Select Medical Holdings - 10-Q quarterly report FY

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the Quarter Ended September 30, 2007


o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Period From to .

Commission File Numbers: 333-133284 and 000-31441

SELECT MEDICAL HOLDINGS CORPORATION

SELECT MEDICAL CORPORATION

(Exact name of Registrants as specified in their charters)


Delaware Delaware (State or other jurisdiction of incorporation or organization)		20-1764048 23-2872718 (I.R.S. employer identification number)

4716 Old 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 the Registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days.

YES þ NO o

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

Large accelerated filerso Accelerated filers o Non-accelerated filers þ

Indicate by check mark whether the Registrants are shell companies (as defined in Rule 12b-2 of the Exchange Act).

YES o NO þ

As of October 31, 2007, Select Medical Holdings Corporation had outstanding 205,166,072 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 Select Medical Holdings Corporation and Select Medical Corporation.

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 stockholders’ equity and comprehensive 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	29

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	52

ITEM 4.	CONTROLS AND PROCEDURES	53

PART II	OTHER INFORMATION	53

ITEM 1.	LEGAL PROCEEDINGS	53

ITEM 1A.	RISK FACTORS	55

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	55

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	55

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	55

ITEM 5.	OTHER INFORMATION	55

ITEM 6.	EXHIBITS	55

SIGNATURES		56
Certification of Chief Executive Officer
Certification of Executive Vice President and Chief Financial Officer
Certification of Chief Executive Officer, pursuant to Section 906
Certification of Executive Vice President and Chief Financial Officer

2

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,			September 30,			December 31,		September 30,
	2006			2007			2006		2007
ASSETS
Current Assets:
Cash and cash equivalents	$	81,600		$	10,103		$	81,600	$	10,103
Restricted cash		4,335			886			4,335		886
Accounts receivable, net of allowance for doubtful accounts of $55,306 and $57,683 in 2006 and 2007, respectively		199,927			257,318			199,927		257,318
Current deferred tax asset		42,613			38,760			42,613		38,760
Prepaid income taxes		—			6,019			—		6,019
Other current assets		16,762			22,872			16,762		22,872

Total Current Assets		345,237			335,958			345,237		335,958

Property and equipment, net		356,336			479,833			356,336		479,833
Goodwill		1,323,572			1,475,530			1,323,572		1,475,530
Other identifiable intangibles		79,230			95,532			79,230		95,532
Other assets held for sale		4,855			3,447			4,855		3,447
Other assets		73,294			67,940			68,412		63,521


Total Assets	$	2,182,524		$	2,458,240		$	2,177,642	$	2,453,821


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Bank overdrafts	$	12,213		$	18,911		$	12,213	$	18,911
Current portion of long-term debt and notes payable		6,209			7,616			6,209		7,616
Accounts payable		72,597			81,488			72,597		81,488
Accrued payroll		55,084			67,068			55,084		67,068
Accrued vacation		27,360			33,398			27,360		33,398
Accrued interest		36,759			16,072			25,270		12,956
Accrued professional liability		24,979			26,272			24,979		26,272
Accrued restructuring		225			20,713			225		20,713
Accrued other		67,084			71,150			67,084		71,150
Income taxes payable		1,937			—			1,937		—
Due to third party payors		12,886			10,791			12,886		10,791

Total Current Liabilities		317,333			353,479			305,844		350,363

Long-term debt, net of current portion		1,532,294			1,728,033			1,224,509		1,419,271
Non-current deferred tax liability		32,075			24,675			30,721		24,275
Other non-current liabilities		—			22,857			—		22,857


Total Liabilities		1,881,702			2,129,044			1,561,074		1,816,766

Commitments and Contingencies

Minority interest in consolidated subsidiary companies		2,566			4,897			2,566		4,897
Preferred stock — Authorized shares (liquidation preference is $467,395 and $485,081 in 2006 and 2007, respectively)		467,395			485,081			—		—

Stockholders’ Equity:
Common stock of Holdings, $0.001 par value, 250,000,000 shares authorized, 204,904,000 shares and 205,165,000 shares issued and outstanding in 2006 and 2007, respectively		205			205			—		—
Common stock of Select, $0.01 par value, 100 shares issued and outstanding		—			—			—		—
Capital in excess of par		(295,256	)		(292,186	)		464,283		475,575
Retained earnings		121,024			130,077			146,774		156,008
Accumulated other comprehensive income		4,888			1,122			2,945		575

Total Stockholders’ Equity		(169,139	)		(160,782	)		614,002		632,158


Total Liabilities and Stockholders’ Equity	$	2,182,524		$	2,458,240		$	2,177,642	$	2,453,821

The accompanying notes are an integral part of this statement.

3

Consolidated Statements of Operations
(unaudited)
(in thousands)


	Select Medical Holdings Corporation						Select Medical Corporation
	For the Quarter Ended September 30,						For the Quarter Ended September 30,
	2006			2007			2006			2007
Net operating revenues	$	443,872		$	500,385		$	443,872		$	500,385


Costs and expenses:
Cost of services		362,070			429,831			362,070			429,831
General and administrative		9,762			12,081			9,762			12,081
Bad debt expense		5,333			10,782			5,333			10,782
Depreciation and amortization		12,394			16,399			12,394			16,399

Total costs and expenses		389,559			469,093			389,559			469,093


Income from operations		54,313			31,292			54,313			31,292

Other income and expense:
Other expense		—			(1,372	)		(3,124	)		(4,065	)
Interest income		319			158			319			158
Interest expense		(33,002	)		(35,678	)		(24,348	)		(27,093	)


Income (loss) from operations before minority interests and income taxes		21,630			(5,600	)		27,160			292

Minority interest in consolidated subsidiary companies		369			237			369			237


Income (loss) from operations before income taxes		21,261			(5,837	)		26,791			55

Income tax expense (benefit)		8,717			(2,731	)		10,652			(669	)


Net income (loss)	$	12,544		$	(3,106	)	$	16,139		$	724

The accompanying notes are an integral part of this statement.

4

Consolidated Statements of Operations
(unaudited)
(in thousands)


	Select Medical Holdings Corporation						Select Medical Corporation
	For the Nine Months Ended September 30,						For the Nine Months Ended September 30,
	2006			2007			2006			2007
Net operating revenues	$	1,405,756		$	1,473,698		$	1,405,756		$	1,473,698


Costs and expenses:
Cost of services		1,119,767			1,218,410			1,119,767			1,218,410
General and administrative		33,511			35,847			33,511			35,847
Bad debt expense		18,766			25,206			18,766			25,206
Depreciation and amortization		34,955			42,042			34,955			42,042

Total costs and expenses		1,206,999			1,321,505			1,206,999			1,321,505


Income from operations		198,757			152,193			198,757			152,193

Other income and expense:
Other income (expense)		—			(199	)		918			(2,548	)
Interest income		738			1,956			738			1,956
Interest expense		(98,525	)		(103,630	)		(72,615	)		(77,798	)


Income from continuing operations before minority interests and income taxes		100,970			50,320			127,798			73,803

Minority interest in consolidated subsidiary companies		1,095			1,373			1,095			1,373


Income from continuing operations before income taxes		99,875			48,947			126,703			72,430

Income tax expense		41,889			20,267			51,278			28,486


Income from continuing operations		57,986			28,680			75,425			43,944

Income from discontinued operations, net of tax (Includes pre-tax gain of $13,950)		10,018			—			10,018			—


Net income	$	68,004		$	28,680		$	85,443		$	43,944

The accompanying notes are an integral part of this statement.

5

Select Medical Holdings Corporation

Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income

(unaudited)

(in thousands)


												Accumulated
	Common			Common		Capital in						Other
	Stock			Stock Par		Excess of			Retained			Comprehensive			Comprehensive
	Issued			Value		Par			Earnings			Income			Income

Balance at December 31, 2006		204,904		$	205	$	(295,256	)	$	121,024		$	4,888
Net income										28,680					$	28,680
Unrealized loss on interest rate swap, net of tax													(3,766	)		(3,766	)

Total comprehensive income															$	24,914

Cumulative impact of change in accounting for uncertainties in income taxes (FIN 48 - see Note 8)										(1,931	)
Vesting of restricted stock							2,791
Issuance of restricted stock		200					200
Exercise of stock options		64					64
Stock option expense							18
Repurchase of common shares		(3	)				(3	)
Accretion of dividends on preferred stock										(17,696	)

Balance at September 30, 2007		205,165		$	205	$	(292,186	)	$	130,077		$	1,122

Select Medical Corporation
Consolidated Statement of Changes in Stockholder’s Equity and Comprehensive Income
(unaudited)
(in thousands)


										Accumulated
	Common		Common		Capital in					Other
	Stock		Stock Par		Excess of		Retained			Comprehensive			Comprehensive
	Issued		Value		Par		Earnings			Income			Income

Balance at December 31, 2006		—	$	—	$	464,283	$	146,774		$	2,945
Net income								43,944					$	43,944
Unrealized loss on interest rate swap, net of tax											(2,370	)		(2,370	)

Total comprehensive income													$	41,574

Cumulative impact of change in accounting for uncertainties in income taxes (FIN 48 - see Note 8)								(1,931	)
Dividends to Holdings								(32,779	)
Federal tax benefit of losses contributed by Holdings						8,219
Additional investment by Holdings						264
Contribution related to restricted stock and stock option award issuances by Holdings						2,809

Balance at September 30, 2007		—	$	—	$	475,575	$	156,008		$	575

The accompanying notes are an integral part of this statement.

6

Consolidated Statements of Cash Flows

(unaudited)

(in thousands)


	Select Medical Holdings Corporation						Select Medical Corporation
	For the Nine Months Ended September 30,						For the Nine Months Ended September 30,
	2006			2007			2006			2007
Operating activities
Net income	$	68,004		$	28,680		$	85,443		$	43,944
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		35,131			42,042			35,131			42,042
Provision for bad debts		18,853			25,206			18,853			25,206
Gain from disposal of assets and sale of business units		(12,532	)		(963	)		(12,532	)		(963	)
Non-cash loss (income) from interest rate swaps		—			—			(918	)		2,350
Non-cash stock compensation expense		2,837			2,809			2,837			2,809
Amortization of debt discount		868			977			—			—
Minority interests		1,435			1,373			1,435			1,373
Changes in operating assets and liabilities, net of effects from acquisition of businesses:
Accounts receivable		(10,811	)		(53,332	)		(10,811	)		(53,332	)
Other current assets		2,494			435			2,494			435
Other assets		3,591			(547	)		3,539			(1,011	)
Accounts payable		4,300			6,558			4,300			6,558
Due to third-party payors		(3,169	)		(2,095	)		(3,169	)		(2,095	)
Accrued interest		(20,021	)		(20,687	)		(12,526	)		(12,314	)
Accrued expenses		(9,991	)		12,678			(9,991	)		12,678
Income and deferred taxes		24,177			11,886			33,562			20,105

Net cash provided by operating activities		105,166			55,020			137,647			87,785


Investing activities
Purchases of property and equipment		(112,132	)		(127,897	)		(112,132	)		(127,897	)
Earnout payments		(100	)		—			(100	)		—
Proceeds from sale of business units		76,806			7,877			76,806			7,877
Sale of building		—			4,500			—			4,500
Changes in restricted cash		1,098			3,449			1,098			3,449
Acquisition of businesses, net of cash acquired		(3,261	)		(213,974	)		(3,261	)		(213,974	)

Net cash used in investing activities		(37,589	)		(326,045	)		(37,589	)		(326,045	)


Financing activities
Borrowings on revolving credit facility		210,000			324,000			210,000			324,000
Payments on revolving credit facility		(290,000	)		(224,000	)		(290,000	)		(224,000	)
Credit facility term loan borrowing		—			100,000			—			100,000
Payments on credit facility term loan		(4,350	)		(4,850	)		(4,350	)		(4,850	)
Principal payments on seller and other debt		(614	)		(1,062	)		(614	)		(1,062	)
Proceeds from (repayment of) bank overdrafts		(11,824	)		6,698			(11,824	)		6,698
Dividends to Holdings		—			—			(32,522	)		(32,779	)
Repurchase of common and preferred stock		(41	)		(14	)		—			—
Proceeds from issuance of restricted stock		—			200			—			—
Exercise of stock options		—			64			—			—
Equity investment by Holdings		—			—			—			264
Distributions to minority interests		(1,604	)		(1,508	)		(1,604	)		(1,508	)

Net cash provided by (used in) financing activities		(98,433	)		199,528			(130,914	)		166,763


Effect of exchange rate changes on cash and cash equivalents		35			—			35			—


Net decrease in cash and cash equivalents		(30,821	)		(71,497	)		(30,821	)		(71,497	)

Cash and cash equivalents at beginning of period		35,861			81,600			35,861			81,600

Cash and cash equivalents at end of period	$	5,040		$	10,103		$	5,040		$	10,103


Supplemental Cash Flow Information
Cash paid for interest	$	114,504		$	120,140		$	81,139		$	87,379
Cash paid for taxes	$	21,840		$	8,460		$	21,840		$	8,460

The accompanying notes are an integral part of this statement.

7

SELECT MEDICAL HOLDINGS CORPORATION AND SELECT MEDICAL CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

On February 24, 2005, Select Medical Corporation (“Select”) merged with a subsidiary of Select Medical Holdings Corporation (“Holdings”), formerly known as EGL Holding Company, and became a wholly-owned subsidiary of Holdings (“Merger”). Generally accepted accounting principles require that any amounts recorded or incurred (such as goodwill and compensation expense) by the parent as a result of the Merger or for the benefit of the subsidiary be “pushed down” and recorded in Select’s consolidated financial statements. 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.

The unaudited condensed consolidated financial statements of the Company as of September 30, 2007 and for the three and nine month periods ended September 30, 2006 and 2007 have been prepared in accordance with generally accepted accounting principles. In the opinion of management, such information contains all adjustments necessary for a fair statement of the financial position, results and cash flow for such periods. All significant intercompany transactions and balances have been eliminated. The results of operations for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the full fiscal year ending December 31, 2007.

Certain information and disclosures normally included in the notes to consolidated financial statements have been condensed or omitted as permitted by 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, 2006 contained in Select’s Form 10-K filed with the SEC on March 28, 2007 and Holdings’ Form 10-K filed with the SEC on March 30, 2007.

2. Accounting Policies

Use of Estimates

The preparation of consolidated financial statements in conformity with generally accepted accounting principles 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 may differ from those estimates.

Reclassifications

Certain reclassifications to amounts previously reported have been made to conform with the current period presentation.

8

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) Issued SFAS No. 159, “Establishing the Fair Value Option for Financial Assets and Liabilities” (“SFAS No. 159”). SFAS No. 159 permits all entities to choose to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157, “Fair Value Measurements.” An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing at November 15, 2007 (or early adoption date). The Company does not expect the adoption of SFAS No. 159 to have a material effect on the Company’s financial statements.

In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company does not believe that the adoption of the provisions of SFAS No. 157 will materially impact its consolidated financial statements.

3. Acquisition

On May 1, 2007, Select completed the acquisition of substantially all of the outpatient rehabilitation division (the “Division”) of HealthSouth Corporation. At the closing, Select acquired 540 outpatient rehabilitation clinics. The closing of the purchase of approximately 30 additional outpatient rehabilitation clinics that was deferred pending certain state regulatory approvals was completed as of October 31, 2007 and resulted in the release of an additional $23.4 million of the purchase price. The aggregate purchase price of $245.0 million was reduced by approximately $7.0 million at closing for assumed indebtedness and other unresolved matters. The amount of the consideration was derived through arm’s length negotiations. Select funded the acquisition through borrowings under its senior credit facility and cash on hand.

The results of operations of the Division have been included in the Company’s consolidated financial statements since May 1, 2007. The Company has included the operations of the Division in its outpatient rehabilitation segment.

