10-Q/A: Quarterly report pursuant to Section 13 or 15(d)

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q/A

(Amendment No. 1)

(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, 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 1-11316

OMEGA HEALTHCARE
INVESTORS, INC.

(Exact name of Registrant as specified in its charter)

 

9690 Deereco Road, Suite 100, Timonium, MD 21093

(Address of principal executive offices)

(410) 427-1700

(Telephone number, including area code)

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 the filing requirements for the past 90 days.

Yes  o                                                   No  x  The registrant has not filed its Form 10-Q for the quarter ended September 30, 2006.

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

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o

No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of July 31, 2006.

Common Stock, $.10 par value		58,866,857
(Class)		(Number of shares)

 

OMEGA HEALTHCARE INVESTORS, INC.

FORM 10-Q/A

June 30, 2006

TABLE OF CONTENTS

 

		Page No.
PART I	Financial Information
Item 1.	Financial Statements:
	Consolidated Balance Sheets June 30, 2006 (unaudited & restated) and December 31, 2005 (audited & restated)	4
	Consolidated Statements of Operations (unaudited & restated) Three and six months ended June 30, 2006 and 2005	5
	Consolidated Statements of Cash Flows (unaudited & restated) Six months ended June 30, 2006 and 2005	6
	Notes to Consolidated Financial Statements June 30, 2006 (unaudited & restated)	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	54
Item 4.	Controls and Procedures	56
PART II	Other Information	57
Item 1.	Legal Proceedings	57
Item 1A.	Risk Factors	57
Item 4.	Submission of Matters to a Vote of Security Holders	57
Item 5.	Other Information	57
Item 6.	Exhibits	58

 

EXPLANATORY NOTE

This Amendment No. 1 to this Quarterly Report on Form 10-Q/A (“Form 10-Q/A”) is being filed in order to correct the previously issued historical consolidated financial statements of Omega Healthcare Investors, Inc. (“Omega” or the “Company”) as of June 30, 2006 and 2005, initially filed with the Securities and Exchange Commission (the “SEC”) on August 4, 2006, for errors in previously reported amounts related to income tax matters and asset values, as well as to reflect as well as the recording of straight-line rental income.

For the convenience of the reader, this Form 10-Q/A includes all of the information contained in the original report on Form 10-Q, and no attempt has been made in this Form 10-Q/A to modify or update the disclosures presented in the original report on Form 10-Q, except as required to reflect the effects of the restatement. The Form 10-Q/A does not reflect events occurring after the filing of the Form 10-Q or modify or update those disclosures, including the exhibits to the Form 10-Q affected by subsequent events. Information not affected by the restatement is unchanged and reflects the disclosures made at the time of the original filing of the Form 10-Q on August 4, 2006.  Accordingly, this Form 10-Q/A should be read in conjunction with our filings made with the Securities and Exchange Commission subsequent to the filing of the original Form 10-Q, including any amendments to those filings. The following items have been amended as a result of the restatement:

·                  Part I – Item 1 – Financial Statements;

·                  Part I – Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations;

·                  Part I – Item 3 – Quantitative and Qualitative Disclosures About Market Risks;

·                  Part I – Item 4 – Controls and Procedures; and

·                  Part II – Item 1A – Risk Factors.

We have not amended and do not intend to amend our previously filed Quarterly Reports on Form 10-Q for periods affected by the restatement other than the Form 10-Q for the fiscal quarter March 31, 2006. For this reason, the consolidated financial statements, auditors’ reports and related financial information for the affected periods contained in any other prior reports should no longer be relied upon.  In addition, this Form 10-Q/A includes current certifications from our CEO and CFO as Exhibits 31.1, 31.2, 32.1 and 32.2.

Our Board of Directors, including our Audit Committee, concluded on October 24, 2006, to restate our audited financial results as of December 31, 2005 and 2004 and for the three years ended December 31, 2005, 2004 and 2003 and for other periods affected, including our unaudited financial statements for each quarterly period in 2004, 2005 and 2006 as necessary (the “Restatement”).  The Restatement reflects the following adjustments:

1.               We have recorded asset values for securities received from Advocat Inc. (“Advocat”) (and the increases therein) since the completion of the restructuring of Advocat obligations pursuant to leases and mortgages for the facilities then operated by Advocat in 2000.  These adjustments will increase net income by $5.9 million and $8.7 million for the three and six months ended June 30, 2006, respectively, and $0.2 million and $0.4 million for the three and six months ended June 30, 2005, respectively.  These adjustments will also increase total assets by $13.6 million and $5.4 million as of June 30, 2006 and December 31, 2005, respectively.  Changes in the fair value of the securities not currently recognized in net income will be reflected in other comprehensive income.

2.               As a result of our holdings of Advocat securities, we have recorded reserves related to a potential tax liability arising from our ownership of such securities.  This tax liability

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along with related interest expense had not been previously accrued for and this adjustment will decrease net income by $0.6 million and $1.1 million for the three and six months ended June 30, 2006, respectively, and $0.6 million and $1.2 million for the three and six months ended June 30, 2005, respectively.  The amount accrued represents the estimated liability, which remains subject to final resolution and therefore is subject to change.

