Rehabcare (RHB) 10-Q 2008 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______________ to ______________

Commission file number 0-19294

RehabCare Group, Inc.

(Exact name of Registrant as specified in its charter)

Delaware	51-0265872
(State of Incorporation)	(I.R.S.  Employer Identification No.)

7733 Forsyth Boulevard, 23rd Floor, St.  Louis, Missouri 63105

(Address of principal executive offices and zip code)

 (314) 863-7422

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.   Yes xNo ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company.

Large accelerated filer   ¨	Accelerated filer   x
Non-accelerated filer   ¨	Smaller reporting company   ¨

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

Yes   ¨No   x

Indicate the number of shares outstanding of the Registrant’s common stock, as of the latest practicable date.

Class	Outstanding at July 31, 2008
Common Stock, par value $.01 per share	18,041,433 (a)

(a) Includes 464,422 shares of unvested restricted stock.

- 1 - -

REHABCARE GROUP, INC.

Index

Part I.  – Financial Information
	Item 1. – Condensed Consolidated Financial Statements
		Condensed Consolidated Balance Sheets as of June 30, 2008 (unaudited) and December 31, 2007	3
		Condensed Consolidated Statements of Earnings for the three months and six months ended June 30, 2008 and 2007 (unaudited)	4
		Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2008 and 2007 (unaudited)	5
		Notes to the condensed consolidated financial statements (unaudited)	6
	Item 2. – Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
	Item 3. – Quantitative and Qualitative Disclosures about Market Risk		27
	Item 4. – Controls and Procedures		27
Part II.  – Other Information
	Item 1. – Legal Proceedings		28
	Item 1A. – Risk Factors		28
	Item 6. – Exhibits		28
	Signatures		29

- 2 - -

PART 1. – FINANCIAL INFORMATION

Item 1. – Condensed Consolidated Financial Statements

REHABCARE GROUP, INC.

Condensed Consolidated Balance Sheets

(dollars in thousands, except per share data)

	June 30,			December 31,
		2008				2007
Assets	(unaudited)
Current assets:
Cash and cash equivalents	$	14,345			$	10,265
Accounts receivable, net of allowance for doubtful accounts of $17,812 and $16,266, respectively		141,981				135,194
Income taxes receivable		755				—
Deferred tax assets		15,101				15,863
Other current assets		8,009				7,892
Total current assets		180,191				169,214
Marketable securities, trading		3,232				3,547
Property and equipment, net		32,387				29,705
Goodwill		174,879				168,517
Intangible assets, net		26,505				28,027
Investment in unconsolidated affiliate		4,719				4,701
Other		4,791				4,849
Total assets	$	426,704			$	408,560
Liabilities and Stockholders’ Equity
Current liabilities:
Current portion of long-term debt	$	6,000			$	9,500
Accounts payable		7,817				5,825
Accrued salaries and wages		52,614				49,886
Income taxes payable		—				192
Accrued expenses		26,218				23,526
Total current liabilities		92,649				88,929
Long-term debt, less current portion		65,000				65,000
Deferred compensation		3,240				3,552
Deferred tax liabilities		6,229				5,375
Other		572				415
Total liabilities		167,690				163,271
Minority interests		3,111				1,267
Stockholders’ equity:
Preferred stock, $.10 par value; authorized 10,000,000 shares, none issued and outstanding		—				—
Common stock, $.01 par value; authorized 60,000,000 shares, issued 21,565,020 shares and 21,466,994 shares as of June 30, 2008 and December 31, 2007, respectively		216				215
Additional paid-in capital		143,218				140,246
Retained earnings		167,335				158,331
Accumulated other comprehensive loss		(162	)			(66	)
Less common stock held in treasury at cost; 4,002,898 shares as of June 30, 2008 and December 31, 2007		(54,704	)			(54,704	)
Total stockholders’ equity		255,903				244,022
Total liabilities and stockholders’ equity	$	426,704			$	408,560

See accompanying notes to condensed consolidated financial statements.

- 3 - -

REHABCARE GROUP, INC.

Condensed Consolidated Statements of Earnings

(in thousands, except per share data)

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
		2008			2007			2008			2007
Operating revenues	$	185,519		$	181,086		$	369,640		$	365,096
Costs and expenses:
Operating		151,132			145,691			300,094			297,913
Selling, general and administrative:
Divisions		12,383			11,744			24,105			23,409
Corporate		10,744			10,283			22,002			20,560
Impairment of intangible asset		—			4,906			—			4,906
Depreciation and amortization		3,734			4,213			7,501			8,525
Total costs and expenses		177,993			176,837			353,702			355,313
Operating earnings		7,526			4,249			15,938			9,783
Interest income		38			713			75			742
Interest expense		(1,006	)		(2,257	)		(2,305	)		(4,576	)
Other income (expense)		25			(63	)		28			(61	)
Equity in net income of affiliate		140			52			298			89
Minority interests		647			14			727			26
Earnings before income taxes		7,370			2,708			14,761			6,003
Income taxes		2,874			1,057			5,757			2,355
Net earnings	$	4,496		$	1,651		$	9,004		$	3,648
Earnings per common share:
Basic	$	0.26		$	0.10		$	0.51		$	0.21
Diluted	$	0.25		$	0.09		$	0.51		$	0.21
Weighted-average number of common shares outstanding:
Basic		17,560			17,171			17,546			17,155
Diluted		17,737			17,407			17,723			17,366

See accompanying notes to condensed consolidated financial statements.

- 4 - -

REHABCARE GROUP, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited; amounts in thousands)

		Six Months Ended,
		June 30,
		2008			2007
Cash flows from operating activities:
Net earnings	$	9,004			3,648
Reconciliation to net cash provided by operating activities:
Depreciation and amortization		7,501			8,525
Provision for doubtful accounts		4,736			4,777
Equity in net income of affiliate		(298	)		(89	)
Minority interests		(727	)		(26	)
Impairment of intangible asset		—			4,906
Stock-based compensation expense		1,636			897
Income tax benefits from share-based payments		510			184
Excess tax benefits from share-based payments		(335	)		(121	)
(Gain) loss on disposal of property and equipment		(28	)		61
Changes in assets and liabilities:
Accounts receivable, net		(9,195	)		(1,071	)
Other current assets		31			(1,841	)
Other assets		151			204
Accounts payable		1,815			(2,935	)
Accrued salaries and wages		2,371			(1,572	)
Income taxes payable and deferred taxes		534			2,037
Accrued expenses		1,161			1,426
Deferred compensation		(244	)		(374	)
Net cash provided by operating activities		18,623			18,636
Cash flows from investing activities:
Additions to property and equipment		(7,485	)		(4,288	)
Purchase of marketable securities		(299	)		(274	)
Proceeds from sale/maturities of marketable securities		546			708
Investment in unconsolidated affiliate		—			(1,119	)
Purchase of businesses, net of cash acquired		(7,009	)		(1	)
Other, net		(141	)		(296	)
Net cash used in investing activities		(14,388	)		(5,270	)
Cash flows from financing activities:
Net change in revolving credit facility		—			(11,000	)
Principal payments on long-term debt		(3,500	)		(559	)
Contributions by minority interest shareholders		1,987			80
Exercise of stock options		1,023			605
Excess tax benefits from share-based payments		335			121
Net cash used in financing activities		(155	)		(10,753	)
Net increase in cash and cash equivalents		4,080			2,613
Cash and cash equivalents at beginning of period		10,265			9,430
Cash and cash equivalents at end of period	$	14,345		$	12,043

See accompanying notes to condensed consolidated financial statements.

- 5 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements

Six Month Periods Ended June 30, 2008 and 2007

(Unaudited)

(1)           Basis of Presentation

The condensed consolidated balance sheets and related condensed consolidated statements of earnings and cash flows contained in this Form 10-Q, which are unaudited, include the accounts of the Company and its wholly and majority owned affiliates.  The Company accounts for its investments in less than 50% owned affiliates using the equity method.  All significant intercompany accounts and activity have been eliminated in consolidation.  In the opinion of management, all entries necessary for a fair presentation of such financial statements have been included.  Certain prior year amounts may have been reclassified to conform to current year presentation.  The results of operations for the three months and six months ended June 30, 2008 are not necessarily indicative of the results to be expected for the fiscal year.

