News Column

HEALTHSOUTH CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

February 20, 2014

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See "Cautionary Statement Regarding Forward-Looking Statements" on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. 30



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Executive Overview Our Business We are the nation's largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. While our national network of inpatient hospitals stretches across 28 states and Puerto Rico, our inpatient hospitals are concentrated in the eastern half of the United States and Texas. As of December 31, 2013, we operated 103 inpatient rehabilitation hospitals (including two hospitals that operate as joint ventures which we account for using the equity method of accounting), 20 outpatient rehabilitation satellite clinics (operated by our hospitals), and 25 licensed, hospital-based home health agencies. In addition to HealthSouth hospitals, we manage three inpatient rehabilitation units through management contracts. For additional information about our business, see Item 1, Business. 2013 Overview Our 2013 strategy focused on the following priorities: • continuing to provide high-quality, cost-effective care to patients in



our existing markets;

• achieving organic growth at our existing hospitals;

• continuing to expand our services to more patients who require

inpatient rehabilitative services by constructing and opportunistically

acquiring new hospitals in new markets; and • considering additional shareholder value-enhancing strategies such as repurchases of our common and preferred stock and common stock dividends, recognizing that some of these actions may increase our leverage ratio. During 2013, discharge growth of 5.0% coupled with a 0.9% increase in net patient revenue per discharge generated 5.9% growth in net patient revenue from our hospitals compared to 2012. Discharge growth was comprised of 2.5% growth from new stores and a 2.5% increase in same-store discharges. Our quality and outcome measures, as reported through the Uniform Data System for Medical Rehabilitation (the "UDS"), remained well above the average for hospitals included in the UDS database, and they did so while we continued to increase our market share throughout 2013. Not only did our hospitals treat more patients and enhance outcomes, they did so in a highly cost-effective manner. As evidenced by the decrease in our Total operating expenses as a percentage of Net operating revenues, we also achieved incremental efficiencies in our cost structure. See the "Results of Operations" section of this Item. Likewise, our growth efforts continued to yield positive results in 2013. Specifically, we: • acquired Walton Rehabilitation Hospital, a 58-bed inpatient rehabilitation hospital in Augusta, Georgia, in April 2013; • began accepting patients at our newly built, 40-bed inpatient rehabilitation hospital in Littleton, Colorado in May 2013; • began accepting patients at our newly built, 34-bed inpatient



rehabilitation hospital in Stuart, Florida in June 2013. This hospital

is a joint venture with Martin Health System; • completed the relocation of HealthSouth Rehabilitation Hospital of Western Massachusetts in Ludlow, Massachusetts to a newly built, 53-bed



inpatient rehabilitation hospital, which replaced a leased facility;

• added 68 beds to existing hospitals; and

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•continued development of the following de novo hospitals:

Actual / Expected Construction Start Expected Location # of Beds Date Operational Date Altamonte Springs, Florida 50 Q4 2013 Q4 2014 Newnan, Georgia 50 Q4 2013 Q4 2014 Middletown, Delaware 34 Q4 2013 Q4 2014 Modesto, California 50 Second Half - 2014 Q4 2015 Franklin, Tennessee* 40 TBD TBD *A certificate of need has been awarded, but it is currently under appeal. In 2013, we followed through on our announced intention to implement additional shareholder value-enhancing strategies. Namely, we: • completed a tender offer for our common stock in March 2013. As a result of the tender offer, we repurchased approximately 9.1 million shares at a price of $25.50 per share for a total cost of $234.1 million, including fees and expenses relating to the tender offer; • initiated a quarterly cash dividend of $0.18 per share on our common stock. The first quarterly dividend was declared in July 2013 and paid in October 2013; and • received authorization from our board of directors in October 2013 for the repurchase of up to an additional $200 million of our common stock. While implementing those shareholder value-enhancing strategies, we took additional steps to increase the strength and flexibility of our balance sheet: • entered into closing agreements with the IRS that settled federal income tax matters related to the previous restatement of our 2000 and 2001 financial statements, as well as certain other tax matters,



through December 31, 2008. As a result of these closing agreements, we

increased our deferred tax assets, primarily our federal net operating

loss carryforward ("NOL"), and recorded a net income tax benefit of approximately $115 million in the second quarter of 2013. This income tax benefit primarily resulted from an approximate $283 million increase to our federal NOL on a gross basis; • amended our credit agreement during the second quarter of 2013 to, among other things, permit unlimited restricted payments so long as the senior secured leverage ratio remains less than or equal to 1.5x and extend the revolver maturity from August 2017 to June 2018;



• purchased the real estate previously subject to leases associated with

four of our hospitals for approximately $70 million during the third quarter of 2013;



• redeemed $30.2 million and $27.9 million of the outstanding principal

amount of our existing 7.25% Senior Notes due 2018 and 7.75% Senior

Notes due 2022, respectively, in November 2013; and

• exchanged $320 million in aggregate principal amount of newly issued

2.00% Convertible Senior Subordinated Notes due 2043 for 257,110 shares

of our outstanding 6.50% Series A Convertible Perpetual Preferred Stock, leaving 96,245 shares of the preferred stock outstanding, in November 2013. See the "Liquidity and Capital Resources" section of this Item and Note 8, Long-term Debt, and Note 16, Income Taxes, to the accompanying consolidated financial statements. Business Outlook We believe our business outlook remains reasonably positive for two primary reasons. First, demographic trends, specifically the aging of the population, will increase long-term demand for inpatient rehabilitative services. While we treat patients of all ages, most of our patients are persons 65 and older (the average age of a HealthSouth patient is 72 years) and have conditions such as strokes, hip fractures, and a variety of debilitating neurological conditions that are generally nondiscretionary in nature. We believe the demand for inpatient rehabilitative healthcare services will continue to increase as 32



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the U.S. population ages and life expectancies increase. The number of Medicare-eligible patients is expected to grow approximately 3% per year for the foreseeable future, creating an attractive market. Second, we are the industry leader in this growing sector. As the nation's largest owner and operator of inpatient rehabilitation hospitals, we believe we differentiate ourselves from our competitors based on our broad platform of clinical expertise, the quality of our clinical outcomes, the sustainability of best practices, our financial strength, and the application of rehabilitative technology. We have invested considerable resources into clinical and management systems and protocols that have allowed us to consistently contain cost growth. Our commitment to technology also includes the on-going implementation of our rehabilitation-specific electronic clinical information system. We believe this system will improve patient care and safety, enhance staff recruitment and retention, and set the stage for connectivity with referral sources and health information exchanges. Our hospitals also participate in The Joint Commission's Disease-Specific Care Certification Program. Under this program, Joint Commission accredited organizations, like our hospitals, may seek certification for chronic diseases or conditions such as brain injury or stroke rehabilitation by complying with Joint Commission standards, effectively using evidence-based, clinical practice guidelines to manage and optimize patient care, and using an organized approach to performance measurement and evaluation of clinical outcomes. Obtaining such certifications demonstrates our commitment to excellence in providing disease-specific care. Currently, 96 of our hospitals hold one or more disease-specific certifications. We also account for approximately 80% of all Joint Commission disease-specific certifications in stroke nationwide. We believe these factors align with our strengths in, and focus on, inpatient rehabilitative care. Unlike many of our competitors that may offer inpatient rehabilitation as one of many secondary services, inpatient rehabilitation is our core business. In addition, we believe we can address the demand for inpatient rehabilitative services in markets where we currently do not have a presence by constructing or acquiring new hospitals. Longer-term, the nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain and will likely remain so for some time. The development of new delivery and payment systems will almost certainly take significant time and expense. Many of the alternative approaches being explored may not work. As outlined in the "Key Challenges-Changes to Our Operating Environment Resulting from Healthcare Reform" section below, we are positioning the Company in a prudent manner to be responsive to industry shifts, whatever they might be. Healthcare has always been a highly regulated industry, and we have cautioned our stakeholders that future Medicare payment rates could be at risk. While the Medicare reimbursement environment may be challenging, HealthSouth has a proven track record of adapting to and succeeding in a highly regulated environment, and we believe we are well-positioned to continue to succeed and grow. Further, we believe the regulatory and reimbursement risks discussed throughout this report may present us with opportunities to grow by acquiring or consolidating the operations of other inpatient rehabilitation providers in our highly fragmented industry. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2018. Over the past few years, we have redeemed our most expensive debt and reduced our interest expense. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. Our balance sheet remains strong. Our leverage ratio is within our target range, we have ample availability under our revolving credit facility, and we continue to generate strong cash flows from operations. Importantly, we have flexibility with how we choose to invest our cash and return value to shareholders, including bed additions, de novos, acquisitions of other inpatient rehabilitation hospitals, purchases of leased properties, repurchases of our common and preferred stock, common stock dividends, and repayment of long-term debt. Specifically, on February 14, 2014, our board of directors approved an increase in our existing common stock repurchase authorization from $200 million to $250 million. See the "Liquidity and Capital Resources - Authorizations for Returning Capital to Stakeholders" section of this Item. For these and other reasons, we believe we will be able to adapt to changes in reimbursement and sustain our business model. We also believe we will be in a position to take action should an attractive acquisition or consolidation opportunity arise. Key Challenges Healthcare, including the inpatient rehabilitation sector, has always been a highly regulated industry. Currently, the industry is facing many well-publicized regulatory and reimbursement challenges. The industry is also facing uncertainty associated with the efforts, primarily arising from initiatives included in the 2010 Healthcare Reform Laws (as defined in Item 1, Business, "Regulatory and Reimbursement Challenges") to identify and implement workable coordinated care delivery models. Successful healthcare providers are those who provide high-quality, cost-effective care and have the ability to adjust to changes in the regulatory and operating environments. We believe we have the necessary capabilities - scale, infrastructure, balance sheet, and management - to adapt to and succeed in a highly regulated industry, and we have a proven track record of doing so. 33



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As we continue to execute our business plan, the following are some of the challenges we face: • Operating in a Highly Regulated Industry. We are required to comply

with extensive and complex laws and regulations at the federal, state,



and local government levels. These rules and regulations have affected,

or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the



costs of compliance, mandating new documentation standards, requiring

licensure or certification of our hospitals, regulating our

relationships with physicians and other referral sources, regulating

the use of our properties, and limiting our ability to enter new

markets or add new beds to existing hospitals. Ensuring continuous

compliance with these laws and regulations is an operating requirement

for all healthcare providers.

