SUN HEALTHCARE GROUP INC
10-Q, 1999-05-20
SKILLED NURSING CARE FACILITIES
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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

     [ X ] Quarterly  report  pursuant to Section 13 or 15(d) of the
           Securities Exchange Act of 1934

                  For the quarterly period ended March 31, 1999

                                       or

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

                         Commission File Number: 1-12040

                           SUN HEALTHCARE GROUP, INC.
             (Exact name of Registrant as specified in its charter)

            Delaware                                      85-0410612
     (State of Incorporation)                         (I.R.S. Employer
                                                       Identification No.)

                               101 Sun Avenue, NE
                          Albuquerque, New Mexico 87109
                                 (505) 821-3355
                  (Address and telephone number of Registrant)


    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 twelve 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 ninety days.

                 Yes  X                               No
                     ---                                 ---

    As of May 17, 1999, there were 60,851,089 shares of the Registrant's
        $.01 par value Common Stock outstanding, net of treasury shares.

    
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<PAGE>


                           SUN HEALTHCARE GROUP, INC.
                                      Index

                 FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 1999

- ------------------------------------------------------------------------------


                          PART I. FINANCIAL INFORMATION


<TABLE>
<CAPTION>
                                                              Page Numbers
                                                              ------------
<S>         <C>                                               <C>

Item 1.     Consolidated Financial Statements                       

            Consolidated Balance Sheets
            March 31, 1999 and December 31, 1998 ....................3-4

            Consolidated Statements of Earnings (Losses)
            For the three months ended March 31, 1999 and 1998 ......5

            Consolidated Statements of Comprehensive Income (Losses)
            For the three months ended March 31, 1999 and 1998 ......6

            Consolidated Statements of Cash Flows
            For the three months ended March 31, 1999 and 1998 ......7-8

            Notes to the Consolidated Financial Statements ..........9-28

Item 2.     Management's Discussion and Analysis of
            Financial Condition and Results of Operations ..........29-49


                           PART II. OTHER INFORMATION

Item 1.     Legal Proceedings ......................................50

Item 6.     Exhibits and Reports on Form 8-K .......................50

Signatures .........................................................51

</TABLE>



                                        2
<PAGE>

                   SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS
                                   (Unaudited)

                                     ASSETS

<TABLE>
<CAPTION>
                                                         March 31,    December 31,
                                                           1999          1998
                                                       -------------  ------------
                                                              (In thousands)
<S>                                                     <C>           <C>
Current assets:
     Cash and cash equivalents ......................   $   47,168    $   27,504
     Accounts receivable, net of allowance for
        doubtful accounts of $86,314 as of March 31,
        1999, and $79,015 as of December 31, 1998 ...      451,216       538,329
     Other receivables ..............................       35,073        48,073
     Inventory, net .................................       50,973        48,862
     Prepaids and other assets ......................       15,536        13,091
     Income tax receivables .........................       14,760        15,874
                                                        ----------    ----------

      Total current assets ..........................      614,726       691,733
                                                        ----------    ----------

     Property and equipment, net ....................      617,482       601,270
     Goodwill, net ..................................      804,691       795,945
     Notes receivable ...............................       34,377        32,334
     Assets held for sale ...........................      178,647       192,447
     Other assets, net ..............................      134,992       148,309
     Deferred tax assets ............................         --           6,000
                                                        ----------    ----------

           Total assets .............................   $2,384,915    $2,468,038
                                                        ==========    ==========
</TABLE>

                                       3

<PAGE>
                   SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                     CONSOLIDATED BALANCE SHEETS (CONTINUED)
                                   (Unaudited)

                      LIABILITIES AND STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
                                                                                        As of          As of
                                                                                      March 31,     December 31,
                                                                                        1999            1998
                                                                                    -------------  -------------
                                                                                           (In thousands)
<S>                                                                                  <C>            <C>
Current liabilities:
       Current portion of long-term debt .........................................   $    85,907    $    80,914
       Credit facility borrowings ................................................       813,305        731,707
       Current portion of obligations under capital leases .......................         3,798          3,703
       Accounts payable ..........................................................        40,174         94,143
       Accrued compensation and benefits .........................................       107,626        102,091
       Accrued interest ..........................................................        25,098         26,095
       Accrued self-insurance obligations ........................................        55,293         54,865
       Other accrued liabilities .................................................       146,438        137,851
                                                                                     -----------    -----------

            Total current liabilities ............................................     1,277,639      1,231,369
                                                                                     -----------    -----------

Long-term debt, net of current portion ...........................................       687,790        705,653
Obligations under capital leases, net of current portion .........................       101,351        103,679
Other long-term liabilities ......................................................        40,384         41,061
                                                                                     -----------    -----------

            Total liabilities ....................................................     2,107,164      2,081,762
                                                                                     -----------    -----------

Commitments and contingencies
Minority interest ................................................................         6,011          7,517
Company-obligated mandatorily redeemable convertible preferred securities
       of a subsidiary trust holding solely 7% convertible junior subordinated
       debentures of the Company .................................................       345,000        345,000

Stockholders' equity:
       Preferred stock of $.01 par value, authorized 5,000,000 shares, none issued          --             --
       Common stock of $.01 par value, authorized 155,000,000 shares 62,610,489
            and 61,930,159 shares issued and outstanding as of March 31, 1999
            and December 31, 1998, respectively ..................................           626            619
       Additional paid-in capital ................................................       775,237        774,860
       Retained deficit ..........................................................      (809,196)      (696,049)
       Accumulated other comprehensive income ....................................        (3,001)         2,902
                                                                                     -----------    -----------
                                                                                         (36,334)        82,332
                                                                                     -----------    -----------
       Less:
       Unearned compensation .....................................................         7,779          8,552
       Common stock held in treasury, at cost, 2,169,443 and 2,124,868 shares
            as of March 31, 1999 and December 31, 1998 respectively ..............        27,231         26,967
       Grantor stock trust, at market, 1,915,925 and 1,989,132 shares as of
            March 31, 1999 and December 31, 1998, respectively ...................         1,916         13,054
                                                                                     -----------    -----------

            Total stockholders' equity ...........................................       (73,260)        33,759
                                                                                     -----------    -----------

            Total liabilities and stockholders' equity ...........................   $ 2,384,915    $ 2,468,038
                                                                                     ===========    ===========



                  The accompanying notes are an integral part of these consolidated balance sheets.

</TABLE>

                                       4
<PAGE>

                   SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                  CONSOLIDATED STATEMENTS OF EARNINGS (LOSSES)
                                   (Unaudited)

<TABLE>
<CAPTION>

                                                           For the Three Months Ended March 31,
                                                           ------------------------------------
                                                                    1999         1998
                                                                    ----         ----
                                                          (In thousands, except per share data)

<S>                                                              <C>          <C>
Total net revenues ...........................................   $ 673,032    $ 741,490
                                                                 ---------    ---------
Costs and expenses:
    Operating ................................................     624,570      608,585
    Corporate general and administrative .....................      42,017       39,301
    Provision for losses on accounts receivable ..............      13,818        6,013
    Depreciation and amortization ............................      21,448       20,474
    Interest, net ............................................      37,170       35,140
    Loss on sale of assets ...................................      12,106         --
    Loss on termination of interest rate swaps ...............       2,488         --
    Restructuring costs ......................................      11,428         --
                                                                 ---------    ---------
       Total costs and expenses ..............................     765,045      709,513

Dividends on convertible preferred securities ................       6,516         --
                                                                 ---------    ---------
Earnings (losses) before income taxes ........................     (98,529)      31,977

Income taxes .................................................         892       13,590
                                                                 ---------    ---------

Net earnings (losses) before cumulative effect of
   change in accounting principle ............................     (99,421)      18,387
                                                                 ---------    ---------
Cumulative effect of change in accounting principle ..........      13,726         --
                                                                 ---------    ---------
Net earnings (losses) ........................................   $(113,147)   $  18,387
                                                                 =========    =========

Net earnings (losses) per common and common equivalent share
   before cumulative effect of change in accounting principle:
       Basic .................................................   $   (1.73)   $    0.39
                                                                 =========    =========

       Diluted ...............................................   $   (1.73)   $    0.37
                                                                 =========    =========

Net earnings (losses) per common and common equivalent share:
       Basic .................................................   $   (1.96)   $    0.39
                                                                 =========    =========

       Diluted ...............................................   $   (1.96)   $    0.37
                                                                 =========    =========
Weighted average number of common and common equivalent
   shares outstanding:
       Basic .................................................      57,621       46,905
                                                                 =========    =========

       Diluted ...............................................      57,621       52,381
                                                                 =========    =========

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

</TABLE>

                                       5
<PAGE>
            SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSSES)
                            (Unaudited)
<TABLE>
<CAPTION>

                                                        For the Three Months Ended March 31,
                                                        ------------------------------------
                                                                1999           1998
                                                                ----           ----
                                                                  (In thousands)

<S>                                                          <C>              <C>     
Net earnings (losses) ....................................   $ (113,147)      $ 18,387

Foreign currency translation adjustments, net of tax .....       (5,903)         3,625
                                                             -----------      ---------

Comprehensive income (losses) ............................   $ (119,050)      $ 22,012
                                                             ===========      =========


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

</TABLE>

                                       6
<PAGE>
                   SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                            For the Three Months Ended March 31,
                                                            ------------------------------------
                                                                      1999        1998
                                                                      ----        ----
                                                                       (In thousands)
<S>                                                                 <C>         <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net earnings (losses) ........................................   $(113,147)  $  18,387
   Adjustments to reconcile net earnings (losses) to net cash
      provided by (used for) operating activities:
          Cumulative effect of change in accounting principle ..       13,726
          Loss on sale of assets ................................      12,106          --
          Depreciation and amortization .........................      21,448      20,474
          Provision for losses on accounts receivable ...........      13,818       6,013
          Other, net ............................................         786       2,086
          Changes in operating assets and liabilities:
             Accounts receivable ................................      70,434     (85,499)
             Other current assets ...............................       7,813     (21,638)
             Other current liabilities ..........................     (41,296)     12,252
             Income taxes payable ...............................        (481)     12,175
                                                                    ----------  ----------

             Net cash used for operating activities .............   $ (14,793)  $ (35,750)
                                                                    ----------  ----------

CASH FLOWS FROM INVESTING ACTIVITIES:
   Capital expenditures, net ....................................     (39,469)    (24,829)
   Acquisitions, net of cash acquired ...........................      (1,225)     (7,339)
   Increase in long-term notes receivable .......................      (2,043)     (6,857)
   Other assets expenditures ....................................      (1,980)     (9,909)
                                                                    ----------  ----------

             Net cash used for investing activities .............     (44,717)    (48,934)
                                                                    ----------  ----------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Long-term debt borrowings ....................................     110,405      88,318
   Long-term debt repayments ....................................     (27,653)    (22,070)
   Conversion of Mediplex 6 1/2% Convertible Subordinated
     Debentures due 2003 ........................................      (5,840)          -
   Net proceeds from issuance of common stock ...................         462         543
   Purchases of treasury stock ..................................        (264)     (1,357)
   Other financing activities ...................................        (283)       (255)
                                                                     ----------  ----------

             Net cash provided by financing activities ..........      76,827      65,179
                                                                    ----------  ----------

Effect of exchange rate on cash and cash equivalents ............      (2,347)       (402)
                                                                    ----------  ----------

Net increase (decrease) in cash and cash equivalents ............      19,664     (19,907)

Cash and cash equivalents at beginning of year ..................      27,504      21,020
                                                                    ----------  ----------

Cash and cash equivalents at end of period ......................   $  47,168   $   1,113
                                                                    ==========  ==========

 The accompanying notes are an integral part of these consolidated financial statements.
                            (Continued on next page)
</TABLE>
                                       7
<PAGE>
                   SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                                  For the Three Months Ended March 31,
                                                                  ------------------------------------
                                                                           1999          1998
                                                                           ----          ----
                                                                            (In thousands)
<S>                                                                      <C>          <C>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
     Cash paid during period for:

       Interest net of $439 and $573 capitalized during the
         three months ended March 31, 1999 and 1998, respectively ....   $  39,692     $ 43,897
                                                                         ==========    =========

       Income taxes ..................................................   $   1,373     $    505
                                                                         ==========    =========

SUPPLEMENTARY SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:

     The Company's acquisitions during the three months ended
       March 31, 1999 and 1998 involved the following:

       Fair value of assets acquired .................................   $   2,275     $  7,438
       Liabilities assumed ...........................................      (1,050)         (99)
                                                                         ----------    ---------

       Cash payments made, net of cash received from others ..........   $   1,225     $  7,339
                                                                         ==========    =========


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

</TABLE>

                                       8
<PAGE>

                   SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)


1. BASIS OF PRESENTATION

     In the opinion of management of Sun Healthcare  Group,  Inc. (the "Company"
or "Sun"), the accompanying  interim  consolidated  financial statements present
fairly the Company's financial position at March 31, 1999 and December 31, 1998,
the  consolidated  results of its  operations  for the three month periods ended
March 31, 1999 and 1998, and the  consolidated  statements of cash flows for the
three month  periods  ended March 31, 1999 and 1998.  All  adjustments  are of a
normal and recurring  nature.  These statements are presented in accordance with
the  rules  and  regulations  of  the  United  States  Securities  and  Exchange
Commission ("SEC"). Accordingly, they are unaudited, and certain information and
footnote  disclosures  normally  included in the Company's  annual  consolidated
financial  statements  have been  condensed or omitted,  as permitted  under the
applicable  rules and regulations.  Readers of these statements  should refer to
the Company's audited  consolidated  financial  statements and notes thereto for
the year ended  December 31,  1998,  which are included in the Company's  Annual
Report on Form 10-K as  amended on Form  10-K/A for the year ended  December 31,
1998.  The  results  of  operations  presented  in  the  accompanying  financial
statements are not necessarily representative of operations for an entire year.

     Certain  amounts in the 1998  consolidated  financial  statements and notes
have been reclassified to conform to the 1999 presentation.

     ADOPTION OF NEW ACCOUNTING PRONOUNCEMENTS

     In 1998,  the American  Institute of Certified  Public  Accountants  issued
Statement of Position,  "Reporting  on the Costs of Start-up  Activities"  ("SOP
98-5").  This statement  requires costs of start-up  activities and organization
costs to be expensed as  incurred.  The  statement is  effective  for  financial
statements  for fiscal years  beginning  after  December 15, 1998.  In the first
quarter of 1999,  the Company  adopted the provisions of SOP 98-5 which resulted
in a cumulative effect of an accounting change pretax charge of $13.7 million.

     Pro Forma amounts, assuming the new accounting principal was applied during
the three months ended March 31, 1998 are as follows:

<TABLE>
<CAPTION>

<S>                                                               <C>
Net earnings as reported .......................................  $ 18,387
                                                                  ========
     Pro Forma net earnings ....................................  $ 15,391
                                                                  ========

Net earnings per common and common equivalent share as reported:
     Basic .....................................................  $    .39
                                                                  ========
     Diluted ...................................................  $    .37
                                                                  ========
Pro Forma net earnings per common and common equivalent share:
     Basic .....................................................  $    .33
                                                                  ========
     Diluted ...................................................  $    .29
                                                                  ========
</TABLE>

                                       9
<PAGE>
                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)

     NEWLY ISSUED ACCOUNTING PRONOUNCEMENTS

     In June 1998, the Financial  Accounting Standards Board issued Statement of
Financial Accounting  Standards No. 133, "Accounting for Derivative  Instruments
and Hedging  Activities"  ("SFAS 133").  Under SFAS 133, which will be effective
January 1, 2000,  all  derivatives  are required to be recognized on the balance
sheet at fair  value.  Gains or  losses  from  changes  in fair  value  would be
recognized  in  earnings  in the  period  of change  unless  the  derivative  is
designated  as a hedging  instrument.  The Company is studying the impact of the
new  standard  and  is  unable  to  predict  at  this  time  the  impact  on its
consolidated financial statements.

2.   NON-COMPLIANCE  WITH  SENIOR  CREDIT  FACILITY'S  FINANCIAL  COVENANTS  AND
     LIQUIDITY
 
     The  Company  was  not  in  compliance  with  certain  financial  covenants
contained  in the Senior  Credit  Facility as of December 31, 1998 and March 31,
1999. Borrowings under the Senior Credit Facility were $745.6 million and $826.8
million at December 31, 1998 and March 31, 1999. On April 29, 1999,  the Company
entered  into an  agreement  that  waives  compliance  with the  covenants  from
December  30, 1998 until May 28,  1999.  The terms of the waiver  require  among
other things that the Company  take  advantage of the 30-day grace period of the
payment of interest on the Company's $150 million 9 3/8% subordinated  notes due
2008,  which  payment  was due May 1,  1999.  If the  Company  does not make the
interest  payment by May 31,  1999,  the Company  would be in default  under the
indenture  for  the 9  3/8%  notes,  which  would  cause  the  Company  to be in
cross-default  on certain  other debt  obligations  of the Company.  The Company
continues to seek an  amendment to its Senior  Credit  Facility  agreement  that
would  bring it into  full  compliance  but  cannot  predict  when or if such an
amendment will be obtained.

     Because the Company was not in compliance with certain financial  covenants
under the terms of the Senior Credit  Facility,  the Lenders could have required
immediate repayment of all amounts outstanding under the Senior Credit Facility.
As a result,  as of December 31, 1998,  the Company  classified  all  borrowings
under the Senior Credit  Facility as current  liabilities.  Although  compliance
with the covenants has been waived,  the borrowings remain classified as current
liabilities  in the  accompanying  consolidated  balance  sheet  because  of the
short-term  nature of the waiver.  The  Company  does not have  sufficient  cash
reserves to repay all amounts  outstanding  under the Senior Credit  Facility at
May 19,  1999.  No further  amounts  may be  borrowed  under the  Senior  Credit
Facility.  Accordingly,  the Company will have to fund all  operations,  capital
expenditures  and regularly  scheduled  debt service from existing cash reserves
and future net cash flows from operations, if any.

     The  Company is in default of certain  Mortgage  Notes  amounting  to $31.8
million and $31.9 million at December 31, 1998 and March 31, 1999, respectively,
because the Company did not meet its debt  service  coverage  requirement  of at
least  1.25  to 1.  The  Company  is  attempting  to  obtain  a  waiver  of  the
non-compliance  with the financial  covenant and to amend these Mortgage  Notes'
financial  covenants so that the financial covenants will be consistent with the
Company's  revised business plan.  However,  as of May 19, 1999, no agreement to
waive the  non-compliance  with the financial covenant or to amend the financial
covenants has been reached.  Because the Company is in  non-compliance  with the
terms of certain Mortgage Notes, the holder of these Mortgage Notes could demand
immediate repayment of all amounts due under the mortgages and foreclose on four
facilities.  Such amounts are  classified as current  liabilities as of December
31, 1998 and March 31, 1999.

                                       10
<PAGE>
                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)
 
     If the  Company is  required  to repay the  amounts  outstanding  under the
Senior  Credit  Facility  and the  Mortgage  Notes,  or is  unable  to fund  all
operations,  capital  expenditures and regularly scheduled debt service, it will
explore a variety of options,  including  seeking relief under the United States
Bankruptcy Code.
 
     The Company also has other debt arrangements that provide that a default on
any mortgage  indenture  or  instrument  which  results in the  acceleration  of
repayment or default in payment of obligations from $0.1 million to in excess of
$20.0 million depending on the terms of the agreement,  would allow the creditor
to demand  immediate  repayment.  No  acceleration of repayment has occurred and
therefore such borrowings which total $520.9 million are classified as long-term
liabilities as of December 31, 1998 and March 31, 1999.
 