3.               Subsequent to October 25, 2006, we made a correction to our accounting for certain leases because these leases contain provisions (such as increases in rent based on the lesser of a fixed amount or two times the Consumer Price Index) that require us to record rental income on a straight-line basis subject to an appropriate evaluation of collectibility.  We had not previously recorded rental income on these leases on a straight-line basis.  As a result of this adjustment, our net income will increase by $0.9 million and $1.9 million for the three and six months ended June 30, 2006, respectively, and $0.6 million and $1.3 million for the three and six months ended June 30, 2005, respectively.  In addition, net accounts receivable and retained earnings will increase by $11.1 million and $9.1 million as of June 30, 2006 and December 31, 2005, respectively, to reflect the effects of this adjustment from inception of the affected leases.

Additional information about the decision to restate these financial statements can be found in our Current Report on Form 8-K, filed with the SEC on October 25, 2006.

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PART I – FINANCIAL INFORMATION

 

Item 1 - Financial Statements

OMEGA HEALTHCARE INVESTORS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

		June 30,			December 31,
		2006			2005
		(Restated)			(Restated)
		(Unaudited)
ASSETS
Real estate properties
Land and buildings at cost		$	1,060,226		$	996,127
Less accumulated depreciation		(171,948		)	(157,255		)
Real estate properties – net		888,278			838,872
Mortgage notes receivable – net		32,381			104,522
		920,659			943,394
Other investments – net		42,632			28,918
		963,291			972,312
Assets held for sale – net		248			1,243
Total investments		963,539			973,555
Cash and cash equivalents		14,053			3,948
Accounts receivable – net		17,402			15,018
Other assets		13,998			37,769
Total assets		$	1,008,992		$	1,030,290
LIABILITIES AND STOCKHOLDERS’ EQUITY
Revolving line of credit		$	—		$	58,000
Unsecured borrowings – net		484,739			505,429
Other long-term borrowings		41,800			2,800
Accrued expenses and other liabilities		22,399			19,563
Income tax liabilities		4,438			3,299
Operating liabilities for owned properties		125			256
Total liabilities		553,501			589,347
Stockholders’ equity:
Preferred stock		118,488			118,488
Common stock and additional paid-in-capital		680,443			663,607
Cumulative net earnings		264,734			237,069
Cumulative dividends paid		(568,150		)	(536,041		)
Cumulative dividends – redemption		(43,067		)	(43,067		)
Unamortized restricted stock awards		—			(1,167		)
Accumulated other comprehensive income		3,043			2,054
Total stockholders’ equity		455,491			440,943
Total liabilities and stockholders’ equity		$	1,008,992		$	1,030,290

 

Note – The balance sheet at December 31, 2005 has been restated and derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

See notes to consolidated financial statements.

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OMEGA HEALTHCARE INVESTORS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

Unaudited

(in thousands, except per share amounts)

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2006			2005			2006			2005
		(Restated)			(Restated)			(Restated)			(Restated)
Revenues
Rental income		$	29,973		$	23,131		$	59,903		$	45,582
Mortgage interest income		1,154			1,240			2,338			3,196
Other investment income – net		947			793			1,884			1,497
Miscellaneous		332			1,146			441			4,312
Total operating revenues		32,406			26,310			64,566			54,587
Expenses
Depreciation and amortization		7,542			6,044			15,060			11,742
General and administrative		2,313			2,123			4,662			4,235
Provision for uncollectible mortgages, notes and accounts receivable		—			83			—			83
Leasehold expiration expense		—			750			—			750
Total operating expenses		9,855			9,000			19,722			16,810
Income before other income and expense		22,551			17,310			44,844			37,777
Other income (expense):
Interest and other investment income		69			24			182			65
Interest		(9,447		)	(6,948		)	(19,056		)	(13,722		)
Interest – amortization of deferred financing costs		(431		)	(525		)	(1,074		)	(1,031		)
Interest – refinancing costs		—			—			(3,485		)	—
Provision for impairment on equity securities		—			(3,360		)	—			(3,360		)
Change in fair value of derivatives		5,474			(229		)	7,908			(411		)
Total other expense		(4,335		)	(11,038		)	(15,525		)	(18,459		)
Income from continuing operations before income taxes		18,216			6,272			29,319			19,318
Provision for income taxes		(590		)	(606		)	(1,139		)	(1,188		)
Income from continuing operations		17,626			5,666			28,180			18,130
(Loss) from discontinued operations		(136		)	(3,219		)	(515		)	(6,033		)
Net income		17,490			2,447			27,665			12,097
Preferred stock dividends		(2,481		)	(2,864		)	(4,962		)	(6,423		)
Preferred stock conversion and redemption charges		—			(2,013		)	—			(2,013		)
Net income (loss) available to common		$	15,009		$	(2,430	)	$	22,703		$	3,661
Income (loss) per common share:
Basic:
Income from continuing operations		$	0.26		$	0.02		$	0.40		$	0.19
Net income (loss)		$	0.26		$	(0.05	)	$	0.39		$	0.07
Diluted:
Income from continuing operations		$	0.26		$	0.02		$	0.40		$	0.19
Net income (loss)		$	0.26		$	(0.05	)	$	0.39		$	0.07
Dividends declared and paid per common share		$	0.24		$	0.21		$	0.47		$	0.41
Weighted-average shares outstanding, basic		58,158			51,031			57,787			50,980
Weighted-average shares outstanding, diluted		58,283			51,365			57,881			51,339
Components of other comprehensive income:
Net income		$	17,490		$	2,447		$	27,665		$	12,097
Unrealized gain on common stock investment		881			—			1,580			—
Unrealized loss on preferred stock investment		(286		)	(264		)	(590		)	(627		)
Total comprehensive income		$	18,085		$	2,183		$	28,655		$	11,470

 

See notes to consolidated financial statements.