The condensed consolidated financial statements do not include all information and footnotes necessary for a complete presentation of financial position, results of operations and cash flows in conformity with U.S. generally accepted accounting principles.  Reference is made to the Company’s audited consolidated financial statements and the related notes as of December 31, 2007 and 2006 and for each of the years in the three-year period ended December 31, 2007, included in the Annual Report on Form 10-K on file with the Securities and Exchange Commission, which provide additional disclosures and a further description of the Company’s accounting policies.

(2)           Critical Accounting Policies and Estimates

The Company’s condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles.  Preparation of these statements requires management to make judgments and estimates.  Some accounting policies have a significant impact on amounts reported in these financial statements.  A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in the Company’s 2007 Annual Report on Form 10-K, filed on March 11, 2008.

(3)           Stock-Based Compensation

The Company adopted Statement of Financial Accounting Standards No.  123 – revised 2004, “Share-Based Payment” (“Statement 123R”), on January 1, 2006.  Statement 123R requires the recognition of compensation expense for all share-based compensation awarded to employees, net of estimated forfeitures, using a fair-value-based method.  Under Statement 123R, the grant-date fair value of each award is amortized to expense over the award’s vesting period.  Compensation expense associated with share-based awards is included in corporate selling, general and administrative expense in the accompanying consolidated statements of earnings.  Total pre-tax compensation expense and its related income tax benefit were as follows (in thousands of dollars):

		Three Months Ended,				Six Months Ended,
		June 30,				June 30,
		2008		2007		2008		2007
Share-based compensation expense	$	860	$	451	$	1,636	$	897
Income tax benefit		332		175		632		347

The Company has various incentive plans that provide long-term incentive and retention awards.  These awards include stock options and restricted stock awards.  At June 30, 2008, a total of 534,538 shares were available for future issuance under the plans.

- 6 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

Stock Options

No stock options were granted during the six months ended June 30, 2008 and 2007.   As of June 30, 2008, there was approximately $0.1 million of unrecognized compensation cost related to nonvested options.  Such cost is expected to be recognized over a weighted-average period of 1.7 years.

Restricted Stock Awards

In 2006, the Company began issuing restricted stock awards to attract and retain key Company executives.  At the end of a three-year restriction period, the awards will vest and be transferred to the participant provided that the participant has been an employee of the Company continuously throughout the restriction period.  In the first quarter of 2007, the Company also began issuing restricted stock awards to its nonemployee directors.  One-fourth of such awards generally vest each quarter over the first four quarters following the date of grant.

The Company’s restricted stock awards have been classified as equity awards under Statement 123R.  In general, the Company will receive a tax deduction for each restricted stock award on the vesting date equal to the fair market value of the restricted stock on the vesting date.

A summary of the status of the Company’s nonvested restricted stock awards as of June 30, 2008 and changes during the six-month period ended June 30, 2008 is presented below:

			Weighted-
			Average
			Grant-Date
Nonvested Restricted Stock Awards	Shares		Fair Value
Nonvested at December 31, 2007	254,760		$16.14
Granted	247,262		21.85
Vested	(17,500	)	19.51
Forfeited	(2,010	)	17.27
Nonvested at June 30, 2008	482,512		$18.94

As of June 30, 2008, there was approximately $6.6 million of unrecognized compensation cost related to nonvested restricted stock awards.  Such cost is expected to be recognized over a weighted-average period of 2.1 years.

(4)           Earnings per Share

Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average common shares outstanding for the period.  Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity (as calculated utilizing the treasury stock method).  These potential shares include dilutive stock options and unvested restricted stock awards.

- 7 - -

 REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2008		2007		2008		2007
Numerator:
Numerator for basic and diluted earnings per share –
net earnings	$	4,496	$	1,651	$	9,004	$	3,648
Denominator:
Denominator for basic earnings per share –
weighted-average shares outstanding		17,560		17,171		17,546		17,155
Effect of dilutive securities:
stock options and restricted stock awards		177		236		177		211
Denominator for diluted earnings per share –
adjusted weighted-average shares		17,737		17,407		17,723		17,366
Basic earnings per share	$	0.26	$	0.10	$	0.51	$	0.21
Diluted earnings per share	$	0.25	$	0.09	$	0.51	$	0.21

For the three months and six months ended June 30, 2008, outstanding stock options totaling approximately 1.1 million potential shares in each period were excluded from the calculation of diluted earnings per share because their effect would have been anti-dilutive.  For the three months and six months ended June 30, 2007, outstanding stock options totaling approximately 1.4 million potential shares in each period were excluded from the calculation of diluted earnings per share because their effect would have been anti-dilutive.

(5)           Comprehensive Income

The following table sets forth the computation of comprehensive income (in thousands):

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2008		2007		2008			2007
Net income	$	4,496	$	1,651	$	9,004		$	3,648
Other comprehensive income (loss), net of tax:
Unrealized gain (loss) on interest rate swap		278		—		(96	)		—
Comprehensive income	$	4,774	$	1,651	$	8,908		$	3,648

(6)           Investment in Unconsolidated Affiliate

In January 2005, the Company paid $3.6 million for a 40% equity interest in Howard Regional Specialty Care, LLC (“HRSC”), which operates a freestanding rehabilitation hospital in Kokomo, Indiana.  The Company uses the equity method to account for its investment in HRSC.  The value of

- 8 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

the Company’s investment in HRSC at the transaction date exceeded its share of the book value of HRSC’s stockholders’ equity by approximately $3.5 million.  This excess is being accounted for as equity method goodwill.  In February 2007, the Company invested an additional $1.1 million of cash in HRSC, and the majority owner invested an additional $1.7 million.  HRSC used these funds to meet its working capital needs and to acquire an outpatient rehabilitation business in Kokomo.  The carrying value of the Company’s investment in HRSC was $4.7 million at both June 30, 2008 and December 31, 2007.

(7)           Business Combinations

Effective June 1, 2008, the Company acquired an 80% equity interest in The Specialty Hospital, LLC for approximately $8.2 million plus costs of executing the acquisition.  The Specialty Hospital is a 24-bed long-term acute care hospital located on the grounds of Floyd Medical Center in Rome, Georgia.  Floyd Healthcare Resources, Inc. has retained a 20% interest in the hospital.  In connection with this transaction, the Company recorded approximately $6.8 million in intangible assets, consisting primarily of goodwill.  This allocation is based on preliminary valuation and estimated working capital information and will be adjusted upon completion of a final valuation and final determination of working capital in accordance with the terms of the purchase agreement.  The Specialty Hospital’s results of operations have been included in the Company’s financial statements prospectively beginning on the date of acquisition.  The Company has not presented the pro forma operations of The Specialty Hospital because the results are not considered material to the Company’s results of operations.

Effective July 1, 2006, the Company acquired all of the outstanding limited liability company membership interests of Symphony Health Services, LLC (“Symphony”) at a cost of approximately $109.9 million.  The Company recognized lease exit costs associated with exiting certain Symphony leased properties as liabilities assumed in the acquisition and included in the allocation of the purchase price for Symphony.  The following table provides a roll-forward of the liability for accrued lease exit costs for the six month period ended June 30, 2008 (in thousands):

Balance, December 31, 2007	$	469
Payments		(131	)
Balance, June 30, 2008	$	338

(8)           Intangible Assets

Under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” intangible assets with indefinite lives are not amortized but must be reviewed for impairment annually and whenever events or changes in circumstances indicate that the asset might be impaired.  If the impairment test indicates that the carrying value of an intangible asset exceeds its fair value, then an impairment loss should be recognized in the consolidated statement of earnings in an amount equal to the excess carrying value.

On May 1, 2007, the Centers for Medicare and Medicaid Services (“CMS”) released a rule extending the so-called 25% Rule to all LTACHs, including those LTACHs that have previously operated under a statutory grandfathering exemption.  The 25% Rule limits LTACH prospective payment system (“PPS”) paid admissions from a single referral source to 25%.  Admissions beyond the 25% threshold would be paid using lower inpatient PPS rates.  Louisiana Specialty Hospital, the Company’s LTACH in New Orleans, Louisiana, had been grandfathered and statutorily exempt from the 25% Rule.  Such exemption provided greater operational flexibility and fewer restrictions on the types of patients that could be admitted to that facility.  Under the May 1, 2007 rule, implementation of the 25% threshold by previously grandfathered facilities was to occur over a three year transition period.

