Edgar Filing: SELECT MEDICAL HOLDINGS CORP

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended June 30, 2014

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: 001 – 34465 and 001 – 31441

SELECT MEDICAL HOLDINGS CORPORATION

SELECT MEDICAL CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware

(State or other jurisdiction of
incorporation or organization)

20-1764048

23-2872718

(I.R.S. employer identification
number)

4714 Gettysburg Road, P.O. Box 2034, Mechanicsburg, Pennsylvania 17055

(Address of principal executive offices and zip code)

(717) 972-1100

(Registrants’ telephone number, including area code)

Indicate by check mark whether the Registrants (1) have 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 periods as such Registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. YES x NO o

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

Indicate by check mark whether the Registrants are large accelerated filers, accelerated filers, non-accelerated filers, or smaller reporting companies. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o Accelerated filer x Non-accelerated filer o

Smaller reporting company o

Indicate by check mark whether the Registrants are shell companies (as defined in Rule 12b-2 of the Exchange Act). YES o NO x

As of July 31, 2014, Select Medical Holdings Corporation had outstanding 130,018,588 shares of common stock.

This Form 10-Q is a combined quarterly report being filed separately by two Registrants: Select Medical Holdings Corporation and Select Medical Corporation. Unless the context indicates otherwise, any reference in this report to “Holdings” refers to Select Medical Holdings Corporation and any reference to “Select” refers to Select Medical Corporation, the wholly-owned operating subsidiary of Holdings. References to the “Company,” “we,” “us” and “our” refer collectively to Holdings and Select.

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TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION	3

ITEM 1.	CONSOLIDATED FINANCIAL STATEMENTS

	Consolidated balance sheets	3

	Consolidated statements of operations	4

	Consolidated statements of changes in equity and income	6

	Consolidated statements of cash flows	7

	Notes to consolidated financial statements	8

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	31

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	57

ITEM 4.	CONTROLS AND PROCEDURES	57

PART II	OTHER INFORMATION	58

ITEM 1.	LEGAL PROCEEDINGS	58

ITEM 1A.	RISK FACTORS	59

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	59

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	60

ITEM 4.	MINE SAFETY DISCLOSURES	60

ITEM 5.	OTHER INFORMATION	60

ITEM 6.	EXHIBITS	60

SIGNATURES

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PART I FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

Consolidated Balance Sheets

(unaudited)

(in thousands, except share and per share amounts)

	Select Medical Holdings Corporation				Select Medical Corporation
	December 31,		June 30,		December 31,			June 30,
	2013		2014		2013			2014

ASSETS
Current Assets:
Cash and cash equivalents	$	4,319	$	3,140	$	4,319		$	3,140
Accounts receivable, net of allowance for doubtful accounts of $40,815 and $41,021 at 2013 and 2014, respectively	391,319		453,184		391,319			453,184
Current deferred tax asset	17,624		16,042		17,624			16,042
Prepaid income taxes	—		678		—			678
Other current assets	41,140		44,081		41,140			44,081
Total Current Assets	454,402		517,125		454,402			517,125

Property and equipment, net	509,102		526,349		509,102			526,349
Goodwill	1,642,633		1,642,869		1,642,633			1,642,869
Other identifiable intangibles	71,907		72,023		71,907			72,023
Other assets	139,578		145,405		139,578			145,405

Total Assets	$	2,817,622	$	2,903,771	$	2,817,622		$	2,903,771

LIABILITIES AND EQUITY
Current Liabilities:
Bank overdrafts	$	12,506	$	9,192	$	12,506		$	9,192
Current portion of long-term debt and notes payable	17,565		14,778		17,565			14,778
Accounts payable	88,285		98,638		88,285			98,638
Accrued payroll	90,011		74,736		90,011			74,736
Accrued vacation	59,730		64,127		59,730			64,127
Accrued interest	12,297		10,985		12,297			10,985
Accrued other	90,471		81,424		90,471			81,424
Income taxes payable	622		—		622			—
Due to third party payors	37		1,981		37			1,981
Total Current Liabilities	371,524		355,861		371,524			355,861

Long-term debt, net of current portion	1,427,710		1,598,754		1,427,710			1,598,754
Non-current deferred tax liability	96,287		95,981		96,287			95,981
Other non-current liabilities	91,875		96,335		91,875			96,335

Total Liabilities	1,987,396		2,146,931		1,987,396			2,146,931

Redeemable non-controlling interests	11,584		11,238		11,584			11,238

Stockholders’ Equity:
Common stock of Holdings, $0.001 par value, 700,000,000 shares authorized, 140,260,968 shares and 130,002,788 shares issued and outstanding at 2013 and 2014, respectively	140		130		—			—
Common stock of Select, $0.01 par value, 100 shares issued and outstanding	—		—		0			0
Capital in excess of par	474,729		410,721		869,576			880,584
Retained earnings (accumulated deficit)	311,365		300,481		(83,342		)	(169,252		)
Total Select Medical Holdings Corporation and Select Medical Corporation Stockholders’ Equity	786,234		711,332		786,234			711,332
Non-controlling interest	32,408		34,270		32,408			34,270
Total Equity	818,642		745,602		818,642			745,602

Total Liabilities and Equity	$	2,817,622	$	2,903,771	$	2,817,622		$	2,903,771

The accompanying notes are an integral part of these consolidated financial statements.

