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TMCNet:  ENSIGN GROUP, INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

[February 13, 2014]

ENSIGN GROUP, INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes, which appear elsewhere in this Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report. See Item 1A. - "Risk Factors" and "Cautionary Note Regarding Forward-Looking Statements." Overview We, through our subsidiaries, provide skilled nursing and rehabilitative care services through the operation of 119 facilities, nine home health and seven hospice operations, seven urgent care centers and a mobile x-ray and diagnostic company as of December 31, 2013, located in Arizona, California, Colorado, Idaho, Iowa, Nebraska, Nevada, Oregon, Texas, Utah and Washington. Our operations, each of which strives to be the operation of choice in the community it serves, provides a broad spectrum of healthcare services including skilled nursing, assisted living, home health and hospice, mobile ancillary, and urgent care services. Our facilities have a collective capacity of approximately 13,200 operational skilled nursing, assisted living and independent living beds. As of December 31, 2013, we owned 96 of its 119 facilities and operated an additional 23 facilities through long-term lease arrangements, and had options to purchase two of those 23 facilities.


The following table summarizes our facilities and operational skilled nursing, assisted living and independent living beds by ownership status as of December 31, 2013: Leased Leased (with a (without a Purchase Purchase Owned Option) Option) Total Number of facilities 96 2 21 119 Percent of total 80.7 % 1.7 % 17.6 % 100.0 % Operational skilled nursing, assisted living and independent living beds 10,443 414 2,347 13,204 Percent of total 79.1 % 3.1 % 17.8 % 100.0 % The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenues. All of our skilled nursing, assisted living and home health and hospice operations are operated by separate, wholly-owned, independent subsidiaries, which have their own management, employees and assets.

In addition, one of our wholly-owned independent subsidiaries, which we call our Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other services to each operating subsidiary through contractual relationships between such subsidiaries. In addition, we have the Captive that provides some claims-made coverage to our operating subsidiaries for general and professional liability, as well as for certain workers' compensation insurance liabilities. References herein to the consolidated "Company" and "its" assets and activities, as well as the use of the terms "we," "us," "our" and similar verbiage in this annual report is not meant to imply that The Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the Captive are operated by the same entity.

Recent Developments Real Estate Investment Trust (REIT) Spin-Off - On November 7, 2013, we announced a plan to separate our healthcare business and real estate business into two separate, publicly traded companies: • Ensign, which will continue to provide healthcare services through its existing operations; and • CareTrust REIT, Inc. (CareTrust), which will own, acquire and lease real estate serving the healthcare industry.

We intend to accomplish the proposed separation by distributing all of the outstanding shares of CareTrust common stock to our stockholders on a pro rata basis (the Spin-Off). At the time of the Spin-Off, CareTrust, which is currently a wholly-owned subsidiary of ours, will hold substantially all of the real property owned by us, and will own and operate three independent living facilities. After the Spin-Off, all of these properties (except for three independent living facilities that CareTrust will operate) will be leased to us on a triple-net basis, under which we will be responsible for all costs at the properties, including property taxes, insurance and maintenance and repair costs.

60-------------------------------------------------------------------------------- Table of Contents The proposed Spin-Off is conditioned on, among other things, final approval by our board of directors, the receipt of a ruling from the IRS that, among other things, the Spin-Off will qualify as a tax-free transaction for U.S. federal income tax purposes, the receipt of an opinion of counsel as to the satisfaction of certain requirements for such tax-free treatment, and the receipt of an opinion of counsel that, commencing with CareTrust's taxable year ending on December 31, 2014, CareTrust has been organized in conformity with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended, and its proposed method of operation will enable it to meet the requirements for qualification and taxation as a REIT.

U.S. Government Inquiry Settlement - In April 2013, we and government representatives reached an agreement in principle to resolve the allegations and close the investigation. Based on these discussions, we recorded and announced an additional charge in the amount of $33.0 million in the first quarter of 2013, increasing the total reserve to resolve the matter to $48.0 million (the Reserve Amount).

In October 2013, we completed and executed a settlement agreement (the Settlement Agreement) with the DOJ and received the final approval of the Office of Inspector General-HHS and the United States District Court for the Central District of California. The settlement agreement fully and finally resolves the previously disclosed DOJ investigation and any ancillary claims which have been pending since 2006. Pursuant to the settlement agreement, we made a single lump-sum remittance to the government in the amount of $48.0 million in October 2013. We have denied engaging in any illegal conduct, and have agreed to the settlement amount without any admission of wrongdoing in order to resolve the allegations and to avoid the uncertainty and expense of protracted litigation.

In connection with the settlement and effective as of October 1, 2013, we entered into a five-year corporate integrity agreement with the Office of Inspector General-HHS (the CIA). The CIA acknowledges the existence of our current compliance program, and requires that we continue during the term of the CIA to maintain a compliance program designed to promote compliance with the statutes, regulations, and written directives of Medicare, Medicaid, and all other Federal health care programs. Our participation in federal healthcare programs is not affected by the Settlement Agreement or the CIA. In the event of an uncured material breach of the CIA, we could be excluded from participation in federal healthcare programs and/or subject to prosecution. See further details of the CIA at Note 19, Commitments and Contingencies of Notes to Consolidated Financial Statements.

Urgent Care Franchising - On March 25, 2013 we announced that our urgent care subsidiary, Immediate Clinic Healthcare, Inc., agreed to terms to sell Doctors Express, a national urgent care franchise system. The sale of specific assets and liabilities of Doctors Express was finalized on April 15, 2013. In accordance with the authoritative guidance for the disposal of long-lived asset, the sale of Doctors Express has been accounted for as discontinued operations.

Accordingly, the results of operations of this business for all periods presented and the loss or impairment related to this divesture have been classified as discontinued operations in the accompanying consolidated statements of income. As the sale was effective April 15, 2013, all assets and liabilities included in the sale were recorded as held for sale on our accompanying consolidated balance sheets as of December 31, 2012. See Note 4, Discontinued Operations in Notes to consolidated Financial Statements.

Facility Acquisition History The following table sets forth the location of our facilities and the number of operational beds located at our facilities as of December 31, 2013: CA AZ TX UT CO WA ID NV NE IA Total Number of facilities 36 13 27 12 6 6 6 3 5 5 119 Operational skilled nursing, assisted living and independent living beds 3,973 1,902 3,353 1,413 505 555 477 304 366 356 13,204 During the first quarter of 2013, we acquired a three home health operations in Washington and Texas, three hospice operations in Arizona, California and Washington, respectively, and one skilled nursing facility in Texas, in six separate transactions, for an aggregate purchase price of approximately $10.6 million, which was paid in cash. The skilled nursing facility acquisition added 150 operational skilled nursing beds to our operations. The home health and hospice acquisitions did not have an impact on our operational bed count.

During the second quarter of 2013, we acquired five skilled nursing facilities in Texas, Nebraska and Washington and three assisted living facilities in Washington, California and Utah in five separate transactions for an aggregate purchase price of approximately $28.7 million, which was paid in cash. These acquisitions added 460 operational skilled nursing beds and 281 operational assisted living units to our operations.

61-------------------------------------------------------------------------------- Table of Contents During the third quarter of 2013, we acquired a skilled nursing facility and an urgent care center in Washington for approximately $6.1 million, which was paid in cash. The skilled nursing acquisition added 82 operational skilled nursing beds to our operations. The urgent care center acquisition did not have an impact on our bed count.

We also entered into a separate operations transfer agreement with the prior tenant as part of each transaction noted above. See further discussion of facility acquisitions in Note 8, Acquisitions in Notes to Consolidated Financial Statements.

Key Performance Indicators We manage our skilled nursing business by monitoring key performance indicators that affect our financial performance. These indicators and their definitions include the following: • Routine revenue: Routine revenue is generated by the contracted daily rate charged for all contractually inclusive skilled nursing services. The inclusion of therapy and other ancillary treatments varies by payor source and by contract. Services provided outside of the routine contractual agreement are recorded separately as ancillary revenue, including Medicare Part B therapy services, and are not included in the routine revenue definition.

• Skilled revenue: The amount of routine revenue generated from patients in our skilled nursing facilities who are receiving higher levels of care under Medicare, managed care, Medicaid, or other skilled reimbursement programs. The other skilled residents that are included in this population represent very high acuity residents who are receiving high levels of nursing and ancillary services which are reimbursed by payors other than Medicare or managed care. Skilled revenue excludes any revenue generated from our assisted living services.

• Skilled mix: The amount of our skilled revenue as a percentage of our total routine revenue. Skilled mix (in days) represents the number of days our Medicare, managed care, or other skilled patients are receiving services at our skilled nursing facilities divided by the total number of days patients (less days from assisted living services) from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).

• Quality mix: The amount of routine non-Medicaid revenue as a percentage of our total routine revenue. Quality mix (in days) represents the number of days our non-Medicaid patients are receiving services at our skilled nursing facilities divided by the total number of days patients from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).

• Average daily rates: The routine revenue by payor source for a period at our skilled nursing facilities divided by actual patient days for that revenue source for that given period.