- 9 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

As part of the purchase price allocation for Louisiana Specialty Hospital, the Company initially recorded the value of the statutory exemption as an indefinite-lived intangible asset at its estimated acquisition date fair value of $5.4 million.  The Company determined that the issuance of the May 1, 2007 rule by CMS resulted in a triggering event during the second quarter of 2007 that required the useful life of the statutory exemption intangible asset to be reassessed as finite-lived and a corresponding impairment analysis to be performed.  Based on that analysis, the Company recognized an impairment loss of $4.9 million in the second quarter of 2007 in the hospitals segment to reduce the carrying value of this intangible asset to its revised estimate of fair value based on the impact of the change in regulations.  The Company computed the fair value of the statutory exemption intangible asset using a present value technique and the Company’s projections of cash flow expected to be generated over the intangible asset’s remaining estimated useful life.

On December 29, 2007, the 2007 Medicare, Medicaid and SCHIP Extension Act was signed into law.  The Act provides that the 25% Rule will not be applied to grandfathered LTACHs, such as the Company’s LTACH in New Orleans, through at least December 31, 2010.  Statement 142 prohibits the reversal of the Company’s previously recognized $4.9 million impairment loss.  Starting on January 1, 2008, the Company will begin amortizing the statutory exemption intangible asset’s remaining carrying value through December 31, 2010.

At June 30, 2008 and December 31, 2007, the Company had the following intangible asset balances (in thousands):

	June 30, 2008					December 31, 2007
	Gross					Gross
	Carrying		Accumulated			Carrying		Accumulated
	Amount		Amortization			Amount		Amortization
Amortizing Intangible Assets:
Noncompete agreements	$	4,550	$	(1,699	)	$	4,460	$	(1,449	)
Customer contracts and relationships		23,096		(8,775	)		23,096		(7,508	)
Trade names		8,953		(1,593	)		8,773		(1,276	)
Medicare exemption		454		(170	)		454		(113	)
Other		1,047		(168	)		905		(125	)
Total	$	38,100	$	(12,405	)	$	37,688	$	(10,471	)
Non-amortizing Intangible Assets:
Trade names	$	810				$	810

Amortization expense on intangible assets was approximately $968,000 and $999,000 for the three months ended June 30, 2008 and 2007, respectively, and $1,934,000 and $2,019,000 for the six months ended June 30, 2008 and 2007, respectively.

The changes in the carrying amount of goodwill for the six months ended June 30, 2008 are as follows (in thousands):

- 10 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

							Other
	Contract						Healthcare
	Therapy		HRS (a)		Hospitals		Services		Total
Balance at December 31, 2007	$	68,459	$	39,715	$	45,239	$	15,104	$	168,517
Acquisitions		—		—		6,362		—		6,362
Balance at June 30, 2008	$	68,459	$	39,715	$	51,601	$	15,104	$	174,879

(a) Hospital rehabilitation services (HRS).

(9)           Long-Term Debt

On June 16, 2006, the Company entered into an Amended and Restated Credit Agreement with Bank of America, N.A., Harris, N.A., General Electric Capital Corporation, National City Bank, U.S. Bank National Association, SunTrust Bank and Comerica Bank, as participating banks in the lending group.  The Amended and Restated Credit Agreement is a $175 million, five-year revolving credit facility.  The revolving credit facility is expandable to $225 million upon the Company’s request, subject to the approval of the lending group and subject to continuing compliance with the terms of the Amended and Restated Credit Agreement.

The Amended and Restated Credit Agreement contains administrative covenants that are ordinary and customary for similar credit facilities.  The credit facility also includes financial covenants, including requirements for us to comply on a consolidated basis with a maximum ratio of senior funded debt to earnings before interest, taxes, depreciation and amortization (EBITDA), a maximum ratio of total funded debt to EBITDA and a minimum ratio of adjusted EBITDA to fixed charges.  As of June 30, 2008, the Company was in compliance with all debt covenants.

Borrowings under the credit facility bear interest at either the lender’s prime rate or the London Interbank Offered Rate (“LIBOR”), at the Company’s option.  The annual fees and applicable interest rate margins to be charged in connection with the credit facility and the outstanding principal balance are variable based upon the Company’s consolidated leverage ratios.  As of June 30, 2008, the balance outstanding against the revolving credit facility was $68.5 million.  On December 28, 2007, the Company entered into an interest rate swap related to a portion of these borrowings.  The swap effectively fixes the interest rate on $25 million of the borrowings at 4.0% plus applicable margins.  After consideration of the swap, the weighted average interest rate on all borrowings under the credit facility was 4.4% at June 30, 2008.

The interest rate swap agreement expires in December 2009.  The Company has formally designated this swap agreement as a cash flow hedge and expects the hedge to be highly effective in offsetting fluctuations in the designated interest payments resulting from changes in the benchmark interest rate (LIBOR).  The fair value of this swap agreement was recorded in the consolidated balance sheets as a liability of $0.3 million and $0.1 million at June 30, 2008 and December 31, 2007, respectively.  The unrealized losses resulting from the change in the fair value of the interest rate swap have been reflected in other comprehensive income.  Over the next 12 months, the Company expects to reclassify an estimated $0.2 million of these losses from accumulated other comprehensive income to interest expense as the related interest payments being hedged are made.

As of June 30, 2008, the Company had $7.2 million in letters of credit outstanding to its insurance carriers as collateral for reimbursement of claims.  The letters of credit reduce the amount the Company may borrow under its line of credit.  As of June 30, 2008, after the consideration of the effects of restrictive covenants, the available borrowing capacity under the line of credit was approximately $73 million.

- 11 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

In connection with the asset purchase of MeadowBrook Healthcare in August 2005, the Company issued a long-term subordinated promissory note to the selling party.  As of June 30, 2008, the remaining aggregate principal balance on the note was $2.5 million.

(10)           Industry Segment Information

The Company operates in the following three business segments, which are managed separately based on fundamental differences in operations: program management services, hospitals and other healthcare services.  Program management services include hospital rehabilitation services (including inpatient acute and subacute rehabilitation and outpatient therapy programs) and contract therapy programs (which focus primarily on rehabilitation in skilled nursing facilities).  The Company’s hospitals segment owns and operates six inpatient rehabilitation hospitals and five long-term acute care hospitals.  The Company’s other healthcare services segment provides healthcare management consulting services and staffing services for therapists and nurses.  Virtually all of the Company’s services are provided in the United States.  Summarized information about the Company’s operations in each industry segment is as follows (in thousands):

		Three Months Ended,						Six Months Ended,
Operating Revenues		June 30,						June 30,
		2008			2007			2008			2007
Program management:
Contract therapy	$	106,304		$	100,272		$	210,584		$	203,107
Hospital rehabilitation services		40,224			41,803			80,405			85,057
Program management total		146,528			142,075			290,989			288,164
Hospitals		28,797			27,008			58,017			53,027
Other healthcare services		10,839			12,225			21,813			24,373
Less intercompany revenues (1)		(645	)		(222	)		(1,179	)		(468	)
Total	$	185,519		$	181,086		$	369,640		$	365,096

		Three Months Ended,						Six Months Ended,
Operating Earnings (Loss)		June 30,						June 30,
		2008			2007			2008			2007
Program management:
Contract therapy	$	5,605		$	1,123		$	9,428		$	(1,102	)
Hospital rehabilitation services		5,311			5,413			9,949			10,592
Program management total		10,916			6,536			19,377			9,490
Hospitals		(3,702	)		(3,126	)		(3,993	)		(1,238	)
Other healthcare services		312			839			554			1,531
Total	$	7,526		$	4,249		$	15,938		$	9,783

- 12 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

		Three Months Ended,				Six Months Ended,
Depreciation and Amortization		June 30,				June 30,
		2008		2007		2008		2007
Program management:
Contract therapy	$	1,604	$	2,115	$	3,274	$	4,241
Hospital rehabilitation services		676		1,043		1,396		2,224
Program management total		2,280		3,158		4,670		6,465
Hospitals		1,323		932		2,569		1,813
Other healthcare services		131		123		262		247
Total	$	3,734	$	4,213	$	7,501	$	8,525

		Three Months Ended,				Six Months Ended,
Capital Expenditures		June 30,				June 30,
		2008		2007		2008		2007
Program management:
Contract therapy	$	842	$	432	$	1,370	$	1,172
Hospital rehabilitation services		228		26		358		112
Program management total		1,070		458		1,728		1,284
Hospitals		3,164		2,534		5,714		2,948
Other healthcare services		29		39		43		56
Total	$	4,263	$	3,031	$	7,485	$	4,288

	Total Assets				Unamortized Goodwill
	June 30,		December 31,		June 30,		December 31,
		2008		2007		2008		2007
Program management:
Contract therapy	$	175,236	$	175,589	$	68,459	$	68,459
Hospital rehabilitation services		103,810		105,292		39,715		39,715
Program management total		279,046		280,881		108,174		108,174
Hospitals (2)		114,266		93,659		51,601		45,239
Other healthcare services		33,392		34,020		15,104		15,104
Total	$	426,704	$	408,560	$	174,879	$	168,517

(1) Intercompany revenues represent sales of services, at market rates, between the Company’s operating segments.