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Consolidated Statements of Operations

(unaudited)

(in thousands, except per share amounts)

	Select Medical Holdings Corporation						Select Medical Corporation
	For the Three Months Ended June 30,						For the Three Months Ended June 30,
	2013			2014			2013			2014

Net operating revenues	$	756,673		$	772,762		$	756,673		$	772,762

Costs and expenses:
Cost of services	625,730			642,881			625,730			642,881
General and administrative	17,927			19,377			17,927			19,377
Bad debt expense	8,846			11,115			8,846			11,115
Depreciation and amortization	15,907			17,196			15,907			17,196
Total costs and expenses	668,410			690,569			668,410			690,569

Income from operations	88,263			82,193			88,263			82,193

Other income and expense:
Loss on early retirement of debt	(17,280		)	—			(17,280		)	—
Equity in earnings of unconsolidated subsidiaries	568			1,239			568			1,239
Interest expense	(21,904		)	(21,663		)	(21,904		)	(21,663		)

Income before income taxes	49,647			61,769			49,647			61,769

Income tax expense	19,769			23,775			19,769			23,775

Net income	29,878			37,994			29,878			37,994

Less: Net income attributable to non-controlling interests	2,098			2,653			2,098			2,653

Net income attributable to Select Medical Holdings Corporation and Select Medical Corporation	$	27,780		$	35,341		$	27,780		$	35,341

Income per common share:
Basic	$	0.20		$	0.27
Diluted	$	0.20		$	0.27

The accompanying notes are an integral part of these consolidated financial statements.

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Consolidated Statements of Operations

(unaudited)

(in thousands, except per share amounts)

	Select Medical Holdings Corporation						Select Medical Corporation
	For the Six Months Ended June 30,						For the Six Months Ended June 30,
	2013			2014			2013			2014

Net operating revenues	$	1,506,628		$	1,535,340		$	1,506,628		$	1,535,340

Costs and expenses:
Cost of services	1,250,634			1,281,645			1,250,634			1,281,645
General and administrative	35,325			37,500			35,325			37,500
Bad debt expense	18,167			22,133			18,167			22,133
Depreciation and amortization	31,709			33,425			31,709			33,425
Total costs and expenses	1,335,835			1,374,703			1,335,835			1,374,703

Income from operations	170,793			160,637			170,793			160,637

Other income and expense:
Loss on early retirement of debt	(18,747		)	(2,277		)	(17,788		)	(2,277		)
Equity in earnings of unconsolidated subsidiaries	1,626			2,147			1,626			2,147
Interest expense	(45,362		)	(42,279		)	(42,952		)	(42,279		)

Income before income taxes	108,310			118,228			111,679			118,228

Income tax expense	41,630			45,867			42,809			45,867

Net income	66,680			72,361			68,870			72,361

Less: Net income attributable to non-controlling interests	4,482			3,976			4,482			3,976

Net income attributable to Select Medical Holdings Corporation and Select Medical Corporation	$	62,198		$	68,385		$	64,388		$	68,385

Income per common share:
Basic	$	0.44		$	0.51
Diluted	$	0.44		$	0.51

The accompanying notes are an integral part of these consolidated financial statements.

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Consolidated Statement of Changes in Equity and Income

(unaudited)

(in thousands)

						Select Medical Holdings Corporation Stockholders
	Comprehensive Income		Total			Common Stock Issued		Common Stock Par Value			Capital in Excess of Par			Retained Earnings			Accumulated Other Comprehensive Income (Loss)		Non-controlling Interests
Balance at December 31, 2013			$	818,642		140,261		$	140		$	474,729		$	311,365		$	—	$	32,408
Net income	$	71,775	71,775											68,385					3,390
Net income - attributable to redeemable non-controlling interests	586
Total comprehensive income	$	72,361
Dividends paid to common stockholders			(27,153		)									(27,153		)
Issuance and vesting of restricted stock			5,329			285		0			5,329
Repurchase of common shares			(127,500		)	(11,286	)	(11		)	(75,015		)	(52,474		)
Stock option expense			382								382
Exercise of stock options			5,297			743		1			5,296
Distributions to non-controlling interests			(1,267		)														(1,267		)
Other			97											358					(261		)
Balance at June 30, 2014			$	745,602		130,003		$	130		$	410,721		$	300,481		$	—	$	34,270

						Select Medical Corporation Stockholders
	Comprehensive Income		Total			Common Stock Issued		Common Stock Par Value			Capital in Excess of Par			Accumulated Deficit			Accumulated Other Comprehensive Income (Loss)		Non-controlling Interests
Balance at December 31, 2013			$	818,642		0		$	0		$	869,576		$	(83,342	)	$	—	$	32,408
Net income	$	71,775	71,775											68,385					3,390
Net income - attributable to redeemable non-controlling interests	586
Total comprehensive income	$	72,361
Additional investment by Holdings			5,297								5,297
Dividends declared and paid to Holdings			(154,653		)									(154,653		)
Contribution related to restricted stock awards and stock option issuances by Holdings			5,711								5,711
Distributions to non-controlling interests			(1,267		)														(1,267		)
Other			97											358					(261		)
Balance at June 30, 2014			$	745,602		0		$	0		$	880,584		$	(169,252	)	$	—	$	34,270

The accompanying notes are an integral part of these consolidated financial statements.

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Consolidated Statements of Cash Flows

(unaudited)

(in thousands)

	Select Medical Holdings Corporation						Select Medical Corporation
	For the Six Months Ended June 30,						For the Six Months Ended June 30,
	2013			2014			2013			2014

Operating activities
Net income	$	66,680		$	72,361		$	68,870		$	72,361
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	31,709			33,425			31,709			33,425
Provision for bad debts	18,167			22,133			18,167			22,133
Equity in earnings of unconsolidated subsidiaries	(1,626		)	(2,147		)	(1,626		)	(2,147		)
Loss on early retirement of debt	18,747			2,277			17,788			2,277
Loss from disposal of assets	81			143			81			143
Non-cash stock compensation expense	3,537			4,120			3,537			4,120
Amortization of debt discount, premium and issuance costs	4,588			3,849			4,499			3,849
Deferred income taxes	3,192			1,275			3,192			1,275
Changes in operating assets and liabilities, net of effects from acquisition of businesses:
Accounts receivable	(83,832		)	(84,249		)	(83,832		)	(84,249		)
Other current assets	(5,894		)	(2,935		)	(5,894		)	(2,935		)
Other assets	144			(3,462		)	144			(3,462		)
Accounts payable	(2,665		)	10,343			(2,665		)	10,343
Due to third-party payors	5,217			1,944			5,217			1,944
Accrued expenses	(28,203		)	(16,030		)	(24,945		)	(16,030		)
Income taxes	(7,819		)	(878		)	(6,640		)	(878		)
Net cash provided by operating activities	22,023			42,169			27,602			42,169

