The failure to effectively integrate any of these businesses could have a material adverse effect on our operations.
 
We generally structure our acquisitions as asset purchase transactions in which we expressly state that we are not assuming any pre-existing liabilities of the seller and obtain indemnification rights from the previous owners for acts or omissions arising prior to the date of such acquisitions. However, the allocation of liability arising from such acts or omissions between the parties could involve the expenditure of a significant amount of time, manpower and capital. Further, the former owners of the agencies and facilities we acquire may not have the financial resources necessary to satisfy our indemnification claims relating to pre-existing liabilities. If we were unsuccessful in a claim for indemnification from a seller, the liability imposed could materially, adversely affect our operations.
 
Our acquisition and internal development activity may impose strains on our existing resources.
 
We have grown significantly over the past four years. As we continue to expand our markets, our growth could strain our resources, including management, information and accounting systems, regulatory compliance, logistics, and other internal controls. Our resources may not keep pace with our anticipated growth. If we do not manage our expected growth effectively, our future prospects could be affected adversely.
 
We may face increased competition for attractive acquisition and joint venture candidates.
 
We intend to continue growing through the acquisition of additional home nursing agencies and the formation of joint ventures with rural hospitals for the operation of home nursing agencies. We face competition for acquisition and joint venture candidates, which may limit the number of acquisition and joint venture opportunities available to us or lead to the payment of higher prices for our acquisitions and joint ventures. Recently, we have observed an increase in the acquisition prices for select home nursing agencies. We cannot assure you that we will be able to identify suitable acquisition or joint venture opportunities in the future or that any such opportunities, if identified, will be consummated on favorable terms, if at all. Without successful acquisitions or joint ventures, our future growth rate could decline. In addition, we cannot assure you that any future acquisitions or joint ventures, if consummated, will result in further growth.
 
We may be unable to secure the additional capital necessary to implement our growth strategy.
 
As of December 31, 2006, we had cash of $26.9 million. Based on our current plan of operations, including acquisitions, we believe this amount, when combined with a revolving line of credit of approximately $22.5 million available under our senior secured credit facility, which, subject to certain conditions, may be increased to $25.0 million, will be sufficient to fund our growth strategy and to meet our currently anticipated operating expenses, capital expenditures and debt service obligations for at least the next 12 months. If our future net service revenue or cash flow from operations is less than we currently anticipate, we may not have sufficient funds to implement our growth strategy. Further, we cannot readily predict the timing, size, and success of our acquisition and internal development efforts and the associated capital commitments. If we do


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not have sufficient cash resources, our growth could be limited unless we are able to obtain additional equity or debt financing.
 
We are a holding company with no operations of our own.
 
We are a holding company with no operations of our own. Accordingly, our ability to service our debt and pay dividends, if any, is dependent upon the earnings from the business conducted by our subsidiaries. The distributions of those earnings or advances or other distributions of funds by these subsidiaries to us are contingent upon the subsidiaries’ earnings and are subject to various business considerations. In addition, distributions by subsidiaries could be subject to statutory restrictions, including state laws requiring that the subsidiary be solvent, or contractual restrictions. If our subsidiaries are unable to make sufficient distributions or advances to us, we may not have the cash resources necessary to service our debt or pay dividends.
 
Our executive officers and directors and their affiliates hold a substantial portion of our stock and could exercise significant influence over matters requiring stockholder approval, regardless of the wishes of other stockholders.
 
Our executive officers and directors, and individuals or entities affiliated with them, beneficially own an aggregate of approximately 22.7% of our outstanding common stock as of December 31, 2006. The interests of these stockholders may differ from your interests. If they were to act together, these stockholders would be able to significantly influence all matters that our stockholders vote upon, including the election of directors, business combinations, the amendment of our certificate of incorporation and other significant corporate actions.
 
Certain provisions of our charter, bylaws and Delaware law may delay or prevent a change in control of our company.
 
Delaware law and our corporate documents contain provisions that may enable our board of directors to resist a change in control of our company. These provisions include:
 
  •  a staggered board of directors;
 
  •  limitations on persons authorized to call a special meeting of stockholders;
 
  •  the authorization of undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; and
 
  •  advance notice procedures required for stockholders to nominate candidates for election as directors or to bring matters before an annual meeting of stockholders.
 
These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing or cause us to take other corporate actions you desire.
 
Our stock price may be volatile and your investment in our common stock could suffer a decline in value.
 
The price at which our common stock will trade may be volatile. The stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices of securities, particularly securities of healthcare companies. The market price of our common stock may be influenced by many factors, including:
 
  •  our operating and financial performance;
 
  •  variances in our quarterly financial results compared to research analyst expectations;
 
  •  the depth and liquidity of the market for our common stock;
 
  •  future sales of our common stock or the perception that sales could occur;


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  •  investor perception of our business, acquisitions and our prospects;
 
  •  developments relating to litigation or governmental investigations;
 
  •  changes or proposed changes in healthcare laws or regulations or enforcement of these laws and regulations, or announcements relating to these matters; or
 
  •  general economic and stock market conditions.
 
In addition, the stock market, and the Nasdaq Global Market, or Nasdaq, in particular, has experienced price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of healthcare provider companies. These broad market and industry factors may materially reduce the market price of our common stock, regardless of our operating performance. In the past, securities class-action litigation has often been brought against companies following periods of volatility in the market price of their respective securities. We may become involved in this type of litigation in the future. Litigation of this type is often expensive to defend and may divert the attention of our senior management as well as resources from the operation of our business.
 
We currently do not intend to pay dividends on our common stock and, consequently, your only opportunity to achieve a return on your investment is if the price of our common stock appreciates.
 
We do not plan to declare dividends on shares of our common stock in the foreseeable future. Further, our senior secured credit facility imposes limits on our ability to pay dividends. Consequently, your only opportunity to achieve a return on your investment in our common stock will be if the market price of our common stock appreciates and you sell your shares at a profit. There is no guarantee that the price of our common stock will ever exceed the price that you pay.
 
We incur costs as a result of being a public company.
 
As a public company, we incur significant legal, accounting and other expenses associated with our public company reporting requirements and corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and the rules of the SEC and Nasdaq. We expect these requirements to continue increasing our legal and financial compliance costs and to make some activities more time-consuming and costly. For example, we expect to continue incurring significant costs in connection with the assessment of our internal controls. We also expect these rules and regulations may make it more expensive for us to obtain director and officer liability insurance. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.
 
If we identify deficiencies in our internal control over financial reporting, our business and our stock price could be adversely affected.
 
Beginning with our annual report for the year ending December 31, 2006, we are required to report on the effectiveness of our internal control over financial reporting as required by Section 404 of Sarbanes-Oxley. Under Section 404, we are required to assess the effectiveness of our internal control over financial reporting and report our conclusion in our annual report. Our auditor is also required to report its conclusion regarding the effectiveness of our internal control over financial reporting. The existence of one or more material weaknesses would require us and our auditor to conclude that our internal control over financial reporting is not effective. If there are identified deficiencies in our internal control over financial reporting, we could be subject to regulatory scrutiny and a loss of public confidence in our financial reporting, which could have an adverse effect on our business and our stock price.
 
Item 1B.   Unresolved Staff Comments
 
Not applicable.


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Item 2.   Properties
 
As of December 31, 2006 we owned or managed 56 locations in Louisiana, 23 in Mississippi, nine in Alabama, seven in Texas, four in West Virginia, eight in Arkansas, 17 in Kentucky, six in Florida, one in Tennessee, and one in Georgia. Our home office is located in Lafayette, Louisiana in 19,159 square feet of leased office space, under a lease that commenced on March 1, 2004 and expires February 28, 2014. Typically, our home nursing agencies are located in leased facilities. Generally, the leases for our home nursing agencies have initial terms of one year, but range from one to five years. Most of the leases either contain multiple options to extend the lease period in one-year increments or convert to a month-to-month lease upon the expiration of the initial term. Six of our long-term acute care hospitals locations are hospitals within a hospital, meaning we have a lease or sublease for space with the host hospital. Generally, our leases or subleases for long-term acute care hospitals have initial terms of five years, but range from three to ten years. Most of our leases and subleases for our long-term acute care hospitals contain multiple options to extend the term in one-year increments.
 
Item 3.   Legal Proceedings
 
We are involved in litigation and proceedings in the ordinary course of our business. We do not believe that the outcome of any of the matters in which we are currently involved, individually or in the aggregate, will have a material adverse effect upon our business, financial condition, or results of operations.
 
Item 4.   Submission of Matters to a Vote of Security Holders
 
No matters were submitted to a vote of the Company’s stockholders during the fourth quarter of 2006.
 
PART II
 
Item 5.   Market for Registrant’s Common Equity and Related Stockholder Matters
 
Holders
 
The Company’s common stock trades on the Nasdaq Global Market under the symbol “LHCG.” As of March 12, 2007, there were approximately 93 registered holders of record of the Company’s common stock and the Company believes there are approximately 8,650 beneficial holders.
 
Dividend Policy
 
The Company has not paid any dividends on its common stock since the initial public offering in 2005 and does not anticipate paying dividends in the foreseeable future. We currently intend to retain future earnings, if any, to support the development and growth of our business. Payment of future dividends, if any, will be at the discretion of our board of directors and subject to any requirements under our then existing credit facility.
 
Price Range of Common Stock
 
The following table provides the high and low prices of the Company’s Common Stock during 2006 and 2005 as quoted by Nasdaq Global Market.
 
                 
    High     Low  
 
2006
               
Fourth Quarter
  $ 29.67     $ 22.23  
Third Quarter
    24.78       18.70  
Second Quarter
    21.35       15.73  
First Quarter
    18.39       13.70  
 


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    High     Low  
 
2005
               
Fourth Quarter
  $ 17.46     $ 14.79  
Third Quarter
    21.70       15.45  
Second Quarter(1)
           
First Quarter(1)
           
 
 
(1) LHC Group completed its initial public offering on June 14, 2005; therefore, there is no applicable price range for its common stock for the first and second quarters of 2005.
 
The closing price of our common stock as reported by Nasdaq on March 12, 2007 was $29.50.
 
Performance Graph
 
This item is incorporated by reference to our annual report to stockholders for the fiscal year ended December 31, 2006.
 
Offering Proceeds
 
The Company completed its initial public offering on June 14, 2005. The net offering proceeds received by us, after deducting the total expenses of $7,393,000 (including $3,430,000 in underwriting discounts and commissions), were approximately $41,607,000. As of December 31, 2006, $21.9 million of the net offering proceeds have been used to repay the following indebtedness: (1) $21.1 million on the credit facility, bearing interest at prime plus 1.5% and due April 10, 2010, with Residential Funding Corporation; (2) $643,000 of outstanding obligations under our loan agreement, bearing interest at 12.0% and due July 1, 2006, with The Catalyst Fund, Ltd. and Southwest/Catalyst Capital, Ltd.; and (3) approximately $178,000 of outstanding indebtedness assumed by us in connection with acquisitions completed by us in 2004. Additionally, $3.3 million has been used to pay minority interest holders for their interests and $14.0 million has been used to fund acquisitions since the initial public offering.
 
On July 19, 2006, the Company closed its follow-on public offering of 4,000,000 shares of common stock at a price of $19.25 per share. Of the 4,000,000 shares of common stock offered, 1,000,000 shares were offered by the Company, with the remaining 3,000,000 shares of common stock sold by the selling stockholders identified in the prospectus supplement. The underwriters exercised an over-allotment of an additional 600,000 shares, 150,000 of which were sold by the Company. The additional net cash provided to the Company from this offering after deducting expenses and underwriting discounts and commissions amounted to approximately $21 million.
 
On July 31, 2006, the Company used approximately $14.7 million of the proceeds from its follow-on public offering in order to acquire the Kentucky-based assets of Lifeline Home Health Care, a privately-held company based in Somerset, Kentucky.

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Item 6.   Selected Financial Data
 
The selected consolidated financial data presented below is derived from our audited consolidated financial statements for each of the years ended December 31, 2002 through December 31, 2006. The financial data for the years ended December 31, 2006, 2005 and 2004 should be read together with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Consolidated Results of Operations” included herein.
 
                                         
    Year Ended December 31,  
    2006     2005     2004     2003     2002  
    (In thousands except share and per share data)  
 
Consolidated Statements of Income Data:
                                       
Net service revenue
  $ 215,248     $ 152,711     $ 116,090     $ 68,515     $ 47,373  
Cost of service revenue
    109,851       79,607       57,672       34,455       22,220  
                                         
Gross margin
    105,397       73,104       58,418       34,060       25,153  
General and administrative expenses
    71,125       45,663       35,168       23,411       15,778  
Impairment loss
                      31        
Equity-based compensation expense(1)
          3,856       1,788       864       124  
                                         
Operating income
    34,272       23,585       21,462       9,754       9,251  
Interest expense
    325       1,059       1,328       1,223       1,131  
Non-operating (income) loss, including gain on sale of assets
    (2,033 )     (574 )     13       (106 )     (124 )
                                         
Income from continuing operations before income taxes and minority interest and cooperative endeavor allocations
    35,980       23,100       20,121       8,637       8,245  
Income tax expense
    10,417       6,538       6,111       2,400       2,260  
Minority interest and cooperative endeavor allocations
    4,795       4,545       4,158       2,837       2,699  
                                         
Income from continuing operations
    20,768       12,017       9,852       3,400       3,285  
Loss from discontinued operations, net
    (811 )     (1,915 )     (851 )     (557 )     (443 )
Gain on sale of discontinued operations, net
    637             312              
                                         
Net income
    20,594       10,102       9,313       2,843       2,842  
Change in the redemption value of redeemable minority interests
    1,163       (1,476 )                  
                                         
Net income available to common stockholders
  $ 21,757     $ 8,626     $ 9,313     $ 2,843     $ 2,842  
                                         
Earnings per share-basic(2):
                                       
Income from continuing operations
  $ 1.21     $ 0.82     $ 0.82     $ 0.28     $ 0.28  
Loss from discontinued operations
    (0.05 )     (0.13 )     (0.07 )     (0.04 )     (0.04 )
Gain on sale of discontinued operations, net
    0.04             0.02              
                                         
Net income
    1.20       0.69       0.77       0.24       0.24  
Change in the redemption value of redeemable minority interests
    0.07       (0.10 )                  
                                         
Net income available to common stockholders
  $ 1.27     $ 0.59     $ 0.77     $ 0.24     $ 0.24  
                                         
Earnings per share-diluted(2):
                                       
Income from continuing operations
  $ 1.21     $ 0.82     $ 0.81     $ 0.27     $ 0.27  
Loss from discontinued operations
    (0.05 )     (0.13 )     (0.07 )     (0.04 )     (0.04 )
Gain on sale of discontinued operations, net
    0.04             0.02              
                                         
Net income
    1.20       0.69       0.76       0.23       0.23  
Change in the redemption value of redeemable minority interests
    0.07       (0.10 )                  
                                         
Net income available to common stockholders
  $ 1.27     $ 0.59     $ 0.76     $ 0.23     $ 0.23  
                                         
Weighted average shares outstanding(2):
                                       
Basic
    17,090,583       14,628,737       12,085,154       12,085,154       11,926,226  
Diluted
    17,104,650       14,684,639       12,145,150       12,114,675       12,084,538  
Cash dividends declared per common share
          .009       .039       .016       .013  
 


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    As of December 31,  
    2006     2005     2004     2003     2002  
    (In thousands)  
 
Consolidated Balance Sheet Data:
                                       
Cash
  $ 26,877     $ 17,398     $ 2,911     $ 1,725     $ 3,179  
Total assets
    152,694       104,418       47,519       27,915       21,485  
Total debt
    3,837       5,427       18,275       12,277       10,542  
Total stockholders’ equity
    121,889       78,444       16,351       6,909       3,593  
 
 
(1) Equity-based compensation expense is allocated as follows:
 
                                         
    Year Ended December 31,  
    2006     2005     2004     2003     2002  
    (In thousands)  
 
Cost of service revenue
  $     $ 565     $ 58     $ 5     $  
General and administrative expenses
          3,291       1,730       859       124  
                                         
Total equity-based compensation expense
  $     $ 3,856     $ 1,788     $ 864     $ 124  
                                         
 
 
(2) All references to shares and per share amounts have been retroactively restated to reflect our incorporation in the State of Delaware and to give effect to a three-for-two stock split with respect to our common stock as if such events occurred as of the beginning of the earliest period presented. See Note 1 to our consolidated financial statements.
 
