UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-Q
S  QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2011
OR
£   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to ____________
Commission file number    001–13489
(Exact name of registrant as specified in its Charter)
Delaware		52–2057472
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization		Identification No.)
100 E. Vine Street
Murfreesboro, TN 37130
(Address of principal executive offices)
(Zip Code)
(615) 890–2020
Registrant's telephone number, including area code
Indicate by check mark whether the registrant: (1) Has filed all reports required to be filed by Section 13 or 15(d), of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  S No. £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such period that the registrant was required to submit and post such files). Yes S      No  £ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of "large accelerated file," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.  (Check one):
Large Accelerated filer  £	Accelerated filer  S
Non-accelerated filer (Do not check if a smaller reporting company)  £	Smaller reporting company  £
Indicate by check mark whether the registrant is a shell company (as is defined in Rule 12b–2 of the Exchange
Act).  Yes  £   No S
13,831,995 shares of common stock of the registrant were outstanding as of August 3, 2011

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements.

NATIONAL HEALTHCARE CORPORATION

Interim Condensed Consolidated Statements of Income

(Unaudited)

(in thousands, except share and per share amounts)

					Three Months Ended June 30						Six Months Ended June 30
					2011			2010			2011			2010
REVENUES:
	Net patient revenues			$	176,844		$	162,848		$	354,397		$	320,809
	Other revenues				13,939			14,074			29,334			29,437
		Net operating revenues			190,783			176,922			383,731			350,246
COSTS AND EXPENSES:
	Salaries, wages and benefits				104,793			97,680			213,555			193,756
	Other operating				51,888			48,358			93,277			97,361
	Facility rent				9,879			9,457			19,744			18,922
	Depreciation and amortization				7,075			6,663			14,037			13,090
	Interest				108			146			197			260
		Total costs and expenses			173,743			162,304			340,810			323,389
Income Before Non-Operating Income					17,040			14,618			42,921			26,857
Non-Operating Income					5,155			4,959			9,716			9,534
Income Before Income Taxes					22,195			19,577			52,637			36,391
Income Tax Provision					(8,584)			(7,727)			(20,302)			(14,134)
Net Income					13,611			11,850			32,335			22,257
Dividends to preferred stockholders					(2,168)			(2,168)			(4,336)			(4,336)
Net income available to common stockholders				$	11,443		$	9,682		$	27,999		$	17,921
Earnings Per Common Share:
	Basic			$	.83		$	.70		$	2.04		$	1.30
	Diluted			$	.83		$	.70		$	1.97		$	1.30
Weighted Average Common Shares Outstanding:
	Basic				13,796,715			13,746,482			13,738,748			13,734,095
	Diluted				13,816,191			13,747,450			16,383,703			13,736,395

The accompanying notes to interim condensed consolidated financial statements are an integral part of these consolidated statements.

2

NATIONAL HEALTHCARE CORPORATION

Interim Condensed Consolidated Balance Sheets

 (in thousands)

					June 30, 2011			December 31, 2010
					(unaudited)
Assets
	Current Assets:
		Cash and cash equivalents			$	37,331		$	28,478
		Restricted cash and cash equivalents				50,199			51,992
		Marketable securities				85,127			85,116
		Restricted marketable securities				78,059			70,877
		Accounts receivable, less allowance for doubtful accounts of $3,803 and $3,942, respectively				66,078			76,559
		Inventories				7,639			7,853
		Prepaid expenses and other assets				2,465			1,251
			Total current assets			326,898			322,126
	Property and Equipment:
		Property and equipment, at cost				653,501			640,150
		Accumulated depreciation and amortization				(218,400)			(203,758)
			Net property and equipment			435,101			436,392
	Other Assets:
		Deposits				402			302
		Goodwill				20,320			20,320
		Notes receivable				22,532			23,671
		Deferred income taxes				12,310			12,000
		Investments in limited liability companies				16,000			14,204
			Total other assets			71,564			70,497
			Total assets		$	833,563		$	829,015

The accompanying notes to interim condensed consolidated financial statements are an integral part of these consolidated statements.

The interim condensed consolidated balance sheet at December 31, 2010 is taken from the audited consolidated financial statements at that date.

3

NATIONAL HEALTHCARE CORPORATION

Interim Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

						June 30, 2011			December 31, 2010
						(unaudited)
Liabilities and Stockholders’ Equity
	Current Liabilities:
		Trade accounts payable			$	11,847		$	10,947
		Accrued payroll				37,797			52,055
		Amounts due to third party payors				17,706			17,667
		Accrued risk reserves				92,242			105,059
		Deferred income taxes				14,356			14,186
		Other current liabilities				17,608			17,895
		Dividends payable				6,344			5,997
			Total current liabilities			197,900			223,806
	Long-Term Debt					10,000			10,000
	Other Noncurrent Liabilities					18,903			18,861
	Deferred Lease Credits					606			1,212
	Deferred Revenue					15,649			13,990
	Commitments, Contingencies and Guarantees
	Stockholders’ Equity:
		Series A Convertible Preferred Stock; $.01 par value; 25,000,000 shares authorized; 10,838,526 and 10,840,608 shares, respectively, issued and outstanding; stated at liquidation of $15.75 per share				170,515			170,548
		Common stock, $.01 par value; 30,000,000 shares authorized; 13,831,995 and 13,637,258 shares, respectively, issued and outstanding				138			136
		Capital in excess of par value				137,117			128,061
		Retained earnings				246,098			226,114
		Unrealized gains on marketable securities, net of taxes				36,637			36,287
			Total stockholders’ equity			590,505			561,146
			Total liabilities and stockholders’ equity		$	833,563		$	829,015

The accompanying notes to interim condensed consolidated financial statements are an integral part of these consolidated statements.

The interim condensed consolidated balance sheet at December 31, 2010 is taken from the audited consolidated financial statements at that date.

4

NATIONAL HEALTHCARE CORPORATION

Interim Condensed Consolidated Statements of Cash Flows

(Unaudited)

							Six Months Ended June 30
							2011			2010
Cash Flows From Operating Activities:							(in thousands)
	Net income					$	32,335		$	22,257
	Adjustments to reconcile net income to net cash
		provided by operating activities:
		Depreciation and amortization					14,037			13,090
		Provision for doubtful accounts receivable					1,033			904
		Equity in earnings of unconsolidated investments					(4,738)			(4,483)
		Distributions from unconsolidated investments					2,942			3,643
		Gains on sale of restricted marketable securities					(164)			(258)
		Deferred income taxes					(328)			(1,121)
		Stock-based compensation					1,753			87
		Changes in operating assets and liabilities:
			Restricted cash and cash equivalents				(3,438)			(5,301)
			Accounts receivable				9,448			(8,796)
			Income tax receivable				-			3,470
			Inventories				214			(963)
			Prepaid expenses and other assets				(1,214)			(1,093)
			Trade accounts payable				900			(306)
			Accrued payroll				(14,258)			(6,237)
			Amounts due to third party payors				39			1,233
			Other current liabilities and accrued risk reserves				(13,104)			1,142
			Entrance fee deposits				(449)			(549)
			Other noncurrent liabilities				42			678
			Deferred income				2,108			2,168
				Net cash provided by operating activities			27,158			19,565
Cash Flows From Investing Activities:
		Additions to and acquisitions of property and equipment					(13,352)			(11,665)
		Acquisition of homecare business					-			(14,342)
		Collections of notes receivable					1,139			759
		Change in restricted cash and cash equivalents					5,231			48,356
		Purchase of restricted marketable securities					(30,023)			(64,443)
		Sale of restricted marketable securities					23,532			15,592
				Net cash used in investing activities			(13,473)			(25,743)
Cash Flows From Financing Activities:
		Tax benefit from stock-based compensation					120			189
		Dividends paid to preferred stockholders					(4,336)			(4,336)
		Dividends paid to common stockholders					(7,668)			(7,132)
		Issuance of common shares					7,152			1,009
		Change in deposits					(100)			13
		Other					-			(24)
				Net cash used in financing activities			(4,832)			(10,281)
Net Increase (Decrease) in Cash and Cash Equivalents							8,853			(16,459)
Cash and Cash Equivalents, Beginning of Period							28,478			39,022
Cash and Cash Equivalents, End of Period						$	37,331		$	22,563

 The accompanying notes to interim condensed consolidated financial statements are an integral part of these consolidated statements.