Investing activities
Purchases of property and equipment	(27,962		)	(50,493		)	(27,962		)	(50,493		)
Investment in businesses, net of distributions	(28,716		)	(175		)	(28,716		)	(175		)
Acquisition of businesses, net of cash acquired	(171		)	(454		)	(171		)	(454		)
Net cash used in investing activities	(56,849		)	(51,122		)	(56,849		)	(51,122		)

Financing activities
Borrowings on revolving credit facility	455,000			515,000			455,000			515,000
Payments on revolving credit facility	(480,000		)	(425,000		)	(480,000		)	(425,000		)
Borrowings on credit facility term loans, net of discount	298,500			—			298,500			—
Payments on credit facility term loans	(592,615		)	(33,994		)	(592,615		)	(33,994		)
Issuance of 6.375% senior notes, includes premium	600,000			111,650			600,000			111,650
Repurchase of senior floating rate notes	(167,300		)	—			—			—
Repurchase of 7 5/8% senior subordinated notes	(70,000		)	—			(70,000		)	—
Borrowings of other debt	6,909			6,111			6,909			6,111
Principal payments on other debt	(4,673		)	(7,049		)	(4,673		)	(7,049		)
Debt issuance costs	(18,583		)	(4,434		)	(18,583		)	(4,434		)
Dividends paid to common stockholders	(13,963		)	(27,153		)	—			—
Dividends paid to Holdings	—			—			(196,825		)	(154,653		)
Repurchase of common stock	(9,983		)	(127,500		)	—			—
Proceeds from issuance of common stock	—			5,297			—			—
Equity investment by Holdings	—			—			—			5,297
Proceeds from (repayment of) bank overdrafts	1,625			(3,314		)	1,625			(3,314		)
Distributions to non-controlling interests	(1,467		)	(1,840		)	(1,467		)	(1,840		)
Net cash provided by (used in) financing activities	3,450			7,774			(2,129		)	7,774

Net decrease in cash and cash equivalents	(31,376		)	(1,179		)	(31,376		)	(1,179		)

Cash and cash equivalents at beginning of period	40,144			4,319			40,144			4,319
Cash and cash equivalents at end of period	$	8,768		$	3,140		$	8,768		$	3,140

Supplemental Cash Flow Information
Cash paid for interest	$	53,914		$	39,107		$	48,335		$	39,107
Cash paid for taxes	$	46,832		$	45,471		$	46,832		$	45,471

The accompanying notes are an integral part of these consolidated financial statements.

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SELECT MEDICAL HOLDINGS CORPORATION AND SELECT MEDICAL CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

The unaudited consolidated financial statements of Select Medical Holdings Corporation (“Holdings”) and Select Medical Corporation (“Select”) as of June 30, 2014 and for the three and six month periods ended June 30, 2013 and 2014 have been prepared in accordance with generally accepted accounting principles (“GAAP”). In the opinion of management, such information contains all adjustments, which are normal and recurring in nature, necessary for a fair statement of the financial position, results of operations and cash flow for such periods. All significant intercompany transactions and balances have been eliminated. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the full fiscal year ending December 31, 2014. Holdings and Select and their subsidiaries are collectively referred to as the “Company.” The consolidated financial statements of Holdings include the accounts of its wholly-owned subsidiary Select. Holdings conducts substantially all of its business through Select and its subsidiaries.

Certain information and disclosures normally included in the notes to consolidated financial statements have been condensed or omitted consistent with the rules and regulations of the Securities and Exchange Commission (the “SEC”), although the Company believes the disclosure is adequate to make the information presented not misleading. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2013 contained in the Company’s Annual Report on Form 10-K filed with the SEC on February 25, 2014.

2. Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers, which supersedes most of the current revenue recognition requirements. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. New disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers are also required. This guidance is effective for the Company in the first quarter of 2017 and early application is not permitted. Entities must adopt the new guidance using one of two retrospective application methods. The Company is currently evaluating the standard to determine the impact of its adoption on the consolidated financial statements.

In April 2014, the FASB issued ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, which changes the criteria for determining which disposals can be presented as discontinued operations and modifies the related disclosure requirements. Under the new guidance,

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a discontinued operation is defined as a disposal of a component or group of components that represents a strategic shift that has, or will have, a major effect on an entity’s operations and financial results. The revised guidance is effective for annual fiscal periods beginning after December 15, 2014. Early adoption is permitted and the Company intends to prospectively adopt ASU No. 2014-08, as applicable.

3. Intangible Assets

The gross carrying amounts of the Company’s indefinite-lived intangible assets consist of the following:

	December 31, 2013		June 30, 2014
	(in thousands)

Goodwill	$	1,642,633	$	1,642,869
Trademarks	57,709		57,709
Certificates of need	12,115		12,231
Accreditations	2,083		2,083
Total	$	1,714,540	$	1,714,892

The Company’s accreditations and trademarks have renewal terms. The costs to renew these intangibles are expensed as incurred. At June 30, 2014, the accreditations and trademarks have a weighted average time until next renewal of approximately 1.5 years and 6.0 years, respectively.

The changes in the carrying amount of goodwill for the Company’s reportable segments for the six months ended June 30, 2014 are as follows:

	Specialty Hospitals			Outpatient Rehabilitation		Total
	(in thousands)
Balance as of December 31, 2013	$	1,334,615		$	308,018	$	1,642,633
Goodwill acquired during the period	—			246		246
Purchase accounting adjustment	(10		)	—		(10		)
Balance as of June 30, 2014	$	1,334,605		$	308,264	$	1,642,869

4. Share Repurchase

On April 30, 2014, Holdings’ board of directors authorized an increase of $150.0 million in the capacity of its common stock repurchase program from $350.0 million to $500.0 million and extended the program until December 31, 2016. Holdings repurchased 11,285,714 shares of common stock at a total cost of $127.5 million, or an average of $11.30 per share, during the six months ended June 30, 2014. The shares were repurchased from Welsh, Carson, Anderson & Stowe IX, L.P. and WCAS Capital Partners IV, L.P. pursuant to stock purchase agreements dated February 26, 2014 and May 5, 2014. The common stock repurchase program has available capacity of $198.9 million as of June 30, 2014.