(2) Hospital total assets include the carrying value of the Company’s equity investment in HRSC.

(11)           Related Party Transactions

The Company’s hospital rehabilitation services division recognized operating revenues for services provided to HRSC, the Company’s 40% owned equity method investment, of approximately $0.4 million for the six months ended June 30, 2007.  In March 2007, the Company canceled its existing management services contract with HRSC.

- 13 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

The Company purchased air transportation services from 55JS Limited, Co. at an approximate cost of $179,000 and $77,000 for the three months ended June 30, 2008 and 2007, respectively, and $321,000 and $226,000 for the six months ended June 30, 2008 and 2007, respectively.  55JS Limited, Co. is owned by the Company’s President and Chief Executive Officer, John Short.  The air transportation services are billed to the Company for hourly usage of 55JS’s plane for Company business.

(12)           Fair Value Measurements

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“Statement 157”).  This statement clarifies the definition of fair value, establishes a framework for measuring fair value and expands the disclosures on fair value measurements.  Statement 157 does not require any new fair value measurements.  In February 2008, the FASB issued FASB Staff Position 157-2, “Effective Date of FASB Statement 157,” which deferred the effective date of Statement 157 to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis.  In accordance with this interpretation, the Company adopted the provisions of Statement 157 on January 1, 2008 with respect to the Company’s financial assets and financial liabilities.  The provisions of Statement 157 have not been applied to nonfinancial assets and nonfinancial liabilities.  The major categories of assets and liabilities that are measured at fair value, for which the Company will wait until 2009 to apply the provisions of Statement 157, are as follows:  reporting units measured at fair value in the first step of a goodwill impairment test under Statement 142 and long-lived assets measured at fair value for an impairment assessment under Statement 144.

The following table sets forth the information required by Statement 157 for the Company’s financial assets and financial liabilities which are measured at fair value on a recurring basis.  The Company uses an income approach to value its liability for the outstanding interest rate swap agreement discussed in Note 9.  The fair value of the swap is estimated using a discounted cash flow model that takes into account observable inputs including the contractual terms of the swap and current market information as of the reporting date such as prevailing interest rates.

				Fair Value Measurements at June 30, 2008 Using:
	Carrying value at June 30, 2008			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Trading securities	$	3,232		$	3,232	$	—		$	—
Interest rate swap		(264	)		—		(264	)		—
Total	$	2,968		$	3,232	$	(264	)	$	—

(13)           Recently Issued Pronouncements

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – including an amendment of FASB Statement No. 115” (“Statement 159”).  This statement permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value, with unrealized gains and losses related to these items reported in earnings at each subsequent reporting date.  The Company adopted this statement on January 1, 2008 and has

- 14 - -

REHABCARE GROUP, INC.

Notes to Condensed Consolidated Financial Statements (Continued)

elected not to apply the fair value option to any items not already carried at fair value in accordance with other accounting standards, so the adoption of Statement 159 did not impact the Company’s consolidated financial statements.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), “Business Combinations” (“Statement 141(R)”) and Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“Statement 160”). Statements 141(R) and 160 require most identifiable assets, liabilities, noncontrolling interests and goodwill acquired in a business combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported as a component of equity.  Both statements are effective for fiscal years beginning after December 15, 2008.  Statement 141(R) will be applied to business combinations occurring after the effective date.  Statement 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date.  The Company has not determined the effect the adoption of Statements 141(R) and 160 will have on the Company’s financial position or results of operations.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, "Disclosures about Derivative Instruments and Hedging Activities" (“Statement 161”), which amends and expands the disclosure requirements of FAS 133 to require qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. Statement 161 will be effective for the Company beginning in 2009.  The adoption of this statement will expand the Company’s disclosures about derivatives held by the Company.

- 15 - -

REHABCARE GROUP, INC.

Item 2. – Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from forecasted results.  These risks and uncertainties may include but are not limited to:

·   our ability to consummate acquisitions and other partnering relationships at reasonable valuations;

·   our ability to integrate acquisitions and partnering relationships within the expected timeframes and to achieve the revenue, cost savings and earnings levels from such acquisitions and relationships at or above the levels projected;

·   our ability to comply with the terms of our borrowing agreements;

·   changes in governmental reimbursement rates and other regulations or policies affecting reimbursement for the services provided by us to clients and/or patients;

·   the operational, administrative and financial effect of our compliance with other governmental regulations and applicable licensing and certification requirements;

·   our ability to attract new client relationships or to retain and grow existing client relationships through expansion of our service offerings and the development of alternative product offerings;

·   the future financial results of any unconsolidated affiliates;

·   our ability to attract and the additional costs of attracting and retaining administrative, operational and professional employees;

·   shortages of qualified therapists and other healthcare personnel;

·   significant increases in health, workers compensation and professional and general liability costs and our ability to predict the ultimate liability for such costs;

·   litigation risks of our past and future business, including our ability to predict the ultimate costs and liabilities or the disruption of our operations; competitive and regulatory effects on pricing and margins;

·   our ability to effectively respond to fluctuations in our census levels and number of patient visits;

·   the adequacy and effectiveness of our information systems;

·   natural disasters and other unexpected events which could severely damage or interrupt our systems and operations;

·   changes in federal and state income tax laws and regulations, the effectiveness of our tax planning strategies and the sustainability of our tax positions; and

·   general and economic conditions, including efforts by governmental reimbursement programs, insurers, healthcare providers and others to contain healthcare costs.

Results of Operations

We operate in the following three business segments, which are managed separately based on fundamental differences in operations: program management services, hospitals and other healthcare services.  Program management services include hospital rehabilitation services (including inpatient acute and subacute rehabilitation and outpatient therapy programs) and contract therapy programs (which focus primarily on rehabilitation in skilled nursing facilities).  Our hospitals segment owns and operates six inpatient rehabilitation hospitals and five long-term acute care hospitals (LTACHs).  Our other healthcare services segment provides healthcare management consulting services and staffing services for therapists and nurses.

- 16 - -

REHABCARE GROUP, INC.

Selected Operating Statistics:

	Three Months Ended June 30,				Six Months Ended June 30,
	2008		2007		2008		2007
Program Management:
Contract Therapy:
Operating revenues (in thousands)	$	106,304	$	100,272	$	210,584	$	203,107
Average number of locations		1,061		1,133		1,058		1,157
Average revenue per location	$	100,212	$	88,531	$	199,069	$	175,521
Hospital Rehabilitation Services:
Operating revenues (in thousands)
Inpatient	$	29,880	$	30,632	$	59,639	$	62,681
Outpatient		10,344		11,171		20,766		22,376
Total	$	40,224	$	41,803	$	80,405	$	85,057
Average number of programs
Inpatient		120		129		121		130
Outpatient		33		35		33		36
Total		153		164		154		166
Average revenue per program
Inpatient	$	248,357	$	236,816	$	494,406	$	481,526
Outpatient		313,460		319,160		629,279		628,398
Total	$	262,370	$	254,352	$	523,377	$	513,075
Hospitals:
Operating revenues (in thousands)	$	28,797	$	27,008	$	58,017	$	53,027
Number of facilities at end of period		11		8		11		8
Other Healthcare Services:
Operating revenues (in thousands)	$	10,839	$	12,225	$	21,813	$	24,373

Three Months Ended June 30, 2008 Compared to Three Months Ended June 30, 2007

Operating Revenues

Consolidated operating revenues during the second quarter of 2008 increased by $4.4 million, or 2.4%, to $185.5 million compared to $181.1 million in the second quarter of 2007.  The revenue increase was due to growth in our contract therapy and hospital businesses, partially offset by decreases in revenues in our hospital rehabilitation services and other healthcare services businesses.

