Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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, 2012

or

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

Commission File Number 001-16817

FIVE STAR QUALITY CARE, INC.

(Exact Name of Registrant as Specified in Its Charter)

400 Centre Street, Newton, Massachusetts 02458

(Address of Principal Executive Offices) (Zip Code)

(Registrant’s Telephone Number, Including Area Code): 617-796-8387

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

Number of registrant’s shares of common stock, $.01 par value, outstanding as of April 30, 2012: 47,899,312.

Table of Contents

FIVE STAR QUALITY CARE, INC.

FORM 10-Q

MARCH 31, 2012

INDEX

As used herein the terms “we”, “us”, and “our” refer to Five Star Quality Care, Inc. and its consolidated subsidiaries unless otherwise noted.

Table of Contents

Part I.    Financial Information

Item 1.  Condensed Consolidated Financial Statements

FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(in thousands, except per share data)

(unaudited)

See accompanying notes.

1

Table of Contents

FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF INCOME

(in thousands, except per share data)

(unaudited)

See accompanying notes.

2

Table of Contents

FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

See accompanying notes.

3

Table of Contents

FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes.

4

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

Note 1.  Basis of Presentation and Organization

The accompanying condensed consolidated financial statements of Five Star Quality Care, Inc. and its subsidiaries, which we refer to as we, us or our, have been prepared without audit.  Certain information and disclosures required by U.S. generally accepted accounting principles, or GAAP, for complete financial statements have been condensed or omitted.  We believe the disclosures made are adequate to make the information presented not misleading.  However, the accompanying financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2011, or our Annual Report.  In the opinion of our management, all adjustments, which include only normal recurring adjustments, considered necessary for a fair presentation have been included.  All material intercompany transactions and balances have been eliminated.  Our operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.

We operate senior living communities, including independent living communities, assisted living communities and skilled nursing facilities, or SNFs.  As of March 31, 2012, we operated 247 senior living communities located in 30 states containing 27,503 living units, including 209 primarily independent and assisted living communities with 24,080 living units and 38 SNFs with 3,423 living units.  We own and operate 31 communities (2,954 living units), we lease and operate 191 communities (20,811 living units) and we manage 25 communities (3,738 living units).  Our 247 senior living communities included 8,838 independent living apartments, 13,196 assisted living suites and 5,469 skilled nursing units.  Two SNFs owned and operated by us containing 271 living units and one assisted living community leased from Senior Housing Properties Trust or its subsidiaries, or SNH, and operated by us containing 103 living units that we have classified as discontinued operations are excluded from all the preceding data in this paragraph.

We also lease and operate two rehabilitation hospitals with 321 beds that provide inpatient rehabilitation services to patients at the two hospitals and at three satellite locations.  In addition, we lease and operate 13 outpatient clinics affiliated with these rehabilitation hospitals.  We also own and operate five institutional pharmacies.

Note 2. Property and Equipment

Property and equipment, at cost, consists of the following:

As of March 31, 2012 and December 31, 2011, we had assets of $6,461 and $7,076, respectively, included in our property and equipment that we intend to sell to SNH for increased rent pursuant to the terms of our leases with SNH; however, we are not obligated to make these sales and SNH is not obligated to purchase the property and equipment.

Note 3.  Financial Data by Segment

Our reportable segments consist of our senior living community business and our rehabilitation hospital business.   In the senior living community segment, we operate for our own account, manage for the account of SNH, or for another owner pending SNH’s acquisition, independent living communities, assisted living communities and SNFs that are subject to centralized oversight and provide housing and services generally to elderly residents.  Our

5

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

rehabilitation hospital segment provides inpatient rehabilitation services to patients at two hospital locations and at three satellite locations and outpatient rehabilitation services at 13 affiliated outpatient clinics.  We do not consider our institutional pharmacy operations to be a material, separately reportable segment of our business.  Consequently, we report our institutional pharmacy revenues and expenses as separate items within our corporate and other activities.  All of our operations and assets are located in the United States, except for the operations of our captive insurance company subsidiary, which participates in our workers’ compensation, professional liability and automobile insurance programs and which operates in the Cayman Islands.

We use segment operating profit as a means to evaluate our performance and for our business decision making purposes.  Segment operating profit excludes interest, dividend and other income, interest and other expense, provision for income taxes, and corporate income and expenses.