The purchase price was allocated to tangible and identifiable intangible assets and liabilities based upon preliminary estimates of fair value, with the remainder allocated to goodwill. The Company is in the process of completing a formal valuation analysis to identify and determine the fair values of tangible and intangible assets acquired and the liabilities assumed. Thus, the final allocation of the purchase price may differ from preliminary estimates used at September 30, 2007. The Company expects to finalize the allocation of the purchase price prior to December 31, 2007. In accordance with the provisions of SFAS No. 142, no amortization of goodwill has been recorded.

9

The preliminary purchase price allocation is as follows (in thousands):


Cash paid, net of cash acquired	$	213,893

Fair value of net tangible assets acquired:
Accounts receivable		31,498
Other current assets		4,366
Property and equipment		39,478
Other assets		820
Current liabilities		(13,731	)
Long-term debt		(972	)

Net tangible assets acquired		61,459
Non-compete, 5-year		20,000
Restructuring reserve		(22,101	)
Goodwill		154,535

	$	213,893

Unaudited pro forma net revenue and net income for the three and nine months ended September 30, 2007 and 2006 for Select and Holdings as if the acquisition occurred as of January 1, 2006 and January 1, 2007 is as follows:


	For the Three Months Ended					For the Nine Months Ended
	September 30,					September 30,
	2006		2007			2006		2007
	(in thousands)
Net revenue	$	513,605	$	500,385		$	1,626,791	$	1,567,319
Net income (loss):
Select Medical Corporation	$	16,208	$	724		$	88,295	$	46,063
Select Medical Holdings Corporation	$	12,635	$	(3,106	)	$	70,932	$	30,842

10

4. Intangible Assets

The Company’s intangible assets consist of the following:


	As of September 30, 2007
	Gross Carrying		Accumulated
	Amount		Amortization
	(in thousands)
Amortized intangible assets:
Contract therapy relationships	$	20,456	$	(10,569	)
Non-compete agreements		40,809		(11,275	)

Total	$	61,265	$	(21,844	)


Indefinite-lived intangible assets:
Goodwill	$	1,475,530
Trademarks		47,857
Certificates of need		6,550
Accreditations		1,704

Total	$	1,531,641

Amortization expense for the Company’s intangible assets with finite lives follows:


	For the Three Months Ended				For the Nine Months Ended
	September 30,				September 30,
	2006		2007		2006		2007
	(in thousands)
Amortization expense	$	1,953	$	2,952	$	5,858	$	7,524

Amortization expense for the Company’s intangible assets primarily relates to the amortization of the value associated with the non-compete agreements entered into in connection with the acquisitions of the HealthSouth outpatient rehabilitation division, Kessler Rehabilitation Corporation and SemperCare Inc. and the value assigned to the Company’s contract therapy relationships. The useful lives of the HealthSouth outpatient rehabilitation division non-compete, Kessler non-compete, SemperCare non-compete and the Company’s contract therapy relationships are approximately five, six, seven and five years, respectively. Amortization expense related to these intangible assets for each of the next five years commencing January 1, 2007 is approximately as follows (in thousands):


2007	$	10,477
2008		11,811
2009		11,811
2010		7,227
2011		4,286
2012		1,333

11

The changes in the carrying amount of goodwill for the Company’s reportable segments for the nine months ended September 30, 2007 are as follows:


	Specialty		Outpatient
	Hospitals		Rehabilitation			Total
	(in thousands)
Balance as of December 31, 2006	$	1,227,533	$	96,039		$	1,323,572
Goodwill acquired during year		423		154,535			154,958
Goodwill allocated to sale of business		—		(3,000	)		(3,000	)

Balance as of September 30, 2007	$	1,227,956	$	247,574		$	1,475,530

On May 1, 2007, the Centers for Medicare & Medicaid Services, or CMS, published its annual payment rate update for the 2008 LTCH-PPS rate year (“RY 2008”) (affecting discharges and cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008). The May 2007 final rule made several changes to LTCH-PPS payment methodologies that were implemented on July 1, 2007. Compliance with the May 2007 final rule may have an adverse effect on the Company’s future net operating revenues and profitability. As a result of these changes, the Company performed a goodwill impairment assessment for its specialty hospital segment in the second quarter of 2007 which indicated that there was no impairment with respect to goodwill or other recorded intangible assets.

5. Restructuring Reserves

In connection with the acquisition of substantially all of the outpatient rehabilitation division of HealthSouth Corporation (see Footnote 3), the Company has recorded a preliminary estimate of $22.1 million for business restructuring which has been accounted for as additional purchase price. The Company expects to finalize the restructuring plan and reserve prior to December 31, 2007. This reserve primarily included costs associated with workforce reductions and lease termination costs in accordance with the Company’s restructuring plan.

The following summarizes the Company’s restructuring reserve:


	Lease
	Termination
	Costs			Severance			Total
	(in thousands)
December 31, 2006	$	225		$	—		$	225
2007 acquisition restructuring reserve		16,673			5,428			22,101
Amounts paid		(798	)		(815	)		(1,613	)

September 30, 2007	$	16,100		$	4,613		$	20,713

The Company expects to pay out the remaining lease termination costs through 2017 and severance costs through 2008.

12

6. Accumulated Other Comprehensive Income

Holdings

Accumulated other comprehensive income consists of a gain on interest rate swaps of $4.9 million, (net of tax of $3.4 million) at December 31, 2006 and $1.1 million (net of tax of $0.8 million) at September 30, 2007.

Select

Accumulated other comprehensive income consists of a gain on interest rate swaps of $2.9 million (net of tax of $2.0 million) at December 31, 2006 and $0.6 million (net of tax of $0.4 million) at September 30, 2007.

7. Segment Information

The Company’s segments consist of (i) specialty hospitals and (ii) outpatient rehabilitation. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The all other category primarily includes the Company’s general and administrative services. The Company evaluates performance of the segments and determines resource allocation based on Adjusted EBITDA. The Company defines Adjusted EBITDA as net income before interest, income taxes, depreciation and amortization, other expense (income), income from discontinued operations, stock compensation expense, and minority interest.

The following tables summarize selected financial data for the Company’s reportable segments for the three and nine months ended September 30, 2006 and 2007. The segment results of Holdings are identical to those of Select with the exception of total assets:


	Three Months Ended September 30, 2006
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total
	(in thousands)
Net operating revenue	$	329,324	$	114,043	$	505		$	443,872
Adjusted EBITDA		60,812		15,737		(8,896	)		67,653
Total assets:
Select Medical Corporation		1,773,586		254,865		97,645			2,126,096
Select Medical Holdings Corporation		1,773,586		254,865		102,610			2,131,061
Capital expenditures		38,671		876		771			40,318

13


	Three Months Ended September 30, 2007
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total
	(in thousands)
Net operating revenue	$	334,023	$	166,290	$	72		$	500,385
Adjusted EBITDA		41,646		18,099		(11,123	)		48,622
Total assets:
Select Medical Corporation		1,853,728		483,386		116,707			2,453,821
Select Medical Holdings Corporation		1,853,728		483,386		121,126			2,458,240
Capital expenditures		32,077		5,010		978			38,065


	Nine Months Ended September 30, 2006
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total
	(in thousands)
Net operating revenue	$	1,049,768	$	353,974	$	2,014		$	1,405,756
Adjusted EBITDA		218,203		48,920		(30,574	)		236,549
Total assets:
Select Medical Corporation		1,773,586		254,865		97,645			2,126,096
Select Medical Holdings Corporation		1,773,586		254,865		102,610			2,131,061
Capital expenditures		107,001		3,827		1,304			112,132


	Nine Months Ended September 30, 2007
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total
	(in thousands)
Net operating revenue	$	1,033,533	$	438,356	$	1,809		$	1,473,698
Adjusted EBITDA		168,367		60,270		(31,593	)		197,044
Total assets:
Select Medical Corporation		1,853,728		483,386		116,707			2,453,821
Select Medical Holdings Corporation		1,853,728		483,386		121,126			2,458,240
Capital expenditures		115,344		9,655		2,898			127,897

14

A reconciliation of Adjusted EBITDA to income (loss) from continuing operations before income taxes is as follows:


	Three Months Ended September 30, 2006
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other

Adjusted EBITDA	$	60,812	$	15,737	$	(8,896	)
Depreciation and amortization		8,388		3,244		762
Stock compensation expense		—		—		946

								Select Medical
								Holdings			Select Medical
								Corporation			Corporation

Income (loss) from operations	$	52,424	$	12,493	$	(10,604	)	$	54,313		$	54,313
Other expense									—			(3,124	)
Interest expense, net									(32,683	)		(24,029	)
Minority interest									(369	)		(369	)


Income from continuing operations before income taxes								$	21,261		$	26,791


	Three Months Ended September 30, 2007
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other

Adjusted EBITDA	$	41,646	$	18,099	$	(11,123	)
Depreciation and amortization		9,916		5,757		726
Stock compensation expense		—		—		931

								Select Medical
								Holdings			Select Medical
								Corporation			Corporation

Income (loss) from operations	$	31,730	$	12,342	$	(12,780	)	$	31,292		$	31,292
Other expense									(1,372	)		(4,065	)
Interest expense, net									(35,520	)		(26,935	)
Minority interest									(237	)		(237	)


Income (loss) from continuing operations before income taxes								$	(5,837	)	$	55


	Nine Months Ended September 30, 2006
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other

Adjusted EBITDA	$	218,203	$	48,920	$	(30,574	)
Depreciation and amortization		22,912		9,759		2,284
Stock compensation expense		—		—		2,837

								Select Medical
								Holdings			Select Medical
								Corporation			Corporation

Income (loss) from operations	$	195,291	$	39,161	$	(35,695	)	$	198,757		$	198,757
Other income									—			918
Interest expense, net									(97,787	)		(71,877	)
Minority interest									(1,095	)		(1,095	)


Income from continuing operations before income taxes								$	99,875		$	126,703

15


	Nine Months Ended September 30, 2007
	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other

Adjusted EBITDA	$	168,367	$	60,270	$	(31,593	)
Depreciation and amortization		27,340		12,717		1,985
Stock compensation expense		—		—		2,809

								Select Medical
								Holdings			Select Medical
								Corporation			Corporation

Income (loss) from operations	$	141,027	$	47,553	$	(36,387	)	$	152,193		$	152,193
Other expense									(199	)		(2,548	)
Interest expense, net									(101,674	)		(75,842	)
Minority interest									(1,373	)		(1,373	)


Income from continuing operations before income taxes								$	48,947		$	72,430

8. Income Tax

The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes (“FIN No. 48”), on January 1, 2007. Upon adoption, the Company recognized a $6.0 million increase to reserves for uncertain tax positions and a $4.1 million increase to deferred tax assets with a net adjustment to the beginning balance of retained earnings of $1.9 million. Including the cumulative effect of the increases in reserves and deferred tax assets, at the beginning of 2007, the Company had approximately $18.3 million of unrecognized tax benefits. Of this total, $6.0 million (net of the federal benefit on state items) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. The remaining amount would not affect the effective income tax rate and would be accounted for as a reduction in goodwill if recognized. During the nine months ended September 30, 2007, there were no material increases or decreases in unrecognized tax benefits and the Company does not anticipate any material increases or decreases over the next twelve months.

The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of multiple state jurisdictions. The Company was subject to Canadian income tax prior to the disposition of its Canadian operations on March 1, 2006. The Company has substantially concluded all U.S. federal income tax matters for years through 2002. Substantially all material state, local and foreign income tax matters have been concluded for years through 2001. Federal income tax returns for 2003 through 2005 are currently under examination.

The Company’s practice is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company recognized $1.3 million of accrued interest upon adoption of FIN No. 48 on January 1, 2007 which is included as a component of the $6.0 million increase to the reserve noted above. The Company recorded additional accrued interest of $0.5 million during the nine months ended September 30, 2007.

9. Discontinued Operations

On March 1, 2006, the Company sold all of the issued and outstanding shares of its wholly-owned subsidiary, Canadian Back Institute Limited (“CBIL”), for approximately C$89.8 million (US$79.0 million). CBIL operated 109 outpatient rehabilitation clinics in seven Canadian provinces. The Company operated all of its Canadian activity through CBIL. CBIL’s operating results have been classified as discontinued operations and cash flows have been included with continuing operations for the nine months ended September 30, 2006.

16

Previously, the operating results of this subsidiary were included in the Company’s outpatient rehabilitation segment.

Summarized income statement information relating to discontinued operations of CBIL is as follows:


	For the Two
	Months Ended
	February 28,
	2006
	(in thousands)
Net revenue	$	12,902

Income from discontinued operations before income tax expense, including gain of $13,950		15,547
Income tax expense		5,529

Income from discontinued operations, net of tax	$	10,018

10. Commitments and Contingencies

Litigation

On August 24, 2004, Clifford C. Marsden and Ming Xu filed a purported class action complaint in the United States District Court for the Eastern District of Pennsylvania on behalf of the public stockholders of Select against Martin F. Jackson, Robert A. Ortenzio, Rocco A. Ortenzio, Patricia A. Rice and Select. In February 2005, the Court appointed James Shaver, Frank C. Bagatta and Capital Invest, die Kapitalanlagegesellschaft der Bank Austria Creditanstalt Gruppe GmbH as lead plaintiffs (“Lead Plaintiffs”).

On April 19, 2005, Lead Plaintiffs filed an amended complaint, purportedly on behalf of a class of shareholders of Select, against Martin F. Jackson, Robert A. Ortenzio, Rocco A. Ortenzio, Patricia A. Rice, and Select as defendants. The amended complaint continues to allege, among other things, failure to disclose adverse information regarding a potential regulatory change affecting reimbursement for Select’s services applicable to long-term acute care hospitals operated as hospitals within hospitals, failure to disclose improper revenue practices and the issuance of false and misleading statements about the financial outlook of Select. The amended complaint seeks, among other things, damages in an unspecified amount, interest and attorneys’ fees. The Company believes that the allegations in the amended complaint are without merit and intends to vigorously defend against this action. In April 2006, the Court granted in part and denied in part Select and the individual officers’ preliminary motion to dismiss the amended complaint. In February 2007, the Court vacated in part its previous decision on Select’s and the individual officers’ motion to dismiss and dismissed Plaintiffs’ claims regarding Select’s alleged improper revenue practices. The Plaintiffs asked the court to reconsider this ruling, and in June 2007, the court denied the Plaintiffs’ request. Select and the individual officers have answered the amended complaint. On October 25, 2007, the court certified a class of investors who purchased Select stock between July 29, 2003 and May 11, 2004, inclusive. The court appointed class representatives and class counsel. Discovery is ongoing. The Company does not believe this claim will have a material adverse effect on its financial position, cash flows or results of operations. However, due to the uncertain nature of such litigation, the Company cannot predict the outcome of this matter.

17

The Company is subject to legal proceedings and claims that arise in the ordinary course of its business, which include malpractice claims covered under insurance policies. In the Company’s opinion, the outcome of these actions will not have a material adverse effect on the financial position, cash flows or results of operations of the Company.

To cover 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. 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.