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5. Indebtedness

The components of long-term debt and notes payable are as follows:

	December 31, 2013		June 30, 2014
	(in thousands)

6.375% senior notes (1)	$	600,000	$	711,580
Senior secured credit facilities:
Revolving loan	20,000		110,000
Term loans (2)	807,815		775,329
Other	17,460		16,623
Total debt	1,445,275		1,613,532
Less: current maturities	17,565		14,778
Total long-term debt	$	1,427,710	$	1,598,754

(1) Includes unamortized premium of $1.6 million at June 30, 2014.

(2) Includes unamortized discounts of $6.3 million and $4.8 million at December 31, 2013 and June 30, 2014, respectively.

Senior Secured Credit Facilities

On June 1, 2011, Select entered into its existing senior secured credit agreement that provided for $1.15 billion in senior secured credit facilities. The following discussion summarizes amendments and significant transactions affecting its senior secured credit facilities.

On August 13, 2012, Select entered into an additional credit extension amendment to its senior secured credit facilities providing for a $275.0 million series A term loan at the same interest rate and with the same term as the original term loan.

On February 20, 2013, Select entered into a credit extension amendment to its senior secured credit facilities providing for a $300.0 million series B term loan. Select used the borrowings under the series B term loan to redeem all of its outstanding 7 5/8% senior subordinated notes due 2015 on March 22, 2013, to finance Holdings’ redemption of all of its senior floating rate notes due 2015 on March 22, 2013 and to repay a portion of the balance outstanding under Select’s revolving credit facility.

On May 28, 2013, Select issued and sold $600.0 million aggregate principal amount of 6.375% senior notes due June 1, 2021. Select used the proceeds of the 6.375% senior notes to pay a portion of the amounts then outstanding on the original term loan and the series A term loan and to pay related fees and expenses.

On June 3, 2013, Select amended its existing senior secured credit facilities in order to, among other things:

· extend the maturity date on $293.3 million of its $300.0 million revolving credit facility from June 1, 2016 to March 1, 2018;

· convert the remaining original term loan and series A term loan to a new series C term loan, and lower the interest rate payable on the series C term loan from Adjusted LIBO plus 3.75%, or Alternate Base Rate plus 2.75%, to Adjusted LIBO plus 3.00%, or Alternate Base Rate plus 2.00%, and amend the

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provision of the series C term loan from providing that Adjusted LIBO will at no time be less than 1.75% to providing that Adjusted LIBO will at no time be less than 1.00%;

· lower the interest rate payable on the series B term loan from Adjusted LIBO plus 3.75%, or Alternate Base Rate plus 2.75%, to Adjusted LIBO plus 3.25%, or Alternate Base Rate plus 2.25%;

· amend the restrictive covenants governing the senior secured credit facilities in order to allow for unlimited restricted payments so long as there is no event of default under the senior secured credit facilities and the total pro forma ratio of total indebtedness to Consolidated EBITDA (as defined in the senior secured credit facilities) is less than or equal to 2.75 to 1.00; and

· amend the definition of “Available Amount” in a manner the effect of which was to increase the amount available for investments, restricted payments and payment of specified indebtedness.

On March 4, 2014, Select made a principal prepayment of $34.0 million associated with its term loans in accordance with the provision in its senior secured credit facilities agreement that requires mandatory prepayments of term loans resulting from excess cash flow as defined in the senior secured credit facilities.

On March 4, 2014, Select amended its senior secured credit facilities in order to, among other things:

· convert the remaining series B term loan to a new series D term loan, and lower the interest rate payable on the series D term loan from Adjusted LIBO plus 3.25%, or Alternate Base Rate plus 2.25%, to Adjusted LIBO plus 2.75%, or Alternate Base Rate plus 1.75%;

· set the maturity date of the series D term loan at December 20, 2016;

· convert the remaining series C term loan to a new series E term loan, and lower the interest rate payable on the series E term loan from Adjusted LIBO plus 3.00% (subject to an Adjusted LIBO rate floor of 1.00%), or Alternate Base Rate plus 2.00%, to Adjusted LIBO plus 2.75% (subject to an Adjusted LIBO rate floor of 1.00%), or Alternate Base Rate plus 1.75%;

· set the maturity date of the series E term loan at June 1, 2018;

· beginning with the quarter ending March 31, 2014, increase the quarterly compliance threshold set forth in the leverage ratio financial maintenance covenant to a level of 5.00 to 1.00 from 4.50 to 1.00;

· provide for a prepayment premium of 1.00% if the senior secured credit facilities are amended at any time prior to September 4, 2014 in the case of the series D term loans and March 4, 2015 in the case of the series E term loans and such amendment reduces the yield applicable to such loans; and

· amend the definition of “Available Amount” in a manner the effect of which was to increase the amount available for investments, restricted payments and the payment of specified indebtedness.

At June 30, 2014, Select’s senior secured credit facilities provide for senior secured financing consisting of:

· a $300.0 million, revolving credit facility, $293.3 million of which matures on March 1, 2018 and the remaining $6.7 million maturing on June 1, 2016, including a $75.0 million sublimit for the issuance of standby letters of credit and a $25.0 million sublimit for swingline loans;

· a $284.6 million series D term loan, maturing on December 20, 2016; and

· a $495.6 million series E term loan, maturing on June 1, 2018.

All borrowings under Select’s senior secured credit facilities are subject to the satisfaction of required conditions, including the absence of a default at the time of and after giving effect to such borrowing and the accuracy of the representations and warranties of the borrowers.

