Overview

National HealthCare Corporation (ANHC@ or the ACompany@) is a leading provider of long-term health care services. We operate or manage, through certain affiliates, 76 long-term health care centers with 9,772 beds in 10 states and provide other services in two additional states. These operations are provided by separately funded and maintained subsidiaries. We provide long-term health care services to patients in a variety of settings including long-term nursing centers, managed care specialty units, sub-acute care units, Alzheimer's care units, hospice programs, homecare programs, assisted living centers and independent living centers. In addition, we provide management and accounting services to owners of long-term health care centers.

Summary of Goals and Areas of Focus

Earnings - To monitor our earnings, we have developed budgets and management reports to monitor labor, census, and the composition of revenues. Inflationary increases in our costs may cause net earnings from patient services to decline.

Development and Growth - In July, 2008 we opened a 60 bed addition to an existing facility located in North Augusta, South Carolina. We broke ground in September, 2008 for construction of a new 120 bed health care center in Bluffton, South Carolina (expected cost $22,645,000), and in 2009 we broke ground on a new assisted living facility in Mauldin, South Carolina (expected cost of $6,600,000).

In January, 2008, we purchased a 109-bed skilled nursing rehabilitation facility from the St. Mary's Health System for $6,347,000 in cash. Holston Health and Rehabilitation Center is located in Knoxville, Tennessee.

Also in January 2008, we purchased for $5,073,000 in cash, two tracts of land located in the state of South Carolina and one tract of land located in the state of Tennessee. The tracts are undeveloped and are held for future development.

Effective February 1, 2008, we were selected by the McKendree Village, Inc. to manage under a five-year contract McKendree Village, a continuing care retirement community located on 42 acres in the Nashville, Tennessee suburb of Hermitage. McKendree Village offers nursing care in the 300-bed McKendree Health Center, assisted living services in the 85-unit McKendree Manor, and independent senior care living in a 234-unit residential tower and in 39 individually designed cottages.

In August 2008, we purchased for $13,250,000 in cash, a 132-bed skilled nursing and rehabilitation facility and a 60-bed assisted living facility located in Charleston, South Carolina.

In 2009, we are continuing to develop an active hospice program in South Carolina independently of our partnership with Caris Healthcare and are also exploring opportunities to expand our home health care services. Effective January 1, 2009, we purchased five hospice locations in South Carolina for approximately $3,100,000. Also during 2009, we will apply for Certificates of Need for additional beds in our markets and also evaluate the feasibility of expansion into new markets by building private pay health care centers or by the purchase of existing health care centers.

Accrued Risk Reserves - Our accrued professional liability reserves, workers= compensation reserves and health insurance reserves totaled $105,370,000 at March 31, 2009 and are a primary area of management focus. We have set aside restricted cash to fund substantially all of our professional liability and workers= compensation reserves.

As to exposure for professional liability claims, we have developed for our centers performance certification criteria to measure and bring focus to the patient care issues most likely to produce professional liability exposure, including in-house acquired pressure ulcers, significant weight loss and numbers of falls. These programs for certification, which we regularly modify and improve, have produced measurable improvements in reducing these incidents. Our experience is that achieving goals in these patient care areas improves both patient and employee satisfaction. Furthermore, we are continuing efforts to identify and restructure the ownership or management of our higher risk operations and locations to eliminate NHC liability exposure.

Application of Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and cause our reported net income to vary significantly from period to period.

Our critical accounting policies that are both important to the portrayal of our financial condition and results and require our most difficult, subjective or complex judgments are as follows:

Revenue Recognition - Third Party Payors - Approximately 61% (2008), 60% (2007), and 63% (2006) of our net revenues are derived from Medicare, Medicaid, and other government programs. Amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries. In our opinion, adequate provision has been made for any adjustments that may result from these reviews.
Any differences between our estimates of settlements and final determinations are reflected in operations in the year finalized. At March 31, 2009, we have made provisions of approximately $15,662,000 for other various Medicare and Medicaid issues for current and prior year cost reports. Consistent with our revenue recognition policies, we will record revenues associated with the various issues when the approvals, including the final cost report audits, are assured. Revenues for such cost report adjustments in the three months ended March 31, 2009 and 2008 were not significant.