5

NATIONAL HEALTHCARE CORPORATION

Interim Condensed Consolidated Statements of Stockholders’ Equity

(in thousands, except share and per share amounts)

(unaudited)

			Preferred Stock				Common Stock				Capital in Excess of Par Value		Retained Earnings		Unrealized Gains on Marketable Securities		Total Stock-holders’ Equity
			Shares		Amount		Shares		Amount
Balance at December 31, 2009			10,841,062	$	170,555		13,717,701	$	137	$	130,867	$	197,140	$	27,080	$	525,779
	Net income		–		–		–		–		–		22,257		–		22,257
	Unrealized gains on securities (net of tax of $1,323)		–		–		–		–		–		–		2,232		2,232
	Total comprehensive income																24,489
	Stock-based compensation		–		–		30,000		–		87		–		–		87
	Tax benefit from exercise of stock options		–		–		–		–		189		–		–		189
	Shares sold - options exercised		–		–		30,764		1		1,008		–		–		1,009
	Shares issued in conversion of preferred stock to common stock		(448)		(7)		107		–		7		–		–		–
	Dividends declared to preferred stockholders ($0.40 per share)		–		–		–		–		–		(4,336)		–		(4,336)
	Dividends declared to common stockholders ($0.54 per share)		–		–		–		–		–		(7,430)		–		(7,430)
Balance at June 30, 2010			10,840,614	$	170,548		13,778,572	$	138	$	132,158	$	207,631	$	29,312	$	539,787
Balance at December 31, 2010			10,840,608	$	170,548		13,637,258	$	136	$	128,061	$	226,114	$	36,287	$	561,146
	Net income		–		–		–		–		–		32,335		–		32,335
	Unrealized gains on securities (net of tax of $187)		–		–		–		–		–		–		350		350
	Total comprehensive income																32,685
	Stock-based compensation		–		–		–		–		1,753		–		–		1,753
	Tax benefit from exercise of stock options		–		–		–		–		120		–		–		120
	Shares sold – options exercised		–		–		194,234		2		7,150		–		–		7,152
	Shares issued in conversion of preferred stock to common stock		(2,082)		(33)		503		–		33		–		–		–
	Dividends declared to preferred stockholders ($0.40 per share)		–		–		–		–		–		(4,336)		–		(4,336)
	Dividends declared to common stockholders ($0.58 per share)		–		–		–		–		–		(8,015)		–		(8,015)
Balance at June 30, 2011			10,838,526	$	170,515		13,831,995	$	138	$	137,117	$	246,098	$	36,637	$	590,505

The accompanying notes to interim condensed consolidated financial statements are an integral part of these consolidated statements.

6

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Note 1 – Description of Business

National HealthCare Corporation (“NHC” or the “Company”) is a leading provider of long-term health care services.  We operate or manage, through certain affiliates, 76 long-term health care centers with 9,548 beds in 10 states and provide other services in one additional state.  These operations are provided by separately funded and maintained subsidiaries.  We provide long-term health care services to patients in a variety of settings including long-term nursing centers, managed care specialty units, sub-acute care units, Alzheimer's care units, hospice programs, homecare programs, assisted living centers and independent living centers.  In addition, we provide insurance services, management and accounting services, and lease properties to operators of long-term health care centers.

Note 2 – Summary of Significant Accounting Policies

The listing below is not intended to be a comprehensive list of all of our significant accounting policies.  In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with limited need for management’s judgment in their application.  There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.  See our audited December 31, 2010 consolidated financial statements and notes thereto which contain accounting policies and other disclosures required by generally accepted accounting principles.  Our audited December 31, 2010 consolidated financial statements are available at our web site: www.nhccare.com.

Basis of Presentation

The unaudited condensed consolidated financial statements to which these notes are attached include all normal, recurring adjustments which are necessary to fairly present the financial position, results of operations and cash flows of NHC.  All significant intercompany transactions and balances have been eliminated in consolidation.  We assume that users of these interim financial statements have read or have access to the audited December 31, 2010 consolidated financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations and that the adequacy of additional disclosure needed for a fair presentation, except in regard to material contingencies, may be determined in that context. Accordingly, footnotes and other disclosures which would substantially duplicate the disclosure contained in our most recent annual report to stockholders have been omitted.  This interim financial information is not necessarily indicative of the results that may be expected for a full year for a variety of reasons.  

Estimates and Assumptions

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

Revenue Recognition – Third Party Payors

Approximately 70% of our net patient revenues are derived from Medicare, Medicaid, and other government programs.  Amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries or their agents.  In our opinion, adequate provision has been made for any adjustments that may result from these reviews.  Any differences between our original estimates of reimbursements and subsequent revisions are reflected in operations in the period in which the revisions are made often due to final determination or the period of payment no longer being subject to audit or review.  We have made provisions of approximately $17,706,000 and $17,667,000 as of June 30, 2011 and December 31, 2010, respectively, for various Medicare and Medicaid current and prior year cost reports and claims reviews.  

7

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Revenue Recognition - Private Pay

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

Revenue Recognition - Subordination of Fees and Uncertain Collections

We provide management services to certain long-term care facilities and to others we provide accounting and financial services.  We generally charge 6% to 7% of net revenues for our management services and a predetermined fixed rate per bed for the accounting and financial services.  Our policy is to recognize revenues associated with both management services and accounting and financial services on an accrual basis as the services are provided.  However, under the terms of our management contracts, payments for our management services are subject to subordination to other expenditures of the long-term care center being managed.  Furthermore, for certain of the third parties with whom we have contracted to provide services and which we have determined, based on insufficient historical collections and the lack of expected future collections, that collection is not reasonably assured, our policy is to recognize income only in the period in which the amounts are realized.  We may receive payment for the unpaid and unrecognized management fees in whole or in part in the future only if cash flows from the operating and investing activities of the centers or proceeds from the sale of the centers are sufficient to pay the fees.  There can be no assurance that such future cash flows will occur.  The realization of such previously unrecognized revenue could cause our reported net income to vary significantly from period to period.

We agree to subordinate our fees to the other expenses of a managed center because we believe we know how to improve the quality of patient services and finances of a long-term care center and because subordinating our fees demonstrates to the owner and employees of the managed center how confident we are of the impact we can have in making the center operations successful.  We may continue to provide services to certain managed centers despite not being fully paid currently so that we may be able to collect unpaid fees in the future from improved operating results and because the incremental savings from discontinuing services to a center may be small compared to the potential benefit.  Also, we may benefit from providing other ancillary services to the managed center.  