The interest rates per annum applicable to borrowings under Select’s senior secured credit facilities are, at its option, equal to either an Alternate Base Rate or an Adjusted LIBO rate for a one, two, three or six month

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interest period, or a nine or twelve month period if available, in each case, plus an applicable margin percentage. The Alternate Base Rate is the greatest of (1) JPMorgan Chase Bank, N.A.’s prime rate, (2) one-half of 1% over the weighted average of rates on overnight Federal funds as published by the Federal Reserve Bank of New York and (3) the Adjusted LIBO rate from time to time for an interest period of one month, plus 1.00%. The Adjusted LIBO rate is, with respect to any interest period, the London interbank offered rate for such interest period, adjusted for any applicable statutory reserve requirements.

Borrowings under the series D term loan bear interest at a rate equal to Adjusted LIBO plus 2.75%, or Alternate Base Rate plus 1.75%. Borrowings under the series E term loan bear interest at a rate equal to Adjusted LIBO plus 2.75%, or Alternate Base Rate plus 1.75%. The Adjusted LIBO for the series E term loan will at no time be less than 1.00%.

Borrowings under the revolving credit facility bear interest at a rate equal to Adjusted LIBO plus a percentage ranging from 2.75% to 3.75%, or Alternate Base Rate plus a percentage ranging from 1.75% to 2.75%, in each case based on Select’s ratio of total indebtedness to Consolidated EBITDA (as defined in the senior secured credit facilities).

On the last day of each calendar quarter Select is required to pay each lender a commitment fee in respect of any unused commitments under the revolving credit facility, which is currently 0.50% per annum subject to adjustment based upon the ratio of Select’s total indebtedness to Consolidated EBITDA (as defined in the senior secured credit facilities).

Subject to exceptions, Select’s senior secured credit facilities require mandatory prepayments of term loans in amounts equal to:

· 50% (as may be reduced based on Select’s ratio of total indebtedness to Consolidated EBITDA (as defined in the senior secured credit facilities)) of Select’s annual excess cash flow;

· 100% of the net cash proceeds from non-ordinary course asset sales or other dispositions, or as a result of a casualty or condemnation event, subject to reinvestment rights and certain other exceptions; and

· 100% of the net cash proceeds from certain incurrences of debt.

Beginning on March 31, 2015, the senior secured credit facilities principal amount will amortize as follows:

· the series D term loan has quarterly principal repayment requirements of $0.7 million until maturity, at which time the remaining balance of $279.5 million is due on December 20, 2016; and

· the series E term loan has quarterly principal repayment requirements of $1.3 million until maturity, at which time the remaining balance of $479.2 million is due on June 1, 2018.

Select’s senior secured credit facilities are guaranteed by Holdings, Select and substantially all of its current subsidiaries, and will be guaranteed by substantially all of Select’s future subsidiaries and secured by substantially all of Select’s existing and future property and assets and by a pledge of its capital stock and the capital stock of its subsidiaries.

Select’s senior secured credit facilities require that it comply on a quarterly basis with certain financial covenants, including a maximum leverage ratio test.

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In addition, Select’s senior secured credit facilities include negative covenants, subject to significant exceptions, restricting or limiting its ability and the ability of Holdings and Select’s restricted subsidiaries, to, among other things:

· incur, assume, permit to exist or guarantee additional debt and issue or sell or permit any subsidiary to issue or sell preferred stock;

· amend, modify or waiver any rights under the certificate of indebtedness, credit agreements, certificate of incorporation, bylaws or other organizational documents which would be materially adverse to the creditors;

· pay dividends or other distributions on, redeem, repurchase, retire or cancel capital stock;

· purchase or acquire any debt or equity securities of, make any loans or advances to, guarantee any obligation of, or make any other investment in, any other company;

· incur or permit to exist certain liens on property or assets owned or accrued or assign or sell any income or revenues with respect to such property or assets;

· sell or otherwise transfer property or assets to, purchase or otherwise receive property or assets from, or otherwise enter into transactions with affiliates;

· merge, consolidate or amalgamate with another company or permit any subsidiary to merge, consolidate or amalgamate with another company;

· sell, transfer, lease or otherwise dispose of assets, including any equity interests;

· repay, redeem, repurchase, retire or cancel any subordinated debt;

· incur capital expenditures;

· engage to any material extent in any business other than business of the type currently conducted by Select or reasonably related businesses; and

· incur obligations that restrict the ability of its subsidiaries to incur or permit to exist any liens on Select’s property or assets or to make dividends or other payments to Select.

Select’s senior secured credit facilities also contain certain representations and warranties, affirmative covenants and events of default. The events of default include payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to certain indebtedness, certain events of bankruptcy, certain events under ERISA, material judgments, actual or asserted failure of any guaranty or security document supporting Select’s senior secured credit facilities to be in full force and effect and any change of control. If such an event of default occurs, the lenders under Select’s senior secured credit facilities will be entitled to take various actions, including the acceleration of amounts due under the senior secured credit facilities and all actions permitted to be taken by a secured creditor.

At June 30, 2014, Select had outstanding borrowings of $780.2 million (excluding unamortized original issue discounts of $4.8 million) under the term loans and borrowings of $110.0 million (excluding letters of credit) under the revolving loan portion of the senior secured credit facilities. Select had $147.7 million of availability under its revolving credit facility (after giving effect to $42.3 million of outstanding letters of credit) at June 30, 2014.

The applicable margin percentage for borrowings under Select’s revolving loan is subject to change based upon the ratio of Select’s leverage ratio (as defined in the senior secured credit facility). The applicable interest rate for revolving loans as of June 30, 2014 was (1) Alternate Base plus 2.75% for alternate base rate loans and (2) LIBO plus 3.75% for adjusted LIBO rate loans.

Select’s senior secured credit facility requires it to maintain certain leverage ratios (as defined in the senior secured credit facility). For the four consecutive fiscal quarters ended June 30, 2014, Select was required

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to maintain its leverage ratio (its ratio of total indebtedness to consolidated EBITDA) at less than 5.00 to 1.00. Select’s leverage ratio was 4.47 to 1.00 as of June 30, 2014.