Health care providers are often 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. A qui tam lawsuit against Select was filed on June 10, 2003 in the United States District Court for the District of Nevada. The action was originally under seal, during which time the federal government was conducting an investigation of matters alleged by this complaint, as is required by law. The Company received subpoenas for patient records and other documents, and other follow-up requests, apparently related to the federal government’s investigation. In July 2007, the federal government declined to intervene in the case, but stated that it would continue its investigation. In August 2007, the judge ordered the complaint to be unsealed and served upon the defendants by the relators. All other previous filings in this matter remain under seal. To date, Select has not been served with the complaint by the relators. However, because the complaint is no longer under seal it is available to the public. The complaint confirms the three relators in this qui tam lawsuit are two former employees of the Company’s Las Vegas, Nevada subsidiary who were terminated by Select in 2001 and a former employee of the Company’s Florida subsidiary who Select asked to resign. The complaint names, as defendants, Select Medical Corporation, Sports Therapy Arthritis Rehabilitation, Inc. (STAR), and Sports and Orthopedic Rehabilitation Services of Florida (SORS). The complaint includes three counts alleging violations of the federal False Claims Act, conspiracy to violate the False Claims Act, and wrongful discharge of one of the relators. Specifically, the complaint alleges that: SORS used unlicensed personnel to provide therapy services to Medicare patients and did not follow the Medicare billing rules for group therapy; Select and STAR billed Medicare patients for services beyond the Medicare approved amount, over-billed Medicare for therapy services, and resubmitted denied Medicare claims; and Select used billing numbers on Medicare claims belonging to therapists no longer employed by Select, waived co-pays from patients without commercial insurance, and granted discounts to patients who paid cash which were not reported on the clinics’ books. Select sued the former Las Vegas employees in state court in Nevada in 2001 for, among other things, return of misappropriated funds. The Company’s lawsuit has been transferred to the federal court in Las Vegas where it could be consolidated with the qui tam lawsuit. The former Las Vegas employees’ counterclaims against the Company in the Company’s lawsuit have been dismissed. While the government has investigated but chosen not to intervene in two previous qui tam lawsuits filed against Select, the Company cannot provide assurance that the government will not intervene in the Nevada qui tam case at a later date or any other existing or future qui tam lawsuit against the Company. The Company does not know whether the relators will pursue the qui tam lawsuit independently. While litigation is inherently uncertain, the Company believes, based on the limited information currently available to the Company, that the Nevada qui tam action will not have a material adverse effect on the Company’s financial position, cash flows or results of operations.

18

Construction Commitments

At September 30, 2007, the Company has outstanding commitments under construction contracts related to improvements and renovations at the Company’s long-term acute care properties and inpatient rehabilitation facilities totaling approximately $16.2 million.

11. Financing Events

Amendment to Credit Agreement

On March 19, 2007, Select entered into an Amendment No. 2 and Waiver to its senior secured credit facility (“Amendment No. 2”) and on March 28, 2007 Select entered into an Incremental Facility Amendment with a group of lenders and JPMorgan Chase Bank, N.A. as administrative agent. Amendment No. 2 increases the general exception to the prohibition on asset sales under Select’s senior secured credit facility from $100.0 million to $200.0 million, relaxed certain financial covenants starting March 31, 2007 and waived Select’s requirement to prepay certain term loan borrowings following its fiscal year ended December 31, 2006. The Incremental Facility Amendment provided to Select an incremental term loan of $100.0 million, the proceeds of which Select used to pay a portion of the purchase price for the HealthSouth transaction.

Interest Rate Swap Agreement

On March 8, 2007, the Company entered into an interest rate swap agreement to hedge the Company’s interest rate risk for a portion of the Company’s term loans under its senior secured credit facility. The effective date of the swap transaction was May 22, 2007. The swap is designated as a cash flow hedge of forecasted LIBOR based variable rate interest payments. The underlying variable rate debt is $200.0 million. The swap is for a period of three years, with quarterly resets on May 22, August 22, November 22 and February 22 of each year, and a termination date of May 22, 2010.

12. Subsequent Event

On October 2, 2007, Select signed a merger agreement to acquire the business of CORA Health Services, Inc. (“CORA”) for approximately $46.0 million in cash. On November 12, 2007, the parties entered into an agreement mutually terminating the merger agreement.

19

13.

Financial Information for Subsidiary Guarantors and Non-Guarantor Subsidiaries under Select’s 7 ⁵/₈% Senior Subordinated Notes

Select’s 7⁵/₈% Senior Subordinated Notes are fully and unconditionally guaranteed on a senior subordinated basis by all of Select’s wholly-owned subsidiaries (the “Subsidiary Guarantors”). Certain of Select’s subsidiaries did not guarantee the 7⁵/₈% Senior Subordinated Notes (the “Non-Guarantor Subsidiaries”).

Select conducts a significant portion of its business through its subsidiaries. Presented below is condensed consolidating financial information for Select, the Subsidiary Guarantors and the Non-Guarantor Subsidiaries at September 30, 2007 and December 31, 2006 and for the three and nine months ended September 30, 2006 and 2007.

The equity method has been used by Select with respect to investments in subsidiaries. The equity method has been used by Subsidiary Guarantors with respect to investments in Non-Guarantor Subsidiaries. Separate financial statements for Subsidiary Guarantors are not presented.

The following table sets forth the Non-Guarantor Subsidiaries:

Caritas Rehab Services, LLC

Canadian Back Institute Limited and its subsidiaries (1)

Cupertino Medical Center, P.C. (2)

Elizabethtown Physical Therapy

Jeff Ayres, PT Therapy Center, Inc.

Jeffersontown Physical Therapy, LLC

Kentucky Orthopedic Rehabilitation, LLC

Kessler Core PT, OT and Speech Therapy at New York, LLC

Langhorne, P.C.

Lester OSM, P.C.

Louisville Physical Therapy, P.S.C.

Medical Information Management Systems, LLC (3)

Metropolitan West Physical Therapy and Sports Medicine Services Inc.

MKJ Physical Therapy, Inc.

New York Physician Services, P.C.

North Andover Physical Therapy, Inc.

OccuMed East, P.C.

Ohio Occupational Health, P.C., Inc.

Partners in Physical Therapy, PLLC

Penn State Hershey Rehabilitation, LLC

Philadelphia Occupational Health, P.C.

Rehabilitation Physician Services, P.C.

Robinson & Associates, P.C.

Select Physical Therapy of Las Vegas Limited Partnership

Select Specialty Hospital — Central Pennsylvania, L.P.

Select Specialty Hospital — Evansville, LLC

Select Specialty Hospital — Houston, L.P.

Select Specialty Hospital — Gulf Coast, Inc.

Sprint Physical Therapy, P.C.

Therex, P.C.

TJ Corporation I, LLC

U.S. Regional Occupational Health II, P.C.

U.S. Regional Occupational Health II of New Jersey, P.C.


(1)		The operating results have been classified as discontinued operations and cash flows have been included with continuing operations for the nine months ended September 30, 2006. The operations were sold on March 1, 2006.

(2)		In December 2006, the Company sold a group of legal entities that operated outpatient clinics. Cupertino Medical Center, P.C. was one of the legal entities sold.

(3)		In February 2007, the Company sold Medical Information Management Systems, LLC.

20

Select Medical Corporation
Condensed Consolidating Balance Sheet
September 30, 2007
(unaudited)


	Select Medical
	Corporation (Parent			Subsidiary			Non-Guarantor
	Company Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
	(in thousands)
Assets
Current Assets:
Cash and cash equivalents	$	5,079		$	4,079		$	945		$	—		$	10,103
Restricted cash		886			—			—			—			886
Accounts receivable, net		292			245,204			11,822			—			257,318
Prepaid income taxes		6,019			—			—			—			6,019
Current deferred tax asset		23,516			12,793			2,451			—			38,760
Other current assets		4,037			16,790			2,045			—			22,872

Total Current Assets		39,829			278,866			17,263			—			335,958

Property and equipment, net		9,115			436,782			33,936			—			479,833
Investment in affiliates		2,009,120			41,210			—			(2,050,330	) (a)(b)		—
Goodwill		—			1,475,530			—			—			1,475,530
Other identifiable intangibles		—			95,532			—			—			95,532
Other assets held for sale		—			3,447			—			—			3,447
Other assets		51,090			10,234			2,197			—			63,521


Total Assets	$	2,109,154		$	2,341,601		$	53,396		$	(2,050,330	)	$	2,453,821


Liabilities and Stockholders’ Equity
Current Liabilities:
Bank overdrafts	$	18,911		$	—		$	—		$	—		$	18,911
Current portion of long-term debt and notes payable		6,920			686			10			—			7,616
Accounts payable		1,921			73,094			6,473			—			81,488
Intercompany accounts		312,631			(284,028	)		(28,603	)		—			—
Accrued payroll		1,531			65,432			105			—			67,068
Accrued vacation		2,951			27,986			2,461			—			33,398
Accrued interest		12,948			8			—			—			12,956
Accrued professional liability		26,272			—			—			—			26,272
Accrued restructuring		—			20,713			—			—			20,713
Accrued other		41,392			27,195			2,563			—			71,150
Due to third party payors		—			20,196			(9,405	)		—			10,791

Total Current Liabilities		425,477			(48,718	)		(26,396	)		—			350,363

Long-term debt, net of current portion		1,030,101			360,535			28,635			—			1,419,271
Noncurrent deferred tax liability		(1,439	)		23,051			2,663			—			24,275
Other non-current liabilities		22,857			—			—			—			22,857


Total Liabilities		1,476,996			334,868			4,902			—			1,816,766

Commitments and Contingencies

Minority interest in consolidated subsidiary companies		—			—			4,897			—			4,897

Stockholders’ Equity:
Common stock		—			—			—			—			—
Capital in excess of par		475,575			—			—			—			475,575
Retained earnings		156,008			275,538			23,201			(298,739	) (b)		156,008
Subsidiary investment		—			1,731,195			20,396			(1,751,591	) (a)		—
Accumulated other comprehensive income		575			—			—			—			575

Total Stockholders’ Equity		632,158			2,006,733			43,597			(2,050,330	)		632,158


Total Liabilities and Stockholders’ Equity	$	2,109,154		$	2,341,601		$	53,396		$	(2,050,330	)	$	2,453,821


(a)		Elimination of investments in subsidiaries.

(b)		Elimination of investments in subsidiaries’ earnings.

- 21 -

Select Medical Corporation
Condensed Consolidating Statement of Operations
For the Three Months Ended September 30, 2007
(unaudited)


	Select Medical
	Corporation (Parent			Subsidiary			Non-Guarantor
	Company Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
	(in thousands)
Net operating revenues	$	72		$	455,300		$	45,013		$	—		$	500,385


Costs and expenses:
Cost of services		45			389,818			39,968			—			429,831
General and administrative		11,959			122			—			—			12,081
Bad debt expense		—			9,857			925			—			10,782
Depreciation and amortization		619			14,619			1,161			—			16,399

Total costs and expenses		12,623			414,416			42,054			—			469,093


Income (loss) from operations		(12,551	)		40,884			2,959			—			31,292

Other income and expense:
Intercompany interest and royalty fees		(13,995	)		13,903			92			—			—
Intercompany management fees		45,432			(43,731	)		(1,701	)		—			—
Other income (expense)		(5,445	)		1,380			—			—			(4,065	)
Interest income		144			14			—			—			158
Interest expense		(20,533	)		(5,994	)		(566	)		—			(27,093	)


Income (loss) before minority interests and income taxes		(6,948	)		6,456			784			—			292

Minority interest in consolidated subsidiary companies		—			—			237			—			237


Income (loss) before income taxes		(6,948	)		6,456			547			—			55

Income tax benefit		(347	)		(163	)		(159	)		—			(669	)


Income (loss)		(6,601	)		6,619			706			—			724

Equity in earnings of subsidiaries		7,325			1,377			—			(8,702	) (a)		—


Net income	$	724		$	7,996		$	706		$	(8,702	)	$	724


(a)		Elimination of equity in net income from consolidated subsidiaries.

- 22 -

Select Medical Corporation
Condensed Consolidating Statement of Operations
For the Nine Months Ended September 30, 2007
(unaudited)


	Select Medical
	Corporation (Parent			Subsidiary			Non-Guarantor
	Company Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
	(in thousands)
Net operating revenues	$	1,629		$	1,344,376		$	127,693		$	—		$	1,473,698


Costs and expenses:
Cost of services		144			1,110,488			107,778			—			1,218,410
General and administrative		35,692			155			—			—			35,847
Bad debt expense		—			22,494			2,712			—			25,206
Depreciation and amortization		1,661			37,141			3,240			—			42,042

Total costs and expenses		37,497			1,170,278			113,730			—			1,321,505


Income (loss) from operations		(35,868	)		174,098			13,963			—			152,193

Other income and expense:
Intercompany interest and royalty fees		(46,825	)		46,473			352			—			—
Intercompany management fees		133,240			(128,697	)		(4,543	)		—			—
Other income (expense)		(3,928	)		1,380			—			—			(2,548	)
Interest income		1,312			644			—			—			1,956
Interest expense		(59,159	)		(16,987	)		(1,652	)		—			(77,798	)


Income (loss) before minority interests and income taxes		(11,228	)		76,911			8,120			—			73,803

Minority interest in consolidated subsidiary companies		—			—			1,373			—			1,373


Income (loss) before income taxes		(11,228	)		76,911			6,747			—			72,430

Income tax expense		287			27,417			782			—			28,486


Income (loss)		(11,515	)		49,494			5,965			—			43,944

Equity in earnings of subsidiaries		55,459			4,763			—			(60,222	) (a)		—


Net income	$	43,944		$	54,257		$	5,965		$	(60,222	)	$	43,944


(a)		Elimination of equity in net income from consolidated subsidiaries.

- 23 -

Select Medical Corporation
Condensed Consolidating Statement of Cash Flows
For the Nine Months Ended September 30, 2007
(unaudited)


	Select Medical
	Corporation
	(Parent Company			Subsidiary			Non-Guarantor
	Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
	(in thousands)
Operating activities
Net income	$	43,944		$	54,257		$	5,965		$	(60,222	) (a)	$	43,944
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,661			37,141			3,240			—			42,042
Provision for bad debts		—			22,494			2,712			—			25,206
Loss (gain) from disposal of assets and sale of business units		(1,123	)		476			(316	)		—			(963	)
Non-cash loss from interest rate swaps		2,350			—			—			—			2,350
Non-cash compensation expense		2,809			—			—			—			2,809
Minority interests		—			—			1,373			—			1,373
Changes in operating assets and liabilities, net of effects from acquisition of businesses:
Equity in earnings of subsidiaries		(55,459	)	$	(4,763	)		—			60,222	(a)		—
Intercompany		(150,751	)		157,064			(6,313	)		—			—
Accounts receivable		(315	)		(55,209	)		2,192			—			(53,332	)
Other current assets		(2,440	)		3,452			(577	)		—			435
Other assets		5,268			(4,624	)		(1,655	)		—			(1,011	)
Accounts payable		(1,962	)		7,322			1,198			—			6,558
Due to third-party payors		—			7,310			(9,405	)		—			(2,095	)
Accrued interest		(12,322	)		8			—			—			(12,314	)
Accrued expenses		744			11,047			887			—			12,678
Income and deferred taxes		20,105			—			—			—			20,105

Net cash provided by (used in) operating activities		(147,491	)		235,975			(699	)		—			87,785


Investing activities
Purchases of property and equipment		(3,102	)		(122,216	)		(2,579	)		—			(127,897	)
Proceeds from sale of business units		2,332			5,545			—			—			7,877
Sale of building		—			4,500			—			—			4,500
Changes in restricted cash		3,449			—			—			—			3,449
Acquisition of businesses, net of cash acquired		—			(213,974	)		—			—			(213,974	)

Net cash provided by (used in) investing activities		2,679			(326,145	)		(2,579	)		—			(326,045	)


Financing activities
Borrowings on revolving credit facility		324,000			—			—			—			324,000
Payments on revolving credit facility		(224,000	)		—			—			—			(224,000	)
Credit facility term loan borrowing		100,000			—			—			—			100,000
Payments on credit facility term loan		(4,850	)		—			—			—			(4,850	)
Principal payments on seller and other debt		—			(1,062	)		—			—			(1,062	)
Proceeds from bank overdrafts		6,698			—			—			—			6,698
Dividends to Holdings		(32,779	)		—			—			—			(32,779	)
Intercompany debt reallocation		(86,687	)		82,445			4,242			—			—
Equity investment by Holdings		264			—			—			—			264
Distributions to minority interests		—			—			(1,508	)		—			(1,508	)

Net cash provided by financing activities		82,646			81,383			2,734			—			166,763


Net decrease in cash and cash equivalents		(62,166	)		(8,787	)		(544	)		—			(71,497	)

Cash and cash equivalents at beginning of period		67,245			12,866			1,489			—			81,600

Cash and cash equivalents at end of period	$	5,079		$	4,079		$	945		$	—		$	10,103


(a)		Elimination of equity in earnings of subsidiary.