Contract therapy revenues increased $6.0 million or 6.0% in the second quarter of 2008 compared to the second quarter of 2007.  Same store revenues grew 12.3% partly due to a 9.8% increase in same store minutes of service.  The same store revenue growth more than offset the impact of a 6.3% decline in the average number of locations operated in the current quarter.   Higher average daily census and improved productivity contributed to the growth in same store revenues and same store minutes of service.

- 17 - -

REHABCARE GROUP, INC.

Hospital rehabilitation services operating revenues declined 3.8% in the second quarter of 2008 compared to the second quarter of 2007 as inpatient revenue declined 2.5% and outpatient revenue declined 7.4%.  The decline in inpatient revenue reflects a 7.0% decline in the average number of units operated, partially offset by a 4.9% increase in inpatient revenue per program.  Same store acute rehabilitation revenues and discharges increased 1.0% and 0.2%, respectively, compared to the second quarter of 2007.  The decline in outpatient revenue reflects a 5.7% decline in the average number of units operated and a 1.8% decline in average revenue per program.  Outpatient same store revenues increased by 0.7% in the second quarter of 2008.

Hospital segment revenues were $28.8 million in the second quarter of 2008 compared to $27.0 million in the second quarter of 2007.  The increase in revenues in 2008 reflects the acquisition of The Specialty Hospital in Rome, Georgia effective June 1, 2008 and a full quarter of operations for our inpatient rehabilitation hospital in Austin, Texas, which received its Medicare provider number in November 2007.  The hospital segment also opened an LTACH in Kansas City, Missouri in April 2008.  This hospital is currently in its length-of-stay demonstration period which means it will be reimbursed at Medicare’s lower inpatient prospective payment system rates for six months, starting on May 6, 2008, the date the hospital received its Medicare provider certification.  After it maintains a Medicare average length-of-stay of 25 days for six months, the hospital will apply to the Centers for Medicare and Medicaid Services (“CMS”) for an LTACH provider number.  Same store revenues declined by $0.9 million or 3.5% in the second quarter of 2008.

Other healthcare services segment revenues were $10.8 million in the second quarter of 2008 compared to $12.2 million in the second quarter of 2007.  This decline in revenues occurred primarily in our Phase 2 Consulting business.

Costs and Expenses
	Three Months Ended June 30,
		2008				2007
			% of				% of
		Amount	Revenue			Amount	Revenue
	(dollars in thousands)
Consolidated costs and expenses:
Operating expenses	$	151,132	81.5	%	$	145,691	80.5	%
Division selling, general and administrative		12,383	6.6			11,744	6.5
Corporate selling, general and administrative		10,744	5.8			10,283	5.7
Impairment of intangible asset		—	—			4,906	2.7
Depreciation and amortization		3,734	2.0			4,213	2.3
Total costs and expenses	$	177,993	95.9	%	$	176,837	97.7	%

Operating expenses as a percentage of revenues increased as our hospital segment incurred an increase in start-up losses and a decline in same store revenues which more than offset operational efficiencies realized by our contract therapy division.  The increase in corporate selling, general and administrative expenses reflects an increase in share-based compensation and other management incentive costs and an investment in back office resources to support the expected growth of our hospital segment.  These cost increases were mostly offset by the cost savings achieved from closing Symphony’s corporate office in Hunt Valley, Maryland at the end of June 2007 and the recognition of a $0.6 million recovery, net of legal fees incurred, related to a noncompete agreement settlement.  The hospital segment incurred a $4.9 million impairment charge in the second quarter of 2007 as discussed in more detail below.  Depreciation and amortization expense decreased primarily due to lower depreciation and amortization associated with software costs and intangible assets which became fully amortized.

- 18 - -

REHABCARE GROUP, INC.

The Company’s provision for doubtful accounts is included in operating expenses.  On a consolidated basis, the provision for doubtful accounts increased from $2.0 million in the second quarter of 2007 to $2.4 million in the second quarter of 2008.  This increase is primarily attributable to our hospital business.

		Three Months Ended June 30,
		2008					2007
			% of Unit					% of Unit
		Amount	Revenue				Amount	Revenue
		(dollars in thousands)
Contract Therapy:
Operating expenses	$	87,624		82.4	%	$	84,438		84.2	%
Division selling, general and administrative		6,112		5.7			5,914		5.9
Corporate selling, general and administrative		5,359		5.1			6,682		6.7
Depreciation and amortization		1,604		1.5			2,115		2.1
Total costs and expenses	$	100,699		94.7	%	$	99,149		98.9	%
Hospital Rehabilitation Services (HRS):
Operating expenses	$	28,306		70.4	%	$	29,625		70.9	%
Division selling, general and administrative		3,657		9.1			3,726		8.9
Corporate selling, general and administrative		2,274		5.6			1,996		4.8
Depreciation and amortization		676		1.7			1,043		2.5
Total costs and expenses	$	34,913		86.8	%	$	36,390		87.1	%
Hospitals:
Operating expenses	$	27,380		95.1	%	$	22,412		83.0	%
Division selling, general and administrative		1,195		4.1			745		2.8
Corporate selling, general and administrative		2,601		9.1			1,139		4.2
Impairment of intangible asset		—		—			4,906		18.2
Depreciation and amortization		1,323		4.6			932		3.4
Total costs and expenses	$	32,499		112.9	%	$	30,134		111.6	%
Other Healthcare Services:
Operating expenses	$	8,467		78.1	%	$	9,438		77.2	%
Division selling, general and administrative		1,419		13.1			1,359		11.1
Corporate selling, general and administrative		510		4.7			466		3.8
Depreciation and amortization		131		1.2			123		1.0
Total costs and expenses	$	10,527		97.1	%	$	11,386		93.1	%

Total contract therapy costs and expenses as a percentage of unit revenue decreased in the second quarter of 2008 compared to the second quarter of 2007 primarily due to operational improvements and the cost savings achieved from closing Symphony’s corporate office in Hunt Valley, Maryland at the end of June 2007.  Direct operating expenses declined as a percentage of unit revenue reflecting the combined impact of continued efficiencies realized from the integration of the former RehabWorks’ units and improved therapist productivity throughout the division.  Division and corporate selling, general and administrative expenses decreased as a percentage of unit revenue primarily due to synergies achieved from the integration of the Symphony business.  Corporate selling, general and administrative expenses for the second quarter of 2008 also include a $0.6 million recovery, net of legal fees incurred, related to a noncompete agreement settlement.  Depreciation and amortization expense decreased primarily because capitalized software assets associated with the Symphony acquisition became fully amortized in the fourth quarter of 2007.  Contract

- 19 - -

REHABCARE GROUP, INC.

therapy’s operating earnings increased from $1.1 million in the second quarter of 2007 to $5.6 million in the second quarter of 2008.

Total hospital rehabilitation services costs and expenses declined from the second quarter of 2007 to the second quarter of 2008 primarily due to a decline in direct operating expenses.  Direct operating expenses declined as average units in operation fell from 164 to 153.  Corporate selling, general and administrative expenses increased reflecting increases in share-based compensation expense and activities related to the appeal of denials resulting from the recovery audit contractor program or local coverage determinations issued by fiscal intermediaries.  Depreciation and amortization expense decreased primarily due to lower amortization associated with capitalized software and intangible assets which became fully amortized.  Total hospital rehabilitation services operating earnings decreased by $0.1 million from $5.4 million in the second quarter of 2007 to $5.3 million in the second quarter of 2008.