• Occupancy percentage (operational beds): The total number of residents occupying a bed in a skilled nursing, assisted living or independent living facility as a percentage of the beds in a facility which are available for occupancy during the measurement period.

• Number of facilities and operational beds: The total number of skilled nursing, assisted living and independent living facilities that we own or operate and the total number of operational beds associated with these facilities.

Skilled and Quality Mix. Like most skilled nursing providers, we measure both patient days and revenue by payor. Medicare, managed care and other skilled patients, whom we refer to as high acuity patients, typically require a higher level of skilled nursing and rehabilitative care. Accordingly, Medicare and managed care reimbursement rates are typically higher than from other payors. In most states, Medicaid reimbursement rates are generally the lowest of all payor types. Changes in the payor mix can significantly affect our revenue and profitability.

62-------------------------------------------------------------------------------- Table of Contents The following table summarizes our overall skilled mix and quality mix for the periods indicated as a percentage of our total routine revenue (less revenue from assisted living services) and as a percentage of total patient days (less days from assisted living services): Year Ended December 31, 2013 2012 2011 Skilled Mix: Days 26.4 % 25.9 % 25.5 % Revenue 50.0 % 50.0 % 51.3 % Quality Mix: Days 40.1 % 39.1 % 38.1 % Revenue 59.5 % 59.5 % 60.1 % Occupancy. We define occupancy as the ratio of actual patient days (one patient day equals one resident occupying one bed for one day) during any measurement period to the number of beds in facilities which are available for occupancy during the measurement period. The number of licensed and independent living beds in a skilled nursing, assisted living or independent living facility that are actually operational and available for occupancy may be less than the total official licensed bed capacity. This sometimes occurs due to the permanent dedication of bed space to alternative purposes, such as enhanced therapy treatment space or other desirable uses calculated to improve service offerings and/or operational efficiencies in a facility. In some cases, three- and four-bed wards have been reduced to two-bed rooms for resident comfort, and larger wards have been reduced to conform to changes in Medicare requirements.

These beds are seldom expected to be placed back into service. We define occupancy in operational beds as the ratio of actual patient days during any measurement period to the number of available patient days for that period. We believe that reporting occupancy based on operational beds is consistent with industry practices and provides a more useful measure of actual occupancy performance from period to period.

The following table summarizes our overall occupancy statistics for the periods indicated: Year Ended December 31, 2013 2012 2011 Occupancy: Operational beds at end of period 13,204 12,198 11,702 Available patient days 4,710,768 4,371,034 3,945,511 Actual patient days 3,648,651 3,452,598 3,124,724Occupancy percentage (based on operational beds) 77.5 % 79.0 % 79.2 % 63 -------------------------------------------------------------------------------- Table of Contents Revenue Sources Our total revenue represents revenue derived primarily from providing services to patients and residents of skilled nursing facilities, and to a lesser extent from assisted living facilities and ancillary services. We receive service revenue from Medicaid, Medicare, private payors and other third-party payors, and managed care sources. The sources and amounts of our revenue are determined by a number of factors, including bed capacity and occupancy rates of our healthcare facilities, the mix of patients at our facilities and the rates of reimbursement among payors. Payment for ancillary services varies based upon the service provided and the type of payor.

The following table sets forth our total revenue by payor source and as a percentage of total revenue for the periods indicated: Years Ended December 31, 2013 2012 2011 $ % $ % $ % (Dollars in thousands) Revenue: Medicaid $ 323,803 35.8 % $ 302,046 36.7 % $ 277,736 36.6 % Medicare 292,917 32.4 278,578 33.8 272,283 35.9 Medicaid-skilled 36,085 4.0 25,418 3.1 20,290 2.7 Total 652,805 72.2 606,042 73.6 570,309 75.2 Managed Care 118,168 13.1 106,268 12.9 94,266 12.4 Private and Other(1) 133,583 14.7 110,845 13.5 93,702 12.4 Total revenue $ 904,556 100.0 % $ 823,155 100.0 % $ 758,277 100.0 % (1) Private and other payors includes revenue from urgent care centers and other ancillary businesses.

Primary Components of Expense Cost of Services (exclusive of facility rent and depreciation and amortization shown separately). Our cost of services represents the costs of operating our facilities and primarily consists of payroll and related benefits, supplies, purchased services, and ancillary expenses such as the cost of pharmacy and therapy services provided to residents. Cost of services also includes the cost of general and professional liability insurance and other general cost of services with respect to our operations.

Facility Rent - Cost of Services. Facility rent - cost of services consists solely of base minimum rent amounts payable under lease agreements to third-party owners of the facilities that we operate but do not own and does not include taxes, insurance, impounds, capital reserves or other charges payable under the applicable lease agreements.

General and Administrative Expense. General and administrative expense consists primarily of payroll and related benefits and travel expenses for our Service Center personnel, including training and other operational support. General and administrative expense also includes professional fees (including accounting and legal fees), costs relating to our information systems, stock-based compensation and rent for our Service Center office.

Depreciation and Amortization. Property and equipment are recorded at their original historical cost. Depreciation is computed using the straight-line method over the estimated useful lives of the depreciable assets. The following is a summary of the depreciable lives of our depreciable assets: Minimum of three years to a maximum of 57 Buildings and improvements years, generally 45 years Shorter of the lease term or estimated useful Leasehold improvements life, generally 5 to 15 years Furniture and equipment 3 to 10 years 64-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.

The preparation of these financial statements and related disclosures requires us to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an ongoing basis we review our judgments and estimates, including, but not limited to, those related to doubtful accounts, income taxes, stock compensation, intangible assets and loss contingencies. We base our estimates and judgments upon our historical experience, knowledge of current conditions and our belief of what could occur in the future considering available information, including assumptions that we believe to be reasonable under the circumstances. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty and actual results could differ materially from the amounts reported. The following summarizes our critical accounting policies, defined as those policies that we believe: (a) are the most important to the portrayal of our financial condition and results of operations; and (b) require management's most subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Revenue Recognition We recognize revenue when the following four conditions have been met: (i) there is persuasive evidence that an arrangement exists; (ii) delivery has occurred or service has been rendered; (iii) the price is fixed or determinable; and (iv) collection is reasonably assured. Our revenue is derived primarily from providing healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis.

Revenue from Medicare and Medicaid programs account for 72.2%, 73.6% and 75.2% of our revenue for the years ended December 31, 2013, 2012, and 2011, respectively. We record revenue from these governmental and managed care programs as services are performed at their expected net realizable amounts under these programs. Our revenue from governmental and managed care programs is subject to audit and retroactive adjustment by governmental and third-party agencies. Consistent with healthcare industry accounting practices, any changes to these governmental revenue estimates are recorded in the period the change or adjustment becomes known based on final settlement. We recorded retroactive adjustments to revenue which were not material to our consolidated revenue for the years ended December 31, 2013, 2012 and 2011.

Our service specific revenue recognition policies are as follows: Skilled Nursing Revenue Our revenue is derived primarily from providing long-term healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis. We record revenue from private pay patients, at the agreed-upon rate, as services are performed.

Home Health Revenue Medicare Revenue Net service revenue is recorded under the Medicare prospective payment system based on a 60-day episode payment rate that is subject to adjustment based on certain variables including, but not limited to: (a) an outlier payment if patient care was unusually costly; (b) a low utilization payment adjustment if the number of visits was fewer than five; (c) a partial payment if the patient transferred to another provider or we received a patient from another provider before completing the episode; (d) a payment adjustment based upon the level of therapy services required; (e) the number of episodes of care provided to a patient, regardless of whether the same home health provider provided care for the entire series of episodes; (f) changes in the base episode payments established by the Medicare Program; (g) adjustments to the base episode payments for case mix and geographic wages; and (h) recoveries of overpayments.

We make adjustments to Medicare revenue on completed episodes to reflect differences between estimated and actual payment amounts, an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. Therefore, we believe that its reported net service revenue and patient accounts receivable will be the net amounts to be realized from Medicare for services rendered.

65-------------------------------------------------------------------------------- Table of Contents In addition to revenue recognized on completed episodes,we also recognize a portion of revenue associated with episodes in progress. Episodes in progress are 60-day episodes of care that begin during the reporting period, but were not completed as of the end of the period. Thereby, estimating revenue and recognizing it on a daily basis.

Non-Medicare Revenue Episodic Based Revenue - We recognize revenue in a similar manner as it recognizes Medicare revenue for episodic-based rates that are paid by other insurance carriers, including Medicare Advantage programs; however, these rates can vary based upon the negotiated terms.

Non-episodic Based Revenue - Revenue is recorded on an accrual basis based upon the date of service at amounts equal to its established or estimated per-visit rates, as applicable.

Hospice Revenue Revenue is recorded on an accrual basis based upon the date of service at amounts equal to the estimated payment rates. The estimated payment rates are daily rates for each of the levels of care we deliver. We make adjustments to revenue for an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. Additionally, as Medicare hospice revenue is subject to an inpatient cap limit and an overall payment cap, we monitor our provider numbers and estimates amounts due back to Medicare if a cap has been exceeded. We record these adjustments as a reduction to revenue and increases to other accrued liabilities.

Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable consist primarily of amounts due from Medicare and Medicaid programs, other government programs, managed care health plans and private payor sources. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.

In evaluating the collectability of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type and the status of ongoing disputes with third-party payors. On an annual basis, the historical collection percentages are reviewed by payor and by state and are updated to reflect the recent collection experience of the Company. In order to determine the appropriate reserve rate percentages which ultimately establish the allowance, the Company analyzes historical cash collection patterns by payor and by state.

The percentages applied to the aged receivable balances are based on the Company's historical experience and time limits, if any, for managed care, Medicare, Medicaid and other payors. The Company periodically refines its estimates of the allowance for doubtful accounts based on experience with the estimation process and changes in circumstances.

Self-Insurance We are partially self-insured for general and professional liability up to a base amount per claim (the self-insured retention) with an aggregate, one-time deductible above this limit. Losses beyond these amounts are insured through third-party policies with coverage limits per claim, per location and on an aggregate basis for us. For claims made after January 1, 2013, the self-insured retention was $0.5 million per claim, subject to an additional one-time deductible of $1.0 million for California facilities and a separate, one-time deductible of $0.8 million for non-California facilities. For all facilities, except those located in Colorado, the third-party coverage above these amounts was $1.0 million per claim, $3.0 million per facility, with a $5.0 million blanket aggregate available to both California and non-California operations separately. In Colorado, the third-party coverage above these limits was $1.0 million per claim and $3.0 million per facility, which is independent of the aforementioned blanket aggregate applicable to our other 113 facilities.

The self-insured retention and deductible limits for general and professional liability and workers' compensation are self-insured through the Captive, the related assets and liabilities of which are included in the accompanying consolidated balance sheets. The Captive is subject to certain statutory requirements as an insurance provider. These requirements include, but are not limited to, maintaining statutory capital. Our policy is to accrue amounts equal to the actuarially estimated costs to settle open claims of insureds, as well as an estimate of the cost of insured claims that have been incurred but not reported. We develop information about the size of the ultimate claims based on historical experience, current industry information and actuarial analysis, and evaluates the estimates for claim loss exposure on a quarterly basis.

Our operating subsidiaries are self-insured for workers' compensation liability in California. To protect ourself against loss exposure in California with this policy, we purchased individual stop-loss insurance coverage that insures individual claims that exceed $0.5 million for each occurrence. In Texas, the operating subsidiaries have elected non-subscriber status for workers' compensation claims and, effective February 1, 2011, we purchased individual stop-loss coverage that insures individual claims 66-------------------------------------------------------------------------------- Table of Contents that exceed $0.8 million for each occurrence. Our operating subsidiaries in other states have third party guaranteed cost coverage. In California and Texas, we accrue amounts equal to the estimated costs to settle open claims, as well as an estimate of the cost of claims that have been incurred but not reported. We use actuarial valuations to estimate the liability based on historical experience and industry information.

We provide self-insured medical (including prescription drugs) and dental healthcare benefits to the majority of its employees. We are fully liable for all financial and legal aspects of these benefit plans. To protect ourself against loss exposure with this policy, we purchased individual stop-loss insurance coverage that insures individual claims that exceed $0.3 million for each covered person with an aggregate individual stop loss deductible of $0.1 million.

We believe that adequate provision has been made in the consolidated balance sheets for liabilities that may arise out of patient care, workers' compensation, healthcare benefits and related services provided to date. The amount of our reserves was determined based on an estimation process that uses information obtained from both company-specific and industry data. This estimation process requires us to continuously monitor and evaluate the life cycle of the claims. Using data obtained from this monitoring and our assumptions about emerging trends, we, with the assistance of an independent actuary, develop information about the size of ultimate claims based on our historical experience and other available industry information. The most significant assumptions used in the estimation process include determining the trend in costs, the expected cost of claims incurred but not reported and the expected costs to settle or pay damage awards with respect to unpaid claims. The self-insured liabilities are based upon estimates, and while management believes that the estimates of loss are reasonable, the ultimate liability may be in excess of or less than the recorded amounts. Due to the inherent volatility of actuarially determined loss estimates, it is reasonably possible that we could experience changes in estimated losses that could be material to net income. If our actual liability exceeds its estimates of loss, its future earnings, cash flows and financial condition would be adversely affected.

Income Taxes Deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities at tax rates in effect when such temporary differences are expected to reverse. We generally expect to fully utilize our deferred tax assets; however, when necessary, we record a valuation allowance to reduce our net deferred tax assets to the amount that is more likely than not to be realized.

When we take uncertain income tax positions that do not meet the recognition criteria, we record a liability for underpayment of income taxes and related interest and penalties, if any. In considering the need for and magnitude of a liability for such positions, we must consider the potential outcomes from a review of the positions by the taxing authorities.

In determining the need for a valuation allowance, the annual income tax rate, or the need for and magnitude of liabilities for uncertain tax positions, we make certain estimates and assumptions. These estimates and assumptions are based on, among other things, knowledge of operations, markets, historical trends and likely future changes and, when appropriate, the opinions of advisors with knowledge and expertise in certain fields. Due to certain risks associated with our estimates and assumptions, actual results could differ.

Noncontrolling Interest The noncontrolling interest in a subsidiary is initially recognized at estimated fair value on the acquisition date and is presented within total equity in our consolidated balance sheets. We present the noncontrolling interest and the amount of consolidated net income attributable to The Ensign Group, Inc. in our consolidated statements of income and net income per share is calculated based on net income attributable to The Ensign Group, Inc.'s stockholders. The carrying amount of the noncontrolling interest is adjusted based on an allocation of subsidiary earnings based on ownership interest.

Derivatives and Hedging Activities We evaluate variable and fixed interest rate risk exposure on a routine basis and to the extent we believe that it is appropriate, we will offset most of our variable risk exposure by entering into interest rate swap agreements. It is our policy to only utilize derivative instruments for hedging purposes (i.e. not for speculation). We formally designate our interest rate swap agreements as hedges and document all relationships between hedging instruments and hedged items. We formally assess the effectiveness of our hedging relationships, both at the hedge inception and on an ongoing basis, then measure and record ineffectiveness. We would discontinue hedge accounting prospectively (i) if it is determined that the derivative is no longer effective in offsetting change in the cash flows of a hedged item, (ii) when the derivative expires or is sold, terminated or exercised, (iii) if it is no longer probable that the forecasted transaction will occur, or (iv) if management determines that designation of the derivative as a hedge instrument is no longer appropriate. The Company's derivative is recorded on the balance sheet at its fair value.

67-------------------------------------------------------------------------------- Table of Contents Recent Accounting Pronouncements Except for rules and interpretive releases of the SEC under authority of federal securities laws and a limited number of grandfathered standards, the FASB Accounting Standards Codification™ (ASC) is the sole source of authoritative GAAP literature recognized by the FASB and applicable to the Company. The Company has reviewed the FASB issued Accounting Standards Update (ASU) accounting pronouncements and interpretations thereof that have effectiveness dates during the periods reported and in future periods. The Company has carefully considered the new pronouncements that alter previous generally accepted accounting principles and does not believe that any new or modified principles will have a material impact on the Company's reported financial position or operations in the near term. The applicability of any standard is subject to the formal review of the Company's financial management and certain standards are under consideration.

Additionally, the FASB and the International Accounting Standards Board are working on joint convergence projects to address accounting differences between GAAP and International Financial Reporting Standards in order to support their commitment to achieve a single set of high-quality global accounting standards.

One of the projects under deliberation includes accounting for leases. If enacted in its current draft form, we anticipate that the lease accounting proposal could have an impact on our consolidated financial statements; however the FASB's standard-setting process is ongoing and until new standards have been finalized and issued, we cannot quantify and determine the impact on our consolidated financial statements that may result from such future changes.