As discussed in Item 1, Business, "Sources of Revenues," the United States Centers for Medicare and Medicaid Services ("CMS") has developed and instituted various Medicare audit programs under which CMS contracts with private companies to conduct claims and medical record audits. One type of audit contractor, the Recovery Audit Contractors ("RACs"), began post-payment audit processes in late 2009 for providers in general. In connection with CMS approved and announced RAC audits related to inpatient rehabilitation facilities ("IRFs"), we received requests in 2013 to review certain patient files for discharges occurring from 2010 to 2013. To date, the Medicare payments that are subject to these audit requests represent less than 1% of our Medicare patient discharges during those years, and not all of these patient file requests have resulted in payment denial determinations by the RACs. While we make provisions for these claims based on our historical experience and success rates in the claim adjudication process, we cannot provide assurance as to our future success in the resolution of these and future disputes, nor can we predict or estimate the scope or number of denials that ultimately may be reviewed. During 2013, we reduced our Net operating revenues by approximately $8 million for post-payment claims that are part of this review process. Unlike the pre-payment denials of certain diagnosis codes by Medicare Administrative Contractors ("MACs") that have been part of our operations for several years, we have not had any experience with RACs in the context of post-payment reviews of this nature. Along with our significant efforts through training and education to ensure compliance with coding and medical necessity coverage rules, we also have a formal process for complying with RAC audits, and we are cooperating fully with the RACs during this process. However, due to additional delays announced by CMS in the related adjudication process, which is the same process we follow for appealing denials of certain diagnosis codes by MACs, we believe the resolution of any claims that are subsequently denied as a result of these RAC audits could take in excess of two years. We have invested, and will continue to invest, substantial time, effort, and expense in implementing and maintaining internal controls and procedures designed to ensure regulatory compliance, and we are committed to continued adherence to these guidelines. More specifically, because Medicare comprises a significant portion of our Net operating revenues, it is important for us to remain compliant with the laws and regulations governing the Medicare program and related matters including anti-kickback and anti-fraud requirements. If we were unable to remain compliant with these regulations, our financial position, results of operations, and cash flows could be materially, adversely impacted. Another challenge relates to reduced Medicare reimbursement, which is also discussed in Item 1A, Risk Factors. We currently estimate sequestration, which began affecting payments received after April 1, 2013, will result in a net decrease in our Net operating revenues of approximately $8 million in 2014. The effect of sequestration on year-over-year comparisons will cease on April 1, 2014. However, unless the United States Congress acts to change or eliminate sequestration, it will continue to result in a 2% decrease to reimbursements otherwise due from Medicare, after taking into consideration other changes to reimbursement rates such as market basket updates. Additionally, concerns held by federal policymakers about the federal deficit, national debt levels, and reforming the sustainable growth rate formula used to pay physicians who treat Medicare beneficiaries (the so called "Doc Fix") could result in enactment of further federal spending reductions, further entitlement reform legislation affecting the Medicare program, and/or further reductions to provider payments. Likewise, issues related to the federal budget or the unwillingess to raise the statutory cap on the federal government's ability to issue debt, also referred to as the "debt ceiling," may have a significant impact on the economy and indirectly on our results of operations and financial position. We cannot predict what alternative or additional deficit reduction initiatives, Medicare payment reductions, or post acute care reforms, if any, will ultimately be enacted into law, or the timing or effect any such initiatives or reductions will have on us. If enacted, such initiatives or reductions would likely be challenging for all providers, would likely have the effect of limiting Medicare beneficiaries' access to healthcare services, and could have an adverse impact on our financial position, results of operations, and cash 34



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flows. However, we believe our efficient cost structure and substantial owned real estate coupled with the steps we have taken to reduce our debt and corresponding debt service obligations should allow us to absorb, adjust to, or mitigate any potential initiative or reimbursement reductions more easily than most other inpatient rehabilitation providers. See also Item 1, Business, "Sources of Revenues" and "Regulation," and Item 1A, Risk Factors, to this report and Note 18, Contingencies and Other Commitments, "Governmental Inquiries and Investigations," to the accompanying consolidated financial statements. Changes to Our Operating Environment Resulting from Healthcare Reform. Our challenges related to healthcare reform are discussed in Item 1, Business, "Sources of Revenue," and Item 1A, Risk Factors. Many provisions within the 2010 Healthcare Reform Laws have impacted, or could in the future impact, our business. Most notably for us are the reductions to our annual market basket updates, including productivity adjustments, and future payment reforms such as Accountable Care Organizations ("ACOs") and bundled payments. In July 2013, CMS released its notice of final rulemaking for fiscal year 2014 (the "2014 Rule") for IRFs under the prospective payment system ("IRFญPPS"). The final rule would implement a net 1.8% market basket increase effective for discharges between October 1, 2013 and September 30, 2014, calculated as follows: Market basket update 2.6% Healthcare reform reduction 30 basis points Productivity adjustment reduction 50 basis points The final rule also includes other pricing changes that impact our hospital-by-hospital base rate for Medicare reimbursement. Such changes include, but are not limited to, updates to the IRF-PPS facility-level rural adjustment factor, low-income patient factor, teaching status adjustment factor, and updates to the outlier fixed loss threshold. Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the rule's release and incorporates other adjustments included in the final rule, we believe the 2014 Rule will result in a net increase to our Medicare payment rates of approximately 1.95% effective October 1, 2013. The healthcare industry in general is facing uncertainty associated with the efforts, primarily arising from initiatives included in the 2010 Healthcare Reform Laws, to identify and implement workable coordinated care delivery models. In a coordinated care delivery model, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the overall value of the services they provide to a patient rather than the number of services they provide. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new delivery model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are positioning the Company in preparation for whatever changes are ultimately made to the delivery system: • 31 of our hospitals already operate as joint ventures with acute care hospitals, and we continue to pursue joint ventures as one of our growth initiatives. These joint ventures create an immediate link to an acute care system and position us to quickly and efficiently integrate our services in a coordinated care model. • Our electronic clinical information system is capable of interfaces with all major acute care electronic medical record systems and health information exchanges making communication easier across the continuum of healthcare providers. • We own the real estate associated with approximately 73% of our hospitals, and all but one of our hospitals are free standing. This combined with our strong balance sheet and consistent strong free cash flows enhances our flexibility to collaborate and partner with other providers. • We have a proven track record of being a high-quality, cost-effective provider. Our FIMฎ Gains consistently exceed industry results, and we have the scale and operating leverage to contribute to a low cost per discharge. 35



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• We have agreed to participate in a few bundling projects as a post-acute rehabilitation provider, and we have expressed interest in participating in several ACOs. As of December 31, 2013, we have executed one ACO participation agreement. Given the complexity and the number of changes in the 2010 Healthcare Reform Laws, we cannot predict their ultimate impact. In addition, the ultimate nature and timing of the transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. • Maintaining Strong Volume Growth. Various factors may impact our ability to maintain our recent volume growth rates, including competition and increasing regulatory and administrative burdens. In any particular market, we may encounter competition from local or



national entities with longer operating histories or other competitive

advantages, such as acute care hospitals with their own rehabilitation

units and other post-acute providers with relationships with referring

acute care hospitals or physicians. Overly aggressive payment review practices by Medicare contractors, excessively strict enforcement of regulatory policies by government agencies, and increasingly



restrictive or burdensome rules, regulations or statutes governing

admissions practices may lead us to not accept patients who would be appropriate for and would benefit from the services we provide. In addition, from time to time, we must get regulatory approval to add beds to our existing hospitals in states with certificate of need laws.



This approval may be withheld or take longer than expected. In the case

of new store volume growth, the addition of hospitals to our portfolio,

whether de novo construction or the product of acquisitions or joint ventures, also may be difficult and take longer than expected. • Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk Factors, for a discussion of competition for staffing, shortages of qualified personnel, and other factors that may increase our labor



costs. Recruiting and retaining qualified personnel for our hospitals

remain a high priority for us. We attempt to maintain a comprehensive

compensation and benefits package that allows us to remain competitive

in this challenging staffing environment while remaining consistent

with our goal of being a high-quality, cost-effective provider of

inpatient rehabilitative services.

See also Item 1, Business, and Item 1A, Risk Factors. These key challenges notwithstanding, we have a strong business model, a strong balance sheet, and a proven track record of achieving strong financial and operational results. We are positioning the Company to respond to any changes in the healthcare delivery system and believe we will be in a position to take advantage of any opportunities that arise as the industry moves to this new stage. We are in a position to continue to grow, adapt to external events, and create value for our shareholders in 2014 and beyond. Results of Operations Payor Mix During 2013, 2012, and 2011, we derived consolidated Net operating revenues from the following payor sources: For the Year Ended December 31, 2013 2012 2011 Medicare 74.5 % 73.4 % 72.0 % Medicaid 1.2 % 1.2 % 1.6 % Workers' compensation 1.2 % 1.5 % 1.6 % Managed care and other discount plans, including Medicare Advantage 18.5 % 19.3 % 19.8 % Other third-party payors 1.8 % 1.8 % 2.0 % Patients 1.1 % 1.3 % 1.2 % Other income 1.7 % 1.5 % 1.8 % Total 100.0 % 100.0 % 100.0 % 36