Total hospital segment costs and expenses increased as a percentage of unit revenue in the second quarter of 2008 despite the recognition of a $4.9 million impairment loss in the second quarter of 2007.  This impairment loss reduced the carrying value of an intangible asset to its revised estimate of fair value based on the impact of a change in LTACH regulations issued by CMS on May 1, 2007.  Operating expenses increased significantly as a percentage of unit revenue in the second quarter of 2008 primarily due to the decrease in same store revenues, an increase in start-up losses and an increase in the provision for doubtful accounts.  During the second quarter of 2007, we recorded favorable revenue adjustments of $1.4 million to net liabilities for prior year Medicare and Medicaid cost reports assumed in the acquisition of the four MeadowBrook hospitals.  These adjustments had a favorable impact on second quarter 2007 revenues and operating earnings; no adjustments of this nature were recorded in the second quarter of 2008.  The division incurred start-up losses of $1.4 million during the quarter ended June 30, 2008 primarily related to the development of an LTACH in Kansas City.  Start-up losses were minimal during the quarter ended June 30, 2007.  Selling, general and administrative expenses increased from the prior year quarter reflecting an investment in back office resources to support the growth in the division expected in 2008 and 2009 and the reallocation of certain resources from our other divisions.  Depreciation and amortization expense increased from the second quarter of 2007 to the second quarter of 2008 primarily due to depreciation associated with leasehold improvements at the Austin hospital.  As a result of these factors, the hospitals segment incurred operating losses of $3.7 million in the second quarter of 2008 and $3.1 million in the second quarter of 2007.

The other healthcare services segment generated operating earnings of $0.3 million and $0.8 million in the quarters ended June 30, 2008 and 2007, respectively.  The decrease in operating earnings is mainly attributable to our Phase 2 Consulting business.

Non-Operating Items

Interest income decreased by $0.7 million from the second quarter of 2007 to the second quarter of 2008 primarily due to the recognition of $0.7 million of interest income in the second quarter of 2007 related to a federal income tax refund claim.

Interest expense decreased from $2.3 million in the second quarter of 2007 to $1.0 million in the second quarter of 2008 primarily due to both a reduction in interest rates and a reduction in borrowings against our revolving credit facility.  The balance outstanding on the revolving credit facility was $68.5 million and $102.5 million at June 30, 2008 and 2007, respectively.  Interest expense also includes interest on subordinated promissory notes issued as partial consideration for various acquisitions completed over the last three years, commitment fees paid on the unused portion of our line of credit, and fees paid on outstanding letters of credit.  As of June 30, 2008, the remaining aggregate principal balance on all subordinated promissory notes was $2.5 million.

- 20 - -

REHABCARE GROUP, INC.

Minority interests in net losses of consolidated affiliates increased to $0.6 million in the second quarter of 2008 from break-even in the second quarter of 2007.  This increase is primarily due to the recognition of the noncontrolling interests’ share of the losses incurred by our LTACH in Kansas City.

Earnings before income taxes increased to $7.4 million in the second quarter of 2008 from $2.7 million in the second quarter of 2007.  The results for the second quarter of 2007 include the impact of the $4.9 million impairment loss discussed earlier.  The provision for income taxes was $2.9 million in the second quarter of 2008 compared to $1.1 million in the second quarter of 2007, reflecting an effective income tax rate of 39.0% in both periods.

Net earnings were $4.5 million in the second quarter of 2008 compared to $1.7 million in the second quarter of 2007.  Diluted earnings per share were $0.25 in the second quarter of 2008 compared to $0.09 in the second quarter of 2007.

Six Months Ended June 30, 2008 Compared to Six Months Ended June 30, 2007

Operating Revenues

Consolidated operating revenues during the first six months of 2008 increased by $4.5 million, or 1.2%, to $369.6 million compared to $365.1 million in the first six months of 2007.  The revenue increase was primarily due to growth in our contract therapy and hospital businesses, partially offset by a decrease in revenues in our hospital rehabilitation services business.

Contract therapy revenues increased $7.5 million or 3.7% in the first six months of 2008 compared to the first six months of 2007.  Same store revenues grew 12.2% reflecting a 10.6% increase in same store minutes of service.  The same store revenue growth more than offset the impact of an 8.6% decline in the average number of locations operated in the first six months of 2008.   Higher average daily census and improved productivity contributed to the growth in same store revenues and same store minutes of service.

Hospital rehabilitation services operating revenues declined 5.5% in the first six months of 2008 compared to the first six months of 2007 as inpatient revenue declined 4.9% and outpatient revenue declined 7.2%.  The decline in inpatient revenue reflects a 7.3% decline in the average number of units operated, partially offset by 2.7% increase in inpatient revenue per program and a 0.8% increase in same store acute rehabilitation revenues.  Same store acute rehabilitation discharges increased 0.5% in the first six months of 2008 as the division’s units were able to increase patient volumes in 2008 following the December 2007 freeze in the 75% Rule’s compliance threshold at 60%.  The decline in outpatient revenue reflects a 7.3% decline in the average number of units operated, partially offset by a 2.6% increase in outpatient same store revenues.

Hospital segment revenues were $58.0 million in the first six months of 2008 compared to $53.0 million in the first six months of 2007.  The increase in revenues in 2008 reflects the acquisition of The Specialty Hospital in Rome, Georgia effective June 1, 2008 and the operations of our inpatient rehabilitation hospital in Austin, Texas, which received its Medicare provider number in November 2007.  The increase in revenues also reflects same store revenue growth of $0.8 million or 1.6% in the first six months of 2008.  Our inpatient rehabilitation hospital in Amarillo, Texas, which was in its ramp-up phase in the first quarter of 2007, contributed $1.3 million to the same store revenue growth.  We define the ramp-up phase as the period during which a recently opened hospital builds its patient census following the receipt of its Medicare provider number.

- 21 - -

REHABCARE GROUP, INC.

Other healthcare services segment revenues were $21.8 million in the first six months of 2008 compared to $24.4 million in the first six months of 2007.  This decline in revenues occurred primarily in our Phase 2 Consulting business.

Costs and Expenses
	Six Months Ended June 30,
		2008				2007
			% of				% of
		Amount	Revenue			Amount	Revenue
	(dollars in thousands)
Consolidated costs and expenses:
Operating expenses	$	300,094	81.2	%	$	297,913	81.6	%
Division selling, general and administrative		24,105	6.5			23,409	6.4
Corporate selling, general and administrative		22,002	6.0			20,560	5.6
Impairment of intangible asset		—	—			4,906	1.4
Depreciation and amortization		7,501	2.0			8,525	2.3
Total costs and expenses	$	353,702	95.7	%	$	355,313	97.3	%

Operating expenses decreased as a percentage of revenues reflecting operational efficiencies realized by our contract therapy division as discussed further below.  The increase in corporate selling, general and administrative expenses reflects an increase in share-based compensation and other management incentive costs and an investment in back office resources to support the expected growth of our hospital segment.  These cost increases were partially offset by the cost savings achieved from closing Symphony’s corporate office in Hunt Valley, Maryland at the end of June 2007.  The hospital segment incurred a $4.9 million impairment charge in the first six months of 2007 as discussed in more detail below.  Depreciation and amortization expense decreased primarily due to lower amortization associated with capitalized software and intangible assets which became fully amortized.

The Company’s provision for doubtful accounts is included in operating expenses.  On a consolidated basis, the provision for doubtful accounts decreased slightly from $4.8 million in the first half of 2007 to $4.7 million in the first half of 2008.

- 22 - -

REHABCARE GROUP, INC.

		Six Months Ended June 30,
		2008					2007
			% of Unit					% of Unit
		Amount	Revenue				Amount	Revenue
		(dollars in thousands)
Contract Therapy:
Operating expenses	$	174,217		82.7	%	$	174,438		85.9	%
Division selling, general and administrative		11,971		5.7			12,055		5.9
Corporate selling, general and administrative		11,694		5.6			13,475		6.6
Depreciation and amortization		3,274		1.5			4,241		2.1
Total costs and expenses	$	201,156		95.5	%	$	204,209		100.5	%
Hospital Rehabilitation Services (HRS):
Operating expenses	$	57,495		71.5	%	$	60,832		71.5	%
Division selling, general and administrative		7,026		8.7			7,415		8.7
Corporate selling, general and administrative		4,539		5.6			3,994		4.7
Depreciation and amortization		1,396		1.8			2,224		2.6
Total costs and expenses	$	70,456		87.6	%	$	74,465		87.5	%
Hospitals:
Operating expenses	$	52,472		90.4	%	$	44,123		83.2	%
Division selling, general and administrative		2,183		3.8			1,199		2.3
Corporate selling, general and administrative		4,786		8.3			2,224		4.2
Impairment of intangible asset		—		—			4,906		9.2
Depreciation and amortization		2,569		4.4			1,813		3.4
Total costs and expenses	$	62,010		106.9	%	$	54,265		102.3	%
Other Healthcare Services:
Operating expenses	$	17,089		78.4	%	$	18,988		77.9	%
Division selling, general and administrative		2,925		13.4			2,740		11.2
Corporate selling, general and administrative		983		4.5			867		3.6
Depreciation and amortization		262		1.2			247		1.0
Total costs and expenses	$	21,259		97.5	%	$	22,842		93.7	%