Our revenues by segment and a reconciliation of segment operating profit (loss) to income (loss) from continuing operations for the three months ended March 31, 2012 and 2011 are as follows:

(1)            Corporate and Other includes operations that we do not consider a material, separately reportable segment of our business and income and expenses that are not attributable to a reportable specific segment.

(2)            General and administrative expenses are not attributable to a reportable specific segment and include items such as corporate payroll and benefits and expenses of our home office activities.

6

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

Note 4. Goodwill and Other Intangible Assets

The changes in the carrying amount of goodwill and other intangible assets from January 1, 2012 to March 31, 2012 are as follows:

(1)             Goodwill and other intangible assets in our Senior Living Communities segment relate to management agreements and trademarks we acquired in connection with a lease we entered into with SNH in 2009 and goodwill of $10,988 we recorded in connection with our senior living community acquisitions in previous years.

(2)             Intangible assets in our Corporate and Other segment relate to customer agreements we acquired in connection with our pharmacy acquisitions.

In May 2011, we agreed to purchase certain assets of six senior living communities located in Indiana, or the Indiana Communities, containing 738 living units for a total purchase price, excluding closing costs, of $122,760.  The Indiana Communities primarily offer independent and assisted living services, which are currently primarily paid by residents from their private resources.  During 2011, we completed our acquisitions of the assets of these Indiana Communities and funded the acquisitions with proceeds of a public offering, or the Public Offering, of shares of our common stock, $.01 par value per share, or our common shares, proceeds of a bridge loan from SNH, or the Bridge Loan, by assuming approximately $19,260 of mortgage notes secured by three of the Indiana Communities, by assuming net working capital liabilities of the Indiana Communities and with cash on hand.  We recorded the acquired land, building and equipment of these Indiana Communities at estimated fair value.  The values assigned to the land, buildings and equipment of our Indiana Communities are based upon preliminary estimates of the fair value of assets acquired.  Consequently, amounts preliminarily assigned to assets acquired could change from those reported in these consolidated financial statements.

Note 5.  Income Taxes

During the fourth quarter of 2011 we evaluated the realizability of certain of our net deferred tax assets, which include, among other things, our net operating losses and tax credits, and determined that it is more likely than not

7

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

that we will realize the benefit of such deferred tax assets, and as a result, we realized in the fourth quarter of 2011, the full amount of the valuation allowance we had previously maintained against these deferred tax assets of $52,111.  For the three months ended March 31, 2012, we recognized tax expense from continuing operations of $602.  We also recognized a tax benefit from discontinued operations of $300.  Our effective income tax rate increased during the three months ended March 31, 2012 to 44.7% compared to 8.4% in the prior year period primarily because our previous rate had been reduced from the statutory rate due to the full utilization of the previously maintained valuation allowance against our net operating loss, or NOL, carry forwards.  As of December 31, 2011, our federal NOL carry forward, which begins to expire in 2025 if unused, was approximately $100,710, and our tax credit carry forward, which begins to expire in 2022 if unused, was approximately $6,820.  Our NOL carry forwards and tax credit carry forwards are subject to audit and adjustments by the Internal Revenue Service.

We do not currently recognize the benefit of certain deferred tax assets related to capital losses because we do not believe it is more likely than not that we will realize such benefit.  As a result, we maintain a partial valuation allowance against these deferred tax assets.  When we believe that we will more likely than not realize the benefit of these deferred tax assets, we will record deferred tax assets as an income tax benefit in our consolidated statement of income, which will affect our results of operations.

Note 6.  Earnings Per Share

We computed basic earnings per common share, or EPS, for the three months ended March 31, 2012 and 2011 using the weighted average number of shares outstanding during the periods.  Diluted EPS for the periods ended March 31, 2012 and 2011 reflects additional common shares related to our convertible senior notes due in 2026, or the Notes, that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income applicable to common shareholders that would result from their assumed issuance.  The weighted average shares outstanding used to calculate basic and diluted EPS include 565 and 512 unvested common shares as of March 31, 2012 and 2011, respectively, issued to our officers and others under our equity compensation plan, or our Share Award Plan.  Unvested shares issued under our Share Award Plan are deemed participating securities because they participate equally in earnings with all of our other common shares.