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Our payor mix is weighted heavily towards Medicare. Our hospitals receive Medicare reimbursements under IRF-PPS. Under IRF-PPS, our hospitals receive fixed payment amounts per discharge based on certain rehabilitation impairment categories established by the United States Department of Health and Human Services. Under IRF-PPS, our hospitals retain the difference, if any, between the fixed payment from Medicare and their operating costs. Thus, our hospitals benefit from being cost-effective providers. For additional information regarding Medicare reimbursement, see the "Sources of Revenues" section of Item 1, Business. Managed Medicare revenues, included in the "managed care and other discount plans" category in the above table, represented approximately 8%, 8%, and 7% of our total revenues during the years ended December 31, 2013, 2012, and 2011, respectively. During 2009, we experienced an increase in managed Medicare and private fee-for-service plans. As part of the Balanced Budget Act of 1997, Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or "Medicare Advantage." The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (Under Medicare Parts A and B) or enrollment in a health maintenance organization ("HMO"), preferred provider organization ("PPO"), point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Prior to 2010, private fee-for-service plans were not required to build provider networks, did not have the same quality reporting requirements to CMS as other plans, and were reimbursed by Medicare at a higher rate. In 2010, these requirements and reimbursement rates were revised to be similar to other existing payor plans. As these requirements changed, payors began actively marketing and converting their members from private-fee-for-service plans to one of their existing HMO or PPO plans, where provider networks and reporting requirements were already established, or back to traditional Medicare coverage. This shift of payors from private fee-for-service plans back to traditional Medicare can be seen in the above table. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services. Net operating revenues also include other revenues generated from management and administrative fees and other nonpatient care services. These other revenues are included in "other income" in the above table. Under IRF-PPS, hospitals are reimbursed on a "per discharge" basis. Thus, the number of patient discharges is a key metric utilized by management to monitor and evaluate our performance. The number of outpatient visits is also tracked in order to measure the volume of outpatient activity each period. 37



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Our Results From 2011 through 2013, our consolidated results of operations were as follows:

For the Year Ended December 31, Percentage Change 2013 2012 2011 2013 v. 2012 2012 v. 2011 (In Millions) Net operating revenues $ 2,273.2$ 2,161.9$ 2,026.9 5.1 % 6.7 % Less: Provision for doubtful accounts (26.0 ) (27.0 ) (21.0 ) (3.7 )% 28.6 % Net operating revenues less provision for doubtful accounts 2,247.2 2,134.9 2,005.9 5.3 % 6.4 % Operating expenses: Salaries and benefits 1,089.7 1,050.2 982.0 3.8 % 6.9 % Hospital-related expenses: Other operating expenses 323.0 303.8 288.3 6.3 % 5.4 % Occupancy costs 47.0 48.6 48.4 (3.3 )% 0.4 % Supplies 105.4 102.4 102.8 2.9 % (0.4 )%



General and administrative expenses 119.1 117.9 110.5

1.0 % 6.7 % Depreciation and amortization 94.7 82.5 78.8 14.8 % 4.7 % Government, class action, and related settlements (23.5 ) (3.5 ) (12.3 ) 571.4 % (71.5 )% Professional fees-accounting, tax, and legal 9.5 16.1 21.0 (41.0 )% (23.3 )% Total operating expenses 1,764.9 1,718.0 1,619.5 2.7 % 6.1 % Loss on early extinguishment of debt 2.4 4.0 38.8 (40.0 )% (89.7 )% Interest expense and amortization of debt discounts and fees 100.4 94.1 119.4 6.7 % (21.2 )% Other income (4.5 ) (8.5 ) (2.7 ) (47.1 )% 214.8 % Equity in net income of nonconsolidated affiliates (11.2 ) (12.7 ) (12.0 ) (11.8 )% 5.8 % Income from continuing operations before income tax expense 395.2 340.0 242.9 16.2 % 40.0 % Provision for income tax expense 12.7 108.6 37.1 (88.3 )% 192.7 % Income from continuing operations 382.5 231.4 205.8 65.3 % 12.4 % (Loss) income from discontinued operations, net of tax (1.1 ) 4.5 48.8 (124.4 )% (90.8 )% Net income 381.4 235.9 254.6 61.7 % (7.3 )% Less: Net income attributable to noncontrolling interests (57.8 ) (50.9 ) (45.9 ) 13.6 % 10.9 % Net income attributable to HealthSouth $ 323.6$ 185.0$ 208.7 74.9 % (11.4 )% 38



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Provision for Doubtful Accounts and Operating Expenses as a % of Net Operating Revenues For the Year Ended December 31, 2013 2012 2011 Provision for doubtful accounts 1.1 % 1.2 % 1.0 % Operating expenses: Salaries and benefits 47.9 % 48.6 % 48.4 % Hospital-related expenses: Other operating expenses 14.2 % 14.1 % 14.2 % Occupancy costs 2.1 % 2.2 % 2.4 % Supplies 4.6 % 4.7 % 5.1 % General and administrative expenses 5.2 % 5.5 % 5.5 % Depreciation and amortization 4.2 % 3.8 % 3.9 % Government, class action, and related settlements (1.0 )% (0.2 )% (0.6 )% Professional fees-accounting, tax, and legal 0.4 % 0.7 % 1.0 % Total operating expenses 77.6 % 79.5 % 79.9 %



Additional information regarding our operating results for the years ended December 31, 2013, 2012, and 2011 is as follows:

For the Year Ended December 31,



Percentage Change

2013 2012 2011



2013 v. 2012 2012 v. 2011

(In Millions) Net patient revenue - inpatient $ 2,130.8$ 2,012.6$ 1,866.4 5.9 % 7.8 % Net patient revenue - outpatient & other 142.4 149.3 160.5 (4.6 )% (7.0 )% Net operating revenues $ 2,273.2$ 2,161.9$ 2,026.9 5.1 % 6.7 % (Actual Amounts) Discharges 129,988 123,854 118,354 5.0 % 4.6 % Net patient revenue per discharge $ 16,392$ 16,250$ 15,770 0.9 % 3.0 % Outpatient visits 806,631 880,182 943,439 (8.4 )% (6.7 )% Average length of stay (days) 13.3 13.4 13.5 (0.7 )% (0.7 )% Occupancy % 69.3 % 68.2 % 67.7 % 1.6 % 0.7 % # of licensed beds 6,825 6,656 6,461 2.5 % 3.0 % Full-time equivalents* 16,093 15,453 15,089 4.1 % 2.4 % Employees per occupied bed 3.42 3.42 3.47 - % (1.4 )% * Excludes approximately 400 full-time equivalents in each year who are



considered part of corporate overhead with their salaries and benefits

included in General and administrative expenses in our consolidated statements of operations. Full-time equivalents included in the above table represent HealthSouth employees who participate in or support the operations of our hospitals and exclude an estimate of full-time equivalents related to contract labor. We actively manage the productive portion of our Salaries and benefits utilizing certain metrics, including employees per occupied bed, or "EPOB." This metric is determined by dividing the number of full-time equivalents, including an estimate of full-time equivalents from the utilization of contract labor, by the number of occupied beds during each period. The number of occupied beds is determined by multiplying the number of licensed beds by our occupancy percentage. In the discussion that follows, we use "same-store" comparisons to explain the changes in certain performance metrics and line items within our financial statements. We calculate same-store comparisons based on hospitals open throughout both the full current period and prior periods presented. These comparisons include the financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 39



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2013 Compared to 2012 Net Operating Revenues Net patient revenue from our hospitals was 5.9% higher for the year ended December 31, 2013 than the year ended December 31, 2012. This increase was attributable to a 5.0% increase in patient discharges and a 0.9% increase in net patient revenue per discharge. Discharge growth included a 2.5% increase in same-store discharges. Same-store discharges were negatively impacted by the divestiture of 41 skilled nursing facility beds in the first quarter of 2013. Approximately 60 basis points of discharge growth from new stores resulted from the consolidation of St. Vincent Rehabilitation Hospital beginning in the third quarter of 2012, as discussed in Note 7, Investments in and Advances to Nonconsolidated Affiliates, to the accompanying consolidated financial statements. The increase in net patient revenue per discharge resulted from pricing adjustments, higher patient acuity, and a higher percentage of Medicare patients, as shown in the above payor mix table. Net patient revenue per discharge was negatively impacted in 2013 by sequestration (became effective for all discharges after April 1, 2013), the impact of post-payment claim reviews (as discussed below), and the ramping up of three new hospitals. New hospitals are required to treat a minimum of 30 patients for zero revenue as part of the Medicare certification process. As discussed in Item 1, Business, and the "Critical Accounting Estimates-Revenue Recognition" section of this Item, CMS has developed and instituted various Medicare audit programs under which CMS contracts with private companies to conduct claims and medical record audits. In connection with CMS approved and announced RAC audits related to IRFs, we received requests in 2013 to review certain patient files for discharges occurring from 2010 to 2013. To date, the Medicare payments that are subject to these audit requests represent less than 1% of our Medicare patient discharges during those years, and not all of these patient file requests have resulted in payment denial determinations by the RACs. While we make provisions for these claims based on our historical experience and success rates in the claim adjudication process, we cannot provide assurance as to our future success in the resolution of these and future disputes, nor can we predict or estimate the scope or number of denials that ultimately may be reviewed. During 2013, we reduced our Net operating revenues by approximately $8 million for post-payment claims that are part of this review process. Decreased outpatient volumes in 2013 compared to 2012 resulted from the closure of outpatient clinics and continued competition from physicians offering physical therapy services within their own offices. We had 20 and 24 outpatient rehabilitation satellite clinics as of December 31, 2013 and 2012, respectively. Outpatient and other revenues for the years ended December 31, 2013 and 2012 included $15 million and $9 million, respectively, of state provider tax refunds. These refunds are explained in more detail in the "2012 Compared to 2011 - Net Operating Revenues" section of this Item. Provision for Doubtful Accounts For several years, under programs designated as "widespread probes," certain of our MACs have conducted pre-payment claim reviews of our billings and denied payment for certain diagnosis codes based on medical necessity. We dispute, or "appeal," most of these denials, and we have historically collected approximately 58% of all amounts denied. For claims we choose to take through all levels of appeal, up to and including administrative law judge hearings, we have historically experienced an approximate 70% success rate. The resolution of these disputes can take in excess of two years, and we cannot provide assurance as to our ongoing and future success of these disputes. As such, we make provisions against these receivables in accordance with our accounting policy that necessarily considers historical collection trends of the receivables in this review process as part of our Provision for doubtful accounts. Therefore, as we experience increases or decreases in these denials, or if our actual collections of these denials differs from our estimated collections, we may experience volatility in our Provision for doubtful accounts. See also Item 1, Business, "Sources of Revenues-Medicare Reimbursement," to this report. The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2013 compared 2012 was primarily the result of a decrease in pre-payment claim denials by MACs. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2013 compared to 2012 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2012 and 2013 development activities, and increased costs associated with medical plan benefits. Because merit increases were foregone in 2012, as discussed below, management determined the Company would absorb all of the increased costs associated with medical plan benefits to employees in 2013. 40