Senior Notes

On March 11, 2014, Select issued and sold $110.0 million aggregate principal amount of additional 6.375% senior notes due June 1, 2021 (the “Additional Notes”), at 101.50% of the aggregate principal amount resulting in gross proceeds of $111.7 million. The notes were issued as additional notes under the indenture pursuant to which it previously issued $600.0 million of 6.375% senior notes due June 1, 2021 (the “Existing Notes” and, together with the Additional notes, the “Notes”). The Additional Notes are treated as a single series with the Existing Notes and have the same terms as those of the Existing Notes.

Interest on the Notes accrues at the rate of 6.375% per annum and is payable semi-annually in cash in arrears on June 1 and December 1 of each year. The Notes are Select’s senior unsecured obligations and rank equally in right of payment with all of its other existing and future senior unsecured indebtedness and senior in right of payment to all of its existing and future subordinated indebtedness. The Notes are fully and unconditionally guaranteed by all of Select’s wholly owned subsidiaries. The Notes are guaranteed, jointly and severally, by Select’s direct or indirect existing and future domestic restricted subsidiaries other than certain non-guarantor subsidiaries.

Select may redeem some or all of the Notes prior to June 1, 2016 by paying a “make-whole” premium. Select may redeem some or all of the Notes on or after June 1, 2016 at specified redemption prices. In addition, prior to June 1, 2016, Select may redeem up to 35% of the Notes with the net proceeds of certain equity offerings at a price of 106.375% plus accrued and unpaid interest, if any. Select is obligated to offer to repurchase the Notes at a price of 101% of their principal amount plus accrued and unpaid interest, if any, as a result of certain change of control events. These restrictions and prohibitions are subject to certain qualifications and exceptions.

The indenture relating to the Notes contains covenants that, among other things, limit Select’s ability and the ability of certain of its subsidiaries to (i) grant liens on its assets, (ii) make dividend payments, other distributions or other restricted payments, (iii) incur restrictions on the ability of Select’s restricted subsidiaries to pay dividends or make other payments, (iv) enter into sale and leaseback transactions, (v) merge, consolidate, transfer or dispose of substantially all of their assets, (vi) incur additional indebtedness, (vii) make investments, (viii) sell assets, including capital stock of subsidiaries, (ix) use the proceeds from sales of assets, including capital stock of restricted subsidiaries, and (x) enter into transactions with affiliates. In addition, the Indenture requires, among other things, Select to provide financial and current reports to holders of the Notes or file such reports electronically with the SEC. These covenants are subject to a number of exceptions, limitations and qualifications set forth in the Indenture.

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Maturities of Long-Term Debt and Notes Payable

Maturities of the Company’s long-term debt for the period from July 1, 2014 through December 31, 2014 and the years after 2014 are approximately as follows and are presented including the discounts on the senior secured credit facility term loans and premium on the senior notes (in thousands):

July 1, 2014 – December 31, 2014	$	9,647
2015	10,538
2016	286,916
2017	4,265
2018	590,216
2019 and beyond	711,950

Loss on Early Retirement of Debt

On March 4, 2014, Select amended its term loans under its senior secured credit facilities. During the six months ended June 30, 2014, the Company recognized a loss of $2.3 million for unamortized debt issuance costs, unamortized original issue discount, and certain fees incurred related to term loan modifications.

On May 28, 2013, Select repaid a portion of its original term loan and series A term loan under its senior secured credit facilities, and on June 3, 2013, Select amended its existing senior secured credit facilities. During the six months ended June 30, 2013, the Company recognized a loss of $17.3 million for unamortized debt issuance costs, unamortized original issue discount and certain debt issuance costs associated with refinancing activities.

On March 22, 2013, the Company redeemed Select’s 7 5/8% senior subordinated notes due 2015 and redeemed Holdings’ senior floating rate notes due 2015. During the three months ended March 31, 2013, the Company recognized a loss on early retirement of debt of $1.5 million for unamortized debt issuance costs of which approximately $0.5 million was associated with Select’s redemption of its 7 5/8% senior subordinated notes due 2015 and approximately $1.0 million was associated with Holdings’ redemption of its senior floating rate notes due 2015.

6. Fair Value

Financial instruments include cash and cash equivalents, notes payable and long-term debt. The carrying amount of cash and cash equivalents approximates fair value because of the short-term maturity of these instruments.

The carrying value of Select’s senior secured credit facilities was $827.8 million and $885.3 million at December 31, 2013 and June 30, 2014, respectively. The fair value of Select’s senior secured credit facilities was $834.7 million and $881.1 million at December 31, 2013 and June 30, 2014, respectively. The fair value of Select’s senior secured credit facilities was based on quoted market prices for this debt in the syndicated loan market.

The carrying value of Select’s 6.375% senior notes was $600.0 million and $711.6 million at December 31, 2013 and June 30, 2014, respectively. The fair value of Select’s 6.375% senior notes was $586.5 million and $742.0 million at December 31, 2013 and June 30, 2014, respectively. The fair value of this debt was based on quoted market prices.

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The Company considers the inputs in the valuation process of its senior secured credit facility and 6.375% senior notes to be Level 2 in the fair value hierarchy. Level 2 in the fair value hierarchy is defined as inputs that are observable for the asset or liability, either directly or indirectly which includes quoted prices for identical assets or liabilities in markets that are not active.

7. Segment Information

The Company’s reportable segments consist of (i) specialty hospitals and (ii) outpatient rehabilitation. Other activities include the Company’s corporate services and certain other non-consolidating joint ventures and minority investments in other healthcare related businesses. The outpatient rehabilitation reportable segment has two operating segments: outpatient rehabilitation clinics and contract therapy. These operating segments are aggregated for reporting purposes as they have common economic characteristics and provide a similar service to a similar patient base. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance of the segments based on Adjusted EBITDA. Adjusted EBITDA is defined as net income before interest, income taxes, depreciation and amortization, gain (loss) on early retirement of debt, stock compensation expense, equity in earnings (losses) of unconsolidated subsidiaries and other income (expense).