     As  of  December  31,  1998  and  March  31,  1999,   the  Company  was  in
non-compliance  with certain  financial  covenants  contained in certain  master
lease  agreements for 96 of its long-term  care  facilities in the United States
and 33 of its long-term care facilities in the United Kingdom.  As a result, the
lessors under these master lease  agreements have certain rights,  including the
right to require that the Company  relinquish the leased  facilities.  As of May
19, 1999,  the lessors had not  exercised  their  rights under their  respective
agreements,  although  there can be no assurance that the lessors will not do so
in the  future.  Prior to  obtaining  a waiver  of  noncompliance  with  certain
financial covenants in the Senior Credit Facility, the Company was also in cross
default  for 14 of its  long-term  care  facilities  in the United  States as of
December 31, 1998 and March 31, 1999. The aggregate net book value of properties
subject to potential  eviction  amounted to $54.8  million at December 31, 1998.
The Company has a substantial  number of other leases which may contain  similar
default or cross default provisions.
 
3.   ACQUISITIONS

     On June 30, 1998, the Company  acquired  Retirement Care  Associates,  Inc.
("RCA")  and  approximately  35% of the common  stock of Contour  Medical,  Inc.
("Contour"),  collectively  referred  to as  the  RCA  Acquisition.  RCA  was an
operator of skilled  nursing  facilities  and assisted  living  centers in eight
states,  primarily in the  southeastern  United  States.  Contour was a national
provider  of medical  and  surgical  supplies.  RCA owned  approximately  65% of
Contour  prior to the RCA  Acquisition.  The Company  issued  approximately  7.6
million  shares of its common  stock  valued at $122.0  million  (based upon the
average  closing price of the Company's  common stock for 20 business days prior
to the acquisition  closing date) for all  outstanding  common stock and certain
redeemable   preferred   shares  of  RCA.  In  addition,   the  Company   issued
approximately 1.9 million shares of its common stock valued at $27.6 million for
the minority interest in Contour's common stock. The Company also issued 298,334
shares of its Series B  Convertible  preferred  stock,  which were  subsequently
converted  into  287,892  shares  of Sun  common  stock,  in  exchange  for  the
outstanding  shares of RCA's  Series F  preferred  stock.  The  Company  assumed
approximately $170.4 million of RCA indebtedness.
 

                                       11
<PAGE>

                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)

     The RCA  Acquisition was accounted for as a purchase and resulted in $234.7
million of  goodwill.  The results of  operations  of RCA and Contour  have been
included  in  the  consolidated   statements  of  earnings   (losses)  from  the
acquisition date. In connection with the purchase, the Company recorded purchase
liabilities including approximately $2.5 million for severance and related costs
and  $1.4  million  for  costs   associated   with  the  shut  down  of  certain
administrative  facilities. The allocation of the RCA Acquisition purchase price
is preliminary  and will be finalized  upon the  completion of long-lived  asset
valuations.  In addition, the Company is still evaluating certain obligations of
RCA prior to the acquisition and further adjustments to the preliminary purchase
price allocation may result.
 
     The following  unaudited pro forma results assumes that the RCA Acquisition
occurred as of January 1, 1998 and  includes its results of  operations  for the
three months ended March 31, 1998 (in thousands, except per share data):

<TABLE>
<CAPTION>
 
                                                                  1998
                                                                  ----
                                                                Unaudited
<S>                                                            <C>
Net revenues ................................................  $ 810,717
Net earnings ................................................      6,792

Per Share Data:
Net earnings per share:
     Basic ..................................................       $.12
     Diluted ................................................       $.12

</TABLE>

     In addition,  during the three  months  ended March 31,  1998,  the Company
acquired from various third parties the net ownership of,  leasehold  rights to,
or the  management  contracts  of, two long-term  care  facilities in the United
States and 15 long-term care facilities in the United Kingdom.  Also, during the
three months ended March 31, 1998, the Company  acquired nine  pharmacies in the
United States.  The pro forma impact of these acquisitions with the exception of
RCA is immaterial.

4.   RESTRUCTURING COSTS
 
     In the first quarter of 1999, the Company initiated a second  restructuring
plan focused on further  reducing the  operating  expenses of its United  States
operations.  Related to the  restructuring  plan,  the Company  recorded a first
quarter  charge of  approximately  $11.4.  The  restructuring  plan includes the
termination of 2,900 of its  rehabilitation  and  respiratory  therapy  services
employees,  and  80 of  its  corporate  employees  including  certain  executive
positions.  The restructuring plan also included the closure of approximately 23
divisional and regional  offices related to the  aforementioned  operations.  In
addition,  the plan  includes the  relocation of the  Company's  medical  supply
subsidiary and temporary therapy services  subsidiary to the Company's corporate
headquarters in Albuquerque,  New Mexico. As part of the relocation, the Company
will  terminate 96 employees of these  subsidiaries.  As of March 31, 1999,  the
Company paid approximately  $4.4 million in termination  benefits under the 1999
restructuring plan. The 1999 restructuring charge consists of approximately $9.1
million related to employee terminations,  approximately $1.4 million related to
lease  termination  costs  and  $0.9  million  related  to  asset  disposals  or
write-offs. As of March 31, 1999, the Company's 1999 restructuring costs reserve
balance was approximately $7.0 million.


                                       12
<PAGE>

                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)

     In the fourth  quarter of 1998,  the Company  had an initial  restructuring
plan and recorded a fourth quarter charge of $4.6 million. As of March 31, 1999,
the Company's 1998  restructuring  costs reserve balance was approximately  $0.5
million and is substantially complete.

5.   ASSETS HELD FOR SALE
 
     Subsequent to December 31, 1998, the Company  decided to dispose of several
non-core  businesses,  including  assisted  living  facilities,   rehabilitation
hospitals and other  in-patient  facilities and other non-core  businesses.  The
Company  recorded  a loss of $161.6  million  in the  fourth  quarter of 1998 to
reduce the carrying amount of the non-core businesses identified for disposal to
fair value based on estimates of selling  value less costs to sell.  The Company
recorded an  additional  net loss of $10.1  million in the first quarter of 1999
based on revised estimates of selling value less costs to sell. In addition, the
Company  has decided not to dispose of certain  non-core  businesses  previously
recorded in assets held for sale.  The  reversal of $7.0  million of the loss on
disposition  was  recognized in 1999. The following is a summary of the carrying
amounts and additional loss for the three months ended March 31, 1999 related to
the non-core businesses to be disposed of as of March 31, 1999 (in thousands):

<TABLE>
<CAPTION>
                                                     Carrying
                                                      Amount        Loss
                                                      ------        ----
<S>                                                 <C>          <C>
Assisted living facilities .......................  $ 111,848    $  5,450
Rehabilitation hospitals and other
 inpatient facilities ............................     90,201      (6,290)
Other non-core businesses ........................     17,882      10,939
                                                    ---------    ---------
    Total ........................................  $ 219,931    $ 10,099
                                                    =========    =========
</TABLE>

     Management expects to complete the sales of these businesses during 1999.
 
     In May 1997,  the  Company  announced  its intent to sell and divest of its
outpatient  rehabilitation  clinics in the United States, as well as Canada. The
carrying  amount of the assets  held for sale was $243.8  million as of December
31, 1998.  The Company  completed  the sale of the Canadian  clinics  during the
first quarter of 1999. The Company  recorded a loss of $2 million on the sale of
the Canadian  clinics.  The results of  operations  of these  businesses  is not
material.


                                       13
<PAGE>
                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)

6. INTEREST RATE SWAP TRANSACTIONS

     In April 1999, the interest rate swap  transactions  were terminated due
to an event of default  relating to the  Company's  non-compliance  with certain
covenants contained in the Senior Credit Facility. The termination resulted in a
$2.5 million pre-tax charge in the first quarter of 1999.

7.   COMMITMENTS

     (A) CONSTRUCTION COMMITMENTS

     The Company had capital  commitments,  as of March 31, 1999,  under various
contracts of  approximately  $32.1 million in the United  States.  These include
contractual commitments to improve existing facilities and to develop, construct
and complete a corporate  office  building and a long-term  care facility in the
United States and two long term care facilities in the United Kingdom.

     (B) FINANCING COMMITMENTS

     The Company has  advanced  $36.3  million and has agreed to advance up to a
total of  $40.0  million,  plus an  additional  $5.0  million  to cover  accrued
interest  due and owing to the Company  and other  lenders,  to a  developer  of
assisted  living  facilities  to  cover  20% of the  costs  of the  development,
construction  and operation of assisted  living  facilities.  Advances under the
arrangement  are  part  of the  Company's  assisted  living  investment  that is
classified as Assets Held for Sale.

     (C) LITIGATION

     The  Company  is a  party  to  various  legal  actions  and  administrative
proceedings  and subject to various  claims  arising in the  ordinary  course of
business (see Note 9).

 8.  NET EARNINGS (LOSSES) PER SHARE

     Basic net earnings  (losses)  per share is based upon the weighted  average
number of common shares outstanding during the period.

     Diluted  net  earnings  per share in periods of  earnings is based upon the
weighted average number of common shares  outstanding during the period plus the
number of incremental shares of common stock contingently issuable upon exercise
of stock options and, if dilutive,  including the assumption  that the Company=s
convertible  securities  were  converted as of the beginning of the period.  Net
earnings,  if  conversion  of the  securities  is assumed,  is adjusted  for the
interest  on the  debentures,  net of  interest  related to  additional  assumed
borrowings to fund the cash  consideration on conversion of certain  convertible
securities  and the related income tax benefits.  In periods of losses,  diluted
net earnings  (losses) per share is based upon the  weighted  average  number of
common shares  outstanding  during the period. As the Company had a net loss for
the  three  months  ended  March 31,  1999,  the  Company's  stock  options  and
convertible debentures were anti-dilutive.


                                       14
<PAGE>

                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)

     Earnings  per share is  calculated  as follows for the three  months  ended
March 31, (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                     1999     1998
                                                     ----     ----
<S>                                               <C>        <C>
BASIC:
Net earnings (losses) before cumulative
  effect of change in accounting principle ...... $ (99,421) $18,387

Earnings per share .............................. $   (1.73) $  0.39
                                                    ======== =======
Net earnings (losses) ........................... $(113,147) $18,387

Earnings (losses) per share ..................... $   (1.96) $  0.39
                                                    ======== =======
Weighted average shares outstanding .............    57,621   46,905

DILUTED:
Net earnings (losses) before cumulative
  effect of change in accounting principle ...... $ (99,421) $18,387
Income impact of assumed conversion .............         -      811
                                                  ---------- -------
Adjusted net earnings (losses) before cumulative
  effect of change in accounting principle ...... $ (99,421) $19,198

Earnings (losses) per share before cumulative
  effect of change in accounting principle ...... $   (1.73) $  0.39
                                                  ========== ======= 

Net earnings (losses) ........................... $ (99,421) $18,387
Income impact of assumed conversion .............         -     811
                                                  ---------- -------
Adjusted net earnings (losses) .................. $ (99,421) $19,198

Earnings (losses) per share ..................... $   (1.96) $  0.37
                                                  ========== =======
Weighted average shares used in basic
  calculation ...................................    57,621   46,905
Effect of dilutive securities:
  Stock options and warrants ....................         -      831
  Assumed conversion of convertible debt ........         -    4,645
                                                  ---------  -------
Weighted average common and common equivalent
  shares outstanding ............................    57,621   52,381
                                                  =========  =======

</TABLE>

9.    OTHER EVENTS

(A)   LITIGATION
 
     In March, April and May, 1999, class action lawsuits were filed against the
Company and three  officers of the Company in the United States  District  Court
for the District of New Mexico on behalf of purchasers  of the Company's  common
stock during the class period. These actions have been consolidated as IN RE SUN
HEALTHCARE GROUP,  INC.  SECURITIES  LITIGATION  MASTER FILE NO. CIV99-269.  The
lawsuits allege,  among other things, that the Company did not disclose material
facts  concerning  the impact  that PPS would have on the  Company's  results of
operations.  The lawsuits seek compensatory  damages and other relief.  Although
the Company intends to vigorously defend itself in this matter,  there can be no
assurance  that the  outcome of this  matter  will not have a  material  adverse
effect on the results of operations and financial condition of the Company.


                                       15
<PAGE> 

                SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)

     In January 1999, the state of Florida filed criminal charges in the Circuit
Court of the Eighth Judicial  Circuit for Alachua County,  Florida against three
subsidiaries  which were acquired by the Company on June 30, 1998: RCA,  Capitol
Care Management Co., Inc. and  Gainesville  Health Care Center,  Inc. All of the
allegations of wrongdoing  relate to activities prior to June 30, 1998, the date
of the RCA acquisition. Florida's allegations include violations of certain RICO
laws, abuse or neglect of elderly or disabled persons,  grand theft and Medicaid
fraud at a nursing home facility in Florida.  Also named as defendants were five
individuals  who  were  involved  in the  operation  of the  facility  in  their
capacities as officers, directors or employees of the defendant entities. If the
defendant entities are convicted, they could be banned from participating in the
Florida  Medicaid  program.  Although  the  Company's  subsidiaries  will defend
themselves vigorously in this matter, there can be no assurance that the outcome
of this  matter  will not have a  material  adverse  effect  on the  results  of
operations and financial condition of the Company.
 
     The Company and certain of its  subsidiaries  are defendants in two QUI TAM
lawsuits brought by private citizens in the United States District Court for the
Eastern District of California  alleging  violations of the federal False Claims
Act. The  plaintiffs  allege that  skilled  nursing  facilities  operated by the
subsidiaries  and others  conspired over the last decade to (i) falsely  certify
compliance with regulatory  requirements in order to participate in the Medicare
and Medicaid  programs,  and (ii) falsify records to conceal failures to provide
services in accordance with such regulatory  requirements.  Although the Company
and its subsidiaries  intend to vigorously  defend  themselves in these matters,
there can be no assurance  that the outcome of any one of these matters will not
have a material  adverse  effect on the  results  of  operations  and  financial
condition of the Company.
 
     In March 1999, the Company and several of its subsidiaries  filed a lawsuit
in the Superior Court of Fulton County in the State of Georgia  against  certain
individuals  who served as directors,  officers or employees of Retirement  Care
Associates,  Inc. ("RCA") prior to the Company's acquisition of RCA, and against
various  entities such  individuals  owned or controlled or with which they have
been affiliated.  The lawsuit alleges, among other things, breaches of fiduciary
duties, breaches of contract and conversion. The Company seeks damages in excess
of $30 million and punitive  amounts.  In May 1999,  certain  defendants in this
lawsuit filed  counterclaims  against certain plaintiffs  alleging,  among other
things,  securities fraud,  negligent  misrepresentation and breach of contract.
Defendants  seek  damages in an amount to be  determined  at trial and  punitive
amounts.
                                       
     Between August 25, 1997 and October 24, 1997, 10 class action lawsuits (the
"Actions")  were  filed in the United  States  District  Court for the  Northern
District of Georgia on behalf of persons who purchased RCA Common Stock,  naming
RCA and certain of its officers and directors as defendants. The complaints have
overlapping  defendants and largely  overlapping  (although not identical) class
periods.  The complaints  allege  violations of Federal  securities  laws by the
defendants for disseminating allegedly false and misleading financial statements
for RCA's fiscal year ended June 30, 1996 and its first three quarters of fiscal
year  1997,   which  the   plaintiffs   allege   materially   overstated   RCA's
profitability.  Generally,  each of the Actions seeks  unspecified  compensatory
damages,  prejudgment and postjudgment  interest,  attorneys' fees and costs and
other equitable and injunctive relief.
 
     On  November  25,  1997,  RCA,  the  Company  and  representatives  of  the
plaintiffs in the Actions  entered into a Memorandum of  Understanding  ("MOU").
Pursuant to the MOU, the Company paid $9 million into an interest-bearing escrow
account  maintained by the Company (the "Escrow  Account") to settle the Actions
(the "Settlement").  RCA also agreed to assign coverage under its directors' and
officers'   liability   insurance  policy  for  these  specific  claims  to  the
plaintiffs. The parties have signed the Settlement Agreement and the hearing for
court approval of the settlement is currently  scheduled for July 21, 1999. Upon
court  approval  of the  Settlement,  all claims by the class that were or could
have been asserted by the plaintiffs  against RCA or any of the other defendants
in the Actions will be settled and  released,  and the Actions will be dismissed
in their  entirety with  prejudice in exchange for the release of all funds from
the  Escrow  Account  to the  Plaintiffs.  No  assurance  can be given  that the
Settlement will become final.


                                       16
<PAGE>

                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)
 
     The Company is a party to various  other legal  actions and  administrative
proceedings  and is subject to various claims arising in the ordinary  course of
business.  The Company does not believe that the ultimate  disposition  of these
other matters will have a material  adverse effect on the financial  position or
results of operations of the Company.
 
(B)  OTHER INQUIRIES
 
     From time to time, fiscal intermediaries and Medicaid agencies examine cost
reports  filed  by  predecessor  operators  of  the  Company's  skilled  nursing
facilities.  If,  as a result  of any such  examination,  it is  concluded  that
overpayments  to a predecessor  operator were made, the Company,  as the current
operator  of such  facilities,  may be held  financially  responsible  for  such
overpayments.  At this time the  Company is unable to predict the outcome of any
existing or future examinations.
 
     The  Company  was  notified  in 1997  by a law  firm  representing  several
national insurance  companies that these companies believed that the Company had
engaged in improper billing and other practices in connection with the Company's
delivery  of therapy and  related  services.  In  response,  the  Company  began
discussions  directly  with these  insurers and hopes to resolve  these  matters
without  litigation;  however,  the  Company  is unable at this time to  predict
whether it will be able to do so, what the eventual outcome may be or the extent
of its liability, if any, to these insurers.
 
(C)  LEGISLATION, REGULATIONS AND MARKET CONDITIONS
 
     The Company is subject to  extensive  Federal,  state and local  government
regulation   relating  to  licensure,   conduct  of  operations,   ownership  of
facilities, expansion of facilities and services and reimbursement for services.
As such,  in the  ordinary  course of business,  the  Company's  operations  are
continuously subject to state and Federal regulatory  scrutiny,  supervision and
control.  Such  regulatory  scrutiny often includes  inquiries,  investigations,
examinations, audits, site visits and surveys, some of which may be non-routine.
The Company  believes that it is in substantial  compliance  with the applicable
laws and regulations.  However,  if the Company is ever found to have engaged in
improper practices,  it could be subjected to civil,  administrative or criminal
fines, penalties or restitutionary relief.


                                       17
<PAGE>
                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)


10.  SUMMARIZED FINANCIAL INFORMATION

     The Company acquired The Mediplex Group, Inc. ("Mediplex") on June 23, 1994
and became a  co-obligor  with  Mediplex  with  respect  to the 62%  Convertible
Subordinated  Debentures and the 11% Senior Subordinated Notes subsequent to the
acquisition.  Summarized financial information of Mediplex is provided below (in
thousands):

<TABLE>
<CAPTION>
                                                      March 31,   December 31,
                                                        1999         1998
                                                      --------    -----------
<S>                                                   <C>          <C>
Current assets ...................................    $ 89,605     $113,585
Noncurrent assets ................................     221,116      225,586
Current liabilities ..............................       3,129       13,165
Noncurrent liabilities ...........................      51,976       69,454
Due to parent ....................................     224,568      206,161
</TABLE>

<TABLE>
<CAPTION>
                                                               Three Months Ended
                                                                    March 31,
                                                             ----------------------
                                                                1999         1998
                                                                ----         ----
<S>                                                          <C>          <C>
Net revenues .............................................   $ 111,435    $ 144,631
Costs and expenses .......................................     109,128      136,106
                                                             ----------  ----------
Earnings (losses) before intercompany charges, 
   income taxes and cumulative effect of change 
   in accounting principle ...............................       2,307        8,525
Intercompany charges (1) .................................      18,767       24,265
                                                             ----------   ----------
Earnings (losses) before income taxes and 
   cumulative effect of change in accounting principle ...     (16,460)     (15,740)
Income taxes (benefit) ...................................         363       (6,763)
                                                             ----------   ----------
Net earnings (losses) before cumulative effect of 
   change in accounting principle ........................     (16,823)      (8,977)
                                                             ----------   ----------
Cumulative effect of change in accounting principle ......       2,520          -
                                                             ----------   ----------
Net earnings (losses) ....................................   $ (19,343)   $  (8,977)
                                                             ==========   ==========
</TABLE>

(1)  Through various  intercompany  agreements entered into by Sun and Mediplex,
     Sun provides  management  services,  licenses the use of its trademarks and
     acts on behalf of Mediplex to make financing  available for its operations.
     Sun charged  Mediplex for  management  services  totaling  $3.7 million and
     $11.4  million  for the  three  months  ended  March  31,  1999  and  1998,
     respectively.  Royalty  fees charged to Mediplex for the three months ended
     March 31, 1999 and 1998 for the use of Sun trademarks were $1.7 million and
     $2.6 million,  respectively.  Intercompany interest charged to Mediplex for
     the three months  ended March 31, 1999 and 1998 for  advances  from Sun was
     $18.8 million and $10.2 million, respectively.