The following table provides a reconciliation of income from continuing operations and loss from discontinued operations and the number of common shares used in the computations of diluted EPS:

Note 7.  Fair Values of Assets and Liabilities

The information below presents the assets and liabilities that are measured at fair value on a recurring and non recurring basis at March 31, 2012, categorized by the level of inputs used in the valuation of each asset and liability.

8

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

(1)  Long lived assets held for sale consist of property and equipment we intend to sell to SNH for increased rent pursuant to the terms of our leases with SNH; however, we are not obligated to make these sales and SNH is not obligated to purchase the property and equipment.  We have either recently acquired the assets or the assets are part of active construction projects and we expect that any sale of these assets to SNH would be for an amount equal to their recorded cost.  Accordingly, the cost of these assets approximates their fair value.

(2)  In September 2011, we recorded a $3,938 asset impairment charge to reduce the carrying value of two SNFs we own that we have classified as discontinued operations to their estimated fair value based upon expected sales prices less costs to sell.

(3)  Cash equivalents, consisting of money market funds held principally for obligations arising from our self insurance programs.

(4)  Investments in available for sale securities are reported on our balance sheet as current and long term investments in available for sale securities and are reported at fair value of $8,773 and $12,871, respectively, at March 31, 2012.  We estimate the fair value of our available for sale investments by reviewing each security’s current market price, the ratings of the security, the financial condition of the issuer and our intent and ability to retain the investment during temporary market price fluctuations or until maturity.   In evaluating the factors described above, we presume a decline in value to be an “other than temporary impairment” if the quoted market price of the security is below the security’s cost basis for an extended period.  However, this presumption may be overcome if there is persuasive evidence indicating the value decline is temporary in nature, such as when the operating performance of the obligor is strong or if the market price of the security is historically volatile.  Additionally, there may be instances in which impairment losses are recognized even if the decline in value does not fall within the criteria described above, such as if we plan to sell the security in the near term and the fair value is below our cost basis.  When we believe that a change in fair value of an available for sale security is temporary, we record a corresponding credit or charge to other comprehensive income for any unrealized gains and losses.  When we determine that an impairment in the fair value of an available for sale security is an “other than temporary impairment”, we record a charge to earnings.

Our investments in available for sale securities had amortized costs of $20,055 and $20,827 as of March 31, 2012 and December 31, 2011, respectively, had unrealized gains of $1,724 and $1,586 as of March 31, 2012 and December 31, 2011, respectively, and had unrealized losses of $135 and $185 as of March 31, 2012 and December 31, 2011, respectively.  At March 31, 2012, nine of the securities we hold are in a loss position that has ranged from one to 11 months.  Since these

9

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

securities have not been in a loss period for an extended period of time, we do not believe these securities are impaired.  During the three months ended March 31, 2012, we received gross proceeds of $772 in connection with the sales of available for sale securities and recorded gross realized gains totaling $2 and gross realized losses totaling $3.

During the three months ended March 31, 2012, we did not change the type of inputs used to determine the fair value of any of our assets and liabilities that we measure at fair value.  Accordingly, there were no transfers of assets or liabilities between levels of the fair value hierarchy during the three months ended March 31, 2012.

The carrying values of our accounts receivable, available for sale securities, accounts payable, mortgage notes payable and the Bridge Loan with SNH approximate fair value as of March 31, 2012 and December 31, 2011.  The carrying value and fair value of the Notes was $37,282 and $35,437, respectively, as of March 31, 2012 and $37,282 and $33,181, respectively, as of December 31, 2011 and are categorized in level one of the fair hierarchy in their entirety.  We estimate the fair value of the Notes using quoted market data for these securities. We measured the fair value of our equity investment in Affiliates Insurance Company, or AIC, which is an Indiana insurance company that we currently own in equal proportion as the other six shareholders of that company (see Note 10), categorized in level two of the fair hierarchy in its entirety, by considering, among other things, the individual assets and liabilities held by AIC, AIC’s overall financial condition and earning trends, and the financial condition and prospects for the insurance industry generally.