Total contract therapy costs and expenses decreased in the first six months of 2008 compared to the first six months of 2007 primarily due to the decrease in the average number of locations operated and the cost savings achieved from closing Symphony’s corporate office in Hunt Valley, Maryland at the end of June 2007.  Direct operating expenses declined as a percentage of unit revenue reflecting the combined impact of continued efficiencies realized from the integration of the former RehabWorks’ units and improved therapist productivity throughout the division.  Labor and benefit costs per minute of service declined by 1.9% from the first six months of 2007 to the first six months of 2008 as therapist productivity improvements during the first six months of 2008 more than offset the impact of wage rate increases.  Division and corporate selling, general and administrative expenses decreased as a percentage of unit revenue primarily due to synergies achieved from the integration of the Symphony business.  Depreciation and amortization expense decreased primarily because capitalized software assets associated with the Symphony acquisition became fully amortized in the fourth quarter of 2007.  Contract therapy’s operating earnings were $9.4 million in the first six months of 2008 compared to a loss of $1.1 million in the first six months of 2007.

Total hospital rehabilitation services costs and expenses declined from the first six months of 2007 to the first six months of 2008 primarily due to a decline in direct operating expenses.  Direct operating expenses declined as average units in operation fell from 166 to 154.  Division selling,

- 23 - -

REHABCARE GROUP, INC.

general and administrative expenses decreased as we reassigned certain HRS division resources to our hospital division and others were moved to a corporate role because they are no longer fully dedicated to HRS.  These activities occurred in the third quarter of 2007.  Corporate selling, general and administrative expenses increased reflecting increases in share-based compensation expense and activities related to the appeal of denials resulting from the recovery audit contractor program or local coverage determinations issued by fiscal intermediaries.  Depreciation and amortization expense decreased primarily due to lower amortization associated with capitalized software and intangible assets which became fully amortized.  Total hospital rehabilitation services operating earnings decreased from $10.6 million in the first six months of 2007 to $9.9 million in the first six months of 2008.

Total hospital segment costs and expenses increased as a percentage of unit revenue in the first six months of 2008 despite the recognition of a $4.9 million impairment loss in the first six months of 2007.  This impairment loss reduced the carrying value of an intangible asset to its revised estimate of fair value based on the impact of a change in LTACH regulations issued by CMS on May 1, 2007.  Operating expenses increased as a percentage of unit revenue in the first six months of 2008 reflecting an increase in start-up losses and an increase in the provision for doubtful accounts.  The division incurred start-up losses of $1.7 million during the six months ended June 30, 2008 primarily related to the development of an LTACH in Kansas City.  Start-up losses were only $0.1 million during the six months ended June 30, 2007.  Also during the first six months of 2007, we recorded favorable revenue adjustments of $1.4 million to net liabilities for prior year Medicare and Medicaid cost reports assumed in the acquisition of the four MeadowBrook hospitals.  These adjustments had a favorable impact on 2007 revenues and operating earnings.  Selling, general and administrative expenses increased from the prior year period reflecting an investment in back office resources to support the growth in the division expected in 2008 and 2009 and the reallocation of certain resources from our other divisions.  Depreciation and amortization expense increased from the first six months of 2007 to the first six months of 2008 primarily due to depreciation associated with leasehold improvements at the Austin hospital.  As a result of these factors, the hospitals segment incurred operating losses of $4.0 million in the first six months of 2008 and $1.2 million in the first six months of 2007.

The other healthcare services segment generated operating earnings of $0.6 million and $1.5 million in the six months ended June 30, 2008 and 2007, respectively.  The decrease in operating earnings is mainly attributable to our Phase 2 Consulting business.

Non-Operating Items

Interest income decreased by $0.7 million from the first six months of 2007 to the first six months of 2008 primarily due to the recognition of $0.7 million of interest income in the second quarter of 2007 related to a federal income tax refund claim.

Interest expense decreased from $4.6 million in the first half of 2007 to $2.3 million in the first half of 2008 primarily due to both a reduction in interest rates and a reduction in borrowings against our revolving credit facility.  The balance outstanding on the revolving credit facility was $68.5 million and $102.5 million at June 30, 2008 and 2007, respectively.  Interest expense also includes interest on subordinated promissory notes issued as partial consideration for various acquisitions completed over the last three years, commitment fees paid on the unused portion of our line of credit, and fees paid on outstanding letters of credit.  As of June 30, 2008, the remaining aggregate principal balance on all subordinated promissory notes was $2.5 million.

Minority interests in net losses of consolidated affiliates increased to $0.7 million in the first six months of 2008 from break-even in the first six months of 2007.  This increase is primarily due to the recognition of the noncontrolling interests’ share of the losses incurred by our LTACH in Kansas City.

- 24 - -

REHABCARE GROUP, INC.

Earnings before income taxes increased to $14.8 million in the first six months of 2008 from $6.0 million in the first six months of 2007.  The provision for income taxes was $5.8 million in the first six months of 2008 compared to $2.4 million in the first six months of 2007, reflecting effective income tax rates of 39.0% and 39.2%, respectively.

Net earnings were $9.0 million in the first six months of 2008 compared to $3.6 million in the first six months of 2007.  Diluted earnings per share were $0.51 in the first six months of 2008 compared to $0.21 in the first six months of 2007.

Liquidity and Capital Resources

As of June 30, 2008, we had $14.3 million in cash and cash equivalents, and a current ratio (the amount of current assets divided by current liabilities) of approximately 1.9 to 1.  Working capital increased by $7.2 million to $87.5 million at June 30, 2008 as compared to $80.3 million at December 31, 2007.  Net accounts receivable were $142.0 million at June 30, 2008 as compared to $135.2 million at December 31, 2007.  The number of days sales outstanding (DSO) in net receivables was 69.6 and 71.8 at June 30, 2008 and December 31, 2007, respectively.   The increase in accounts receivable reflects an $11.9 million increase in revenues from the fourth quarter of 2007 to the second quarter of 2008.  The improvement in DSO occurred primarily in our contract therapy division.

We generated cash from operations of $18.6 million in both the six months ended June 30, 2008 and the six months ended June 30, 2007.  Capital expenditures were $7.5 million and $4.3 million in the six months ended June 30, 2008 and 2007, respectively.  Our capital expenditures primarily relate to the construction of new hospitals, investments in information technology systems, equipment additions and replacements and various other capital improvements.  The Company expects total capital expenditures in 2008 to approximate $15 million to $25 million.  Actual amounts spent will be dependent upon the timing of individual projects.  Over the next few years, we plan to continue to invest significantly in information technology systems and the development and renovation of hospitals.

The Company has historically financed its operations with funds generated from operating activities and borrowings under credit facilities and long-term debt instruments.  We believe our cash on hand, cash generated from operations and availability under our credit facility will be sufficient to meet our future working capital, capital expenditures, internal and external business expansion, and debt service requirements.  We have a $175 million, five-year revolving credit facility, dated June 16, 2006, with $68.5 million outstanding as of June 30, 2008 at a weighted-average interest rate of approximately 4.4%.  The revolving credit facility is expandable to $225 million, subject to the approval of the lending group and subject to our continued compliance with the terms of the credit agreement.  As of June 30, 2008, we had $7.2 million in letters of credit issued to insurance carriers as collateral for reimbursement of claims.  The letters of credit reduce the amount we may borrow under the revolving credit facility.  As of June 30, 2008, after consideration of the effects of restrictive covenants, the available borrowing capacity under the line of credit was approximately $73 million.

As part of the purchase of the MeadowBrook business in 2005, we issued a long-term subordinated promissory note to the selling party.  This note bears interest at 6.0%.  As of June 30, 2008, $2.5 million of this note remained outstanding, all of which is payable within the next three months.

- 25 - -

REHABCARE GROUP, INC.