The following tables summarize selected financial data for the Company’s reportable segments. The segment results of Holdings are identical to those of Select.

	Three Months Ended June 30, 2013
	Specialty Hospitals		Outpatient Rehabilitation		Other			Total
	(in thousands)

Net operating revenues	$	559,386	$	197,080	$	207		$	756,673
Adjusted EBITDA	96,393		26,054		(16,489		)	105,958
Total assets	2,229,458		502,497		113,100			2,845,055
Capital expenditures	10,203		2,999		761			13,963

	Three Months Ended June 30, 2014
	Specialty Hospitals		Outpatient Rehabilitation		Other			Total
	(in thousands)

Net operating revenues	$	557,833	$	214,798	$	131		$	772,762
Adjusted EBITDA	88,688		30,432		(17,766		)	101,354
Total assets	2,271,256		532,529		99,986			2,903,771
Capital expenditures	19,800		2,546		848			23,194

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	Six Months Ended June 30, 2013
	Specialty Hospitals		Outpatient Rehabilitation		Other			Total
	(in thousands)

Net operating revenues	$	1,117,137	$	389,181	$	310		$	1,506,628
Adjusted EBITDA	189,740		48,887		(32,588		)	206,039
Total assets	2,229,458		502,497		113,100			2,845,055
Capital expenditures	21,100		5,844		1,018			27,962

	Six Months Ended June 30, 2014
	Specialty Hospitals		Outpatient Rehabilitation		Other			Total
	(in thousands)

Net operating revenues	$	1,122,458	$	412,648	$	234		$	1,535,340
Adjusted EBITDA	180,838		51,421		(34,077		)	198,182
Total assets	2,271,256		532,529		99,986			2,903,771
Capital expenditures	41,298		6,176		3,019			50,493

A reconciliation of Adjusted EBITDA to income before income taxes is as follows:

	Three Months Ended June 30, 2013
	Specialty Hospitals			Outpatient Rehabilitation			Other
	(in thousands)
Adjusted EBITDA	$	96,393		$	26,054		$	(16,489	)
Depreciation and amortization	(11,932		)	(3,001		)	(974		)
Stock compensation expense	—			—			(1,788		)

										Select Medical Holdings Corporation			Select Medical Corporation
Income (loss) from operations	$	84,461		$	23,053		$	(19,251	)	$	88,263		$	88,263
Loss on early retirement of debt										(17,280		)	(17,280		)
Equity in earnings of unconsolidated subsidiaries										568			568
Interest expense										(21,904		)	(21,904		)
Income before income taxes										$	49,647		$	49,647

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	Three Months Ended June 30, 2014
	Specialty Hospitals			Outpatient Rehabilitation			Other
	(in thousands)
Adjusted EBITDA	$	88,688		$	30,432		$	(17,766	)
Depreciation and amortization	(13,067		)	(3,225		)	(904		)
Stock compensation expense	—			—			(1,965		)

										Select Medical Holdings Corporation			Select Medical Corporation
Income (loss) from operations	$	75,621		$	27,207		$	(20,635	)	$	82,193		$	82,193
Equity in earnings of unconsolidated subsidiaries										1,239			1,239
Interest expense										(21,663		)	(21,663		)
Income before income taxes										$	61,769		$	61,769

	Six Months Ended June 30, 2013
	Specialty Hospitals			Outpatient Rehabilitation			Other
	(in thousands)
Adjusted EBITDA	$	189,740		$	48,887		$	(32,588	)
Depreciation and amortization	(23,794		)	(5,970		)	(1,945		)
Stock compensation expense	—			—			(3,537		)

										Select Medical Holdings Corporation			Select Medical Corporation
Income (loss) from operations	$	165,946		$	42,917		$	(38,070	)	$	170,793		$	170,793
Loss on early retirement of debt										(18,747		)	(17,788		)
Equity in earnings of unconsolidated subsidiaries										1,626			1,626
Interest expense										(45,362		)	(42,952		)
Income before income taxes										$	108,310		$	111,679

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	Six Months Ended June 30, 2014
	Specialty Hospitals			Outpatient Rehabilitation			Other
	(in thousands)
Adjusted EBITDA	$	180,838		$	51,421		$	(34,077	)
Depreciation and amortization	(25,162		)	(6,437		)	(1,826		)
Stock compensation expense	—			—			(4,120		)

										Select Medical Holdings Corporation			Select Medical Corporation
Income (loss) from operations	$	155,676		$	44,984		$	(40,023	)	$	160,637		$	160,637
Loss on early retirement of debt										(2,277		)	(2,277		)
Equity in earnings of unconsolidated subsidiaries										2,147			2,147
Interest expense										(42,279		)	(42,279		)
Income before income taxes										$	118,228		$	118,228

8. Income per Common Share

The Company applies the two-class method for calculating and presenting income per common share. The two-class method is an earnings allocation formula that determines earnings per share for each class of stock participation rights in undistributed earnings. The following table sets forth for the periods indicated the calculation of income per common share in the Company’s consolidated statement of operations and the differences between basic weighted average shares outstanding and diluted weighted average shares outstanding used to compute basic and diluted income per common share, respectively:

	For the Three Months Ended June 30,				For the Six Months Ended June 30,
	2013		2014		2013		2014
	(in thousands, except per share amounts)
Numerator:
Net income attributable to Select Medical Holdings Corporation	$	27,780	$	35,341	$	62,198	$	68,385
Less: Earnings allocated to unvested restricted stockholders	593		919		1,304		1,683
Net income available to common stockholders	$	27,187	$	34,422	$	60,894	$	66,702

Denominator:
Weighted average shares – basic	136,609		127,038		136,997		131,266
Effect of dilutive securities:
Stock options	134		503		168		500
Weighted average shares – diluted	136,743		127,541		137,165		131,766