Note 8.  Indebtedness

We have a $35,000 revolving secured line of credit, or our Credit Agreement, that matures on March 18, 2013 when all amounts outstanding will be due. Borrowings under our Credit Agreement are available for acquisitions, working capital and general business purposes.  Funds available under our Credit Agreement may be drawn, repaid and redrawn until maturity and no principal payment is due until maturity.  We borrow in U.S. dollars and borrowings under our Credit Agreement bear interest at LIBOR (with a floor of 2% per annum) plus 400 basis points, or 6% as of March 31, 2012.  We are the borrower under our Credit Agreement and certain of our subsidiaries guarantee our obligations under our Credit Agreement, which is secured by our and our guarantor subsidiaries’ accounts receivable and related collateral. Our Credit Agreement contains covenants requiring us to maintain certain financial ratios, places limits on our ability to incur or assume debt or create liens with respect to certain of our properties and has other customary provisions. Our Credit Agreement also provides for acceleration of payment of all amounts due thereunder or upon the occurrence and continuation of certain events of default.  As of March 31, 2012, no amounts were outstanding under our Credit Agreement. As of March 31, 2012, we believe we were in compliance with all applicable covenants under our Credit Agreement. We incurred interest expense and other associated costs related to our Credit Agreement of $176 and $147 for the three months ended March 31, 2012 and 2011, respectively.

In May 2011, we entered into the Bridge Loan agreement with SNH under which SNH agreed to lend us up to $80,000 to fund a part of the purchase price for our acquisitions of certain assets of the Indiana Communities.  During 2011, we completed our acquisitions of the assets of the Indiana Communities and, in connection with the acquisitions, borrowed $80,000 under the Bridge Loan.  We subsequently repaid $42,000 of this advance with proceeds from the Public Offering and cash generated by operations.  As of March 31, 2012, an aggregate principal amount of $38,000 was outstanding under the Bridge Loan.  In April 2012, we repaid in full the principal amount outstanding under the Bridge Loan, resulting in termination of the Bridge Loan.  We incurred interest expense and other associated costs related to the Bridge Loan of $275 for the three months ended March 31, 2012.

On April 13, 2012, we entered into a new $150,000 secured revolving credit facility with Citibank, N.A. and a syndicate of other lenders, or our New Credit Facility, which is in addition to our existing Credit Agreement.  The maturity date of our New Credit Facility is April 13, 2015, and, subject to the payment of extension fees and meeting certain other conditions, we have options to extend the maturity date for two, one year periods.  The proceeds of our New Credit Facility are available for general business purposes, including the repayment of debt.  We initially borrowed $35,500 under our New Credit Facility, which was applied, together with cash on hand, to repay in full the $38,000 principal amount outstanding under the Bridge Loan.

10

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

Our New Credit Facility bears interest, at our election, at LIBOR plus 250 basis points or Citibank N.A.’s base rate plus 150 basis points.  Borrowings under our New Credit Facility are guaranteed by certain of our subsidiaries and secured by our guarantor subsidiaries’ accounts receivable and related collateral and real estate mortgages on 15 senior living communities with 1,549 living units owned by our guarantor subsidiaries.  Funds available under our New Credit Facility may be drawn, repaid and redrawn until maturity and there are no scheduled principal payments prior to maturity.  Our New Credit Facility provides for acceleration of payment of all amounts payable upon the occurrence and continuation of certain events of default, including a change of control of us.  Our New Credit Facility contains a number of financial covenants which generally restrict our ability to incur debts in excess of calculated amounts, require us to maintain a minimum net worth and require us to maintain various financial ratios.

In connection with our New Credit Facility, we amended our existing Credit Agreement to release certain of the guarantor subsidiaries and collateral thereunder, as well as receive the consent of the agent and lenders under our Credit Agreement to our New Credit Facility.

In October 2006, we issued $126,500 principal amount of the Notes.  Our net proceeds from this issuance were approximately $122,600.  The Notes bear interest at a rate of 3.75% per annum and are convertible into our common shares at any time.  The initial conversion rate, which is subject to adjustment, is 76.9231 common shares per $1 principal amount of the Notes, which represents an initial conversion price of $13.00 per share.  The Notes are guaranteed by certain of our wholly owned subsidiaries.  The Notes mature on October 15, 2026.  We may prepay the Notes at any time and the holders may require that we purchase all or a portion of these Notes on each of October 15 of 2013, 2016 and 2021 at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus any accrued and unpaid interest.  If a “fundamental change”, as defined in the indenture governing the Notes, occurs, holders of the Notes may require us to repurchase all or a portion of their Notes for cash at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus any accrued and unpaid interest and, in certain circumstances, plus a make whole premium as defined in the indenture governing the Notes.  Interest expense and other associated costs related to the Notes was $367 and $354 for the three months ended March 31, 2012 and 2011, respectively.  We issued the Notes pursuant to an indenture which contains various customary covenants.  As of March 31, 2012, we believe we were in compliance with all applicable covenants of the indenture governing the Notes.