Revenue Recognition - Private Pay - For private pay patients in skilled nursing or assisted living facilities, we bill room and board in advance for the current month with payment being due upon receipt of the statement in the month the services are performed. Charges for ancillary, pharmacy, therapy and other services to private patients are billed in the month following the performance of services. All billings are recognized as revenue when the services are performed.

Valuations and Impairments to our Investment in Cash Fund in Liquidation - At March 31, 2009, we reported an aggregate investment of $5,618,000 in the Columbia Strategic Cash Portfolio Fund (the "Fund") which invests principally in high quality corporate debt, mortgage-backed securities and asset-backed securities. During December, 2007 the Fund's manager notified us that due to turmoil in credit markets in the United States (1) Fund cash redemptions to investors were suspended, (2) the Fund's valuation will be based on the market value of the underlying securities instead of amortized cost, (3) interest would continue to accrue and be paid and (4) the Fund would begin an orderly liquidation and dissolution of its assets for distribution to the Fund holders that is expected to be completed in early 2009. As the Fund is liquidated, we expect to receive our pro rata share of the Fund in cash distributions.

Our investment in the Fund totaled $35,900,000 on December 7, 2007. Since that date, we have received cash distributions of $31,278,000, reported realized losses of $808,000, and reported losses to reduce the Fund balance to its net asset value of $1,796,000. Our investment in the Fund totaled $5,618,000 at March 31, 2009.

The Fund's valuation fluctuates based on changes in the market values of the securities held by the Fund. Considering the continuing deterioration in market conditions during the fourth quarter of 2008 and the lack of current observable market activity, our investment in the Fund was transferred from Level 2 to Level 3 as of October 1, 2008 under the three-tier value hierarchy of SFAS 157.

It is possible that future events could require us to make significant adjustments or revisions to our estimates of the Fund value. Because the Fund is invested in financial instruments with exposure to the current turmoil in the credit markets in the United States, we consider the write-down amounts to be other-than-temporary impairments. It is difficult to predict the timing or magnitude of these other-than-temporary impairments and additional impairments may occur. Management does not expect that the current illiquidity of the Fund will prevent us from meeting our obligations as they come due or from making new investments when and as opportunities arise.

Accrued Risk Reserves - We are principally self-insured for risks related to employee health insurance, workers= compensation and professional and general liability claims. Our accrued risk reserves primarily represent the accrual for self-insured risks associated with employee health insurance, workers= compensation and professional and general liability claims. The accrued risk reserves include a liability for reported claims and estimates for incurred but unreported claims. Our policy with respect to a significant portion of our workers= compensation and professional and general liability claims is to use an actuary to support the estimates recorded for incurred but unreported claims.
Our health insurance reserve is based on our known claims incurred and an estimate of incurred but unreported claims determined by our analysis of historical claims paid. We reassess our accrued risk reserves on a quarterly basis.

Professional liability remains an area of particular concern to us. The entire long term care industry has seen personal injury/wrongful death claims based on alleged negligence by nursing homes and their employees in providing care to residents. As of March 31, 2009, we and/or our managed centers are defendants in 53 such claims inclusive of years 1999 through 2009. It remains possible that these pending matters plus potential unasserted claims could exceed our reserves, which would have a material adverse effect on our financial position, results of operations and cash flows. It is also possible that future events could cause us to make significant adjustments or revisions to these reserve estimates and cause our reported net income to vary significantly from period to period.

We maintain insurance coverage for incidents occurring in all provider locations owned, leased or managed by us. The coverages include both primary policies and umbrella policies.

For 2002, we maintain primary coverage through our own insurance company with excess coverage provided by a third party insurance company. For 2003-2009, we maintain both primary and excess coverage through our own insurance subsidiary.
In all years, settlements, if any, in excess of available insurance policy limits and our own reserves would be expensed by us.