                                       18
<PAGE>
                SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)


11.  SEGMENT INFORMATION

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

<TABLE>
<CAPTION>
                                   Rehabilitation
                                        and
                                    Respiratory   Pharmaceutical
                         Inpatient    Therapy       and Medical     International    Other               Intersegment
                         Services    Services     Supply Services    Operations   Operations Corporate  Eliminations  Consolidated
                         -----------------------------------------------------------------------------------------------------------
<S>                      <C>        <C>              <C>              <C>          <C>        <C>        <C>            <C>
For the Three Months Ended March 31, 1998

Total Net Revenues ..... $485,177    $177,393        $52,877          $66,306      $67,256    $  332     $(107,851)     $741,490
Operating expenses,
  corporate general 
  and administrative
  expenses, provision 
  for losses on
  accounts receivable ..  449,196    117,720        45,057              60,005       61,396       26,471   (105,946)      653,899
Depreciation and      
    amortization .......    8,917      2,087         1,506               5,099        1,060        1,805       -           20,474

Interest, net ..........    1,174       (2)              8               4,582           40       29,338       -           35,140

Earnings (losses)    
  before corporate    
  allocations ..........   25,890     57,588         6,306              (3,380)       4,760      (57,282)    (1,905)       31,977
Corporate interest   
  allocation ...........   11,302      3,963         2,114               6,459        1,768      (25,606)      -              -
Corporate management
  fees .................   20,365      7,156         2,087                 624        1,305      (29,632)    (1,905)          -
Net segment earnings
  (losses) .............   (5,777)    46,469         2,105             (10,463)       1,687       (2,044)      -           31,977
Intersegment revenues ..    5,969     79,547        15,220                -           7,115         -      (107,851)          -   
Identifiable segment
  assets ...............  652,892    253,216        98,502             552,890      102,992    1,802,275   (774,781)    2,687,986
Segment capital 
 expenditures, net .....    6,660      4,441           793               5,500          -          7,435       -           24,829

</TABLE>


                                       19
<PAGE>
                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)


<TABLE>
<CAPTION>
                                    Rehabilitation
                                         and
                                     Respiratory   Pharmaceutical
                          Inpatient    Therapy       and Medical    International    Other               Intersegment
                           Services    Services    Supply Services    Operations   Operations Corporate  Eliminations  Consolidated
                          ----------------------------------------------------------------------------------------------------------
<S>                        <C>          <C>           <C>              <C>          <C>        <C>         <C>           <C>
For the Three Months Ended March 31, 1999

Total Net Revenues ......  $461,105     $70,066       $75,822          $71,664      $64,514    $  (968)   $(69,171)     $673,032
Operating expenses,    
  corporate general and
  administrative expenses,
  provision for losses on
  accounts receivable ...   447,201      67,426        73,766           67,560       63,075     30,548     (69,171)      680,405
Depreciation and        
  amortization ..........     8,464       2,140         2,072            3,514        2,751      2,507         -          21,448
Interest, net ...........     2,260          74            21            3,214        2,047     29,554         -          37,170
Dividend on convertible     
 preferred securities ...       -           -             -                -            -        6,516         -           6,516
Earnings (losses)           
  before corporate
  allocations ...........     3,180         426           (37)          (2,624)      (3,359)   (70,093)                  (72,507)
Corporate interest                
  allocation ............    13,517       3,463         3,398            5,122        2,904    (28,404)        -             - 
Corporate management
  fees ..................    18,140       2,795         3,007              711        1,902    (26,555)        -             -
Net segment earnings
  (losses) ..............   (28,477)     (5,832)       (6,442)          (8,457)      (8,165)   (15,134)        -         (72,507)

Intersegment revenues ...       150      38,770        23,774              -          6,428         49     (69,171)          -
Identifiable segment
  assets ................   727,417     205,866       131,072          448,701      284,509  1,631,676  (1,044,326)    2,384,915
Segment capital 
  expenditures, net ....     12,366       2,413         1,692           (2,630)       4,221     16,147         -          39,469

</TABLE>

12.  SUMMARIZED CONSOLIDATING INFORMATION
 
     In connection with the Company's  offering of the 9 1/2% Notes in July 1997
and the 9 3/8% Notes in May,  1998 all direct and indirect  subsidiaries  of the
Company  other than the  Company's  direct and  indirect  foreign  subsidiaries,
CareerStaff  and  its  direct  and  indirect  subsidiaries,  and  certain  other
immaterial  subsidiaries  of the Company (the  "Guarantors")  have,  jointly and
severally,  unconditionally  guaranteed the 9 1/2% Notes and 9 3/8% Notes. These
guarantees  are  subordinated  to  all  existing  and  future  senior  debt  and
guarantees of the Guarantors and are unsecured.
 
     The Company conducts all of its business through and derives  virtually all
of its income from its  subsidiaries.  Therefore,  the Company's ability to make
required  payments with respect to its indebtedness  (including the 9 1/2% Notes
and the 9 3/8% Notes) and other obligations depends on the financial results and
condition  of its  subsidiaries  and its  ability  to  receive  funds  from  its
subsidiaries.  There are no  restrictions on the ability of any of the Company's
subsidiaries to transfer funds to the Company, except as provided by appropriate
law.


                                       20
<PAGE>
 
                  SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)


     Pursuant  to  Rule  3-10  of  Regulation  S-X,  the  following   summarized
consolidating  information is for the Company, the wholly-owned Guarantors,  and
the Company's  non-Guarantor  subsidiaries  with respect to the 9 1/2% Notes and
the 9 3/8% Notes. This summarized  financial  information has been prepared from
the  books  and  records  maintained  by the  Company,  the  Guarantors  and the
non-Guarantor  subsidiaries.   The  summarized  financial  information  may  not
necessarily be indicative of results of operations or financial position had the
Guarantors or non-Guarantor  subsidiaries operated as independent entities.  The
separate  financial  statements  of the  Guarantors  are not  presented  because
management has determined they would not be material to investors.


                                       21
<PAGE>
                   SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                           CONSOLIDATING BALANCE SHEET

                             As of December 31, 1998
                                 (In thousands)

<TABLE>
<CAPTION>
                                                             Combined       Combined
                                               Parent        Guarantor    Non-Guarantor
                                              Company       Subsidiaries  Subsidiaries   Elimination  Consolidated
                                              -------       ------------  -------------  -----------  ------------
<S>                                        <C>            <C>            <C>            <C>           <C>
Current assets:
   Cash and cash equivalents ...........   $    (9,964)   $    26,406    $    11,062    $      -      $    27,504
   Accounts receivable, net ............           311        485,293         60,313        (7,588)       538,329
   Other receivables ...................        14,304         17,600         16,169           -           48,073
   Inventory, net ......................            13         39,640          9,209           -           48,862
   Prepaids and other assets ...........         2,651          9,151          1,289           -           13,091
   Income tax receivable ...............        15,874            -              -             -           15,874
                                           -----------    -----------    -----------   -----------    -----------
     Total current assets ..............        23,189        578,090         98,042        (7,588)       691,733
                                           -----------    -----------    -----------   -----------    -----------

   Property and equipment, net .........        66,341        228,732        306,197           -          601,270
   Goodwill, net .......................           -          669,785        126,160           -          795,945
   Notes receivable ....................        21,999            693          9,642           -           32,334
   Assets held for sale ................           -          192,447            -             -          192,447
   Other assets, net ...................        75,710         50,287         22,312           -          148,309
   Investment in subsidiaries ..........          (904)           -              -             904            -
   Deferred tax assets .................         6,000            -              -             -            6,000
                                           -----------    -----------    -----------   -----------    -----------
     Total assets ......................   $   192,335    $ 1,720,034    $   562,353   $    (6,684)   $ 2,468,038
                                           ===========    ===========    ===========   ============   ===========
Current liabilities:
   Current portion of long-term debt ...   $   728,032    $    57,212    $    27,377    $      -          812,621
   Current portion of obligations under
     capital leases ....................         1,134          2,333            236           -            3,703
   Accounts payable ....................        63,170         17,192         21,369        (7,588)        94,143
   Accrued compensation and benefits ...        19,160         69,510         13,421           -          102,091
   Accrued interest payable ............        19,616          5,957            522           -           26,095
   Accrued self insurance obligations ..        (2,713)        56,241          1,337           -           54,865
   Other accrued liabilities ...........        23,699         77,128         37,024           -          137,851
                                           -----------    -----------    -----------   -----------    ----------- 
    Total current liabilities ..........       852,098        285,573        101,286        (7,588)     1,231,369
                                           -----------    -----------    -----------   -----------    -----------

Long-term debt, net of current portion .       502,822        162,061         40,770           -          705,653
Obligations under capital leases, 
    net of current portion .............           -           27,731         75,948           -          103,679
Other long-term liabilities ............           -           39,123          1,938           -           41,061
                                           -----------    -----------    -----------   -----------    -----------
     Total liabilities .................     1,354,920        514,488        219,942        (7,588)     2,081,762
                                           -----------    -----------    -----------   -----------    -----------

Intercompany payables/(receivables) ....    (1,541,344)     1,398,795        142,549           -              -
Minority interest ......................           -            6,118          1,399           -            7,517
Company-obligated manditorily redeemable
   convertible preferred securities of
   a subsidiary trust holding solely
   7% convertible junior subordinated
   debentures of the Company ...........       345,000            -              -             -          345,000
Total stockholders' equity .............        33,759       (199,367)       198,463           904         33,759
                                           -----------    -----------    -----------   -----------    -----------

     Total liabilities and            
     stockholders' equity .............    $   192,335    $ 1,720,034    $   562,353   $   (6,684)    $ 2,468,038
                                           ===========    ===========    ===========   ============   ===========
</TABLE>

                                       22
<PAGE>
                  SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                           CONSOLIDATING BALANCE SHEET

                              As of March 31, 1999
                                 (In thousands)
                                  (Unaudited)


<TABLE>
<CAPTION>
                                                             Combined       Combined
                                               Parent        Guarantor    Non-Guarantor
                                              Company       Subsidiaries  Subsidiaries   Elimination  Consolidated
                                              -------       ------------  -------------  -----------  ------------
<S>                                        <C>              <C>           <C>            <C>           <C>
Current assets:
   Cash and cash equivalents ...........   $   (7,093)      $   43,547     $  10,714     $       -      $   47,168   
   Accounts receivable, net ............            -          399,683        51,533             -         451,216
   Other receivables ...................        7,124            9,353        18,596             -          35,073
   Inventory, net ......................           12           41,080         9,881             -          50,973
   Prepaids and other assets ...........        5,755            8,131         1,650             -          15,536
   Income tax receivable ...............       14,760                -             -             -          14,760
                                           -----------      -----------    -----------   -----------    -----------
     Total current assets ..............       20,558          501,794        92,374             -         614,726
                                           -----------      -----------    -----------   -----------    -----------

   Property and equipment, net .........       80,992          237,988       298,502             -         617,482
   Goodwill, net .......................            -          690,079       114,612             -         804,691
   Notes receivable ....................       23,780            1,241         9,356             -          34,377
   Assets held for sale ................            -          178,647             -             -         178,647
   Other assets, net ...................       98,153           18,820        18,019             -         134,992
   Investment in subsidiaries ..........      439,745         (439,745)            -             -               -
                                            -----------     -----------    -----------   -----------    -----------
     Total assets ......................   $  663,228       $1,888,824     $ 532,863     $       -      $2,384,915
                                           ===========      ===========    ===========   ===========    ===========
Current liabilities:
   Current portion of long-term debt ...   $   15,386       $   44,828     $  25,693     $       -      $   85,907
   Current facility borrowings .........      813,305                                                      813,305
   Current portion of obligations under
     capital leases ....................        1,134            2,438           226             -           3,798                
   Accounts payable ....................       28,555           (8,873)       20,492             -          40,174
   Accrued compensation and benefits ...        3,073           89,897        14,656             -         107,626
   Accrued interest payable ............       18,022            6,190           886             -          25,098
   Accrued self insurance obligations ..      (10,793)          65,319           767             -          55,293
   Other accrued liabilities ...........       20,665           87,425        38,348             -         146,438
                                           -----------      -----------    -----------   -----------    ----------- 
    Total current liabilities ..........      889,347          287,224       101,068     $       -      $1,277,639
                                           -----------      -----------    -----------   -----------    -----------

Long-term debt, net of current portion .   $  501,002       $  140,590     $  46,198     $       -      $  687,790    
Obligations under capital leases,
    net of current portion .............            -           27,437        73,914             -         101,351
Other long-term liabilities ............            -           38,842         1,542             -          40,384
                                           -----------      -----------    -----------   -----------    -----------
     Total liabilities .................   $1,390,349       $  494,093     $ 222,722     $       -      $2,107,164
                                           -----------      -----------    -----------   -----------    -----------

Intercompany payables/(receivables) ....   $ (906,385)      $1,698,403     $ 141,077     $(933,095)     $        -
Minority interest ......................            -            5,844           167             -           6,011
Company-obligated manditorily redeemable
   convertible preferred securities of
   a subsidiary trust holding solely
   7% convertible junior subordinated
   debentures of the Company ...........      345,000                -             -             -         345,000

Total stockholders' equity .............   $ (165,736)     $(1,009,516)    $ 168,897     $ 933,095      $  (73,260)  
                                           -----------     ------------    -----------   -----------    -----------

     Total liabilities and            
     stockholders' equity ..............   $  663,228      $ 1,188,824     $ 532,863     $       -      $2,384,915     
                                           ===========     ============    ===========   ===========    ===========
</TABLE>

                                       23
<PAGE>
                  SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                  CONSOLIDATING STATEMENT OF EARNINGS (LOSSES)

                              As of March 31, 1998
                                 (In thousands)
                                  (Unaudited)


<TABLE>
<CAPTION>
                                                        Combined      Combined
                                            Parent      Guarantor    Non-Guarantor
                                           Company     Subsidiaries  Subsidiaries  Elimination  Consolidated
                                           -------     ------------  ------------- -----------  ------------
<S>                                        <C>         <C>           <C>           <C>          <C>    
Total net revenues ......................  $   332      $637,121       $105,474     $(1,437)      $741,490
                                           -------      --------       --------     --------      --------
Costs and expenses: 
   Operating ............................        -       518,316         91,706      (1,437)       608,585
   Corporate general and administrative .   26,717         8,231          4,353           -         39,301
   Provision for losses on accounts                                                                       
     receivable .........................        -         5,690            323           -          6,013
   Depreciation and amortization.........    1,439        13,523          5,512           -         20,474
   Interest, net.........................   28,969         1,593          4,578           -         35,140
   Equity interest in (earnings)                                                                            
    loss of subsidiaries ................       36             -              -         (36)             -
                                          ---------    ----------    ----------    ---------     ---------
        Total costs and expenses.........  $ 57,161     $547,353       $106,472     $(1,473)      $709,513
                                          ---------    ----------    ----------    ---------     ---------

Earnings (loss) before income taxes                                                                       
  and intercompany charges ..............   (56,829)      89,768           (998)         36         31,977
Intercompany charges.....................   (86,099)      84,683          1,416           -              -
                                          ----------   ---------      ---------    ---------     ---------
Earnings (loss) before income taxes......    29,270        5,085         (2,414)         36         31,977
Income taxes.............................    10,883        2,946           (239)          -         13,590
                                          ----------   ---------      ----------   ---------     ---------

Net earnings (losses).................... $  18,387    $   2,139     $   (2,175)   $     36       $ 18,387
                                          ==========   =========     ===========   =========   ===========
</TABLE>

                                       24
<PAGE>
                  SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                  CONSOLIDATING STATEMENT OF EARNINGS (LOSSES)

                              As of March 31, 1999
                                 (In thousands)
                                  (Unaudited)


<TABLE>
<CAPTION>
                                                        Combined      Combined
                                            Parent      Guarantor    Non-Guarantor
                                           Company     Subsidiaries  Subsidiaries  Elimination Consolidated
                                           -------     ------------  ------------- ----------- ------------
<S>                                       <C>          <C>           <C>           <C>         <C>    
Total net revenues ...................... $    (968)    $ 580,426     $  93,574          -       $ 673,032
Costs and expenses:
   Operating ............................      -          536,092        88,476          -         624,568
   Corporate general and administrative .    31,530         6,740         3,747          -          42,017
   Provision for losses on accounts    
     receivable .........................      -           13,699           119          -          13,818       
   Depreciation and amortization.........     2,066        15,411         3,971          -          21,448
   Interest, net.........................    28,732         4,886         3,552          -          37,170
   Loss on sale of assets................     3,007         8,099         1,000          -          12,106
   Restructuring costs...................     3,805         6,359         1,265          -          11,429
   Loss on interest rate swap............     2,488           -             -            -           2,488
   Equity in (earnings) losses of
     subsidiary..........................   120,147           -             -        (120,147)         -
   Intercompany interest (income) 
     expense.............................    (5,031)        5,031           -            -             -
                                          ----------    ----------    ----------   -----------   ----------
        Total costs and expenses ........ $ 186,744     $ 596,317     $ 102,130    $ (120,147)   $ 765,044
                                          ----------    ----------    ----------   -----------   ----------

Operating income......................... $(187,712)      (15,891)       (8,556)      120,147      (92,012)

Dividend convertible preferred 
  securities.............................     6,516           -             -            -           6,516

Management fee (income) expense..........   (89,669)       87,923         1,746          -             -

Earnings (loss) before income taxes
  and extraordinary losses...............  (104,559)     (103,814)      (10,302)      120,147     (98,528)

Income taxes.............................     5,519        (5,038)          411          -            892

Earnings before change in accounting.....  (110,078)      (98,776)      (10,713)      120,147     (99,420)

Cumulative effect of change in 
  accounting principle...................     3,069         9,352         1,306          -         13,727
                                          ----------    ----------    ----------   -----------   ----------
     Net earnings (losses)............... $(113,147)    $(108,128)    $ (12,019)   $  120,147    $(113,147)
                                          ==========    =========     ==========   ==========    ==========

</TABLE>

                                       25
<PAGE>
                  SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                      CONSOLIDATING STATEMENT OF CASH FLOWS

                              As of March 31, 1998
                                 (In thousands)
                                  (Unaudited)

<TABLE>
<CAPTION>
                                                                Combined      Combined
                                                    Parent      Guarantor    Non-Guarantor
                                                   Company     Subsidiaries  Subsidiaries Elimination Consolidated
                                                   -------     ------------  ------------ ----------- ------------
<S>                                               <C>          <C>           <C>          <C>         <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net earnings (losses) .......................  $  18,387     $   2,139    $  (2,175)    $     36     $  18,387
   Adjustments to reconcile net earnings
      (losses) to net cash provided by
      (used for) operating activities --
      Equity in earnings in subsidiaries .......         36             -            -          (36)            -
      Depreciation and amortization ............      1,439        13,523        5,512            -        20,474
      Provision for losses on accounts                                                                      
        receivable .............................          -         5,690          323            -         6,013
      Other, net ...............................      2,494          (358)         (50)           -         2,086
      Changes in operating assets and
        liabilities:
          Accounts receivable ..................          -       (75,249)     (10,250)           -       (85,499)
          Other current assets .................     (7,481)      (11,469)      (2,688)           -       (21,638)
          Other current liabilities ............     10,428        (1,515)       3,339            -        12,252
          Income taxes payable .................     10,754         1,400           21            -        12,175
                                                  ---------     ----------    ---------    ---------    ----------
     Net cash provided by (used for)
        operating activities....................     36,057       (65,839)      (5,968)           -       (35,750)
                                                  ---------     ----------    ---------    ---------    ----------
 
CASH FLOWS FROM INVESTING ACTIVITIES:
   Capital expenditures, net ...................     (7,245)      (11,861)      (5,723)           -       (24,829)
   Acquisitions, net of cash acquired ..........          -        (1,502)      (5,837)           -        (7,339)
   Increase in long-term note receivable .......     (7,344)          487            -            -        (6,857)
   Other assets expenditures ...................     (8,929)       (1,384)         404            -        (9,909)
                                                  ----------    ----------    ---------    ---------    ----------
      Net cash used for investing activities ...    (23,518)      (14,260)     (11,156)           -       (48,934)
                                                  ----------    ----------    ---------    ---------    ----------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Long-term debt borrowings ...................     86,521            58        1,739            -        88,318
   Long-term debt repayments ...................     (8,396)       (6,626)      (7,048)           -       (22,070)
   Net proceeds from issuance of common stock ..        543             -            -            -           543
   Purchase of treasury stock ..................     (1,357)            -            -            -        (1,357)
   Financing fees paid .........................       (403)          148            -            -          (255)
   Intercompany advances .......................   (100,731)       76,302       24,429            -             -
                                                   ---------    ----------    ---------    ---------    ----------
      Net cash provided by (used for)
        financing activities ...................    (23,823)       69,882       19,120            -        65,179
                                                   ---------    ----------    ---------    ---------    ----------
Effect of exchange rate on cash and
   cash equivalents ............................           -            -         (402)           -          (402)
                                                   ---------    ----------    ---------    ---------   -----------
Net increase (decrease) in cash and
   cash equivalents ............................    (11,284)      (10,217)       1,594            -       (19,907)
Cash and cash equivalents at beginning of year .     (1,581)       20,010        2,591            -        21,020
                                                   ---------    ----------    ---------    ---------   -----------

Cash and cash equivalents at end of period .....   $(12,865)    $   9,793     $  4,185     $      -    $    1,113
                                                   =========    ==========    =========    =========   ===========
</TABLE>

                                       26
<PAGE>
                  SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                      CONSOLIDATING STATEMENT OF CASH FLOWS

                              As of March 31, 1999
                                 (In thousands)
                                  (Unaudited)


<TABLE>
<CAPTION>
                                                                Combined      Combined
                                                    Parent      Guarantor    Non-Guarantor
                                                   Company     Subsidiaries  Subsidiaries Elimination  Consolidated
                                                   -------     ------------  ------------ -----------  ------------
<S>                                               <C>          <C>           <C>          <C>          <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net earnings (losses) .......................  $(113,147)   $ (108,128)   $  (12,019)   $ 120,147    $(113,147)
   Adjustments to reconcile net earnings
      (losses) to net cash provided by
      (used for) operating activities --       
      Equity in earnings in subsidiaries .......    120,147             -             -     (120,147)           -        
      Cumulative effect ........................      3,069         9,351         1,306            -       13,726
      Loss on sale of assets ...................      3,007         8,099         1,000                    12,106
      Depreciation and amortization ............      2,066        15,411         3,971            -       21,448
      Provision for losses on accounts 
        receivable .............................          -        13,699           119            -       13,818
      Other, net ...............................        786             -             -            -          786
      Changes in operating assets and
        liabilities:
          Accounts receivable ..................      1,811        59,843         8,780            -       70,434
          Other current assets .................      3,060         1,293         3,460            -        7,813
          Other current liabilities ............    (61,264)       16,897         3,071            -      (41,296)
          Income taxes payable .................       (481)            -             -            -         (481)
      Net cash provided by (used for)             ---------    ----------    ----------   ----------  ------------
        operating activities ...................  $ (40,946)   $   16,465    $    9,688   $        -  $   (14,793)
                                                  ---------    ----------    ----------   ----------  ------------
 
CASH FLOWS FROM INVESTING ACTIVITIES:
   Capital expenditures, net ...................  $ (16,096)   $  (17,163)   $  (6,210)   $       -   $   (39,469)
   Acquisitions, net of cash acquired ..........          -        (1,901)         676            -        (1,225)
   Increase in long-term note receivable .......      1,779        (4,108)         286            -        (2,043)
   Other assets expenditures ...................     (6,177)          (96)       4,293            -        (1,980)
                                                  ----------   -----------   ----------   ---------   ------------
      Net cash used for investing activities ...  $ (20,494)   $  (23,268)   $    (955)   $       -   $   (44,717)
                                                  ----------   -----------   ----------   ---------   ------------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Long-term debt borrowings ...................  $ 103,351    $   (2,333)   $   9,387    $       -   $   110,405
   Long-term debt repayments ...................     (4,511)      (20,093)      (3,049)           -       (27,653)   
   Conversion of Mediplex 6 1/2% Convertible
     Subordinated Debentures due 2003 ..........          -        (5,840)           -            -        (5,840)
   Net proceeds from issuance of common stock ..        462             -            -            -           462     
   Purchases of treasury stock .................       (264)            -            -            -          (264)
   Other financing activities ..................        394          (281)        (396)           -          (283)
   Intercompany advances .......................    (35,121)       52,491      (17,370)           -             -
                                                  ---------    ----------    ---------    ---------   ------------
      Net cash provided by (used for) 
        financing activities ...................  $  64,311    $   23,944    $ (11,428)   $       -   $    76,827 
                                                  ---------    ----------    ---------    ---------   ------------
Effect of exchange rate on cash and
   cash equivalents ............................  $       -    $        -    $   2,347    $       -   $     2,347
                                                  ---------    ----------    ---------    ---------   ------------
Net increase (decrease) in cash and 
   cash equivalents ............................  $   2,871    $   17,141    $    (348)   $       -   $    19,664
Cash and cash equivalents at beginning of year .     (9,964)       26,406       11,062            -        27,504
                                                  ---------    ----------    ---------    ---------   -----------

Cash and cash equivalents at end of period .....  $  (7,093)   $   43,547    $  10,714    $       -   $    47,168
                                                  ==========   ==========    =========    =========   ===========
</TABLE>


                                       27
<PAGE>

                 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

               FOR THE THREE MONTHS ENDED MARCH 31, 1999 AND 1998
                                   (UNAUDITED)

     


                                       28
<PAGE>
                SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

     Sun Healthcare Group,  Inc.,  through its direct and indirect  subsidiaries
(collectively  referred to as "Sun" or the "Company"),  is a leading provider of
high  quality and cost  efficient  long-term,  subacute  and  related  specialty
healthcare  services in the United  States and the United  Kingdom.  The Company
also has  operations  in Spain,  Germany and  Australia.  The  Company  operates
through four principal business segments:
 
     INPATIENT SERVICES: This segment provides, among other services,  inpatient
skilled nursing and custodial  services as well as  rehabilitative,  restorative
and transitional medical services.  The Company provides 24-hour nursing care in
these facilities by registered  nurses,  licenses practical nurses and certified
nursing  assistants.  At March 31,  1999,  the Company  operated  397  inpatient
facilities  with 44,930  licensed  beds compared to 310  facilities  with 35,759
licensed  beds at March 31, 1998.  Included in the  preceding  are 16 facilities
with 1,927 licensed beds which the Company has announced its intention to divest
or not renew leases on certain facilities.
 
     REHABILITATION  AND RESPIRATORY  THERAPY  SERVICES:  This segment provides,
among other services,  physical,  occupational,  speech and respiratory  therapy
services to affiliated and nonaffiliated skilled nursing facilities. As of March
31, 1999 the Company's  rehabilitation and respiratory  therapy services segment
provided services to 1,620 facilities in 44 states, 1,237 of which were operated
by  nonaffiliated  parties  compared to 1,676  facilities  as of March 31, 1998,
1,316 of which were nonaffiliated.
 
     PHARMACEUTICAL AND MEDICAL SUPPLY SERVICES: This segment is comprised of an
institutional  pharmaceutical  subsidiary and a medical supply  subsidiary.  The
pharmaceutical  subsidiary  provides  pharmaceutical  products primarily to long
term and subacute care  facilities for such purposes as infusion  therapy,  pain
management,  antibiotic  therapy and  parenteral  nutrition as well as providing
consultant pharmacist services. The medical supply subsidiary primarily provides
medical supplies to long-term care and sub-acute care facilities.  The Company's
pharmaceutical  subsidiary provided  pharmaceutical products and services to 955
long term and sub-acute care facilities, including 592 nonaffiliated facilities,
as of March 31, 1999 through its 39 pharmacies and 2 pharmaceutical  billing and
consulting centers. At March 31, 1998 pharmaceutical  products and services were
provided to approximately 840 facilities including 554 nonaffiliated facilities.
The  Company's  medical  supply  subsidiary  provided  products  to  over  2,070
affiliated and nonaffiliated facilities as of March 31, 1999.
 
     INTERNATIONAL   OPERATIONS:   This  segment   consists  of  long-term  care
facilities  in the  United  Kingdom,  Spain and  Germany  as well as acute  care
hospitals in Australia.  This segment also provides  pharmaceutical  services in
the United  Kingdom,  Germany and Spain and medical  supplies in  Australia.  At
March 31,  1999,  the  Company  operated  155  inpatient  facilities  with 8,705
licensed beds in the United Kingdom; 10 inpatient  facilities with 1,604 beds in
Spain;  16 facilities  with 1,122  licensed beds in Germany and 5 hospitals with
309 licensed beds in Australia  compared to 152  facilities  with 8,517 licensed
beds in the United  Kingdom;  8 facilities with 1,328 licensed beds in Spain; 11
facilities with 934 licensed beds in Germany;  and 6 hospitals with 353 licensed
beds in Australia as of March 31, 1998.


                                       29
<PAGE>
 
     The Company's  international  operations also included  outpatient  therapy
service  operations in Canada which were  included in assets held for sale.  The
Company  completed  the sale of its Canadian  operations in the first quarter of
1999. The loss on sale was $12.1 million.
 
OTHER OPERATIONS

     The Company's other operations include temporary therapy services, assisted
living  services,  home  health  and  hospice,  software  development  and other
ancillary services.  The Company's temporary therapy service operations provided
approximately  290,417 temporary therapy staffing hours to nonaffiliates for the
three months ended March 31, 1999 compared to 678,041 hours for the three months
ended March 31, 1998. The assisted living subsidiary operated 32 assisted living
facilities with 3,450 beds in the United States as of March 31, 1999 compared to
8 assisted living  facilities with 729 beds in the United States as of March 31,
1998.  The Company  has  announced  that it is planning to divest  itself of its
assisted living facilities. No agreements have been entered into for the sale of
these assets held for sale as of May 19, 1999.
 
     On June 30,  1998,  a  wholly  owned  subsidiary  of the  Company  acquired
Retirement  Care  Associates,  Inc.  ("RCA"),  an operator of 98 skilled nursing
facilities  and  assisted  living  centers  in  eight  states  primarily  in the
southeastern United States. RCA also owned approximately 65% of Contour Medical,
Inc. ("Contour"),  a national provider of medical/surgical supplies. The Company
also acquired the remaining 35% of Contour on June 30, 1998. Both the RCA merger
and the Contour acquisition were accounted for as purchases.
 
     The  Company's   earnings  growth  has   historically   resulted  from  the
acquisition of long-term and subacute care facilities,  use of its long-term and
subacute  care  operations  as a base for  expansion  of certain  its  ancillary
services,  provision  of  ancillary  services to  nonaffiliated  facilities  and
expansion of ancillary services through acquisitions.  Ancillary services,  such
as  rehabilitation  and  respiratory  therapy  services and  pharmaceutical  and
medical supply services,  have had  significantly  higher operating margins than
the margins  associated  with the  provision of routine  services to patients at
long-term  and  subacute  care  facilities  and  accordingly  have  historically
provided  more than half of the  Company's  operating  profits.  In addition,  a
substantial  portion  of  the  Company's   consolidated   interest  expense  was
attributable  to the Company's  long-term and subacute  services and its foreign
operations  due to the  capital  intensive  nature  of these  businesses  and to
related  acquisitions.  The  higher  operating  margins  from the  provision  of
ancillary services have been primarily  attributable to favorable  reimbursement
rates under the Medicare reimbursement system. However,  effective July 1, 1998,
Medicare began a four year phase in of a prospective  payment system ("PPS") for
Part  A  patients  which  will  provide  reimbursement  of all  costs  including
ancillary service and  capital-related  costs at a fixed fee. A small percentage
of the long-term and subacute care industry transitioned to PPS on July 1, 1998,
including the Company's  facilities  that were acquired in the RCA  Acquisition.
The vast majority of the industry  transitioned  to PPS on January 1, 1999.  The
Company's  average per diem rates  under PPS are less than the amounts  received
under cost based  reimbursement.  The  Company's  RCA  facilities  results  were
negatively  impacted by the  implementation of PPS. The implementation of PPS at
the Company's remaining facilities resulted in a significant decline in Medicare
revenues. In addition,  as a result of the industry-wide  reductions in Medicare
reimbursement,  the Company's  nonaffiliated  ancillary  service  customers have
significantly  reduced their usage of such  services.  In the fourth  quarter of
1998, the Company  experienced a significant and rapid decline in the demand for
its  ancillary  services  as  its  nonaffiliated   customers  prepared  for  the
implementation of PPS. This negative trend continued during the first quarter of
1999. See "Effects from Changes in Reimbursement."


                                       30
<PAGE>

     The following table sets forth certain operating data for the Company as of
the dates indicated:

<TABLE>
<CAPTION>
                                                                         March 31,      December 31,
                                                                         ---------      ------------
                                                                      1999      1998        1998
                                                                      ----      ----        ----
<S>                                                                   <C>       <C>     <C>
Inpatient Services:
     Facilities ..................................................     397       310         397
     Licensed beds ...............................................  44,930    35,759      44,941

Rehabilitation and Respiratory Therapy Service
     Operations:
     Nonaffiliated facilities served .............................   1,237     1,316       1,294
     Affiliated facilities served ................................     383       360         421
                                                                     -----     -----       -----
        Total ....................................................   1,620     1,676       1,715
                                                                     =====     =====       =====
Pharmaceutical and Medical Supply Services:
     Nonaffiliated facilities served .............................     592       554         584
     Affiliated facilities served ................................     363       286         346
                                                                      ----     -----       -----
        Total ....................................................     955       840         930
                                                                      ====    ======      ======
International Operations:
     Facilities
       United Kingdom ............................................     155       152         155
       Other foreign .............................................      31        25          31
                                                                      ----     -----      ------
        Total ....................................................     186       177         186   
                                                                      ====     =====      ======
     Licensed beds
       United Kingdom ............................................   8,705     8,517       8,705
       Other foreign .............................................   3,035     2,615       3,048
                                                                     -----     -----      ------
        Total ....................................................  11,740    11,132      11,753
                                                                    ======    ======      ======
</TABLE>

                                       31
<PAGE>

RESULTS OF OPERATIONS
 
     The following table sets forth the amount of certain  elements of total net
revenues for the periods presented (dollars in thousands):

<TABLE>
<CAPTION>
 
                                                    Three Months Ended
                                                    ------------------
                                                         March 31,
                                                         ---------
                                                     1999         1998
                                                     ----         ----
<S>                                                  <C>          <C>
Inpatient Services ..................................$461,105     $485,175
Rehabilitation and Respiratory Therapy Services .....  70,066      177,393
Pharmaceutical and Medical Supply Services ..........  75,822       52,877
International Operations ............................  71,664       66,306
Other Operations ....................................  64,514       67,258
Corporate ...........................................    (968)         332
Intersegment Eliminations ........................... (69,171)    (107,851)
                                                      --------    ---------
     Total net revenues .............................$673,032     $741,490
                                                     =========    =========
</TABLE>

     Inpatient  facilities  revenues  for  long-term  care,  subacute  care  and
assisted  living  services  include  revenues billed to patients for therapy and
pharmaceutical   services  and  medical  supplies   provided  by  the  Company's
affiliated  operations.  Revenues for  rehabilitation  and  respiratory  therapy
services provided to domestic affiliated facilities were $38.8 million and $79.5
million  for the  three  months  ended  March 31,  1999 and 1998,  respectively.
Revenues for  pharmaceutical  and medical supply  services  provided to domestic
affiliated  facilities were $23.8 million and $15.2 million for the three months
ended March 31, 1999 and 1998,  respectively.  Revenues for services provided by
other  non-reportable  segments to affiliated  facilities  were $6.4 million and
$7.1 million for the three months ended March 31, 1999 and 1998, respectively.
 
     The following table sets forth the amount of net segment earnings  (losses)
for the periods presented (dollars in thousands):
 
 <TABLE>
<CAPTION>
 
                                                    Three Months Ended
                                                    ------------------
                                                         March 31,
                                                         ---------
                                                     1999         1998
                                                     ----         ----
<S>                                                  <C>          <C>
Inpatient Services ..................................$  3,180     $25,890
Rehabilitation and Respiratory Therapy Services .....     426      57,588
Pharmaceutical and Medical Supply Services ..........     (37)      6,306
International Operations ............................  (2,624)     (3,380)
Other Operations ....................................  (3,359)      4,760
                                                     ---------    --------
Earnings (losses) before income taxes, corporate
 allocation of interest and management fees .........  (2,414)     91,164
Corporate ........................................... (70,093)    (57,282)
Intersegment Eliminations ........................... (  -   )    ( 1,905)
                                                     ---------    --------
     Net Segment Earnings (losses) ..................$(72,507)    $31,977
                                                     =========    ========
</TABLE>

                                       32
<PAGE>

     Corporate  expenses include amounts for interest and corporate  general and
overhead  expenses.   The  Company  allocates  these  to  its  segments  through
management fees and intercompany interest charges.  Management fees are assessed
based on segment net revenues.  Interest is charged based upon average net asset
balances at rates  determined  by  management,  and is intended to be consistent
with the rates incurred under the Company's Senior Credit Facility.

     The  following   table  presents  the  percentage  of  total  net  revenues
represented by certain items for the Company for the periods presented:
 

  <TABLE>
<CAPTION>
 
                                                    Three Months Ended
                                                    ------------------
                                                         March 31,
                                                         ---------
                                                     1999         1998
                                                     ----         ----
<S>                                                  <C>          <C>
Total net revenues ..................................100.00%      100.00%
                                                     -------      -------
     Costs and expenses:
     Operating ...................................... 92.8%         82.1%
     Corporate general and administrative ...........  6.2%          5.3%
     Provision for loss on accounts receivable ......  2.1%          0.8%
     Depreciation and amoritzation ..................  3.2%          2.8%
     Interest, net ..................................  5.5%          4.7%
     Loss on sale of assets .........................  1.8%            -
     Loss on termination of interest rate swaps .....  0.4%            -
     Restructuring costs ............................  1.7%            -
                                                     -------      -------          
          Total costs and expenses ..................113.7%         95.7%
     Dividends on convertible preferred securities ..  1.0%            -
                                                     -------      -------
     Earnings (losses) before income tax and
       cumulative effect of change in accounting
       principle ....................................(14.7%)         4.3%
     Income taxes....................................  0.1%          1.8%
                                                     ------       -------
     Net earnings (losses) before cumulative
       effect of change in accounting principle .....(14.8%)         2.5%
     Cumulative effect of change in accounting
       principle ....................................  2.0%            -
                                                     -------      -------
Net earnings (losses) ...............................(16.8%)         2.5%
                                                     =======      =======
</TABLE>


THREE MONTHS ENDED MARCH 31, 1999 COMPARED TO THREE MONTHS ENDED  MARCH 31, 1998

INPATIENT SERVICES
 
     Net  revenues,   which  include   revenues   generated   from  therapy  and
pharmaceutical services provided at the Inpatient Services facilities, decreased
approximately $24.1 million from $485.2 million for the three months ended March
31, 1998 to $461.1  million for the three  months  ended  March 31,  1999,  a 5%
decrease. After considering $57.7 million of net revenues from the 75 facilities
acquired in the RCA  acquisition on June 30, 1998,  net revenues  declined $73.7
million or 15.4%.  This decrease is primarily the result of the reduced Medicare
rates received  under PPS in the first quarter of 1999.  Excluding the effect of
the RCA acquisition on Medicare revenues, average Medicare rates declined by 35%
(see "Effects of Changes in Reimbursement").


                                       33
<PAGE>

     Operating  expenses,  which include rent expense of $52.9 million and $45.8
million  for the  three  months  ended  March 31,  1999 and 1998,  respectively,
decreased  1.1% from $439.9 million for the three months ended March 31, 1998 to
$435.2  million for the three  months ended March 31,  1999.  After  considering
$50.8 million of operating  expenses  related to the facilities  acquired in the
RCA  acquisition,  operating  expenses  decreased  $55.5  million or 12.6%.  The
decrease  resulted  primarily  from  cost  restructuring  in  response  to  PPS,
including reduced ancillary service costs from affiliated  providers.  Operating
expenses  as a  percentage  of net  revenues  excluding  the  effect  of the RCA
acquisition,  increased  from 90.7% for the three months ended March 31, 1998 to
95.3% for the three  months  ended March 31,  1999.  The  increase in  operating
expenses as a  percentage  of revenue is  primarily  due to  decreased  Medicare
revenue as a result of the  implementation  of PPS at the  Company's  facilities
without a  corresponding  decline in the level of service  provided  to Medicare
patients.
 
     Corporate  general and  administrative  expenses,  which  include  regional
costs,  related to the  supervision  of  operations,  were $8.2 million and $8.1
million for the three months ended March 31, 1999 and 1998,  respectively.  As a
percentage  of net  revenues,  corporate  general  and  administrative  expenses
remained constant at 1.7% for the three months ended March 31, 1999 and 1998.

     Provision  for  losses  on  accounts  receivable  increased  232% from $1.2
million for the three  months ended March 31, 1998 to $3.8 million for the three
months ended March 31, 1999.  As a percentage  of net  revenues,  provision  for
losses on accounts  receivable  increased  from 0.2% for the three  months ended
March 31, 1998 to 0.8% for the three months ended March 31, 1999. The change was
primarily due to increased aging of certain accounts receivable.

     Depreciation  and  amortization  decreased  5.1% from $8.9  million for the
three  months  ended March 31, 1998 to $8.5  million for the three  months ended
March 31, 1999. As a percentage of net revenues,  depreciation  and amortization
expense remained  constant at 1.8% for the three months ended March 31, 1999 and
1998.  
 
     Net interest expense increased 92.5% from $1.2 million for the three months
ended March 31, 1998 to $2.3  million for the three months ended March 31, 1999.
As a percentage of net revenues,  interest  expense  increased from .02% for the
three  months  ended March 31, 1998 to 0.5% for the three months ended March 31,
1999.  The  increase is  primarily a result of certain  facility  specific  debt
assumed in the RCA acquisition.

REHABILITATION AND RESPIRATORY THERAPY SERVICES

     Net revenues from rehabilitation and respiratory therapy services decreased
60.5% from  $177.4  million for the three  months  ended March 31, 1998 to $70.1
million  for the three  months  ended March 31,  1999.  Revenues  from  services
provided to  affiliated  facilities  decreased  from $79.5 million for the three
months  ended March 31, 1998 to $38.8  million for the three  months ended March
31, 1999, a decrease of 51.3%.  Revenues from services provided to nonaffiliated
facilities decreased approximately $66.6 million, or 68%, from $97.8 million for
the three  months  ended  March 31, 1998 to $31.3  million for the three  months
ended March 31, 1999. The decrease is a result of the  industry's  transition to
PPS and the resulting decline in demand for the Company's  therapy services.  In
addition to the decline in demand for the  Company's  therapy  services,  market
rates for these services have declined significantly. This decline is attributed
to downward  pricing pressure as a result of an excess supply of therapy service
providers  due  to  the  industry's   restructuring  in  response  to  decreased
reimbursement under PPS (see "Effects of Changes in Reimbursement").


                                       34
<PAGE>
 
     Operating expenses decreased 42.7% from $113.7 million for the three months
ended March 31, 1998 to $65.1 million for the three months ended March 31, 1999.
The decrease resulted primarily from the decline in the demand for the Company's
therapy services  resulting in a reduction in the number of therapists  employed
by the Company's therapy services (see "Other Special and Non-Recurring  Charges
- -  Restructuring  Costs").  Operating  expenses as a percentage of total revenue
increased  from 64.1% for the three months ended March 31, 1998 to 92.9% for the
three months ended March 31, 1999.  This  increase is  attributable  to downward
pricing  pressure as a result of the excess supply of therapy service  providers
due to the industry's  restructuring in response to the decreased  reimbursement
under PPS.

     Provision  for  losses on  accounts  receivable  decreased  42.3% from $4.0
million for the three  months ended March 31, 1998 to $2.3 million for the three
months ended March 31, 1999.  As a percentage  of net  revenues,  provision  for
losses on accounts  receivable  increased  from 2.2% for the three  months ended
March 31, 1998 to 3.3% for the three months  ended March 31, 1999.  The increase
is a result of increased  reserves  recorded due to the impact of PPS, which for
certain  nonaffiliated  customers  has  negatively  affected  their cash  flows,
adversely affecting the collectibility of amounts due to the Company.
 
     Depreciation  and  amortization  remained  constant at $2.1 million for the
three months ended March 31, 1999 and 1998.  As a  percentage  of net  revenues,
depreciation and amortization  expense  increased from 1.2% for the three months
ended  March  31,  1998 to 3.0% for the  three  months  ended  March  31,  1999,
respectively. The increase is primarily a result of increased equipment costs.

PHARMACEUTICAL AND MEDICAL SUPPLY OPERATIONS
 
     Net revenues from  pharmaceutical  and medical  supply  services  increased
43.3% from $52.9  million for the three months ended March 31, 1998 to $75.8 for
the three  months  ended March 31,  1999.  Approximately  $17.2  million of this
increase is a result of the  company's  medical  supply  operations  acquired in
connection  with the RCA  acquisition  in June 1998.  The remaining  increase is
primarily a result of the addition of four pharmacies since March 31, 1998.
 
     Operating  expenses increased 49.6% from $44.6 million for the three months
ended March 31, 1998 to $67.1 million for the three months ended March 31, 1999.
The increase is primarily related to the Company's medical supply operations and
the additional  four  pharmacies  that opened in 1998.  Operating  expenses as a
percentage of revenue  increased from 85.0% for the three months ended March 31,
1998 to 88.6% for the three  months  ended  March 31,  1999.  This  increase  is
primarily a result of the  acquisition  of Contour,  which has higher  operating
costs  than  the  Company's  pharmacy  services  operation.  Excluding  Contour,
operating expenses as a percentage of revenue was 86.3%.


                                       35
<PAGE>

     Provision for losses on accounts receivable increased from $0.1 million for
the three months ended March 31, 1998 to $6.6 million for the three months ended
March 31, 1999.  As a percentage  of net  revenues,  the provision for losses on
accounts  receivable  increased  from 0.2% for the three  months ended March 31,
1998 to 8.7% for the three  months  ended  March 31,  1999.  This  increase is a
result  of the  effect  PPS has had on  nonaffiliated  customers'  cash flow (as
discussed above under Rehabilitation and Respiratory Therapy Services).
 
     Depreciation  and  amortization  increased  37.6% from $1.5 million for the
three  months  ended March 31, 1998 to $2.1  million for the three  months ended
March 31, 1999. As a percentage of net revenues,  depreciation  and amortization
expense  was 2.7% and 2.8% for the three  months  ended March 31, 1999 and 1998,
respectively.
 
INTERNATIONAL OPERATIONS
 
     Revenues  from  international   operations  excluding  the  effect  of  the
disposition of the Canadian  operations,  increased $9.6 million, or 15.4%, from
$62.1 million for the three months ended March 31, 1998 to $71.7 million for the
three months ended March 31, 1999.  Approximately  $4.0 million of this increase
was provided by U.K.  inpatient services whose net revenues increased from $42.8
million for the three months ended March 31, 1998 to $46.8 million for the three
months  ended  March 31,  1999.  The  increase  in U.K.  revenues  is due to the
addition of four  facilities  during  1998 as well as an  increase in  occupancy
rates  from 77.8% for the three  months  ended  March 31,  1998 to 78.8% for the
three months ended March 31, 1999.  The  remaining  increase was  primarily  the
result of facility  additions and occupancy  increases at inpatient  services in
Spain, Germany and Australia.
 
     Operating  expenses,  which  include  rent expense of $6.4 million and $9.7
million  for the  three  months  ended  March 31,  1998 and 1999,  respectively,
increased  approximately  14.3% from $56.6  million for the three  months  ended
March 31, 1998 to $64.8  million for the three months ended March 31, 1999. As a
percentage of revenues,  operating  expenses  increased from 85.5% for the three
months  ended March 31, 1998 to 90.4% for the three months ended March 31, 1999.
The increase is primarily attributable to increased temporary staffing costs due
to a nursing  shortage and  increases in rent expense  primarily a result of the
sale-leaseback of 32 facilities completed October 1998.
 
     Depreciation and amortization for international  operations decreased 31.1%
from $5.1  million for the three months ended March 31, 1998 to $3.2 million for
the three months ended March 31, 1999. The decrease is primarily a result of the
write-off in the fourth quarter of 1998 of goodwill and certain other long-lived
assets   pursuant  to   Statement   of  Financial   Accounting   Standards   No.
121 - Impairment of Long-Lived Assets.
 
OTHER  NONREPORTABLE  SEGMENTS  AND  CORPORATE  GENERAL AND  ADMINISTRATIVE
DEPARTMENTS

     Nonreportable  segments include temporary  therapy  staffing,  home health,
assisted living,  software  development and other ancillary  services.  Revenues
from other  nonreportable  segments  decreased  4.1% from $67.3  million for the
three  months  ended March 31, 1998 to $64.5  million for the three months ended
March 31, 1999.  Operating  expenses  increased  1.8% from $59.3 million for the
three  months  ended March 31, 1998 to $60.3 for the three month  periods  ended
March 31, 1999. Total revenues and operating expenses for nonreportable segments
represent  less  than  10% of the  consolidated  Company's  results.  Growth  in
revenues  and  operating  expenses  relates  primarily  to  acquisitions  in the
Company's home health, assisted living, disease state management, laboratory and
radiology  subsidiaries.  These increases were offset by significant declines in
revenues and operating  expenses in the  Company's  temporary  therapy  staffing
subsidiary  which  was  adversely  affected  by the long  term  care  industry's
transition to PPS.  Operating results were also negatively  impacted by expenses
related to software development costs incurred by the Company's subsidiary,  Sun
Healthcare Systems.  These costs are being expensed in accordance with Statement
of  Financial  Accounting  Standards  No. 86:  Accounting  for Costs of Computer
Software to be Sold, Leased or Otherwise Marketed.  Development of the Company's
products  are not  expected  to reach the stage under  which  capitalization  is
permitted until late 1999 or 2000.

     Corporate  general and  administrative  costs not  directly  attributed  to
segments increased 15.4% from $26.5 million for the three months ended March 31,
1998 to $30.5  million at March 31, 1999. As a percentage  of  consolidated  net
revenues of $741.5  million and $673.0  million for the three months ended March
31, 1999 and 1998,  respectively,  corporate general and administrative expenses
not directly  attributed to segments  increased from 3.6% to 4.5%. This increase
was  primarily  due to an increase in costs  relating  to the  expansion  of the
Company's corporate infrastructure to support newly acquired domestic operations
including Regency and RCA, as well as implementation of new business strategies.


                                       36
<PAGE>
 
     Net interest  expense not directly  attributed to segments  increased  1.0%
from $29.3  million for the three months  ended March 31, 1998 to $29.5  million
for the three months ended March 31, 1999. As a percentage of  consolidated  net
revenues,  interest expense increased from 4.0% for the three months ended March
31, 1998 to 4.4% for the three  months  ended March 31,  1999.  The increase was
related to (i) an increase  in the  Company's  weighted  average  interest  rate
resulting from the issuance of $250 million of 9 1/2% Notes in July 1997 and the
Company's  issuance  of $150  million of 9 3/8% Notes in May 1998,  (ii)  higher
interest rates and borrowing costs under the Company's Senior Credit Facility as
compared to the previous  credit  facility that was retired in October 1997, and
(iii) an increase in  borrowings  under the  Company's  Senior  Credit  Facility
principally related to various acquisitions during 1998.

DIVIDENDS ON CONVERTIBLE PREFERRED STOCK

     In May 1998, the Company issued $345 million of 7% Convertible Trust Issued
Preferred Securities.

OTHER SPECIAL AND NON-RECURRING CHARGES



CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE

     In 1998,  the American  Institute of Certified  Public  Accountants  issued
Statement of Position,  "Reporting  on the Costs of Start-up  Activities"  ("SOP
98-5").  This statement  requires costs of start-up  activities and organization
costs to be expensed as  incurred.  The  statement is  effective  for  financial
statements  for fiscal years  beginning  after  December 15, 1998.  In the first
quarter of 1999,  the Company  adopted the provisions of SOP 98-5 which resulted
in a cumulative effect of an accounting change pretax charge of $13.7 million.

OTHER LONG-LIVED ASSETS


 
LOSS ON SALE OF ASSETS
 
     A net  non-cash  charge of  approximately  $10.1  million  was  recorded to
further reduce the carrying amount of certain assets that the Company determined
were not integral to its core  business  operations.  In  addition,  the Company
recorded  a loss  of  approximately  $2  million  on the  sale  of its  Canadian
operations. See footnote 5.

RESTRUCTURING COSTS
 
     In response to the industry  changes mandated by PPS the Company recorded a
charge of approximately  $11.4 million for the three months ended March 31, 1999
predominately  related to restructuring  its operations in order to more closely
align the inpatient  services,  rehabilitation and respiratory therapy services,
and  pharmaceutical  and medical supply  services  divisions (see "Liquidity and
Capital Resources").

LOSS ON TERMINATION OF INTEREST RATE SWAPS

     In April 1999, the interest rate swap  transactions  were terminated due to
an event of default relating to the Company's with certain  covenants  contained
in the Senior  Credit  Facility.  The  termination  resulted  in a $2.5  million
pre-tax charge in the first quarter of 1999.
 

                                       37
<PAGE>
CONSOLIDATED RESULTS OF OPERATIONS

     Income tax  expense  for the three  months  ended  March 31,  1999 was $0.9
million  compared to $13.6 million for the three months ended March 31, 1998. In
the three months  ended March 31,  1999,  the Company  increased  its  valuation
allowance by $33.5  million for deferred tax assets which may not be realized as
a result of the adverse effect of the new operating environment under PPS. Also,
in 1999 the Company  established a valuation  allowance of $1.5 million for U.K.
deferred tax assets, which may not be realizable.
 
     The net loss for the three months  ended March 31, 1999 was $113.1  million
compared to net  earnings of $18.4  million for the three months ended March 31,
1998. Before considering the loss on sale of assets, the restructuring costs and
the loss on termination of interest rate swaps, the loss before income taxes for
the three  months  ended March 31, 1999 was $72.4  million  compared to earnings
before  income taxes of $31.9 million for the three months ended March 31, 1998.
The loss in the first quarter of 1999 was due to the  implementation  of PPS and
its resulting adverse impact on the demand for ancillary services.

LIQUIDITY AND CAPITAL RESOURCES

     The  Company  was  not  in  compliance  with  certain  financial  covenants
contained  in the Senior  Credit  Facility as of December 31, 1998 and March 31,
1999.  On April 29, 1999,  the Company  entered  into an  agreement  that waives
compliance  with the covenants  from  December 30, 1998 until May 28, 1999.  The
terms of the waiver  require among other things that the Company take  advantage
of the 30-day  grace  period of the payment of interest  on the  Company's  $150
million 9 3/8%  subordinated  notes due 2008, which payment was due May 1, 1999.
If the Company does not make the interest  payment by May 31, 1999,  the Company
would be in default under the indenture for the 9 3/8% notes,  which would cause
the Company to be in  cross-default  on certain  other debt  obligations  of the
Company.  The  Company  continues  to seek an  amendment  to its  Senior  Credit
Facility  agreement that would bring it into full  compliance but cannot predict
when or if such an amendment will be obtained.

     Because the Company was not in compliance with certain financial  covenants
under the terms of the Senior Credit  Facility,  the Lenders could have required
immediate repayment of all amounts outstanding under the Senior Credit Facility.
As a result,  as of December 31, 1998,  the Company  classified  all  borrowings
under the Senior Credit  Facility as current  liabilities.  Although  compliance
with the covenants has been waived,  the borrowings remain classified as current
liabilities  in the  accompanying  consolidated  balance  sheets  because of the
short-term nature of the waiver.

     As a result,  at March 31, 1999, the Company had a working  capital deficit
of $662.9  million  including cash and cash  equivalents  of $47.2  million,  as
compared to a working capital deficit of $539.6 million, including cash and cash
equivalents of $27.5 million at December 31, 1998. Without classification of the
amounts  under the Senior  Credit  Facility as current,  the Company  would have
positive  working  capital of $150.4  million as of March 31, 1999.  The Company
does not have  sufficient cash reserves to repay all amounts  outstanding  under
the Senior Credit Facility at May 19, 1999.

     The  Company is in default of certain  Mortgage  Notes  amounting  to $31.8
million and $31.9 million at March 31, 1999 and December 31, 1998, respectively,
because the Company did not meet its debt  service  coverage  requirement  of at
least  1.25  to 1.  The  Company  is  attempting  to  obtain  a  waiver  of  the
non-compliance  with the financial  covenant and to amend these Mortgage  Notes'
financial  covenants so that the financial covenants will be consistent with the
Company's  revised business plan.  However,  as of May 19, 1999, no agreement to
waive the  non-compliance  with the financial covenant or to amend the financial
covenants has been reached.  Because the Company is in  non-compliance  with the
terms of these  Mortgage  Notes,  the holder of the Mortgage  Notes could demand
immediate repayment of all amounts due under the mortgages and foreclose on four
facilities.  Such amounts are  classified as current  liabilities as of December
31, 1998 and March 31, 1999.

     The Company also has other debt arrangements that provide that a default on
any mortgage  indenture  or  instrument  which  results in the  acceleration  of
repayment or default in payment of obligations from $0.1 million to in excess of
$20.0 million depending on the terms of the agreement,  would allow the creditor
to demand  immediate  repayment.  No  acceleration of repayment has occurred and
therefore such borrowings which total $520.9 million are classified as long-term
liabilities as of December 31, 1998 and March 31, 1999.


                                       38
<PAGE>
 
     As  of  December  31,  1998  and  March  31,  1999,   the  Company  was  in
non-compliance  with certain  financial  covenants  contained in certain  master
lease  agreements for 96 of its long-term  care  facilities in the United States
and 33 of its long-term care facilities in the United Kingdom.  As a result, the
lessors under these master lease  agreements have certain rights,  including the
right to require that the Company  relinquish the leased  facilities.  As of May
19, 1999,  the lessors had not  exercised  their  rights under their  respective
agreements,  although  there can be no assurance that the lessors will not do so
in the future.  Prior to obtaining a waiver of the  non-compliance  with certain
financial covenants in the Senior Credit Facility, the Company was also in cross
default  for 14 of its  long-term  care  facilities  in the United  States as of
December 31, 1998 and March 31, 1999. The aggregate net book value of properties
subject to potential  eviction  amounted to $54.8  million at December 31, 1998.
The Company has a substantial  number of other leases which may contain  similar
default or cross default provisions.
 
     For the three months ended March 31, 1999, net cash used for operations was
$14.4 million compared to net cash used by operations for the three months ended
March 31, 1998 of $35.8 million.  The net cash used for operations for the three
months  ended  March 31, 1999  reflects  the  significant  losses  incurred  (as
discussed in "Results of Operations" above).
 
     The Company's  accounts  receivable have increased since December 31, 1998.
Accounts  receivable  increased in part  because of the growth in the  Company's
inpatient,  therapy and  pharmaceutical  services  businesses since December 31,
1998.  RCA and  Contour  represent  $72.0  million  of the gross  increase.  The
implementation of PPS for certain nonaffiliated  ancillary service customers has
negatively   affected   their  cash  flows  thereby   adversely   affecting  the
collectibility  of amounts due to the  Company.  Other  nonaffiliated  ancillary
service customers, due to the transition to PPS, have slowed, reduced or stopped
payment for  service in  anticipation  of the  adverse  effect PPS would have on
their cash flow. As a result,  accounts receivable from nonaffiliated  customers
has increased, and the Company has increased its provision for doubtful accounts
in the first quarter of 1999.  Also,  accounts  receivable for therapy  services
have  increased  in part  because the  ability of  nonaffiliated  facilities  to
provide  timely  payment  has been  impacted by their  receipt of payments  from
fiscal intermediaries which, in some instances,  have been delayed due, in part,
to the fiscal intermediaries conducting reviews of facilities' therapy claims.

     Other  significant  operating uses of cash for the three months ended March
31,  1999 were $39.7  million for net  interest  payments  and $1.4  million for
income taxes.

     The Company  believes that its existing cash reserves ($55.6 million at May
18, 1999) and the successful execution of its operational and financial recovery
plan will provide sufficient cash for its operations,  capital  expenditures and
regularly  scheduled  debt service  throughout  1999. The projected cash balance
during  1999 would not be adequate  if the  Company  were  required to repay the
balance  outstanding under the Senior Credit Facility or certain Mortgage Notes.
No  assurance  can be given  that the  Company  will  have  sufficient  cash for
operations, capital expenditures and regularly scheduled debt service throughout
1999.  Further, no assurance can be given that the Company will be successful in
negotiating  waivers and  amendments to the Senior  Credit  Facility and certain
Mortgage  Notes or that the Company  will be able to meet any amended  financial
covenants  prospectively.  If the Company is unable to generate  sufficient cash
flow from its  operations or  successfully  negotiate an amendment of the Senior
Credit Facility, it would explore a variety of other options,  including but not
limited to other sources of financing,  additional asset dispositions, or relief
under the United States Bankruptcy code.

     As a result of the Company's recent financial  results,  the New York Stock
Exchange  (the  "Exchange")  has  notified the Company that the Company does not
currently meet the Exchange's  quantitative  continued listing criteria.  At the
request of the Exchange, the Company intends to submit to the Exchange a written
proposal regarding the appropriateness of the continued listing of the Company's
common stock.  No assurance can be given that the Exchange will continue to list
the Company's common stock.

     In response to the significant  losses experienced in the fourth quarter of
1998  which  have  continued  in the first  quarter  of 1999,  the  Company  has
developed an operational and financial recovery plan that is intended to restore
the Company's profitability in the new operating environment under PPS, although
no assurance can be given that the plan will be successful.

                                       39
<PAGE>

     The Company incurred $31.5 million in capital expenditures during the three
months ended March 31, 1999.  Expenditures related primarily to the construction
of a corporate  office building and to the Company's  long-term  care,  subacute
care and assisted living facility operations including the construction of three
new  facilities  in the  United  States and three new  facilities  in the United
Kingdom  as well as  routine  capital  expenditures.  The  Company  had  capital
expenditure  commitments as of March 31, 1999, under various  contracts of $32.1
million in the United States.  These include contractual  commitments to improve
existing  facilities and to develop,  construct and complete a corporate  office
building.
 
     On June 30, 1998, a wholly owned subsidiary of the Company merged with RCA,
an operator of skilled  nursing  facilities and assisted living centers in eight
states   principally  in  the  southeastern   United  States.   RCA  also  owned
approximately 65% of Contour, a national provider of medical/surgical  supplies.
Under  the  amended  terms  of  the  merger   agreement,   the  Company   issued
approximately  7.6 million  shares of its common stock (valued at $122.0 million
based  upon the  average  closing  price of the  Company's  common  stock for 20
business days prior to the acquisition  closing date,  which was $16.03) for all
outstanding common stock of RCA and certain redeemable  preferred shares of RCA.
The Company also issued  298,334  shares of its Series B  Convertible  Preferred
Stock in exchange for the outstanding  shares of RCA's Series F Preferred Stock,
which were subsequently converted into 287,892 shares of Sun common stock valued
at $2.8  million at June 30, 1998.  As of December  31,  1998,  all the Series B
Shares have been  converted  into Sun common  stock.  In  addition,  the Company
assumed  approximately  $170.4  million  of RCA  indebtedness.  The  merger  was
accounted for as a purchase and resulted in $234.7 million of goodwill.
 
     On June 30, 1998,  the Company also  acquired the remaining 35% of Contour.
The Company issued  approximately 1.9 million shares of its common stock (valued
at  approximately  $27.6 million) for the remaining  outstanding  Contour common
stock.  The  acquisition  was  accounted for as a purchase and resulted in $23.4
million of additional goodwill.
 
     In  connection  with  the  RCA  Merger,   the  Company  recorded   purchase
liabilities  including  $24.7  million for  severance and related costs and $1.4
million  for  costs  associated  with the  shutdown  of  certain  administrative
facilities.

     In  the  fourth  quarter  of  1998,  the  Company  implemented  an  initial
restructuring  plan and recorded a fourth quarter charge of $4.6 million.  As of
March 31, 1999,  the Company's  1998  restructuring  costs  reserve  balance was
approximately $0.5 million and is substantially complete.
 
     In the first quarter of 1999, the Company initiated a second  restructuring
plan focused on further  reducing the  operating  expenses of its United  States
operations.  Related to the  restructuring  plan,  the Company  recorded a first
quarter  charge of  approximately  $11.4.  The  restructuring  plan included the
termination of 2,900 of its  rehabilitation  and  respiratory  therapy  services
employees,  and  80 of  its  corporate  employees  including  certain  executive
positions.  The restructuring plan also included the closure of approximately 23
divisional and regional  offices related to the  aforementioned  operations.  In
addition,  the plan  includes the  relocation of the  Company's  medical  supply
subsidiary and temporary therapy services  subsidiary to the Company's corporate
headquarters in Albuquerque,  New Mexico. As part of the relocation, the Company
will  terminate 96 employees of these  subsidiaries.  As of March 31, 1999,  the
Company paid approximately  $4.4 million in termination  benefits under the 1999
restructuring plan. The 1999 restructuring charge consists of approximately $9.1
million related to employee  terminations,  approximately 1.4 million related to
lease  termination  costs  and  $0.8  million  related  to  asset  disposals  or
write-offs. As of March 31, 1999, the Company's 1999 restructuring costs reserve
balance was approximately $6.9 million.


                                       40
<PAGE>

     The Company also conducts business in the United Kingdom,  Spain, Australia
and Germany.  International  operations  accounted  for 11% and 9% the Company's
total  net  revenues  during  the three  months  ended  March 31,  1999 and 1998
respectively, and 18% of the Company's consolidated total assets as of March 31,
1999. The Company's financial condition and results of operations are subject to
foreign   exchange  risk.   Exceptional   planned  foreign  currency  cash  flow
requirements,  such as acquisitions  overseas, are hedged selectively to prevent
fluctuations in the anticipated foreign currency value. Changes in the net worth
of the Company's  foreign  subsidiaries  arising from currency  fluctuations are
reflected  in  the  accumulated   other   comprehensive   income   component  of
stockholders' equity.
 
     Subsequent to December 31, 1998, the Company  decided to dispose of several
non-core  businesses   including  assisted  living  facilities,   rehabilitation
hospitals and other non-core  businesses.  The Company recorded a loss of $161.6
million  before  unrecorded  gains in the  fourth  quarter of 1998 to reduce the
carrying amount of these businesses  identified for disposal to fair value based
on estimates of selling value and of costs to sell. The Company  recorded a loss
of $10.1 million for the three months ended March 31, 1999 to further reduce the
carrying  value based on current sale  negotiations  and market  conditions.  In
addition,  the Company has decided not to dispose of certain non-core businesses
previously recorded in assets held for sale. The reversal of $7.0 of the loss on
disposition  was  recognized  in 1999.  The aggregate  carrying  amount of these
businesses  is  approximately  $219.9  million at March 31,  1999.  The  Company
expects net proceeds  including cash related to those operations with unrecorded
gains of $93.4  million  after the  reduction of related  debt of  approximately
$108.3 million.  Under the terms of the Senior Credit Facility such proceeds are
required  to be used to  permanently  reduce  outstanding  borrowings  under the
Senior Credit Facility.
 
     In May 1997,  the  Company  announced  its intent to sell and divest of its
outpatient  rehabilitation  clinics in the United States as well as Canada.  The
carrying amount of the assets held for sale was $22.5 million as of December 31,
1998. The Company  completed the sales of the Canadian  clinics during the first
quarter of 1999 which  resulted in an  additional  loss on sale of $2.1 million.
The results of operations of these businesses is not material.
 
     Under the terms of an Amended and Restated subordinated Loan Agreement (the
"Subordinated  Loan"),  the Company has advanced $36.3 million and has agreed to
advance up to a total of $40  million,  plus an  additional  $5 million to cover
accrued interest due and owing to the Company and other lenders,  to a developer
of  assisted  living  facilities  to cover 20% of the costs of the  development,
construction and operation of assisted living  facilities.  Advances are subject
to certain  conditions,  including  the approval of each project by the Company.
Advances  under the  Subordinated  Loan are part of the  assets  related  to the
Company's  assisted  living  facilities  which the Company intends to divest (as
discussed above).
 
     At March 31, 1999, the Company had on a consolidated basis, $1.7 billion of
outstanding  indebtedness including capital lease obligations and $826.8 million
of indebtedness  under its Senior Credit  Facility.  The Company also had
$42.6 million of outstanding  standby  letters of credit under its Senior Credit
Facility as of March 31, 1999.


                                       41
<PAGE>
 
     In May 1998, the Company issued $345 million of 7% Convertible Trust Issued
Preferred   Securities   (the  "CTIPS")  and  $150  million  of  9  3/8%  Senior
Subordinated  Notes due 2008 (yield of 9.425%)  (collectively  the "Offerings").
Each  convertible  preferred  security is convertible  into 1.2419 shares of Sun
common  stock,  par value  $0.01 per  share,  of Sun  (equivalent  to an initial
conversion price of $20.13 per share of Sun common stock).  Of the net proceeds,
$300 million from the Offerings  were used by the Company to  permanently  repay
certain outstanding  borrowings under the term loan portion of the Senior Credit
Facility and the remainder of the net proceeds  from the Offerings  were used to
reduce certain outstanding  borrowings under the revolving credit portion of the
Company's Senior Credit Facility.  On April 14, 1999, the Company announced that
it was exercising its right to defer the dividend payment,  scheduled for May 1,
1999, on the CTIPS.
 
     On May 5, 1998, the Company entered into certain interest rate transactions
with an  aggregate  notional  value of $850 million to minimize the risks and/or
costs associated with certain  long-term debt of the Company.  On April 9, 1999,
the interest rate swap  transactions  were terminated due to an event of default
relating to the Company's non-compliance with certain covenants contained in the
Senior  Credit  Facility.  The  termination  resulted in a pre-tax  loss of $2.5
million in the first  quarter of 1999.  The Company does not  otherwise  utilize
financial  instruments for trading or other speculative  purposes.  The interest
rate swap transactions were designated as hedges for accounting purposes.

EFFECTS FROM CHANGES IN REIMBURSEMENT
 
     The Company  derives a substantial  percentage  of its total  revenues from
Medicare,  Medicaid and private insurance. The Company's financial condition and
results of  operations  may be affected by the  revenue  reimbursement  process,
which is complex and can involve  lengthy  delays  between  the  recognition  of
revenue and the time reimbursement  amounts are settled. Net revenues realizable
under  third-party payor agreements are subject to change due to examination and
retroactive  adjustment  by payors  during the  settlement  process.  Payors may
disallow in whole or in part requests for reimbursement  based on determinations
that certain costs are not  reimbursable  or  reasonable  or because  additional
supporting  documentation  is necessary.  The Company  recognizes  revenues from
third-party  payors and accrues  estimated  settlement  amounts in the period in
which the related services are provided.  The Company estimates these settlement
balances by making  determinations based on its prior settlement  experience and
its  understanding of the manner in which the third-party  payors will interpret
the applicable reimbursement rules and regulations.  The majority of third-party
payor  balances  are settled  two to three  years  following  the  provision  of
services.
 
     The  Company  has  historically  experienced  differences  between  the net
amounts accrued and subsequent  settlements,  which  differences are recorded in
operations  at the time of  settlement.  For example,  in the fourth  quarter of
1998, the Company recorded negative revenue adjustments  totalling $34.7 million
primarily for the projected  settlement of 1997 facility cost reports which were
not settled as of December  31, 1998 and the  projected  settlement  of the 1998
cost reports based on historical information. Accounts receivable have also been
negatively  impacted in part because the ability of nonaffiliated  facilities to
provide  timely  payments has been  impacted by their  receipt of payments  from
fiscal  intermediaries  which, in some  instances,  have been delayed due to the
fiscal intermediaries conducting reviews of facilities' therapy claims.
 
     The  implementation  of PPS for  certain  nonaffiliated  ancillary  service
customers has negatively affected their cash flows, which has adversely affected
the  collectibility  of  amounts  due  to the  Company.  As a  result,  accounts
receivable  for  nonaffiliated  customers  has  increased,  and the  Company has
increased its provision for doubtful accounts in the first quarter of 1999.


                                       42
<PAGE>

     The  Company's  results of  operations  could be  materially  and adversely
affected  if the  amounts  actually  received  from  third-party  payors  in any
reporting period differed  materially from the amounts accrued in prior periods.
The Company's financial condition and results of operations may also be affected
by the timing of  reimbursement  payments and rate  adjustments from third-party
payors.  The Company has from time to time experienced delays in receiving final
settlement and reimbursement from government agencies.
 
     Various cost  containment  measures adopted by governmental and private pay
sources  restrict the scope and amount of reimbursable  healthcare  expenses and
limit increases in reimbursement  rates for medical services.  Any reductions in
reimbursement levels under Medicaid,  Medicare or private payor programs and any
changes in applicable  government  regulations  or  interpretations  of existing
regulations could significantly affect the Company's profitability. Furthermore,
government programs are subject to statutory and regulatory changes, retroactive
rate adjustments,  administrative  rulings and government funding  restrictions,
all of  which  may  materially  affect  the  rate of  payment  to the  Company's
facilities and its therapy and pharmaceutical services businesses.  There can be
no assurance  that payments  under  governmental  or private payor programs will
remain at levels  comparable to present  levels or will be adequate to cover the
costs of  providing  services to patients  eligible  for  assistance  under such
programs.  Significant  decreases in  utilization  and changes in  reimbursement
could have a material  adverse effect on the Company's  financial  condition and
results of operations, including the possible impairment of certain assets.
 
     In the  Balanced  Budget  Act of 1997  ("BBA"),  Congress  passed  numerous
changes to the reimbursement  policies  applicable to exempt hospital  services,
skilled  nursing,  therapy and other  ancillary  services.  The BBA mandates the
implementation of a prospective  payment system for skilled nursing  facilities.
PPS  became  effective  on July 1,  1998 for the  Company's  facilities  that it
acquired  with RCA and on January 1, 1999 for the  remainder of its  facilities.
Under PPS, Medicare pays skilled nursing  facilities a fixed fee per patient per
day based on the acuity level of the patient to cover all post-hospital extended
care routine service costs (i.e. Medicare Part A patients),  including ancillary
and capital related costs for beneficiaries receiving skilled services. Prior to
the implementation of PPS, the costs of many of such services were reimbursed on
a "pass  through"  basis.  During  the first  three  years of the PPS  phase-in,
payments will generally be based on a blend of the facility's  historical  costs
based on 1995 cost data and a federally  established per diem rate.  Although it
is  unclear  what the  long-term  impact of PPS will be, the  transition  to PPS
negatively  impacted the Company's earnings for the quarters ended September 30,
1998,  December 31, 1998, and March 31, 1999. There can be no assurance that PPS
will not have a long-term  material  adverse effect on the results of operations
and financial condition of the Company.
 
     The   Company's   revenues  from  its   inpatient   facilities   have  been
significantly  affected  by the  federally  established  PPS per diem rate.  The
Company's  experience has been that the average per diem  reimbursement  rate is
less than the amount the  Company's  inpatient  facilities  received  on a daily
basis under cost-based reimbursement. In response, the Company has taken various
actions  to reduce  its  costs.  Moreover,  since the  Company  treats a greater
percentage of higher acuity  patients than many nursing  homes,  the Company has
also been adversely  impacted  because  federal per diem rates for higher acuity
patients do not adequately  compensate  the Company for the additional  expenses
and risks for caring for such patients.  There can be no assurance that PPS will
not  have  a  long-term  material  adverse  effect  on the  Company's  financial
condition and results of operations.


                                       43
<PAGE>
 
     In  addition,  the  implementation  of PPS has  resulted in a greater  than
expected  decline  in  demand  for  the  Company's  therapy  and  pharmaceutical
services.  For  instance,  the nursing home  industry has responded to the lower
reimbursement  levels under PPS by,  among other  things,  seeking  lower acuity
residents who need less  ancillary  services and by providing  therapy  services
in-house,  which has  resulted  in a  significant  decline in the demand for the
Company's therapy services.  Prior to the implementation of PPS, Sun's ancillary
services,   such  as  rehabilitation   and  respiratory   therapy  services  and
pharmaceutical  services,  had  significantly  higher operating margins than the
margins  associated  with Sun's  long-term  and  subacute  care  facilities  and
accordingly such services provided most of Sun's operating profits. Although the
Company has taken and continues to take actions to reduce its costs of providing
ancillary  services,  there can be no assurance that the Company will be able to
maintain its prior profit margins on its ancillary services.
 
     The  Company's   response  to  the   implementation  of  PPS  includes  the
establishment  of SunSolution.  SunSolution  provides  ancillary  services for a
fixed fee to  nonaffiliated  facilities.  As of April 19, 1999,  SunSolution has
secured fewer  contracts with  nonaffiliated  facilities  than projected and the
average revenue per contract was significantly  less than the Company projected.
There  can be no  assurance  that the  Company  will  develop  a market  for the
SunSolution  products and services.  Even if there is a market for SunSolution's
services,  no assurance can be given that the costs of providing the  contracted
services  will be less than the  fixed  fee  received  by the  Company  for such
services. Given the importance of the profitability of Sun's ancillary services,
there can be no assurance  that PPS will not have a long-term  material  adverse
effect  on the  Company's  margins  and  ultimately  the  Company's  results  of
operations and financial condition.
 
     Effective  January 1, 1999,  for all nursing home  patients  not  receiving
post-hospital extended care services (i.e., Medicare Part B patients),  Medicare
reimbursement for ancillary services,  including rehabilitation therapy, medical
supplies,  pharmacy and other  ancillary  services,  will be made to the skilled
nursing  facility  pursuant to fee  schedules  published on November 2, 1998. In
addition,  effective  January 1, 1999, there is an annual per beneficiary cap of
$1,500 on Medicare  reimbursement  for  outpatient  physical  therapy and speech
therapy and an annual per  beneficiary  cap of $1,500 on Medicare  reimbursement
for occupational therapy. Facilities will be permitted to bill patients directly
for  services  rendered  in  excess  of these  caps;  however,  there  can be no
assurance  that the  Company  will  receive any payment in excess of these caps.
There can also be no assurance  that such fee schedules and caps will not have a
material adverse effect on the Company.
 