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These cost increases were offset by adjustments to our workers' compensation accruals in 2013 due to favorable trends in claims and industry-wide loss development trends. As a result of these continued favorable trends, we also lowered the statistical confidence level used to determine our self-insurance reserves in 2013. See the "Critical Accounting Estimates-Self-Insured Risks" section of this Item. Salaries and benefits as a percent of Net operating revenues decreased in 2013 compared to 2012 due to our increasing revenue base, the favorable adjustments to our workers' compensation accruals discussed above, and the one-time, merit-based, year-end bonus paid in the fourth quarter of 2012 to all eligible nonmanagement employees in lieu of an annual merit increase. The fourth quarter of 2013 included a 2.2% merit increase whereas the fourth quarter of 2012 included an approximate $10 million bonus in lieu of a merit increase resulting in a year-over-year benefit of approximately $5.5 million in Salaries and benefits in 2013. The positive impact of all of the above items were offset by sequestration. Hospital-related Expenses Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals. These expenses include such items as contract services, utilities, non-income related taxes, insurance, professional fees, and repairs and maintenance. Other operating expenses increased during 2013 compared to 2012 primarily as a result of increased patient volumes, including new hospitals, and the ongoing implementation of our clinical information system. Other operating expenses associated with the ongoing implementation of our clinical information system were approximately $3 million higher in 2013 than in 2012. As a percent of Net operating revenues, Other operating expenses increased during 2013 compared to 2012 due to the effects of sequestration, the ramping up of operations at three new hospitals, and higher expenses associated with the ongoing implementation of our clinical information system offset by growth in our revenue base and a reduction in general and professional liability reserves due to favorable trends in claims and industry-wide loss development trends. As a result of these continued favorable trends, we also lowered the statistical confidence level used to determine our self-insurance reserves in 2013. See the "Critical Accounting Estimates-Self-Insured Risks" section of this Item. Occupancy costs Occupancy costs include amounts paid for rent associated with leased hospitals and outpatient rehabilitation satellite clinics, including common area maintenance and similar charges. These costs decreased as a percent of Net operating revenues in 2013 compared to 2012 due to our purchases of the real estate previously subject to operating leases at certain of our hospitals in 2013 and 2012. See the "Liquidity and Capital Resources" section of this Item. Occupancy costs are expected to continue to decrease as a percent of Net operating revenues going forward. Supplies Supplies expense includes all costs associated with supplies used while providing patient care. Specifically, these costs include pharmaceuticals, food, needles, bandages, and other similar items. Supplies expense decreased as a percent of Net operating revenues in 2013 compared to 2012 due to our supply chain efforts and continual focus on monitoring and actively managing pharmaceutical costs offset by sequestration. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our corporate headquarters in Birmingham, Alabama. These expenses also include stock-based compensation expenses. General and administrative expenses decreased as a percent of Net operating revenues in 2013 compared to 2012 due primarily to our increasing revenue base. In March 2008, we sold our corporate campus to Daniel Corporation ("Daniel"), a Birmingham, Alabama-based real estate company. The sale included a deferred purchase price component related to an incomplete 13-story building located on the property, often referred to as the Digital Hospital. Under the agreement, Daniel was obligated upon sale of its interest in the building to pay to us 40% of the net profit realized from the sale. In June 2013, Daniel sold the building to Trinity Medical Center. In the third quarter of 2013, we received $10.8 million in cash from Daniel in connection with the sale of the building. The gain associated with this transaction is being deferred and amortized over five years, which is the remaining life of our 41



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lease agreement with Daniel for the portion of the property we continue to occupy with our corporate office, as a component of General and administrative expenses. Approximately $1 million of this gain was included in General and administrative expenses in 2013. Depreciation and Amortization Depreciation and amortization increased during 2013 compared to 2012 due to our increased capital expenditures throughout 2012 and 2013. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Government, Class Action, and Related Settlements The gain included in Government, class action, and related settlements in 2013 resulted from a noncash reduction in the estimated liability associated with the apportionment obligation to the plaintiffs in the January 2007 comprehensive settlement of the consolidated securities action, the collection of final judgments against former officers, and the recovery of assets from former officers, as discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. The gain included in Government, class action, and related settlements in 2012 resulted from the recovery of assets from former officers. Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2013 and 2012 related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. These expenses in 2012 also included legal and consulting fees for the pursuit of our remaining income tax benefits as discussed in Note 16, Income Taxes, to the accompanying consolidated financial statements. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt in 2013 resulted from the redemption of 10% of the outstanding principal amount of our existing 7.25% Senior Notes due 2018 and our existing 7.75% Senior Notes due 2022 in November 2013. The Loss on early extinguishment of debt in 2012 resulted from the amendment to our credit agreement in August 2012 and the redemption of 10% of the outstanding principal amount of our existing 7.25% Senior Notes due 2018 and our existing 7.75% Senior Notes due 2022 in October 2012. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees during 2013 compared to 2012 resulted from an increase in our average borrowings outstanding offset by a decrease in our average cash interest rate. Average borrowings outstanding increased during 2013 compared to 2012 primarily as a result of our issuance of $275 million aggregate principal amount of 5.75% Senior Notes due 2024 in September 2012. Our average cash interest rate approximated 7.1% and 7.2% during 2013 and 2012, respectively. The decrease in our average cash interest rate primarily resulted from the August 2012 amendment to our credit agreement that lowered the interest rate spread on our revolving credit facility by 50 basis points. In November 2013, we exchanged $320 million in aggregate principal amount of newly issued 2.00% Convertible Senior Subordinated Notes due 2043 for 257,110 shares of our outstanding preferred stock. Due to discounts and financing costs, the effective interest rate on the convertible notes is 6.0%. As a result of this exchange, interest expense is expected to increase in 2014. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income is primarily comprised of interest income and gains and losses on sales of investments. In 2012, Other income included a $4.9 million gain as a result of our consolidation of St. Vincent Rehabilitation Hospital and the remeasurement of our previously held equity interest at fair value. See Note 7, Investments in and Advances to Nonconsolidated Affiliates, to the accompanying consolidated financial statements. 42



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Income from Continuing Operations Before Income Tax Expense The increase in our pre-tax income from continuing operations in 2013 compared to 2012 resulted from increased Net operating revenues and continued disciplined expense management. Pre-tax income in 2013 and 2012 included gains of $23.5 million and $3.5 million, respectively, related to Government, class action, and related settlements, as discussed above. Pre-tax income for 2012 also included a $4.9 million gain on the consolidation of St. Vincent Rehabilitation Hospital, as discussed above. Provision for Income Tax Expense Due to our federal and state NOLs, our cash income taxes approximated $8 million, net of refunds, in 2013. These payments resulted primarily from state income tax expense of subsidiaries which have separate state filing requirements, alternative minimum taxes, and federal income taxes for subsidiaries not included in our federal consolidated income tax return. In 2014, we estimate we will pay approximately $10 million to $15 million of cash income taxes, net of refunds. In 2013 and 2012, current income tax expense was $6.3 million and $5.9 million, respectively. In April 2013, we entered into closing agreements with the IRS that settled federal income tax matters related to the previous restatement of our 2000 and 2001 financial statements, as well as certain other tax matters, through December 31, 2008. As a result of these closing agreements, we increased our deferred tax assets, primarily our federal NOL, and recorded a net income tax benefit of approximately $115 million in the second quarter of 2013. This income tax benefit primarily resulted from an approximate $283 million increase to our federal NOL on a gross basis. Our effective income tax rate for 2013 was 3.2%. Our Provision for income tax expense in 2013 was less than the federal statutory rate of 35.0% primarily due to: (1) the IRS settlement discussed above, (2) the impact of noncontrolling interests, and (3) a decrease in our valuation allowance offset by (4) state income tax expense. The decrease in our valuation allowance in 2013 related primarily to our capital loss carryforwards, our current forecast of future earnings in each jurisdiction, and changes in certain state tax laws. During the second quarter of 2013, we determined a valuation allowance related to our capital loss carryforwards was no longer required as sufficient positive evidence existed to substantiate their utilization. This evidence included our partial utilization of these assets as a result of realizing capital gains in 2013 and the identification of sufficient taxable capital gain income within the available capital loss carryforward period. See also Note 1, Summary of Significant Accounting Policies, "Income Taxes," to the accompanying consolidated financial statements for a discussion of the allocation of income or loss related to pass-through entities, which we refer to as the impact of noncontrolling interests in this discussion. Our effective income tax rate for 2012 was 31.9%. Our Provision for income tax expense in 2012 was less than the federal statutory rate of 35.0% primarily due to: (1) the impact of noncontrolling interests and (2) a decrease in the valuation allowance offset by (3) state income tax expense. In certain state jurisdictions, we do not expect to generate sufficient income to use all of the available NOLs prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable state tax jurisdiction, or if the timing of future tax deductions differs from our expectations. We recognize the financial statement effects of uncertain tax positions when it is more likely than not, based on the technical merits, a position will be sustained upon examination by and resolution with the taxing authorities. Total remaining gross unrecognized tax benefits were $1.1 million and $78.0 million as of December 31, 2013 and 2012, respectively. The amount of gross unrecognized tax benefits changed during 2013 primarily due to the settlement with the IRS discussed above. See Note 16, Income Taxes, to the accompanying consolidated financial statements and the "Critical Accounting Estimates" section of this Item. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests represents the share of net income or loss allocated to members or partners in our consolidated affiliates. Fluctuations in these amounts are primarily driven by the financial performance of the applicable hospital population each period. Approximately $4 million of the increase in noncontrolling interests in 2013 compared to 2012 was due to changes at two of our existing hospitals. During 2013, we entered into an agreement to convert our 100% owned hospital in Jonesboro, Arkansas into a joint venture with St. Bernards Healthcare, as discussed in Note 11, 43