Revenue Recognition - Subordination of Fees and Uncertain Collections - We provide management services to certain long-term care facilities and to others we provide accounting and financial services. We generally charge 6% of net revenues for our management services and a predetermined fixed rate per bed for the accounting and financial services. Our policy is to recognize revenues associated with both management services and accounting and financial services on an accrual basis as the services are provided. However, under the terms of our management contracts, payments for our management services are subject to subordination to other expenditures of the long-term care center being managed.
Furthermore, there are certain of the third parties with whom we have contracted to provide services and which we have determined, based on insufficient historical collections and the lack of expected future collections, that collection is not reasonably assured and our policy is to recognize income only in the period in which the amounts are realized. We recognize the expenses related to the provision of those services in the period in which they are incurred. We may receive payment for the unpaid and unrecognized management fees in whole or in part in the future only if cash flows from the operating and investing activities of the centers are sufficient to pay the fees. There can be no assurance that such future cash flows will occur. The realization of such previously unrecognized revenue could cause our reported net income to vary significantly from period to period.

We agree to subordinate our fees to the other expenses of a managed center because we believe we know how to improve the quality of patient services and finances of a long-term care center and because subordinating our fees demonstrates to the owner and employees of the managed center how confident we are of the impact we can have in making the center operations successful. We may continue to provide services to certain managed centers despite not being fully paid currently so that we may be able to collect unpaid fees in the future from improved operating results and because the incremental savings from discontinuing services to a center may be small compared to the potential benefit. Also, we may benefit from providing other ancillary services to the managed center. We may receive payment for the unrecognized management fees in whole or in part in the future only if cash flows from the operating and investment activities of the centers are sufficient to pay the fees. There can be no assurance that such future cash flows will occur.

Certain of our accounts receivable from private paying patients and certain of our notes receivable are subject to credit losses. We have attempted to reserve for expected accounts receivable credit losses based on our past experience with similar accounts receivable and believe our reserves to be adequate.

We continually monitor and evaluate the carrying amount of our notes receivable in accordance with Statement of Financial Accounting Standards No. 114, AAccounting by Creditors for Impairment of a Loan - An Amendment of FASB Statements No. 5 and 15.@ It is possible, however, that the accuracy of our estimation process could be materially impacted as the composition of the receivables changes over time. We continually review and refine our estimation process to make it as reactive to these changes as possible. However, we cannot guarantee that we will be able to accurately estimate credit losses on these balances. It is possible that future events could cause us to make significant adjustments or revisions to these estimates and cause our reported net income to vary significantly from period to period.

Potential Recognition of Deferred Income - During 1988, we sold the assets of eight long-term health care centers to National Health Corporation (ANational@), our administrative general partner at the time of the sale. The resulting profit of $15,745,000 was deferred. $10,000,000 of the deferred gain and related deferred income taxes of $4,000,000 was recognized as income in December 2007 with the collection of the $10,000,000 note from National. $3,745,000 of the deferred gain has been amortized into income on a straight-line basis over the 20-year management contract period. Additional deferred income of $2,000,000 will be reported when the Company no longer has an obligation to advance the $2,000,000 working capital loan which obligation was extended until January 20, 2018 with the extension of the management agreement with National to that date.

Guarantees - At March 31, 2009, no agreements to guarantee debt of other parties are outstanding.

Uncertain Tax Positions - NHC continually evaluates for uncertain tax positions. These uncertain positions may arise where tax laws may allow for alternative interpretations or where the timing of recognition of income is subject to judgment. We believe we have adequate provisions for our uncertain tax positions including related penalties and interest. However, because of uncertainty of interpretation by various tax authorities and the possibility that there are issues that have not been recognized by management, we cannot guarantee we have accurately estimated our tax liabilities.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management=s judgment in their application. There are also areas in which management=s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto which contain accounting policies and other disclosures required by generally accepted accounting principles.

Government Program Financial Changes

Cost containment will continue to be a priority for Federal and State governments for health care services, including the types of services we provide. Government reimbursement programs such as Medicare and Medicaid prescribe, by law, the billing methods and amounts that health care providers may charge and be reimbursed to care for patients covered by these programs. Congress has passed a number of laws that have effected major changes in the Medicare and Medicaid programs. The Balanced Budget Act of 1997 sought to achieve a balanced federal budget by, among other things, reducing federal spending on Medicare and Medicaid to various providers. In February 2006, Congress enacted the Deficit Reduction Act, or DRA, which reduced net Medicare and Medicaid spending, and in December 2006, Congress passed the Tax Relief and Health Care Act of 2006, which also affects payments under the Medicare and Medicaid programs. In the Tax Relief and Health Care Act of 2006, Congress reduced the limit on Medicaid provider taxes for the period January 1, 2008 through September 30, 2011 from the 6 percent set by CMS regulations to a 5.5 percent limit set by statute.