68-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth details of our revenue, expenses and earnings as a percentage of total revenue for the periods indicated: Year Ended December 31, 2013 2012 2011 Revenue 100.0 % 100.0 % 100.0 % Expenses: Cost of services (exclusive of facility rent, general and administrative expense and depreciation and amortization shown separately below) 80.3 79.7 79.2 U.S. Government inquiry settlement 3.6 1.8 - Facility rent-cost of services 1.5 1.6 1.8 General and administrative expense 4.4 3.9 3.9 Depreciation and amortization 3.8 3.4 3.1 Total expenses 93.6 90.4 88.0 Income from operations 6.4 9.6 12.0 Other income (expense): Interest expense (1.4 ) (1.5 ) (1.8 ) Interest income - - - Other expense, net (1.4 ) (1.5 ) (1.8 ) Income before provision for income taxes 5.0 8.1 10.2 Provision for income taxes 2.2 3.1 3.9 Income from continuing operations 2.8 5.0 6.3 Loss from discontinued operations (0.2 ) (0.2 ) - Net income 2.6 4.8 6.3 Less: net loss attributable to the noncontrolling interests (0.1 ) (0.1 ) - Net income attributable to The Ensign Group, Inc. 2.7 % 4.9 % 6.3 % 69-------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 Years Ended December 31, 2013 2012 (Dollars in thousands) Change % Change Total Facility Results: Revenue $ 904,556 $ 823,155 $ 81,401 9.9 % Number of facilities at period end 119 108 11 10.2 % Actual patient days 3,648,651 3,452,598 196,053 5.7 % Occupancy percentage - Operational beds 77.5 % 79.0 % (1.5 )% Skilled mix by nursing days 26.4 % 25.9 % 0.5 % Skilled mix by nursing revenue 50.0 % 50.0 % - % Years Ended December 31, 2013 2012 (Dollars in thousands) Change % Change Same Facility Results(1): Revenue $ 679,610 $ 670,747 $ 8,863 1.3 % Number of facilities at period end 77 77 - - % Actual patient days 2,618,541 2,638,029 (19,488 ) (0.7 )% Occupancy percentage - Operational beds 80.8 % 81.2 % (0.4 )% Skilled mix by nursing days 28.3 % 27.5 % 0.8 % Skilled mix by nursing revenue 52.1 % 52.0 % 0.1 % Years Ended December 31, 2013 2012 (Dollars in thousands) Change % Change Transitioning Facility Results(2): Revenue $ 141,180 $ 135,639 $ 5,541 4.1 % Number of facilities at period end 25 25 - - % Actual patient days 724,243 736,995 (12,752 ) (1.7 )% Occupancy percentage - Operational beds 73.8 % 74.9 % (1.1 )% Skilled mix by nursing days 20.2 % 18.2 % 2.0 % Skilled mix by nursing revenue 42.0 % 39.2 % 2.8 % Years Ended December 31, 2013 2012 (Dollars in thousands) Change % Change Recently Acquired Facility Results(3): Revenue $ 83,766 $ 16,769 $ 66,997 NM Number of facilities at period end 17 6 11 NM Actual patient days 305,867 77,574 228,293 NM Occupancy percentage - Operational beds 62.7 % 55.5 % NM Skilled mix by nursing days 18.0 % 11.2 % NM Skilled mix by nursing revenue 38.1 % 20.9 % NM _______________________ (1) Same Facility results represent all facilities purchased prior to January 1, 2010.

(2) Transitioning Facility results represents all facilities purchased from January 1, 2010 to December 31, 2011.

(3) Recently Acquired Facility (or "Acquisitions") results represent all facilities purchased on or subsequent to January 1, 2012.

70-------------------------------------------------------------------------------- Table of Contents Revenue. Revenue increased $81.4 million, or 9.9%, to $904.6 million for the year ended December 31, 2013 compared to $823.2 million for the year ended December 31, 2012. Of the $81.4 million increase, Medicare and managed care revenue increased $26.2 million, or 6.8%, Medicaid custodial revenue increased $21.8 million, or 7.2%, private and other revenue increased $22.7 million, or 20.5% and Medicaid skilled revenue increased $10.7 million, or 42.0%. Revenue generated by Recently Acquired Facilities increased by approximately $67.0 million. Since January 1, 2012, the Company has acquired seventeen facilities, five home health and four hospice operations in seven states.

Revenue generated by Same Facilities increased $8.9 million, or 1.3%, for the year ended December 31, 2013 compared to the year ended December 31, 2012. This increase was primarily due to an increase in skilled mix days of 0.8% to 28.3% as compared to 2012. This increase was primarily due to an increase in managed care days of 11.1% during the year ended December 31, 2013 as compared to the year ended December 31, 2012, partially offset by a decrease in Medicare days of 5.4% during the year ended December 31, 2013 as compared to the year ended December 31, 2012.

Revenue at Transitioning Facilities increased by $5.5 million, or 4.1% for the year ended December 31, 2013 as compared to the year ended December 31, 2012.

This increase was due to a 2.0% increase in skilled mix days primarily attributable to increases in Medicare days of 5.6% and managed care days of 13.3% for the year ended December 31, 2013 as compared to the year ended December 31, 2012.

The following table reflects the change in the skilled nursing average daily revenue rates by payor source, excluding services that are not covered by the daily rate: Years Ended December 31, Same Facility Transitioning Acquisitions Total % 2013 2012 2013 2012 2013 2012 2013 2012 Change Skilled Nursing Average Daily Revenue Rates: Medicare $ 564.45 $ 555.44 $ 474.16 $ 471.25 $ 461.98 $ 418.73 $ 544.51 $ 541.63 0.5 % Managed care 398.86 391.08 378.70 395.32 458.55 427.52 400.44 391.32 2.3 % Other skilled 455.88 457.58 708.32 529.85 253.00 - 460.76 458.67 0.5 % Total skilled revenue 492.13 490.63 462.86 460.25 460.78 418.88 487.53 486.98 0.1 % Medicaid 176.97 168.85 158.45 155.16 167.26 204.57 174.04 167.78 3.7 % Private and other payors 188.44 189.62 167.45 165.93 154.87 168.26 179.40 181.52 (1.2 )% Total skilled nursing revenue $ 267.38 $ 259.48 $ 222.39 $ 213.93 $ 218.10 $ 223.11 $ 257.67 $ 252.18 2.2 % The average Medicare daily rate increased by 0.5%. This rate was impacted by a 1.8% market basket increase, which went into effect in October 2012 and a market basket increase of 1.3%, which went into effect October 2013. These market basket increases were offset by a 2% sequestration payment reduction that went into effect on April 1, 2013. The average Medicaid daily rate increased 3.7% for the year ended December 31, 2013 relative to the same period in the prior year, primarily due to increases in rates in various states, including Arizona and California.

71-------------------------------------------------------------------------------- Table of Contents Payor Sources as a Percentage of Skilled Nursing Services. We use both our skilled mix and quality mix as measures of the quality of reimbursements we receive at our skilled nursing facilities over various periods. The following tables set forth our percentage of skilled nursing patient revenue and days by payor source: Years Ended December 31, Same Facility Transitioning Acquisitions Total 2013 2012 2013 2012 2013 2012 2013 2012 Percentage of Skilled Nursing Revenue: Medicare 31.3 % 33.0 % 35.1 % 33.3 % 26.6 % 20.6 % 31.4 % 32.9 % Managed care 15.2 13.7 5.7 5.3 11.5 0.3 13.9 12.4 Other skilled 5.6 5.3 1.2 0.6 - - 4.7 4.7 Skilled mix 52.1 52.0 42.0 39.2 38.1 20.9 50.0 50.0 Private and other payors 7.5 7.6 21.4 22.6 12.1 11.2 9.5 9.5 Quality mix 59.6 59.6 63.4 61.8 50.2 32.1 59.5 59.5 Medicaid 40.4 40.4 36.6 38.2 49.8 67.9 40.5 40.5 Total skilled nursing 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Years Ended December 31, Same Facility Transitioning Acquisitions Total 2013 2012 2013 2012 2013 2012 2013 2012 Percentage of Skilled Nursing Days: Medicare 14.8 % 15.4 % 16.5 % 15.1 % 12.6 % 11.0 % 14.8 % 15.3 % Managed care 10.2 9.1 3.3 2.8 5.4 0.2 8.9 8.0 Other skilled 3.3 3.0 0.4 0.3 - - 2.7 2.6 Skilled mix 28.3 27.5 20.2 18.2 18.0 11.2 26.4 25.9 Private and other payors 10.7 10.4 28.4 29.2 17.0 14.7 13.7 13.2 Quality mix 39.0 37.9 48.6 47.4 35.0 25.9 40.1 39.1 Medicaid 61.0 62.1 51.4 52.6 65.0 74.1 59.9 60.9 Total skilled nursing 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Cost of Services (exclusive of facility rent and depreciation and amortization shown separately). Cost of services increased $69.6 million, or 10.6%, to $726.0 million for the year ended December 31, 2013 compared to $656.4 million for the year ended December 31, 2012. Of the $69.6 million increase, Same Facilities increased $7.9 million, or 1.5%, and Recently Acquired Facilities increased $55.9 million. The increase at Same Facilities was primarily related to an increase in quality assurance fee of $3.7 million in certain states where related Medicaid rates were also increased. In addition, we recorded additional costs of $1.5 million related to the class action staffing lawsuit during the year ended December 31, 2013. Cost of services increased as a percent of total revenue to 80.3% for the year ended December 31, 2013 as compared to 79.7% for the year ended December 31, 2012.

Charge Related to U.S. Government Inquiry. The Company recorded an additional charge in the amount of $33.0 million during the year ended December 31, 2013 related to investigation into some of our subsidiaries conducted by the DOJ.

During the year ended December 31, 2012, the Company accrued an estimated liability of $15.0 million. See further discussion of the DOJ investigation and related estimated settlement in Liquidity and Capital Resources.

Facility Rent - Cost of Services. Facility rent - cost of services increased $0.3 million, or 2.3%, to $13.6 million for the year ended December 31, 2013 as compared to $13.3 million for the year ended December 31, 2012. Facility rent-cost of services decreased as a percent of total revenue to 1.5% for the year ended December 31, 2013 as compared to 1.6% for the year ended December 31, 2012.

72-------------------------------------------------------------------------------- Table of Contents General and Administrative Expense. General and administrative expense increased $8.3 million, or 26.1%, to $40.1 million for the year ended December 31, 2013 compared to $31.8 million for the year ended December 31, 2012. General and administrative expenses increased as a percent of total revenue to 4.4% for the year ended December 31, 2013 as compared to 3.9% for the year ended December 31, 2012. The $8.3 million increase was primarily due to costs incurred in connection with the Company's proposed spin-off of its real estate assets to a newly formed publicly traded real estate investment trust (REIT) and wages and benefits as a result of enhancements made to its internal compliance team.

Depreciation and Amortization. Depreciation and amortization expense increased $5.5 million, or 19.4%, to $33.9 million for the year ended December 31, 2013 compared to $28.4 million for the year ended December 31, 2012. Depreciation and amortization expense increased as a percent of total revenue to 3.8% for the year ended December 31, 2013 as compared to 3.4% for the year ended December 31, 2012. This increase was primarily related to the additional depreciation of $3.5 million at Recently Acquired Facilities, as well as an increase of $1.9 million at Same Facilities due to recent renovations and the purchase of the underlying assets of three of our skilled nursing facilities which we previously operated under long-term lease agreements during the year ended December 31, 2012. Of the $3.5 million increase at Recently Acquired Facilities, $0.7 million represented amortization expense of patient base intangible assets which are amortized over four to eight months.

Other Income (Expense). Other expense, net increased $0.3 million, or 2.6%, to $12.3 million for the year ended December 31, 2013 as compared to $12.0 million for the year ended December 31, 2012. Other expenses, net decreased as a percent of total revenue to 1.4% for the year ended December 31, 2013 as compared to 1.5% for the year ended December 31, 2012.

Provision for Income Taxes. Provision for income taxes decreased $5.1 million, or 20.3%, to $20.0 million for the year ended December 31, 2013 as compared to $25.1 million for the year ended December 31, 2012. This decrease resulted from the decrease in income before income taxes. Our effective tax rate was 43.8% for the year ended December 31, 2013 as compared to 37.9% for the year ended December 31, 2012.

73-------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011 Years Ended December 31, 2012 2011 (Dollars in thousands) Change % Change Total Facility Results: Revenue $ 823,155 $ 758,277 $ 64,878 8.6 % Number of facilities at period end 108 102 6 5.9 % Actual patient days 3,452,598 3,124,724 327,874 10.5 % Occupancy percentage - Operational beds 79.0 % 79.2 % (0.2 )% Skilled mix by nursing days 25.9 % 25.5 % 0.4 % Skilled mix by nursing revenue 50.0 % 51.3 % (1.3 )% Years Ended December 31, 2012 2011 (Dollars in thousands) Change % Change Same Facility Results(1): Revenue $ 563,719 $ 568,087 $ (4,368 ) (0.8 )% Number of facilities at period end 62 62 - - % Actual patient days 2,152,011 2,137,951 14,060 0.7 % Occupancy percentage - Operational beds 82.7 % 82.2 % 0.5 % Skilled mix by nursing days 29.5 % 29.0 % 0.5 % Skilled mix by nursing revenue 54.2 % 55.4 % (1.2 )% Years Ended December 31, 2012 2011 (Dollars in thousands) Change % Change Transitioning Facility Results(2): Revenue $ 147,104 $ 138,521 $ 8,583 6.2 % Number of facilities at period end 20 20 - - % Actual patient days 662,290 640,396 21,894 3.4 % Occupancy percentage - Operational beds 75.0 % 72.7 % 2.3 % Skilled mix by nursing days 18.3 % 16.3 % 2.0 % Skilled mix by nursing revenue 39.0 % 37.3 % 1.7 % Years Ended December 31, 2012 2011 (Dollars in thousands) Change % Change Recently Acquired Facility Results(3): Revenue $ 112,332 $ 51,669 $ 60,663 NM Number of facilities at period end 26 20 6 NM Actual patient days 638,297 346,377 291,920 NM Occupancy percentage - Operational beds 72.1 % 74.9 % NM Skilled mix by nursing days 17.5 % 14.2 % NM Skilled mix by nursing revenue 38.2 % 34.0 % NM _______________________ (1) Same Facility results represent all facilities purchased prior to January 1, 2009.

(2) Transitioning Facility results represents all facilities purchased from January 1, 2009 to December 31, 2010.

(3) Recently Acquired Facility (or "Acquisitions") results represent all facilities purchased on or subsequent to January 1, 2011.

74-------------------------------------------------------------------------------- Table of Contents Revenue. Revenue increased $64.9 million, or 8.6%, to $823.2 million for the year ended December 31, 2012 compared to $758.3 million for the year ended December 31, 2011. Of the $64.9 million increase, Medicare and managed care revenue increased­$18.3 million, or 5.0%, Medicaid revenue increased $24.3 million, or 8.8%, private and other revenue increased $17.2 million, or 20.0% and other skilled revenue increased $5.1 million, or 25.3%. Revenue generated by Recently Acquired Facilities increased by approximately $60.7 million, due to the Company's acquisition of 26 facilities, five home health and two hospice operations in ten states since January 1, 2011.

Revenue generated by Same Facilities decreased $4.4 million, or 0.8%, for the year ended December 31, 2012 as compared to the year ended December 31, 2011.

Medicare revenue per patient day at Same Facilities decreased 8.6% during the year ended December 31, 2012 as compared to the year ended December 31, 2011.

This decrease was primarily due to the impact of the CMS-imposed 11.1% reduction in Medicare skilled nursing PPS payments and therapy changes, which were implemented on October 1, 2011. This reduction was partially offset by an increase in occupancy of 0.5% to 82.7%, as well as an increase in skilled mix by nursing days of 0.5%, to 29.5%, which was the result of an increase in other skilled patient days at Same Facilities of 9.8%, as well as increases in Medicare and managed care patient days as compared to the year ended December 31, 2011.

Revenue at Transitioning Facilities increased by $8.6 million, or 6.2%, for the year ended December 31, 2012 as compared to the year ended December 31, 2011.

This increase was achieved despite a decrease in Medicare revenue per patient day of 7.1% at Transitioning Facilities for the year ended December 31, 2012.

This increase in revenue was primarily due to an increase in occupancy of 2.3% to 75.0%, as well as an increase in skilled mix by nursing days of 2.0%, to 18.3%, which was the result of increases in managed care and Medicare patient days of 35.4% and 6.6%, respectively, as compared to the year ended December 31, 2011.

The following table reflects the change in the skilled nursing average daily revenue rates by payor source, excluding services that are not covered by the daily rate: Years Ended December 31, Same Facility Transitioning Acquisitions Total % 2012 2011 2012 2011 2012 2011 2012 2011 Change Skilled Nursing Average Daily Revenue Rates: Medicare $ 564.94 $ 618.22 $ 485.07 $ 522.28 $ 471.49 $ 464.57 $ 541.63 $ 595.30 (9.0 )% Managed care 377.94 367.74 408.23 415.82 400.94 408.28 382.13 372.41 2.6 % Other skilled 521.11 542.93 571.97 554.10 610.62 - 528.00 564.60 (6.5 )% Total skilled revenue 492.71 519.82 470.08 497.87 461.19 458.06 486.98 515.90 (5.6 )% Medicaid 170.76 168.36 164.91 161.43 154.04 138.48 167.78 165.11 1.6 % Private and other payors 196.64 188.21 167.34 173.40 165.64 158.35 181.52 179.42 1.2 % Total skilled nursing revenue $ 268.24 $ 272.35 $ 221.20 $ 218.01 $ 211.56 $ 191.02 $ 252.18 $ 256.34 (1.6 )% The 2011 results include the impact of the implementation of RUGS IV on both revenue reimbursement and related cost structure changes included in MDS 3.0 and concurrent therapy in the first three quarters of 2011. Medicare daily rates decreased by 9.0%, due to the impact of the CMS imposed 11.1% reduction in Medicare skilled nursing PPS payments and therapy changes, which were implemented in October 2011. The average Medicaid rate increased 1.6% for the year ended December 31, 2012 relative to the same period in the prior year, primarily due to increases in rates in several states and increased acuity in case mix states where rates were cut, partially offset by decreases in rates in Arizona due to changes in base reimbursement rates.

Historically, we have generally experienced lower occupancy rates, lower skilled mix and quality mix at Recently Acquired Facilities and therefore, we anticipate generally lower overall occupancy during years of growth. In the future, if we acquire additional facilities into our overall portfolio, we expect this trend to continue. Accordingly, we anticipate our overall occupancy will vary from quarter to quarter based upon the maturity of the facilities within our portfolio.

75-------------------------------------------------------------------------------- Table of Contents Payor Sources as a Percentage of Skilled Nursing Services. We use both our skilled mix and quality mix as measures of the quality of reimbursements we receive at our skilled nursing facilities over various periods. The following tables set forth our percentage of skilled nursing patient revenue and days by payor source: Years Ended December 31, Same Facility Transitioning Acquisitions Total 2012 2011 2012 2011 2012 2011 2012 2011 Percentage of Skilled Nursing Revenue: Medicare 34.4 % 37.1 % 26.3 % 28.3 % 33.3 % 30.5 % 32.9 % 35.3 % Managed care 15.6 14.7 9.4 7.5 4.9 3.5 13.4 12.9 Other skilled 4.2 3.6 3.3 1.5 - - 3.7 3.1 Skilled mix 54.2 55.4 39.0 37.3 38.2 34.0 50.0 51.3 Private and other payors 7.1 7.1 10.3 10.6 24.9 30.3 9.5 8.8 Quality mix 61.3 62.5 49.3 47.9 63.1 64.3 59.5 60.1 Medicaid 38.7 37.5 50.7 52.1 36.9 35.7 40.5 39.9 Total skilled nursing 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Years Ended December 31, Same Facility Transitioning Acquisitions Total 2012 2011 2012 2011 2012 2011 2012 2011 Percentage of Skilled Nursing Days: Medicare 16.3 % 16.3 % 12.0 % 11.8 % 14.9 % 12.5 % 15.3 % 15.2 % Managed care 11.2 10.9 5.1 3.9 2.6 1.7 9.0 8.9 Other skilled 2.0 1.8 1.2 0.6 - - 1.6 1.4 Skilled mix 29.5 29.0 18.3 16.3 17.5 14.2 25.9 25.5 Private and other payors 9.7 10.3 13.6 13.4 31.9 36.6 13.2 12.6 Quality mix 39.2 39.3 31.9 29.7 49.4 50.8 39.1 38.1 Medicaid 60.8 60.7 68.1 70.3 50.6 49.2 60.9 61.9 Total skilled nursing 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Cost of Services (exclusive of facility rent and depreciation and amortization shown separately). Cost of services increased $55.6 million, or 9.3%, to $656.4 million for the year ended December 31, 2012 compared to $600.8 million for the year ended December 31, 2011. Of the $55.6 million increase, Same Facilities increased $1.4 million, or 0.3% and Recently Acquired Facilities increased $49.0 million. The $1.4 million increase in Same Facility cost of services was primarily due to an increase in ancillary expenses, partially offset by decreases in wages and benefits. The increase in ancillary expenses was primarily due to increased therapy costs as was anticipated due to the change in therapy regulation implemented on October 1, 2011. The decrease in wages and benefits was primarily due to reduced performance during the year ended December 31, 2012 as compared to 2011. Included in the $49.0 million increase in cost of services at Recently Acquired Facilities were impairment charges to intangible assets of $2.2 million resulting from a decline in fair value of DRX.

See further discussion of impairment charges at Note 11, Goodwill and Other Indefinite-Lived Intangibles in Notes to Consolidated Financial Statements. Cost of services increased as a percent of total revenue to 79.7% for the year ended December 31, 2012 as compared to 79.2% for the year ended December 31, 2011.

Charge Related to U.S. Government Inquiry. During the year ended December 31, 2012, the Company accrued an estimated liability of $15.0 million related to the ongoing investigation into some of our subsidiaries being conducted by the DOJ.

See further discussion of the DOJ investigation and related estimated settlement in Liquidity and Capital Resources.

76-------------------------------------------------------------------------------- Table of Contents Facility Rent - Cost of Services. Facility rent - cost of services decreased $0.4 million, or 2.9%, to $13.3 million for the year ended December 31, 2012 compared to $13.7 million for the year ended December 31, 2011. Facility rent-cost of services decreased as a percent of total revenue to 1.6% for the year ended December 31, 2012 as compared to 1.8% for the year ended December 31, 2011. The decrease in facility rent is due to our purchase of the underlying assets of eight of our skilled nursing facilities in California, Utah and Idaho which we previously operated under long-term lease agreements, partially offset by additional rent recognized for a facility for which the Company has begun construction activities, but has not commenced operations of a skilled nursing facility as of December 31, 2012, new leases related to our urgent care centers, and normal annual increases in rent at leased facilities.

General and Administrative Expense. General and administrative expense increased $2.0 million, or 6.7%, to $31.8 million for the year ended December 31, 2012 compared to $29.8 million for the year ended December 31, 2011. General and administrative expenses remained consistent as a percent of total revenue at 3.9% for the year ended December 31, 2012 and 2011. The $2.0 million increase was primarily due to increases in wages and benefits due to our growth and increased legal costs incurred in connection with the ongoing investigation into the billing and reimbursement process of some of our subsidiaries being conducted by the DOJ.

Depreciation and Amortization. Depreciation and amortization expense increased $5.1 million, or 21.9%, to $28.4 million for the year ended December 31, 2012 compared to $23.3 million for the year ended December 31, 2011. Depreciation and amortization expense increased as a percent of total revenue to 3.4% for the year ended December 31, 2012 as compared to 3.1% for the year ended December 31, 2011. This increase was primarily related to the additional depreciation of $1.9 million at Recently Acquired Facilities, as well as increases of $2.0 million and $1.2 million at Same and Transitioning Facilities, respectively, due to recent renovations and the purchase of the underlying assets of eight of our skilled nursing facilities which we previously operated under a long-term lease agreements. Of the $1.9 million increase at Recently Acquired Facilities, $0.5 million represented amortization expense of patient base intangible assets which are amortized over four to eight months.

Other Income (Expense). Other expense, net decreased $1.5 million, or 11.5%, to $12.0 million for the year ended December 31, 2012 compared to $13.5 million for the year ended December 31, 2011. The decrease in other expense, net was primarily the result of a one-time exit fee and related extinguishment fees of $2.5 million upon prepaying the Six Project Note and exiting our former revolving credit facility during the year ended December 31, 2011. This decrease was partially offset by increased interest expense due to the additional $21.5 million in long-term debt added with the promissory notes with RBS Asset Finance, Inc. (2012 RBS Loan) in February 2012.

Provision for Income Taxes. Provision for income taxes decreased $4.4 million, or 14.9%, to $25.1 million for the year ended December 31, 2012 compared to $29.5 million for the year ended December 31, 2011. This decrease resulted from the decrease in income before income taxes of $10.9 million, or 14.1%. In addition, our effective tax rate decreased 0.3% to 37.9% for the year ended December 31, 2012 as compared to 38.2% for the year ended December 31, 2011.

Liquidity and Capital Resources Our primary sources of liquidity have historically been derived from our cash flow from operations and long-term debt secured by our real property and our revolving credit facilities.

Since 2004, we have financed the majority of our facility acquisitions primarily through refinancing of existing facilities, and cash generated from operations.

Cash paid for business acquisitions was $45.4 million, $31.6 million and $106.7 million for the years ended December 31, 2013, 2012 and 2011, respectively. Cash paid for asset acquisitions was $0, $11.3 million and $23.4 million for the years ended December 31, 2013, 2012 and 2011, respectively.

Where we enter into a facility lease agreement, we typically do not pay any material amount to the prior facility operator, nor do we acquire any assets or assume any liabilities, other than our rights and obligations under the new lease and operations transfer agreement, as part of the transaction. Total capital expenditures for property and equipment were $29.8 million, $38.9 million and $40.8 million for the years ended December 31, 2013, 2012 and 2011, respectively. We currently have a combined $30.0 million budgeted for renovation projects for 2014.

We believe our current cash balances, our cash flow from operations and the revolving credit facility portion of our senior credit facility with a six-bank lending consortium arranged by SunTrust and Wells Fargo (the Senior Credit Facility), which was increased from $75.0 million to $150.0 million on February 1, 2013, will be sufficient to cover our operating needs for at least the next 12 months. We may in the future seek to raise additional capital to fund growth, capital renovations, operations and other business activities, but such additional capital may not be available on acceptable terms, on a timely basis, or at all.

77-------------------------------------------------------------------------------- Table of Contents Our cash and cash equivalents as of December 31, 2013 consisted of bank term deposits, money market funds and U.S. Treasury bill related investments. In addition, as of December 31, 2013, we held debt security investments of approximately $22.4 million, which were split between AA- and A-rated securities. Our market risk exposure is interest income sensitivity, which is affected by changes in the general level of U.S. interest rates. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Due to the low risk profile of our investment portfolio, an immediate 10% change in interest rates would not have a material effect on the fair market value of our portfolio. Accordingly, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio.

In connection with the Spin-Off, we anticipate that CareTrust will assume the mortgage debt related to certain of the properties it acquires. CareTrust will also issue senior unsecured notes and mortgage indebtedness. A portion of those proceeds is expected to be transferred to us. We expect that we will use the proceeds to repay certain outstanding third-party bank debt and other indebtedness and, subject to the approval of and declaration by our board of directors, pay up to eight regular quarterly dividends. The Spin-Off and related transactions are subject to conditions, and their terms are subject to change in the sole discretion of our board of directors. Further details can be found at CareTrust's registration statement on Form 10 (File No. 001-36181) filed with the Securities and Exchange Commission on February 13, 2014.

The following table presents selected data from our consolidated statement of cash flows for the periods presented: Year Ended December 31, 2013 2012 2011 (In thousands) Net cash provided by operating activities $ 37,424 $ 82,050 $ 72,687 Net cash used in investing activities (65,235 ) (84,496 ) (156,052 ) Net cash provided by financing activities 52,881 13,547 40,861 Net increase (decrease) in cash and cash equivalents 25,070 11,101 (42,504 ) Cash and cash equivalents at beginning of period 40,685 29,584 72,088 Cash and cash equivalents at end of period $ 65,755 $ 40,685 $ 29,584 Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 Net cash provided by operations for the year ended December 31, 2013 was $37.4 million compared to $82.1 million for the year ended December 31, 2012, a decrease of $44.7 million. This decrease was primarily due to the payment of the U.S. Government investigation settlement of $15.0 million, an increase in accounts receivable of $11.1 million as compared to the year ended December 31, 2012 and an increase in prepaid income taxes of $8.2 million as compared to the year ended December 31, 2012, due to the timing of payments.

Net cash used in investing activities for the year ended December 31, 2013 was $65.2 million compared to $84.5 million for the year ended December 31, 2012, a decrease of $19.3 million. The decrease was primarily the result of $71.3 million in cash paid for business acquisitions, asset acquisitions and purchased property and equipment in the year ended December 31, 2013 compared to $86.2 million in the year ended December 31, 2012, a decrease of $14.9 million. The remainder of this difference is due to cash proceeds received on the sale of the Company's urgent care franchising business of $3.6 million and equity method investment of $1.6 million during the year ended December 31, 2013.

Net cash provided by financing activities for the year ended December 31, 2013 was $52.9 million as compared to $13.5 million for the year ended December 31, 2012, an increase of $39.4 million. This increase was primarily due to the receipt of $58.7 million in borrowing proceeds from our Senior Credit Facility during the year ended December 31, 2013 as compared to $36.5 million during the year ended December 31, 2012, an increase of $22.2 million, combined with a decrease in long-term debt repayments of $7.2 million for the year ended December 31, 2013 as compared to $16.8 million for the year ended December 31, 2012, a decrease of $9.6 million.

78-------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2012 Compared to Year Ended December 31, 2011 Net cash provided by operating activities for the year ended December 31, 2012 was $82.1 million compared to $72.7 million for the year ended December 31, 2011, an increase of $9.4 million. The increase was primarily due to our improved operating results, which contributed $94.5 million in 2012 after adding back depreciation and amortization, the charge related to U.S. Government inquiry, impairment charges, deferred income taxes, provision for doubtful accounts, share-based compensation, excess tax benefits from share-based compensation and loss on disposition of property and equipment (non-cash charges), as compared to $85.3 million for 2011, an increase of $9.2 million.

Net cash used in investing activities for the year ended December 31, 2012 was $84.5 million compared to $156.1 million for the year ended December 31, 2011, a decrease of $71.8 million. The decrease was primarily the result of $86.2 million in cash paid for business acquisitions, asset acquisitions and purchased property and equipment in the year ended December 31, 2012 compared to $156.7 million in the year ended December 31, 2011.

Net cash provided by financing activities for the year ended December 31, 2012 was $13.5 million as compared to $40.9 million for the year ended December 31, 2011, a decrease of $27.4 million. This decrease was primarily due to the receipt of $75.0 million in proceeds from the term loan portion of the Senior Credit Facility during the year ended December 31, 2011 as compared to $21.5 million in proceeds received from the 2012 RBS Loan during the year ended December 31, 2012, a decrease of $53.5 million. The reduction in long-term debt proceeds received was partially offset by a decrease in long-term debt repayments from $46.3 million for the year ended December 31, 2011 to $16.8 million for the year ended December 31, 2012, a difference of $29.5 million. The remaining decrease is due to the use of long-term debt proceeds to repay existing debt in the prior year.

Principal Debt Obligations and Capital Expenditures Total long-term debt obligations, net of debt discount, outstanding as of December 31, 2013, 2012, 2011, 2010 and 2009 were as follows: December 31, 2009 2010 2011 2012 2013 (in thousands) Senior Credit Facility $ - $ - $ 88,125 $ 89,375 $ 144,325 Ten Project Note 53,200 52,229 51,185 50,072 48,864 Six Project Loan 39,970 39,495 - - -Mortgage Loan and Promissory Notes 15,064 49,744 48,560 68,245 66,117 Bond payable 1,232 1,038 - - - Total $ 109,466 $ 142,506 $ 187,870 $ 207,692 $ 259,306 The following table represents the Company's cumulative facility growth from 2008 to the present: December 31, 2008 2009 2010 2011 2012 2013Cumulative number of facilities 63 77 82 102 108 119 Senior Credit Facility with a Lending Consortium Arranged by SunTrust and Wells Fargo (the Senior Credit Facility) On April 22, 2013, we entered into the fourth amendment to the Senior Credit Facility (the Fourth Amendment), which amended our existing Senior Credit Facility Agreement, dated as of July 15, 2011, to amend certain covenants, representations and other key provisions in the credit agreement to, among other things, (i) allow for the settlement relating to the previously disclosed federal civil investigation that has been conducted by the U.S. DOJ and related federal agencies in an amount up to $50.0 million and (ii) permit us to enter into a corporate integrity agreement with the Office of Inspector General-HHS.

Except as set forth in the Fourth Amendment, all other terms and conditions of the Senior Credit Facility, as amended, remain in full force.

79-------------------------------------------------------------------------------- Table of Contents On February 1, 2013, we entered into the third amendment to the Senior Credit Facility (the Third Amendment), which amended our existing Senior Credit Facility Agreement, dated as of July 15, 2011. The Third Amendment revised the Senior Credit Facility Agreement to, among other things, (i) increase the revolving credit portion of the Senior Credit Facility by $75.0 million to an aggregate principal amount of $150.0 million, of which $78.7 million was drawn as of December 31, 2013, and (ii) extend the maturity date of the Senior Credit Facility from July 15, 2016 to February 1, 2018. Except as set forth in the Third Amendment, all other terms and conditions of the Senior Credit Facility remained in full force and effect as described below.

On July 15, 2011, we entered into the Senior Credit Facility in an aggregate principal amount of up to $150.0 million comprised of a $75.0 million revolving credit facility and a $75.0 million term loan advanced in one drawing on July 15, 2011. Borrowings under the term loan portion of the Senior Credit Facility amortize in equal quarterly installments that commenced on September 30, 2011, in an aggregate annual amount equal to 5.0% per annum of the original principal amount. Interest rates per annum applicable to the Senior Facility will be, at our option, (i) LIBOR plus an initial margin of 2.5% or (ii) the Base Rate (as defined under the Senior Credit Facility) plus an initial margin of 1.5%. Under the terms of the Senior Credit Facility, the applicable margin adjusts based on our leverage ratio as set forth in further detail in the Senior Credit Facility agreement. Amounts borrowed pursuant to the Senior Credit Facility are guaranteed by certain of our wholly-owned subsidiaries and secured by substantially all of our personal property. To reduce the risk related to interest rate fluctuations, we, on behalf of the subsidiaries, entered into an interest rate swap agreement to effectively fix the interest rate on the term loan portion of the Senior Credit Facility. See further details of the interest rate swap at Note 6, Fair Value Measurements in Notes to Condensed Consolidated Financial Statements.

Among other things, under the Senior Credit Facility, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a maximum net leverage ratio, minimum interest coverage ratio and minimum asset coverage ratio. The loan documents also include certain additional reporting, affirmative and negative covenants including limitations on the incurrence of additional indebtedness, liens, investments in other businesses, dividends declared in excess of 20% of consolidated net income, stock repurchases and capital expenditures. As of December 31, 2013, we were in compliance with all loan covenants. As of December 31, 2013, our subsidiaries had $144.3 million outstanding on the Senior Credit Facility.

Promissory Notes with RBS Asset Finance, Inc.

On February 22, 2012, two of our real estate holding subsidiaries as Borrowers executed a promissory note in favor of RBS Asset Finance, Inc. (RBS) as Lender for an aggregate of $21.5 million (the 2012 RBS Loan). The 2012 RBS Loan was secured by a Commercial Deed of Trust, Security Agreement, Assignment of Leases and Rents and Fixture Filings on the two properties owned by the two Borrowers, and other related instruments and agreements, including without limitation a promissory note and a Company guaranty. The 2012 RBS Loan bears interest at a fixed rate of 4.75%. Amounts borrowed under the 2012 RBS Loan may be prepaid starting after the second anniversary of the note subject to certain prepayment fees. The term of the RBS Loan is for seven years, with monthly principal and interest payments commencing on March 1, 2012 and the balance due on March 1, 2019.

Among other things, under the 2012 RBS Loan, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum debt service coverage ratio, an average occupancy rate and a minimum project yield. The Loan Documents also include certain additional affirmative and negative covenants, including limitations on the disposition of the Borrowers and the collateral and minimum average cash balance requirements. As of December 31, 2013, we were in compliance with all loan covenants. As of December 31, 2013, our subsidiaries had $20.3 million outstanding on the 2012 RBS Loan.

Promissory Notes with RBS Asset Finance, Inc.

On December 31, 2010, four of our real estate holding subsidiaries as Borrowers executed a promissory note with RBS as Lender for an aggregate of $35.0 million (RBS Loan). The 2010 RBS Loan was secured by Commercial Deeds of Trust, Security Agreements, Assignment of Leases and Rents and Fixture Fillings on the four properties owned by the four Borrowers, and other related instruments and agreements, including without limitation a promissory note and a Company guaranty. The 2010 RBS Loan bears interest at a fixed rate of 6.04%. Amounts borrowed under the 2010 RBS Loan may be prepaid starting after the second anniversary of the note subject to certain prepayment fees. The term of the 2010 RBS Loan is for seven years, with monthly principal and interest payments commencing on February 1, 2011 and the balance due on January 1, 2018.

80-------------------------------------------------------------------------------- Table of Contents Among other things, under the 2010 RBS Loan, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum debt service coverage ratio, an average occupancy rate and a minimum project yield. The Loan Documents also include certain additional affirmative and negative covenants, including limitations on the disposition of the Borrowers and the collateral and minimum average cash balance requirements. As of December 31, 2013, we were in compliance with all loan covenants. As of December 31, 2013, our subsidiaries had $32.1 million outstanding on the 2010 RBS Loan.

Term Loan with General Electric Capital Corporation On December 29, 2006, a number of our independent real estate holding subsidiaries jointly entered into the Third Amended and Restated Loan Agreement, with GECC, which consists of an approximately $55.7 million multiple-advance term loan, further referred to as the Ten Project Note. The Ten Project Note matures in June 2016, and is currently secured by the real and personal property comprising the ten facilities owned by these subsidiaries. The Ten Project Note was funded in advances, with each advance bearing interest at a separate rate.

The interest rates range from 6.95% to 7.50% per annum.

Under the Ten Project Note, we are subject to standard reporting requirements and other typical covenants for a loan of this type. Effective October 1, 2006 and continuing each calendar quarter thereafter, we are subject to restrictive financial covenants, including average occupancy, Debt Service (as defined in the agreement) and Project Yield (as defined in the agreement). As of December 31, 2013, we were in compliance with all loan covenants. As of December 31, 2013, our subsidiaries had $48.9 million outstanding on the Ten Project Note.

Promissory Notes with Johnson Land Enterprises, Inc.

On October 1, 2009, four of our subsidiaries entered into four separate promissory notes with Johnson Land Enterprises, LLC, for an aggregate of $10.0 million, as a part of our acquisition of three skilled nursing facilities in Utah. The unpaid balance of principal and accrued interest from these notes is due on September 30, 2019. The notes bear interest at a rate of 6.0% per annum. As a part of this transaction, the Company recorded a discount to the debt balance in the form of imputed interest of $1.2 million. This amount will be amortized over the term of the promissory notes, or 10 years. As of December 31, 2013, our subsidiaries had $8.9 million outstanding on the Promissory Notes.

Mortgage Loan with Continental Wingate Associates, Inc.

Ensign Southland LLC, a subsidiary of The Ensign Group, Inc., entered into a mortgage loan on January 30, 2001 with Continental Wingate Associates, Inc. The mortgage loan is insured with the U.S. Department of Housing and Urban Development, or HUD, which subjects our Southland facility to HUD oversight and periodic inspections. As of December 31, 2013, the balance outstanding on this mortgage loan was approximately $5.4 million. The unpaid balance of principal and accrued interest from this mortgage loan is due on February 1, 2027. The mortgage loan bears interest at the rate of 7.5% per annum.

This mortgage loan is secured by the real property comprising the Southland Care Center facility and the rents, issues and profits thereof, as well as all personal property used in the operation of the facility.

Common Stock Repurchase Program In the fourth quarter of 2012, the board of directors authorized the renewal of our common stock repurchase program, authorizing the repurchase of up to $10.0 million of our common stock over the next 12 months. Under this program, we are authorized to repurchase our issued and outstanding common shares from time to time in open-market and privately negotiated transactions and block trades in accordance with federal securities laws, including Rule 10b-18 promulgated under the Securities Exchange Act of 1934 as amended.

The number of shares repurchased will depend entirely upon the levels of cash available, the attractiveness of alternate investment and business opportunities either at hand or on the horizon, Management's perception of value relative to market price and other legal, regulatory and contractual requirements. The repurchase program does not obligate us to repurchase any particular dollar amount or number of shares of common stock. The repurchase program expired on November 15, 2013. During the year ended December 31, 2013, we did not repurchase any shares of our common stock. During the year ended December 31, 2012, we repurchased 7,340 shares of our common stock for a total of $0.2 million.

81-------------------------------------------------------------------------------- Table of Contents Contractual Obligations, Commitments and Contingencies Our principal contractual obligations and commitments as of December 31, 2013 were as follows: 2014 2015 2016 2017 2018 Thereafter Total (In thousands) Operating lease obligations $ 13,693 $ 13,677 $ 13,686 $ 13,722 $ 13,764 $ 71,093 $ 139,635 Long-term debt obligations 7,411 7,672 52,589 6,584 157,790 27,960 260,006 Interest payments on long-term debt 11,674 11,117 9,486 7,333 2,166 1,900 43,676 Total $ 32,778 $ 32,466 $ 75,761 $ 27,639 $ 173,720 $ 100,953 $ 443,317 Not included in the table above are our actuarially determined self-insured general and professional malpractice liability, worker's compensation and medical (including prescription drugs) and dental healthcare obligations which are broken out between current and long-term liabilities in our financial statements included in this annual report.

We lease certain facilities and our Service Center office under operating leases, most of which have initial lease terms ranging from five to 20 years.

Most of these leases contain options to renew or extend the lease term, some of which involve rent increases. We also lease a majority of our equipment under operating leases with initial terms ranging from three to five years. Total rent expense, inclusive of straight-line rent adjustments, was $14.2 million, $13.8 million and $14.2 million during the years ended December 31, 2013, 2012 and 2011, respectively.

US Government Inquiry In late 2006, we learned that we might be the subject of an on-going criminal and civil investigation by the DOJ. This was confirmed in March 2007. The investigation was prompted by a whistleblower complaint, and related primarily to claims submitted to the Medicare program for rehabilitation services provided at skilled nursing facilities in Southern California. We, through our outside counsel and a special committee of independent directors established by our board, worked cooperatively with the U.S. Attorney's office to produce information requested by the government as part of an ongoing dialogue designed to resolve the issue.

In December 2011, the DOJ notified us that it had closed its criminal investigation without action although, as is typical, it reserved the right to reopen the criminal case if new facts came to light. This left only the civil investigation to resolve, and we continued to supply requested information to the DOJ and the Office of the Inspector General of the United States Department of Health and Human Services (HHS), including specific patient records and documents from 2007 to 2011 from six Southern California skilled nursing facilities that had been the subject of previous requests.

In early 2013, discussions between government representatives and our special committee, our outside counsel and their experts had advanced sufficiently that we recorded an initial estimated liability in the amount of $15.0 million in the fourth quarter of 2012 for the resolution of claims connected to the investigation. In April 2013, we and government representatives reached an agreement in principle to resolve the allegations and close the investigation.

Based on these discussions, we recorded and announced an additional charge in the amount of $33.0 million in the first quarter of 2013, increasing the total reserve to resolve the matter to $48.0 million (the Reserve Amount).

In October 2013, we and the government executed a final settlement agreement in accordance with the April agreement and we remitted full payment of the Reserve Amount. In addition, we executed a corporate integrity agreement with the Office of Inspector General HHS as part of the resolution.

See additional description of our contingencies in Notes 15, 16, 17 and 19 in Notes to Condensed Consolidated Financial Statements.

Inflation We have historically derived a substantial portion of our revenue from the Medicare program. We also derive revenue from state Medicaid and similar reimbursement programs. Payments under these programs generally provide for reimbursement levels that are adjusted for inflation annually based upon the state's fiscal year for the Medicaid programs and in each October for the Medicare program. These adjustments may not continue in the future, and even if received, such adjustments may not reflect the actual increase in our costs for providing healthcare services.

82-------------------------------------------------------------------------------- Table of Contents Labor and supply expenses make up a substantial portion of our cost of services.

Those expenses can be subject to increase in periods of rising inflation and when labor shortages occur in the marketplace. To date, we have generally been able to implement cost control measures or obtain increases in reimbursement sufficient to offset increases in these expenses. We may not be successful in offsetting future cost increases.

Off-Balance Sheet Arrangements As of December 31, 2013 and 2012, we had approximately $2.0 million of borrowing capacity on the Revolver pledged as collateral to secure outstanding letters of credit, respectively.

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