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Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. In addition, our share of profits from our joint venture hospital in Memphis, Tennessee decreased in 2013 from 70% to 50% pursuant to the terms of that partnership agreement entered into in 1993. 2012 Compared to 2011 Net Operating Revenues Net patient revenue from our hospitals was 7.8% higher for the year ended December 31, 2012 than the year ended December 31, 2011. This increase was attributable to a 4.6% increase in patient discharges and a 3.0% increase in net patient revenue per discharge. Discharge growth was comprised of 1.7% growth from new stores and a 2.9% increase in same-store discharges. Discharge growth was enhanced during 2012 compared to 2011 by the additional day in February due to leap year as well as a 60 basis point increase in discharges resulting from the consolidation of St. Vincent Rehabilitation Hospital beginning in the third quarter of 2012, as discussed in Note 7, Investments in and Advances to Nonconsolidated Affiliates, to the accompanying consolidated financial statements. Net patient revenue per discharge in 2012 benefited from pricing adjustments, higher patient acuity, and a higher percentage of Medicare patients (as shown in the above payor mix table). Outpatient and other revenues include the receipt of state provider taxes. A number of states in which we operate hospitals assess a provider tax to certain healthcare providers. Those tax revenues at the state level are generally matched by federal funds. In order to induce healthcare providers to serve low income patients, many states redistribute a substantial portion of these funds back to the various providers. These redistributions are based on different metrics than those used to assess the tax, and are thus in different amounts and proportions than the initial tax assessment. As a result, some providers receive a net benefit while others experience a net expense. See the discussion of Other operating expenses below for information on state provider tax expenses. While state provider taxes are a regular component of our operating results, during 2011, a new provider tax was implemented in Pennsylvania where we operate nine inpatient hospitals. As a result of the implementation of this new provider tax in Pennsylvania, we recorded approximately $5 million in revenues related to the period from July 1, 2010 through December 31, 2010 when we were notified by Pennsylvania of the specific provider tax refund to be issued to us after Pennsylvania had received approval from CMS on its amended state plan relative to these taxes. Excluding the state provider tax refunds discussed above, outpatient and other revenues decreased during 2012 compared to 2011 due to the decrease in outpatient volumes, the closure of outpatient satellite clinics in prior periods, and a reduction in home health pricing related to the 2012 Medicare home health rule. Outpatient volumes in the fourth quarter of 2012 were negatively impacted by the implementation of therapy caps to all hospital-based outpatient programs. The Middle Class Tax Relief and Job Creation Act of 2012 applied therapy caps limiting how much Medicare will pay for medically necessary outpatient therapy services per Medicare patient in any one calendar year starting October 1, 2012. When this was implemented in October 2012, many Medicare beneficiaries had already reached their cap limit for 2012 and chose not to receive additional outpatient therapy services since such services would not be covered by Medicare. The decrease in outpatient volumes was slightly offset by an increase in the number of home health visits included in these volume metrics. Provision for Doubtful Accounts The change in the Provision for doubtful accounts as a percent of Net operating revenues in 2012 compared to 2011 was primarily the result of an increase in Medicare claim denials and a lengthening in the related adjudication process. Salaries and Benefits Salaries and benefits increased in 2012 compared to 2011 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2012 and 2011 development activities and the consolidation of St. Vincent Rehabilitation Hospital discussed above, an approximate 2% merit increase provided to employees on October 1, 2011, a change in the skills mix of employees at our hospitals, and a one-time, merit-based, year-end bonus paid in the fourth quarter of 2012 to all eligible nonmanagement employees. As part of the standardization of our labor practices across all of our hospitals and as part of our efforts to continue to provide high-quality inpatient rehabilitative services, our hospitals are utilizing more registered nurses and certified rehabilitation registered nurses, which increases our average cost per full-time equivalent, and fewer licensed practical nurses. These increases were offset by reductions in self-insured workers' compensation costs primarily due to revised actuarial estimates resulting from better-than-expected claims experience in prior years and a reduction in group medical costs due to favorable claim trends. 44



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We did not grant a merit increase to our employees on October 1, 2012. Rather, we replaced merit increases in 2012 with a one-time, merit-based, year-end bonus paid in the fourth quarter of 2012 to all eligible nonmanagement employees. We did this to reward our nonmanagement employees for their performance in 2012 while not carrying the additional costs associated with a merit increase into 2013 and beyond where we face the impact of sequestration and the risk of potential additional Medicare reimbursement reductions. Salaries and benefits increased by approximately $10 million in the fourth quarter of 2012 as a result of this special bonus. This bonus was approximately $4.5 million more than would have been included in our fourth quarter 2012 results had we given a 2.25% merit increase to all nonmanagement employees effective October 1, 2012. Salaries and benefits as a percent of Net operating revenues increased in 2012 compared to 2011. This increase was primarily attributable to the higher skills mix of our employees in 2012 compared to 2011, the one-time bonus discussed above, and the ramping up of operations at our newly opened hospital in Ocala, Florida (i.e., costs with no to little revenues) offset by continued improvement in labor productivity, as shown in our EPOB metric above. Hospital-related Expenses Other Operating Expenses As a percent of Net operating revenues, Other operating expenses decreased during 2012 compared to 2011 due primarily to our increasing revenue base as well as a decrease in self-insurance costs in 2012. As disclosed previously, we update our actuarial estimates surrounding our self-insurance reserves in June and December of each year. Self-insurance costs associated with professional and general liability risks were less in 2012 than in 2011 due to revised actuarial estimates resulting from better-than-expected claims experience in prior years. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements. Other operating expenses in 2011 included approximately $3 million of expenses associated with the implementation of the new Pennsylvania state provider tax program, as discussed above, offset by a $2.4 million nonrecurring franchise tax recovery. Other operating expenses associated with the implementation of our electronic clinical information system were approximately $3 million higher in 2012 than in 2011. Occupancy costs Occupancy costs decreased as a percent of Net operating revenues in 2012 compared to 2011 due to our purchase of the land and building previously subject to an operating lease associated with our joint venture hospital in Fayetteville, Arkansas. Supplies Supplies expense decreased as a percent of Net operating revenues in 2012 compared to 2011 due to our increasing revenue base, our supply chain efforts, and our continual focus on monitoring and actively managing pharmaceutical costs. General and Administrative Expenses The increase in General and administrative expenses during 2012 compared to 2011 primarily resulted from increased expenses associated with stock-based compensation. Our restricted stock awards contain vesting requirements that include a service condition, market condition, performance condition, or a combination thereof. Due to the Company's operating performance, our noncash expenses associated with these awards increased in 2012. Depreciation and Amortization While our capital expenditures increased during the latter half of 2011 and all of 2012, the majority of these expenditures related to land and construction in progress for our de novo hospitals and capitalized software costs associated with the implementation of our electronic clinical information system at our hospitals. Depreciation on these assets, excluding land which is nondepreciable, does not begin until the applicable assets are placed in service. Therefore, while we expect depreciation and amortization to increase going forward, we did not experience a significant increase in these charges during 2012. 45



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Government, Class Action, and Related Settlements The gain included in Government, class action, and related settlements in 2012 and 2011 resulted from the recovery of assets from former officers, as discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Professional Fees - Accounting, Tax, and Legal In 2012 and 2011, Professional fees-accounting, tax, and legal related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. These fees in 2012 and 2011 specifically included $1.4 million and $5.2 million, respectively, related to our obligation to pay 35% of any recovery from Richard Scrushy to the attorneys for the derivative shareholder plaintiffs. These expenses in 2012 also included legal and consulting fees for the pursuit of our remaining income tax benefits, as discussed in Note 16, Income Taxes, to the accompanying consolidated financial statements. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt in 2012 resulted from the amendment to our credit agreement in August 2012 and the redemption of 10% of the outstanding principal amount of our existing 7.25% Senior Notes due 2018 and our existing 7.75% Senior Notes due 2022 in October 2012. The Loss on early extinguishment of debt in 2011 was the result of our redemption of all of our 10.75% Senior Notes due 2016 in June and September of 2011. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The decrease in Interest expense and amortization of debt discounts and fees during 2012 compared to 2011 was due to a decrease in our average borrowings outstanding and a decrease in our average cash interest rate. During 2011, we reduced total debt by approximately $257 million, including the redemption of our 10.75% Senior Notes due 2016. Our average cash interest rate was 7.2% during 2012 compared to 8.0% for 2011. Our average cash interest rate decreased as a result of the redemption of the 10.75% Senior Notes due 2016 during 2011, which was our most expensive debt, as well as the amendment to our credit agreement in May 2011 which reduced by 100 basis points each of the various applicable interest rates for any outstanding balance on our revolving credit facility. In addition, pricing on our term loan and revolving credit facility declined an additional 25 basis points in the third quarter of 2011 in conformity with our credit agreement's leverage grid. In addition, the August 2012 amendment to our credit agreement lowered the interest rate spread on our revolving credit facility by an additional 50 basis points. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Other Income In 2012, Other income included a $4.9 million gain as a result of our consolidation of St. Vincent Rehabilitation Hospital and the remeasurement of our previously held equity interest at fair value. See Note 7, Investments in and Advances to Nonconsolidated Affiliates, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Excluding the Loss on early extinguishment of debt during 2011, the increase in our pre-tax income from continuing operations in 2012 compared to 2011 resulted from increased Net operating revenues, improved operating leverage and labor productivity, and a decrease in interest expense. Provision for Income Tax Expense Our effective income tax rate for 2012 was 31.9%. Our Provision for income tax expense in 2012 was less than the federal statutory rate of 35.0% primarily due to: (1) the impact of noncontrolling interests and (2) a decrease in the valuation allowance offset by (3) state income tax expense. Our effective income tax rate for 2011 was 15.3%. The Provision for income tax expense in 2011 was less than the federal statutory rate primarily due to: (1) an approximate $28 million benefit associated with a current period net reduction in the valuation allowance and (2) an approximate $18 million net benefit associated with settlements with various taxing authorities including the settlement of federal income tax claims with the Internal Revenue Service for tax years 2007 and 2008 offset by (3) approximately $7 million of net expense primarily related to corrections to 2010 deferred tax assets associated 46