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OMEGA HEALTHCARE INVESTORS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited (in thousands)

		Six Months Ended June 30,
		2006			2005
		(Restated)			(Restated)
Operating activities
Net income		$	27,665		$	12,097
Adjustment to reconcile net income to cash provided by operating activities:
Depreciation and amortization (including amounts in discontinued operations)		15,069			12,793
Provision for impairment on real estate properties (including amounts in discontinued operations)		121			3,700
Provision for uncollectible mortgages, notes and accounts receivable		—			83
Provision for impairment on equity securities		—			3,360
Refinancing costs		3,485			—
Amortization of deferred financing costs		1,074			1,031
Loss on assets sold – net		381			4,202
Restricted stock amortization expense		585			571
Change in fair value of derivatives		(7,908		)	411
Income from accretion of marketable securities to redemption value		(827		)	(815		)
Other		(23		)	(1,516		)
Net change in accounts receivable		(2,384		)	220
Net change in other assets		1,598			135
Net change in tax liabilities		1,139			1,188
Net change in operating assets and liabilities		2,708			(3,077		)
Net cash provided by operating activities		42,683			34,383
Cash flows from investing activities
Acquisition of real estate		—			(120,696		)
Proceeds from sale of real estate investments		657			24,995
Cash in transit from sale		—			(12,689		)
Capital improvements and funding of other investments		(3,649		)	(1,338		)
Proceeds from other investments		17,242			1,262
Investments in other investments		(20,339		)	(5,897		)
Collection of mortgage principal		10,392			60,492
Net cash provided by (used in) investing activities		4,303			(53,871		)
Cash flows from financing activities
Proceeds from credit facility borrowings		48,200			168,000
Payments on credit facility borrowings		(106,200		)	(81,500		)
Receipts from other long-term borrowings		39,000			—
Prepayment of re-financing penalty		(755		)	—
Receipts from dividend reinvestment plan		17,320			757
Receipts/(payments) from exercised options – net		225			(810		)
Dividends paid		(32,109		)	(28,134		)
Redemption of preferred stock		—			(50,013		)
Payment on common stock offering		(178		)	(28		)
Deferred financing costs paid		(2,384		)	(333		)
Net cash (used in) provided by financing activities		(36,881		)	7,939
Increase (decrease) in cash and cash equivalents		10,105			(11,549		)
Cash and cash equivalents at beginning of period		3,948			12,083
Cash and cash equivalents at end of period		$	14,053		$	534
Interest paid during the period		$	12,644		$	13,867

 

See notes to consolidated financial statements.

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OMEGA HEALTHCARE INVESTORS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Unaudited

June 30, 2006

NOTE 1 – BASIS OF PRESENTATION

Business Overview

We have one reportable segment consisting of investments in real estate.  Our business is to provide financing and capital to the long-term healthcare industry with a particular focus on skilled nursing facilities located in the United States.  Our core portfolio consists of long-term lease and mortgage agreements.  All of our leases are “triple-net” leases, which require the tenants to pay all property-related expenses.  Our mortgage revenue derives from fixed-rate mortgage loans, which are secured by first mortgage liens on the underlying real estate and personal property of the mortgagor.  Substantially all depreciation expenses reflected in the consolidated statements of operations relate to the ownership of our investment in real estate.

Restated Financial Data

We have restated certain historical results in the accompanying consolidated financial statements to correct errors in previously reported amounts related to income tax matters and certain debt and equity investments in Advocat Inc. (“Advocat”), as well as to record certain straight-line rental income.  See Note 2 – Restatement of Previously Issued Financial Statements.

Basis of Presentation

The accompanying unaudited consolidated financial statements for Omega Healthcare Investors, Inc. (“Omega” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In our opinion, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Certain reclassifications have been made to the 2005 financial statements for consistency with the presentation adopted for 2006.  Such reclassifications have no effect on previously reported earnings or equity.

Operating results for the three- and six-month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.  For further information, refer to the financial statements and footnotes included in our annual report on Form 10-K/A for the year ended December 31, 2005.

Our consolidated financial statements include the accounts of Omega, all direct and indirect wholly owned subsidiaries and one variable interest entity (“VIE”) for which we are the primary beneficiary.  All inter-company accounts and transactions have been eliminated in consolidation of the financial statements.

FAS 123R Adoption

In December 2004, the Financial Accounting Standards Board (“FASB”) issued FAS No. 123 (revised 2004), Share-Based Payment (“FAS No. 123R”), which is a revision of FAS No. 123, Accounting for Stock-Based Compensation.  FAS No. 123R supersedes Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and amends FAS No. 95, Statement of Cash Flows.  We adopted FAS No. 123R on January 1, 2006.

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FIN 46R

 

Financial Accounting Standards Board Interpretation No. 46R, Consolidation of Variable Interest Entities, (“FIN 46R”), addresses the consolidation by business enterprises of VIEs.  As a result of the adoption of FIN 46R, we consolidate all VIEs for which we are the primary beneficiary.  Generally, a VIE is an entity with one or more of the following characteristics: (a) the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support; (b) as a group the holders of the equity investment at risk lack (i) the ability to make decisions about an entity’s activities through voting or similar rights, (ii) the obligation to absorb the expected losses of the entity, or (iii) the right to receive the expected residual returns of the entity; or (c) the equity investors have voting rights that are not proportional to their economic interests, and substantially all of the entity’s activities either involve, or are conducted on behalf of, an investor that has disproportionately few voting rights.  FIN 46R requires a VIE to be consolidated in the financial statements of the entity that is determined to be the primary beneficiary of the VIE.  The primary beneficiary generally is the entity that will receive a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both.