- 24 -

Select Medical Corporation
Condensed Consolidating Balance Sheet
December 31, 2006
(unaudited)


	Select Medical
	Corporation (Parent			Subsidiary			Non-Guarantor
	Company Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
							(in thousands)
Assets
Current Assets:
Cash and cash equivalents	$	67,245		$	12,866		$	1,489		$	—		$	81,600
Restricted cash		4,335			—			—			—			4,335
Accounts receivable, net		(23	)		182,861			17,089			—			199,927
Current deferred tax asset		24,438			16,018			2,157			—			42,613
Other current assets		1,597			13,697			1,468			—			16,762

Total Current Assets		97,592			225,442			22,203			—			345,237

Property and equipment, net		10,979			315,141			30,216			—			356,336
Investment in affiliates		1,968,074			32,150			—			(2,000,224	) (a)(b)		—
Goodwill		—			1,323,572			—			—			1,323,572
Other identifiable intangibles		—			79,230			—			—			79,230
Other assets held for sale		—			4,855			—			—			4,855
Other assets		56,358			11,512			542			—			68,412


Total Assets	$	2,133,003		$	1,991,902		$	52,961		$	(2,000,224	)	$	2,177,642


Liabilities and Stockholders’ Equity
Current Liabilities:
Bank overdrafts	$	12,213		$	—		$	—		$	—		$	12,213
Current portion of long-term debt and notes payable		5,921			288			—			—			6,209
Accounts payable		3,883			63,439			5,275			—			72,597
Intercompany accounts		489,795			(471,284	)		(18,511	)		—			—
Accrued payroll		730			54,098			256			—			55,084
Accrued vacation		2,902			22,292			2,166			—			27,360
Accrued interest		25,270			—			—			—			25,270
Accrued professional liability		24,979			—			—			—			24,979
Accrued restructuring		—			225			—			—			225
Accrued other		42,791			22,473			1,820			—			67,084
Due to third party payors		—			12,523			363			—			12,886
Income taxes payable		(17,235	)		20,202			(1,030	)		—			1,937

Total Current Liabilities		591,249			(275,744	)		(9,661	)		—			305,844

Long-term debt, net of current portion		922,638			277,492			24,379			—			1,224,509
Noncurrent deferred tax liability		5,114			23,265			2,342			—			30,721

Total Liabilities		1,519,001			25,013			17,060			—			1,561,074

Commitments and Contingencies

Minority interest in consolidated subsidiary companies		—			—			2,566			—			2,566

Stockholders’ Equity:
Common stock		—			—			—			—			—
Capital in excess of par		464,283			—			—			—			464,283
Retained earnings		146,774			221,281			17,323			(238,604	) (b)		146,774
Subsidiary investment		—			1,745,608			16,012			(1,761,620	) (a)		—
Accumulated other comprehensive income		2,945			—			—			—			2,945

Total Stockholders’ Equity		614,002			1,966,889			33,335			(2,000,224	)		614,002


Total Liabilities and Stockholders’ Equity	$	2,133,003		$	1,991,902		$	52,961		$	(2,000,224	)	$	2,177,642


(a)		Elimination of investments in subsidiaries.

(b)		Elimination of investments in subsidiaries’ earnings.

- 25 -

Select Medical Corporation
Condensed Consolidating Statement of Operations
For the Three Months Ended September 30, 2006
(unaudited)


	Select Medical						Non-
	Corporation (Parent			Subsidiary			Guarantor
	Company Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
							(in thousands)
Net operating revenues	$	94		$	406,272		$	37,506		$	—		$	443,872


Costs and expenses:
Cost of services		58			329,975			32,037			—			362,070
General and administrative		9,631			131			—			—			9,762
Bad debt expense		—			5,026			307			—			5,333
Depreciation and amortization		631			11,000			763			—			12,394

Total costs and expenses		10,320			346,132			33,107			—			389,559


Income (loss) from operations		(10,226	)		60,140			4,399			—			54,313

Other income and expense:
Intercompany interest and royalty fees		(17,298	)		17,202			96			—			—
Intercompany management fees		42,518			(41,113	)		(1,405	)		—			—
Other expense		(3,124	)		—			—			—			(3,124	)
Interest income		303			16			—			—			319
Interest expense		(18,126	)		(5,998	)		(224	)		—			(24,348	)


Income (loss) before minority interests and income taxes		(5,953	)		30,247			2,866			—			27,160

Minority interest in consolidated subsidiary companies		—			—			369			—			369


Income (loss) from continuing operations before income taxes		(5,953	)		30,247			2,497			—			26,791

Income tax expense		58			10,487			107			—			10,652


Income (loss) from continuing operations		(6,011	)		19,760			2,390			—			16,139

Equity in earnings of subsidiaries		22,150			2,719			—			(24,869	) (a)		—


Net income	$	16,139		$	22,479		$	2,390		$	(24,869	)	$	16,139


(a)		Elimination of equity in net income from consolidated subsidiaries.

- 26 -

Select Medical Corporation
Condensed Consolidating Statement of Operations
For the Nine Months Ended September 30, 2006
(unaudited)


	Select Medical						Non-
	Corporation (Parent			Subsidiary			Guarantor
	Company Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
							(in thousands)
Net operating revenues	$	474		$	1,288,351		$	116,931		$	—		$	1,405,756


Costs and expenses:
Cost of services		174			1,022,233			97,360			—			1,119,767
General and administrative		33,342			169			—			—			33,511
Bad debt expense		—			17,736			1,030			—			18,766
Depreciation and amortization		1,841			30,688			2,426			—			34,955

Total costs and expenses		35,357			1,070,826			100,816			—			1,206,999


Income (loss) from operations		(34,883	)		217,525			16,115			—			198,757

Other income and expense:
Intercompany interest and royalty fees		(46,508	)		46,212			296			—			—
Intercompany management fees		124,023			(120,852	)		(3,171	)		—			—
Other income		918			—			—			—			918
Interest income		700			38			—			—			738
Interest expense		(55,340	)		(16,180	)		(1,095	)		—			(72,615	)


Income (loss) before minority interests and income taxes		(11,090	)		126,743			12,145			—			127,798

Minority interest in consolidated subsidiary companies		—			—			1,095			—			1,095


Income (loss) from continuing operations before income taxes		(11,090	)		126,743			11,050			—			126,703

Income tax expense (benefit)		(264	)		50,574			968			—			51,278


Income (loss) from continuing operations		(10,826	)		76,169			10,082			—			75,425

Income from discontinued operations, net of tax		9,068			—			950			—			10,018

Equity in earnings of subsidiaries		87,201			9,697			—			(96,898	) (a)		—


Net income	$	85,443		$	85,866		$	11,032		$	(96,898	)	$	85,443


(a)		Elimination of equity in net income from consolidated subsidiaries.

- 27 -

Select Medical Corporation
Condensed Consolidating Statement of Cash Flows
For the Nine Months Ended September 30, 2006
(unaudited)


	Select Medical
	Corporation						Non-
	(Parent Company			Subsidiary			Guarantor
	Only)			Guarantors			Subsidiaries			Eliminations			Consolidated
							(in thousands)
Operating activities
Net income	$	85,443		$	85,866		$	11,032		$	(96,898	) (a)	$	85,443
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,841			30,688			2,602			—			35,131
Provision for bad debts		—			17,736			1,117			—			18,853
Gain from sale of business		(13,950	)		—			—			—			(13,950	)
Non cash income from hedge		(918	)		—			—			—			(918	)
Non-cash compensation expense		2,837			—			—			—			2,837
Minority interests		—			—			1,435			—			1,435
Loss on disposal of assets		232			1,132			54			—			1,418
Changes in operating assets and liabilities, net of effects from acquisition of businesses:
Equity in earnings of subsidiaries		(87,201	)		(9,697	)		—			96,898	(a)		—
Intercompany		41,724			(6,275	)		(35,449	)		—			—
Accounts receivable		264			(15,596	)		4,521			—			(10,811	)
Other current assets		761			(1,456	)		3,189			—			2,494
Other assets		(1,037	)		3,312			1,264			—			3,539
Accounts payable		1,458			6,810			(3,968	)		—			4,300
Due to third-party payors		(6,099	)		(5,423	)		8,353			—			(3,169	)
Accrued interest		(12,526	)		—			—			—			(12,526	)
Accrued expenses		3,522			(12,206	)		(1,307	)		—			(9,991	)
Income taxes		33,562			—			—			—			33,562

Net cash provided by (used in) operating activities		49,913			94,891			(7,157	)		—			137,647


Investing activities
Purchases of property and equipment		(1,094	)		(98,879	)		(12,159	)		—			(112,132	)
Proceeds from sale of business		76,806			—			—			—			76,806
Earnout payments		—			(100	)		—			—			(100	)
Restricted cash		1,098			—			—			—			1,098
Acquisition of businesses, net of cash acquired		—			(1,239	)		(2,022	)		—			(3,261	)

Net cash provided by (used in) investing activities		76,810			(100,218	)		(14,181	)		—			(37,589	)


Financing activities
Borrowings on revolving credit facility		210,000			—			—			—			210,000
Payments on revolving credit facility		(290,000	)		—			—			—			(290,000	)
Payments on credit facility term loan		(4,350	)		—			—			—			(4,350	)
Dividends to Holdings		(32,522	)		—			—			—			(32,522	)
Intercompany debt reallocation		(14,049	)		5,309			8,740			—			—
Principal payments on seller and other debt		—			(577	)		(37	)		—			(614	)
Payment of bank overdrafts		(11,824	)		—			—			—			(11,824	)
Distributions to minority interests		—			—			(1,604	)		—			(1,604	)

Net cash provided by (used in) financing activities		(142,745	)		4,732			7,099			—			(130,914	)


Effect of exchange rate changes on cash and cash equivalents		35			—			—			—			35


Net decrease in cash and cash equivalents		(15,987	)		(595	)		(14,239	)		—			(30,821	)

Cash and cash equivalents at beginning of period		16,738			3,631			15,492			—			35,861

Cash and cash equivalents at end of period	$	751		$	3,036		$	1,253		$	—		$	5,040


(a)		Elimination of equity in earnings of subsidiary.

- 28 -


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

You should read this discussion together with our unaudited consolidated financial statements and the accompanying notes.

Forward Looking Statements

This discussion contains forward-looking statements relating to the financial condition, results of operations, plans, objectives, future performance and business of Select Medical Corporation and Select Medical Holdings Corporation. These statements include, without limitation, statements preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “estimates” or similar expressions. These forward-looking statements involve risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to factors including the following:

	•		additional changes in government reimbursement for our services may result in increased costs and have an adverse effect on our future net operating revenues and profitability, such as the regulations released by the Centers for Medicare & Medicaid Services, or CMS, on May 2, 2006 and May 1, 2007;

	•		the failure of our long-term acute care hospitals, or LTCHs, to maintain their status as such may cause our net operating revenues and profitability to decline;

	•		the failure of our facilities operated as “hospitals within hospitals,” or HIHs, to qualify as hospitals separate from their host hospitals may cause our net operating revenues and profitability to decline;

	•		implementation of modifications to the admissions policies for our inpatient rehabilitation facilities, as required to achieve compliance with Medicare guidelines, may result in a loss of patient volume at these hospitals and, as a result, may reduce our future net operating revenues and profitability;

	•		implementation of annual caps that limit the amounts that can be paid for outpatient therapy services rendered to any Medicare beneficiary may reduce our future net operating revenues and profitability;

	•		a government investigation or assertion that we have violated applicable regulations may result in sanctions or reputational harm and increased costs;

	•		integration of recently acquired operations (such as the outpatient rehabilitation division of HealthSouth Corporation) and future acquisitions may prove difficult or unsuccessful, use significant resources or expose us to unforeseen liabilities;

	•		private third-party payors for our services may undertake future cost containment initiatives that limit our future net operating revenues and profitability;

	•		the failure to maintain established relationships with the physicians in our markets could reduce our net operating revenues and profitability;

	•		shortages in qualified nurses or therapists could increase our operating costs significantly;

	•		competition may limit our ability to grow and result in a decrease in our net operating revenues and profitability;

	•		the loss of key members of our management team could significantly disrupt our operations; and

	•		the effect of claims asserted against us or lack of adequate available insurance could subject us to substantial uninsured liabilities.

29

Overview

We are a leading operator of specialty hospitals in the United States. We are also a leading operator of outpatient rehabilitation clinics in the United States. As of September 30, 2007, we operated 87 long-term acute care hospitals and four acute medical rehabilitation hospitals in 26 states and 1,021 outpatient rehabilitation clinics in 37 states and the District of Columbia. We also provide medical rehabilitation services on a contract basis at nursing homes, hospitals, assisted living and senior care centers, schools and work sites. We began operations in 1997 under the leadership of our current management team.

We manage our company through two business segments, our specialty hospital segment and our outpatient rehabilitation segment. We had net operating revenues of $1,473.7 million for the nine months ended September 30, 2007. Of this total, we earned approximately 70% of our net operating revenues from our specialty hospitals and approximately 30% from our outpatient rehabilitation business.

Our specialty hospital segment consists of hospitals designed to serve the needs of long-term stay acute patients and hospitals designed to serve patients that require intensive medical rehabilitation care. Patients in our long-term acute care hospitals typically suffer from serious and often complex medical conditions that require a high degree of care. Patients in our inpatient rehabilitation facilities typically suffer from debilitating injuries, including traumatic brain and spinal cord injuries, and require rehabilitation care in the form of physical and vocational rehabilitation services. Our outpatient rehabilitation business consists of clinics and contract services that provide physical, occupational and speech rehabilitation services. Our outpatient rehabilitation patients are typically diagnosed with musculoskeletal impairments that restrict their ability to perform normal activities of daily living.

Recent Trends and Events

Acquisition of CORA Health Services, Inc.

On October 2, 2007, Select signed a merger agreement to acquire the business of CORA Health Services, Inc. (“CORA”) for approximately $46.0 million in cash. On November 12, 2007, the parties entered into an agreement mutually terminating the merger agreement.

Acquisition of HealthSouth Corporation’s Outpatient Rehabilitation Division

On May 1, 2007, Select completed the acquisition of substantially all of the outpatient rehabilitation division of HealthSouth Corporation. At the closing, Select acquired 540 outpatient rehabilitation clinics. The closing of the purchase of approximately 30 additional outpatient rehabilitation clinics that was deferred pending certain state regulatory approvals was completed as of October 31, 2007 and resulted in the release of an additional $23.4 million of the purchase price. The aggregate purchase price of $245.0 million was reduced by approximately $7.0 million at closing for assumed indebtedness and other unresolved matters. The amount of

30

the consideration was derived through arm’s length negotiations. Select funded the acquisition through borrowings under its senior credit facility and cash on hand.

In conjunction with the acquisition, we have recorded an estimated liability of $22.1 million for restructuring costs associated with workforce reductions and lease termination costs resulting from our preliminary plans for integrating the acquired business. This estimated liability was accounted for as additional purchase price. The restructuring plan and liability will be finalized prior to December 31, 2007. We expect to pay the severance costs through 2008 and the lease termination costs through 2017.

Amendment to Credit Agreement

On March 19, 2007, Select entered into an Amendment No. 2 and Waiver to its senior secured credit facility (“Amendment No. 2”) and on March 28, 2007 Select entered into an Incremental Facility Amendment with a group of lenders and JPMorgan Chase Bank, N.A. as administrative agent. Amendment No. 2 increased the general exception to the prohibition on asset sales under Select’s senior secured credit facility from $100.0 million to $200.0 million, relaxed certain financial covenants starting March 31, 2007 and waived Select’s requirement to prepay certain term loan borrowings following its fiscal year ended December 31, 2006. The Incremental Facility Amendment provided to Select an incremental term loan of $100.0 million, the proceeds of which Select used to pay a portion of the purchase price for the HealthSouth transaction.