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with our NOLs and corresponding valuation allowance. See Note 1, Summary of Significant Accounting Policies, "Out-of-Period Adjustments," to the accompanying consolidated financial statements. In 2012, we paid approximately $10 million of cash income taxes, net of refunds. In 2011, we received $0.5 million of net income tax refunds. In 2012 and 2011, current income tax expense was $5.9 million and $0.6 million, respectively. See Note 16, Income Taxes, to the accompanying consolidated financial statements. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests increased in 2012 compared to 2011 due to the financial performance of the applicable hospital population each period, bed additions at joint venture hospitals, the consolidation of St. Vincent Rehabilitation Hospital beginning in the third quarter of 2012 (see Note 7, Investments in and Advances to Nonconsolidated Affiliates, to the accompanying consolidated financial statements), and the purchase of the land and building previously subject to an operating lease associated with our joint venture hospital in Fayetteville, Arkansas. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. While we believe the current economic climate may help to moderate wage increases in the near term, there can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing pharmaceutical costs has enabled to us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions are not material to our operations, and therefore, are not presented as a separate discussion within this Item. Results of Discontinued Operations The operating results of discontinued operations are as follows (in millions): For the Year Ended December 31, 2013 2012 2011 Net operating revenues $ 0.2$ 1.0$ 95.7 Less: Provision for doubtful accounts 0.3 - (1.5 ) Net operating revenues less provision for doubtful accounts 0.5 1.0 94.2 Costs and expenses 0.2 0.2 66.3 Impairments 1.1 - 6.8 (Loss) income from discontinued operations (0.8 ) 0.8 21.1 (Loss) gain on disposal of assets/sale of investments of discontinued operations (0.4 ) 5.0 65.6 Income tax benefit (expense) 0.1 (1.3 ) (37.9 ) (Loss) income from discontinued operations, net of tax $ (1.1 ) $



4.5 $ 48.8

Our results of discontinued operations primarily included the operations of six long-term acute care hospitals ("LTCHs"). In August 2011, we completed a transaction to sell five LTCHs to certain subsidiaries of LifeCare Holdings, Inc. for an aggregate purchase price of $117.5 million. We closed the sixth LTCH in August 2011 and sold the associated real estate in December 2013. 47



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In addition, as discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements, in April 2011, we entered into a definitive settlement and release agreement with the state of Delaware (the "Delaware Settlement") relating to a previously disclosed audit of unclaimed property conducted on behalf of Delaware and two other states by Kelmar Associates, LLC. During 2011, we recorded a $24.8 million gain in connection with this settlement as part of our results of discontinued operations. The impairment charges presented in the above table for 2013 and 2011 related to the LTCH that was closed in 2011. We determined the fair value of the impaired long-lived assets at this LTCH based on offers from potential buyers of the closed facility's real estate. The impairment charges for 2011 also relate to the Dallas Medical Center that was closed in 2008. We determined the fair value of the impaired long-lived assets at this hospital based on the assets' estimated fair value using valuation techniques that included third-party appraisals and offers from potential buyers. During 2012, we recognized gains associated with the sale of the real estate of Dallas Medical Center and an investment we had in a cancer treatment center that was part of our former diagnostic division. As a result of the transaction to sell five of our LTCHs, we recorded a $65.6 million pre-tax gain as part of our results of discontinued operations in 2011. Income tax expense recorded as part of our results of discontinued operations in 2011 related primarily to the gain from the sale of five of our LTCHs and the Delaware Settlement. See also Note 15, Assets and Liabilities in and Results of Discontinued Operations, to the accompanying consolidated financial statements. In connection with the 2007 sale of our surgery centers division (now known as Surgical Care Affiliates, or "SCA") to ASC Acquisition LLC, an affiliate of TPG Partners V, L.P. ("TPG"), a private investment partnership, we received an option, subject to terms and conditions set forth below, to purchase up to a 5% equity interest in SCA. The price of the option is equal to the original issuance price of the units subscribed for by TPG and certain other co-investors in connection with the acquisition plus a 15% annual premium, compounded annually. The option has a term of ten years and is exercisable upon certain liquidity events, including a public offering of SCA's shares of common stock that results in 30% or more of SCA's common stock being listed or traded on a national securities exchange. On November 4, 2013, SCA announced the closing of its initial public offering, which was not a qualifying liquidity event. If there is a secondary offering that results in a qualifying liquidity event under our option agreement with TPG, we intend to exercise our rights pursuant to the option. If the option becomes exercisable, we believe it will have a strike price below the price of the asset being purchased. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Maintaining adequate liquidity includes supporting the execution of our operating and strategic plans and allowing us to weather temporary disruptions in the capital markets and general business environment. Maintaining flexibility in our capital structure includes limiting concentrations of debt maturities in any given year, allowing for debt prepayments without onerous penalties, and ensuring our debt agreements are limited in restrictive terms and maintenance covenants. With these objectives in mind, in June 2013, we amended our credit agreement to, among other things, permit unlimited restricted payments so long as the senior secured leverage ratio remains less than or equal to 1.5x and extend the revolver maturity from August 2017 to June 2018 (see Note 8, Long-term Debt, to the accompanying consolidated financial statements). We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2018. Our balance sheet remains strong. Our leverage ratio is within our target range, and we have ample availability under our revolving credit facility. We continue to generate strong cash flows from operations, and we have flexibility with how we choose to invest our cash and return value to shareholders. Current Liquidity As of December 31, 2013, we had $64.5 million in Cash and cash equivalents. This amount excludes $52.4 million in Restricted cash and $47.6 million of restricted marketable securities ($42.9 million of restricted marketable securities are included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 3, Cash and Marketable Securities, to the accompanying consolidated financial statements. 48



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In addition to Cash and cash equivalents, as of December 31, 2013, we had approximately $519 million available to us under our revolving credit facility. Our credit agreement governs the majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to $75 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As of December 31, 2013, the maximum leverage ratio requirement per our credit agreement was 4.5x and the minimum interest coverage ratio requirement was 2.75x, and we were in compliance with these covenants. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2018, and our bonds all mature in 2018 and beyond. See the "Contractual Obligations" section below for information related to our contractual obligations as of December 31, 2013. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing core business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common and preferred stock and common stock dividends, recognizing that these actions may increase our leverage ratio. And, we will continue to consider reductions to our long-term debt. See also the "Authorizations for Returning Capital to Stakeholders" section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years ended December 31, 2013, 2012, and 2011 (in millions): For the Year Ended December 31, 2013 2012 2011



Net cash provided by operating activities $ 470.3$ 411.5$ 342.7 Net cash used in investing activities

(226.2 ) (178.8 ) (24.6 ) Net cash used in financing activities (312.4 )



(130.0 ) (336.3 ) (Decrease) increase in cash and cash equivalents $ (68.3 )$ 102.7$ (18.2 )

2013 Compared to 2012 Operating activities. Net cash provided by operating activities increased from 2012 to 2013 due primarily to increased Net operating revenues and continued disciplined expense management. Investing activities. The increase in Net cash used in investing activities during 2013 compared to 2012 primarily resulted from increased capital expenditures and the acquisition of Walton Rehabilitation Hospital. The increase in our capital expenditures in 2013 primarily resulted from the purchase of the real estate previously subject to leases associated with four of our hospitals, as discussed below. Net cash used in investing activities during 2013 also included the receipt of $10.8 million related to the sale of the Digital Hospital. See Note 2, Business Combinations, and Note 5, Property and Equipment, to the accompanying consolidated financial statements. Financing activities. The increase in Net cash used in financing activities during 2013 compared to 2012 primarily resulted from repurchases of our common stock as part of the tender offer completed in the first quarter of 2013. As discussed in Note 17, Earnings per Common Share, to the accompanying consolidated financial statements, we repurchased approximately 9.1 million shares of our common stock for $234.1 million, including fees and expenses related to the tender offer. 2012 Compared to 2011 Operating activities. The increase in Net cash provided by operating activities from 2011 to 2012 primarily resulted from the increase in our Net operating revenues, improved operating leverage, and a decrease in interest expense. Net cash provided by operating activities for 2011 included $26.9 million related to the premium paid in conjunction with the redemption of our 10.75% Senior Notes and a $16.2 million decrease in the liability associated with refunds due patients and 49



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other third-party payors. The decrease in this liability primarily related to a settlement discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Investing activities. Cash flows used in investing activities during 2011 included $107.9 million of proceeds from the sale of five of our LTCHs in August 2011. Excluding these proceeds, the increase in Cash flows used in investing activities resulted from increased capital expenditures, including capitalized software costs, in 2012 compared to 2011. The increase in our capital expenditures in 2012 primarily resulted from: de novo development activities including land purchases, increased hospital refresh projects, implementation of our electronic clinical information system, and the purchase of the real estate associated with our joint venture hospital in Fayetteville, Arkansas (see also "financing activities" below). Financing activities. Cash flows used in financing activities during 2012 included the repurchase of 46,645 shares of our convertible perpetual preferred stock, distributions to noncontrolling interests of consolidated affiliates, dividends paid on our preferred stock, and net principal payments on debt offset by capital contributions from consolidated affiliates primarily associated with the purchase of the real estate associated with our joint venture hospital in Fayetteville, Arkansas. Cash flows used in financing activities during 2011 included net principal payments on debt, including the redemption of our 10.75% Senior Notes due 2016, distributions to noncontrolling interests of consolidated affiliates, and dividends paid on our preferred stock. Net debt payments, including debt issue costs, were approximately $21 million and $271 million for the years ended December 31, 2012 and 2011, respectively. Contractual Obligations Our consolidated contractual obligations as of December 31, 2013 are as follows (in millions): 2019 and Total 2014 2015-2016 2017-2018 thereafter Long-term debt obligations: Long-term debt, excluding revolving credit facility and capital lease obligations (a) $ 1,383.6$ 6.3$ 4.9$ 274.6$ 1,097.8 Revolving credit facility 45.0 - - 45.0 - Interest on long-term debt (b) 682.3 89.3 177.8 172.1 243.1 Capital lease obligations (c) 175.5 12.3 27.1 26.9 109.2 Operating lease obligations (d)(e) 253.9 37.9 67.0 48.3 100.7 Purchase obligations (e)(f) 121.4 26.3 48.4 20.9 25.8 Other long-term liabilities (g)(h) 3.8 0.2 0.4 0.4 2.8 Total $ 2,665.5$ 172.3$ 325.6$ 588.2$ 1,579.4



(a) Included in long-term debt are amounts owed on our bonds payable and other

notes payable. These borrowings are further explained in Note 8, Long-term

Debt, to the accompanying consolidated financial statements.