During the three months ended March 31, 2011, we purchased and retired $623 par value of the outstanding Notes and recorded a gain of $1, net of related unamortized costs, on early extinguishment of debt included in interest, dividend and other income.  We funded these purchases principally with cash on hand.  As a result of these purchases and other purchases we made in prior years, at March 31, 2012, $37,282 in principal amount of the Notes remained outstanding.  In April 2012, we purchased and retired $12,410 par value of the outstanding Notes and will record a gain of $45, net of related unamortized costs, on early extinguishment of debt.  We funded this purchase principally with borrowings under our New Credit Facility and cash on hand.   As a result of this purchase and other purchases we made in prior years, $24,872 in principal amount of the Notes remain outstanding.

At March 31, 2012, two of our communities, which we have classified as discontinued operations, were encumbered by United States Department of Housing and Urban Development, or HUD, insured mortgage notes, one of our communities was encumbered by a Federal National Mortgage Association, or FNMA, mortgage note, and three of our communities were encumbered by Federal Home Loan Mortgage Corporation, or FMCC, mortgage notes.  These mortgages contain HUD, FNMA and FMCC standard mortgage covenants.  We recorded a mortgage premium in connection with our assumption of the FNMA and FMCC mortgage notes in order to record the assumed mortgage notes at their estimated fair value.  We are amortizing the mortgage premiums as a reduction of interest expense until the maturity of the respective mortgage notes.  The weighted average interest rate on these six notes was 6.68% as of March 31, 2012.  Payments of principal and interest are due monthly until maturities at varying dates ranging from June 2023 to May 2039.  We incurred mortgage interest expense, including premium amortization, of $717 and $111 for the three months ended March 31, 2012 and 2011, respectively, with respect to these six notes.  As of March 31, 2012, we believe we were in compliance with all applicable covenants under these mortgages.

11

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

Note 9. Off Balance Sheet Arrangements

As of March 31, 2012, we had no off balance sheet arrangements that we expect have had or which we believe would be reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources, except for the pledge of certain of our assets, such as accounts receivable, with a carrying value of $21,602 arising from our operation of 56 properties owned by SNH and leased to us which secures SNH’s borrowings from its lender, FNMA.

Note 10. Related Person Transactions

We were formerly a 100% owned subsidiary of SNH.  In 2001, SNH distributed substantially all of our then outstanding common shares to its shareholders.  SNH is our largest stockholder and, as of the date of this report, SNH owned 4,235 of our common shares, or approximately 8.8% of our outstanding common shares.  One of our Managing Directors, Mr. Barry Portnoy, is also a managing trustee of SNH.  Mr. Portnoy’s son, Mr. Adam Portnoy, serves as a managing trustee of SNH.  SNH is our largest landlord and we manage several senior living communities for SNH.  As of March 31, 2012, we leased 188 of our 247 senior living communities (including one that we have classified as discontinued operations) and two rehabilitation hospitals from SNH and managed 23 senior living communities for the account of SNH.

Under our leases with SNH, we generally pay SNH rent based on minimum annual rent amounts plus percentage rent based on increases in gross revenues at certain properties.  Our total minimum annual rent payable to SNH under those leases as of March 31, 2012 was $195,746, excluding percentage rent.  Our total rent expense under all of our leases with SNH was $49,804 and $47,728 for the three months ended March 31, 2012 and 2011, respectively, net of $225 amortization of a lease inducement from SNH in each period. During the three months ended March 31, 2012 and 2011, pursuant to the terms of our existing leases with SNH, we sold $6,318 and $10,837, respectively, of improvements made to properties leased from SNH, and, as a result, our annual rent payable to SNH increased by approximately $512 and $869, respectively, pursuant to the terms of the leases.