Basic income per common share	$	0.20	$	0.27	$	0.44	$	0.51
Diluted income per common share	$	0.20	$	0.27	$	0.44	$	0.51

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The following share amounts are shown here for informational and comparative purposes only since their inclusion would be anti-dilutive:

	For the Three Months Ended June 30,		For the Six Months Ended June 30,
	2013	2014	2013	2014
	(in thousands)
Stock options	2,165	—	1,554	—

9. Commitments and Contingencies

Litigation

The Company is a party to various legal actions, proceedings and claims (some of which are not insured), and regulatory and other governmental audits and investigations in the ordinary course of its business. The Company cannot predict the ultimate outcome of pending litigation, proceedings and regulatory and other governmental audits and investigations. These matters could potentially subject the Company to sanctions, damages, recoupments, fines and other penalties. The Department of Justice, Centers for Medicare & Medicaid Services (“CMS”) or other federal and state enforcement and regulatory agencies may conduct additional investigations related to the Company’s businesses in the future that may, either individually or in the aggregate, have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

To address claims arising out of the operations of the Company’s specialty hospitals and outpatient rehabilitation facilities, the Company maintains professional malpractice liability insurance and general liability insurance, subject to self-insured retention of $2.0 million per medical incident for professional liability claims and $2.0 million per occurrence for general liability claims. The Company also maintains umbrella liability insurance covering claims which, due to their nature or amount, are not covered by or not fully covered by the Company’s other insurance policies. These insurance policies also do not generally cover punitive damages and are subject to various deductibles and policy limits. Significant legal actions, as well as the cost and possible lack of available insurance, could subject the Company to substantial uninsured liabilities. In the Company’s opinion, the outcome of these actions, individually or in the aggregate, will not have a material adverse effect on its financial position, results of operations, or cash flows.

Healthcare providers are subject to lawsuits under the qui tam provisions of the federal False Claims Act. Qui tam lawsuits typically remain under seal (hence, usually unknown to the defendant) for some time while the government decides whether or not to intervene on behalf of a private qui tam plaintiff (known as a relator) and take the lead in the litigation. These lawsuits can involve significant monetary damages and penalties and award bounties to private plaintiffs who successfully bring the suits. The Company has been a defendant in these cases in the past, and may be named as a defendant in similar cases from time to time in the future.

On January 8, 2013, a federal magistrate judge unsealed an Amended Complaint in United States of America and the State of Indiana, ex rel. Doe I, Doe II and Doe III v. Select Medical Corporation, Select Specialty Hospital-Evansville, Evansville Physician Investment Corporation, Dr. Richard Sloan and Dr. Jeffrey Selby. The Amended Complaint, which was served on the Company on February 15, 2013, is a civil action filed under seal on September 28, 2012 in the United States District Court for the Southern District of Indiana by private plaintiff-relators on behalf of the United States and the state of Indiana under the federal False Claims Act and Indiana False Claims and Whistleblower Protection Act. Although the Amended Complaint

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identifies the relators by fictitious pseudonyms, on March 28, 2013, the relators filed a Notice identifying themselves as the former CEO at the Company’s long term acute care hospital in Evansville, Indiana (“SSH-Evansville”) and two former case managers at SSH-Evansville. The named defendants include the Company, SSH-Evansville, and two physicians who have practiced at SSH-Evansville. On March 26, 2013, the defendants, relators and the United States filed a joint motion seeking a stay of the proceedings, in which the United States notified the court that its investigation has not been completed and therefore it is not yet able to decide whether or not to intervene, and on March 29, 2013, the magistrate judge granted the motion and stayed all deadlines in the case for 90 days. The court has subsequently granted additional motions filed by the United States to continue the stay, and the current stay extends through September 15, 2014.

In January 2014, representatives of the United States Attorney’s Office for the Southern District of Indiana and the Office of Attorney General for the State of Indiana informed the Company that, while they have not yet decided whether to intervene in the case, their investigation is continuing concerning allegations that SSH-Evansville admitted patients for whom long-term acute care was not medically necessary, up-coded diagnoses at admission, discharged patients too early or held patients too long, readmitted patients discharged to short-stay acute care hospitals only after nine days to enable billing for two admissions, and allowed unnecessary bronchoscopies to be performed. The Company is involved in ongoing discussions with the government regarding this matter.

As previously disclosed, beginning in April 2012, the Company and SSH-Evansville have received various subpoenas and demands for documents relating to SSH-Evansville, including a request for information and subpoenas from the Office of Inspector General of the U.S. Department of Health and Human Services and subpoenas from the Office of Attorney General for the State of Indiana, and the Evansville (Indiana) Police Department has executed a search warrant at SSH-Evansville. The Company has produced and will continue to produce documents in response to, and intends to fully cooperate with, these governmental investigations. At this time, the Company is unable to predict the timing and outcome of this matter.

On July 22, 2014, the United States District Court for the Western District of Wisconsin unsealed a qui tam Complaint in United States of America and State of Wisconsin ex rel. Todd Schmadl v. Select Medical Holdings Corporation and Select Specialty Hospital — Madison, Inc. The Complaint was unsealed after the United States notified the Court on July 21, 2014, that the United States and the State of Wisconsin have decided not to intervene in the case. The Complaint, which has not yet been served on the Company, is a civil action that was filed under seal on July 17, 2013, on behalf of the United States and the State of Wisconsin by a nurse formerly employed at the Company’s long term acute care hospital in Madison. The Complaint alleges violations of the federal False Claims Act and the Wisconsin False Claims for Medical Assistance Act based on inadequate medical care; billing for services that were not performed, were performed by unqualified personnel or were unnecessary; manipulation of patient lengths of stay and readmissions; and providing substandard care at the hospital. The Company intends to vigorously defend this action if the relator pursues it, but at this time the Company is unable to predict the timing and outcome of this matter.

Construction Commitments

At June 30, 2014, the Company had outstanding commitments under construction contracts related to new construction, improvements and renovations at the Company’s long term acute care properties and inpatient rehabilitation facilities totaling approximately $13.8 million.