Accrued Risk Reserves  

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

Professional liability remains an area of particular concern to us.  The entire long term care industry has seen a dramatic increase in personal injury/wrongful death claims based on alleged negligence by nursing homes and their employees in providing care to residents.  As of June 30, 2011, we and/or our managed centers are defendants in 24 such claims inclusive of years 2002 through 2011.  It remains possible that those pending matters plus potential unasserted claims could exceed our reserves, which could have a material adverse effect on our financial position, results of operations and cash flows.  It is also possible that future events could cause us to make significant adjustments or revisions to these reserve estimates and cause our reported net income to vary significantly from period to period.  

We maintain insurance coverage for incidents occurring in all providers owned or leased by us.  The coverages include both primary policies and excess policies.  In all years, settlements, if any, in excess of available insurance policy limits and our own reserves would be expensed by us.

8

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Credit Losses  

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

We continually monitor and evaluate the carrying amount of our notes receivable in accordance with ASC Topic 310, Receivables.  It is possible, however, that the accuracy of our estimation process could be materially impacted as the composition of the receivables changes over time.  We continually review and refine our estimation process to make it as reactive to these changes as possible.  However, we cannot guarantee that we will be able to accurately estimate credit losses on these balances.  It is possible that future events could cause us to make significant adjustments or revisions to these estimates and cause our reported net income to vary significantly from period to period.   

Uncertain Tax Positions

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

New Accounting Pronouncements

In July 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-07, which is included in the Codification under ASC 954, “Health Care Entities.”  This updated guidance requires healthcare organizations that perform services for patients for which the ultimate collection of all or a portion of the amounts billed or billable cannot be determined at the time services are rendered to present all bad debt expense associated with patient service revenue as an offset to the patient service revenue line item in the statement of operations. The ASU also requires certain qualitative disclosures about the Company’s policy for recognizing revenue and bad debt expense for patient service transactions. This update is effective for fiscal years beginning after December 15, 2011, and will be adopted by the Company in the first quarter of 2012. The Company is currently assessing the potential impact of the adoption and believes the adoption will not have a material impact on the Company’s consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, which is included in the Codification under ASC 220, “Comprehensive Income.”  This updated guidance requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  This standard is required to be applied retrospectively and is effective for fiscal years beginning after December 15, 2011, and will be adopted by the Company in the first quarter of 2012.  The Company has not yet determined which method it will elect upon adoption.

In May 2011, the FASB issued ASU No. 2011-04, which is included in the Codification under ASC 820, “Fair Value Measurement.”  The amendments in this update result in common fair value measurement and disclosure requirements in U.S. GAAP and International Financial Reporting Standards (IFRS).  The amendments are effective for fiscal years beginning after December 15, 2011, and will be adopted by the Company in the first quarter of 2012.  We believe this adoption will not have a material impact on the Company’s consolidated financial statements.  

In April 2011, the FASB issued ASU No. 2011-02, which is included in the Codification under ASC 470, “Debt.”  This updated guidance clarifies when a loan modification or restructuring is considered a troubled debt restructuring (TDR).  This new guidance is effective for the first interim or annual period beginning on or after June 15, 2011, and will be adopted by the Company in the third quarter of 2011. We are currently evaluating the new requirements; however, we do not expect the adoption to have a material effect on our consolidated financial statements.

9

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

In December 2010, the FASB issued ASU No. 2010-29, which is included in the Codification under ASC 805, “Business Combinations.” This update provides guidance on the disclosure of supplemental pro forma information for business combinations. This guidance became effective for our interim and annual reporting periods beginning January 1, 2011. The adoption of this guidance did not have a material impact on our condensed consolidated financial statements.

Also in December 2010, the FASB issued ASU No. 2010-28, which is included in the Codification under ASC 350, “Intangibles – Goodwill and Other.” This update provides guidance on applying the goodwill impairment test for reporting units with zero or negative carrying amounts. This guidance became effective for our interim and annual reporting periods beginning January 1, 2011. The adoption of this guidance did not have a material impact on our condensed consolidated financial statements.

In August 2010, the FASB issued ASU No. 2010-24, which is included in the Codification under ASC 954, “Health Care Entities”.  This update provides clarification to companies in the healthcare industry on the accounting for professional liability and workers’ compensation insurance.  This update states that receivables related to insurance recoveries should not be netted against the related claim liability and such claim liabilities should be determined without considering insurance recoveries.  This guidance became effective for our interim and annual reporting periods beginning January 1, 2011.  The adoption of this guidance did not have a material impact on our condensed consolidated financial statements.

Reclassifications

Certain prior period amounts have been reclassified to conform to the current financial statement presentation, with no effect on the Company’s financial position or results of operations.

Note 3 – Other Revenues

Other revenues are outlined in the table below.  Revenues from insurance services include premiums for workers’ compensation, health insurance, and professional liability insurance policies that our wholly-owned limited purpose insurance subsidiaries have written for certain long-term health care centers to which we provide management or accounting services. Revenues from management and accounting services include management and accounting fees provided to managed and other long-term health care centers. Revenues from rental income include health care real estate properties owned by us and leased to third party operators.  "Other" revenues include miscellaneous health care related earnings.

Other revenues include the following:

			Three Months Ended June 30						Six Months Ended    June 30
(in thousands)			2011			2010			2011			2010
Insurance services		$	4,011		$	4,361		$	8,096		$	8,750
Management and accounting services fees			4,731			4,862			10,623			11,070
Rental income			4,753			4,435			9,612			8,771
Other			444			416			1,003			846
		$	13,939		$	14,074		$	29,334		$	29,437

 

Management Fees from National

Certain of our affiliates manage five long-term care centers owned by National Health Corporation ("National"). During the six months ended June 30, 2011 and 2010, we recognized management fees and interest on management fees of $1,793,000 and $2,248,000, respectively, from these centers.  

10

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

The unpaid fees from the five centers owned by National, because the amount collectable could not be reasonably determined when the management services were provided, and because we cannot estimate the timing or amount of expected future collections, will be recognized as revenues only when fixed or determinable and collectibility of these fees can be reasonably assured.  Under the terms of our management agreement with National, the payment of these fees to us may be subordinated to other expenditures of the five long-term care centers.  We continue to manage these centers so that we may be able to collect our fees in the future and because the incremental savings from discontinuing services to a center may be small compared to the potential benefit.  We may receive payment for the unrecognized management fees in whole or in part in the future only if cash flows from the operating and investing activities of the five centers or the proceeds from the sale of the centers are sufficient to pay the fees.  There can be no assurance that such future improved cash flows will occur.  

Management Fees from Other Nursing Centers

We continue to manage eight long-term care centers (excluding the five National centers) for third-party owners where the management fees are recognized only when realized.  During the six months ended June 30, 2011 and 2010, we recognized $755,000 and $505,000, respectively, of management fees and interest from these eight long-term care centers.  

The unpaid fees from these eight centers, because of insufficient historical collections and the lack of expected future collections, are recognized only when realized.  Under the terms of the management agreements, the payment of these fees to us may be subordinated to other expenditures of each of the long-term care centers.  Our affiliates continue to manage these centers so that we may be able to collect our fees in the future and because the incremental savings from discontinuing services to a center may be small compared to the potential benefit.  We may receive payment for the unrecognized management fees in whole or in part in the future only if cash flows from operating and investing activities of the centers or the proceeds from the sale of the centers are sufficient to pay the fees.  There can be no assurance that such future improved cash flows will occur.  

Rental Income

The health care properties currently owned and leased to third party operators include nine skilled nursing facilities and four assisted living communities.  Effective January 1, 2011, we renewed the rental agreements with the third party operators.  The rental agreements continue for a five year period ending on December 31, 2015.

Note 4 - Non-Operating Income

Non-operating income is outlined in the table below.  Non-operating income includes equity in earnings of unconsolidated investments, dividends and other realized gains and losses on securities, and interest income.  Our most significant equity method investment is a 57.4% non-controlling ownership interest in Caris HealthCare L.P., a business that specializes in hospice care services.  

			Three Months Ended June 30						Six Months Ended June 30
(in thousands)			2011			2010			2011		2010
Equity in earnings of unconsolidated investments		$	2,657		$	2,225		$	4,738	$	4,483
Dividends and other net realized gains and losses on sales of securities			1,248			1,323			2,519		2,463
Interest income			1,250			1,411			2,459		2,588
		$	5,155		$	4,959		$	9,716	$	9,534

11

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Note 5 – Other Operating Expenses

Other operating expenses include the costs of care and services that we provide to the residents of our facilities and the costs of maintaining our facilities.  Our primary patient care costs include drugs, medical supplies, purchased professional services, food, and professional liability insurance and licensing fees.  The primary facility costs include utilities and property insurance.  For the six months ended June 30, 2011, the decrease in other operating expense is primarily due to the favorable results within our accrued risk reserves of approximately $8,269,000 compared to the same period a year ago.

Note 6 – Earnings per Share

Basic net income per share is computed based on the weighted average number of common shares outstanding for each period presented.  Diluted net income per share reflects the potential dilution that would have occurred if securities to issue common stock were exercised, converted, or resulted in the issuance of common stock that would have then shared in our earnings.  

The following table summarizes the earnings and the weighted average number of common shares used in the calculation of basic and diluted earnings per share.

			Three Months Ended June 30						Six Months Ended June 30
(in thousands, except for share and per share amounts)			2011			2010			2011		2010
Basic:
Weighted average common shares outstanding			13,796,715			13,746,482			13,738,748		13,734,095
Net income		$	13,611		$	11,850		$	32,335	$	22,257
Dividends to preferred stockholders			(2,168)			(2,168)			(4,336)		(4,336)
Net income available to common stockholders			11,443			9,682			27,999		17,921
Earnings per common share, basic		$	.83		$	.70		$	2.04	$	1.30
Diluted:
Weighted average common shares outstanding			13,796,715			13,746,482			13,738,748		13,734,095
Dilutive effect of stock options			14,368			–			14,464		1,816
Dilutive effect of restricted stock			5,108			968			6,939		484
Convertible preferred stock			–			–			2,623,552		–
Assumed average common shares outstanding			13,816,191			13,747,450			16,383,703		13,736,395
Net income available to common stockholders		$	11,443		$	9,682		$	27,999	$	17,921
Add dilutive preferred stock dividends for effect of assumed conversion of preferred stock			–			–			4,336		–
Net income for diluted earnings per common share			11,443			9,682			32,335		17,921
Earnings per common share, diluted		$	.83		$	.70		$	1.97	$	1.30

In the above table, 1,394,379 and 515,007 options to purchase our common stock have been excluded for 2011 and 2010, respectively, due to their anti-dilutive impact.  We have excluded 2,623,552 and 2,623,971 of potential common shares issuable upon the conversion of preferred stock for the three month period ended June 30, 2011 and for both periods presented in 2010 due to their anti-dilutive impact, respectively.

Note 7 - Investments in Marketable Securities

Our investments in marketable securities are classified as available for sale securities.  Realized gains and losses from securities sales are determined on the specific identification of the securities.

12

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Marketable securities and restricted marketable securities consist of the following:

				June 30, 2011						December 31, 2010
(in thousands)				Amortized Cost			Fair Value			Amortized   Cost			Fair Value
Investments available for sale:
	Marketable equity securities		$	29,604		$	85,127		$	29,604		$	85,116
Restricted investments available for sale:
	Corporate debt securities			32,729			33,399			28,683			29,182
	Commercial mortgage-backed securities			30,966			31,677			26,282			26,866
	U.S. Treasury securities			6,388			6,381			8,192			8,030
	U.S. government sponsored enterprise securities			–			–			2,340			2,423
	State and municipal securities			6,421			6,602			4,348			4,376
			$	106,108		$	163,186		$	99,449		$	155,993

Included in the available for sale marketable equity securities are the following:

(in thousands, except share amounts)

		June 30, 2011								December 31, 2010
		Shares			Cost			Fair Value		Shares			Cost			Fair Value
NHI Common Stock		1,630,642		$	24,734		$	72,449		1,630,642		$	24,734		$	73,412

The amortized cost and estimated fair value of debt securities classified as available for sale, by contractual maturity, are as follows:

			June 30, 2011						December 31, 2010
(in thousands)			Cost			Fair Value			Cost			Fair Value
Maturities:
Within 1 year		$	5,997		$	6,035		$	3,551		$	3,562
1 to 5 years			48,097			49,179			46,461			47,340
6 to 10 years			21,488			21,898			18,313			18,454
Over 10 years			922			947			1,520			1,521
		$	76,504		$	78,059		$	69,845		$	70,877

Gross unrealized gains related to available for sale securities are $57,227,000 and $56,911,000 as of June 30, 2011 and December 31, 2010, respectively.  Gross unrealized losses related to available for sale securities were $149,000 and $367,000 as of June 30, 2011 and December 31, 2010, respectively.

Proceeds from the sale of investments in marketable securities during the six months ended June 30, 2011 and 2010 were $23,532,000 and $15,592,000, respectively.  Investment gains of $164,000 and $258,000 were realized on these sales during the six months ended June 30, 2011 and 2010, respectively.

Note 8 - Fair Value Measurements

The carrying amounts of cash and cash equivalents, restricted cash and cash equivalents, accounts receivable, and accounts payable approximate fair value due to their short-term nature.  The estimated fair value of notes receivable approximates the carrying value based principally on their underlying interest rates and terms, maturities, collateral and

13

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

credit status of the receivables.  Our long-term debt approximates fair value due to variable interest rates.  At June 30, 2011 and December 31, 2010, there were no material differences between the carrying amounts and fair values of NHC’s financial instruments stated above.    

The accounting standard for fair value measurements provides a framework for measuring fair value and requires expanded disclosures regarding fair value measurements.  Fair value is defined as the price that would be received for an asset or the exit price that would be paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date.  This accounting standard establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs, where available.  The following summarizes the three levels of inputs that may be used to measure fair value:

Level 1 – The valuation is based on quoted prices in active markets for identical instruments.

Level 2 – The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.  

Level 3 – The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument.  Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  

The Company determines fair value for marketable securities with Level 1 inputs through quoted market prices.  The Company determines fair value for marketable securities with Level 2 inputs through broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency.  Our Level 2 marketable securities have been initially valued at the transaction price and subsequently valued, at the end of each month, typically utilizing third party pricing services or other market observable data.  The pricing services utilize industry standard valuation models, including both income and market based approaches and observable market inputs to determine value.  These observable market inputs include reportable trades, benchmark yields, credit spreads, broker/dealer quotes, bids, offers, and other industry and economic events.  We did not have any transfers of assets between Level 1 and Level 2 of the fair value measurement hierarchy during the six months ended June 30, 2011.  

The following table summarizes fair value measurements by level at June 30, 2011 and December 31, 2010 for assets and liabilities measured at fair value on a recurring basis (in thousands):

		Fair Value Measurements Using
June 30, 2011		Fair Value		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Cash and cash equivalents	$	37,331	$	37,331	$	–	$	–
Restricted cash and cash equivalents		50,199		50,199		–		–
Marketable equity securities		85,127		85,127		–		–
Corporate debt securities		33,399		–		33,399		–
Commercial mortgage-backed securities		31,677		–		31,677		–
U.S. Treasury securities		6,381		6,381		–		–
State and municipal securities		6,602		–		6,602		–
Total financial assets	$	250,716	$	179,038	$	71,678	$	–

14

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

		Fair Value Measurements Using
December 31, 2010		Fair Value		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Cash and cash equivalents	$	28,478	$	28,478	$	–	$	–
Restricted cash and cash equivalents		51,992		51,992		–		–
Marketable equity securities		85,116		85,116		–		–
Corporate debt securities		29,182		–		29,182		–
Commercial mortgage-backed securities		26,866		–		26,866		–
U.S. Treasury securities		8,030		8,030		–		–
U.S. government sponsored enterprise securities		2,423		–		2,423		–
State and municipal securities		4,376		–		4,376		–
Total financial assets	$	236,463	$	173,616	$	62,847	$	–

Note 9 - Long-Term Debt and Commitments

Long-term debt consists of the following:

		Weighted Average Interest Rate		Maturities			Long-Term Debt
(dollars in thousands)							6/30/11			12/31/10
Revolving Credit Facility, interest payable monthly		Variable, 1.19%		2011		$	–		$	–
Unsecured term note payable to National, interest payable quarterly, principal payable at maturity		Variable, 2.8%		2018			10,000			10,000
							10,000			10,000
Less current portion							–			–
						$	10,000		$	10,000

Note 10 - $75,000,000 Revolving Credit Facility

 Effective October 26, 2010, we extended the maturity of our Credit Agreement (the "Credit Agreement") with Bank of America, N.A., as lender (the "Lender").  The Credit Agreement provides for a $75,000,000 revolving credit facility (the "Credit Facility"), of which up to $5,000,000 may be utilized for letters of credit.  

Borrowings bear interest at either (i) the Eurodollar rate plus 1.00% or (ii) the prime rate.  Letter of credit fees are equal to 1.00% times the maximum amount available to be drawn under outstanding letters of credit.  The rates and fees are unchanged from those in effect prior to the extension.

15

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Commitment fees are payable on the daily unused portion of the Credit Facility at a rate of twenty (20) basis points per annum.  NHC is permitted to prepay the loans outstanding under the Credit Facility at any time, without penalty.  

The Credit Facility matures on October 25, 2011.  We currently anticipate renewing the credit agreement at that time and while we have had no indication from the lender that there is any question about renewal, there has been no commitment at this time.  If the Lender elects to consent to such extension, subject to certain conditions, the maturity date will be extended to the date which is 364 days after the then maturity date.

 NHC’s obligations under the Credit Agreement are guaranteed by certain NHC subsidiaries and are secured by pledges by NHC and the guarantors of (i) 100% of the equity interests of domestic subsidiaries and (ii) up to 65% of the voting equity interests and 100% of the non-voting equity interests of foreign subsidiaries, in each case, held by NHC or the guarantors.

The Credit Agreement contains customary representations and warranties, and covenants, including covenants that restrict, among other things, asset dispositions, mergers and acquisitions, dividends, restricted payments, debt, liens, investments and affiliate transactions.  The Credit Agreement contains customary events of default.

The Credit Facility is available for general corporate purposes, including working capital and acquisitions.

Note 11 – Stock-Based Compensation

NHC recognizes stock-based compensation for all stock options and restricted stock granted over the requisite service period using the fair value for these grants as estimated at the date of grant either using the Black-Scholes pricing model for stock options or the quoted market price for restricted stock.

The 2005 and 2010 Stock-Based Compensation Plans

The Compensation Committee of the Board of Directors (“the Committee”) has the authority to select the participants to be granted options; to designate whether the option granted is an incentive stock option (“ISO”), a non–qualified option, or a stock appreciation right; to establish the number of shares of common stock that may be issued upon exercise of the option; to establish the vesting provision for any award; and to establish the term any award may be outstanding.  The exercise price of any ISO’s granted will not be less than 100% of the fair market value of the shares of common stock on the date granted and the term of an ISO may not be any more than ten years.  The exercise price of any non–qualified options granted will not be less than 100% of the fair market value of the shares of common stock on the date granted unless so determined by the Committee.

In May 2005, our stockholders approved the 2005 Stock Option, Employee Stock Purchase, Physician Stock Purchase and Stock Appreciation Rights Plan (“the 2005 Plan”) pursuant to which 1,200,000 shares of our common stock were available to grant as stock-based payments to key employees, directors, and non-employee consultants.  In March 2011, the Company granted stock options to purchase 756,583 shares of our common stock in accordance with the 2005 Plan.  These particular stock options become vested and exercisable thirty days prior to the expiration date of the options, which is five years after the date of grant.  At June 30, 2011, 30,000 shares were available for future grants under the 2005 Plan.

In May 2010, our stockholders approved the 2010 Omnibus Equity Incentive Plan (“the 2010 Plan”) pursuant to which 1,200,000 shares of our common stock were available to grant as stock-based payments to key employees, directors, and non-employee consultants.  In March 2011, the Company granted stock options to purchase 443,417 shares of common stock in accordance with the 2010 Plan.  These particular stock options become vested and exercisable thirty days prior to the expiration date of the options, which is five years after the date of the grant. In May 2011, the Company granted non-employee directors stock options to purchase 45,000 shares of common stock in accordance with the 2010 Plan.  These particular stock options became vested and exercisable immediately and have a maximum five year term.  At

16

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

June 30, 2011, 534,824 shares were available for future grants under the 2010 Plan.

Compensation expense is recognized only for the awards that ultimately vest.  Stock-based compensation totaled $1,753,000 and $87,000 for the six months ended June 30, 2011 and 2010, respectively.  The expense for the 2011 period increased $771,000 due to the Company choosing to accelerate the vesting date of options to purchase 158,000 shares of stock that were granted in June 2010.  The options had an original vesting date in June 2015.  At June 30, 2011, we had $8,972,000 of unrecognized compensation cost related to unvested stock-based compensation awards, which consisted of $8,176,000 for stock options and $796,000 for restricted stock.  This expense will be recognized over the remaining weighted average vesting period, which is approximately 4.6 years for stock options and 2.3 years for restricted stock.  Stock-based compensation is included in “Salaries, wages and benefits” in the Interim Condensed Consolidated Statements of Income.

Stock Options

The following table summarizes the assumptions used to value the options granted for the six months ended June 30, 2011 and for the year ended December 31, 2010.

		2011		2010
Risk-free interest rate		2.02%		1.88%
Expected volatility		23.66%		25.30%
Expected life, in years		4.9 years		4.5 years
Expected dividend yield		3.62%		3.55%
Expected forfeiture rate		0.00%		0.00%

The following table summarizes our outstanding stock options for the six months ended June 30, 2011 and for the year ended December 31, 2010.  

		Number of Shares			Weighted Average Exercise Price			Aggregate Intrinsic Value
Options outstanding at December 31, 2009		385,305		$	44.78
Options granted		180,485			35.55
Options exercised		(72,149)			36.69
Options cancelled or expired		(21,314)			32.01
Options outstanding at December 31, 2010		472,327			43.07
Options granted		1,263,843			46.65
Options exercised		(194,234)			36.82
Options cancelled or expired		(30,000)			44.25
Options outstanding at June 30, 2011		1,511,936		$	46.84		$	4,545,000
Options exercisable at June 30, 2011		293,177		$	47.50		$	1,031,000

Options Outstanding June 30, 2011		Exercise Prices		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life in Years
72,557		$37.70		$37.70		2.8
1,263,759		$45.80 - $46.69		$46.65		4.6
175,620		$51.50 - $52.50		$51.99		1.3
1,511,936				$46.84		4.1

17

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Restricted Stock

The following table summarizes our restricted stock activity for the six months ended June 30, 2011 and for the year ended December 31, 2010.

		Number of Shares			Weighted Average Grant Date Fair Value		Aggregate Intrinsic Value
Unvested restricted shares at December 31, 2009		–		$	–
Award shares granted		30,000			34.46
Award shares vested		–			–
Unvested restricted shares at December 31, 2010		30,000			34.46
Award shares granted		–			–
Award shares vested		6,000			34.46
Unvested restricted shares at June 30, 2011		24,000		$	34.46	$	363,000

The weighted average remaining contractual life of restricted stock at June 30, 2011 is 2.3 years.

Note 12 – Accounting for Uncertainty in Income Taxes

NHC continually evaluates for uncertain tax positions.  Uncertain tax positions may arise where tax laws may allow for alternative interpretations or where the timing of recognition of income is subject to judgment.  We believe we have made adequate provision for unrecognized tax benefits related to uncertain tax positions.  However, because of uncertainty of interpretation by various tax authorities and the possibility that there are issues that have not been recognized by management, we cannot guarantee we have accurately estimated our tax liabilities.  We believe that our liabilities reflect the anticipated outcome of known uncertain tax positions in conformity with ASC Topic 740, Income Taxes.  Our liabilities for unrecognized tax benefits are presented in the consolidated balance sheets within Other Noncurrent Liabilities.

At June 30, 2011, we had $14,721,000 of unrecognized tax benefits, composed of $9,258,000 of deferred tax assets, $-0- of deferred tax liabilities, and $5,463,000 of permanent differences.  Accrued interest and penalties of $4,182,000 relate to unrecognized tax benefits at June 30, 2011.  Unrecognized tax benefits of $5,463,000, net of federal benefit, at June 30, 2011, attributable to permanent differences, would favorably impact our effective tax rate if recognized.  Accrued interest and penalties of $2,161,000 relate to these permanent differences at June 30, 2011.  We do not expect to recognize significant increases or decreases in unrecognized tax benefits within twelve months beginning June 30, 2011, except for the effect of decreases related to the lapse of statute of limitations estimated at $2,450,000, composed of temporary differences of $-0-, and permanent tax differences of $2,450,000.  Interest and penalties of $856,000 relate to these permanent difference changes within 12 months beginning June 30, 2011.  

Interest and penalties expense related to U.S. federal and state income tax returns are included within income tax expense.  

The Company is no longer subject to U.S. federal and state examinations by tax authorities for years before 2007 (with certain state exceptions). Currently, there are no U.S. federal or state returns under examination.  

Our deferred tax assets have been evaluated for realization based on historical taxable income, tax planning strategies, the expected timing of reversals of existing temporary differences and future taxable income anticipated.  Our deferred tax assets are more likely than not to be realized in full due to the existence of sufficient taxable income of the appropriate character under the tax law.  There is no need for a valuation allowance.

18

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Note 13 – Guarantees and Contingencies

Accrued Risk Reserves

 

We are self insured for risks related to health insurance and have wholly-owned limited purpose insurance companies that insure risks related to workers’ compensation and general and professional liability insurance claims both for our owned or leased entities and certain of the entities to which we provide management or accounting services.  The liability we have recognized for reported claims and estimates for incurred but unreported claims totals $92,242,000   and $105,059,000 at June 30, 2011 and December 31, 2010, respectively.  This liability is classified as a current liability based on the uncertainty regarding the timing of potential payments.  The liability is included in accrued risk reserves in the consolidated balance sheets and is subject to adjustment for actual claims incurred.  It is possible that these claims plus unasserted claims could exceed our insurance coverages and our reserves, which could have a material adverse effect on our financial position, results of operations and cash flows.

As a result of the terms of our insurance policies and our use of wholly-owned limited purpose insurance companies, we have retained significant insurance risk with respect to workers’ compensation and general and professional liability.  We use independent actuaries to estimate our exposures for claims obligations (for both asserted and unasserted claims) related to deductibles and exposures in excess of coverage limits, and we maintain reserves for these obligations.  Such estimates are based on many variables including historical and statistical information and other factors.  

Workers’ Compensation

For workers’ compensation, we utilize a wholly-owned Tennessee domiciled property/casualty insurance company to write coverage for NHC affiliates and for third-party customers.  Policies are written for a duration of twelve months and cover only risks related to workers’ compensation losses.  All customers are companies which operate in the long-term care industry.  Business is written on a direct basis.  Direct business coverage is written for statutory limits and the insurance company’s losses in excess of $1,000,000 per claim are covered by reinsurance.  

For these workers’ compensation insurance operations, the premium revenues reflected in the consolidated financial statements within "Other Revenues" for the six months ended June 30, 2011 and 2010, respectively, are $2,605,000 and $2,645,000.  Associated losses and expenses are reflected in the interim condensed consolidated financial statements as "Other operating costs and expenses".

General and Professional Liability Lawsuits and Insurance

The long term care industry has experienced significant increases in both the number of personal injury/wrongful death claims and in the severity of awards based upon alleged negligence by nursing facilities and their employees in providing care to residents.  As of June 30, 2011, we and/or our managed centers are currently defendants in 24 such claims covering the years 2002 through June 30, 2011.

In 2002, we established and capitalized a wholly-owned licensed liability insurance company.  Thus, since 2002, insurance coverage for incidents occurring at all NHC owned providers, and most providers managed by us is provided through this wholly-owned insurance company.  

Our coverages for all years include primary policies and excess policies.  In 2002, deductibles were eliminated and first dollar coverage was provided through the wholly-owned insurance company, while the excess coverage was provided by a third party insuror.  

For 2003-2011, both primary professional liability insurance coverage and excess coverage is provided through our wholly-owned liability insurance company.  The primary coverage is in the amount of $1 million per incident, $3 million per location with an annual primary policy aggregate limit of $19.0 million for 2011, $17.0 million for 2009 and

19

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

2010, $16.0 million for 2008, $14.0 million for 2006 and 2007, and $12.0 million for 2003-2005.  The excess coverage is $7.5 million annual excess in the aggregate applicable to years 2003-2007 and subsequently for $9.0 million annual excess in the aggregate for years 2008-2011.  

For these professional liability insurance operations, the premium revenues reflected in the financials as "Other Revenues" for the six months ended June 30, 2011 and 2010, respectively, are $2,191,000 and $2,222,000.  Associated losses and expenses including those for self-insurance are included in the interim condensed consolidated financial statements as "Other operating costs and expenses".  

Other Matters

On July 24, 2009, the Company received a civil investigative demand from the Tennessee Attorney General’s Office, requesting production of documents related to NHC’s business relationships with non-profit entities.  The Company has responded to the demand and complied as required with the terms of the demand.

Note 14 – Subsequent Event

On July 29, 2011, the Centers for Medicare & Medicaid Services ("CMS") published its final rule for skilled nursing reimbursement rates for its fiscal 2012 period, which will reduce reimbursement rates by 11.1%.  For a more detailed discussion, see "Item 2 – Management's Discussion and Analysis".

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations.

Overview

National HealthCare Corporation (“NHC” or the “Company”) is a leading provider of long-term health care services.  We operate or manage, through certain affiliates, 76 long-term health care centers with 9,548 beds in 10 states and provide other services in one additional state.  These operations are provided by separately funded and maintained subsidiaries.  We provide long-term health care services to patients in a variety of settings including long-term nursing centers, managed care specialty units, sub-acute care units, Alzheimer's care units, hospice programs, homecare programs, assisted living centers and independent living centers.  In addition, we provide insurance services, management and accounting services, and lease properties to operators of long-term health care centers.

Summary of Goals and Areas of Focus

Earnings

To monitor our earnings, we have developed budgets and management reports to monitor labor, census, and the composition of revenues.  

20

NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Development and Growth

We are undertaking to expand our long-term care operations while protecting our existing operations and markets.  The following table lists our recent or expected construction and purchase activities.

Type of Operation		Description		Size		Location		Placed in Service
Skilled Nursing		New Facility		120 Beds		Bluffton, SC		January 2010
Assisted Living		New Facility		45 Units		Mauldin, SC		March 2010
Homecare		Acquisition		353 ADC		Columbia, Rock Hill, and Summerville, SC		May, 2010
Skilled Nursing		Acquisition		120 Beds		Macon, MO		December, 2010
Skilled Nursing		Acquisition		120 Beds		Osage Beach, MO		December, 2010
Skilled Nursing		Acquisition		120 Beds		Springfield, MO		December, 2010
Assisted Living		New Facility		75 Units		Columbia, SC		May, 2011
Assisted Living		Addition		46 Units		Franklin, TN		June, 2011

In the second quarter of 2011, we opened a 75-unit assisted living community in Columbia, South Carolina, as well as a 46-unit assisted living addition in Franklin, Tennessee.  Also, in 2011, we expect to begin construction on a 90-bed skilled nursing facility in Tullahoma, Tennessee and a 92-bed skilled nursing facility in Hendersonville, Tennessee.  

During 2011, we will apply for Certificates of Need for additional beds in our markets and also evaluate the feasibility of expansion into new markets by building private pay health care centers or by the purchase of existing health care centers.  We will also evaluate the feasibility of construction of new assisted living facilities in select markets.

Accrued Risk Reserves

Our accrued professional liability reserves, workers’ compensation reserves and health insurance reserves totaled $92,242,000 at June 30, 2011, a 15.9% reduction since June 30, 2010, and are a primary area of management focus.  The reduction in our accrued risk reserves within the past twelve months is due to the settlements of claims and the revision to estimates within the reserves.  We have set aside restricted cash and cash equivalents and marketable securities to fund substantially all of our professional liability and workers’ compensation liabilities.  

As to exposure for professional liability claims, we have developed performance certification criteria to measure and bring focus to the patient care issues most likely to produce professional liability exposure, including in–house acquired pressure ulcers, significant weight loss and numbers of falls. These programs for certification, which we regularly modify and improve, have produced measurable improvements in reducing these incidents.  Our experience is that achieving goals in these patient care areas improves both patient and employee satisfaction.  

Application of Critical Accounting Policies

There have been no significant changes during the six month period ended June 30, 2011 to the items we disclosed as our critical accounting policies and estimates in our discussion and analysis of financial condition and results of operations in our December 31, 2010 Annual Report on Form 10-K filed with the SEC.

Government Program Financial Changes

Cost containment will continue to be a priority for Federal and State governments for health care services, including the types of services we provide.  Government reimbursement programs such as Medicare and Medicaid prescribe, by law, the billing methods and amounts that health care providers may charge and be reimbursed to care for patients covered by these programs. Congress has passed a number of laws that have effected major changes in the Medicare and Medicaid programs. The Balanced Budget Act of 1997 sought to achieve a balanced federal budget by,

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NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

among other things, reducing federal spending on Medicare and Medicaid to various providers.  The Balanced Budget Act of 1997 defined the Medicare Prospective Payment System ("PPS") and this System has subsequently been refined in 1999, 2000, 2005, 2006 and 2010.

Federal Health Care Reform

In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act ("PPACA") and the Health Care and Education Reconciliation Act of 2010 ("HCERA"), which represents significant changes to the current U.S. health care system (collectively the "Acts"). The Acts affect aging services providers, our partners (employees) and our patients and residents in a multitude of ways.  We have evaluated the provisions of the Acts and do not expect material effects on our results of operations, liquidity and cash flows in 2011.  We anticipate many of the provisions of the Acts may be subject to further clarification and modification through the rule-making process.  It is uncertain at this time the effect the Acts and their modifications will have on our future results of operations or cash flows.  

In December 2010, President Obama signed into law the Medicare and Medicaid Extenders Act (“MMEA”).  This legislation affects numerous health care providers and makes several important technical corrections to the health reform laws enacted earlier in 2010.  An important item provided for in the MMEA legislation is for an immediate and retroactive updated methodology (Resource Utilization Group – Version Four, “RUG-IV”) for determining Medicare payment rates to skilled nursing centers.  The retroactive date goes back to October 1, 2010.  Under the federal health reform law passed in March 2010, Congress imposed a moratorium on implementing the updated methodology until October 1, 2011.  The MMEA repeals that provision, and ends the delay in implementing RUG-IV, allowing skilled nursing center rates determined by RUG-IV to be applied as of October 1, 2010.  

Medicare

Effective October 1, 2010, the federal RUG rates had a market basket increase of 2.3%.  There was also a (0.6%) forecasting error adjustment, generating a net market basket increase of 1.7%.  According to the CMS, the transition from RUG-III to RUG-IV would be on a budget neutral basis.  CMS states RUG-IV was needed to recalibrate the case-mix system after changes in fiscal year 2006 caused payments to skilled nursing centers to exceed budget neutrality estimates. The effect of the RUG-IV rate changes on our revenues is dependent upon our census and the mix of our patients at the PPS pay rates.  The PPS rates had a net market basket decrease of 1.1% in 2009.   

For the first six months of 2011, our average Medicare per diem rate increased 19.8% compared to the same period in 2010.  

On July 29, 2011, CMS issued a final rule providing for, among other things, a net 11.1% reduction in PPS payments to skilled nursing facilities for CMS's fiscal year 2012 (which begins October 1, 2011) as compared to PPS payments in CMS's fiscal year 2011 (which ends September 30, 2011).  The 11.1% reduction is on a net basis, after the application of a 2.7% market basket increase less a 1.0% multi-factor productivity adjustment required by the Patient Protection and Affordable Care Act of 2010 ("PPACA").  The final CMS rule also adjusts the method by which group therapy is counted for reimbursement purposes, and changes the timing in which patients who are receiving therapy must be reassessed for purposes of determining their RUG category.  We anticipate that, assuming other factors remain constant, CMS's reduced reimbursement rates and other changes effective for its fiscal year 2012 will have a significant and adverse effect on our results of operations when compared to the periods in CMS's fiscal year 2011.  The effect of the fiscal year 2012 Medicare rate changes on our revenues is dependent upon our census and the mix of our patients at the recalibrated PPS pay rates.   