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis contains forward-looking statements about our plans and expectations of what may happen in the future. Forward-looking statements are based on a number of assumptions and estimates that are inherently subject to significant risks and uncertainties, and our results could differ materially from the results anticipated by our forward-looking statements as a result of many known or unknown factors, including, but not limited to, those factors discussed on pages 27 to 37 under the heading “Risk Factors.” Also, please read the cautionary notice regarding forward-looking statements set forth at the beginning of this annual report.
 
Please read the following discussion in conjunction with our consolidated financial statements and the related notes contained elsewhere in this annual report on Form 10-K.
 
Overview
 
We provide post-acute healthcare services primarily to Medicare beneficiaries in rural markets in the southern United States. We provide these post-acute healthcare services through our home nursing agencies, hospices, long-term acute care hospitals, outpatient rehabilitation clinic, and a critical access hospital. Since our founders began operations in 1994 with one home nursing agency in Palmetto, Louisiana, we have grown to 132 locations in Louisiana, Mississippi, Alabama, Texas, West Virginia, Arkansas, Kentucky, Florida, Tennessee, and Georgia as of December 31, 2006.
 
Segments
 
We operate in two segments for financial reporting purposes: home-based services and facility-based services. We derived 76.5%, 69.1% and 70.3% of our net service revenue during the year ended December 31, 2006, 2005, and 2004, respectively, from our home-based services segment and derived the balance of our net service revenue from our facility-based services segment.
 
Through our home-based services segment we offer a wide range of services, including skilled nursing, private duty nursing, physical, occupational, and speech therapy, medically-oriented social services, and hospice care. As of December 31, 2006, we owned and operated 106 home nursing locations, six hospices, a

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diabetes self management company, and a home health pharmacy. Of our 114 home-based services locations, 78 are wholly-owned by us and 36 are majority-owned or controlled by us through joint ventures. We also manage the operations of four home nursing agencies and one hospice in which we have no ownership interest. We intend to increase the number of home nursing agencies that we operate through continued acquisition and development, primarily in underserved rural markets, as we implement our growth strategy. As we acquire and develop home nursing agencies, we anticipate the percentage of our net service revenue and operating income derived from our home-based services segment will increase.
 
We provide facility-based services principally through our long-term acute care hospitals and outpatient rehabilitation clinics. As of December 31, 2006, we owned and operated four long-term acute care hospitals with seven locations, of which all but one are located within host hospitals. We also owned and operated an outpatient rehabilitation clinic, a critical access hospital, a pharmacy, a medical equipment company, a health club, and provided contract rehabilitation services to third parties. Of these 12 facility-based services locations, six are wholly-owned by us and six are majority-owned or controlled by us through joint ventures. We also manage the operations of one inpatient rehabilitation facility in which we have no ownership interest. Because of the recent changes in the regulations applicable to long-term acute care hospitals operated as hospitals within hospitals, we do not intend to expand the number of hospital within a hospital long-term acute care hospitals that we operate. Due to our emphasis on expansion through the acquisition and development of home nursing agencies, we anticipate that the percentage of our net service revenue and operating income derived from our facility-based segment will decline.
 
Development Activities
 
From January 1, 2002 through December 31, 2006, we acquired all or a majority of the economic interests in 62 home nursing agencies for a total consideration of approximately $36.9 million: eight in Louisiana, seven in Alabama, 14 in Mississippi, six in Texas, one in Arkansas, 16 in Kentucky, six in Florida, one in Tennessee, one in Georgia, and two in West Virginia. During this same period, we also internally developed 22 home nursing agencies: ten in Louisiana, and 12 in Mississippi. Also from January 1, 2002 through December 31, 2006, we acquired all or a majority of the economic interests in six hospices, three located in Louisiana, two located in Arkansas, and one located in West Virginia, for approximately $362,000.
 
From January 1, 2002 through December 31, 2006, we acquired all or a majority of the economic interests in two long-term acute care hospital locations and three outpatient rehabilitation clinics located in Louisiana for approximately $3.6 million. During this same period, we internally developed four long-term acute care hospital locations, one short-term acute care hospital, two inpatient rehabilitation facilities and two outpatient rehabilitation clinics located in Louisiana. During 2005, we converted the short-term acute care hospital and inpatient rehabilitation facilities to long-term acute care hospitals. Since January 2002, we have expanded the number of licensed beds at our long-term acute care hospital locations facilities from 22 beds to 156 beds as of December 31, 2006.
 
In February 2004, we sold three hospices, two in Louisiana and one in Mississippi and one home nursing agency in Louisiana for $500,000. Also in February 2004, we sold one inpatient rehabilitation facility located in Louisiana for $129,000 and closed one outpatient rehabilitation clinic and one long-term acute care hospital, both located in Louisiana. In October 2004, we closed one home nursing agency and one outpatient rehabilitation clinic. In December 2004, we closed one home nursing agency.
 
In March 2006, we sold one home nursing agency in Louisiana for $240,000. In April 2006, we sold one outpatient rehabilitation clinic for a promissory note totaling $946,000 and closed another. Both were located in Louisiana. In May 2006, we sold one Long-Term Acute Care Hospital located in Louisiana for $1.2 million. Typically, we sold or closed these locations because they were not performing according to our expectations.


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The following table is a summary of our acquisitions, divestitures and internal development activities from January 1, 2002 through December 31, 2006. This table does not include the six management services agreements under which we manage the operations of four home nursing agencies, one hospice and one inpatient rehabilitation facility.
 
                                 
                Long-Term Acute Care
       
                Hospitals, Critical
    Specialty and
 
                Access Hospitals
    Outpatient
 
    Home Nursing
          and Inpatient
    Rehabilitation
 
Year
  Agencies     Hospices     Rehabilitation Facilities     Clinics  
 
Total at January 1, 2002
    26       3       1       1  
Developed
    1             2        
Acquired
    7       1              
                                 
Total at January 1, 2003
    34       4       3       1  
Developed
    7       1       2       2  
Acquired
    2       1       2       1  
                                 
Total at January 1, 2004
    43       6       7       4  
Developed
    7             2       2  
Acquired
    6                   3  
Divested/Closed
    (3 )     (3 )     (2 )     (2 )
                                 
Total at January 1, 2005
    53       3       7       7  
Converted
                      (1 )
Developed
    2             1        
Acquired
    16       1       1       2  
                                 
Total at January 1, 2006
    71       4       9       8  
Developed
    5                    
Acquired
    31       2             1  
Divested/Closed
    (1 )           (1 )     (3 )
                                 
Total at December 31, 2006
    106       6       8       6  
                                 
 
Recent Developments
 
Medicare
 
Home-Based Services.  The base payment rate for Medicare home nursing in 2006 was $2,264 per 60-day episode. Since the inception of the prospective payment system in October 2000, the base episode rate payment has varied due to both the impact of annual market basket based increases and Medicare-related legislation. The passage of the MMA resulted in two changes in Medicare reimbursement. First, for episodes ended on or after April 1, 2004 through December 31, 2006, the base episode rate increase (3.6%) was reduced by 0.8% to 2.8%. Secondly, a 5.0% payment increase was provided for services furnished in a non-Metropolitan Statistical Area, or MSA, setting for episodes ending on or after April 1, 2004 and before April 1, 2005. Approximately 55.4%, 46.3%, and 41.8%, respectively, of our net service revenue for the year ended December 31, 2006, 2005, and 2004 was derived from patients who reside in non-MSAs.
 
Home health payment rates are updated annually by either the full home health market basket percentage, or by the home health market basket percentage as adjusted by Congress. CMS establishes the home health market basket index, which measures inflation in the prices of an appropriate mix of goods and services included in home health services.
 
On November 1, 2006, CMS released the final rule updating the home health perspective payment systems for calendar year 2007. The rule finalizes the market basket increase of 3.3%, a 0.2% increase over the proposed rule. This equates to a 3.1% update for urban HHAs and a 3.6% update for rural HHAs after


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accounting for changes in the wage index. The update increases the national 60-day episode payment rate for urban home health agencies from the current level of $2,264.38 to $2,339.00. Under the final rule, HHAs will get the full home health market basket as long as they submit required quality data using the OASIS. With some limited exceptions, if an HHA does not provide this data, then its home health market basket update of 3.3% will be reduced by two percentage points. The final rule discontinues the temporary 5% add-on payment for rural HHAs in 2007, except for episodes that begin before January 1, 2007. The final rule does not modify the current case-mix methodology for 2007.
 
In August 2006, CMS announced the payment rates for hospice care furnished from October 1, 2006 through September 30, 2007. These rates are 3.4% higher more than the rates for the previous year. In addition, CMS announced that the hospice cap amount for the year ending October 31, 2006 is $20,585.
 
Facility-Based Services.  Under the long-term acute care hospital prospective payment system implemented on October 1, 2002, each patient discharged from our long-term acute care hospitals is assigned a long-term care diagnosis-related group. CMS establishes these long-term care diagnosis-related groups by categorizing diseases by diagnosis, reflecting the amount of resources needed to treat a given disease. For each patient, we are paid a pre-determined fixed amount applicable to the particular long-term care diagnosis-related group to which that patient is assigned. Effective for discharges on or after October 1, 2006, CMS has published the new relative weights applicable to the long-term care diagnosis-related group system. In addition, on May 12, 2006 CMS published a final rule maintaining the standard federal rate at $38,086.04 and the budget neutrality factor at 0, while decreasing the cost outlier fixed loss threshold to $14,877. These updates became effective July 1, 2006 and will apply through June 30, 2007.
 
CMS has also stated its intention to develop long-term acute care hospital patient-specific criteria to refine the definition of such facilities. To this end, CMS awarded a contract to RTI for the purpose of evaluating patient and facility level characteristics for long-term care hospitals in order to differentiate the role of long-term acute care hospitals from general acute care hospitals. RTI recently released its study results, many of which are similar to MedPAC’s findings released in a 2004 report. Like MedPAC, RTI recommended the development and use of facility and patient criteria as a method of ensuring that patients admitted to LTACHs are medically complex and have a good chance of improvement. Also, while MedPAC recommended that QIOs review LTACH admissions for medical necessity and monitor whether facilities comply with the criteria, RTI recommended that CMS clarify QIO roles in overseeing the appropriateness of LTACH admissions. Additionally, RTI examined several key issues that MedPAC had not yet researched. The RTI report is advisory in nature, and it is uncertain which, if any, of its recommendations will be enacted, many of which require Congressional approval.
 
Under Medicare, we are reimbursed for rehabilitation services based on a fee schedule for services provided adjusted by the geographical area in which the facility is located. Outpatient therapy services are subject to an annual cap of $1,780 per beneficiary effective January 1, 2007. The Deficit Reduction Act of 2005 and the Tax Relief and Health Care Act of 2006 provided for an “exceptions” process that effectively prevents application of the caps. The exceptions process ends January 1, 2008. We are unable to predict whether Congress will extend the exceptions process for 2008. We cannot assure you that one or more of our outpatient rehabilitation clinics will not exceed the caps in the future.
 
Office of Inspector General
 
OIG has a responsibility to report both to the Secretary of the Department of Health and Human Services and to Congress any program and management problems related to programs such as Medicare. The OIG’s duties are carried out through a nationwide network of audits, investigations and inspections. Each year, the OIG outlines areas it intends to study relating to a wide range of providers. In fiscal year 2007, the OIG indicated its intent to study topics relating to, among others, home health, hospice, long-term care hospitals, and certain outpatient rehabilitation services. No estimate can be made at this time regarding the impact, if any, of the OIG’s findings.


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Components of Expenses
 
Cost of Service Revenue
 
Our cost of service revenue consists primarily of the following expenses incurred by our clinical and clerical personnel in our agencies and facilities:
 
  •  salaries and related benefits;
 
  •  transportation, primarily mileage reimbursement; and
 
  •  supplies and services, including payments to contract therapists.
 
General and Administrative Expenses
 
Our general and administrative expenses consist primarily of the following expenses incurred by our home office and administrative field personnel:
 
  •  Home office:
 
  •  salaries and related benefits;
 
  •  insurance;
 
  •  costs associated with advertising and other marketing activities; and
 
  •  rent and utilities;
 
  •  Supplies and services:
 
  •  accounting, legal and other professional services; and
 
  •  office supplies;
 
  •  Depreciation; and
 
  •  Provision for bad debts.
 
Equity-Based Compensation Expense
 
Under our KEEP Plan certain of our employees were granted KEEP Units. The KEEP Units, which have no exercise price, vest over a five-year period. The KEEP Units function as stock appreciation rights whereby an individual is entitled to receive, on a per unit basis, the increase in estimated fair value, as determined by us, of our units from the date of grant until the date upon which the employee dies, retires or is terminated for any reason other than cause. Accordingly, the KEEP Units are subject to variable accounting until such time as the obligation to the employee is settled. Upon completion of the initial public offering at a price of $14.00 per share, all obligations relating to our KEEP Units were settled by conversion into shares of our common stock and we incurred a final, non-recurring equity-based compensation charge in the amount of approximately $3.4 million ($1.7 million net of taxes).
 
Our equity-based compensation expense is allocated to our home-based and facility-based services segments in accordance with our home office allocation, which is calculated based on the percentage of our net service revenue contributed by each segment during the applicable period.


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2006 and 2005 Operational Data
 
The following table sets forth, for the period indicated, data regarding admissions and Medicare admissions to our home-based segment and patient days and outpatient visits for our facility-based segment. Certain historical data has been restated in order to present a more comparative analysis of the statistical data.
 