We manage certain of SNH’s senior living communities pursuant to management agreements.  We and SNH have entered into a pooling agreement, which pools SNH’s managed assisted living communities, and pursuant to which the determinations of fees and expenses of the various communities that are subject to the pooled management contracts are aggregated, including determination of our incentive fees and SNH’s return of its invested capital.  We expect that managed communities with only independent living apartments will be subject to a future separate pooling agreement, which would similarly aggregate the managed independent living apartments.  We began managing communities for the account of SNH in June 2011 in connection with SNH’s acquisition of certain senior living communities at that time.  For the three months ended March 31, 2012, we recorded $1,068 in management fee revenue and $22,962 of reimbursed costs incurred in connection with the communities that we manage for the account of SNH.  We expect that we may enter into additional management arrangements with SNH for senior living communities that SNH may acquire in the future on terms similar to those management arrangements we currently have with SNH, including two communities SNH has agreed to acquire and which we are currently managing for the current owner pending SNH’s acquisition and another independent living community SNH has recently agreed to acquire.  SNH’s acquisitions of those communities are subject to conditions and may not occur.  There can be no assurances that we will manage additional senior living communities for SNH’s account.

As discussed above in Note 8, in May 2011, we and SNH entered into the Bridge Loan, under which SNH agreed to lend us up to $80,000 to help fund our purchase of the Indiana Communities.  As of March 31, 2012, there was $38,000 aggregate principal amount outstanding under the Bridge Loan.  We incurred interest expense of $275 for the three months ended March 31, 2012, which is included in interest and other expenses in our condensed consolidated statement of income.  In April 2012, we repaid in full the outstanding principal amount under the Bridge Loan, resulting in termination of the Bridge Loan.

Reit Management & Research LLC, or RMR, provides us with certain business management and shared services under a business management and shared services agreement, or our business management agreement.  RMR also provides management services to SNH.  One of our Managing Directors, Mr. Barry Portnoy, is Chairman, majority owner and an employee of RMR.  Our other Managing Director, Mr. Gerard Martin, is a director of RMR.  Our

12

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

President and Chief Executive Officer and our Treasurer and Chief Financial Officer are officers of RMR.  Mr. Barry Portnoy’s son, Mr. Adam Portnoy, is an owner, President, Chief Executive Officer and a director of RMR and serves as a managing trustee of SNH.  Our Independent Directors also serve as independent directors or independent trustees of other public companies to which RMR provides management services.  Mr. Barry Portnoy serves as a managing director or managing trustee of those companies and his son serves as a managing trustee of a majority of those companies.  Pursuant to our business management agreement with RMR, we incurred expenses of $3,228 and $2,807 for the three months ended March 31, 2012 and 2011, respectively.  These amounts are included in general and administrative expenses in our condensed consolidated statement of income.  We lease our headquarters from an affiliate of RMR for annual rent of approximately $730, and our rent expense, which included our proportionate share of utilities and real estate taxes, under this lease for the three months ended March 31, 2012 and 2011 was $381 and $297, respectively.

We, SNH, RMR and four other companies to which RMR provides management services each currently own approximately 14.3% of AIC, an Indiana insurance company.  All of our Directors, all of the trustees and directors of the other publicly held AIC shareholders and nearly all of the directors of RMR currently serve on the board of directors of AIC.  RMR provides management and administrative services to AIC pursuant to a management and administrative services agreement with AIC.  Although we own less than 20% of AIC, we use the equity method to account for this investment because we believe that we have significant influence over AIC because all of our Directors are also directors of AIC.  We may invest additional amounts in AIC in the future if the expansion of this insurance business requires additional capital, but we are not obligated to do so.  During the three months ended March 31, 2012 and 2011, we recognized income of $45 and $37, respectively, related to this investment.  In June 2010, we and the other shareholders of AIC purchased property insurance providing $500,000 of coverage pursuant to an insurance program arranged by AIC and with respect to which AIC is a reinsurer of certain coverage amounts.  This program was modified and extended in June 2011 for a one year term and we paid a premium of $4,500 in connection with that renewal, which amount may be adjusted from time to time in response to our acquisition and disposition of properties that are included in that program. We currently expect that we will renew this program, as it may be modified, in June 2012.  We are also currently investigating the possibilities to expand our insurance relationships with AIC to include other types of insurance.  By participating in this insurance business with RMR and the other companies to which RMR provides management services, we expect that we may benefit financially by possibly reducing our insurance expenses or by realizing our pro-rata share of any profits of this insurance business.