     The Company's  growth  strategy has relied  heavily on the  acquisition  of
long-term  and subacute  care  facilities.  Regardless  of the legal form of the
acquisition,  the Medicare and Medicaid  programs often require that the Company
assume  certain  obligations  relating to the  reimbursement  paid to the former
operators of the facilities  acquired by the Company.  From time to time, fiscal
intermediaries  and  Medicaid  agencies  examine  cost  reports  filed  by  such
predecessor  operators.  The Company is  currently  the subject of several  such
examinations.  If, as a result of any such  examinations,  it is concluded  that
overpayments  to a predecessor  operator were made, the Company,  as the current
operator  of such  facilities,  may be held  financially  responsible  for  such
overpayments.  At this time the  Company is unable to predict the outcome of any
examinations.

     Prior to the implementation of PPS,  reimbursement for therapy services was
evaluated under Medicare's reasonable cost principles. In 1995, and periodically
since  then,  HCFA  provided  information  to fiscal  intermediaries  for use in
determining   reasonable  costs  for  occupational  and  speech  therapy.   This
information,  although  not intended to impose  limits on such costs,  suggested
that fiscal  intermediaries  should carefully review costs which appear to be in
excess of what a "prudent buyer" would pay for those services.  While the effect
of these  directives is still  uncertain,  they are a factor  considered by such
intermediaries in evaluating the reasonableness of amounts paid by providers for
the services of the Company's rehabilitation therapy subsidiary for fiscal years
prior to the  implementation of PPS. Because PPS payments and fee schedules have
become the methods of  reimbursement  for these  services,  HCFA  directives and
reasonable  cost  guidelines  discussed in this  paragraph have no impact on the
Company as to services rendered after January 1, 1999. A retroactive  adjustment
of Medicare  reimbursement could,  however, be made for some prior periods. With
respect to nonaffiliated  facilities,  an adjustment of reimbursement  rates for
therapy services could result in indemnity claims against the Company,  based on
the terms of  substantially  all of the Company's  existing  contracts with such
facilities,  for payments previously made by such facilities to the Company that
are reduced by Medicare in the audit process.


                                       44
<PAGE>

     Medicare regulations address transactions between related parties,  such as
between the Company's  subsidiaries that operate skilled nursing  facilities and
subsidiaries  which  provide  ancillary  services.  For  periods  prior  to  the
effective date of PPS, these  regulations are relevant to the amount of Medicare
reimbursement  that the Company's  skilled  nursing  facilities  are entitled to
receive for certain  rehabilitation  and respiratory  therapy and pharmaceutical
services provided by the Company's ancillary service subsidiaries.  An exception
to the related party regulations is available provided that, among other things,
a  substantial  part of the  services  of the  relevant  subsidiary  supplier be
transacted with nonaffiliated entities. When that exception applies, the skilled
nursing  facility  may  receive  reimbursement  for  services  provided  by  the
Company's  ancillary  service  subsidiaries at the rates  applicable to services
provided  to  nonaffiliated  entities.  The  related  party  regulations  do not
indicate a specific  level of services  that must be  provided to  nonaffiliated
entities  in  order  to  satisfy  the  "substantial  part"  requirement  of this
exception.  In  instances  where this  issue has been  litigated  by others,  no
consistent  standard has emerged as to the  appropriate  threshold  necessary to
satisfy the  "substantial  part"  requirement.

     The Company's net revenues from rehabilitation therapy services,  including
net revenues from temporary therapy staffing services, provided to nonaffiliated
facilities  represented 56%, 70% and 71% of total  rehabilitation  and temporary
therapy  staffing  services net revenues for the years ended  December 31, 1998,
1997  and  1996,   respectively.   Respiratory   therapy  services  provided  to
nonaffiliated  facilities  represented  46%,  63% and 58% of  total  respiratory
therapy  services net revenues for the years ended  December 31, 1998,  1997 and
1996,  respectively.   Net  revenues  from  pharmaceutical  services  billed  to
nonaffiliated  facilities  represented 70%, 79% and 78% of total  pharmaceutical
services  revenues  for the  years  ended  December  31,  1998,  1997 and  1996,
respectively.  The Company considers RCA a nonaffiliated  entity for all periods
prior  to  its   acquisition.   The  Company  believes  that  it  satisfies  the
requirements  of  the  exception  to  the  regulations  regarding  nonaffiliated
business. Consequently, it has claimed and received reimbursement under Medicare
for rehabilitation and respiratory therapy and pharmaceutical  services provided
to patients in its own  facilities at fair market value,  rather than at Company
cost,  which  would have  applied if it did not satisfy  the  exception.  If the
Company were deemed to not have satisfied these  regulations,  the reimbursement
that the  Company  receives  for  rehabilitation  and  respiratory  therapy  and
pharmaceutical  services  provided to its own facilities  would be significantly
reduced,  as a result of which the Company's  financial condition and results of
operations would be materially and adversely affected. If, upon audit by Federal
or state reimbursement  agencies,  such agencies find that the exception has not
been satisfied,  and if, after appeal, such findings are sustained,  the Company
could be required to refund  some or all of the  difference  between its cost of
providing  these services to any entity found to be subject to the related party
regulations  and the fair  market  value  amount  actually  received.  While the
Company  believes  that it has  satisfied  these  regulations,  there  can be no
assurance that its position would prevail if contested by relevant reimbursement
agencies. The foregoing statements with respect to the Company's ability satisfy
these  regulations  are  forward  looking  and could be  affected by a number of
factors,  including the  interpretation  of Medicare  regulations  by Federal or
state  reimbursement  agencies and the Company's  ability to provide services to
nonaffiliated  facilities.  The  implementation of PPS and the fee schedules has
significantly  reduced the Medicare  reimbursement  impact of the related  party
rule.


                                       45
<PAGE>
 
     The office of the  Inspector  General of the U.S.  Department of Health and
Human Services  ("OIG") has begun to conduct a national  medical audit that will
assess the medical  necessity  of physical  and  occupational  therapy  services
provided to skilled nursing facility patients.  Generally, the OIG has indicated
the  results  of the audit will be used to  quantify  overpayments  for  therapy
services in facilities  audited and to develop baseline data that can be used to
assess the impact of the BBA.  The  Company is unable to  determine  what if any
impact this audit might have on the Company.
 
REGULATION
 
     The  Company's  subsidiaries,  including  those that  provide  subacute and
long-term  care,  rehabilitation  and  respiratory  therapy  and  pharmaceutical
services, are engaged in industries that are extensively regulated.  As such, in
the ordinary  course of  business,  the  operations  of these  subsidiaries  are
continuously subject to state and federal regulatory  scrutiny,  supervision and
control.  Such  regulatory  scrutiny often includes  inquiries,  investigations,
examinations, audits, site visits and surveys, some of which may be non-routine.
The   Company's   subsidiaries   are  currently  the  subject  of  several  such
investigations.  In addition to being subject to the direct regulatory oversight
of state and  federal  regulatory  agencies,  these  industries  are  frequently
subject to the regulatory supervision of fiscal intermediaries.
 
     If a provider is ever found by a court of  competent  jurisdiction  to have
engaged in improper practices, it could be subject to civil, administrative,  or
criminal  fines,   penalties  or   restitutionary   relief,   and  reimbursement
authorities  could also seek the  suspension  or  exclusion  of the  provider or
individuals from  participation in their program.  If a facility is decertified,
the facility  will not be reimbursed  by the Federal  government  for caring for
residents  that are covered by Medicare and Medicaid,  and the facility would be
forced to care for such residents  without being  reimbursed or to transfer such
residents.  The Company currently has several facilities that are the subject of
decertification   efforts   by  HCFA,   which   the   Company   is   contesting.
Decertification  could cause material adverse financial and operational  effects
on individual facilities.
 
     It is the policy of the  Company  to comply  with all  applicable  laws and
regulations.   However,  given  the  extent  to  which  the  interpretation  and
implementation  of applicable  laws and  regulations  vary and the lack of clear
guidance  in many of the areas  which are the  subject of  regulatory  scrutiny,
there  can be no  assurance  that  the  business  activities  of  the  Company's
subsidiaries  will  not from  time to time  become  the  subject  of  regulatory
scrutiny, or that such scrutiny will not result in interpretations of applicable
laws or  regulations  by government  regulators or  intermediaries  which differ
materially from those taken by the Company's subsidiaries.
 
     Pursuant to Health Insurance  Portability and  Accountability  Act of 1996,
Congress has provided  additional  funding to Medicare and Medicaid  enforcement
units to investigate  potential cases of reimbursement  abuse in the health care
services industry. The Act also sets guidelines to encourage federal, state, and
local law  enforcement  agencies to share general  information and to coordinate
specific law enforcement activities including conducting investigations, audits,
evaluations,  and inspections relating to the delivery of and payment for health
care. From time to time  enforcement  agencies  conduct audits,  inspections and
investigations with respect to the reimbursement  activities of the subsidiaries
of the Company. The Company's  subsidiaries are currently the subject of several
such  investigations.  It is the Company's  practice to cooperate  fully in such
matters.


                                       46
<PAGE>
LITIGATION

    In March, April and May, 1999, class action lawsuits were filed against the
Company and three  officers of the Company in the United States  District  Court
for the District of New Mexico on behalf of purchasers  of the Company's  common
stock during the class period. These actions have been consolidated as IN RE SUN
HEALTHCARE GROUP,  INC.  SECURITIES  LITIGATION  MASTER FILE NO. CIV99-269.  The
lawsuits allege,  among other things, that the Company did not disclose material
facts  concerning  the impact  that PPS would have on the  Company's  results of
operations.  The lawsuits seek compensatory  damages and other relief.  Although
the Company intends to vigorously defend itself in this matter,  there can be no
assurance  that the  outcome of this  matter  will not have a  material  adverse
effect on the results of operations and financial condition of the Company.
 
     In January 1999, the state of Florida filed criminal charges in the Circuit
Court of the Eighth Judicial  Circuit for Alachua County,  Florida against three
subsidiaries  which were acquired by the Company on June 30, 1998: RCA,  Capitol
Care Management Co., Inc. and  Gainesville  Health Care Center,  Inc. All of the
allegations of wrongdoing  relate to activities prior to June 30, 1998, the date
of the RCA acquisition. Florida's allegations include violations of certain RICO
laws, abuse or neglect of elderly or disabled persons,  grand theft and Medicaid
fraud at a nursing home facility in Florida.  Also named as defendants were five
individuals  who  were  involved  in the  operation  of the  facility  in  their
capacities as officers, directors or employees of the defendant entities. If the
defendant entities are convicted, they could be banned from participating in the
Florida  Medicaid  program.  Although  the  Company's  subsidiaries  will defend
themselves vigorously in this matter, there can be no assurance that the outcome
of this  matter  will not have a  material  adverse  effect  on the  results  of
operations and financial condition of the Company.
 
     The Company and certain of its  subsidiaries  are defendants in two QUI TAM
lawsuits brought by private citizens in the United States District Court for the
Eastern District of California  alleging  violations of the federal False Claims
Act. The  plaintiffs  allege that  skilled  nursing  facilities  operated by the
subsidiaries  and others  conspired over the last decade to (i) falsely  certify
compliance with regulatory  requirements in order to participate in the Medicare
and Medicaid  programs,  and (ii) falsify records to conceal failures to provide
services in accordance with such regulatory  requirements.  Although the Company
and its subsidiaries  intend to vigorously  defend  themselves in these matters,
there can be no assurance  that the outcome of any one of these matters will not
have a material  adverse  effect on the  results  of  operations  and  financial
condition of the Company.
 
     In March 1999, the Company and several of its subsidiaries  filed a lawsuit
in the Superior Court of Fulton County in the State of Georgia  against  certain
individuals  who served as directors,  officers or employees of Retirement  Care
Associates,  Inc. ("RCA") prior to the Company's acquisition of RCA, and against
various  entities such  individuals  owned or controlled or with which they have
been affiliated.  The lawsuit alleges, among other things, breaches of fiduciary
duties, breaches of contract and conversion. The Company seeks damages in excess
of $30 million and punitive  amounts.  In May 1999,  certain  defendants in this
lawsuit filed  counterclaims  against certain plaintiffs  alleging,  among other
things,  securities fraud,  negligent  misrepresentation and breach of contract.
Defendants  seek  damages in an amount to be  determined  at trial and  punitive
amounts.

     Between August 25, 1997 and October 24, 1997, 10 class action lawsuits (the
"Actions")  were  filed in the United  States  District  Court for the  Northern
District of Georgia on behalf of persons who purchased RCA Common Stock,  naming
RCA and certain of its officers and directors as defendants. The complaints have
overlapping  defendants and largely  overlapping  (although not identical) class
periods.  The complaints  allege  violations of Federal  securities  laws by the
defendants for disseminating allegedly false and misleading financial statements
for RCA's fiscal year ended June 30, 1996 and its first three quarters of fiscal
year  1997,   which  the   plaintiffs   allege   materially   overstated   RCA's
profitability.  Generally,  each of the Actions seeks  unspecified  compensatory
damages,  prejudgment and postjudgment  interest,  attorneys' fees and costs and
other equitable and injunctive relief.
 
     On  November  25,  1997,  RCA,  the  Company  and  representatives  of  the
plaintiffs in the Actions  entered into a Memorandum of  Understanding  ("MOU").
Pursuant to the MOU, the Company paid $9 million into an interest-bearing escrow
account  maintained by the Company (the "Escrow  Account") to settle the Actions
(the "Settlement").  RCA also agreed to assign coverage under its directors' and
officers'   liability   insurance  policy  for  these  specific  claims  to  the
plaintiffs. The parties have signed the Settlement Agreement and the hearing for
court approval of the settlement is currently  scheduled for July 21, 1999. Upon
court  approval  of the  Settlement,  all claims by the class that were or could
have been asserted by the plaintiffs  against RCA or any of the other defendants
in the Actions will be settled and  released,  and the Actions will be dismissed
in their  entirety with  prejudice in exchange for the release of all funds from
the  Escrow  Account  to the  Plaintiffs.  No  assurance  can be given  that the
Settlement will become final.


                                       47
<PAGE>

     In 1997,  the  Company  was  notified  by a law firm  representing  several
national insurance  companies that these companies believed that the Company had
engaged in improper billing and other practices in connection with the Company's
delivery  of therapy and  related  services.  In  response,  the  Company  began
discussions  directly  with these  insurers and hopes to resolve  these  matters
without  litigation;  however,  the  Company  is unable at this time to  predict
whether it will be able to do so, what the eventual outcome may be or the extent
of its liability, if any, to these insurers.
 
     The Company is a party to various  other legal  actions and  administrative
proceedings  and is subject to various claims arising in the ordinary  course of
business.  The Company does not believe that the ultimate  disposition  of these
other matters will have a material  adverse effect on the financial  position or
results of operations of the Company.
 
YEAR 2000 RISK
 
     STATE OF  READINESS.  The Company has  implemented a process to address its
Year  2000  compliance  issues.  The  process  includes  (i)  an  inventory  and
assessment  of the  compliance  of the  essential  systems and  equipment of the
Company and of critical suppliers,  customers and other third parties,  (ii) the
remediation  of  non-compliant  systems  and  equipment,  and (iii)  contingency
planning.  The  Company  has  completed  its  inventory  and  assessment  of its
information  technology  ("IT")  systems and  equipment  and non-IT  systems and
equipment  (embedded  technology)  and  approximately  90% of its  inventory and
assessment  of the systems and  equipment of critical  suppliers,  customers and
other third parties.
 
     With respect to the Year 2000  compliance of critical  third  parties,  the
Company  derives a  substantial  portion of its  revenues  from the Medicare and
Medicaid programs. Congress' General Accounting Office concluded in 1998 that it
is highly unlikely that all Medicare systems will be compliant on time to ensure
the delivery of uninterrupted benefits and services into the Year 2000.
 
     The Company has completed  approximately 90% of the remediation process for
critical IT and non-IT  systems and  equipment.  The Company has also  completed
approximately  80% of contingency  planning in the event that essential  systems
and equipment fail to be Year 2000 compliant. The Company is planning to be Year
2000 compliant for all its essential systems and equipment by the fourth quarter
of 1999,  although  there can be no assurance that it will achieve its objective
by such date or by January 1, 2000 or that such  potential  non-compliance  will
not  have a  material  adverse  effect  on  the  Company's  business,  financial
condition or results of operations.  In addition, there can be no assurance that
all of the Company's critical suppliers,  customers and other third parties will
be Year 2000 compliant by January 1, 2000, or that such potential non-compliance
will not have a material  adverse  effect on the  Company's  business  financial
condition or results of operations.
 
     COSTS.  The Company  currently  estimates that its aggregate costs directly
related to Year 2000 compliance  efforts will be approximately  $12 million,  of
which approximately $2.5 million has been spent through March 31, 1999. Of these
costs,  the Company  estimates  that  approximately  $3 million will be spent to
repair systems and equipment and $9 million will be spent to replace systems and
equipment.  The Company's Year 2000 efforts are ongoing and its overall plan and
cost estimations will continue to evolve as new information  becomes  available.
The Company's  analysis of its Year 2000 issues is based in part on  information
from third party  suppliers and  customers;  there can be no assurance that such
information is accurate or complete.


                                       48
<PAGE>

     RISKS.  The failure of the  Company or third  parties to be fully Year 2000
compliant for essential systems and equipment by January 1, 2000 could result in
interruptions of normal business work operations.  The Company's potential risks
include  (i) the  inability  to deliver  critical  care,  resulting  in death or
personal injury of residents of the Company's  facilities and in  non-affiliated
facilities,  (ii) the delayed receipt of reimbursement from the Federal or State
governments,  private payors, or  intermediaries,  (iii) the failure of security
systems, elevators,  heating systems or other operational systems and equipment,
resulting in death or personal  injury of residents of the Company's  facilities
and (iv) the inability to receive critical  equipment and supplies from vendors.
Each of these  events  could have a  material  adverse  affect on the  Company's
business, results of operations and financial condition.
 
     CONTINGENCY  PLANS.  The Company  has  completed  approximately  80% of its
contingency plan for Year 2000-related  issues. These plans include, but are not
limited to, identification of alternate supplies, alternate electronic processes
and alternate manual systems.  The company is planning to have contingency plans
completed for essential  systems and equipment by July 1, 1999;  however,  there
can be no assurance  that it will meet this objective by such date or by January
1, 2000.
 
     FORWARD-LOOKING  STATEMENTS.  The Year  2000  disclosure  set  forth  above
contains forward-looking statements. Specifically, such statements are contained
in sentences  including  the words  "plans,"  "expects" or  "anticipates."  Such
forward-looking  statements are subject to inherent risks and uncertainties that
may cause actual results to differ  materially  from those  contemplated  by the
forward-looking  statements.  Factors  that may cause  actual  results to differ
materially from those  contemplated by the  forward-looking  statements  include
availability  and cost of  personnel  trained in this area,  and the  failure of
third  parties  to (i)  respond to the  Company's  inquiries  as to whether  the
systems and equipment  supplied to the Company are compliant and (ii) adequately
remediate  Year 2000  issues.  The Company  could  experience  material  adverse
affects to its business, results of operations, and financial condition if it is
unable to  identify  and  remediate  all  non-compliant  essential  systems  and
equipment on the time schedule currently planned.
 
     YEAR  2000  INFORMATION  AND  READINESS   DISCLOSURE  ACT.  The  Year  2000
disclosure  set forth above is intended  to be a "year 2000  statement"  as such
term is defined in the Year 2000  Information  and Readiness  Disclosure  Act of
1998 (the "Year 2000 Act") and,  to the extent such  disclosure  relates to year
2000  processing  of the  Company  or to  products  or  services  offered by the
Company, is also intended to be a "Year 2000 readiness  disclosure" as such term
is defined in the Year 2000 Act.


                                       49
<PAGE>

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     Information with respect to this item is found in "Management's  Discussion
and Analysis of Financial  Condition and Results of Operations - Litigation" and
is incorporated by reference herein.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)  Exhibits

     (10.1)    Limited  Waiver and  Agreement,  dated as of April 27, 1999, to
               Credit Agreement among Sun, certain lenders,  certain  co-agents,
               and NationsBank of Texas, as Administrative Lender.

     (27.1)    Financial Data Schedule

(b)  Reports on Form 8-K

     Report  dated  April 5, 1999 and filed April 13,  1999  reporting  that the
     Company's  acquisition  of  Retirement  Care  Associates,   Inc.  would  be
     accounted for as a purchase  rather than a pooling of interests as a result
     of the Company's decision to divest certain of its non-core  businesses and
     based on discussions with the SEC and the Company's accountants.

     Report  dated March 31, 1999 and filed  April 15, 1999  reporting  that the
     Company  filed  its Form 10-K for the year  ended  December  31,  1998 with
     certain sections  omitted,  and that an amendment would be filed to include
     the omitted sections.


                                       50
<PAGE>


                                   SIGNATURES


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


                                         SUN HEALTHCARE GROUP, INC.


Date:  May 20, 1999                      By:  /s/ Robert D. Woltil   *
                                              -------------------------
                                               Robert D. Woltil
                                               Chief Financial Officer




*Signing  on the  behalf  of the  Registrant  and  as  principal  financial
 officer.



                                       

                                       51
<PAGE>


                                                                 EXHIBIT 10.1

                          LIMITED WAIVER AND AGREEMENT

     This  LIMITED  WAIVER  AND  AGREEMENT,  dated as of April  27,  1999  (this
"Agreement"),  is  entered  into by and  among SUN  HEALTHCARE  GROUP,  INC.,  a
Delaware  corporation  ("Borrower"),  the entities listed on the signature pages
hereto as Guarantors  (collectively,  "Guarantors"),  the entities listed on the
signature  pages  hereto as Lenders  (collectively,  "Lenders"),  the  Co-Agents
listed  on  the  signature   pages  hereto  as  Co-Agents   (collectively,   the
"Co-Agents"),  and  NATIONSBANK,  N.A.  (successor by merger to  NationsBank  of
Texas,  N.A.), as Administrative  Agent (in said capacity,  the  "Administrative
Agent").

     This  Agreement is made with  reference to that  certain  Credit  Agreement
dated as of  October 8,  1997,  by and among  Borrower,  Lenders,  Co-Agents and
Administrative  Agent,  as amended by that  certain  First  Amendment  to Credit
Agreement,  dated as of  November 12,  1997,  that certain  Second  Amendment to
Credit  Agreement,  dated as of March 27,  1998, that certain Third Amendment to
Credit Agreement,  dated as of May 29, 1998 and that certain Fourth Amendment to
Credit  Agreement,  dated  as of  October 30,  1998  (as  amended,  the  "Credit
Agreement").  Capitalized  terms used herein without  definition  shall have the
same meanings herein as set forth in the Credit Agreement.

     WHEREAS,  the Lenders have extended  Advances and made other  extensions of
credit to Borrower and Guarantors have  guaranteed the  Obligations  pursuant to
the Subsidiary Guaranties; and

     WHEREAS,  Borrower  has failed to comply with certain  covenants  and other
provisions set forth in the Credit Agreement (the "Designated Covenants") as set
forth on Schedule A attached hereto (the "Scheduled Defaults"), and

     WHEREAS,  Borrower has requested  that Lenders agree to waive the Scheduled
Defaults as of December  30, 1998 and Lenders have agreed to do so for a limited
period of time,  and only to the  extent  and on the  terms set forth  expressly
below.

     NOW,  THEREFORE,   in  consideration  of  the  covenants,   conditions  and
agreements hereinafter set forth, and for other good and valuable consideration,
the receipt and adequacy of which are all hereby acknowledged, the Borrower, the
Guarantors,  the Lenders,  the Co-Agents and  Administrative  Agent covenant and
agree as follows:

I.   ACKNOWLEDGEMENTS; REPRESENTATIONS; ADDITIONAL AGREEMENTS.

     A. Each of Borrower  and the  Guarantors  acknowledges  and agrees that the
terms of the Loan  Documents are the valid and binding  obligations  of Borrower
and the  Guarantors,  as the case may be,  enforceable in accordance  with their
terms and are not subject to any claims, offsets, defenses or counterclaims.

     B. Each of Borrower  and the  Guarantors  acknowledges  and agrees that the
Scheduled  Defaults have occurred and are continuing and, absent the waivers and
amendments  contained herein, such Scheduled Defaults would constitute Events of
Defaults that would entitle Lenders to declare the  Obligations  immediately due
and payable and to take action to collect the Obligations.

                                       1
<PAGE>

     C. Borrower  represents  that,  except for the Scheduled  Defaults,  (i) no
Defaults  or Events of Default  have  occurred  or are  continuing  and (ii) the
representations  and warranties  made in the Loan Documents are true and correct
in all  material  respects as of the date hereof as though made at and as of the
date hereof, except for (x) such representations and warranties that relate to a
particular  date or which  fail to be true and  correct as a result of events or
occurrences permitted under the Loan Documents,  and (y) such matters as are set
forth in the  Borrower's  Report on Form 10-K for the fiscal year ended December
31, 1998,  including  amendments on Form 10-KA, as filed with the Securities and
Exchange Commission through April 23, 1999.

     D. Borrower will deliver the following information to Administrative Agent:

     1.   Notice by facsimile  immediately,  and in any event on the same day if
          received  by noon  Albuquerque  time and by the  next day if  received
          after noon  Albuquerque  time, of any  communication  (whether oral or
          written),  notice or legal process from or on behalf of a holder of or
          representative  of  (including,  without  limitation,  a trustee)  any
          Subordinated Debt, Sun Financing Preferred  Securities,  or other debt
          in a principal  amount in excess of  $10,000,000  on which Borrower or
          any of its Subsidiaries is obligated, together with a copy of any such
          written  notice  or  communication  received  by  Borrower;  provided,
          however,  that  Borrower  shall not be required  to provide  notice of
          communications with holders of Borrower's debt requesting  information
          concerning  Borrower's  financial  or operating  status or  intentions
          concerning payment of the holder's debt, which  communication does not
          involve an  indenture  trustee  or counsel  and in which the holder or
          representative of such debt does not discuss the formation of a formal
          or  informal  committee  of debt  holders,  acceleration  or any other
          action to enforce remedies.

     2.   Promptly  upon  receipt  or   availability,   (i)  monthly   financial
          statements  (including a balance sheet and statement of cash flows) in
          the form provided to management, (ii) weekly cash flow projections for
          the following  three month period in the form provided to  management,
          (iii) notice of any assertion  that the obligor (or any agent thereof)
          on any Medicaid or Medicare account  receivable  asserts that it has a
          claim against Borrower or any of its Subsidiaries or intends to assert
          a right of setoff or  recoupment  (or similar  payment),  involving in
          excess of $10,000,000  in the  aggregate,  together with a copy of any
          written notice or communication related thereto and (iv) other reports
          or information as may be reasonably requested by Administrative Agent.
          Borrower shall deliver the monthly financial statements  referenced in
          clause  (i)  of  this  Section  for  January  through  March  1999  to
          Administrative Agent no later than May 7, 1999.

     E. Borrower and its Restricted Subsidiaries shall deliver to Administrative
Agent weekly  statements of the cash position of the Borrower and its Restricted
Subsidiaries showing balances and locations of accounts.

     F. Borrower,  Guarantors and Lenders agree that,  notwithstanding  Sections
7.4(a) or 2.5(c) of the  Credit  Agreement,  during the time that the waiver set
forth in Section II hereof is in effect  (the  "Waiver  Period"),  Borrower  and
Guarantors  shall not be entitled to retain the Net Cash  Proceeds of any assets
sold, leased, transferred or disposed of as permitted by Section 7.4(a)(viii) of
the Credit  Agreement  and all such  proceeds  shall be applied to the Term Loan
Advances as set forth in Section  2.5(c)(i) of the Credit  Agreement.  Borrower,
Guarantors and Lenders further agree that  notwithstanding  anything in any Loan
Documents to the contrary,  during the Waiver  Period,  Borrower and  Guarantors
shall promptly deliver to  Administrative  Agent for application to the Advances
in the  case of cash  proceeds,  or to  secure  the  Obligations  in the case of
proceeds  other  than  cash,  all  proceeds  of the  note  executed  by  Liberty
Healthcare Management Group, Inc. pledged to the Lenders.

                                       2
<PAGE>

     G. Notwithstanding Section 11.6 of the Credit Agreement,  during the Waiver
Period, Borrower's prior consent shall not be required for sale by a Lender of a
Participation or the assignment by a Lender of its rights and obligations  under
the Credit Agreement and the Loan Documents.

     H. Borrower and Guarantors acknowledge that pursuant to Section 11.2 of the
Credit  Agreement they are obligated to reimburse the  reasonable  out-of-pocket
expenses of the Lenders,  including  the working  group of Lenders,  incurred in
connection with this Agreement, a possible amendment to the Credit Agreement and
related matters.

II. WAIVER; ADVANCES.

     A. Subject to the terms hereof and in reliance on the  representations  and
warranties of the Borrower herein contained,  Lenders,  Administrative Agent and
Co-Agents  hereby waive the Scheduled  Defaults from December 30, 1998 until the
earlier of (x) 5:00 p.m.  E.D.T. on May 28, 1999 and (y) the date upon which any
of the  Conditions set forth in Section III hereof is not satisfied or ceases to
continue to be satisfied  (the earlier of clauses (x) and (y) being  referred to
as the "Waiver Termination  Date")). The Credit Agreement is hereby amended, (x)
effective as of December  30,  1998,  to excuse  compliance  solely  through the
Waiver  Termination  Date with the Designated  Covenants solely to the extent of
the Scheduled  Defaults;  and (y) on the Waiver Termination Date, to reinstitute
all  Designated  Covenants  and  to  require  Borrower's  compliance  with  such
Designated Covenants including compliance with such Designated Covenants for the
fiscal quarters ended December 31, 1998 and March 31, 1999.

     B. Borrower is not authorized to receive any Revolving Credit Advances that
would increase the amount of the Revolving Credit Advances outstanding as of the
date hereof and Borrower is not  authorized to have issued any Letters of Credit
that would increase the Reimbursement Obligations from the amount outstanding as
of the date hereof. Borrower will not request any such Revolving Credit Advances
or the issuance of any such Letters of Credit.  Prior to the Waiver  Termination
Date,  Borrower may reborrow  Revolving  Credit  Advances  repaid after the date
hereof and may  designate  outstanding  Advances as Base Rate  Advances or LIBOR
Advances,  and the applicable  Interest Period for any LIBOR  Advances,  in each
case in accordance with the terms of the Credit Agreement.

III. CONDITIONS.

     The waiver  set forth in  Section II hereof is subject to the  satisfaction
and continuation of the following conditions (the "Conditions").

     A. No Default or Event of Default  other  than a  Scheduled  Default  shall
occur.

     B. Neither Borrower nor any  Subsidiaries  shall have made or set apart any
payment on account of any  Subordinated  Debt,  including,  without  limitation,
payment of interest,  principal,  conversion,  redemption  or  defeasance of any
Subordinated  Debt other than payment (in an amount not to exceed  $1,050,000 in
the aggregate) on conversion of the Convertible Bonds.

                                        3
<PAGE>

     C. Neither Sun Financing, Borrower nor any of Borrower's Subsidiaries shall
declare  any  Dividends  or pay any  Dividends  in respect of the Sun  Financing
Preferred Securities.

     D.  Neither  any holder of any  Subordinated  Debt nor any  trustee for any
Subordinated  Debt  shall  have  accelerated  any  such  debt or  commenced  any
collection proceeding in respect thereto.

     E. Borrower  shall have  satisfied and be in compliance  with each term and
condition of this Agreement.

     F. No event or circumstance shall hereafter occur, or shall have heretofore
occurred but is hereafter  discovered  by Lenders,  that has a Material  Adverse
Effect,  regardless of whether such event or  circumstance  would  constitute an
Event of Default.

IV. RESERVATION OF RIGHTS.

     A. Without  limiting the  generality of the  provisions in Section 11.11 of
the Credit  Agreement,  the waiver and  amendment  set forth above in Section II
shall be  limited  precisely  as written  and  relates  solely to the  Scheduled
Defaults  during  the Waiver  Period in the  manner and to the extent  above set
forth, and nothing in this Agreement shall be deemed to:

     1.   Constitute  a waiver of  compliance  by Borrower  with  respect to the
          Designated  Covenants  in  any  other  instance  or  any  other  term,
          provision or condition of the Credit Agreement or any other instrument
          or agreement referred to therein; or

     2.   Prejudice any right or remedy that Administrative Agent, the Co-Agents
          or any Lender may now have  (except to the extent such right or remedy
          was based upon the  Scheduled  Defaults that will not exist during the
          Waiver Period upon giving effect to this Agreement) or may have in the
          future under or in connection  with the Credit  Agreement or any other
          instrument or agreement referred to therein.

     Except as expressly set forth herein, the terms,  provisions and conditions
of the Credit  Agreement and the other Loan Documents shall remain in full force
and effect and in all other respects are hereby ratified and confirmed.

     B.  Without  limiting  the  generality  of  the  foregoing,   Borrower  and
Subsidiaries  will not claim  that any prior  action  or  course of  conduct  by
Administrative  Agent,  Co-Agents or any of the Lenders constitutes an agreement
or  obligation  to  continue  such  action or course of conduct  in the  future.
Borrower and Subsidiaries  acknowledge that Administrative Agent,  Co-Agents and
Lenders  have  made no  commitment  as to how  the  Scheduled  Defaults  will be
resolved upon the Waiver Termination Date.

     C. Borrower,  Guarantors,  Administrative Agent, Co-Agents and Lenders may,
from time to time,  engage in negotiations  concerning the Obligations which may
be lengthy and complex. None of Administrative  Agent,  Co-Agents or the Lenders
shall have any obligation to modify, amend and/or restructure the Obligations or
any of the Loan  Documents in connection  with such  negotiations  or otherwise.
Each of  Administrative  Agent,  Co-Agents  and the Lenders may  terminate  such
negotiations at any time, in its sole  discretion,  with or without notice,  and
without  liability of any kind. None of Administrative  Agent,  Co-Agents or the
Lenders shall have any  obligation  or liability by virtue of the  commencement,
prosecution or termination of  negotiations  concerning any possible  amendment.
None of Administrative Agent, Co-Agents or the Lenders shall waive any rights or
incur  any  liability  by  negotiation  nor by the  passage  of time  associated
therewith.

                                        4
<PAGE>

     D.  Subject  only  to the  terms  of this  Agreement,  and  subject  to any
applicable notice, grace or cure periods,  Administrative  Agent,  Co-Agents and
Lenders may exercise any right or remedy  available to them pursuant to the Loan
Documents or by applicable law or in equity during the Waiver Period, including,
without limitation,  as the result of a Default or Event of Default other than a
Scheduled  Default,  and nothing  herein shall  operate to restrict,  inhibit or
prohibit Administrative Agent, Co-Agents or the Lenders from exercising any such
right or remedy or from the  prosecution or continued  prosecution of any action
or proceeding in furtherance of the foregoing.

     E. The Loan  Documents  are in full force and effect,  and shall  remain in
full  force  and  effect,  unless  and  until an  agreement  modifying  the Loan
Documents is executed and delivered by the applicable parties,  and then only to
the extent such an agreement actually modifies such Loan Documents.

     F. At any time on or after  the  Waiver  Termination  Date,  Administrative
Agent,  Co-Agents and the Lenders shall be entitled to exercise all their rights
and remedies  (including  rights and remedies based on the Scheduled  Defaults),
whether under the Loan Documents or at law or in equity,  without further notice
or demand.

V. CONDITIONS TO EFFECTIVENESS.

     This Agreement  shall be effective upon the  satisfaction  of the following
conditions:

     A. Administrative Agent shall have received  counterparts of this Agreement
executed by the Determining Lenders;

     B. Administrative Agent shall have received  counterparts of this Agreement
executed by Borrower and acknowledged by each Guarantor;

     C.  Administrative  Agent  shall  have  received,  in  form  and  substance
satisfactory  to  Administrative  Agent and its counsel,  such other  documents,
certificates and instruments as Administrative Agent shall require;

     D. Borrower  shall have paid all fees and expenses  billed through the date
hereof owing to Administrative Agent and Lenders,  including without limitation,
fees and expenses of counsel to Administrative Agent;

     Borrower   shall  have  paid  to   O'Melveny   &  Myers  LLP,   counsel  to
Administrative   Agent,   a  retainer  in  the  amount  of   $250,000,   and  to
PricewaterhouseCoopers  LLP,  financial  advisors  to  Administrative  Agent,  a
retainer in the amount of $250,000, in each case to be applied to future amounts
owing under Section 11.2 of the Credit  Agreement so that Borrower need not make
additional  payments  under  Section  11.2 of the  Credit  Agreement  until such
retainers  have been  exhausted,  and which  retainers  shall be in  addition to
Borrower's  obligation  to pay  amounts  owing to  Administrative  Agent  billed
through the date hereof, as required by Section V.D above; and

     Borrower shall have delivered evidence satisfactory to Administrative Agent
and its counsel  that  Borrower has  exercised  its right to extend the interest
payment on the Borrower Subordinated Debentures due on May 1, 1999.

VI. GUARANTORS' ACKNOWLEDGEMENT.

     A. By signing below, each of the Guarantors: (a) acknowledges, consents and
agrees to the execution, delivery and performance by Borrower of this Agreement,
and (b)  acknowledges  and  agrees  that its  obligations  with  respect  to its
Subsidiary  Guaranty  or any other  Loan  Documents  executed  by it are (i) not
released,  diminished,  waived, modified,  impaired or affected in any manner by
this Agreement, (ii) hereby ratified and confirmed, and (iii) not subject to any
claims, offsets, defenses or counterclaims.

     B. By signing  below,  each  Guarantor  acknowledges  and  agrees  that (i)
notwithstanding  the conditions to  effectiveness  set forth in this  Agreement,
such  Guarantor is not required by the terms of any  Subsidiary  Guaranty or any
other Loan  Document to consent to the terms of this  Agreement and (ii) nothing
in this  Agreement or any of the Loan  Documents  shall be deemed to require the
consent of such  Guarantor to any future  amendments to or  modifications  of or
waivers with respect to the Credit Agreement,  or shall diminish or release such
Guarantor's guarantee of the Obligations if such consent is not obtained.


                                       5
<PAGE>
VII. OTHER MATTERS.

     A. ENTIRE AGREEMENT.  THE CREDIT AGREEMENT,  AS AFFECTED BY THIS AGREEMENT,
AND THE OTHER LOAN DOCUMENTS  REPRESENT THE FINAL AGREEMENT  BETWEEN THE PARTIES
AND MAY NOT BE CONTRADICTED BY EVIDENCE OF PRIOR, CONTEMPORANEOUS, OR SUBSEQUENT
ORAL  AGREEMENTS  BETWEEN THE PARTIES.  THERE ARE NO UNWRITTEN  ORAL  AGREEMENTS
BETWEEN THE PARTIES.

     B. This Agreement  shall be governed by, and interpreted in accordance with
Texas law without regard to principles of conflicts of law.

     C. This  Agreement  may be  executed in any number of  counterparts  and by
different  parties  hereto  in  separate  counterparts,  each of  which  when so
executed  and  delivered  shall be deemed to be an original  and all which taken
together shall constitute but one and the same instrument.

     D. Section  headings in this Agreement are included  herein for convenience
of  reference  only and shall not  constitute a part of this  Agreement  for any
other purpose.



                            [signature pages omitted]



                                       6

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<FISCAL-YEAR-END>                              DEC-31-1999
<PERIOD-START>                                 JAN-01-1999
<PERIOD-END>                                   MAR-31-1999
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<SECURITIES>                                           0
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<ALLOWANCES>                                      86,314
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