                                         
    Three Months
    Three Months
    Three Months
    Three Months
       
    Ended
    Ended
    Ended
    Ended
    Year Ended
 
    March 31, 2006     June 30, 2006     September 30, 2006     December 31, 2006     December 31, 2006  
 
Home-Based Services Data:
                                       
Average census
    9,138       9,807       13,029       14,073       12,982  
Average Medicare census
    7,251       7,944       9,537       10,429       9,573  
Admissions
    5,570       5,852       7,377       8,173       26,972  
Medicare admissions
    4,018       4,210       5,225       5,685       19,138  
Facility-Based Services Data:
                                       
Patient days
    11,699       11,110       11,674       10,978       45,461  
Outpatient visits
    8,775       5,157       4,287       2,907       21,126  
 
                                         
    Three Months
    Three Months
    Three Months
    Three Months
       
    Ended
    Ended
    Ended
    Ended
    Year Ended
 
    March 31, 2005     June 30, 2005     September 30, 2005     December 31, 2005     December 31, 2005  
 
Home-Based Services Data:
                                       
Average census
    7,078       7,229       7,501       8,376       7,515  
Average Medicare census
    5,738       6,020       6,271       6,785       6,177  
Admissions
    4,215       4,069       4,266       4,404       16,954  
Medicare admissions
    3,284       2,983       3,153       3,225       12,645  
Facility-Based Services Data:
                                       
Patient days
    10,376       10,519       11,437       12,353       44,685  
Outpatient visits
    11,485       11,639       9,768       8,985       41,877  


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Consolidated Results of Operations
 
The following table sets forth, for the periods indicated, certain items included in our consolidated statement of income as a percentage of our net service revenue:
 
                         
    Year Ended December 31,  
    2006     2005     2004  
 
Net service revenue
    100.0 %     100.0 %     100.0 %
Cost of service revenue
    51.0       52.1       49.7  
                         
Gross margin
    49.0       47.9       50.3  
General and administrative expenses
    33.1       29.9       30.3  
Equity-based compensation expense
          2.5       1.5  
                         
Operating income
    15.9       15.5       18.5  
Interest expense
    .2       0.7       1.1  
Non-operating income, including gain on sales of assets
    (0.9 )     (0.4 )      
Income tax expense
    4.8       4.3       5.3  
Minority interest and cooperative endeavor allocations
    2.2       3.0       3.6  
                         
Income from continuing operations
    9.6 %     7.9 %     8.5 %
                         
 
The following table sets forth, for the periods indicated, net service revenue, cost of service revenue, general and administrative expenses, equity-based compensation expense and operating income by segment. The table also includes data regarding total admissions and total Medicare admissions for our home-based services segment and patient days and outpatient visits for our facility-based services segment.
 
                         
    Year Ended December 31,  
    2006     2005     2004  
    (In thousands, except for admissions, patient day and outpatient visit data)  
 
Home-Based Services Data:
                       
Net service revenue
  $ 164,701     $ 105,587     $ 81,624  
Cost of service revenue
    79,070       51,254       39,402  
General and administrative expenses
    55,700       33,650       25,227  
Equity-based compensation expense
          2,699       1,252  
Operating income
    29,931       17,984       15,743  
Average census
    12,982       7,515       5,653  
Average Medicare census
    9,573       6,177       4,460  
Total admissions
    26,972       16,954       15,601  
Total Medicare admissions
    19,138       12,645       11,531  
Facility-Based Services Data:
                       
Net service revenue
  $ 50,547     $ 47,124     $ 34,466  
Cost of service revenue
    30,781       28,353       18,270  
General and administrative expenses
    15,425       12,013       9,941  
Equity-based compensation expense
          1,157       536  
Operating income
    4,341       5,601       5,719  
Patient days
    45,461       44,685       32,023  
Outpatient visits
    21,126       41,877       28,092  


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Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
 
Net Service Revenue
 
Net service revenue for the year ended December 31, 2006 was $215.2 million, an increase of $62.5 million, or 41.0%, from $152.7 million in 2005. For the year ended December 31, 2006 and 2005, 81.6% and 85.6%, respectively, of net service revenue was derived from Medicare. For the year ended December 31, 2006, home-based services accounted for 76.5% of revenue and facility-based services was 23.5% of revenue compared with 69.1% and 30.9%, respectively, for the comparable prior year period.
 
Home-Based Services.  Net service revenue from the home-based services for the year ended December 31, 2006 was $164.7 million, an increase of $59.1 million, or 56.0%, from $105.6 million for the year ended December 31, 2005. Organic growth in this service sector was approximately $35.0 million, or 34.5%, during the period. Total admissions increased 59.1% to 26,972 during the period, versus 16,954 for the same period in 2005. Organic growth in admissions was 22.8%. Average home-based patient census for the year ended December 31, 2006, increased 72.7% to 12,982 patients as compared with 7,515 patients for the year ended December 31, 2005. Organic growth in home-based patient census was 42.9%. Approximately $26.2 million of the increase in net service revenue was attributable to acquisition or internal development activity during 2005. An additional $24.0 million increase in net service revenue was attributable to acquisition or internal development activity during 2006. The remaining increase of approximately $8.9 million reflects our internal growth. The increase in net service revenue from internal growth resulted in part from a 42.9% increase in organic census from 6,645 in the year ended December 31, 2005 to 9,497 in the year ended December 31, 2006. Improvements in case mix and an increase in therapy utilization within our home health episodes also contributed to the increase.
 
                                                                         
    2005
    2006
    %
    2005
    2006
    %
    2005
    2006
    %
 
    Revenue     Revenue     Growth     Admits     Admits     Growth     Census     Census     Growth  
 
Organic
  $ 101,464     $ 136,508       34.5 %     15,279       18,755       22.8 %     6,645       9,497       42.9 %
Acquired
  $ 4,123     $ 28,193       583.8 %     1,675       8,217       390.6 %     870       3,485       300.6 %
Total
  $ 105,587     $ 164,701       56.0 %     16,954       26,972       59.1 %     7,515       12,982       72.7 %
 
Facility-Based Services.  Net service revenue from the facility-based services for the year ended December 31, 2006, increased $3.4 million, or 7.3%, to $50.5 million compared with $47.1 million for the year ended December 31, 2005. Organic growth made up the total growth in this service sector during the period. The increase in net service revenue was due in part to an increase in patient days of 1.7% to 45,461 in the year ended December 31, 2006, from 44,685 in the year ended December 31, 2005. Outpatient visits decreased 50.0% to 21,126 at December 31, 2006, compared with 41,877 for the year ended December 31, 2005, due to the sale of one of our outpatient clinics and the closure of another clinic on April 1, 2006. Approximately $2.1 million of the increase in net service revenue was attributable to acquisition activity during 2005. The remaining increase of approximately $1.3 million reflects our internal growth.
 
                                                                         
                      2005
    2006
                         
    2005
    2006
    %
    Patient
    Patient
    %
    2005
    2006
    %
 
    Revenue     Revenue     Growth     Days     Days     Growth     Discharges     Discharges     Growth  
 
Organic
  $ 46,190     $ 50,547       9.4 %     44,381       45,461       2.4 %     1,596       1,763       10.5 %
Acquired
  $ 934     $       (100.0 )%     304             (100.0 )%     42             (100.0 )%
Total
  $ 47,124     $ 50,547       7.3 %     44,685       45,461       1.7 %     1,638       1,763       7.6 %
 
Cost of Service Revenue
 
Cost of service revenue for the year ended December 31, 2006 was $109.9 million, an increase of $30.2 million, or 38.0%, from $79.6 million for the year ended December 31, 2005. Cost of service revenue represented approximately 51.0% and 52.1% of our net service revenue for the years ended December 31, 2006 and 2005, respectively.
 
Home-Based Services.  Cost of service revenue from the home-based services for the year ended December 31, 2006 was $79.0 million, an increase of $27.8 million, or 54.3%, from $51.3 million for the year ended December 31, 2005. Approximately $23.0 million of this increase resulted from an increase in salaries


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and benefits, of which $12.0 million was incurred as a result of acquisition or development activity during 2005 and $12.5 million was incurred as a result of acquisition or development activity during 2006. Salaries and benefits expense due to internal growth decreased approximately $1.5 million. Supplies and services expense and transportation expense contributed $2.7 million and $2.1 million, respectively, to the increase in cost of service revenue. Cost of service revenue in the home-based segment for the year ended December 31, 2006 represented 48.0% of our net service revenue compared to 48.5% during the year ended December 31, 2005.
 
Facility-Based Services.  Cost of service revenue from the facility-based services for the year ended December 31, 2006 was $30.8 million, an increase of $2.4 million, or 8.6%, from $28.4 million for the year ended December 31, 2005. Approximately $1.9 million of this increase resulted from an increase in salaries and benefits. Of this increase in salaries and benefits, $1.3 million was incurred as a result of acquisition and internal development activity during 2005. The increase in salaries and benefits expense from internal growth within our facility-based services segment amounted to $600,000. Supplies and services expense contributed approximately $489,000 of the increase in cost of service revenue which while transportation expense contributed approximately $82,000. Cost of service revenue in the facility-based segment for the year ended December 31, 2006 represented 60.9% of our net service revenue compared to 60.2% during the year ended December 31, 2005.
 
General and Administrative Expenses
 
General and administrative expenses for the year ended December 31, 2006 were $71.1 million, an increase of $25.4 million, or 55.8%, from $45.7 million for the year ended December 31, 2005. General and administrative expenses represented approximately 33.1% and 29.9% of our net service revenue for the years ended December 31, 2006 and 2005, respectively.
 
Home-Based Services.  General and administrative expenses from the home-based services for the year ended December 31, 2006 were $55.7 million, an increase of $22.0 million, or 65.5%, from $33.7 million for the year ended December 31, 2005. Approximately $10.3 million of this increase was attributable to acquisition or internal development activity during 2005. Internal growth accounted for approximately $4.4 million and the remaining $7.3 million of the increase in general and administrative expense was due to acquisition and internal development activity during the 2006 period. Included in these increases is an increase to bad debt expense of $800,000 related to receivables acquired in business combinations in late 2005 and 2006. General and administrative expenses in the home-based segment for the year ended December 31, 2006 represented 33.8% of our net service revenue compared to 31.9% during the year ended December 31, 2005.
 
Facility-Based Services.  General and administrative expenses from the facility-based services for the year ended December 31, 2006 were $15.4 million, an increase of $3.4 million, or 28.3%, from $12.0 million for the year ended December 31, 2005. Approximately $1.7 million of the increase was attributable to the increased acquisition and internal development activity during the 2005 period and the remaining $1.7 million increase is due to internal growth. General and administrative expenses in the facility-based segment for the year ended December 31, 2006 represented 30.5% of our net service revenue compared to 25.5% during the year ended December 31, 2005.
 
Equity-Based Compensation Expense
 
There was no Equity-based compensation expense for the year ended December 31, 2006. Equity-based compensation expense for the year ended December 31, 2005 was $3.9 million. This was related to the mark-to-market valuation adjustment for the KEEP Units in conjunction with the initial public offering. Of the $3.9 million expense we incurred in the year ended December 31, 2005, approximately $565,000 was attributable to cost of service revenue and $3.3 million attributable to general and administrative expenses.
 
Non-operating income
 
Non-operating income for the year ended December 31, 2006 was $2.0 million, an increase of $1.4 million from $600,000 for the year ended December 31, 2005. The increase in non-operating income is due primarily


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to $1.0 in proceeds received from the life insurance policy on our former CFO who unexpectedly died in a plane crash after retiring from the Company.
 
Income Tax Expense
 
The effective tax rates for the years ended December 31, 2006 and 2005 were 33.4% and 34.7%, respectively. The effective tax rate for the year ended December 31, 2006 decreased due to $1.0 million credit related to the Gulf Opportunity Act. The effective tax rate for the year ended December 31, 2005 was effected by an income tax benefit of $342,000 related to a $900,000 equity-based compensation charge stemming from shares issued by one of the Company’s principal shareholders to an officer of the Company in 2001. At the time, the Company did not believe it would be able to deduct the equity-based compensation charge for income tax purposes. In conjunction with the initial public offering, the Company determined that it would be able to deduct the $900,000 equity-based compensation charge and as a result, has recognized an income tax benefit associated with that charge of $342,000.
 
Minority Interest and Cooperative Endeavor Allocations
 
The minority interest and cooperative endeavor allocations expense for the year ended December 31, 2006 was $4.8 million, an increase of $300,000, compared to $4.5 million for the year ended December 31, 2005. Minority interest and cooperative endeavor expense varies depending on the operations of each joint venture.
 
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
 
Net Service Revenue
 
Net service revenue for the year ended December 31, 2005 was $152.7 million, an increase of $36.6 million, or 31.5%, from $116.1 million in 2004. For the year ended December 31, 2005 and 2004, 85.6% and 86.3%, respectively, of net service revenue was derived from Medicare. For the year ended December 31, 2005, home-based services accounted for 69.1% of revenue and facility-based services was 30.9% of revenue compared with 70.3% and 29.7%, respectively, for the comparable prior year period.
 
Home-Based Services.  Net service revenue from the home-based services for the year ended December 31, 2005 was $105.6 million, an increase of $24.0 million, or 29.4%, from $81.6 million for the year ended December 31, 2004. Organic growth in this service sector was approximately $22.0 million, or 27.7%, during the period. Total admissions increased 8.7% to 16,954 during the period, versus 15,601 for the same period in 2004. Organic growth in admissions was 1.2%. Average home-based patient census for the year ended December 31, 2005, increased 32.9% to 7,515 patients as compared with 5,653 patients for the year ended December 31, 2004. Organic growth in home-based patient census was 23.3%. Approximately $5.8 million of the increase in net service revenue was attributable to acquisition or internal development activity during 2004. An additional $7.1 million increase in net service revenue was attributable to acquisition or internal development activity during 2005. The remaining increase of approximately $11.1 million reflects our internal growth. The increase in net service revenue from internal growth resulted in part from a 23.3% increase in organic census from 5,389 in the year ended December 31, 2004 to 6,645 in the year ended December 31, 2005.
 
                                                                         
    2004
    2005
    %
    2004
    2005
    %
    2004
    2005
    %
 
    Revenue     Revenue     Growth     Admits     Admits     Growth     Census     Census     Growth  
 
Organic
  $ 79,486     $ 101,464       27.7 %     15,098       15,279       1.2 %     5,389       6,645       23.3 %
Acquired
  $ 2,138     $ 4,123       92.8 %     503       1,675       233.0 %     264       870       229.5 %
Total
  $ 81,624     $ 105,587       29.4 %     15,601       16,954       8.7 %     5,653       7,515       32.9 %
 
Facility-Based Services.  Net service revenue from facility-based services for the year ended December 31, 2005, increased $12.7 million, or 36.7%, to $47.1 million compared with $34.5 million for the year ended December 31, 2004. Organic growth in this service sector was approximately $12.9 million, or 38.7%, during the period. The increase in net service revenue resulted in part from a 24.8% increase in the aggregate number of licensed beds at our long-term acute care hospitals and inpatient rehabilitation facilities from 137


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beds at December 31, 2004 to 171 beds at December 31, 2005. Additionally, patient days increased 39.5% from 32,023 in the year ended December 31, 2004 to 44,685 in the year ended December 31, 2005. Outpatient visits increased 49.1% to 41,877 at December 31, 2005, compared with 28,092 for the year ended December 31, 2004, due to the acquisition of two outpatient clinics in 2004. Approximately $8.9 million of the increase in net service revenue was attributable to acquisition activity during 2004 while $0.9 million was attributable to acquisition activity during 2005. The remaining increase of approximately $2.8 million reflects our internal growth.
 
                                                                         
                      2004
    2005
                         
    2004
    2005
    %
    Patient
    Patient
    %
    2004
    2005
    %
 
    Revenue     Revenue     Growth     Days     Days     Growth     Discharges     Discharges     Growth  
 
Organic
  $ 33,310     $ 46,190       38.7 %     32,023       44,381       38.6 %     783       1,596       103.8 %
Acquired
  $ 1,156     $ 934       (19.2 )%           304       %           42       %
Total
  $ 34,466     $ 47,124       36.7 %     32,023       44,685       39.5 %     783       1,638       109.2 %
 
Cost of Service Revenue
 
Cost of service revenue for the year ended December 31, 2005 was $79.6 million, an increase of $21.9 million, or 38.0%, from $57.7 million for the year ended December 31, 2004. Cost of service revenue represented approximately 52.1% and 49.7% of our net service revenue for the years ended December 31, 2005 and 2004, respectively.
 
Home-Based Services.  Cost of service revenue from the home-based services for the year ended December 31, 2005 was $51.3 million, an increase of $11.9 million, or 30.1%, from $39.4 million for the year ended December 31, 2004. Approximately $9.4 million of this increase resulted from an increase in salaries and benefits, of which $2.4 million was incurred as a result of acquisition or development activity during 2004. The increase in salaries and benefits expense due to internal growth accounted for approximately $2.5 million of the increase in this category. The remaining increase in salaries and benefits expense was attributable to 2005 acquisitions of $4.5 million. Supplies and services expense and transportation expense contributed $1.1 million and $1.4 million, respectively, to the increase in cost of service revenue. Cost of service revenue for the year ended December 31, 2005 represented 48.5% of our net service revenue compared to 48.3% during the year ended December 31, 2004.
 
Facility-Based Services.  Cost of service revenue from the facility-based services for the year ended December 31, 2005 was $28.4 million, an increase of $10.1 million, or 55.2%, from $18.3 million for the year ended December 31, 2004. Approximately $7.0 million of this increase resulted from an increase in salaries and benefits. Of this increase in salaries and benefits, $3.3 million was incurred as a result of acquisition and internal development activity during 2004 and $300,000 from acquisition and internal development activity in 2005. The increase in salaries and benefits expense from internal growth within our facility-based services segment amounted to $3.4 million. Supplies and services expense contributed approximately $3.4 million of the increase in cost of service revenue which was offset by a $300,000 decrease in transportation expense. Cost of service revenue for the year ended December 31, 2005 represented 60.2% of our net service revenue compared to 53.0% during the year ended December 31, 2004.
 
General and Administrative Expenses
 
General and administrative expenses for the year ended December 31, 2005 were $45.7 million, an increase of $10.5 million, or 29.8%, from $35.2 million for the year ended December 31, 2004. General and administrative expenses represented approximately 29.9% and 30.3% of our net service revenue for the years ended December 31, 2005 and 2004, respectively.
 
Home-Based Services.  General and administrative expenses from the home-based services for the year ended December 31, 2005 were $33.7 million, an increase of $8.4 million, or 33.4%, from $25.2 million for the year ended December 31, 2004. Approximately $2.1 million of this increase was attributable to acquisition or internal development activity during 2004. Internal growth accounted for approximately $3.7 million and the remaining $2.6 million of the increase in general and administrative expense was due to acquisition and


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internal development activity during the 2005 period. Included in these increases is an increase to bad debt expense of $1.2 million to provide for receivables that aged during our billing system conversion. General and administrative expenses in the home-based segment for the year ended December 31, 2005 represented 31.9% of our net service revenue compared to 30.9% during the year ended December 31, 2004.
 
Facility-Based Services.  General and administrative expenses from the facility-based services for the year ended December 31, 2005 were $12.0 million, an increase of $2.1 million, or 20.8%, from $9.9 million for the year ended December 31, 2004. The majority, or $2.9 million, of the increase was attributable to the increased acquisition and internal development activity during the 2004 period. Acquisition and internal development activity during the 2005 period accounted for $400,000 of the increase. These increases were offset by a decrease in internal growth of $1.2 million due to cost-cutting measures. General and administrative expenses in the facility-based segment for the year ended December 31, 2005 represented 25.5% of our net service revenue compared to 28.8% during the year ended December 31, 2004.
 
Equity-Based Compensation Expense
 
Equity-based compensation expense for the year ended December 31, 2005 was $3.9 million, an increase of approximately $2.1 million from $1.8 million for the year ended December 31, 2004. This increase was related to the mark-to-market valuation adjustment for the KEEP Units in conjunction with the initial public offering. Of the $3.9 million expense we incurred in the year ended December 31, 2005, approximately $565,000 was attributable to cost of service revenue and $3.3 million attributable to general and administrative expenses.
 
Income Tax Expense
 
The effective tax rates for the years ended December 31, 2005 and 2004 were 34.7% and 38.3%, respectively. The effective tax rate for the year ended December 31, 2005 decreased due to the Company recording an income tax benefit of $342,000 related to a $900,000 equity-based compensation charge stemming from shares issued by one of the Company’s principal shareholders to an officer of the Company in 2001. At the time, the Company did not believe it would be able to deduct the equity-based compensation charge for income tax purposes. In conjunction with the initial public offering, the Company determined that it would be able to deduct the $900,000 equity-based compensation charge and as a result, has recognized an income tax benefit associated with that charge of $342,000.
 
Minority Interest and Cooperative Endeavor Allocations
 
The minority interest and cooperative endeavor allocations expense for the year ended December 31, 2005 was $4.5 million, an increase of $500,000, compared to $4.0 million for the year ended December 31, 2004. Minority interest and cooperative endeavor expense varies depending on the operations of each joint venture.
 
Liquidity and Capital Resources
 
Our principal source of liquidity for our operating activities is the collection of our accounts receivable, most of which are collected from governmental and third party commercial payors. Our reported cash flows from operating activities are impacted by various external and internal factors, including the following:
 
  •  Operating Results — Our net income has a significant impact on our operating cash flows. Any significant increase or decrease in our net income could have a material impact on our operating cash flows.
 
  •  Start Up Costs — Following the completion of an acquisition, we generally incur substantial start up costs in order to implement our business strategy. There is generally a delay between our expenditure of these start up costs and the increase in net service revenue, and subsequent cash collections, which adversely affects our cash flows from operating activities.


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  •  Timing of Payroll — Our employees are paid bi-weekly on Fridays; therefore, operating cash flows decline in reporting periods that end on a Friday. Conversely, for those reporting periods ending on a day other than Friday, our cash flows are higher because we have not yet paid our payroll.
 
  •  Medical Insurance Plan Funding — We are self funded for medical insurance purposes. Any significant changes in the amount of insurance claims submitted could have a direct impact on our operating cash flows.
 
  •  Medical Supplies — A significant expense associated with our business is the cost of medical supplies. Any increase in the cost of medical supplies, or in the use of medical supplies by our patients, could have a material impact on our operating cash flows.
 
Cash used in investing activities is primarily for acquisitions of home nursing agencies, while cash provided by financing activities is derived from the proceeds from our issuance of common stock.
 
Operating activities during the year ended December 31, 2006 provided $21.8 million in cash compared to $6.8 million for year ended December 31, 2005. Net income provided cash of $20.6 million. Non-cash items such as depreciation and amortization, provision for bad debts, equity-based compensation, directors’ restricted stock expense, minority interest in earnings of subsidiaries, deferred income taxes and gain on sale of assets totaled $10.1 million. Changes in operating assets and liabilities, excluding cash, offset these non-cash charges.
 
Days sales outstanding, or DSO, for the year ended December 31, 2006, was 68 days compared with 65 days for the same period in 2005. DSO, when adjusted for acquisitions and unbilled accounts receivables, was 59 days. The adjustment takes into account $6.1 million of unbilled receivables that the Company is delayed in billing at this time due to the lag time in receiving the change of ownership after acquiring companies. For the comparable period in 2005, adjusted DSO was 60 days, taking into account $2.3 million in unbilled accounts receivable.
 
Investing activities used $27.5 million and $12.5 million in cash for the year ended December 31, 2006 and 2005, respectively. In the year ended December 31, 2006, cash provided by investing activities was $1.4 million from the sale of an extended care operation and a home nursing agency, offset in part by cash used of $3.9 million for the purchases of property and equipment and $25.0 million in the cost of acquisitions.
 
Financing activities provided for $15.2 million and $20.3 in the year ended December 31, 2006 and 2005, respectively. Cash provided by financing activities in the year ended December 31, 2006 included $21.0 million in proceeds from the follow-on public offering. This increase was offset by cash used in financing activities in the year ended December 31, 2006 which included net principal payments on debt and capital leases of $1.6 million, offering costs incurred of $300,000 and minority interest distributions of $4.2 million.
 
At December 31, 2006, we had working capital of $68.4 million compared to $49.2 million at December 31, 2005, an increase of $19.2 million. This increase in working capital was due primarily to proceeds from the follow-on public offering and increases in accounts receivable due to increased revenue.
 
Offering Proceeds
 
The Company completed its initial public offering on June 14, 2005. The net offering proceeds received by us, after deducting the total expenses of $7,393,000 (including $3,430,000 in underwriting discounts and commissions), were approximately $41,607,000. As of December 31, 2006, $21.9 million of the net offering proceeds have been used to repay the following indebtedness: (1) $21.1 million on the credit facility, bearing interest at prime plus 1.5% and due April 10, 2010, with Residential Funding Corporation; (2) $643,000 of outstanding obligations under our loan agreement, bearing interest at 12.0% and due July 1, 2006, with The Catalyst Fund, Ltd. and Southwest/Catalyst Capital, Ltd.; and (3) approximately $178,000 of outstanding indebtedness assumed by us in connection with acquisitions completed by us in 2004. Additionally, $3.3 million has been used to pay minority interest holders for their interests and $14.0 million has been used to fund acquisitions since the initial public offering.


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On July 19, 2006, the Company closed its follow-on public offering of 4,000,000 shares of common stock at a price of $19.25 per share. Of the 4,000,000 shares of common stock offered, 1,000,000 shares were offered by the Company, with the remaining 3,000,000 shares of common stock sold by the selling stockholders identified in the prospectus supplement. The underwriters exercised an over-allotment of an additional 600,000 shares, 150,000 of which were sold by the Company. The additional net cash provided to the Company from this offering after deducting expenses and underwriting discounts and commissions amounted to approximately $21 million.
 
On July 31, 2006, the Company used approximately $14.7 million of the proceeds from its follow on public offering in order to acquire the Kentucky-based assets of Lifeline Home Health Care, a privately-held company based in Somerset, Kentucky.
 
Indebtedness
 
Our total long-term indebtedness was $3.8 million at December 31, 2006 and $5.4 million at December 31, 2005, respectively, including the current portions of $700,000 and $1.8 million. In April 2005, we entered into an amended and restated senior secured credit facility with Residential Funding Corporation due April 15, 2010. We, together with certain of our subsidiaries, may become borrowers under the credit facility. Our obligations and the obligations of our subsidiary borrowers under our credit facility agreement are secured by a lien on substantially all of our assets (including the capital stock or other forms of ownership interests we hold in our subsidiaries and affiliates) and the assets of those subsidiaries and affiliates.
 
Our credit facility makes available to us up to $22.5 million in revolving loans. The total availability may be increased up to a maximum of $25.0 million, subject to certain terms and conditions. Total availability under our credit facility may be limited from time to time based on the value of our receivables. As of December 31, 2006, we had no outstanding balance under our credit facility.
 
Interest on outstanding borrowings under our credit facility accrues at a variable base rate (based on Wells Fargo Bank’s prime rate or the federal funds rate), plus a margin of 1.5%.
 
Our credit facility contains customary affirmative, negative and financial covenants. For example, we are restricted in incurring additional debt, disposing of assets, making investments, allowing fundamental changes to our business or organization, and making certain payments in respect of stock or other ownership interests, such as dividends and stock repurchases. Financial covenants include requirements that we maintain: a debt to EBITDA ratio of no greater than 1.5 to 1.0 and a fixed charge coverage ratio of not less than 1.4 to 1.0.
 
Our credit facility also contains customary events of default. These include bankruptcy and other insolvency events, cross-defaults to other debt agreements, a change in control involving us or any subsidiary guarantor (other than due to this offering), and the failure to comply with certain covenants.
 
Contingent Convertible Minority Interests
 
During 2004, in conjunction with the acquisition/sale of joint venture interests, the Company entered into agreements with minority interest holders in three of its majority owned subsidiaries that allowed these minority interest holders to put their minority interests to the Company in the event the Company is sold, merged or otherwise acquired or completes an initial public offering (“IPO”). These put options were deemed to be part of the underlying minority interest shares, thus rendering the shares to be puttable shares. In September and November of 2004, the Company entered into forward exchange contracts with the minority interest holders in two of these subsidiaries, Acadian Home Health Care Services, LLC (“Acadian”) and Hebert, Thibodeaux, Albro and Touchet Therapy Group, Inc. (“Hebert”) which required the minority interest holders in these subsidiaries to sell their interests to the Company in the event of an IPO. In conjunction with the Company’s IPO, the forward exchange contracts were consummated and the minority interest holders of Acadian and Hebert sold their minority interests to the Company in exchange for cash and shares of the Company’s common stock. The Company had accrued the cash payment of approximately $2.2 million to be paid under these forward exchange contracts. Since the IPO, this amount has been paid in full.


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In the third majority owned subsidiary, St. Landry Extended Care Hospital, (“St. Landry”), the put option allows the minority interest holders to convert their minority interests into shares of the Company based upon St. Landry’s EBITDA for the prior fiscal year in relation to the Company’s EBITDA over the same period. The put option became exercisable by the minority interest holders in St. Landry upon the completion of the IPO. However, due to applicable laws and regulations, the minority interest holders can not convert their minority interests in St. Landry unless certain conditions are met including, but not limited to, the Company having stockholders’ equity in excess of $75 million at the end of its most recent fiscal year or on average during the previous three fiscal years. If the St. Landry minority interest holders do not or are unable to convert their minority interests into shares of the Company, the minority interest holders shall have the option to redeem their minority interests at any time following thirty days after the IPO for cash consideration equal to the value of the shares the minority interest holders would have received if they had converted their minority interests into shares of the Company multiplied by the average closing price of the Company’s shares for the thirty days preceding the date of the minority interest holders’ exercise of the redemption option. As of December 31, 2006, the Company has exceeded $75 million in stockholders’ equity. As of March 14, 2007, approximately 76.5% of the doctors have converted their minority interests to cash.
 
The above put/redemption options and exchange agreements have been presented in the historical financial statements under the guidance in Accounting Series Release (ASR) No. 268 and EITF Topic D-98, which generally require a public company’s stock subject to redemption requirements that are outside the control of the issuer to be excluded from the caption “stockholders’ equity” and presented separately in the issuer’s balance sheet. Under EITF Topic D-98, once it becomes probable that the minority interest would become redeemable, the minority interest should be adjusted to its current redemption amount. As noted above, the St. Landry put option allowed the minority interest holders in St. Landry’s to have their interests redeemed for cash upon the completion of the IPO, and therefore, the Company recorded an adjustment of approximately $1.5 million to minority interests subject to exchange contracts and/or put options and to retained earnings which represents the redemption value of St. Landry’s interests at June 30, 2005. In September 2005, certain minority interest holders redeemed their interests in St. Landry’s. This resulted in a cash payment of approximately $214,000. In connection with the partial redemption of certain minority interest in September 2005, we decreased our minority interests by approximately $149,000 and increased our retained earnings by the same amount. Simultaneously, we recorded goodwill of $214,000 to represent the value of the minority interests redeemed. Also at the end of the September 30, 2005 quarter, we recorded a mark to market charge of $404,000.
 
In November 2005, the agreement was amended to allow minority interest holders to redeem their minority interests based on the St. Landry’s rolling twelve month EBITDA in relation to the Company’s EBITDA over the same period. At December 31, 2005, the Company recorded an additional mark to market benefit of $266,000 to mark the liability to redemption value at the end of the quarter.
 
In connection with the partial redemption of certain minority interest in the year ended December 31, 2006, we decreased one minority interest by approximately $1.0 million and increased our retained earnings by the same amount. Simultaneously, we recorded goodwill of $979,000 to represent the value of the minority interest redeemed. Also for the year ended December 31, 2006, we recorded a mark-to-market benefit of $124,000.


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Commitments
 
The following table discloses aggregate information about our contractual obligations and the periods in which payments are due as of December 31, 2006:
 
                                         
    Payment due by period  
          Less Than
                More Than
 
Contractual Cash Obligation
  Total     1 Year     1-3 Years     3-5 Years     5 Years  
    (In thousands)  
 
Long-term debt (includes line of credit)
  $ 3,479     $ 428     $ 854     $ 534     $ 1,663  
Capital lease obligations
    358       211       147              
Operating leases
    12,849       5,191       5,263       1,420       975  
                                         
Total contractual cash obligations
  $ 16,686     $ 5,830     $ 6,264     $ 1,954     $ 2,638  
                                         
 
Off-Balance Sheet Arrangements
 
We do not currently have any off-balance sheet arrangements with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships.
 
Critical Accounting Policies
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 revenue and expenses during the reported period. Actual results could differ from those estimates. Changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below.
 
Principles of Consolidation
 
Our consolidated financial statements include all subsidiaries and entities controlled by us. We define “control” as ownership of a majority of the voting interest of an entity. Our consolidated financial statements also include entities in which we absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity.
 
The decision to consolidate or not consolidate an entity would not impact our earnings, as we would include our portion of these entities’ profits and losses either through consolidation or the equity method of accounting if we did not consolidate.
 
All significant intercompany accounts and transactions have been eliminated in consolidation. Business combinations accounted for as purchases have been included in the consolidated financial statements from the respective dates of acquisition.


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The following table summarizes the percentage of net service revenue earned by type of ownership or relationship we had with the operating entity:
 
                         
    2006     2005     2004  
 
Wholly owned subsidiaries
    39.2 %     33.6 %     41.7 %
Equity joint ventures
    45.7       50.1       40.3  
Cooperative endeavors
    1.5       2.0       5.3  
License leasing arrangements
    11.0       11.4       11.1  
Management services
    2.6       2.9       1.6  
                         
      100.0 %     100.0 %     100.0 %
                         
 
The following discussion sets forth our consolidation policy with respect to our equity joint ventures, cooperative endeavors, license leasing arrangements and management services agreements.
 
Equity Joint Ventures
 
Our equity joint ventures are structured as limited liability companies in which we typically own a majority equity interest ranging from 51.0% to 99.0%. Each member of all but one of our equity joint ventures participates in profits and losses in proportion to their equity interests. We have one equity joint venture partner whose participation in losses is limited. We consolidate these entities, as we absorb a majority of the entities’ expected losses, receive a majority of the entities’ expected residual returns and generally have voting control.
 
Cooperative Endeavors
 
We have arrangements with certain partners that involve the sharing of profits and losses. Unlike our equity joint ventures, we own 100.0% of the equity interests in our cooperative endeavors. In these cooperative endeavors, we possess interests in the net profits and losses ranging from 67.0% to 70.0%. We have one cooperative endeavor partner whose participation in losses is limited. We consolidate these entities, as we own 100.0% of the outstanding equity interests, absorb a majority of the entities’ expected losses and receive a majority of the entities’ expected residual returns.
 
License Leasing Arrangements
 
We lease, through our wholly-owned subsidiaries, home health licenses necessary to operate certain of our home nursing agencies. As with our wholly owned subsidiaries, we own 100.0% of the equity interests of these entities and consolidate them based on such ownership, as well as our right to receive a majority of the entities’ expected residual returns and our obligation to absorb a majority of the entities’ expected losses.
 
Management Services
 
We have various management services agreements under which we manage certain operations of agencies and facilities. We do not consolidate these agencies or facilities, as we do not have an equity interest and do not have a right to receive a majority of the agencies’ or facilities’ expected residual returns or an obligation to absorb a majority of the agencies’ or facilities’ expected losses.
 
Revenue Recognition
 
We report net service revenue at the estimated net realizable amount due from Medicare, Medicaid, commercial insurance, managed care payors, patients, and others for services rendered. Under Medicare, our home nursing patients are classified into a home health resource group prior to the receipt of services. Based on this home health resource group we are entitled to receive a prospective Medicare payment for delivering care over a 60 day period. Medicare adjusts these prospective payments based on a variety of factors, such as low utilization, patient transfers, changes in condition and the level of services provided. In calculating our reported net service revenue from our home nursing services, we adjust the prospective Medicare payments by


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an estimate of the adjustments. We calculate the adjustments based on a rolling average of these types of adjustments for claims paid during the preceding three months. Historically we have not made any material revisions to reflect differences between our estimate of the Medicare adjustments and the actual Medicare adjustments. For our home nursing services, we recognize revenue based on the number of days elapsed during the episode of care.
 
Under Medicare, patients in our long-term acute care facilities are classified into long-term care diagnosis-related groups. Based on this classification, we are then entitled to receive a fixed payment from Medicare. This fixed payment is also subject to adjustment by Medicare due to factors such as short stays. In calculating our reported net service revenue for services provided in our long-term acute care hospitals, we reduce the prospective payment amounts by an estimate of the adjustments. We calculate the adjustment based on a historical average of these types of adjustments for claims paid during the preceding three months. For our long-term acute care hospitals we recognize revenue as services are provided.
 
For hospice services we are paid by Medicare under a prospective payment system. We receive one of four predetermined daily or hourly rates based upon the level of care we furnish. We record net service revenue from our hospice services based on the daily or hourly rate. We recognize revenue for hospice as services are provided.
 
Under Medicare we are reimbursed for our rehabilitation services based on a fee schedule for services provided adjusted by the geographical area in which the facility is located. We recognize revenue as these services are provided.
 
Our Medicaid reimbursement is based on a predetermined fee schedule applied to each service we provide. Therefore, we recognize revenue for Medicaid services as services are provided based on this fee schedule. Our managed care payors reimburse us in a manner similar to either Medicare or Medicaid. Accordingly, we recognize revenue from our managed care payors in the same manner as we recognize revenue from Medicare or Medicaid.
 
We record management services revenue as services are provided in accordance with the various management services agreements to which we are a party. The agreements generally call for us to provide billing, management, and other consulting services suited to and designed for the efficient operation of the applicable home nursing agency or inpatient rehabilitation facility. We are responsible for the costs associated with the locations and personnel required for the provision of the services. We are generally compensated based on a percentage of net billings or an established base fee. In addition, for certain of the management agreements, we may earn incentive compensation.
 
Accounts Receivable and Allowances for Uncollectible Accounts
 
We report accounts receivable net of estimated allowances for uncollectible accounts and adjustments. Accounts receivable are uncollateralized and primarily consist of amounts due from third-party payors and patients who receive final bills once all documentation is completed. Using detailed accounts receivable aging reports produced by our billing system, our collections department monitors and pursues payment. We have adopted a charity care policy that provides the criteria a patient must meet in order to be considered indigent and his or her balance considered for write-off. All other accounts that are deemed uncollectible are turned over to an outside collection agency for further collection efforts. To provide for accounts receivable that could become uncollectible in the future, we establish an allowance for uncollectible accounts to reduce the carrying amount of such receivables to their estimated net realizable value. The credit risk for concentrations of receivables is limited due to the significance of Medicare as the primary payor. The amount of the provision for bad debts is based upon our assessment of historical and expected net collections, business and economic conditions, trends in government reimbursement and other collection indicators.
 
A portion of the estimated Medicare prospective payment system reimbursement from each submitted home nursing episode is received in the form of a request for accelerated payment, or RAP, before all services are rendered. The estimated episodic payment is billed at the commencement of the episode. We receive a RAP for 60.0% of the estimated reimbursement at the initial billing for the initial episode of care per patient


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and the remaining reimbursement is received upon completion of the episode. For any subsequent episodes of care contiguous with the first episode of care for a patient we receive a RAP for 50.0% of the estimated reimbursement at initial billing. The remaining 50.0% reimbursement is received upon completion of the episode. We have earned net service revenue in excess of billings rendered to Medicare. Only a nominal portion of the amounts due to the Medicare program represent cash collected in advance of providing services.
 
Our Medicare population is paid at a prospectively set amount that can be determined at the time services are rendered. Our Medicaid reimbursement is based on a predetermined fee schedule applied to each individual service we provide. Our managed care contracts are structured similar to either the Medicare or Medicaid payment methodologies. Because of our payor mix, we are able to calculate our actual amount due at the patient level and adjust the gross charges down to the actual amount at the time of billing. This negates the need for an estimated contractual allowance to be booked at the time we report net service revenue for each reporting period.
 
At December 31, 2006, our allowance for uncollectible accounts, as a percentage of patient accounts receivable, was approximately 10.3%. For the year ended December 31, 2006, the provision for doubtful accounts increased to 2.2% of net service revenue compared to 2.1% of net service revenue for the same period in 2005. Adverse changes in general economic conditions, billing operations, payor mix, or trends in federal or state governmental coverage could affect our collection of accounts receivable, cash flows and results of operations.
 
The following table sets forth our aging of accounts receivable (based on the billing date) as of December 31, 2006:
 
                                                         
Payor
  0-30     31-60     61-90     91-120     121-150     151+     Total  
    (In thousands)  
 
Medicare
  $ 15,944     $ 2,516     $ 1,688     $ 1,581     $ 1,587     $ 6,379     $ 29,695  
Medicaid
    1,740       1,058       666       585       633       2,843       7,525  
Other
    2,947       1,799       1,980       1,366       1,091       9,395       18,578  
                                                         
Total
  $ 20,631     $ 5,373     $ 4,334     $ 3,532     $ 3,311     $ 18,617     $ 55,798  
                                                         
 
Goodwill and Intangible Assets
 
Goodwill and other intangible assets with indefinite lives are reviewed annually, or more frequently if circumstances indicate impairment may have occurred.
 
The Company estimates the fair value of its identified reporting units and compares those estimates against the related carrying value. For each of the reporting units, the estimated fair value is determined based on a multiple of earnings before interest, taxes, depreciation, and amortization or on the estimated fair value of assets in situations when it is readily determinable.
 
Included in intangible assets are other intangible assets such as licenses to operate home-based and/or facility-based services and trade names. The Company has valued these intangible assets separately from goodwill for each acquisition completed during the year ended December 31, 2006. The Company has concluded that these licenses and trade names have indefinite lives, as management has determined that there are no legal, regulatory, contractual, economic or other factors that would limit the useful life of these intangible assets and the Company intends to renew and operate the licenses and uses these trade names indefinitely. Prior to January 1, 2006, the Company elected to recognize the fair value of indefinite-lived licenses and trade names together with goodwill as a single asset for financial reporting purposes.
 
Components of the Company’s home nursing operating segment are generally represented by individual subsidiaries or joint ventures with individual licenses to conduct specific operations within geographic markets as limited by the terms of each license. Components of the Company’s facility-based services are represented by individual operating entities. Effective January 1, 2004, management began aggregating the components of these two segments into two reporting units for purposes of evaluating impairment. Prior to January 1, 2004, management evaluated each operating entity separately for impairment. Modifications to the Company’s management of the segments and reporting provided management with a basis to change the reporting unit structure.


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Recently Issued Accounting Pronouncements
 
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
 
We adopted SFAS No. 123(R) on January 1, 2006 using the modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date.
 
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for the Uncertainty in Income Taxes,” (“FIN 48”). FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of our 2007 fiscal year. The Company is currently evaluating the impact, if any, that FIN 48 will have on the financials statements.
 
In September 2006, the U.S. Securities and Exchange Commission (“SEC”) adopted Staff Accounting Bulletin No. 108 (“SAB No. 108”), which expresses the SEC’s staff views on the process of quantifying financial statement misstatements. SAB 108 requires that registrants consider evaluating errors under both the “rollover” and “iron curtain” approaches to determine if such errors are material, thus requiring a restatement to prior period financial statements. SAB 108 is effective for fiscal years ending on or after November 15, 2006 and allowed the registrant to avoid restating prior period financial statements for such errors that are governed by SAB 108 if the registrant properly disclosed such errors in its financial statement during the period of adoption. The Company adopted this new standard as of December 31, 2006 and it did not have an impact on the Company’s consolidated financial position or results of operations.
 
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. SFAS No. 157 will be effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the requirements of this new standard and has not concluded its analysis on the impact to the Company’s consolidated financial position or results of operations.
 
Item 7A.   Quantitative and Qualitative Disclosures about Market Risk
 
As of December 31, 2006, we had cash of $26.9 million, which consisted of highly liquid money market instruments with maturities less than 90 days. Because of the short maturities of these instruments, a sudden change in market interest rates would not be expected to have a material impact on the fair value of the portfolio. We would not expect our operating results or cash flows to be materially affected by the effect of a sudden change in market interest rates on our portfolio. At times, cash in banks is in excess of the FDIC insurance limit. The Company has not experienced any loss as a result of those deposits and does not expect any in the future.
 
Our exposure to market risk relates to changes in interest rates for borrowings under the new senior secured credit facility we entered into in April 2005. A hypothetical 100 basis point adverse move (increase) in interest rates would not have materially affected the interest expense for the year ended December 31, 2006 since there were no amounts outstanding on the credit agreement during this period.


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Item 8.   Financial Statements and Supplementary Data
 
The consolidated financial statements and financial statement schedules in Part IV, Item 15 of this report are incorporated by reference into this Item 8.
 
Item 9.   Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
 
None.
 
Item 9A.   Controls and Procedures
 
Disclosure Controls and Procedures
 
Our Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective in timely making known to them material information relating to the Company and the Company’s subsidiaries required to be disclosed in the Company’s reports filed or submitted under the Exchange Act.
 
Management’s Report on Internal Control Over Financial Reporting
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f)/15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
 
In connection with the 2005 audit of our financial statements and management’s required assessment of our disclosure controls and procedures, Ernst & Young, LLP, our independent registered public accounting firm, issued a management letter which noted a material weakness in our internal control over financial reporting relating to preventing posting errors within the patient billing system for certain rebilled accounts, specifically, that our personnel lacked sufficient knowledge and experience in our billing and revenue management software and we did not establish appropriate controls to detect or correct errors relating to these rebilled transactions. The correction of these posting errors resulted in a $900,000 increase to revenue for the year ended December 31, 2005. The potential effects of these posting errors on our financial statements issued during the interim periods of 2005 were not material. Subsequent to identifying this material weakness, we initiated the process of improving our internal controls over rebilled transactions through the requirement of additional training on our software for those individuals recording these transactions, the implementation of strict procedural controls and documentation requirements over rebilled transactions, and newly established monitoring, review and approval controls over these transactions. The processes that we have implemented in our internal controls over rebilled transactions have remedied the issue and as of December 31, 2006, no material weaknesses in our internal control over financial reporting were identified in the 2006 audit.
 
Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP. Ernst & Young has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting. The report is included herein.
 
Changes in Internal Control Over Financial Reporting
 
Except as described above, there have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-a5(f) under the Exchange Act, as amended) that occurred during the quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, the our internal control over financial reporting.


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM —
INTERNAL CONTROL OVER FINANCIAL REPORTING
 
TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF
LHC GROUP, INC.
 
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that LHC Group, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). LHC Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may be inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, management’s assessment that LHC Group, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, LHC Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of LHC Group, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March 14, 2007 expressed an unqualified opinion thereon.
 
Ernst & Young LLP
 
New Orleans, Louisiana
March 14, 2007


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Item 9B.   Other Information
 
None.
 
PART III
 
Item 10.   Directors, Executive Officers and Corporate Governance
 
Executive Officers and Directors
 
The information required by this Item is incorporated by reference to the sections entitled “Directors and Executive Officers” in the definitive Proxy Statement relating to the Company’s 2007 Annual Meeting of Stockholders.
 
Compliance with Section 16(a) of the Exchange Act
 
The information required by this Item is incorporated by reference to the sections entitled “Directors and Executive Officers” in the definitive Proxy Statement relating to the Company’s 2007 Annual Meeting of Stockholders.
 
Code of Conduct and Ethics
 
We have adopted a code of ethics that applies to all of our directors, officers and employees. This code is publicly available in the investor relations area of our website at www.lhcgroup.com. This code of ethics is not incorporated in this report by reference. Copies of our code of ethics may also be requested in print by writing to Investor Relations at LHC Group, Inc., 420 West Pinhook Rd., Suite A, Lafayette, Louisiana, 70503.
 
Item 11.   Executive Compensation
 
The information required by this Item is incorporated by reference to the sections entitled “Executive Compensation” in the definitive Proxy Statement relating to the Company’s 2007 Annual Meeting of Stockholders.
 
Item 12.   Security Ownership of Certain Beneficial Owners and Managers
 
Equity Compensation Plan Information
 
                         
    (a)     (b)     (c)  
                Number of Shares
 
    Number of Shares to
          Remaining Available
 
    be Issued Upon
    Weighted-Average
    for Future Issuance
 
    Exercise of
    Exercise Price of
    Under Equity
 
    Outstanding
    Outstanding Price
    Compensation Plans
 
    Options, Warrants,
    of Outstanding
    (Excluding Securities
 
Plan Category
  and Rights     Rights     Reflected in Column(a))  
 
Equity compensation plans approved by Stockholders:
    21,000       17.45       1,108,688 (1)
Equity compensation plans not approved by Stockholders:
                 
                         
Total
    21,000       17.45       1,108,688  
                         
 
 
(1) 865,784 of these shares are reserved under the LHC Group, Inc. 2005 Long-Term Incentive Plan and are available for issuance pursuant to the exercise or grant of stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares or unrestricted stock. 242,904 of these shares are reserved and available for issuance under the 2006 LHC Group, Inc. Employee Stock Purchase Plan.


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Security Ownership of Certain Beneficial Owners and Management
 
The information required by this Item is incorporated by reference to the sections entitled “Security Ownership of Certain Beneficial Owners and Management” in the definitive Proxy Statement relating to the Company’s 2007 Annual Meeting of Stockholders.
 
Item 13.   Certain Relationships and Related Transactions
 
The information required by this Item is incorporated by reference to the sections entitled “Certain Relationships and Related Transactions” in the definitive Proxy Statement relating to the Company’s 2007 Annual Meeting of Stockholders.
 
Item 14.   Principal Accountant Fees and Services
 
The information required by this Item is incorporated by reference to the sections entitled “Principal Accounting Fees and Services” in the definitive Proxy Statement relating to the Company’s 2007 Annual Meeting of Stockholders.


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PART IV
 
Item 15.   Exhibits and Financial Statement Schedules
 
(a) Documents to be filed with Form 10-K:
 
(1) Financial Statements
 
         
Report of Independent Registered Public Accounting Firm
  F-1
Balance Sheets as of December 31, 2006 and 2005
  F-2
For each of the three years in the period ended December 31, 2006, 2005 and 2004
   
Statements of Income
  F-3
Statements of Changes in Stockholders’ Equity
  F-4
Statements of Cash Flows
  F-5
Notes to the Consolidated Financial Statements
  F-6
 
(2) Financial Statement Schedules
 
There are no financial statement schedules included in this report.
 
(3) Exhibits
 
The Exhibits are listed in the Index of Exhibits Required by Item 601 of Regulation S-K included herewith, which is incorporated by reference.


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders of LHC Group, Inc.
 
We have audited the accompanying consolidated balance sheets of LHC Group, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of LHC Group, Inc. and subsidiaries at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
 
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation on January 1, 2006.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of LHC Group, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2007, expressed an unqualified opinion thereon.
 
Ernst & Young LLP
 
New Orleans, Louisiana
March 14, 2007


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Table of Contents

LHC GROUP, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share data)
 
                 
    As of December 31,  
    2006     2005  
 
ASSETS
Current assets:
               
Cash
  $ 26,877     $ 17,398  
Receivables:
               
Patient accounts receivable, less allowance for uncollectible accounts of $5,769, and $2,544 at December 31, 2006 and 2005, respectively
    50,029       34,810  
Other receivables
    3,367       3,365  
Employee receivables
    34       1,888  
Amounts due from governmental entities
    2,518       4,519  
                 
      55,948       44,582  
Deferred income taxes
    1,935       152  
Income taxes recoverable
          869  
Prepaid expenses and other current assets
    4,120       3,714  
Assets held for sale
    1,171        
                 
Total current assets
    90,051       66,715  
Property, building, and equipment, net
    11,705       10,224  
Goodwill
    39,681       26,103  
Intangible assets, net
    8,262        
Other assets
    2,995       1,576  
                 
Total assets
  $ 152,694     $ 104,618  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                 
                 
                 
Current liabilities:
               
Accounts payable and other accrued liabilities
  $ 5,903     $ 6,474  
Salaries, wages, and benefits payable
    10,572       6,124  
Amounts due to governmental entities
    3,223       3,080  
Amounts payable under cooperative endeavor agreements
    51       37  
Income taxes payable
    1,219        
Current portion of capital lease obligations
    211       400  
Current portion of long-term debt
    428       1,406  
                 
Total current liabilities
    21,607       17,521  
Deferred income taxes
    2,104       1,573  
Capital lease obligations, less current portion
    147       347  
Long-term debt, less current portion
    3,051       3,274  
Minority interests subject to exchange contracts and/or put options
    317       1,511  
Other minority interests
    3,579       1,948  
Stockholders’ equity:
               
Common stock — $0.01 par value: 40,000,000 shares authorized; 20,682,317 and 19,507,887 shares issued and 17,732,258 and 16,557,828 shares outstanding at December 31, 2006 and 2005, respectively
    177       166  
Treasury stock — 2,950,059 shares at cost at December 31, 2006 and 2005
    (2,856 )     (2,856 )
Additional paid-in capital
    80,273       58,596  
Retained earnings
    44,295       22,538  
                 
Total stockholders’ equity
    121,889       78,444  
                 
Total liabilities and stockholders’ equity
  $ 152,694     $ 104,618  
                 
 
See accompanying notes.


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Table of Contents

LHC GROUP, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF INCOME
(Amounts in thousands, except share and per share data)
 
                         
    For the Year Ended December 31,  
    2006     2005     2004  
 
Net service revenue
  $ 215,248     $ 152,711     $ 116,090  
Cost of service revenue
    109,851       79,607       57,672  
                         
Gross margin
    105,397       73,104       58,418  
General and administrative expenses
    71,125       45,663       35,168  
Equity-based compensation expense(1)
          3,856       1,788  
                         
Operating income
    34,272       23,585       21,462  
Interest expense
    325       1,059       1,328  
Non-operating (income) loss, including gain or loss on sales of assets
    (2,033 )     (574 )     13  
                         
Income from continuing operations before income taxes and minority interest and cooperative endeavor allocations
    35,980       23,100       20,121  
Income tax expense
    10,417       6,538       6,111  
Minority interest and cooperative endeavor allocations
    4,795       4,545       4,158  
                         
Income from continuing operations
    20,768       12,017       9,852  
Loss from discontinued operations (net of income taxes of $497, $1,174, and $17 in the years ended December 31, 2006, 2005, and 2004, respectively)
    (811 )     (1,915 )     (851 )
Gain on sale of discontinued operations (net of income taxes of $390 and $195 for the year ended December 31, 2006 and 2004, respectively)
    637             312  
                         
Net income
    20,594       10,102       9,313  
Change in the redemption value of redeemable minority interests
    1,163       (1,476 )      
                         
Net income available to common stockholders
  $ 21,757     $ 8,626     $ 9,313  
                         
Earnings per share — basic:
                       
Income from continuing operations
  $ 1.21     $ 0.82     $ 0.82  
Loss from discontinued operations, net
    (0.05 )     (0.13 )     (0.07 )
Gain on sale of discontinued operations, net
    0.04             0.02  
                         
Net income
    1.20       0.69       0.77  
Change in the redemption value of redeemable minority interests
    0.07       (0.10 )      
                         
Net income available to common shareholders
  $ 1.27     $ 0.59     $ 0.77  
                         
Earnings per share — diluted:
                       
Income from continuing operations
  $ 1.21     $ 0.82     $ 0.81  
Loss from discontinued operations, net
    (0.05 )     (0.13 )     (0.07 )
Gain on sale of discontinued operations, net
    0.04             0.02  
                         
Net income
    1.20       0.69       0.76  
Change in the redemption value of redeemable minority interests
    0.07       (0.10 )      
                         
Net income available to common shareholders
  $ 1.27     $ 0.59     $ 0.76  
                         
Weighted average shares outstanding:
                       
Basic
    17,090,583       14,628,737       12,085,154  
Diluted
    17,104,660       14,684,639       12,145,150  
 
 
(1) Equity-based compensation is allocated as follows:
 
                         
    2006     2005     2004  
 
Cost of service revenue
  $     $ 565     $ 58  
General and administrative expenses
          3,291       1,730  
                         
Total equity-based compensation expense
  $     $ 3,856     $ 1,788  
                         
 
See accompanying notes.


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Table of Contents

LHC GROUP, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(Amounts in thousands, except share and per share data)
 
                                                                 
                                  Notes
             
    Common Stock     Additional
    Receivable
             
    Issued     Treasury     Paid-In
    From
    Retained
       
    Amount     Shares     Amount     Shares     Capital     Officer     Earnings     Total  
 
Balances at January 1, 2004
  $ 121       15,000,004     $ (782 )     2,914,850     $ 2,361     $     $ 5,209     $ 6,909  
Net income
                                        9,313       9,313  
Sale of shares to officer in exchange for note
                40       (150,000 )     683       (123 )           600  
Rescission of share sale to officer
                (1,500 )     150,000       1,377       123              
Dividends to stockholders ($0.039 per share)
                                        (471 )     (471 )
                                                                 
Balances at December 31, 2004
    121       15,000,004       (2,242 )     2,914,850       4,421             14,051       16,351  
Net income
                                        10,102       10,102  
Dividends to stockholders ($0.009 per share)
                                        (139 )     (139 )
Sale of 3,500,000 shares of common stock at the initial public offering price of $14 per share, net of underwriting discount and offering costs of $7,393
    35       3,500,000                   41,572                   41,607  
Issuance of common stock to two joint venture partners upon conversion of their equity interests into shares of common stock
    5       518,036                   7,247                   7,252  
Issuance of common stock upon conversion of outstanding KEEP units
    5       481,680                   5,239                   5,244  
Issuance of 8,167 shares of vested restricted stock
          8,167                   117                   117  
Treasury shares redeemed for payment of income taxes
                (614 )     35,209                         (614 )
Recording minority interest in joint venture at redemption value
                                        (1,476 )     (1,476 )
                                                                 
Balances at December 31, 2005
    166       19,507,887       (2,856 )     2,950,059       58,596             22,538       78,444  
Net income
                                        20,594       20,594  
Sale of 1,150,000 shares of common stock at $19.25 per share, net of underwriting discount and offering costs of $1,403
    11       1,150,000                   20,711                   20,722  
Stock option compensation
                            128                   128  
Exercise of stock options
          8,000                   165                   165  
Nonvested stock compensation
                            484                   484  
Issuance of 1,167 shares of vested restricted stock
          1,167                   23                   23  
Issuance of nonvested stock
          8,167                                      
Issuance of common stock under Employee Stock Purchase Plan
          7,096                   166                   166  
Change in redemption value of redeemable minority interest
                                        1,163       1,163  
                                                                 
Balances at December 31, 2006
  $ 177       20,682,317     $ (2,856 )     2,950,059     $ 80,273     $     $ 44,295     $ 121,889  
                                                                 
 
See accompanying notes.


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Table of Contents

LHC GROUP, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
 
                         
    For the Year Ended December 31,  
    2006     2005     2004  
 
Operating activities
                       
Net income
  $ 20,594     $ 10,102     $ 9,313  
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Depreciation and amortization expense
    2,427       1,751       1,021  
Provision for bad debts
    4,778       3,188       1,556  
Equity based compensation expense
          3,856       1,788  
Stock based compensation expense
    635       177        
Minority interest in earnings of subsidiaries
    4,471       4,527       3,304  
Deferred income taxes
    (1,253 )     673       (85 )
Gain on divestitures and sale of assets
    (979 )     (211 )     (339 )
Changes in operating assets and liabilities, net of acquisitions:
                       
Receivables
    (15,625 )     (14,478 )     (10,945 )
Prepaid expenses, other assets
    (1,466 )     (196 )     (648 )
Accounts payable and accrued expenses
    6,022       (2,681 )     1,480  
Net amounts due under cooperative endeavor agreements
    14       172       (415 )
Net amounts due governmental entities
    2,144       (105 )     532  
                         
Net cash provided by operating activities
    21,762       6,775       6,562  
Investing activities
                       
Purchases of property, building, and equipment
    (3,938 )     (2,134 )     (4,144 )
Proceeds from sale of property and equipment
    7             180  
Proceeds from sale of entities
    1,440       730       470  
Cost of acquisitions, primarily goodwill, intangible assets and patient accounts receivable
    (25,009 )     (11,137 )     (1,700 )
                         
Net cash used in investing activities
    (27,500 )     (12,541 )     (5,194 )
Financing activities
                       
Issuance of common stock, net of underwriting discounts of $1,104 in 2006 and $3,430 in 2005
    21,033       45,570        
Dividends paid
          (227 )     (445 )
Principal payments on debt
    (1,201 )     (2,937 )     (1,625 )
Payments on capital leases
    (389 )     (1,105 )     (446 )
Proceeds from issuance of debt
          24       1,205  
Net (payments) proceeds from lines of credit and revolving debt arrangements
          (14,288 )     5,478  
Offering costs incurred
    (311 )     (2,224 )     (1,739 )
Proceeds from exercise of stock options
    135              
Proceeds from issuance of common stock under ESPP
    140              
Minority interest contributions, net of (distributions)
    (4,190 )     (4,560 )     (2,610 )
                         
Net cash provided by (used in) financing activities
    15,217       20,253       (182 )
                         
Change in cash
    9,479       14,487       1,186  
Cash at beginning of period
    17,398       2,911       1,725  
                         
Cash at end of period
  $ 26,877     $ 17,398     $ 2,911  
                         
Supplemental disclosures of cash flow information
                       
Interest paid
  $ 342     $ 1,068     $ 1,344  
                         
Income taxes paid
  $ 9,370     $ 5,821     $ 5,783  
                         
 
Supplemental disclosure of non-cash transactions:
 
In the year ended December 31, 2006 the company sold a clinic for promissory notes totaling $946 and recognized a loss on the sale of $28.
 
In the year ended December 31, 2005, the Company issued common stock valued at $7,252 to two joint venture partners upon the acquisition of their minority interest. Additionally, the Company’s shareholder’s equity from the initial public offering was reduced by offering costs incurred by the Company of $3,951. The Company financed the purchase of an airplane for $3.0 million. The Company also financed the purchase of various types of insurance in the amount of $2.2 million.
 
See accompanying notes.


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Table of Contents

LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.   Organization
 
LHC Group, Inc. (the “Company”) is a healthcare provider specializing in the post-acute continuum of care primarily for Medicare beneficiaries in rural markets in the southern United States. The Company provides home-based services, primarily through home nursing agencies and hospices, and facility-based services, primarily through long-term acute care hospitals and outpatient rehabilitation clinics. The Company, through its wholly and majority-owned subsidiaries, equity joint ventures, and controlled affiliate, currently operates in Louisiana, Mississippi, Arkansas, Alabama, Texas, West Virginia, Kentucky, Florida, Tennessee, and Georgia.
 
The Company operated as Louisiana Health Care Group, Inc. (“LHCG”), until March 2001, when the shareholders of LHCG transferred to The Health Care Group, Inc. (“THCG”), all of the issued and outstanding shares of common stock of LHCG in exchange for shares in THCG. On January 1, 2003, the Company began operating as LHC Group, LLC, a Louisiana limited liability company. The THCG shareholders exchanged their shares for membership interests in the Company (“units”).
 
Prior to February 9, 2005, the Company operated under the terms of an operating agreement which provided that the Company did not have a finite life and that the members’ personal liability was limited to his or her capital contribution. There was only one class of member interest.
 
Plan of Merger and Recapitalization
 
In January 2005, LHC Group, LLC established a wholly-owned Delaware subsidiary, LHC Group, Inc. Effective February 9, 2005, LHC Group, LLC merged with and into LHC Group, Inc. In connection with the merger, each outstanding membership unit in LHC Group, LLC was converted into shares of the $0.01 par value common stock of LHC Group, Inc. based on an exchange ratio of three-for-two. Each KEEP Unit was also converted during the initial public offering into shares of common stock of LHC Group, Inc. pursuant to the same three-for-two ratio. LHC Group, Inc. has 40,000,000 shares of $0.01 par value common stock authorized and 5,000,000 shares of $0.01 par value preferred stock authorized. All references to common stock, share, and per share amounts have been retroactively restated to reflect the merger and recapitalization as if the merger and recapitalization had taken place as of the beginning of the earliest period presented.
 
As used herein, the “Company” includes LHC Group, Inc. and all predecessor entities.
 
Initial Public Offering
 
On June 9, 2005, the Company began its initial public offering of 4,800,000 shares of its common stock at a price of $14.00 per share. The Company offered 3,500,000 shares along with 1,300,000 shares that were sold by certain stockholders of LHC Group. The Company received no proceeds from the sale of the shares by the selling stockholders. The shares began trading on the NASDAQ National Market under the symbol “LHCG” on June 9, 2005. The initial public offering was completed on June 14, 2005. The underwriters exercised an option to purchase an additional 720,000 shares from certain stockholders solely to cover over-allotments. The Company received $45,570,000, net of underwriting discounts of $3,430,000 in proceeds from the offering. The Company incurred approximately $3,963,000 in costs related to the initial public offering through December 31, 2005.
 
2.   Significant Accounting Policies
 
Use of Estimates
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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


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Table of Contents

 
LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

and the reported revenue and expenses during the reported period. Actual results could differ from those estimates.
 
Critical Accounting Policies
 
The most critical accounting policies relate to the principles of consolidation, revenue recognition, accounts receivable and allowances for uncollectible accounts, and accounting for goodwill and intangible assets.
 
Principles of Consolidation
 
The consolidated financial statements include all subsidiaries and entities controlled by the Company. Control is generally defined by the Company as ownership of a majority of the voting interest of an entity. The consolidated financial statements include entities in which the Company absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity.
 
All significant inter-company accounts and transactions have been eliminated in consolidation. Business combinations accounted for as purchases have been included in the consolidated financial statements from the respective dates of acquisition.
 
The following describes the Company’s consolidation policy with respect to its various ventures excluding wholly owned subsidiaries:
 
Equity Joint Ventures
 
The Company’s joint ventures are structured as limited liability companies in which the Company typically owns a majority equity interest ranging from 51% to 99%. Each member of all but one of the Company’s equity joint ventures participates in profits and losses in proportion to their equity interests. The Company has one joint venture partner whose participation in losses is limited. The Company consolidates these entities as the Company absorbs a majority of the entities’ expected losses, receives a majority of the entities’ expected residual returns and generally has voting control over the entity.
 
Cooperative Endeavors
 
The Company has arrangements with certain partners that involve the sharing of profits and losses. Unlike the equity joint ventures, the Company owns 100% of the equity in these cooperative endeavors. In these cooperative endeavors, the Company possesses interests in the net profits and losses ranging from 67% to 70%. The Company has one cooperative endeavor partner whose participation in losses is limited. The Company consolidates these entities as the Company owns 100% of the outstanding equity and the Company absorbs a majority of the entities’ expected losses and receives a majority of the entities expected residual returns.
 
License Leasing Arrangements
 
The Company, through wholly owned subsidiaries, leases home health licenses necessary to operate certain of its home nursing agencies. As with wholly owned subsidiaries, the Company owns 100% of the equity of these entities and consolidates them based on such ownership as well as the Company’s right to receive a majority of the entities’ expected residual returns and the Company’s obligation to absorb a majority of the entities’ expected losses.


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Table of Contents

 
LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Management Services
 
The Company has various management services agreements under which the Company manages certain operations of agencies and facilities. The Company does not consolidate these agencies or facilities, as the Company does not have an ownership interest and does not have a right to receive a majority of the agencies’ or facilities’ expected residual returns or an obligation to absorb a majority of the agencies’ or facilities’ expected losses.
 
The following table summarizes the percentage of net service revenue earned by type of ownership or relationship the Company had with the operating entity:
 
                         
    2006     2005     2004  
 
Wholly owned subsidiaries
    39.2 %     33.6 %     41.7 %
Equity joint ventures
    45.7       50.1       40.3  
Cooperative endeavors
    1.5       2.0       5.3  
License leasing arrangements
    11.0       11.4       11.1  
Management services
    2.6       2.9       1.6  
                         
      100.0 %     100.0 %     100.0 %
                         
 
Revenue Recognition
 
The Company reports net service revenue at the estimated net realizable amount due from Medicare, Medicaid, commercial insurance, managed care payors, patients, and others for services rendered. Under Medicare, the Company’s home nursing patients are classified into a group referred to as a home health resource group prior to the receipt of services. Based on this home health resource group the Company is entitled to receive a prospective Medicare payment for delivering care over a 60 day period referred to as an episode. Medicare adjusts these prospective payments based on a variety of factors, such as low utilization, patient transfers, changes in condition and the level of services provided. In calculating the Company’s reported net service revenue from home nursing services, the Company adjusts the prospective Medicare payments by an estimate of the adjustments. The Company calculates the adjustments based on a historical average of these types of adjustments. For home nursing services, the Company recognizes revenue based on the number of days elapsed during the episode of care.
 
For the Company’s long-term acute care hospitals, revenue is recognized as services are provided. Under Medicare, patients in the Company’s long-term acute care facilities are classified into long-term diagnosis-related groups. Based on this classification, the Company is then entitled to receive a fixed payment from Medicare. This fixed payment is also subject to adjustment by Medicare due to factors such as short stays. In calculating reported net service revenue for services provided in the Company’s long-term acute care hospitals, the Company reduces the prospective payment amounts by an estimate of the adjustments. The Company calculates the adjustment based on a historical average of these types of adjustments for claims paid.
 
For hospice services the Company is paid by Medicare under a per diem payment system. The Company receives one of four predetermined daily or hourly rates based upon the level of care the Company furnished. The Company records net service revenue from hospice services based on the daily or hourly rate. The Company recognizes revenue for hospice as services are provided.
 
Under Medicare the Company is reimbursed for rehabilitation services based on a fee schedule for services provided adjusted by the geographical area in which the facility is located. The Company recognizes revenue as these services are provided.
 
The Company’s Medicaid reimbursement is based on a predetermined fee schedule applied to each service provided. Therefore, revenue is recognized for Medicaid services as services are provided based on


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

this fee schedule. The Company’s managed care payors reimburse the Company in a manner similar to either Medicare or Medicaid. Accordingly, the Company recognizes revenue from managed care payors in the same manner as the Company recognizes revenue from Medicare or Medicaid.
 
The Company records management services revenue as services are provided in accordance with the various management services agreements to which the Company is a party. The agreements generally call for the Company to provide billing, management, and other consulting services suited to and designed for the efficient operation of the applicable home nursing agency or inpatient rehabilitation facility. The Company is responsible for the costs associated with the locations and personnel required for the provision of the services. The Company is generally compensated based on a percentage of net billings or an established base fee. In addition, for certain of the management agreements, the Company may earn incentive compensation.
 
Net service revenue was comprised of the following:
 
                         
    2006     2005     2004  
 
Home-based services
    76.5 %     69.1 %     70.3 %
Facility-based services
    23.5       30.9       29.7  
                         
      100.0 %     100.0 %     100.0 %
                         
 
The following table sets forth the percentage of net service revenue earned by category of payor:
 
                         
    2006     2005     2004  
 
Payor:
                       
Medicare
    81.6 %     85.6 %     86.3 %
Medicaid
    6.1       6.0       4.8  
Other
    12.3       8.4       8.9  
                         
      100.0 %     100.0 %     100.0 %
                         
 
Home-Based Services
 
Home Nursing Services.  The Company receives a standard prospective Medicare payment for delivering care. The base payment, established through federal legislation, is a flat rate that is adjusted upward or downward based upon differences in the expected resource needs of individual patients as indicated by clinical severity, functional severity, and service utilization. The magnitude of the adjustment is determined by each patient’s categorization into one of 80 payment groups, known as home health resource groups, and the costliness of care for patients in each group relative to the average patient. The Company’s payment is also adjusted for differences in local prices using the hospital wage index. The Company performs payment variance analyses to verify the models utilized in projecting total net service revenue are accurately reflecting the payments to be received.
 
Medicare rates are subject to change. Due to the length of the Company’s episodes of care, a situation may arise where Medicare rate changes affect prior period’s net service revenue. In the event that Medicare rates experience change, the net effect of that change will be reflected in the current reporting period.
 
Final payments from Medicare may reflect one of five retroactive adjustments to ensure the adequacy and effectiveness of the total reimbursement: (a) an outlier payment if the patient’s care was unusually costly; (b) a low utilization adjustment if the number of visits was fewer than five; (c) a partial payment if the patient transferred to another provider before completing the episode; (d) a change-in-condition adjustment if the patient’s medical status changes significantly, resulting in the need for more or less care; or (e) a payment adjustment based upon the level of therapy services required in the population base. Management estimates


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the impact of these payment adjustments based on historical experience and records this estimate during the period the services are rendered.
 
Hospice Services.  The Company’s Medicare hospice reimbursement is based on an annually-updated prospective payment system. Hospice payments are also subject to two caps. One cap relates to individual programs receiving more than 20% of its total Medicare reimbursement from inpatient care services. The second cap relates to individual programs receiving reimbursements in excess of a “cap amount,” calculated by multiplying the number of beneficiaries during the period by a statutory amount that is indexed for inflation. The determination for each cap is made annually based on the 12-month period ending on October 31 of each year. This limit is computed on a program-by-program basis. We have not received notification that any of our hospices have exceeded the cap on inpatient care seniors during 2006. None of the Company’s hospices exceeded either cap during the year ended December 31, 2005, or 2004.
 
Facility-Based Services
 
Long-Term Acute Care Services.  The Company is reimbursed by Medicare for services provided under the long-term acute care hospital prospective payment system, which was implemented on October 1, 2002. Each patient is assigned a long-term care diagnosis-related group. The Company is paid a predetermined fixed amount applicable to that particular group. This payment is intended to reflect the average cost of treating a Medicare patient classified in that particular long-term care diagnosis-related group. For selected patients, the amount may be further adjusted based on length of stay and facility-specific costs, as well as in instances where a patient is discharged and subsequently readmitted, among other factors. Similar to other Medicare prospective payment systems, the rate is also adjusted for geographic wage differences.
 
Outpatient Rehabilitation Services.  Outpatient therapy services are reimbursed on a fee schedule, subject to annual limitations. Outpatient therapy providers receive a fixed fee for each procedure performed, adjusted by the geographical area in which the facility is located. The Company recognizes revenue as the services are provided. There are also annual per Medicare beneficiary caps that limit Medicare coverage for outpatient rehabilitation services.
 
Accounts Receivable and Allowances for Uncollectible Accounts
 
The Company reports accounts receivable net of estimated allowances for uncollectible accounts and adjustments. Accounts receivable are uncollateralized and primarily consist of amounts due from third-party payors and patients. To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for uncollectible accounts to reduce the carrying amount of such receivables to their estimated net realizable value. The credit risk for other concentrations of receivables is limited due to the significance of Medicare as the primary payor. The Company does not believe that there are any other significant concentrations of receivables from any particular payor that would subject it to any significant credit risk in the collection of accounts receivable.
 
The amount of the provision for bad debts is based upon the Company’s assessment of historical and expected net collections, business and economic conditions, and trends in government reimbursement. Uncollectible accounts are written off when the Company has determined the account will not be collected.
 
A portion of the estimated Medicare prospective payment system reimbursement from each submitted home nursing episode is received in the form of a request for accelerated payment (“RAP”). The Company submits a RAP for 60% of the estimated reimbursement for the initial episode at the start of care. The full amount of the episode is billed after the episode has been completed. The RAP received for that particular episode is deducted from the final payment. If the final bill is not submitted within the greater of 120 days from the start of the episode, or 60 days from the date the RAP was paid, any RAP’s received for that episode will be recouped by Medicare from any other claims in process for that particular provider. The RAP and final


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

payment must then be resubmitted. For any subsequent episodes of care contiguous with the first episode for a particular patient, the Company submits a RAP for 50% instead of 60% of the estimated reimbursement. The remaining 50% reimbursement is requested upon completion of the episode. The Company has earned net service revenue in excess of billings rendered to Medicare. Only a nominal portion of the amounts due to the Medicare program represent cash collected in advance of providing services.
 
Goodwill and Intangible Assets
 
Goodwill and other intangible assets with indefinite lives are reviewed annually, or more frequently if circumstances indicate impairment may have occurred.
 
The Company estimates the fair value of its identified reporting units and compares those estimates against the related carrying value. For each of the reporting units, the estimated fair value is determined based on a multiple of earnings before interest, taxes, depreciation, and amortization or on the estimated fair value of assets in situations when it is readily determinable.
 
Included in intangible assets, net are other intangible assets such as licenses to operate home-based and/or facility-based services and trade names. The Company has valued these intangible assets separately from goodwill for each acquisition completed during the year ended December 31, 2006. The Company has concluded that these licenses and trade names have indefinite lives, as management has determined that there are no legal, regulatory, contractual, economic or other factors that would limit the useful life of these intangible assets and the Company intends to renew and operate the licenses and use these trade names indefinitely. Prior to January 1, 2006, the Company elected to recognize the fair value of indefinite-lived licenses and trade names together with goodwill as a single asset for financial reporting purposes.
 
Components of the Company’s home nursing operating segment are generally represented by individual subsidiaries or joint ventures with individual licenses to conduct specific operations within geographic markets as limited by the terms of each license. Components of the Company’s facility-based services are represented by individual operating entities. Effective January 1, 2004, management aggregates the components of these two segments into two reporting units for purposes of evaluating impairment.
 
Other Significant Accounting Policies
 
Due to/from Governmental Entities
 
Prior to October 1, 2000, the Company recorded Medicare home nursing services revenues at the lower of actual costs, the per visit cost limit, or a per beneficiary cost limit on an individual provider basis. Additionally, the Company’s critical access hospital and long-term acute care hospitals are reimbursed for certain activities based on tentative rates. Final reimbursement is determined based on submission of annual cost reports and audits by the fiscal intermediary. Adjustments are accrued on an estimated basis in the period the related services were rendered and further adjusted as final settlements are determined. These adjustments are accounted for as changes in estimates. There have been no significant changes in estimates during the twelve months ended December 31, 2006 and 2005.
 
Property, Building, and Equipment
 
Property, building, and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the individual assets, generally ranging from three to ten years and up to thirty-nine years on buildings. Depreciation expense for the years ended December 31, 2006, 2005, and 2004 was $2.4 million, $1.8 million, and $1.0, respectively.
 
Capital leases, primarily consisting of transportation equipment, are included in equipment. Capital leases are recorded at the present value of the future rentals at lease inception and are amortized over the shorter of


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LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the applicable lease term or the useful life of the equipment. Amortization of assets under the capital lease obligations is included in depreciation and amortization expense.
 
Long-Lived Assets
 
The Company reviews the recoverability of long-lived assets whenever events or circumstances occur which indicate recorded costs may not be recoverable. If the expected future cash flows (undiscounted) are less than the carrying amount of such assets, the Company recognizes an impairment loss for the difference between the carrying amount of the assets and their estimated fair value.
 
Income Taxes
 
The Company accounts for income taxes using the liability method. Under the liability method, deferred taxes are determined based on differences between the financial reporting and tax bases of assets and liabilities, and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. Management provides a valuation allowance for any net deferred tax assets when it is more likely than not that a portion of such net deferred tax assets will not be recovered.
 
Minority Interest and Cooperative Endeavor Agreements
 
The interest held by third parties in subsidiaries owned or controlled by the Company is reported on the consolidated balance sheets as minority interest. Minority interest reported in the consolidated statements of income reflects the respective interests in the income or loss of the subsidiaries attributable to the other parties, the effect of which is removed from the Company’s consolidated results of operations.
 
Several of the Company’s home health agencies have cooperative endeavor agreements with third parties that allow the third parties to be paid or recover a fee based on the profits or losses of the respective agencies. The Company accrues for the settlement of the third party’s profits or losses during the period the amounts are earned. Under the agreements, the Company has incurred net amounts due to the third parties of $246,000, $316,000, and $753,000 for the twelve months ended December 31, 2006, 2005 and 2004, respectively. The cooperative endeavor agreements have terms expiring through June 2008.
 
For agreements where the third party is a healthcare institution, the agreements typically require the Company to lease building and equipment and receive housekeeping and maintenance from the healthcare institutions. Ancillary services related to these arrangements are also typically provided by the healthcare institution.
 
Minority Interest Subject to Exchange Contracts and/or Put Options
 
During 2004, in conjunction with the acquisition/sale of joint venture interests, the Company entered into agreements with minority interest holders in three of its majority owned subsidiaries that allowed these minority interest holders to put their minority interests to the Company in the event the Company is sold, merged or otherwise acquired or completes an initial public offering (“IPO”). These put options were deemed to be part of the underlying minority interest shares, thus rendering the shares to be puttable shares. In September and November of 2004, the Company entered into forward exchange contracts with the minority interest holders in two of these subsidiaries, Acadian Home Health Care Services, LLC (“Acadian”) and Hebert, Thibodeaux, Albro and Touchet Therapy Group, Inc. (“Hebert”) which required the minority interest holders in these subsidiaries to sell their interests to the Company in the event of an IPO. In conjunction with the Company’s IPO, the forward exchange contracts were consummated and the minority interest holders of Acadian and Hebert sold their minority interests to the Company in exchange for cash and shares of the Company’s common stock. The Company paid approximately $2.2 million under these forward exchange contracts.


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LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
In the third majority owned subsidiary, St. Landry Extended Care Hospital, (“St. Landry”), the put option allows the minority interest holders to convert their minority interests into shares of the Company based upon St. Landry’s EBITDA for the prior fiscal year in relation to the Company’s EBITDA over the same period. The put option became exercisable by the minority interest holders in St. Landry upon the completion of the IPO. However, due to applicable laws and regulations, the minority interest holders can not convert their minority interests in St. Landry unless certain conditions are met including, but not limited to, the Company having stockholders’ equity in excess of $75 million at the end of its most recent fiscal year or on average during the previous three fiscal years. If the St. Landry minority interest holders do not or are unable to convert their minority interests into shares of the Company, the minority interest holders shall have the option to redeem their minority interests at any time following thirty days after the IPO for cash consideration equal to the number of shares the minority interest holders would have received if they had converted their minority interests into shares of the Company multiplied by the average closing price of the Company’s shares for the thirty days preceding the date of the minority interest holders’ exercise of the redemption option. As of December 31, 2006, the Company has exceeded $75 million in stockholders’ equity. As of March 14, 2007, approximately 76.5% of the doctors have converted their minority interests to cash.
 
The above put/redemption options and exchange agreements have been presented in the historical financial statements under the guidance in Accounting Series Release (ASR) No. 268 and EITF Topic D-98, which generally require a public company’s stock subject to redemption requirements that are outside the control of the issuer to be excluded from the caption “stockholders’ equity” and presented separately in the issuer’s balance sheet. Under EITF Topic D-98, once it becomes probable that the minority interest would become redeemable, the minority interest should be adjusted to its current redemption amount. As noted above, the St. Landry put option allowed the minority interest holders in St. Landry’s to have their interests redeemed for cash upon the completion of the IPO and, therefore, the Company recorded an adjustment of approximately $1.5 million to minority interests subject to exchange contracts and/or put options and to retained earnings which represents the redemption value of St. Landry interests at June 30, 2005. In September 2005, certain minority interest holders redeemed their interests in St. Landry’s. This resulted in a cash payment of approximately $214,000. In connection with the partial redemption of certain minority interest in September 2005, we decreased our minority interests by approximately $149,000 and increased our retained earnings by the same amount. Simultaneously, we recorded goodwill of $214,000 to represent the value of the minority interests redeemed. Also at the end of the September 30, 2005 quarter, we recorded a mark to market charge of $404,000.
 
In November 2005, the agreement was amended to allow minority interest holders to redeem their minority interests based on the St. Landry’s rolling twelve month EBITDA in relation to the Company’s EBITDA over the same period. At December 31, 2005, the Company recorded an additional mark to market benefit of $266,000 to mark the liability to redemption value at the end of the quarter.
 
In connection with the partial redemption of certain minority interest in the year ended December 31, 2006, the Company decreased minority interest by approximately $1,039,000 and increased retained earnings by the same amount. Simultaneously, The Company recorded goodwill of $979,000 to represent the value of the minority interest redeemed. Also for the year ended December 31, 2006, the Company recorded a mark to market benefit of $124,000.
 
Equity-Based Compensation Expense
 
During 2003, the Company began sponsoring a Key Employee Equity Participation (“KEEP”) Plan whereby certain individuals were granted participation equity units (“KEEP Units”). The KEEP Plan was terminated in conjunction with the initial public offering when the outstanding units were converted to 481,680 shares of common stock. The KEEP Plan functioned as a stock appreciation rights plan whereby an individual was entitled to receive, on a per KEEP Unit basis, the increase in estimated fair value of the


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LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Company’s common stock from the date of grant until the date that the employee dies, retires, or is terminated for other than cause. Accordingly, the KEEP Units were subject to variable accounting until such time as the obligation to the employee was settled. The Company had a call right, under which, it could purchase all or a portion of the KEEP Units. The individuals receiving KEEP Units vested in those rights in a graded manner over a five-year period and, accordingly, the Company recorded compensation expense for the vested portion of the KEEP Units. The KEEP Units had no exercise price.
 
Compensation expense, and a corresponding increase in paid-in capital, was also recognized each period for any change in value associated with certain KEEP Units that were held by an officer of the Company.
 
In conjunction with the initial public offering, the outstanding KEEP Units were converted to common stock. In conjunction with this conversion, the Company incurred a charge to equity based compensation of approximately $3.0 million. For the years ended December 31, 2005 and 2004, the Company recorded approximately $3.9 million and $1.8 million respectively in equity based compensation related to the KEEP Units. There was no equity based compensation related to the KEEP units recorded for the year ended December 31, 2006.
 
Stock-based Compensation
 
The Company adopted Statement of Financial Accounting Standards (SFAS) No.  123(R) (revised 2004), Share-Based Payment, a revision of SFAS No. 123, Accounting for Stock-Based Compensation, on January 1, 2006 using the modified prospective method. This method requires compensation cost to be recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date. Under this method, prior periods are not restated to reflect the impact of adopting the new standard.
 
Prior to adopting SFAS No. 123R, the Company accounted for issuances of restricted stock and stock option grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations (“APB 25”). Accordingly, the Company did not recognize compensation cost in the Consolidated Statements of Income for years prior to adoption of SFAS No. 123R in connection with the issuance of the stock options, as the options granted had an exercise price equal to the market value of the Company’s common stock on the date of grant. The Company did recognize compensation cost in connection with the issuance of restricted stock.


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LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following proforma information illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to options granted in all periods presented. For purposes of this proforma disclosure, the value of the options is estimated using the Black-Scholes option pricing formula and amortized to expense over the options’ vesting period (in thousands, except per share amounts):
 
                 
    2005     2004  
 
Net income, as reported
  $ 10,102     $ 9,313  
Redeemable minority interests
    (1,476 )      
                 
Net income available to common stockholders, as reported
    8,626       9,313  
Adjustments:
               
Stock-based compensation expense included in reported net income
           
Stock-based compensation expense determined under fair value method
    (53 )      
                 
Pro forma income available to common stockholders
  $ 8,573     $ 9,313  
                 
Net income per common share:
               
As reported:
               
Basic
  $ 0.69     $ 0.77  
Diluted
  $ 0.69     $ 0.76  
Pro Forma:
               
Basic
  $ 0.69     $ 0.77  
Diluted
  $ 0.68     $ 0.76  
Net income available to common stockholders per common share:
               
As reported:
               
Basic
  $ 0.59     $ 0.77  
Diluted
  $ 0.59     $ 0.76  
Pro Forma:
               
Basic
  $ 0.59     $ 0.77  
Diluted
  $ 0.58     $ 0.76  
 
Black-Scholes option pricing model assumptions:
 
         
    December 31,
 
    2005  
 
Risk free interest rate
    3.72-4.54 %
Expected life (years)
    5  
Volatility
    41.62-43.50  
Expected annual dividend yield
     
 
Earnings Per Share
 
Basic per share information is computed by dividing the item by the weighted-average number of shares outstanding during the period. Diluted per share information is computed by dividing the item by the weighted-average number of shares outstanding plus dilutive potential shares.


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LHC GROUP, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
The following table sets forth shares used in the computation of basic and diluted per share information for the years ended December 31, 2006, 2005 and 2004.
 
                         
    2006     2005     2004  
 
Weighted average number of shares outstanding for basic per share calculation
    17,090,583       14,628,737       12,085,154  
Effect of dilutive potential shares:
                       
Options
    2,399       790        
Restricted stock
    11,678       1,112        
KEEP Units
          54,000       59,996  
Adjusted weighted average shares for diluted per share calculation
    17,104,660       14,684,639       12,145,150  
 
Recently Issued Accounting Pronouncements
 
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for the Uncertainty in Income Taxes,” (“FIN 48”). FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of our 2007 fiscal year. The Company is currently evaluating the impact, if any, that FIN 48 will have on the financials statements.
 
In September 2006, the U.S. Securities and Exchange Commission (“SEC”) adopted Staff Accounting Bulletin No. 108 (“SAB No. 108”), which expresses the SEC’s staff views on the process of quantifying financial statement misstatements. SAB 108 requires that registrants consider evaluating errors under both the “rollover” and “iron curtain” approaches to determine if such errors are material, thus requiring a restatement to prior period financial statements. SAB 108 is effective for fiscal years ending on or after November 15, 2006 and allowed the registrant to avoid restating prior period financial statements for such errors that are governed by SAB 108 if the registrant properly disclosed such errors in its financial statement during the period of adoption. The Company adopted this new standard as of December 31, 2006 and it did not have an impact on the Company’s consolidated financial position or results of operations.
 
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. SFAS No. 157 will be effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the requirements of this new standard and has not concluded its analysis on the impact to the Company’s consolidated financial position or results of operations.
 
Reclassifications
 
Certain prior year amounts on the Consolidated Statements of Cash Flows have been reclassified to conform with the current year presentation.
 
3.   Acquisitions and Divestitures
 
The following acquisitions were completed pursuant to the Company’s strategy of becoming the leading provider of post-acute healthcare services to Medicare patients in selected rural markets in the southern United States. The purchase price of each acquisition was determined based on the Company’s analysis of comparable acquisitions and target market’s potential cash flows. Goodwill generated from the acquisitions was recognized based on the expected contributions of each acquisition to the overall