Overview of Third Quarter Ended September 30, 2007

For the three months ended September 30, 2007, our net operating revenues increased 12.7% to $500.4 million compared to $443.9 million for the three months ended September 30, 2006. This increase was primarily attributable to the revenues generated by clinics acquired from HealthSouth on May 1, 2007. We realized income from operations for the three months ended September 30, 2007 of $31.3 million compared to $54.3 million for the three months ended September 30, 2006. The decline in income from operations is principally related to a decline in the profitability of our specialty hospitals and an increase in our general and administration costs. Holdings’ interest expense for the three months ended September 30, 2007 was $35.7 million compared to $33.0 million for the three months ended September 30, 2006. Select’s interest expense for the three months ended September 30, 2007 was $27.1 million compared to $24.3 million for the three months ended September 30, 2006. The increase in interest expense for both Holdings and Select is related to higher outstanding debt balances resulting primarily from the HealthSouth transaction and slightly higher interest rates under Select’s senior credit facility.

For the nine months ended September 30, 2007, our net operating revenues increased 4.8% to $1,473.7 million compared to $1,405.8 million for the nine months ended September 30, 2006. This increase was attributable to the revenues generated by clinics acquired from HealthSouth on May 1, 2007, offset by a decline in both our specialty hospital net operating revenues and net operating revenues generated from outpatient rehabilitation clinics we owned prior to the HealthSouth transaction. The decline in our specialty hospital net operating revenues is primarily a result of lost net operating revenues resulting from hospital closures. The decline in our net operating revenues generated from outpatient rehabilitation clinics we owned prior to the HeathSouth transaction is due to a decline in the number of clinics we operate resulting from clinic sales and closures and the volume of visits occurring at the operating clinics. We had income from operations for the nine months ended September 30, 2007 of $152.2 million compared to $198.8 million for the nine months ended September 30, 2006. The decline in income from operations is principally related to a decline in the profitability of our specialty hospitals and an increase in our general and administrative costs. Holdings’ interest expense for the nine months ended September 30, 2007 was $103.6 million compared to $98.5 million for the nine months ended September 30, 2006. Select’s interest expense for the nine months ended September

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30, 2007 was $77.8 million compared to $72.6 million for the nine months ended September 30, 2006. The increase in interest expense for both Holdings and Select is related to higher outstanding debt balances resulting primarily from the HealthSouth transaction and slightly higher interest rates under Select’s senior credit facility.

Cash flow from operations provided $55.0 million of cash for the nine months ended September 30, 2007 for Holdings and $87.8 million of cash for the nine months ended September 30, 2007 for Select.

Regulatory Changes

August 2004 Final Rule. On August 11, 2004, CMS published final regulations applicable to long-term acute care hospitals that are operated as HIHs. Effective for hospital cost reporting periods beginning on or after October 1, 2004, subject to certain exceptions, the final regulations provide lower rates of reimbursement to HIHs for those Medicare patients admitted from their host hospitals that are in excess of a specified percentage threshold. For HIHs opened after October 1, 2004, the Medicare admissions threshold has been established at 25%. For HIHs that meet specified criteria and were in existence as of October 1, 2004, including all but two of our then existing HIHs, the Medicare admissions thresholds are phased-in over a four-year period starting with hospital cost reporting periods that began on or after October 1, 2004. For discharges during the cost reporting period that began on or after October 1, 2005 and before October 1, 2006, the Medicare admissions threshold was the lesser of the Fiscal 2004 Percentage of Medicare discharges admitted from the host hospital or 75%. For discharges during the cost reporting period beginning on or after October 1, 2006 and before October 1, 2007, the Medicare admissions threshold is the lesser of the Fiscal 2004 Percentage of Medicare discharges admitted from the host hospital or 50%. For discharges during cost reporting periods beginning on or after October 1, 2007, the Medicare admissions threshold is 25%. As used above, “Fiscal 2004 Percentage” means, with respect to any HIH, the percentage of all Medicare patients discharged by such HIH during its cost reporting period beginning on or after October 1, 2003 and before October 1, 2004 who were admitted to such HIH from its host hospital, but in no event is the Fiscal 2004 Percentage less than 25%.The HIH regulations also established exceptions to the Medicare admissions thresholds with respect to patients who reach “outlier” status at the host hospital, HIHs located in “MSA-dominant hospitals” or HIHs located in rural areas.

Because these rules are complex and are based on the volume of Medicare admissions from our host hospitals as a percent of our overall Medicare admissions, we cannot predict with any certainty the impact on our future net operating revenues of compliance with these regulations. However, we expect the financial impact to increase as the Medicare admissions thresholds decline during the phase-in of the regulations.

During the nine months ended September 30, 2007, we recorded an additional liability of approximately $4.5 million related to estimated repayments to Medicare for host admissions exceeding an HIH hospital’s admission threshold. The liability has been recorded through a reduction in our net revenue.

August 2005 Final Rule. On August 12, 2005, CMS published the IPPS final rule for fiscal year 2006, which included an update of the LTC-DRG relative weights for fiscal year 2006. CMS estimated the changes to the relative weights would reduce LTCH Medicare payments-per-discharge by approximately 4.2 percent in its fiscal year 2006 which is the period from October 1, 2005 through September 30, 2006.

May 2006 Final Rule. On May 2, 2006, CMS released its final annual payment rate updates for the 2007 LTCH-PPS rate year (affecting discharges and cost reporting periods beginning on or after July 1, 2006 and before July 1, 2007 or “RY 2007”). For discharges occurring on or after July 1, 2006, the rule changed the payment methodology for Medicare patients with a length of stay less than or equal to five-sixths of the geometric average length of stay for each SSO case. Payment for these patients had been based on the lesser of (1) 120 percent of the cost of the case; (2) 120 percent of the LTC-DRG specific per diem amount multiplied by

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the patient’s length of stay; or (3) the full LTC-DRG payment. The May 2006 final rule modified the limitation in clause (1) above to reduce payment for SSO cases to 100 percent (rather than 120 percent) of the cost of the case. The final rule also added a fourth limitation, capping payment for SSO cases at a per diem rate derived from blending 120 percent of the LTC-DRG specific per diem amount with a per diem rate based on the general acute care hospital IPPS. Under this methodology, as a patient’s length of stay increases, the percentage of the per diem amount based upon the IPPS component will decrease and the percentage based on the LTC-DRG component will increase.

In addition, for discharges occurring on or after July 1, 2006, the May 2006 final rule provided for (i) a zero-percent update to the LTCH-PPS standard federal rate used as a basis for LTCH-PPS payments for the 2007 LTCH-PPS rate year; (ii) the elimination of the surgical case exception to the three-day or less interruption of stay policy, under which surgical exception Medicare reimburses a general acute care hospital directly for surgical services furnished to a long-term acute care hospital patient during a brief interruption of stay from the long-term acute care hospital, rather than requiring the long-term acute care hospital to bear responsibility for such surgical services; and (iii) increasing the costs that a long-term acute care hospital must bear before Medicare will make additional payments for a case under its high-cost outlier policy for the 2007 LTCH-PPS rate year.

CMS estimated that the changes in the May 2006 final rule would result in an approximately 3.7 percent decrease in LTCH Medicare payments-per-discharge as compared to the 2006 rate year, largely attributable to the revised SSO payment methodology. We estimate that the May 2006 final rule reduced Medicare revenues associated with SSO cases and high-cost outlier cases to our long-term acute care hospitals by approximately $29.3 million for the 2006 rate year (July 1, 2006 to June 30, 2007). Of this amount, we estimate an effect of approximately $15.3 million on our Medicare payments for 2007.

Additionally, had CMS updated the LTCH-PPS standard federal rate by the 2007 estimated market basket index of 3.4 percent rather than applying the zero-percent update, we estimate that we would have received approximately $31.0 million in additional annual Medicare revenues, based on our historical Medicare patient volumes and revenues (such revenues would have been paid to our hospitals for discharges beginning on or after July 1, 2006).

August 2006 Final Rule. On August 18, 2006, CMS published the IPPS final rule for fiscal year 2007 which is the period from October 1, 2006 through September 30, 2007, which included an update of the LTC-DRG relative weights for fiscal year 2007. CMS estimated the changes to the relative weights would reduce LTCH Medicare payments-per-discharge by approximately 1.3 percent in fiscal year 2007. The August 2006 final rule also included changes to the diagnosis related groups in IPPS that apply to LTCHs, as the LTC-DRGs are based on the IPPS DRGs. CMS created twenty new DRGs and modified thirty-two others, including LTC-DRGs. Prior to the August 2006 final rule, certain HIHs that were in existence on or before September 30, 1995, and certain satellite facilities that were in existence on or before September 30, 1999, referred to as “grandfathered” HIHs or satellites, were not subject to certain HIH “separateness and control” requirements as long as the “grandfathered” HIHs or satellites continued to operate under the same terms and conditions, including the number of beds and square footage, in effect on September 30, 2003 (for grandfathered HIHs) or September 30, 1999 (for grandfathered satellites). These grandfathered HIHs were also not subject to the payment adjustments for discharged Medicare patients admitted from their host hospitals in excess of the specified percentage threshold, as discussed in the August 2004 rule above. The August 2006 final rule revised the regulations to provide grandfathered HIHs and satellites more flexibility in adjusting square footage upward or downward, or decreasing the number of beds without being subject to the “separateness and control” requirements and payment adjustment provisions. As of September 30, 2007, we operated two grandfathered LTCH HIHs.

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May 2007 Final Rule. On May 1, 2007, CMS published its annual payment rate update for the 2008 LTCH-PPS rate year (“RY 2008”) (affecting discharges and cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008). The final rule makes several changes to LTCH-PPS payment methodologies and amounts during RY 2008. The May 2007 final rule may have an adverse effect on our future net operating revenues and profitability.

For cost reporting periods beginning on or after July 1, 2007, the final rule expands the current Medicare HIH admissions threshold to apply to Medicare patients admitted from any individual hospital. Previously, the admissions threshold was applicable only to Medicare HIH admissions from hospitals co-located with a LTCH or satellite of an LTCH. Under the final rule, free-standing LTCHs and grandfathered LTCH HIHs are subject to the Medicare admission thresholds, as well as HIHs and satellites that admit Medicare patients from non-co-located hospitals. To the extent that any LTCH’s or LTCH satellite facility’s discharges that are admitted from an individual hospital (regardless of whether the referring hospital is co-located with the LTCH or LTCH satellite) exceed the applicable percentage threshold during a particular cost reporting period, the payment rate for those discharges would be subject to a downward payment adjustment. Cases admitted in excess of the applicable threshold will be reimbursed at a rate comparable to that under general acute care IPPS, which is generally lower than LTCH-PPS rates. Cases that reach outlier status in the discharging hospital would not count toward the limit and would be paid under LTCH-PPS. CMS estimates the impact of the expansion of the Medicare admission thresholds will result in a reduction of 2.2% of the aggregate payments to all LTCHs in RY 2008.

The applicable percentage threshold will generally be 25%, subject to the phase-in period described below. The percentage threshold for LTCH discharges from a referring hospital that is an “MSA-dominant” hospital or a single urban hospital will be the percentage of total Medicare discharges in the metropolitan statistical area (“MSA”) that are from the referring hospital, but no less than 25% nor more than 50%. For Medicare discharges from LTCHs or LTCH satellites located in rural areas, as defined by the Office of Management and Budget, the percentage threshold would be 50% from any individual referring hospital.

The expanded 25% rule will be phased in over a 3-year period, except that discharges admitted from hospitals co-located with a LTCH or a satellite of an LTCH will remain subject to the current transition period, which will be fully phased-in to the 25% rule for cost reporting periods beginning on or after October 1, 2007. For all other LTCH discharges admitted from a hospital (free-standing LTCHs and grandfathered LTCH HIHs), the 3-year transition period starts with cost reporting periods beginning on or after July 1, 2007 and before July 1, 2008, when the threshold will be the lesser of 75% or the percentage of the LTCH’s or LTCH satellite’s admissions discharged from the referring hospital during its cost reporting period beginning on or after July 1, 2004 and before July 1, 2005 (“RY 2005”). For cost reporting periods beginning on or after July 1, 2008 and before July 1, 2009, the threshold will be the lesser of 50% or the percentage of the LTCH’s or LTCH satellite’s admissions from the referring hospital, during its RY 2005 cost reporting period. For cost reporting periods beginning on or after July 1, 2009, all LTCHs are subject to the 25% threshold (or applicable threshold for rural, urban-single, or MSA-dominant hospitals).

The May 2007 final rule also revised the payment adjustment formula for short stay outlier (“SSO”) patients. Beginning with discharges on or after July 1, 2007, for cases with a length of stay that is less than the average length of stay plus one standard deviation for the same DRG under IPPS (the so-called “IPPS comparable threshold”), the rule effectively lowers the LTCH payment to a rate based on the general acute care hospital IPPS. SSO cases with covered lengths of stay that exceed the IPPS comparable threshold would continue to be paid under the current SSO payment policy. Cases with a covered length of stay less than or equal to the IPPS comparable threshold will be paid at an amount comparable to the IPPS per diem.

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The May 2007 final rule updated the standard Federal rate by 0.71% for RY 2008. As a result, the Federal rate for RY 2008 will equal $38,356.45, as compared to $38,086.04 for RY 2007. In a technical correction to the final rule, CMS increased the fixed-loss amount for high cost outlier in RY 2008 to $20,738, compared to $14,887 in RY 2007. CMS projects an estimated 0.4% decrease in LTCH payments in RY 2008 due to this change in the fixed-loss amount.

In a technical correction to the May 2007 final rule published on July 5, 2007, CMS estimated the overall impact of the May 2007 final rule to be a 1.2% decrease in total estimated LTCH PPS payments for RY 2008.

The May 2007 final rule provides that beginning with the annual payment rate updates to the LTC-DRG classifications and relative weights for the fiscal year 2008 (“FY 2008”) (affecting discharges beginning on or after October 1, 2007 and before September 30, 2008) that annual updates to the LTC-DRG classification and relative weights are to have a budget neutral impact. Under the May 2007 final rule, future LTC-DRG reclassification and recalibrations, by themselves, should neither increase nor decrease the estimated aggregated LTCH PPS payments.

The May 2007 final rule has made several changes to LTCH-PPS payment methodologies that were implemented beginning on July 1, 2007. As a result of these changes, we performed a goodwill impairment assessment for our specialty hospital segment and determined that there was no impairment with respect to goodwill or other recorded intangible assets.

August 2007 Final Rule. On August 1, 2007, CMS published the IPPS final rule for FY 2008, which creates a new patient classification system, with categories referred to as MS-DRGs and MS-LTC-DRGs, respectively, for hospitals reimbursed under IPPS and LTCH PPS. Beginning with discharges on or after October 1, 2007, the new classification categories take into account the severity of the patient’s condition. CMS assigned proposed relative weights to each MS-DRG and MS-LTC-DRG to reflect their relative use of medical care resources. We believe that, because of the proposed relative weights and length of stay assigned to the MS-LTC-DRGs for the patient populations served by our hospitals, our long-term acute care hospital payments may be adversely affected.

The August 2007 final rule published a budget neutral update to the MS-LTC-DRG classification and relative weights. In the preamble to the IPPS final rule for FY 2008, CMS restated that it intends to continue to update the LTC-DRG weights annually in the IPPS rulemaking and those weights would be modified by a budget neutrality adjustment factor to ensure that estimated aggregate LTCH payments after reweighting are equal to estimated aggregate LTCH payments before reweighting.