(b) Interest on our fixed rate debt is presented using the stated interest

rate. Interest expense on our variable rate debt is estimated using the

rate in effect as of December 31, 2013. Interest related to capital lease

obligations is excluded from this line. Future minimum payments, which are

accounted for as interest, related to sale/leaseback transactions

involving real estate accounted for as financings are included in this

line (see Note 5, Property and Equipment, and Note 8, Long-term Debt, to

the accompanying consolidated financial statements). Amounts exclude amortization of debt discounts, amortization of loan fees, or fees for lines of credit that would be included in interest expense in our consolidated statements of operations.



(c) Amounts include interest portion of future minimum capital lease payments.

(d) We lease approximately 27% of our hospitals as well as other property and

equipment under operating leases in the normal course of business. Some of

our hospital leases contain escalation clauses based on changes in the

Consumer Price Index while others have fixed escalation terms. The minimum

lease payments do not include contingent rental expense. Some lease agreements provide us with the option to renew the lease or purchase the leased property. Our future operating lease obligations would change if we exercised these renewal options and if we entered into additional



operating lease agreements. For more information, see Note 5, Property and

Equipment, to the accompanying consolidated financial statements. 50



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(e) Future operating lease obligations and purchase obligations are not recognized in our consolidated balance sheet.



(f) Purchase obligations include agreements to purchase goods or services that

are enforceable and legally binding on HealthSouth and that specify all

significant terms, including: fixed or minimum quantities to be purchased;

fixed, minimum, or variable price provisions; and the approximate timing

of the transaction. Purchase obligations exclude agreements that are

cancelable without penalty. Our purchase obligations primarily relate to

software licensing and support.

(g) Because their future cash outflows are uncertain, the following noncurrent

liabilities are excluded from the table above: general liability,

professional liability, and workers' compensation risks, noncurrent

amounts related to third-party billing audits, and deferred income taxes.

Also, as of December 31, 2013, we had $1.1 million of total gross

unrecognized tax benefits. For more information, see Note 9, Self-Insured

Risks, Note 16, Income Taxes, and Note 18, Contingencies and Other

Commitments, to the accompanying consolidated financial statements. See

also the discussion below of our purchases of the real estate associated

with leased properties. (h) The table above does not include Redeemable noncontrolling interests of $13.5 million because of the uncertainty surrounding the timing and amounts of any related cash outflows. Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year ended December 31, 2013, we made capital expenditures of $216.5 million for property and equipment and capitalized software. These expenditures included costs associated with our investment in a new hospital to replace our formerly leased hospital in Ludlow, Massachusetts as well as approximately $70 million to purchase four leased properties, as discussed below. This amount is exclusive of $28.9 million related to the acquisition of Walton Rehabilitation Hospital in Augusta, Georgia. Approximately $75 million of the total spent was considered nondiscretionary expenditures, which we may refer to in other filings as "maintenance" expenditures. During 2014, we expect to spend approximately $185 million to $230 million for capital expenditures. This estimated range for capital expenditures is exclusive of acquisitions. Approximately $90 million to $100 million of this budgeted amount is considered nondiscretionary expenditures. This range of nondiscretionary expenditures includes approximately $12 million of hospital and technology equipment that was received in 2013 but not paid for until 2014. These items were not reflected in our statement of cash flows for 2013. Actual amounts spent will be dependent upon the timing of construction projects. In the third quarter of 2013, we purchased the real estate previously subject to leases associated with four of our hospitals for approximately $70 million: Tallahassee, Florida; Montgomery, Alabama; Nittany Valley, Pennsylvania; and York, Pennsylvania. In addition, we have given notice of our intent to exercise the purchase option included in one other lease agreement associated with our hospitals. We continue to negotiate with the applicable landlord to finalize the fair value purchase price under the related lease agreement. In December 2013, we signed an agreement to acquire an additional 30% equity interest from UMass Memorial Health Care, our joint venture partner in Fairlawn Rehabilitation Hospital in Worcester, Massachusetts. This transaction, which is subject to regulatory approval and is expected to close in 2014, will increase our ownership interest from 50% to 80% and will, when completed, result in a change in accounting for this hospital from the equity method of accounting to a consolidated entity. As a result of the consolidation of this hospital and the remeasurement of our previously held equity interest at fair value, we expect to record a $22 million to $32 million gain during 2014. Authorizations for Returning Capital to Stakeholders On February 15, 2013, our board of directors approved an increase in our existing common stock repurchase authorization from $125 million to $350 million. Consistent with our strategy of deploying financial resources towards long-term, shareholder value-creating opportunities, during the first quarter of 2013, we completed a tender offer for our common stock. As a result of the tender offer, we purchased approximately 9.1 million shares at a price of $25.50 per share for a total cost of $234.1 million, including fees and expenses relating to the tender offer. We used a combination of cash on hand and availability under our revolving credit facility to fund the repurchases. The remaining repurchase authorization expired at the end of the tender offer. On July 25, 2013, our board of directors approved the initiation of a quarterly cash dividend on our common stock of $0.18 per share. The first quarterly dividend was paid on October 15, 2013 to stockholders of record as of the close of business on October 1, 2013. On October 25, 2013, our board of directors declared a cash dividend of $0.18 per share payable on January 15, 2014 to stockholders of record on January 2, 2014. We expect quarterly dividends to be paid in January, April, July, 51



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and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates, will be established by our board of directors each quarter after consideration of various factors, including our capital position and the best interests of our stockholders. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our revolving credit facility. The payment of cash dividends on our common stock triggers antidilution adjustments, except in instances when such adjustments are deemed de minimis, under some of our securities that are convertible or exercisable into common stock. See Note 17, Earnings per Common Share, to the accompanying consolidated financial statements. On October 25, 2013, our board of directors authorized the repurchase of up to $200 million of our common stock. On February 14, 2014, our board of directors approved an increase in this common stock repurchase authorization from $200 million to $250 million. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. Any repurchases under this authorization are expected to be funded using a combination of cash on hand and availability under our $600 million revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 8, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement-our interest coverage ratio and our leverage ratio-could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might not be on terms favorable to those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. In general terms, the credit agreement definition of Adjusted EBITDA, referred to as "Adjusted Consolidated EBITDA" there, allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to $10 million in a year may be cash expenditures), (2) costs and expenses related to refinancing transactions (in years prior to 2012), (3) any losses from discontinued operations and closed locations, (4) costs and expenses, including legal fees and expert witness fees, incurred with respect to litigation associated with stockholder derivative litigation, including the matters related to Ernst & Young LLP and Richard Scrushy discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements, and (5) share-based compensation expense. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent increasing consolidated Net income. Under the credit agreement, the Adjusted EBITDA calculation does not include net income attributable to noncontrolling interests and includes (1) gain or loss on disposal of assets, (2) professional fees unrelated to the stockholder derivative litigation, and (3) unusual or nonrecurring cash expenditures in excess of $10 million. These items may not be indicative of our ongoing performance, so the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. 52



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Our Adjusted EBITDA for the years ended December 31, 2013, 2012, and 2011 was as follows (in millions):

Reconciliation of Net Income to Adjusted EBITDA

For the Year Ended December 31, 2013 2012 2011 Net income $ 381.4$ 235.9$ 254.6 Loss (income) from discontinued operations, net of tax, attributable to HealthSouth 1.1 (4.5 ) (49.9 ) Provision for income tax expense 12.7 108.6 37.1 Interest expense and amortization of debt discounts and fees 100.4 94.1 119.4 Loss on early extinguishment of debt 2.4 4.0 38.8 Professional fees-accounting, tax, and legal 9.5 16.1 21.0 Government, class action, and related settlements (23.5 ) (3.5 ) (12.3 ) Net noncash loss on disposal or impairment of assets 5.9 4.4 4.3 Depreciation and amortization 94.7 82.5 78.8 Stock-based compensation expense 24.8 24.1 20.3 Net income attributable to noncontrolling interests (57.8 ) (50.9 ) (45.9 ) Gain on consolidation of St. Vincent Rehabilitation Hospital - (4.9 ) - Adjusted EBITDA $ 551.6$ 505.9$ 466.2 Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA For the Year Ended December 31, 2013 2012 2011



Net cash provided by operating activities $ 470.3$ 411.5$ 342.7 Provision for doubtful accounts

(26.0 ) (27.0 ) (21.0 ) Professional fees-accounting, tax, and legal 9.5 16.1 21.0 Interest expense and amortization of debt discounts and fees 100.4 94.1 119.4 Equity in net income of nonconsolidated affiliates 11.2 12.7 12.0 Net income attributable to noncontrolling interests in continuing operations (57.8 ) (50.9 ) (47.0 ) Amortization of debt discounts and fees (5.0 ) (3.7 ) (4.2 ) Distributions from nonconsolidated affiliates (11.4 ) (11.0 ) (13.0 ) Current portion of income tax expense 6.3 5.9 0.6 Change in assets and liabilities 48.9 58.1 41.4 Premium received on bond issuance - - (4.1 ) Premium paid on bond redemption 1.7 1.9 26.9 Operating cash used in (provided by) discontinued operations 1.9 (2.0 ) (9.1 ) Other 1.6 0.2 0.6 Adjusted EBITDA $ 551.6$ 505.9$ 466.2 Growth in Adjusted EBITDA in each year was due primarily to revenue growth and disciplined expense management. Adjusted EBITDA for 2013 benefited from $6.7 million of adjustments to self-insurance reserves resulting from our change in assumptions related to our statistical confidence level, as discussed in the "Critical Accounting Estimates-Self-Insured Risks" section of this Item. Sequestration negatively impacted Adjusted EBITDA by approximately $25 million during 2013. 53



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Off-Balance Sheet Arrangements In accordance with the definition under SEC rules, the following qualify as off-balance sheet arrangements: • any obligation under certain guarantees or contracts; • a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that



serves as credit, liquidity, or market risk support to that entity for

such assets;

• any obligation under certain derivative instruments; and

• any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the registrant, or engages in leasing, hedging, or research and development services with the registrant. As of December 31, 2013, we do not have any material off-balance sheet arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities ("SPEs"), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2013, we are not involved in any unconsolidated SPE transactions. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates, and judgments to ensure our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, as they require our most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the audit committee of our board of directors. Revenue Recognition We recognize net patient service revenue in the reporting period in which we perform the service based on our current billing rates (i.e., gross charges) less actual adjustments and estimated discounts for contractual allowances (principally for patients covered by Medicare, Medicaid, and managed care and other health plans). See Note 1, Summary of Significant Accounting Policies, "Net Operating Revenues," to the accompanying consolidated financial statements for a complete discussion of our revenue recognition policies. Our patient accounting system calculates contractual allowances on a patient-by-patient basis based on the rates in effect for each primary third-party payor. Other factors that are considered and could further influence the level of our reserves include the patient's total length of stay for in-house patients, each patient's discharge destination, the proportion of patients with secondary insurance coverage and the level of reimbursement under that secondary coverage, and the amount of charges that will be disallowed by payors. Such additional factors are assumed to remain consistent with the experience for patients discharged in similar time periods for the same payor classes, and additional reserves are provided to account for these factors. Management continually reviews the contractual estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. In addition, laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. 54



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In addition, CMS has developed and instituted various Medicare audit programs under which CMS contracts with private companies to conduct claims and medical record audits. In connection with CMS approved and announced RAC audits related to IRFs, we received requests in 2013 to review certain patient files for discharges occurring from 2010 to 2013. To date, the Medicare payments that are subject to these audit requests represent less than 1% of our Medicare patient discharges during those years, and not all of these patient file requests have resulted in payment denial determinations by the RACs. While we make provisions for these claims based on our historical experience and success rates in the claim adjudication process, we cannot provide assurance as to our future success in the resolution of these and future disputes, nor can we predict or estimate the scope or number of denials that ultimately may be reviewed. During 2013, we reduced our Net operating revenues by approximately $8 million for post-payment claims that are part of this review process. Due to complexities involved in determining amounts ultimately due under reimbursement arrangements with third-party payors, which are often subject to interpretation and review, we may receive reimbursement for healthcare services authorized and provided that is different from our estimates, and such differences could be material. However, we continually review the amounts actually collected in subsequent periods in order to determine the amounts by which our estimates differed. Historically, such differences have not been material from either a quantitative or qualitative perspective. Allowance for Doubtful Accounts The collection of outstanding receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. We provide for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. See Note 1, Summary of Significant Accounting Policies, "Accounts Receivable and the Allowance for Doubtful Accounts," and Note 4, Accounts Receivable, to the accompanying consolidated financial statements for a complete discussion of our policies related to the allowance for doubtful accounts. Our primary collection risks relate to patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding. Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. We estimate our allowance for doubtful accounts based on the aging of our accounts receivable, our historical collection experience for each type of payor, and other relevant factors so that the remaining receivables, net of allowances, are reflected at their estimated net realizable values. For several years, under programs designated as "widespread probes,"certain of our MACs have conducted pre-payment claim reviews of our billing and denied payment for certain diagnosis codes based on medical necessity. We dispute, or "appeal," most of these denials, and we collect approximately 58% of all amounts denied. For claims we choose to take through all levels of appeal, up to and including administrative law judge hearings, we have historically experienced an approximate 70% success rate. Because we do not write-off receivables until all collection efforts have been exhausted, we do not write-off receivables related to denied claims while they are in this review process. The resolution of these disputes can take in excess of two years. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. As of December 31, 2013 and 2012, $22.5 million and $20.4 million, or 7.8%, of our patient accounts receivable represented denials by MACs that were in the pre-payment medical necessity review process. During the years ended December 31, 2013, 2012, and 2011, we wrote off $3.5 million, $0.2 million, and $0.5 million, respectively, of previously denied claims while we collected $1.7 million, $4.3 million, and $1.9 million, respectively, of previously denied claims. 55



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The table below shows a summary of our net accounts receivable balances as of December 31, 2013 and 2012. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, "Accounts Receivable and the Allowance for Doubtful Accounts," to the accompanying consolidated financial statements. As of December 31, 2013 2012 (In Millions) 0 - 30 Days $ 194.1$ 178.9 31 - 60 Days 21.7 19.6 61 - 90 Days 10.2 9.4 91 - 120 Days 3.4 4.6 120 + Days 20.0 18.8 Current patients accounts receivable, net 249.4 231.3 Noncurrent patient accounts receivable, net 16.6 - Other accounts receivable 12.4 18.0 Accounts receivable, net $ 278.4$ 249.3 Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers' compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers' compensation risks are insured through a wholly owned insurance subsidiary. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost to settle reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers' compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: • Historical claims experience



• Trending of loss development factors

• Trends in the frequency and severity of claims

• Coverage limits of third-party insurance

• Demographic information

• Statistical confidence levels

• Medical cost inflation • Payroll dollars • Hospital patient census The time period to resolve claims can vary depending upon the jurisdiction and whether the claims are settled or litigated. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. 56



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Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): Net self-insurance reserves as of December 31, 2013: As reported, with 50% statistical confidence level $ 107.7 With 70% statistical confidence level 114.4 Over the past few years, we have experienced volatility in our estimates of prior year claim reserves due primarily to favorable trends in claims and industry-wide loss development trends. We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. With the accumulation of this additional historical data and current favorable trends, when we analyzed our assumptions during our semi-annual review of our self-insurance reserves in the fourth quarter of 2013, we lowered the statistical confidence level used to determine our self-insurance reserves from 70% to 50%. This change, which reflects our current best estimate based on the trends we are experiencing in the resolution of claims, reduced our reserves included in continuing operations by $6.7 million in the fourth quarter of 2013. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management's estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as of October 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our single reporting unit. We assess qualitative factors in our single reporting unit to determine whether it is necessary to perform the first step of the two-step quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not our reporting unit's fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must proceed to Step 1, we would determine the fair value of our reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of our reporting unit determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting unit. The income approach includes the use of our reporting unit's projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management's best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company's stock price. See Note 1, Summary of Significant Accounting Policies, "Goodwill and Other Intangibles," and Note 6, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of our reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic



conditions, limitations on accessing capital, or other developments in

equity and credit markets; • Industry and market considerations and changes in healthcare regulations, including reimbursement and compliance requirements under the Medicare and Medicaid programs; 57



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• Cost factors, such as an increase in labor, supply, or other costs;

• Overall financial performance, such as negative or declining cash flows

or a decline in actual or forecasted revenue or earnings;

• Other relevant company-specific events, such as material changes in

management or key personnel or outstanding litigation;

• Material events, such as a change in the composition or carrying amount

of our reporting unit's net assets, including acquisitions and dispositions; and



• Consideration of the relationship of our market capitalization to our

book value, as well as a sustained decrease in our share price.

In the fourth quarter of 2013, we assessed the qualitative factors described above for our reporting unit and concluded it is more likely than not the fair value of our reporting unit is greater than its carrying amount. As a result of this assessment of qualitative factors, we determined it was not necessary to perform the two-step goodwill impairment test on our reporting unit. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our reporting unit is not at risk for any impairment charges. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, "Income Taxes," and Note 16, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year ended December 31, 2013, we decreased our valuation allowance by $9.1 million. As of December 31, 2013, we had a remaining valuation allowance of $30.7 million which related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the deferred tax assets before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management's estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as of December 31, 2013 will be realized, no such assurances can be provided. If management's expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is 58



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different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, "Litigation Reserves," and Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Item 7A. Quantitative and Qualitative Disclosures about Market Risk Our primary exposure to market risk is to changes in interest rates on our variable rate long-term debt. We use sensitivity analysis models to evaluate the impact of interest rate changes on our variable rate debt. As of December 31, 2013, our primary variable rate debt outstanding related to $45.0 million in advances under our revolving credit facility. Assuming outstanding balances were to remain the same, a 1% increase in interest rates would result in an incremental negative cash flow of approximately $0.4 million over the next 12 months, while a 1% decrease in interest rates would result in an incremental positive cash flow of approximately $0.1 million over the next 12 months, assuming floating rate indices are floored at 0%. 59



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The fair value of our fixed rate debt is determined using inputs, including quoted prices in nonactive markets, that are observable either directly or indirectly, or Level 2 inputs within the fair value hierarchy, and is summarized as follows (in millions):

December 31, 2013 December 31, 2012 Financial Instrument: Book Value Market Value Book Value Market Value 7.25% Senior Notes due 2018 Carrying Value $ 272.4 $ - $ 302.9 $ - Unamortized debt premium (1.0 ) - (1.4 ) - Principal amount 271.4 291.4 301.5 328.6 8.125% Senior Notes due 2020 Carrying Value 286.6 - 286.2 - Unamortized debt discount 3.4 - 3.8 - Principal amount 290.0 319.4 290.0 321.5 7.75% Senior Notes due 2022 Carrying Value 252.5 - 280.7 - Unamortized debt premium (1.4 ) - (1.7 ) - Principal amount 251.1 275.0 279.0 306.5 5.75% Senior Notes due 2024 Carrying Value 275.0 - 275.0 - Unamortized debt discount - - - - Principal amount 275.0 273.6 275.0 277.1 2.00% Convertible Senior Subordinated Notes due 2043 Carrying Value 249.5 - - - Unamortized debt discount 70.5 - - - Principal amount 320.0 339.7 - -



Foreign operations, and the related market risks associated with foreign currencies, are currently, and have been, insignificant to our financial position, results of operations, and cash flows.


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