Effective October 1, 2010, hospice agencies received Medicare payments which represented a 1.8% increase.  We estimate the effect of the revenue increase for NHC hospice programs to be approximately $200,000 annually, or $50,000 per quarter.  On July 29, 2011, CMS announced its fiscal year 2012 final ruling for Medicare payments to hospice companies.  Effective October 1, 2011, hospice agencies will receive a 2.5% increase in their Medicare payments over fiscal year 2011.

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NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

Effective January 2011, home health agencies received Medicare payments which represented a 5.2% decrease.  We estimate the effect of the revenue decrease for NHC homecare programs to be approximately $3,400,000 annually, or $850,000 per quarter.  

Medicaid

Tennessee annual Medicaid rate increases were implemented effective July 1, 2010.  Tennessee Medicaid fully funded the ceiling rate increases for all skilled and intermediate providers.  The resulting increase in revenue from this payment source was approximately $592,000 per quarter.  Due to state budgetary allocations, no rate increases will be implemented effective July 1, 2011.

On April 18, 2011, effectively immediately, South Carolina implemented a three percent Medicaid rate reduction.  We estimate the resulting decrease in revenue will be approximately $370,000 per quarter.  

For the first six months of 2011, our average Medicaid per diem overall increased by 1.5% compared to the same period in 2010.  We face challenges with respect to states’ Medicaid payments because many states currently do not cover the total costs incurred in providing care to those patients. States will continue to control Medicaid expenditures but also look for adequate funding sources, including provider assessments.  Other provisions could increase state funding for home and community-based services, potentially having an impact on funding for nursing facilities. There is no assurance that the funding for our services will increase or decrease in the future.

Results of Operations

Three Months Ended June 30, 2011 Compared to Three Months Ended June 30, 2010

Results for the three month period ended June 30, 2011 include a 7.8% increase in net operating revenues and 13.4% increase in income before taxes compared to the same period in 2010.  

Net patient revenues increased $13,996,000 or 8.6% compared to the same period last year. Medicare, Managed Care, and Medicaid per diem rates increased 20.8%, 9.1%, and 0.8%, respectively, compared to the quarter a year ago.  The newly constructed or acquired businesses (three skilled nursing facilities, one assisted living community, and three homecare programs) helped increase net patient revenues approximately $4,599,000.

The total census at owned and leased long-term health care centers for the quarter averaged 90.5% compared to an average of 92.2% for the same quarter a year ago.

Other revenues decreased $135,000 or 1.0% in the three-month 2011 period to $13,939,000 from $14,074,000 in the 2010 three-month period.  Insurance and management fee revenue that is included in other revenues decreased primarily due to the December 2010 acquisition of the three Missouri skilled healthcare facilities.  We previously managed the three facilities; therefore, revenues from these facilities were shown as “Other revenues”.  For the current quarter, operating revenues from these facilities are reported under “Net patient revenues”. Rental income, that is also included in other revenues, increased $318,000 due to the renewed rental agreements of thirteen of our properties with third party operators.  The rental agreements include increases in the base rent amount and continue for a five year period ending on December 31, 2015.

Non-operating income increased by $196,000 to $5,155,000 in the three-month 2011 period in comparison to $4,959,000 for the three-month 2010 period.  

Total costs and expenses for the 2011 second quarter compared to the 2010 second quarter increased $11,439,000 or 7.0% to $173,743,000 from $162,304,000.  Salaries, wages and benefits, the largest operating costs of this service company, increased $7,113,000 or 7.3% to $104,793,000 from $97,680,000.  Other operating expenses

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NATIONAL HEALTHCARE CORPORATION

Notes to Interim Condensed Consolidated Financial Statements

June 30, 2011

(unaudited)

increased $3,530,000 or 7.3% to $51,888,000 for the 2011 period compared to $48,358,000 for the 2010 period.  Facility rent expense increased $422,000 or 5.2% to $9,879,000.  Depreciation and amortization increased to 6.2% to $7,075,000.  

The increase in salaries, wages and benefits is primarily due to the increased staffing from the opening or acquisition of three skilled nursing facilities, one assisted living community, and three homecare programs ($2,514,000).  We also had increased costs in our existing skilled nursing facilities ($2,234,000), increased costs for therapist services ($1,423,000), an increased provision for health insurance claims ($782,000), and inflationary wage increases.

The increase in other operating expenses is primarily due to the opening or acquisition of the new operations in the amount of $2,293,000.  

Facility rent expense for the three months ended June 30, 2011 increased by approximately $422,000 compared to the quarter a year ago.  The increase is due to the increased percentage rent accrued and paid to National Health Investors, Inc. (“NHI”).  Percentage rent to NHI is equal to 4% of the increase in facility revenues over the 2007 revenues, the base year of the lease agreement.

Depreciation expense increased primarily due to the acquisition and construction of depreciable assets in the last year.  The increase in depreciation for the three months ended June 30, 2011 was $412,000.  

The income tax provision for the three months ended June 30, 2011 is $8,584,000 (an effective income tax rate of 38.7% which is in line with management's expectations).  The income tax provision and effective tax rate for the three months ended June 30, 2011 were unfavorably impacted by permanent differences including non-deductible expenses.  The income tax provision for the three months ended June 30, 2010 was $7,727,000 (an effective tax rate of 39.5%).   The income tax provision and effective tax rate for the three months ended June 30, 2010 were unfavorably impacted by permanent differences including non-deductible expenses.

Six Months Ended June 30, 2011 Compared to Six Months Ended June 30, 2010

Results for the six month period ended June 30, 2011 include a 9.6% increase in net revenues and a 44.6% increase in income before taxes compared to the same period in 2010.  

Net patient revenues increased $33,588,000 or 10.5% compared to the same period last year. Medicare, Managed Care, and Medicaid per diem rates increased 19.8%, 9.1%, and 1.5%, respectively, compared to the six months a year ago.  The newly constructed or acquired businesses (three skilled nursing facilities, one assisted living community, and three homecare programs) helped increase net patient revenues approximately $10,627,000.

The total census at owned and leased long-term health care centers for the six months averaged 90.8% compared to an average of 92.0% for the same period a year ago.

Other revenues decreased $103,000 or 0.3% in the six-month 2011 period to $29,334,000 from $29,437,000 in the 2010 six-month period.  Insurance and management fee revenue that is included in other revenues decreased primarily due to the December 2010 acquisition of the three Missouri skilled healthcare facilities.  We previously managed the three facilities; therefore, revenues from these facilities were shown as “Other revenues”.  For the current period, operating revenues from these facilities are reported under “Net patient revenues”. Rental income, that is also included in other revenues, increased $841,000 due to the renewed rental agreements of thirteen of our properties with third party operators.  The rental agreements include increases in the base rent amount and continue for a five year period ending on December 31, 2015.

Non-operating income increased by $182,000 to $9,716,000 in the six-month 2011 period in comparison to $9,534,000 for the six-month 2010 period.