Transition Plan

Following the adoption of the August 2004 final rule with respect to HIH admissions, we developed a business plan and strategy to adapt to the HIH admission regulations. Our plan included managing admissions at existing HIHs, relocating certain HIHs to leased spaces in smaller host hospitals in the same markets, consolidating HIHs in certain of our markets, relocating certain of our facilities to alternative settings, building or buying free-standing facilities and closing some of our facilities. As a result of the additional regulatory changes regarding admissions to long-term acute care hospitals being implemented by the May 2007 Final Rule, our business plans and strategies in many markets require further review and revision. Given the volatility in the LTCH regulatory environment, it is difficult for us to determine a final business plan and strategy that we will implement in our hospital markets.

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Development of New Specialty Hospitals and Clinics

We expect to continue evaluating opportunities to develop hospitals. We also intend to open new outpatient rehabilitation clinics in our current markets where we can benefit from existing referral relationships and brand awareness to produce incremental growth.

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Operating Statistics

The following table sets forth operating statistics for our specialty hospitals and our outpatient rehabilitation clinics for each of the periods presented. The data in the table reflect the changes in the number of specialty hospitals and outpatient rehabilitation clinics we operate that resulted from acquisitions, start-up activities, closures and consolidations. The operating statistics reflect data for the period of time these operations were managed by us.


	Three Months
	Ended						Nine Months Ended
	September 30,						September 30,
	2006			2007			2006			2007
Specialty hospital data(1):
Number of hospitals — start of period		100			92			101			96
Number of hospital start-ups		1			2			3			3
Number of hospitals closed		(3	)		(3	)		(4	)		(4	)
Number of hospitals consolidated		(1	)		—			(3	)		(4	)

Number of hospitals — end of period		97			91			97			91

Available licensed beds		3,825			3,934			3,825			3,934
Admissions		9,485			9,856			30,122			30,095
Patient days		236,094			242,115			734,070			741,959
Average length of stay (days)		25			25			24			25
Net revenue per patient day(2)	$	1,361		$	1,352		$	1,401		$	1,367
Occupancy rate		66	%		67	%		69	%		69	%
Percent patient days — Medicare		72	%		68	%		73	%		70	%
Outpatient rehabilitation data (3):
Number of clinics owned — start of period		542			996			553			477
Number of clinics acquired		—			1			—			542
Number of clinic start-ups		2			1			7			6
Number of clinics closed/sold		(7	)		(86	)		(23	)		(113	)

Number of clinics owned — end of period		537			912			537			912
Number of clinics managed — end of period		68			109			68			109

Total number of clinics (all) — end of period		605			1,021			605			1,021

Number of visits		714,064			1,160,870			2,261,080			2,887,134
Net revenue per visit (4)	$	95		$	101		$	93		$	100


(1)		Specialty hospitals consist of long-term acute care hospitals and inpatient rehabilitation facilities.

(2)		Net revenue per patient day is calculated by dividing specialty hospital inpatient service revenues by the total number of patient days.

(3)		Clinic data excludes clinics operated by CBIL. CBIL was sold March 1, 2006 and is being reported as discontinued operations for the nine months ended September 30, 2006.

(4)		Net revenue per visit is calculated by dividing outpatient rehabilitation clinic revenue by the total number of visits. For purposes of this computation, outpatient rehabilitation clinic revenue does not include contract services revenue.

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Results of Operations

The following tables outline, for the periods indicated, selected operating data as a percentage of net operating revenues:


	Select Medical
	Holdings						Select Medical
	Corporation						Corporation
	Three Months						Three Months
	Ended						Ended
	September 30,						September 30,
	2006			2007			2006			2007
Net operating revenues		100.0	%		100.0	%		100.0	%		100.0	%
Cost of services(1)		81.6			85.9			81.6			85.9
General and administrative		2.2			2.4			2.2			2.4
Bad debt expense		1.2			2.1			1.2			2.1
Depreciation and amortization		2.8			3.3			2.8			3.3

Income from operations		12.2			6.3			12.2			6.3
Other expense		—			(0.2	)		—			(0.8	)
Interest expense, net		(7.3	)		(7.2	)		(6.1	)		(5.4	)

Income (loss) before minority interests and income taxes		4.9			(1.1	)		6.1			0.1
Minority interests		0.1			0.1			0.1			0.1

Income (loss) before income taxes		4.8			(1.2	)		6.0			—
Income tax expense (benefit)		2.0			(0.6	)		2.4			(0.1	)

Net income (loss)		2.8	%		(0.6	)%		3.6	%		0.1	%

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	Select Medical
	Holdings						Select Medical
	Corporation						Corporation
	Nine Months						Nine Months
	Ended						Ended
	September 30,						September 30,
	2006			2007			2006			2007
Net operating revenues		100.0	%		100.0	%		100.0	%		100.0	%
Cost of services(1)		79.7			82.7			79.7			82.7
General and administrative		2.4			2.4			2.4			2.4
Bad debt expense		1.3			1.7			1.3			1.7
Depreciation and amortization		2.5			2.9			2.5			2.9

Income from operations		14.1			10.3			14.1			10.3
Other expense		—			—			—			(0.2	)
Interest expense, net		(6.9	)		(6.9	)		(5.0	)		(5.1	)

Income from continuing operations before minority interests and income taxes		7.2			3.4			9.1			5.0
Minority interests		0.1			0.1			0.1			0.1

Income from continuing operations before income taxes		7.1			3.3			9.0			4.9
Income tax expense		3.0			1.4			3.6			1.9

Income from continuing operations		4.1			1.9			5.4			3.0
Income from discontinued operations, net of tax		0.7			—			0.7			—

Net income		4.8	%		1.9	%		6.1	%		3.0	%

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The following tables summarize selected financial data by business segment, for the periods indicated:


	Select Medical Holdings Corporation									Select Medical Corporation
	Three Months Ended									Three Months Ended
	September 30,									September 30,
	2006			2007			% Change			2006			2007			% Change
	(in thousands)									(in thousands)
Net operating revenues:
Specialty hospitals	$	329,324		$	334,023			1.4	%	$	329,324		$	334,023			1.4	%
Outpatient rehabilitation		114,043			166,290			45.8			114,043			166,290			45.8
Other		505			72			(85.7	)		505			72			(85.7	)

Total company	$	443,872		$	500,385			12.7	%	$	443,872		$	500,385			12.7	%


Income (loss) from operations:
Specialty hospitals	$	52,424		$	31,730			(39.5	)%	$	52,424		$	31,730			(39.5	)%
Outpatient rehabilitation		12,493			12,342			(1.2	)		12,493			12,342			(1.2	)
Other		(10,604	)		(12,780	)		(20.5	)		(10,604	)		(12,780	)		(20.5	)

Total company	$	54,313		$	31,292			(42.4	)%	$	54,313		$	31,292			(42.4	)%


Adjusted EBITDA:(2)
Specialty hospitals	$	60,812		$	41,646			(31.5	)%	$	60,812		$	41,646			(31.5	)%
Outpatient rehabilitation		15,737			18,099			15.0			15,737			18,099			15.0
Other		(8,896	)		(11,123	)		(25.0	)		(8,896	)		(11,123	)		(25.0	)

Adjusted EBITDA margins:(2)
Specialty hospitals		18.5	%		12.5	%		(32.4	)%		18.5	%		12.5	%		(32.4	)%
Outpatient rehabilitation		13.8			10.9			(21.0	)		13.8			10.9			(21.0	)
Other		N/M			N/M			N/M			N/M			N/M			N/M

Total assets:
Specialty hospitals	$	1,773,586		$	1,853,728					$	1,773,586		$	1,853,728
Outpatient rehabilitation		254,865			483,386						254,865			483,386
Other		102,610			121,126						97,645			116,707

Total company	$	2,131,061		$	2,458,240					$	2,126,096		$	2,453,821


Purchases of property and equipment, net:
Specialty hospitals	$	38,671		$	32,077					$	38,671		$	32,077
Outpatient rehabilitation		876			5,010						876			5,010
Other		771			978						771			978

Total company	$	40,318		$	38,065					$	40,318		$	38,065

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	Select Medical Holdings Corporation									Select Medical Corporation
	Nine Months Ended									Nine Months Ended
	September 30,									September 30,
	2006			2007			% Change			2006			2007			% Change
	(in thousands)									(in thousands)
Net operating revenues:
Specialty hospitals	$	1,049,768		$	1,033,533			(1.5	)%	$	1,049,768		$	1,033,533			(1.5	)%
Outpatient rehabilitation		353,974			438,356			23.8			353,974			438,356			23.8
Other		2,014			1,809			(10.2	)		2,014			1,809			(10.2	)

Total company	$	1,405,756		$	1,473,698			4.8	%	$	1,405,756		$	1,473,698			4.8	%


Income (loss) from operations:
Specialty hospitals	$	195,291		$	141,027			(27.8	)%	$	195,291		$	141,027			(27.8	)%
Outpatient rehabilitation		39,161			47,553			21.4			39,161			47,553			21.4
Other		(35,695	)		(36,387	)		(1.9	)		(35,695	)		(36,387	)		(1.9	)

Total company	$	198,757		$	152,193			(23.4	)%	$	198,757		$	152,193			(23.4	)%


Adjusted EBITDA:(2)
Specialty hospitals	$	218,203		$	168,367			(22.8	)%	$	218,203		$	168,367			(22.8	)%
Outpatient rehabilitation		48,920			60,270			23.2			48,920			60,270			23.2
Other		(30,574	)		(31,593	)		(3.3	)		(30,574	)		(31,593	)		(3.3	)

Adjusted EBITDA margins:(2)
Specialty hospitals		20.8	%		16.3	%		(21.6	)%		20.8	%		16.3	%		(21.6	)%
Outpatient rehabilitation		13.8			13.7			(0.7	)		13.8			13.7			(0.7	)
Other		N/M			N/M			N/M			N/M			N/M			N/M

Total assets:
Specialty hospitals	$	1,773,586		$	1,853,728					$	1,773,586		$	1,853,728
Outpatient rehabilitation		254,865			483,386						254,865			483,386
Other		102,610			121,126						97,645			116,707

Total company	$	2,131,061		$	2,458,240					$	2,126,096		$	2,453,821


Purchases of property and equipment, net:
Specialty hospitals	$	107,001		$	115,344					$	107,001		$	115,344
Outpatient rehabilitation		3,827			9,655						3,827			9,655
Other		1,304			2,898						1,304			2,898

Total company	$	112,132		$	127,897					$	112,132		$	127,897

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The following tables reconcile same store hospitals information:


	Select Medical Holdings Corporation							Select Medical Corporation
	Three Months Ended							Three Months Ended
	September 30,							September 30,
	2006			2007				2006			2007
	(in thousands)						(in thousands)
Net operating revenue
Specialty hospitals net operating revenue	$	329,324		$	334,023			$	329,324		$	334,023
Less: Specialty hospitals in development, opened or closed after 1/1/06		13,713			10,214				13,713			10,214

Specialty hospitals same store net operating revenue	$	315,611		$	323,809			$	315,611		$	323,809


Adjusted EBITDA(2)
Specialty hospitals Adjusted EBITDA(2)	$	60,812		$	41,646			$	60,812		$	41,646
Less: Specialty hospitals in development, opened or closed after 1/1/06		(1,907	)		(5,862	)			(1,907	)		(5,862	)

Specialty hospitals same store Adjusted EBITDA(2)	$	62,719		$	47,508			$	62,719		$	47,508


All specialty hospitals Adjusted EBITDA margin(2)		18.5	%		12.5	%			18.5	%		12.5	%
Specialty hospitals same store Adjusted EBITDA margin(2)		19.9	%		14.7	%			19.9	%		14.7	%


	Select Medical Holdings Corporation						Select Medical Corporation
	Nine Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2007			2006			2007
	(in thousands)						(in thousands)
Net operating revenue
Specialty hospitals net operating revenue	$	1,049,768		$	1,033,533		$	1,049,768		$	1,033,533
Less: Specialty hospitals in development, opened or closed after 1/1/06		51,024			32,944			51,024			32,944

Specialty hospitals same store net operating revenue	$	998,744		$	1,000,589		$	998,744		$	1,000,589


Adjusted EBITDA(2)
Specialty hospitals Adjusted EBITDA(2)	$	218,203		$	168,367		$	218,203		$	168,367
Less: Specialty hospitals in development, opened or closed after 1/1/06		1,008			(10,550	)		1,008			(10,550	)

Specialty hospitals same store Adjusted EBITDA(2)	$	217,195		$	178,917		$	217,195		$	178,917


All specialty hospitals Adjusted EBITDA margin(2)		20.8	%		16.3	%		20.8	%		16.3	%
Specialty hospitals same store Adjusted EBITDA margin(2)		21.7	%		17.9	%		21.7	%		17.9	%

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N/M — Not Meaningful.

(1)		Cost of services include salaries, wages and benefits, operating supplies, lease and rent expense and other operating costs.

(2)		We define Adjusted EBITDA as net income before interest, income taxes, depreciation and amortization, other expense (income), income from discontinued operations, stock compensation expense, and minority interest. We believe that the presentation of Adjusted EBITDA is important to investors because Adjusted EBITDA is used by management to evaluate financial performance and determine resource allocation for each of our operating units. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles. Items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Because Adjusted EBITDA is not a measurement determined in accordance with generally accepted accounting principles and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. See footnote 7 to our interim unaudited consolidated financial statements for the period ended September 30, 2007 for a reconciliation of net income to Adjusted EBITDA as utilized by us in reporting our segment performance in accordance with SFAS No. 131.

Three Months Ended September 30, 2007 Compared to Three Months Ended September 30, 2006

In the following discussion, we address the results of operations of Select and Holdings. With the exception of incremental interest expense and income taxes, the results of operations of Holdings are identical to those of Select. Therefore, the discussion related to net operating revenue, operating expenses, Adjusted EBITDA, income from operations, minority interest and income from discontinued operations is identical for Holdings and Select.

Net Operating Revenues

Our net operating revenues increased by 12.7% to $500.4 million for the three months ended September 30, 2007 compared to $443.9 million for the three months ended September 30, 2006.

Specialty Hospitals. Our specialty hospital net operating revenues increased 1.4% to $334.0 million for the three months ended September 30, 2007 compared to $329.3 million for the three months ended September 30, 2006. Net operating revenues for the specialty hospitals opened as of January 1, 2006 and operated by us throughout both periods increased 2.6% to $323.8 million for the three months ended September 30, 2007 from $315.6 million for the three months ended September 30, 2006. This increase resulted from growth in non-Medicare patient volume offset by a decline in non-Medicare revenue per patient day and a decline in Medicare patient volume. Our patient days for these same store hospitals increased 4.0%. This increase in patient days was due to an increase in non-Medicare volume, which was offset by a decline in Medicare volume of 1.4%.

Outpatient Rehabilitation. Our outpatient rehabilitation net operating revenues increased 45.8% to $166.3 million for the three months ended September 30, 2007 compared to $114.0 million for the three months ended September 30, 2006. The number of patient visits in our outpatient rehabilitation clinics increased 62.6% for the three months ended September 30, 2007 to 1,160,870 visits, compared to 714,064 visits for the three months ended September 30, 2006. Substantially all of the increase in net operating revenues and patient visits was related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation, offset in part by a decrease in net operating revenues due to the sale of a group of clinics at the end of 2006. Net revenue per visit in our clinics was $101 for the three months ended September 30, 2007 compared to $95 for the three months ended September 30, 2006.

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Other. Our other revenues were de minimis for the three months ended September 30, 2007. For the three months ended September 30, 2006 our other revenues were $0.5 million.

Operating Expenses

Our operating expenses increased by 20.0% to $452.7 million for the three months ended September 30, 2007 compared to $377.2 million for the three months ended September 30, 2006. Our operating expenses include our cost of services, general and administrative expense and bad debt expense. The increase in operating expenses was principally related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation. As a percentage of our net operating revenues, our operating expenses were 90.4% for the three months ended September 30, 2007 compared to 85.0% for the three months ended September 30, 2006. Cost of services as a percentage of operating revenues was 85.9% for the three months ended September 30, 2007 compared to 81.6% for the three months ended September 30, 2006. This increase in the relative percentage for cost of services is due to an increase in labor costs at our specialty hospitals and a higher relative labor cost component in the outpatient operations acquired from HealthSouth. Another component of cost of services is facility rent expense, which was $25.6 million for the three months ended September 30, 2007 compared to $20.0 million for the three months ended September 30, 2006. The increase in rent expense was principally related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation. During the same time period, general and administrative expense increased as a percentage of net operating revenues to 2.4% compared to 2.2% for the three months ended September 30, 2006. This increase is due to higher incentive compensation costs in 2007. Our bad debt expense as a percentage of net operating revenues was 2.1% for the three months ended September 30, 2007 compared to 1.2% for the three months ended September 30, 2006. This increase occurred across both business segments. In our specialty hospital segment we have experienced an increase in our bad debts associated with the write-off of uncollectible Medicare co-payments and deductibles. In our outpatient segment we have experienced an aging of our accounts receivable which has generated higher reserve requirements and an increase in bad debt expense under our reserve methodology.

Adjusted EBITDA

Specialty Hospitals. Adjusted EBITDA for our specialty hospitals decreased by 31.5% to $41.6 million for the three months ended September 30, 2007 compared to $60.8 million for the three months ended September 30, 2006. Our Adjusted EBITDA margins decreased to 12.5% for the three months ended September 30, 2007 from 18.5% for the three months ended September 30, 2006. The hospitals opened as of January 1, 2006 and operated by us throughout both periods had Adjusted EBITDA of $47.5 million for the three months ended September 30, 2007, a decrease of $15.2 million or 24.3% over the Adjusted EBITDA of these hospitals for the three months ended September 30, 2006. Our Adjusted EBITDA margin in these same store hospitals decreased to 14.7% for the three months ended September 30, 2007 from 19.9% for the three months ended September 30, 2006. The decrease in our Adjusted EBITDA is the result of a decline in our non-Medicare rate per patient day and increases in our labor costs and bad debt expenses offset by the increase in Adjusted EBITDA resulting from the increase in our non-Medicare volume.

Outpatient Rehabilitation. Adjusted EBITDA for our outpatient rehabilitation clinics increased by 15.0% to $18.1 million for the three months ended September 30, 2007 compared to $15.7 million for the three months ended September 30, 2006. Our Adjusted EBITDA margins decreased to 10.9% for the three months ended September 30, 2007 from 13.8% for the three months ended September 30, 2006. The increase in Adjusted EBITDA was the result of Adjusted EBITDA contributed by the acquisition of the outpatient rehabilitation division of HealthSouth Corporation and an increase in the net revenue per visit at our existing clinics, offset in

44

part by a reduction due to the sale of a group of clinics at the end of 2006. Our Adjusted EBITDA margins decreased due to lower margins generated by the clinics acquired from HealthSouth Corporation.

Other. The Adjusted EBITDA loss was $11.1 million for the three months ended September 30, 2007 compared to an Adjusted EBITDA loss of $8.9 million for the three months ended September 30, 2006. This reduction in the Adjusted EBITDA loss was primarily the result of the increase in our general and administrative costs.

Income from Operations

For the three months ended September 30, 2007 we had income from operations of $31.3 million compared to $54.3 million for the three months ended September 30, 2006. The decrease in income from operations resulted from the Adjusted EBITDA changes described above and an increase in depreciation and amortization expense. The increase in depreciation and amortization expense resulted primarily from increased depreciation expense associated with free-standing hospitals we have placed in service and an increase in depreciation and amortization expense related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation.

Interest Expense

Select Medical Corporation. Interest expense was $27.1 million for the three months ended September 30, 2007 compared to $24.3 million for the three months ended September 30, 2006. The increase in interest expense is related to higher outstanding debt balances and slightly higher interest rates under Select’s senior credit facility. The increase in outstanding debt is principally related to the borrowings used to fund the acquisition of the outpatient rehabilitation division of HealthSouth Corporation.

Select Medical Holdings Corporation. Interest expense was $35.7 million for the three months ended September 30, 2007 compared to $33.0 million for the three months ended September 30, 2006. The increase in interest expense is related to higher outstanding debt balances and slightly higher interest rates under Select’s senior credit facility. The increase in outstanding debt is principally related to the borrowings used to fund the acquisition of the outpatient rehabilitation division of HealthSouth Corporation.

Minority Interests

Minority interests in consolidated earnings was $0.2 million for the three months ended September 30, 2007 compared to $0.4 million for the three months ended September 30, 2006.

Income Taxes

Select Medical Corporation. We recorded an income tax benefit of $0.7 million for the three months ended September 30, 2007. The benefit reflected the realization of certain tax losses. For the three months ended September 30, 2006, we recorded income tax expense of $10.7 million, representing an effective tax rate of 39.8%.

Select Medical Holdings Corporation. We recorded an income tax benefit of $2.7 million for the three months ended September 30, 2007. The benefit recoups tax paid at a rate of 46.8%. For the three months ended September 30, 2006, we recorded income tax expense of $8.7 million. This expense represented an effective tax rate of 41.0%.

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Nine Months Ended September 30, 2007 Compared to Nine Months Ended September 30, 2006

In the following discussion, we address the results of operations of Select and Holdings. With the exception of incremental interest expense and income taxes, the results of operations of Holdings are identical to those of Select. Therefore, the discussion related to net operating revenue, operating expenses, Adjusted EBITDA, income from operations, minority interest and income from discontinued operations is identical for Holdings and Select.

Net Operating Revenues

Our net operating revenues increased by 4.8% to $1,473.7 million for the nine months ended September 30, 2007 compared to $1,405.8 million for the nine months ended September 30, 2006.

Specialty Hospitals. Our specialty hospital net operating revenues decreased 1.5% to $1,033.5 million for the nine months ended September 30, 2007 compared to $1,049.8 million for the nine months ended September 30, 2006. The decline was primarily related to the loss of net operating revenues resulting from hospital closures. Net operating revenues for the specialty hospitals opened as of January 1, 2006 and operated by us throughout both periods increased 0.2% to $1,000.6 million for the nine months ended September 30, 2007 from $998.7 million for the nine months ended September 30, 2006. This increase resulted primarily from an increase in our non-Medicare patient volume that generally has payment rates exceeding our Medicare rates offset by a decline in our Medicare rates due to the LTCH regulatory changes that reduced our Medicare payments by approximately $20.4 million. Our patient days for these same store hospitals increased 2.9%. This increase in patient days was due to an increase in non-Medicare volume, which was offset by a decline in Medicare volume of 1.1%.

Outpatient Rehabilitation. Our outpatient rehabilitation net operating revenues increased 23.8% to $438.4 million for the nine months ended September 30, 2007 compared to $354.0 million for the nine months ended September 30, 2006. The number of patient visits in our outpatient rehabilitation clinics increased 27.7% for the nine months ended September 30, 2007 to 2,887,134 visits, compared to 2,261,080 visits for the nine months ended September 30, 2006. Substantially all of the increase in net operating revenues and patient visits was related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation, offset in part by a reduction due to the sale of a group of clinics at the end of 2006. Net revenue per visit in our clinics was $100 for the nine months ended September 30, 2007 compared to $93 for the nine months ended September 30, 2006.

Other. Our other revenues were $1.8 million for the nine months ended September 30, 2007 compared to $2.0 million for the nine months ended September 30, 2006.

Operating Expenses

Our operating expenses increased by 9.2% to $1,279.5 million for the nine months ended September 30, 2007 compared to $1,172.0 million for the nine months ended September 30, 2006. Our operating expenses include our cost of services, general and administrative expense and bad debt expense. The increase in operating expenses was principally related to the acquisition of the outpatient division of HealthSouth Corporation. As a percentage of our net operating revenues, our operating expenses were 86.8% for the nine months ended September 30, 2007 compared to 83.4% for the nine months ended September 30, 2006. Cost of services as a percentage of operating revenues was 82.7% for the nine months ended September 30, 2007 compared to 79.7% for the nine months ended September 30, 2006. This increase in the relative percentage for cost of services is due to the significant decline in our specialty hospital Medicare revenue and an increase in labor costs at our specialty hospitals. Another component of cost of services is facility rent expense, which was

46

$70.8 million for the nine months ended September 30, 2007 compared to $61.1 million for the nine months ended September 30, 2006. The increase in rent expense is principally related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation. During the same time period, general and administrative expense remained constant as a percent of net operating revenues at 2.4%. Our bad debt expense as a percentage of net operating revenues was 1.7% for the nine months ended September 30, 2007 compared to 1.3% for the nine months ended September 30, 2006. This increase occurred across both business segments. In our specialty hospital segment we have experienced an increase in our bad debts associated with the write-off of uncollectible Medicare co-payments and deductibles. In our outpatient segment we have experienced an aging of our accounts receivable which has generated higher reserve requirements and an increase in bad debt expense under our reserve methodology.

Adjusted EBITDA

Specialty Hospitals. Adjusted EBITDA for our specialty hospitals decreased by 22.8% to $168.4 million for the nine months ended September 30, 2007 compared to $218.2 million for the nine months ended September 30, 2006. Our Adjusted EBITDA margins decreased to 16.3% for the nine months ended September 30, 2007 from 20.8% for the nine months ended September 30, 2006. The hospitals opened as of January 1, 2006 and operated by us throughout both periods had Adjusted EBITDA of $178.9 million for the nine months ended September 30, 2007, a decrease of $38.3 million or 17.6% compared to the Adjusted EBITDA of these hospitals for the nine months ended September 30, 2006. Our Adjusted EBITDA margin in these same store hospitals decreased to 17.9% for the nine months ended September 30, 2007 from 21.7% for the nine months ended September 30, 2006. The decrease in our Adjusted EBITDA is principally due to a $20.4 million decline in our Medicare net operating revenues resulting from LTCH regulatory changes that reduced our payment rates for Medicare cases without any corresponding reduction in the costs to care for those Medicare cases. We also experienced a decline in our non-Medicare rate per patient day and increase in our labor costs that contributed to the decrease in our Adjusted EBITDA. These contributors to the decline in our Adjusted EBITDA were offset by an increase in Adjusted EBITDA resulting from an increase in our non-Medicare volume.

Outpatient Rehabilitation. Adjusted EBITDA for our outpatient rehabilitation clinics increased by 23.2% to $60.3 million for the nine months ended September 30, 2007 compared to $48.9 million for the nine months ended September 30, 2006. Our Adjusted EBITDA margins decreased slightly to 13.7% for the nine months ended September 30, 2007 from 13.8% for the nine months ended September 30, 2006. The increase in Adjusted EBITDA was the result of the Adjusted EBITDA contributed by the acquisition of the outpatient rehabilitation division of HealthSouth Corporation and an increase in the net revenue per visit at our existing clinics, offset in part by a reduction due to the sale of a group of clinics at the end of 2006.

Other. The Adjusted EBITDA loss was $31.6 million for the nine months ended September 30, 2007 compared to an Adjusted EBITDA loss of $30.6 million for the nine months ended September 30, 2006 and is principally composed of our general and administrative costs.

Income from Operations

For the nine months ended September 30, 2007 we had income from operations of $152.2 million compared to $198.8 million for the nine months ended September 30, 2006. The decrease in income from operations resulted from the Adjusted EBITDA changes described above and an increase in depreciation and amortization expense. The increase in depreciation and amortization expense resulted primarily from increased depreciation expense associated with free-standing hospitals we have placed in service and an increase in depreciation and amortization expense related to the acquisition of the outpatient rehabilitation division of HealthSouth Corporation.

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Interest Expense

Select Medical Corporation. Interest expense was $77.8 million for the nine months ended September 30, 2007 compared to $72.6 million for the nine months ended September 30, 2006. The increase in interest expense is related to higher outstanding debt balances and slightly higher interest rates under Select’s senior credit facility. The increase in outstanding debt is principally related to borrowings used to fund the acquisition of the outpatient rehabilitation division of HealthSouth Corporation.

Select Medical Holdings Corporation. Interest expense was $103.6 million for the nine months ended September 30, 2007 compared to $98.5 million for the nine months ended September 30, 2006. The increase in interest expense is related to higher outstanding debt balances and slightly higher interest rates under Select’s senior credit facility. The increase in outstanding debt is principally related to borrowings used to fund the acquisition of the outpatient rehabilitation division of HealthSouth Corporation.

Minority Interests

Minority interests in consolidated earnings was $1.4 million for the nine months ended September 30, 2007 compared to $1.1 million for the nine months ended September 30, 2006.

Income Taxes

Select Medical Corporation. We recorded income tax expense of $28.5 million for the nine months ended September 30, 2007. The expense represented an effective tax rate of 39.3%. For the nine months ended September 30, 2006, we recorded income tax expense of $51.3 million. This expense represented an effective tax rate of 40.5%.

Select Medical Holdings Corporation. We recorded income tax expense of $20.3 million for the nine months ended September 30, 2007. The expense represented an effective tax rate of 41.4%. For the nine months ended September 30, 2006, we recorded income tax expense of $41.9 million. This expense represented an effective tax rate of 41.9%.

Income from Discontinued Operations, Net of Tax

On March 1, 2006, we sold our wholly-owned subsidiary, Canadian Back Institute Limited (“CBIL”), for approximately C$89.8 million in cash (US$79.0 million). We conducted all of our Canadian operations through CBIL. The financial results of CBIL have been reclassified as discontinued operations for all periods presented in this report. We recognized a gain on sale (net of tax) of $9.1 million in the quarter ended March 31, 2006.

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Liquidity and Capital Resources

The following table summarizes the statement of cash flows of Holdings and Select for the nine months ended September 30, 2006 and 2007:


	Select Medical Holdings
	Corporation						Select Medical Corporation
	Nine Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2007			2006			2007
	(in thousands)						(in thousands)
Cash flows provided by operating activities	$	105,166		$	55,020		$	137,647		$	87,785
Cash flows used in investing activities		(37,589	)		(326,045	)		(37,589	)		(326,045	)
Cash flows provided by (used in) financing activities		(98,433	)		199,528			(130,914	)		166,763
Effect of exchange rate changes on cash and cash equivalents		35			—			35			—

Net decrease in cash and cash equivalents		(30,821	)		(71,497	)		(30,821	)		(71,497	)
Cash and cash equivalents at beginning of period		35,861			81,600			35,861			81,600

Cash and cash equivalents at end of period	$	5,040		$	10,103		$	5,040		$	10,103

Operating activities of Holdings provided $55.0 million and $105.2 million of cash flow for the nine months ended September 30, 2007 and September 30, 2006, respectively. Our days sales outstanding increased to 47 days at September 30, 2007, from 41 days at December 31, 2006. The increase in days sales outstanding is primarily related to the timing of the periodic interim payments we received from Medicare for the services provided at our specialty hospitals. The decline in cash flows provided by operating activities is a result of the decline in our operating performance described above.

The operating cash flow of Select exceeds the operating cash flow of Holdings by $32.8 million for the nine months ended September 30, 2007 and by $32.5 million for the nine months ended September 30, 2006. The difference primarily relates to interest payments related to Holdings senior subordinated notes and senior floating rate notes.

Investing activities used $326.0 million of cash flow for the nine months ended September 30, 2007. Investing activities used $37.6 million of cash flow for the nine months ended September 30, 2006. The primary use of cash for the nine months ended September 30, 2007 was for building improvements and equipment purchases of $127.9 million and acquisition payments of $214.0 for the acquisition of HealthSouth’s outpatient rehabilitation division, offset in part by aggregate proceeds of $12.4 million from a sale of business units and a building. The primary source of cash from investing activities in the nine months ended September 30, 2006 was from the sale of CBIL, which generated cash proceeds of $76.8 million, which was offset by cash disbursements of $112.1 million for building improvements and equipment purchases and acquisition payments of $3.3 million which primarily related to the repurchase of minority interests.

Financing activities of Holdings provided $199.5 million of cash flow for the nine months ended September 30, 2007. The primary source of cash related to borrowings on Select’s senior credit facility net of repayments of $195.2 million and offset by distributions to minority interests of $1.5 million. The primary purpose of the borrowings under Select’s senior credit facility was to fund the acquisition of HealthSouth’s outpatient rehabilitation division. Financing activities of Holdings used $98.4 million of cash for the nine months ended

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September 30, 2006. The cash usage resulted primarily from principal repayments on Select’s senior credit facility of $84.4 million and repayment of bank overdrafts of $11.8 million.

The difference in cash flows provided by (used in) financing activities of Holdings compared to Select of $32.8 million for the nine months ended September 30, 2007 and $32.5 million for the nine months ended September 30, 2006 relates to dividends paid by Select to Holdings to service Holdings’ interest obligations related to its senior subordinated notes and its senior floating rate notes.

Capital Resources

Holdings’ had a net working capital deficit of $17.5 million at September 30, 2007 compared to a working capital surplus of $27.9 million at December 31, 2006. Select’s net working capital deficit was $14.4 million at September 30, 2007 compared to a working capital surplus of $39.4 million at December 31, 2006. The difference between Holdings’ and Select’s net working capital is related to the timing of the interest payments on Holdings 10% senior subordinated notes and its senior floating rate notes and the funding of these interest payments by Select through a dividend to Holdings.

On March 19, 2007, Select entered into an Amendment No. 2 and Waiver to its senior secured credit facility, and on March 28, 2007, Select entered into an Incremental Facility Amendment with a group of lenders and JPMorgan Chase Bank, N.A. as administrative agent. Amendment No. 2 increased the general exception to the prohibition on asset sales under Select’s senior secured credit facility from $100.0 million to $200.0 million, relaxed certain financial covenants starting March 31, 2007 and waived Select’s requirement to prepay certain term loan borrowings following its fiscal year ended December 31, 2006. The Incremental Facility Amendment provided to us an incremental term loan of $100.0 million, the proceeds of which we used to pay a portion of the purchase price for the HealthSouth transaction.

After giving effect to the Incremental Facility Amendment, Select’s senior secured credit facility provides for senior secured financing of up to $980.0 million, consisting of:

•

a $300.0 million revolving loan facility that will terminate on February 24, 2011, including both a letter of credit sub-facility and a swingline loan sub-facility, and

•

a $680.0 million term loan facility that matures on February 24, 2012.

The interest rates per annum applicable to loans, other than swingline loans, under Select’s senior secured credit facility are, at its option, equal to either an alternate base rate or an adjusted LIBOR rate for a one, two, three or six month 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 greater of (1) JPMorgan Chase Bank, N.A.’s prime rate and (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. The adjusted LIBOR rate is determined by reference to settlement rates established for deposits in dollars in the London interbank market for a period equal to the interest period of the loan and the maximum reserve percentages established by the Board of Governors of the United States Federal Reserve to which our lenders are subject. The applicable margin percentage for borrowings under our revolving loans is subject to change based upon the ratio of our total indebtedness to our consolidated EBITDA (as defined in the credit agreement). The applicable margin percentage for revolving loans will increase from (1) 1.25% to 1.50% for alternate base rate loans and (2) 2.25% to 2.50% for adjusted LIBOR loans upon the delivery of Select’s September 30, 2007 consolidated financial statements to JPMorgan Chase Bank, N.A. as administrative agent to Select’s senior secured credit facility. The applicable margin percentages for the term loans after giving effect

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to the incremental facility amendment, are (1) 1.00% for alternate base rate loans and (2) 2.00% for adjusted LIBOR loans.

On June 13, 2005, Select entered into a five year interest rate swap transaction with an effective date of August 22, 2005. On March 8, 2007, Select entered into an additional interest rate swap transaction for three years with an effective date of May 22, 2007. The swaps are designated as a cash flow hedge of forecasted LIBOR-based variable rate interest payments. The underlying variable rate debt is $400.0 million.

On February 24, 2005, EGL Acquisition Corp. issued and sold $660.0 million in aggregate principal amount of 7 ⁵/₈% senior subordinated notes due 2015, which Select assumed in connection with the Merger. The net proceeds of the offering were used to finance a portion of the funds needed to consummate the Merger with EGL Acquisition Corp. The notes were issued under an indenture between EGL Acquisition Corp. and U.S. Bank Trust National Association, as trustee. Interest on the notes is payable semi-annually in arrears on February 1 and August 1 of each year. The notes are guaranteed by all of our wholly-owned subsidiaries, subject to certain exceptions. On or after February 1, 2010, the notes may be redeemed at our option, in whole or in part, at redemption prices that decline annually to 100% on and after February 1, 2013, plus accrued and unpaid interest. Prior to February 1, 2008, we may at our option on one or more occasions with the net cash proceeds from certain equity offerings redeem the outstanding notes in an aggregate principal amount not to exceed 35% of the aggregate principal amount originally issued at a redemption price of 107.625%, plus accrued and unpaid interest to the redemption date. Upon a change of control of Holdings, each holder of notes may require us to repurchase all or any portion of the holder’s notes at a purchase price equal to 101% of the principal amount plus accrued and unpaid interest to the date of purchase.

On September 29, 2005, Holdings sold $175.0 million of senior floating rate notes due 2015, which bear interest at a rate per annum, reset semi-annually, equal to the 6-month LIBOR plus 5.75%. Interest is payable semi-annually in arrears on March 15 and September 15 of each year, with the principal due in full on September 15, 2015. The senior floating rate notes are general unsecured obligations of Holdings and are not guaranteed by Select or any of our subsidiaries. In connection with the issuance of the senior floating rate notes, we entered into an interest rate swap transaction. The notional amount of the interest rate swap is $175.0 million. The variable interest rate of the debt was 11.3 % and the fixed rate after the swap was 10.2% at September 30, 2007. The net proceeds of the issuance of the senior floating rate notes, together with cash was used to reduce the amount of our preferred stock, to make a payment to participants in our long-term incentive plan and to pay related fees and expenses.

We believe internally generated cash flows and borrowings of revolving loans under Select’s senior secured credit facility will be sufficient to finance operations for at least the next twelve months.

Following the adoption of the August 2004 final rule with respect to HIH admissions, we developed a business plan and strategy to adapt to the HIH admission regulations. Our plan included managing admissions at existing HIHs, relocating certain HIHs to leased spaces in smaller host hospitals in the same markets, consolidating HIHs in certain of our markets, relocating certain of our facilities to alternative settings, building or buying free-standing facilities and closing some of our facilities. As a result of the additional regulatory changes regarding admissions to long-term acute care hospitals being implemented by the May 2007 Final Rule, our business plans and strategies in many markets require further review and revision. Given the volatility in the LTCH regulatory environment, it is difficult for us to determine a final business plan and strategy that we will implement in our hospital markets.

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During the nine months ended September 30, 2007, we relocated nine of our HIH hospitals into two new free standing buildings and four new HIH hospitals. Additionally, we opened two free standing hospitals and closed four HIH hospitals during the nine months ended September 30, 2007.

We also continue to evaluate opportunities to develop hospitals. We also intend to open new outpatient rehabilitation clinics in our current markets where we can benefit from existing referral relationships and brand awareness to produce incremental growth.

We periodically investigate strategic acquisitions that could increase our market share in one or both of our business segments. We cannot predict the likelihood that any of these business acquisitions will be consummated nor can we predict the cost of this type of acquisition.

Inflation

The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. In addition, suppliers pass along rising costs to us in the form of higher prices. We have implemented cost control measures, including our case and resource management program, to curtail increases in operating costs and expenses. We cannot predict our ability to cover or offset future cost increases.

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) Issued SFAS No. 159, “Establishing the Fair Value Option for Financial Assets and Liabilities” (“SFAS No. 159”). SFAS No. 159 permits all entities to choose to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157, “Fair Value Measurements.” An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing at November 15, 2007 (or early adoption date). The Company does not expect the adoption of SFAS No. 159 to have a material effect on the Company’s financial statements.

In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to current practice resulting from the application of SFAS No. 157 relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company does not expect that the adoption of the provisions of SFAS No. 157 will materially impact its consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Quantitative and Qualitative Disclosures About Market Risk

We are subject to interest rate risk in connection with our long-term indebtedness. Our principal interest rate exposure relates to the loans outstanding under Select’s senior secured credit facility and Holdings’ senior floating rate notes. As of September 30, 2007, Select had $765.0 million in term and revolving loans

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outstanding under its senior secured credit facility, which bear interest at variable rates. On June 13, 2005, Select entered into a five year interest rate swap transaction with an effective date of August 22, 2005. On March 8, 2007, Select entered into an additional interest rate swap transaction for three years with an effective date of May 22, 2007. Select entered into the swap transactions to mitigate the risks of future variable rate interest payments. The notional amount of the interest rate swaps are $400.0 million and the underlying variable rate debt is associated with the senior secured credit facility. Each eighth point change in interest rates on the variable rate portion of our long-term indebtedness would result in a $0.5 million change in annual interest expense on the term loans.

In conjunction with the issuance of the Holdings’ senior floating rate notes, on September 29, 2005 we entered into a swap transaction to mitigate the risks of future variable rate interest payments associated with this debt. The notional amount of the interest rate swap is $175.0 million and the swap is for a period of five years.

ITEM 4T. CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered in this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures, including the communication of disclosure to our principal executive officer and principal financial officer as appropriate to allow timely decisions regarding disclosure, are effective to provide reasonable assurance that material information required to be included in our periodic SEC reports is recorded, processed, summarized and reported within the time periods specified in the relevant SEC rules and forms.

During the period covered by this report, there has been no change to our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On August 24, 2004, Clifford C. Marsden and Ming Xu filed a purported class action complaint in the United States District Court for the Eastern District of Pennsylvania on behalf of the public stockholders of Select against Martin F. Jackson, Robert A. Ortenzio, Rocco A. Ortenzio, Patricia A. Rice and Select. In February 2005, the Court appointed James Shaver, Frank C. Bagatta and Capital Invest, die Kapitalanlagegesellschaft der Bank Austria Creditanstalt Gruppe GmbH as lead plaintiffs (“Lead Plaintiffs”).

On April 19, 2005, Lead Plaintiffs filed an amended complaint, purportedly on behalf of a class of shareholders of Select, against Martin F. Jackson, Robert A. Ortenzio, Rocco A. Ortenzio, Patricia A. Rice and the Company as defendants. The amended complaint continues to allege, among other things, failure to disclose adverse information regarding a potential regulatory change affecting reimbursement for the Company’s services applicable to long-term acute care hospitals operated as hospitals within hospitals, failure to disclose alleged improper revenue practices, and the issuance of false and misleading statements about the financial outlook of Select. The amended complaint seeks, among other things, damages in an unspecified amount, interest and attorneys’ fees. We believe that the allegations in the amended complaint are without merit and intend to vigorously defend against this action. In April 2006, the Court granted in part and denied in part Select’s and the individual officers’ preliminary motion to dismiss the amended complaint. In February 2007,

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the Court vacated in part its previous decision on the Company’s and the individual officers’ motion to dismiss and dismissed plaintiffs’ claims regarding Select’s alleged improper revenue practices. The Plaintiffs have asked the court to reconsider this ruling and in June 2007 the court denied the plaintiffs’ request. Select and the individual officers have answered the amended complaint. On October 25, 2007, the court certified a class of investors who purchased Select stock between July 29, 2003 and May 11, 2004, inclusive. The court appointed class representatives and class counsel. Discovery is ongoing. We do not believe this claim will have a material adverse effect on our financial position, cash flows or results of operations. However, due to the uncertain nature of such litigation, we cannot predict the outcome of this matter.

We are subject to legal proceedings and claims that arise in the ordinary course of our business, which include malpractice claims covered under insurance policies. In our opinion, the outcome of these actions will not have a material adverse effect on our financial position, cash flows or results of operations.

To cover claims arising out of the operations of our hospitals and outpatient rehabilitation facilities, we maintain professional malpractice liability insurance and general liability insurance. We also maintain umbrella liability insurance covering claims which, due to their nature or amount, are not covered by or not fully covered by our 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 us to substantial uninsured liabilities.

Health care providers are often 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. A qui tam lawsuit against Select was filed on June 10, 2003 in the United States District Court for the District of Nevada. The action was originally under seal, during which time the federal government was conducting an investigation of matters alleged by this complaint as required by law. We received subpoenas for patient records and other documents apparently related to the federal government’s investigation. In July 2007, the federal government declined to intervene in the case, but stated that it would continue its investigation. In August 2007, the judge ordered the complaint to be unsealed and served upon the defendants by the relators. All other previous filings in this matter remain under seal. To date, Select has not been served with the complaint by the relators. However, because the complaint is not longer under seal it is available to the public. The complaint confirms the three relators in this qui tam lawsuit are two former employees of our Las Vegas, Nevada subsidiary who were terminated by Select in 2001 and a former employee of our Florida subsidiary who we asked to resign. The complaint names, as defendants, Select Medical Corporation, Sports Therapy Arthritis Rehabilitation, Inc. (STAR), and Sports and Orthopedic Rehabilitation Services of Florida (SORS). The complaint includes three counts alleging violations of the federal False Claims Act, conspiracy to violate the False Claims Act, and wrongful discharge of one of the relators. Specifically, the complaint alleges that: SORS used unlicensed personnel to provide therapy services to Medicare patients and did not follow the Medicare billing rules for group therapy; Select and STAR billed Medicare patients for services beyond the Medicare approved amount, over-billed Medicare for therapy services, and resubmitted denied Medicare claims; and Select used billing numbers on Medicare claims belonging to therapists no longer employed by Select, waived co-pays from patients without commercial insurance, and granted discounts to patients who paid cash which were not reported on the clinics’ books. Select sued the former Las Vegas employees in state court in Nevada in 2001 for, among other things, return of misappropriated funds. The Company’s lawsuit has been transferred to the federal court in Las Vegas where it could be consolidated with the qui tam lawsuit. The former Las Vegas employees’ counterclaims against the Company in the Company’s lawsuit have been dismissed. While the government has investigated but chosen not to intervene in two previous qui tam lawsuits filed against Select,

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the Company cannot provide assurance that the government will not intervene in the Nevada qui tam case at a later date or any other existing or future qui tam lawsuit against the Company. The Company does not know whether the relators will pursue the qui tam lawsuit independently. While litigation is inherently uncertain, we believe, based on the limited information currently available to us, that this qui tam action will not have a material adverse effect on our financial position, cash flows or results of operations.

ITEM 1A. RISK FACTORS.

There have been no material changes from our risk factors as previously reported in our Annual Report on Form 10-K for the year ended December 31, 2006, as updated in our Quarterly Report on Form 10-Q for the three months ended March 31, 2007.

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

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

The exhibits to this report are listed in the Exhibit Index appearing on page 57 hereof.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.


	SELECT MEDICAL CORPORATION
	By:	/s/ Martin F. Jackson
		Martin F. Jackson
		Executive Vice President and Chief Financial Officer (Duly Authorized Officer)



	By:	/s/ Scott A. Romberger
		Scott A. Romberger
		Senior Vice President, Chief Accounting Officer and Controller (Principal Accounting Officer)

Dated: November 13, 2007


	SELECT MEDICAL HOLDINGS CORPORATION
	By:	/s/ Martin F. Jackson
		Martin F. Jackson
		Executive Vice President and Chief Financial Officer (Duly Authorized Officer)



	By:	/s/ Scott A. Romberger
		Scott A. Romberger
		Senior Vice President, Chief Accounting Officer and Controller (Principal Accounting Officer)

Dated: November 13, 2007

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EXHIBIT INDEX


Exhibit		Description

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Executive Vice President and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

C 32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Executive Vice President and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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Select Medical Holdings - 10-Q quarterly report FY

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