In accordance with FIN 46R, we determined that we were the primary beneficiary of one VIE.  This VIE is derived from a financing relationship entered into between Omega and one company that is engaged in the ownership and rental of six skilled nursing facilities (“SNFs”) and one assisted living facility (“ALF”).  The consolidation of the VIE as of June 30, 2006 resulted in an increase in our consolidated total assets (primarily real estate) and liabilities (primarily indebtedness) of approximately $38.2 million.  The creditors of the VIE do not have recourse to our assets.

FIN 48 Evaluation

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for 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.  We are currently evaluating the impact, if any, that FIN 48 will have on our financial statements.

NOTE 2 – RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS

Summary of Restatement Items

Our Board of Directors, including our Audit Committee, concluded on October 24, 2006, to restate certain historical results to correct errors in previously reported amounts related to tax matters and asset values, as well as to record certain straight-line rental income (the “Restatement”).  The Restatement reflects the following adjustments:

1.               We have recorded asset values for securities received from Advocat (and the increases therein) since the completion of the restructuring of Advocat obligations pursuant to leases and mortgages for the facilities then operated by Advocat in 2000.  These adjustments will increase net income by $5.9 million and $8.7 million for the three and six months ended June 30, 2006, respectively, and $0.2 million and $0.4 million for the three and six months ended June 30, 2005, respectively.  These adjustments will also increase total assets by $13.6 million and $5.4 million as of June 30, 2006 and December 31, 2005, respectively.  Changes in the fair value of the securities not currently recognized in net income will be reflected in other comprehensive income.

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2.               As a result of our holdings of Advocat securities, we have recorded reserves related to a potential tax liability arising from our ownership of such securities.  This tax liability along with related interest expense had not been previously accrued for and this adjustment will decrease net income by $0.6 million and $1.1 million for the three and six months ended June 30, 2006, respectively, and $0.6 million and $1.2 million for the three and six months ended June 30, 2005, respectively.  The amount accrued represents the estimated liability, which remains subject to final resolution and therefore is subject to change.

3.               Subsequent to October 25, 2006, we made a correction to our accounting for certain leases because these leases contain provisions (such as increases in rent based on the lesser of a fixed amount or two times the Consumer Price Index) that require us to record rental income on a straight-line basis subject to an appropriate evaluation of collectibility.  We had not previously recorded rental income on these leases on a straight-line basis.  As a result of this adjustment, our net income will increase by $0.9 million and $1.9 million for the three and six months ended June 30, 2006, respectively, and $0.6 million and $1.3 million for the three and six months ended June 30, 2005, respectively. In addition, net accounts receivable and retained earnings will increase by $11.1 million and $9.1 million as of June 30, 2006 and December 31, 2005, respectively, to reflect the effects of this adjustment from inception of the affected leases.

Additional information about the decision to restate these financial statements can be found in our Current Report on Form 8-K, filed with the SEC on October 25, 2006.

Events Causing the Restatement - Advocat Restructuring

In November 2000, Advocat, an operator of various skilled nursing facilities owned by or mortgaged to us, was in default on its obligations to us.  As a result, we entered into an agreement with Advocat with respect to the restructuring of Advocat’s obligations pursuant to leases and mortgages for the facilities then operated by Advocat (the “Initial Advocat Restructuring”).  As part of the Initial Advocat Restructuring in 2000, Advocat issued to us (i) 393,658 shares of Advocat’s Series B non-voting, redeemable (on or after September 30, 2007), convertible preferred stock, which was convertible into up to 706,576 shares of Advocat’s common stock (representing 9.9% of the outstanding shares of Advocat’s common stock on a fully diluted, as-converted basis and accruing dividends at 7% per annum), and (ii) a secured convertible subordinated note in the amount of $1.7 million bearing interest at 7% per annum with a September 30, 2007 maturity.

Subsequent to the Initial Advocat Restructuring, Advocat’s operations and financial condition have improved and there has been a significant increase in the market value of Advocat’s common stock from approximately $0.31 per share at the time of the Initial Advocat Restructuring to the closing price on October 20, 2006 of $18.84.  As a result of the significant increase in the value of the common stock underlying the Series B preferred stock of Advocat held by us, on October 20, 2006 we again restructured our relationship with Advocat (the “Second Advocat Restructuring”) by entering into a Restructuring Stock Issuance and Subscription Agreement with Advocat (the “2006 Advocat Agreement”). Pursuant to the 2006 Advocat Agreement, we exchanged the Advocat Series B preferred stock and subordinated note issued in the Initial Advocat Restructuring for 5,000 shares of Advocat’s Series C non-convertible, redeemable (at our option after September 30, 2010) preferred stock with a face value of approximately $4.9 million and a dividend rate of 7% payable quarterly, and a secured non-convertible subordinated note in the amount of $2.5 million maturing September 30, 2007 and bearing interest at 7% per annum.  As part of the Second Advocat Restructuring, we also amended our Consolidated Amended and Restated Master Lease by and between one of our subsidiaries, as lessor, and a subsidiary of Advocat, as lessee, to commence a new 12-year lease term through September 30, 2018 (with a renewal option for an additional 12 year term) and Advocat has agreed to increase the master lease annual rent by approximately $687,000 to approximately $14 million commencing on January 1, 2007.

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Management believes that certain of the terms of the Advocat Series B preferred stock previously held by us could be interpreted as affecting our compliance with federal income tax rules applicable to real estate investment trusts (“REITs”) regarding related party tenant income as described below.

In 2000 at the time of the Initial Advocat Restructuring, we determined that no value should be ascribed to the Advocat preferred stock and subordinated note and, as a result, no value was recorded on our financial statements at that time or in any subsequent period.  Management now believes that the accounting treatment in previous periods was incorrect and, in addition to the related party tenant issues described below, the Restatement reflects the appropriate carrying value (in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (“FAS No. 115”)) of the Advocat preferred stock of $4.6 million and $4.3 million and an embedded derivative (in accordance with FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS No. 133) of $9.0 million and $1.1 million on our restated balance sheets as of June 30, 2006 and December 31, 2005, respectively.  In addition, in accordance with FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan (“FAS No. 114”), the Advocat subordinated note of $1.7 million was fully reserved at June 30, 2006 and December 31, 2005, respectively.

The market value for Advocat’s common stock has increased significantly since the completion of the Initial Advocat Restructuring.  In connection with exploring the potential disposition of the Advocat Series B preferred stock as part of the Second Advocat Restructuring, we were advised by our tax counsel that due to the structure of the Initial Advocat Restructuring, Advocat may be deemed to be a “related party tenant” under applicable federal income tax rules and, in such event, rental income from Advocat would not be qualifying income under the gross income tests that are applicable to REITs.

In order to maintain qualification as a REIT, we annually must satisfy certain tests regarding the source of our gross income.  The applicable federal income tax rules provide a “savings clause” for REITs that fail to satisfy the REIT gross income tests, if such failure is due to reasonable cause.  A REIT that qualifies for the savings clause will retain its REIT status but will pay a tax under section 857(b)(5) and related interest.

We currently plan to submit to the IRS a request for a closing agreement to resolve the “related party tenant” issue.  While we believe there are valid arguments that Advocat should not be deemed a “related party tenant,” the matter is not free from doubt, and we believe it is in our best interest to request a closing agreement in order to resolve the matter, minimize potential interest charges and obtain assurances regarding its continuing REIT status.  By submitting a request for a closing agreement, we intend to establish that any failure to satisfy the gross income tests was due to reasonable cause.  In the event that it is determined that the “savings clause” described above does not apply, we could be treated as having failed to qualify as a REIT for one or more taxable years.  If we fail to qualify for taxation as a REIT for any taxable year, our income will be taxed at regular corporate rates, and we could be disqualified as a REIT for the following four taxable years.

As noted above, we have completed the Second Advocat Restructuring and have been advised by tax counsel that we will not receive any non-qualifying related party tenant income from Advocat in future fiscal years.  Accordingly, we do not expect to incur tax expense associated with related party tenant income in future periods commencing January 1, 2007.  We will continue to accrue an income tax liability related to this matter during 2006.

Recording of Rental Income

During the course of preparing the Restatement due to the issues related to Advocat described above, we determined that we should correct our accounting for certain leases because these leases contain provisions (such as increases in rent based on the lesser of a fixed amount or two times the Consumer Price Index) that require us to record rental income on a straight-line basis subject to an appropriate evaluation of collectibility.  Historically, we have recorded rental income for leases with these

10

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provisions based on contractual scheduled rent payments, rather than on a straight-line basis.  In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 13, Accounting for Leases and Financial Accounting Standards Board Technical Bulletin No. 88-1 Issues Related to Accounting for Leases, we have determined that the recording of rental revenue associated with these leases should be on a straight-line basis.  As a result of this adjustment, our net income will increase by $0.9 million and $1.9 million for the three and six months ended June 30, 2006, respectively, and $0.6 million and $1.3 million for the three and six months ended June 30, 2005, respectively.  In addition, net accounts receivable and retained earnings will increase by $11.1 million and $9.1 million as of June 30, 2006 and December 31, 2005, respectively, to reflect the effects of this adjustment from inception of the affected leases.

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The following table sets forth the effects of the adjustments related to the Restatement on our consolidated balance sheets as of June 30, 2006 and December 31, 2005:

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands)

		As of June 30, 2006,
		As Reported			Adjustments			Restated
ASSETS
Real estate properties
Land and buildings at cost		$	1,060,226		$	—		$	1,060,226
Less accumulated depreciation		(171,948		)	—			(171,948		)
Real estate properties – net		888,278			—			888,278
Mortgage notes receivable – net		32,381			—			32,381
		920,659			—			920,659
Other investments – net		29,060			13,572			42,632
		949,719			13,572			963,291
Assets held for sale – net		248			—			248
Total investments		949,967			13,572			963,539
Cash and cash equivalents		14,053			—			14,053
Accounts receivable – net		6,342			11,060			17,402
Other assets		13,998			—			13,998
Total assets		$	984,360		$	24,632		$	1,008,992
LIABILITIES AND STOCKHOLDERS’ EQUITY
Revolving line of credit		$	—		$	—		$	—
Unsecured borrowings – net		484,739			—			484,739
Other long-term borrowings		41,800			—			41,800
Accrued expenses and other liabilities		22,399			—			22,399
Income tax liabilities		—			4,438			4,438
Operating liabilities for owned properties		125			—			125
Total liabilities		549,063			4,438			553,501
Stockholders’ equity:
Preferred stock		118,488			—			118,488
Common stock and additional paid-in-capital		680,443			—			680,443
Cumulative net earnings		245,843			18,891			264,734
Cumulative dividends paid		(568,150		)	—			(568,150		)
Cumulative dividends – redemption		(43,067		)	—			(43,067		)
Unamortized restricted stock awards		—			—			—
Accumulated other comprehensive income		1,740			1,303			3,043
Total stockholders’ equity		435,297			20,194			455,491
Total liabilities and stockholders’ equity		$	984,360		$	24,632		$	1,008,992

 

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CONSOLIDATED BALANCE SHEETS

(Audited)

(in thousands)

		As of December 31, 2005,
		As Reported			Adjustments			Restated
ASSETS
Real estate properties
Land and buildings at cost		$	996,127		$	—		$	996,127
Less accumulated depreciation		(157,255		)	—			(157,255		)
Real estate properties – net		838,872			—			838,872
Mortgage notes receivable – net		104,522			—			104,522
		943,394			—			943,394
Other investments – net		23,490			5,428			28,918
		966,884			5,428			972,312
Assets held for sale – net		1,243			—			1,243
Total investments		968,127			5,428			973,555
Cash and cash equivalents		3,948			—			3,948
Accounts receivable – net		5,885			9,133			15,018
Other assets		37,769			—			37,769
Total assets		$	1,015,729		$	14,561		$	1,030,290
LIABILITIES AND STOCKHOLDERS’ EQUITY
Revolving line of credit		$	58,000		$	—		$	58,000
Unsecured borrowings – net		505,429			—			505,429
Other long–term borrowings		2,800			—			2,800
Accrued expenses and other liabilities		19,563			—			19,563
Income tax liabilities		—			3,299			3,299
Operating liabilities for owned properties		256			—			256
Total liabilities		586,048			3,299			589,347
Stockholders’ equity:
Preferred stock		118,488			—			118,488
Common stock and additional paid-in-capital		663,607			—			663,607
Cumulative net earnings		227,701			9,368			237,069
Cumulative dividends paid		(536,041		)	—			(536,041		)
Cumulative dividends – redemption		(43,067		)	—			(43,067		)
Unamortized restricted stock awards		(1,167		)	—			(1,167		)
Accumulated other comprehensive income		160			1,894			2,054
Total stockholders’ equity		429,681			11,262			440,943
Total liabilities and stockholders’ equity		$	1,015,729		$	14,561		$	1,030,290

 

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The effects of the adjustments related to the Restatement for the three and six months ended June 30, 2006 and 2005 are summarized below:

CONSOLIDATED STATEMENTS OF OPERATIONS

Unaudited

(in thousands, except per share amounts)

		Three Months Ended June 30, 2006
		As Reported			Adjustments			Restated
Revenues
Rental income		$	29,042		$	931		$	29,973
Mortgage interest income		1,154			—			1,154
Other investment income - net		533			414			947
Miscellaneous		332			—			332
Total operating revenues		31,061			1,345			32,406
Expenses
Depreciation and amortization		7,542			—			7,542
General and administrative		2,313			—			2,313
Total operating expenses		9,855			—			9,855
Income before other income and expense		21,206			1,345			22,551
Other income (expense):
Interest and other investment income		69			—			69
Interest		(9,447		)	—			(9,447		)
Interest – amortization of deferred financing costs		(431		)	—			(431		)
Change in fair value of derivatives		—			5,474			5,474
Total other expense		(9,809		)	5,474			(4,335		)
Income from continuing operations before income taxes		11,397			6,819			18,216
Provision for income taxes		—			(590		)	(590		)
Income from continuing operations		11,397			6,229			17,626
Loss from discontinued operations		(136		)	—			(136		)
Net income		11,261			6,229			17,490
Preferred stock dividends		(2,481		)	—			(2,481		)
Net income available to common		$	8,780		$	6,229		$	15,009
Income per common share:
Basic:
Income from continuing operations		$	0.15		$	0.11		$	0.26
Net income		$	0.15		$	0.11		$	0.26
Diluted:
Income from continuing operations		$	0.15		$	0.11		$	0.26
Net income		$	0.15		$	0.11		$	0.26
Dividends declared and paid per common share		$	0.24		$	—		$	0.24
Weighted-average shares outstanding, basic		58,158			—			58,158
Weighted-average shares outstanding, diluted		58,283			—			58,283
Components of other comprehensive income:
Net income		$	11,261		$	6,229		$	17,490
Unrealized gain (loss) on common stock investment		881			—			881
Unrealized gain (loss) on preferred stock investment		—			(286		)	(286		)
Total comprehensive income		$	12,142		$	5,943		$	18,085

 

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		Three Months Ended June 30, 2005
		As Reported			Adjustments			Restated
Revenues
Rental income		$	22,514		$	617		$	23,131
Mortgage interest income		1,240			—			1,240
Other investment income – net		385			408			793
Miscellaneous		1,146			—			1,146
Total operating revenues		25,285			1,025			26,310
Expenses
Depreciation and amortization		6,044			—			6,044
General and administrative		2,123			—			2,123
Provision for uncollectible mortgages, notes and accounts receivable		83			—			83
Leasehold expiration expense		750			—			750
Total operating expenses		9,000			—			9,000
Income before other income and expense		16,285			1,025			17,310
Other income (expense):
Interest and other investment income		24			—			24
Interest		(6,948		)	—			(6,948		)
Interest – amortization of deferred financing costs		(525		)	—			(525		)
Provision for impairment on equity securities		(3,360		)	—			(3,360		)
Change in fair value of derivatives		—			(229		)	(229		)
Total other expense		(10,809		)	(229		)	(11,038		)
Income from continuing operations before income taxes		5,476			796			6,272
Provision for income taxes		—			(606		)	(606		)
Income from continuing operations		5,476			190			5,666
Loss from discontinued operations		(3,219		)	—			(3,219		)
Net income		2,257			190			2,447
Preferred stock dividends		(2,864		)	—			(2,864		)
Preferred stock conversion and redemption charges		(2,013		)	—			(2,013		)
Net income available to common		$	(2,620	)	$	190		$	(2,430	)
Income per common share:
Basic:
Income from continuing operations		$	0.01		$	0.01		$	0.02
Net income		$	(0.05	)	$	0.00		$	(0.05	)
Diluted:
Income from continuing operations		$	0.01		$	0.01		$	0.02
Net income		$	(0.05	)	$	0.00		$	(0.05	)
Dividends declared and paid per common share		$	0.21		$	—		$	0.21
Weighted-average shares outstanding, basic		51,031			—			51,031
Weighted-average shares outstanding, diluted		51,365			—			51,365
Components of other comprehensive income:
Net income		$	2,257		$	190		$	2,447
Unrealized gain (loss) on common stock investment		—			—			—
Unrealized gain (loss) on preferred stock investment		—			(264		)	(264		)
Total comprehensive income		$	2,257		$	(74	)	$	2,183

 

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		Six Months Ended June 30, 2006
		As Reported			Adjustments			Restated
Revenues
Rental income		$	57,975		$	1,928		$	59,903
Mortgage interest income		2,338			—			2,338
Other investment income – net		1,058			826			1,884
Miscellaneous		441			—			441
Total operating revenues		61,812			2,754			64,566
Expenses
Depreciation and amortization		15,060			—			15,060
General and administrative		4,662			—			4,662
Total operating expenses		19,722			—			19,722
Income before other income and expense		42,090			2,754			44,844
Other income (expense):
Interest and other investment income		182			—			182
Interest		(19,056		)	—			(19,056		)
Interest – amortization of deferred financing costs		(1,074		)	—			(1,074		)
Interest – refinancing costs		(3,485		)	—			(3,485		)
Change in fair value of derivatives		—			7,908			7,908
Total other expense		(23,433		)	7,908			(15,525		)
Income from continuing operations before income taxes		18,657			10,662			29,319
Provision for income taxes		—			(1,139		)	(1,139		)
Income from continuing operations		18,657			9,523			28,180
Loss from discontinued operations		(515		)	—			(515		)
Net income		18,142			9,523			27,665
Preferred stock dividends		(4,962		)	—			(4,962		)
Net income available to common		$	13,180		$	9,523		$	22,703
Income per common share:
Basic:
Income from continuing operations		$	0.24		$	0.16		$	0.40
Net income		$	0.23		$	0.16		$	0.39
Diluted:
Income from continuing operations		$	0.24		$	0.16		$	0.40
Net income		$	0.23		$	0.16		$	0.39
Dividends declared and paid per common share		$	0.47		$	—		$	0.47
Weighted-average shares outstanding, basic		57,787			—			57,787
Weighted-average shares outstanding, diluted		57,881			—			57,881
Components of other comprehensive income:
Net income		$	18,142		$	9,523		$	27,665
Unrealized gain (loss) on common stock investment		1,580			—			1,580
Unrealized gain (loss) on preferred stock investment		—			(590		)	(590		)
Total comprehensive income		$	19,722		$	8,933		$	28,655

 

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		Six Months Ended June 30, 2005
		As Reported			Adjustments			Restated
Revenues
Rental income		$	44,262		$	1,320		$	45,582
Mortgage interest income		3,196			—			3,196
Other investment income – net		682			815			1,497
Miscellaneous		4,312			—			4,312
Total operating revenues		52,452			2,135			54,587
Expenses
Depreciation and amortization		11,742			—			11,742
General and administrative		4,235			—			4,235
Provision for uncollectible mortgages, notes and accounts receivable		83			—			83
Leasehold expiration expense		750			—			750
Total operating expenses		16,810			—			16,810
Income before other income and expense		35,642			2,135			37,777
Other income (expense):
Interest and other investment income		65			—			65
Interest		(13,722		)	—			(13,722		)
Interest – amortization of deferred financing costs		(1,031		)	—			(1,031		)
Provision for impairment on equity securities		(3,360		)	—			(3,360		)
Change in fair value of derivatives		—			(411		)	(411		)
Total other expense		(18,048		)	(411		)	(18,459		)
Income from continuing operations before income taxes		17,594			1,724			19,318
Provision for income taxes		—			(1,188		)	(1,188		)
Income from continuing operations		17,594			536			18,130
Loss from discontinued operations		(6,033		)	—			(6,033		)
Net income		11,561			536			12,097
Preferred stock dividends		(6,423		)	—			(6,423		)
Preferred stock conversion and redemption charges		(2,013		)	—			(2,013		)
Net income available to common		$	3,125		$	536		$	3,661
Income per common share:
Basic:
Income from continuing operations		$	0.18		$	0.01		$	0.19
Net income		$	0.06		$	0.01		$	0.07
Diluted:
Income from continuing operations		$	0.18		$	0.01		$	0.19
Net income		$	0.06		$	0.01		$	0.07
Dividends declared and paid per common share		$	0.41		$	—		$	0.41
Weighted-average shares outstanding, basic		50,980			—			50,980
Weighted-average shares outstanding, diluted		51,339			—			51,339
Components of other comprehensive income:
Net income		$	11,561		$	536		$	12,097
Unrealized gain (loss) on common stock investment		—			—			—
Unrealized gain (loss) on preferred stock investment		—			(627		)	(627		)
Total comprehensive income		$	11,561		$	(91	)	$	11,470

 

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NOTE 3 – PROPERTIES

In the ordinary course of our business activities, we periodically evaluate investment opportunities and extend credit to customers.  We also regularly engage in lease and loan extensions and modifications. Additionally, we actively monitor and manage our investment portfolio with the objectives of improving credit quality and increasing returns.  In connection with portfolio management, we may engage in various collection and foreclosure activities.