Regulatory and Legislative Update

The 2007 Medicare, Medicaid and SCHIP Extension Act (“the SCHIP Extension Act”), which was signed into law on December 29, 2007, extended the Medicare Part B therapy cap exception process through June 30, 2008.  The therapy caps are $1,810 for occupational therapy, and an annual combined cap of $1,810 for physical and speech therapy.  Most of our Medicare Part B patients qualify for an automatic exception to these caps due to their clinical complexities.  On July 15, 2008 President Bush vetoed HR 6331, the Medicare Improvements for Patients and Providers Act of 2008.  That same day Congress held a successful override vote and the bill became law.  Among other things, the bill extended the therapy cap exception process through December 31, 2009.  While the effective date of this extension is July 1, 2008, the disruption caused by the therapy caps in first two weeks of July is expected to impede the contract therapy division’s operating performance in the third quarter.

To participate in Medicare, inpatient rehabilitation facilities, such as those operated in our hospital division, and acute rehabilitation units, such as those managed within our HRS division, must satisfy what is known as the 75% Rule.  The rule requires that a certain percentage of patients fall within thirteen specific diagnostic categories.  Following an initial moratorium, the 75% Rule came back into effect in 2004 at a 50% compliance threshold with a phase-in to the full 75% compliance level by July 2008.  For cost reporting years beginning July 1, 2007, the compliance threshold was 65%.  The SCHIP Extension Act permanently set the compliance threshold at 60%, where it was prior to July 1, 2007.

The SCHIP Extension Act also established a three-year moratorium on the establishment or classification of any new LTACH facilities, any satellite facilities and increases in bed capacity at existing LTACHs.  On May 21, 2008, CMS issued an interim final rule outlining criteria for an exemption from the three-year moratorium as well as for exceptions to this rule.  In working with our joint venture partners, we believe that only one partner, The Reading Hospital, will need to file for an exception.

On August 1, 2008, CMS issued final payment rules for skilled nursing facilities (“SNFs”) and inpatient rehabilitation facilities (“IRFs”) for reporting year 2009.  The rules include a 3.4% market basket increase for SNFs and no market basket change for IRFs.  While we believe the SNF rule will have a favorable impact on our contract therapy division, we are still evaluating the impact of the IRF rule on our HRS and hospital businesses.

The Medicare program is administered by contractors and fiscal intermediaries. Under the authority granted by CMS, certain fiscal intermediaries have issued local coverage determinations that are intended to clarify the clinical criteria under which Medicare reimbursement is available. Certain local coverage determinations attempt to require evidence of a greater level of medical necessity for inpatient rehabilitation facility patients.  Those local coverage determinations have been used by fiscal intermediaries to deny admission or reimbursement for some patients in our hospital rehabilitation services and hospital divisions.  Where appropriate, we and our clients will appeal such denials and many times are successful in overturning the original decision of the fiscal intermediary.

The Medicare Modernization Act of 2003 directed CMS to create a program using independent recovery audit contractors to collect improper Medicare overpayments.  The recovery audit contractor program began with a demonstration pilot in three states and is scheduled to be expanded to all 50 states by 2010.  We will continue to challenge and appeal any claims that we believe have been inappropriately denied.

Medicare reimbursement for outpatient rehabilitation services is based on the lesser of the provider’s actual charge for such services or the applicable Medicare physician fee schedule amount established by CMS. This reimbursement system applies regardless of whether the therapy

- 26 - -

REHABCARE GROUP, INC.

services are furnished in a hospital outpatient department, a skilled nursing facility, an assisted living facility, a physician’s office, or the office of a therapist in private practice.  The physician fee schedule is subject to change from year to year.  The Medicare Improvements for Patients and Providers Act of 2008 provided a 0.5% increase in the fee schedule for the balance of 2008 and a 1.1% increase for 2009.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Our significant accounting policies, including the use of estimates, were presented in the notes to consolidated financial statements included in our 2007 Annual Report on Form 10-K, filed on March 11, 2008.

Critical accounting policies are those that are considered most important to the presentation of our financial condition and results of operations, require management’s most difficult, subjective and complex judgments, and involve uncertainties.  Our most critical accounting policies pertain to allowance for doubtful accounts, contractual allowances, goodwill and other intangible assets, impairment of long-lived assets, health, workers compensation and professional liability insurance accruals and accounting for investments in unconsolidated affiliates.  Each of these critical accounting policies was discussed in our 2007 Annual Report on Form 10-K in the Critical Accounting Policies and Estimates section of “Item 7.  – Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  There were no significant changes in the application of critical accounting policies during the first six months of 2008.

Item 3. – Quantitative and Qualitative Disclosures About Market Risks

The Company’s primary market risk exposure consists of changes in interest rates on certain borrowings that bear interest at floating rates.  Borrowings under our credit facility bear interest at the lender’s prime rate and the London Interbank Offered Rate (“LIBOR”), at our option, with applicable margins varying based upon our consolidated total leverage ratio.  Our LIBOR contracts can vary in length from 30 to 180 days.  As of June 30, 2008, the balance outstanding against the revolving credit facility was $68.5 million.  On December 28, 2007, the Company entered into an interest rate swap agreement that effectively fixed the interest rate at 4.0% plus applicable margins on $25 million of the borrowings under our credit facility for a two-year period.

After consideration of the swap contract mentioned above, as of June 30, 2008, we had $43.5 million of variable rate debt outstanding under the credit facility at a weighted-average variable interest rate of approximately 3.9%.  Adverse changes in short-term interest rates could affect our overall borrowing rate when contracts are renewed.  Based on the variable rate debt outstanding under the credit facility at June 30, 2008, a 100 basis point increase in the LIBOR rate would result in additional interest expense of approximately $0.4 million on an annualized basis.

Item 4. – Controls and Procedures

As of June 30, 2008, the Company’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, have conducted an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-14(c) and  15d-14(c) under the Securities Exchange Act of 1934, as amended).  Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective in making known in a timely fashion material information required to be filed in this report.  There have been no changes in the Company’s internal controls over financial reporting during

- 27 - -

REHABCARE GROUP, INC.

the quarter ended June 30, 2008 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. – OTHER INFORMATION

Item 1. – Legal Proceedings

At the current time, we are not a party to any material pending legal proceedings.

In the ordinary course of our business, we are a party to a number of other claims and lawsuits, as both plaintiff and defendant, which we regard as immaterial.  From time to time, and depending upon the particular facts and circumstances, we may be subject to indemnification obligations under our contracts with our hospital and healthcare facility clients.  We do not believe that any liability resulting from such matters, after taking into consideration our insurance coverage and amounts already provided for, will have a material effect on our consolidated financial position or overall liquidity; however, such matters, or the expense of prosecuting or defending them, could have a material effect on cash flows and results of operations in a particular quarter or fiscal year as they develop or as new issues are identified.

Item 1A. – Risk Factors

For information regarding risk factors, please refer to the Company’s 2007 Annual Report on Form 10-K.  There were no material changes in the Company’s risk factors in the first six months of 2008.

Item 6. - Exhibits

See exhibit index

- 28 - -

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.

REHABCARE GROUP, INC.

August 5, 2008

By:	/s/  Jay W. Shreiner
	Jay W. Shreiner
	Executive Vice President,
	Chief Financial Officer

- 29 - -

EXHIBIT INDEX

3.1 Restated Certificate of Incorporation (filed as Exhibit 3.1 to the Registrant’s Registration Statement on Form S-1, dated May 9, 1991 [Registration No.  33-40467], and incorporated herein by reference)

3.2 Certificate of Amendment of Certificate of Incorporation (filed as Exhibit 3.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended May 31, 1995 and incorporated herein by reference)

3.3 Amended and Restated Bylaws, dated October 30, 2007 (filed as Exhibit 3.1 to the Registrant’s Current Report on Form 8-K dated October 31, 2007 and incorporated herein by reference)

4.1 Rights Agreement, dated August 28, 2002, by and between the Registrant and Computershare Trust Company, Inc. (filed as Exhibit 1 to the Registrant’s Registration Statement on Form 8-A filed September 5, 2002 and incorporated herein by reference)

31.1 Certification by Chief Executive Officer in accordance with Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification by Chief Financial Officer in accordance with Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

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

32.2 Certification by Chief Financial Officer in accordance with 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

_________________________

 

- 30 -