Medicare-

Effective October 1, 2008, our PPS rates were increased by 3.4% due to an inflation update. Our annual 2008 Medicare revenues increased by 6.5% over our annual 2007 Medicare revenues. The inflation update (or market basket increase) was 3.1% in 2006 and 3.3% in 2007.

For the first three months of 2009 our average Medicare per diem increased by 4.9% over the same period of 2008. No assurances can be given as to whether Congress will increase or decrease reimbursement in the future, the timing of any action or the form of relief, if any, that may be enacted.

Medicaid-

Tennessee annual Medicaid rate increases were implemented effective July 1, 2008. The increase in revenue was approximately $514,000 per quarter.

Missouri Medicaid funded a global rate increase for all providers of $6.00 per day effective after July 1, 2008. The first three months of 2009 effect was approximately $330,000.

For the first three months of 2009, our average Medicaid per diem increased by 2.4% over the same period in 2008. We face challenges with respect to states' Medicaid payments, because many currently do not cover the total costs incurred in providing care to those patients. States will continue to control Medicaid expenditures but also look for adequate funding sources, including provider assessments. The DRA includes several provisions designed to reduce Medicaid spending. These provisions include, among others, provisions strengthening the Medicaid asset transfer restrictions for persons seeking to qualify for Medicaid long-term care coverage, which could, due to the timing of the penalty period, increase facilities' exposure to uncompensated care. Other provisions could increase state funding for home and community-based services, potentially having an impact on funding for nursing facilities. There is no assurance that the funding for our services will increase or decrease in the future.

Results of Operations

Three Months Ended March 31, 2009 Compared to Three Months Ended March 31, 2008.

Results for the three month period ended March 31, 2009 include a 5.3% increase in net revenues and a 12.4% increase in net income compared to the same period in 2008.

Net patient revenues increased $9,102,000 or 6.3% compared to the same period last year. Medicare, Medicaid and private pay per diem rates increased 4.9%, 2.4%, and 5.3%, respectively, compared to the quarter a year ago. Additionally, the January 1, 2009 acquisition of five hospice locations in South Carolina and acquisition of a 132-bed skilled nursing and rehabilitation facility and a 60-bed assisted living facility located in Charleston, South Carolina, effective August 1, 2008 added approximately $4,497,000 in net patient revenues.

The total census at owned and leased centers for the quarter averaged 91.6% compared to an average of 93.0% for the same quarter a year ago.

Other revenues decreased $574,000 or 3.5% in the three month 2009 period to $15,602,000 from $16,176,000 in the 2008 three month period. Decreases in other revenues include decreased collections of management and accounting services fees ($274,000), decreased dividends and other realized gains on securities due to lower dividend rates ($126,000), and decreased rental income ($573,000).

Decreases in other revenues in the 2009 period over the 2008 period were offset in part due to greater earnings from our equity in unconsolidated investments (primarily from Caris HealthCare L.P. ($464,000) and increased insurance revenues ($227,000).

Total costs and expenses for the 2009 first quarter compared to the 2008 first quarter increased $6,123,000 or 4.2% to $153,067,000 from $146,989,000.
Salaries, wages and benefits, the largest operating costs of this service company, increased $3,185,000 or 3.6% to $90,726,000 from $87,541,000. Other operating expenses increased $2,654,000 or 5.9% to $47,968,000 for the 2009 period compared to $45,314,000 in the 2008 period. Rent expense increased $50,000 to $7,968,000 compared to $7,918,000 in the 2008 period. Depreciation and amortization increased $246,000 or 4.1% to $6,243,000 from $5,997,000.
Interest costs decreased $12,000 to $207,000.

Increases in salaries, wages and benefits are due to increased staffing due to the acquisition of a skilled health care facility (132 long-term beds), a 60-bed assisted living facility and five hospice locations and due to inflationary wage increases. Increases in other operating costs are due to costs associated with the acquisition of a health care facility (132 long-term beds), a 60-bed assisted living facility, five hospice locations and inflationary increases offset in part due to decreases in professional liability expenses ($930,000).

Depreciation expense increased primarily due to the acquisition of certain depreciable assets during the last year, including a 132-bed skilled health facility and a 60-bed assisted living facility.

The income tax provision for the three months ended March 31, 2009 is $6,373,000 (an effective income tax rate of 41.0%), which is in line with management's expectations. The income tax provision for the three months ended March 31, 2008 was $4,980,000 (an effective tax rate of 37.9%). The 3.1% increase in the effective tax rate in 2009 is due to the effect of permanent differences.

Liquidity, Capital Resources, and Financial Condition

Sources and Uses of Funds - Our primary sources of cash include revenues from the healthcare and senior living facilities we operate, insurance services, management services and accounting services. Our primary uses of cash include salaries, wages and other operating costs of our home office and the facilities we operate, the cost of additions to and acquisitions of real property, rent expenses, debt service payments (including principal and interest) and dividend distributions. These sources and uses of cash are reflected in our Consolidated Statements of Cash Flows and are discussed in further detail below. The following is a summary of our sources and uses of cash flows (dollars in thousands):

                                              Three Months Ended
                                                   March 31             Three Month Change
                                               2009         2008           $          %
Cash and Cash equivalents at beginning
of period                                  $  49,033     $  2,379    $   46,654    1,961.1%

Cash provided from (used in) operating
activities                                     4,411        8,474        (4,063)    (47.9)%

Cash provided from (used in) investing
activities                                    (4,048)      10,772       (14,820)   (137.6)%

Cash provided from (used in) financing
activities                                    11,222       (4,337)       15,559      358.8%

Cash and cash equivalents at end of
period                                     $  60,618     $ 17,288    $   43,330      250.6%

Operating Activities - Net cash provided by operating activities for the three months ended March 31, 2009, was $4,411,000 as compared to $8,474,000 provided in the same period last year. Cash provided by operating activities for the current period benefited from increases in other current liabilities and accrued risk reserves, deferred income, and accounts receivable. The increases to operating activities were offset by increases in the equity in earnings of unconsolidated investments, restricted cash and decreases in accrued payroll.
Increases in restricted cash totaled $550,000 compared to $10,184,000 the prior period. The decrease in accounts receivable is due to collections and timing differences.

The increase in restricted cash in the current period is due primarily to the increase in cash reserved for our accrued risk reserves, including professional liability claims and workers' compensation insurance claims, due to cash paid out for those claims.

The increase in other current liabilities and accrued risks reserves accounted for $2,028,000 in 2009 and $5,353,000 in 2008 of the cash provided by operating activities. If the risks materialize as expected, which may not be finally known for several years, they will require the use of our restricted cash.

Investing Activities - Cash used in investing activities totaled $4,448,000 for the three months ended March 31, 2009, as compared to $10,772,000 provided from investing activities for the three months ended March 31, 2008. Cash used for property and equipment additions was $9,456,000 for the three months ended March 31, 2009 and $4,910,000 in the comparable period in 2008. Investments in notes receivable totaled $11,000 in 2009 compared to $1,900,000 in 2008. Cash provided by net collections of notes receivable was $3,166,000 in 2009 compared to $4,207,000 in 2008. Collections of our investment in the cash fund in liquidation balance totaled $2,186,000 in the first three months of 2009 compared to $12,376,000 in 2008.

Costs included in property and equipment additions include $3,972,000 for a new 120-bed long-term health care center under construction in Mauldin, South Carolina and $111,000 for a 60-bed assisted living facility in Columbia, South Carolina.

Net cash provided by financing activities totaled $11,620,000 in the three months ended March 31, 2009 compared to $4,337,000 net cash used for the same period in 2008. Cash used for payments of debt totaled $-0- and dividend payments to common and preferred shareholders totaled $5,291,000. In the prior year, cash used for payments of debt totaled $7,431,000, dividend payments to common and preferred shareholders totaled $4,506,000. Tax benefits from exercise of stock options provided cash of $3,499,000 in 2009 and $124,000 in 2008. In the current period, $13,091,000 cash was provided by the issuance of common stock compared to $194,000 in the same period last year.

At March 31, 2009, our ratio of long-term debt to total capitalization (total debt plus deferred income plus shareholders equity) is 10.4%.

Table of Contractual Cash Obligations


Our contractual cash obligations for periods subsequent to March 31, 2009 are as
follows (in thousands):

. . .