If we acquire real estate pursuant to a foreclosure, lease termination or bankruptcy proceeding and do not immediately re-lease or sell the properties to new operators, the assets will be included on the balance sheet as “foreclosed real estate properties,” and the value of such assets is reported at the lower of cost or estimated fair value.

The table below summarizes our number of properties and investment by category for the six months ended June 30, 2006:

					Mortgage						Total
		Leased			Notes			Facilities			Healthcare
		Property			Receivable			Held for Sale			Facilities
Facility Count
Balance at December 31, 2005		192			32			3			227
Properties sold/mortgages paid		—			(15		)	(3		)	(18		)
Properties transferred to assets held for sale		(1		)	—			1			—
Properties transferred to purchase/leaseback		7			(7		)	—			—
Balance at June 30, 2006		198			10			1			209
Investment ($000’s)
Balance at December 31, 2005		$	996,127		$	104,522		$	1,243		$	1,101,892
Properties sold/mortgages paid		—			(48,990		)	(1,860		)	(50,850		)
Properties transferred to assets held for sale		(865		)	—			865			—
Properties transferred to purchase/leaseback		61,750			(22,750		)	—			39,000
Impairment on properties		(121		)	—			—			(121		)
Capital expenditures and other		3,335			(401		)	—			2,934
Balance at June 30, 2006		$	1,060,226		$	32,381		$	248		$	1,092,855

 

Leased Property

Our leased real estate properties, represented by 196 long-term care facilities and two rehabilitation hospitals at June 30, 2006, are leased under provisions of single leases and master leases with initial terms typically ranging from 5 to 15 years, plus renewal options.  Substantially all of the leases and master leases provide for minimum annual rentals that are subject to annual increases based upon increases in the Consumer Price Index (“CPI”).  Under the terms of the leases, the lessee is responsible for all maintenance, repairs, taxes and insurance on the leased properties.

Set forth below is a summary of the transactions that occurred in the six months ended June 30, 2006.

Haven Eldercare, LLC

·                  During the three months ended March 31, 2006, Haven Eldercare, LLC (“Haven”), an existing operator of ours, entered into a $39 million first mortgage loan with General Electric Capital Corporation (“GE Loan”).  Haven used the $39 million of proceeds to partially repay on a $62 million mortgage it has with us.  Simultaneously, we subordinated the payment of our remaining $23 million of the mortgage note, due in October 2012, to that of the GE Loan.  As a result of this transaction, the interest rate on our remaining mortgage note to Haven rose from 10% to approximately 15%, with annual escalators.

·                  In conjunction with the above transactions and the application of FIN 46R, we consolidated the financial statements and related real estate of this Haven entity into our financial statements.  The

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consolidation resulted in the following changes to our consolidated balance sheet as of June 30, 2006: (1) an increase in total gross investments of $39.0 million; (2) an increase in accumulated depreciation of $0.8 million; (3) an increase in other long-term borrowings of $39.0 million; and (4) a reduction of $0.8 million in cumulative net earnings for the six months ended June 30, 2006 due to the increased depreciation expense.  General Electric Capital Corporation and Haven’s other creditors do not have recourse to our assets.  We have an option to purchase the mortgaged facilities for a fixed price in 2012.  Our results of operations reflect the effects of the consolidation of this entity, which is being accounted for similarly to our other purchase-leaseback transactions.

Acquisitions

·                  There were no acquisitions made during the three and six months ended June 30, 2006.

Assets Sold or Held for Sale

Assets Sold

·                  On June 30, 2006, we sold two SNFs in California resulting in an accounting loss of approximately $0.1 million.

·                  On March 31, 2006, we sold a SNF in Illinois resulting in an accounting loss of approximately $0.2 million.

Held for Sale

·                  At June 30, 2006, we had one asset held for sale with a net book value of approximately $0.2 million.

·                  During the three months ended March 31, 2006, a $0.1 million provision for impairment charge was recorded to reduce the carrying value to its sales price of one facility that was under contract to be sold that was subsequently sold during the second quarter of 2006.

Mortgage Notes Receivable

Mortgage notes receivable relate to 10 long-term care facilities.  The mortgage notes are secured by first mortgage liens on the borrowers’ underlying real estate and personal property.  The mortgage notes receivable relate to facilities located in five states, operated by seven independent healthcare operating companies.  We monitor compliance with mortgages and when necessary have initiated collection, foreclosure and other proceedings with respect to certain outstanding loans.  As of June 30, 2006, we had no foreclosed property, and none of our mortgages were in foreclosure proceedings.

Mortgage interest income is recognized as earned over the terms of the related mortgage notes.  Reserves are taken against earned revenues from mortgage interest when collection of amounts due becomes questionable or when negotiations for restructurings of troubled operators lead to lower expectations regarding ultimate collection.  When collection is uncertain, mortgage interest income on impaired mortgage loans is recognized as received after taking into account application of security deposits.

Hickory Creek Healthcare Foundation, Inc.

On June 16, 2006, we received approximately $10 million in proceeds on a mortgage loan payoff.  We held mortgages on 15 facilities located in Indiana, representing 619 beds.

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