For further information about these and other such relationships and related person transactions, please see elsewhere in this Quarterly Report on Form 10-Q, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related Person Transactions” in Part I, Item 2 and “Warning Concerning Forward Looking Statements,” and our Annual Report, our Proxy Statement for our 2012 Annual Meeting of Shareholders dated February 21, 2012, or our Proxy Statement, and our other filings with the Securities and Exchange Commission, or the SEC, including Note 15 to our Consolidated Financial Statements included in our Annual Report, the sections captioned  “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related Person Transactions” and “Warning Concerning Forward Looking Statements” of our Annual Report and the section captioned “Related Person Transactions and Company Review of Such Transactions” and the information regarding our Directors and executive officers in our Proxy Statement.  In addition, please see the section captioned “Risk Factors” of our Annual Report for a description of risks that may arise from these transactions and relationships.  Our filings with the SEC, including our Annual Report and our Proxy Statement, are available at the SEC’s website at www.sec.gov.  In addition, copies of certain of our agreements with these parties, including our leases, forms of management agreements and related pooling agreement and Bridge Loan agreement with SNH, our business management agreement and headquarters lease with RMR and its affiliate and our shareholders agreement with AIC and its shareholders, are also publicly available as exhibits to our public filings with the SEC and accessible at the SEC’s website.

13

Table of Contents

FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars and shares in thousands, except per share data)

(unaudited)

Note 11.  Discontinued Operations

In 2011, we decided to offer for sale two SNFs we own that are located in Michigan with a total of 271 living units.  While we continue to market these properties, we can provide no assurance that a sale of these SNFs will be completed.

In August 2011, we agreed with SNH that SNH should sell one assisted living community located in Pennsylvania with 103 living units, which we lease from SNH.  We and SNH are in the process of selling this assisted living community and, if sold, our annual minimum rent payable to SNH will decrease by 9.0% of the net proceeds of the sale to SNH, in accordance with the terms of our lease with SNH.

We have reclassified the consolidated balance sheet and the consolidated statement of income for all periods presented to show the financial position and results of operations of the communities which have been sold or are expected to be sold as discontinued.  Below is a summary of the operating results of these discontinued operations included in the financial statements for the three months ended March 31, 2012 and 2011:

Note 12.   Unaudited Pro Forma Financial Information

The following table shows operating results attributable to the Indiana Communities we acquired during 2011 that are included in our condensed consolidated statement of operations for the three months ended March 31, 2012.

The pro forma financial information in the table below gives effect to the following transactions as if they had occurred as of January 1, 2011: (i) our acquisition of the assets of the Indiana Communities; (ii) our assumption of $19,260 of mortgage notes with respect to three of the Indiana Communities; (iii) our net borrowings of $48,000 under the Bridge Loan in connection with our acquisition of the assets of the Indiana Communities; (iv) our assumption of net working capital liabilities of the Indiana Communities; and (v) the Public Offering.

This pro forma financial information is presented for informational purposes only and is not necessarily indicative of our consolidated operating results that would have been reported had the transactions been completed as described herein, and the pro forma financial information is not necessarily indicative of our consolidated operating results for any future period.

14

Table of Contents

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

RESULTS OF OPERATIONS

Our reportable segments consist of our senior living community business and our rehabilitation hospital business.   In the senior living community segment, we operate for our own account, manage for the account of SNH, or for another owner pending SNH’s acquisition, independent living communities, assisted living communities and SNFs that are subject to centralized oversight and provide housing and services generally to elderly residents.  Our rehabilitation hospital segment provides inpatient rehabilitation services to patients at two hospital locations and at three satellite locations and outpatient rehabilitation services at 13 affiliated outpatient clinics.  We do not consider our institutional pharmacy operations to be a material, separately reportable segment of our business. Consequently, we report our institutional pharmacy revenues and expense as separate items within our corporate and other activities.  All of our operations and assets are located in the United States, except for the operations of our captive insurance company subsidiary, which participates in our workers’ compensation, professional liability and automobile insurance programs and operates in the Cayman Islands.

We use segment operating profit as a means to evaluate our performance and for our business decision making purposes.  Segment operating profit excludes interest, dividend and other income, interest and other expense, provision for income taxes, and corporate income and expenses.

Key Statistical Data For the Three Months Ended March 31, 2012 and 2011:

The following tables present a summary of our operations for the three months ended March 31, 2012 and 2011:

Senior living communities: