**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe year ended December 31, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**CommissionFile No. 0-12991**

**LANGER, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                       | **11-2239561**          |
|------------------------------------|-------------------------|
| (State or other  jurisdiction      | (I.R.S. employer        |
| of incorporation  or organization) | identification  number) |

 

**450 Commack Road, Deer Park, New York 11729-4510**

(Address of principal executive offices) (Zip code)

Registrant’s telephone number, including area code: **(631) 667-1200**

Securities registered pursuant to Section 12(b) ofthe Act: **NONE**

Securities registered pursuant to Section 12(g) ofthe Act:

**Common Stock, par value $0.02 per share**

(Title of Class)

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o   No x

Indicateby check mark if the registrant is not required to file reports pursuant tosection 13 or Section 15(d) of the Exchange Act. Yes o   No x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x   No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. Yes x   No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. (as defined in Rule 12b-2of the Exchange Act).

Large accelerated filer o      Accelerated filer  o      Non-accelerated filer x

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

As ofJune 30, 2005 (*i.e.,* thelast day of registrant’s most recently completed second quarter), the aggregatemarket value of the common equity held by non-affiliates of the registrant was$42,584,640, as computed by reference to the closing sale price on the NasdaqNational Market of such common stock ($6.50) multiplied by the number of sharesof voting stock outstanding on June 30, 2005 held by non-affiliates(6,551,483 shares). Exclusion of shares from the calculation of aggregatemarket value does not signify that a holder of any such shares is an “affiliate”of the Company.

Thenumber of shares of the registrant’s common stock outstanding at March 15,2006 was 9,948,623 shares.

**DOCUMENTS INCORPORATED BYREFERENCE**

Theinformation required by Part III of this report is incorporated herein byreference to the Company’s proxy statement for the 2006 annual meeting of theregistrant’s stockholders, which will be filed not later than 120 daysafter the end of the fiscal year covered by this report.

 

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**Langer, Inc.**

**Annual Report on Form 10-K**

**For The Year Ended December 31,2005**

**Tableof Contents**

|                   | ** ** | ** **                                                                                                         | ** ** | **Page** | ** ** |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I**   |       |
| ITEM 1.           |       | BUSINESS                                                                                                           |       |     | 1          |   |   |
| ITEM  1A.         |       | RISK  FACTORS                                                                                                      |       |     | 14         |   |   |
| ITEM 1B.          |       | UNRESOLVED STAFF COMMENTS                                                                                          |       |     | 28         |   |   |
| ITEM 2.           |       | PROPERTIES                                                                                                         |       |     | 29         |   |   |
| ITEM  3.          |       | LEGAL  PROCEEDINGS                                                                                                 |       |     | 29         |   |   |
| ITEM  4.          |       | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                               |       |     | 31         |   |   |
| **PART II**  |       |
| ITEM 5.           |       | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED  STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |       |     | 32         |   |   |
| ITEM  6.          |       | SELECTED  FINANCIAL DATA                                                                                           |       |     | 33         |   |   |
| ITEM 7.           |       | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS                        |       |     | 34         |   |   |
| ITEM 7A.          |       | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                              |       |     | 61         |   |   |
| ITEM 8.           |       | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                        |       |     | 62         |   |   |
| ITEM 9.           |       | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURE                              |       |     | 103        |   |   |
| ITEM 9A.          |       | CONTROLS AND PROCEDURES                                                                                            |       |     | 103        |   |   |
| ITEM  9B.         |       | OTHER  INFORMATION                                                                                                 |       |     | 103        |   |   |
| **PART III** |       |
| ITEM 10.          |       | DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY                                                                    |       |     | 104        |   |   |
| ITEM 11.          |       | EXECUTIVE COMPENSATION                                                                                             |       |     | 104        |   |   |
| ITEM 12.          |       | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND  MANAGEMENT AND RELATED STOCKHOLDER MATTERS                    |       |     | 104        |   |   |
| ITEM 13.          |       | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                     |       |     | 104        |   |   |
| ITEM 14.          |       | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                             |       |     | 104        |   |   |
| **PART IV**  |       |
| ITEM 15.          |       | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                                         |       |     | 105        |   |   |
| SIGNATURES        |       |                                                                                                               | 110        |     |       |

 

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**PART I**

**ITEM 1.**                BUSINESS

**Overview**

We design, manufacture and distribute a broad range ofmedical products targeting the orthopedic, orthotic and prosthetic markets. Wealso offer a diverse line of skincare products for the medical, therapeutic andretail markets. We sell our products primarily in the United States and Canada,as well as in more than 30 other countries, to national, regional,international and independent medical distributors and directly to healthcareprofessionals.

Our broad range of over 500orthopedic products, including custom foot and ankle orthotic devices,pre-fabricated foot products, rehabilitation products, and gel-based orthopedicand prosthetics products, are designed to correct, protect, heal and providecomfort for the patient. Our line of over 50 skincare products, which includescar management products and gel-based therapeutic gloves and socks, isdesigned to improve skin appearance and transmit moisture agents, vitamins andnutrients to the skin.

**Acquisition History**

In February 2001, an investor group andmanagement team, led by our current Chairman of the Board of Directors WarrenB. Kanders, our former President and Chief Executive Officer and Director,Andrew H. Meyers, and former Board of Directors member Gregory R. Nelson,purchased a controlling interest in Langer, a custom orthotics companydistributing its products primarily to podiatric professionals.

The investor group and management team sought Langeras a platform to pursue a growth strategy in the orthopedic industry. Sincethat time, in connection with our growth strategy, we have consummated thefollowing three strategic acquisitions:

• *Silipos*.   OnSeptember 30, 2004, we acquired Silipos Inc., our largest acquisitionto date, from SSL International plc (“SSL”). Silipos is a leading designer,manufacturer and marketer of gel-based products focusing on the orthopedic,orthotic, prosthetic, and skincare markets. We acquired Silipos because of itsdistribution channels and proprietary products, and to enable us to expand intoadditional product lines that are part of our market focus. The aggregateconsideration paid by us in connection with this acquisition was approximately$17.3 million, including transaction costs, paid in cash and notes.

• *Bi-Op*.   OnJanuary 13, 2003, we acquired Bi-Op Laboratories, Inc., which isengaged in the design, manufacture and sale of footwear and foot orthoticdevices as well as orthotic and prosthetic services. We acquired Bi-Op to gainaccess to additional markets and complementary product lines. The aggregateconsideration, including transaction costs, was approximately$2.2 million, paid in cash and shares of our common stock.

• *Benefoot*.   On May 6, 2002, weacquired the net assets of Benefoot, Inc., and Benefoot ProfessionalProducts, Inc. (together, “Benefoot”). Benefoot designed, manufactured anddistributed custom orthotic, custom Birkenstock® sandals, therapeutic shoes, and prefabricatedorthotic devices to healthcare professionals. We acquired Benefoot to gain additionalscale in our historic custom orthotics business as well as to gain access tocomplementary product lines. The aggregate consideration, including transactioncosts, was approximately $7.9 million, consisting of cash, notes, theassumption of liabilities consisting of approximately $0.3 million oflong-term debt paid at closing and shares of our common stock.

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**Our Addressable Markets**

*Orthopedic*

The orthopedic market we target is comprised oforthotic devices and prosthetic componentry for non-invasive use. Orthotics arespecialized devices to supplement or support abnormal or weakened limbs orjoints. These devices are specially designed to improve function and correctinjuries or deformities of existing limbs or body parts and can be both customdesigned to individual patient requirements or pre-fabricated for off-the-shelfuse. Orthotic products range from full body spinal orthoses and customfabricated arch supports to braces for the back, shoulder, arm or knee; theymay be rigid, semi-rigid, or soft and flexible depending on the requirement ofthe patient as evaluated by the doctor treating the patient.

Prosthetics involve the design, fabrication andfitting of artificial limbs for patients who have lost their limbs due totraumatic injuries, vascular diseases, diabetes, cancer and congenitaldiseases. Our target market is comprised of the production and distribution ofthe components utilized in the fabrication of these prosthetic devices.Prosthetic componentry includes external mechanical joints such as hips andknees, artificial feet and hands, and sheaths and liners utilized as aninterface between the amputee’s skin and prosthetic socket.

Based on third-party research, we believe thatthe global orthopedic markets that we target are expected to grow toapproximately $3.4 billion by the end of 2008.

We believe that growth of the orthopedic markets wetarget will be driven by the following factors:

• *Aging Population*.   By2010, it is estimated that the number of people in the United States betweenthe ages of 40 and 60 will grow from approximately 58 million today tomore than 64 million. With longer life expectancy, expanded insurancecoverage, improved technology and devices, and greater mobility, individualsare expected to seek orthopedic rehabilitation services and products moreoften.

• *Increased Demandfor Non-Invasive Procedures*.   We believe there is growingawareness and clinical acceptance by patients and healthcare professionals ofthe benefits of non-invasive solutions, which should continue to drive demandfor non-operative rehabilitation products.

• *TechnologicalSophistication of Orthotic and Prosthetic Devices*.   In recentyears the development of stronger, lighter and cosmetically appealing materialshas led to advancements in design technology, driving growth in the orthoticand prosthetic industries. A continuation of this trend should enable themanufacture of new products that provide greater protection and comfort, andthat more closely replicate the function of natural body parts.

• *Need forReplacement and Continuing Care*.   Most prosthetic orthoticdevices have useful lives ranging from three to five years, necessitatingongoing warranty replacement and retrofitting for the life of the patient.

• *Growing Emphasis on Physical Fitness, Leisure Sportsand Conditioning*.   As a large number of individuals participatein athletic activities, many of them suffer strains and injuries, requiringnon-operative orthopedic rehabilitation products.

*Skincare*

Skincare products are generally sold in the retailcosmetic marketplace and include cleansers, toners, moisturizers, exfoliants,and facial masks. Independent research has reported that moisturizing productsaccount for the predominant portion of the skincare market. Many of theseproducts combine traditional moisturizing agents with compounds such asretinoids, hydroxy acids, and anti-oxidants that smooth and soothe dry skin,retain water in the outer layer skin cells and help maintain or reinforce theskin’s protective barrier, particularly skin tissue damaged from surgery orinjury.

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Based on third-party research, we believe thatthe U.S. skincare moisturizer market is expected to grow to approximately $2.5 billionby the end of 2008.

We believe that growth inthis market will be driven by an aging population, an increasing number ofimage-conscious consumers, and the growth and popularity of spas andbody/facial treatment centers.

**Growth Strategy**

·       *Gain Access to New Sales Channels and LeverageCustomer Relationships.  *We are focused on expanding ourcustomer base and offering an increasing array of products within ourdistribution channels to improve profitability. Our distribution historicallyfocused on individual podiatry practices while Silipos focuses much of its marketingefforts on medical distributors. We believe this diversification willfacilitate access to a new customer base for our historical products, as wellas provide the opportunity to offer new products to our existing customers.

·       *Continue to Introduce New Products and ProductEnhancements and Improve Manufacturing Operations.  *We have ahistory of product innovation. Since 2003, we have introduced over 80 newproducts, including activity-specific custom orthotics, proprietarycustom ankle-foot orthotics, an enhanced version of our Explorer® mineral oil-based prosthetic liner, theSoftZone® heel pad product line, and a new line of shockabsorption materials. In September 2005, we introduced our new DuraGelTM liner,an advanced prosthetic liner, which is designed for increased activity anddurability, and skin protection. For the year ended December 31, 2005,these products accounted for approximately 11% of our revenues. We are alsoworking to improve the manufacturing process for custom orthotics in an effortto improve cycle times and production and output consistency, reduce work-in-progressinventory and lower unit production costs. We believe that new productintroductions and enhancements and operational improvements will furtherenhance growth and provide an advantage over our competitors in the future.

·       *Increase Penetration in Existing Markets and Expandinto New Markets.  *We believe our intellectual property andresearch and development capabilities will allow us to increase penetration inour existing markets and enter new markets. For example, gel technologiesdeveloped by Silipos are used to augment our orthopedic product offerings withinternally developed prosthetic and skincare products. We intend to continueexploring additional applications of our intellectual property to grow ourbusiness.

·       *Acquire Complementary Businesses.  *SinceFebruary 2001, we have consummated three acquisitions. These acquisitionshave increased our net sales by approximately 233% from the fiscal year ended February 28,2001 to the fiscal year ended December 31, 2005. We intend to continue ourprogram of targeted acquisitions, subject to the availability of financing, togain access to new sales channels, acquire new product lines, increasepenetration of our existing markets, and gain entry into new market sectors.

**Competitive Strengths**

*ManagementTeam.**  *Ourmanagement team has been involved in the acquisition and integration of asubstantial number of companies. Our Chairman of the Board of Directors, WarrenB. Kanders, brings a track record spanning over 20 years of buildingpublic companies through strategic acquisitions to enhance organic growth. W.Gray Hudkins, who became our Chief Operating Officer on October 1, 2004,and our President and Chief Executive Officer on January 1, 2006, brings astrong investment banking background and has been involved in the acquisitionand integration of acquired companies prior to joining us, and since joining ushas played a significant role in the acquisition and the integration ofSilipos.

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*ScalableInfrastructure to Support Growth.**  *We have recently upgraded ourinformation technology platform and other back office functions, and we believewe now have an infrastructure capable of supporting future organic growth andgrowth through acquisitions.

*StrongBase Business.**  *Weoffer a broad range of over 500 orthopedic products and we believe our brandnames represent a high level of quality in the markets in which we sell. Wealso hold approximately 35 patents and patent applications and a number oftrademarks for technologies and brands related to our product offerings. Webelieve this combination of diversified products, brands, and intellectualproperty provides a competitive advantage in our markets.

*Strength AcrossDistribution Channels.**  *Webelieve we maintain strong relationships across various distribution channels,including over 4,000 individual practitioners, a network of national, regional,independent and international distributors, medical catalog companies, grouppurchasing organizations, original equipment manufacturers, specialtyretailers, and consumer catalog companies.

**Products**

*Orthotics.**  *We manufacture custom orthotic footdevices, which are contoured molds made from plastic, graphite, or compositematerials, that are placed in the patient’s shoe to correct or mitigateabnormalities in gait and relieve symptoms associated with foot or posturalmisalignment. Our product line includes Sporthotics® that are specifically designed for variousathletic activities, fashion oriented orthotics, custom sandals that integratean orthotic shell into authentic Birkenstock® components, orthotics for patients who areprone to pre-ulcerative sites, and controlling devices for patients with moresevere foot abnormalities. In 2002, we introduced a line of custom Ankle-Footorthotic devices (“AFO’s”), which are used to support the foot/ankle region.These products are often used for the more difficult and challenging foot andankle injuries. In addition, in 2000, we introduced pre-fabricated (non-customized)orthotic devices for various applications as a cost effective solution forpatients with less complex foot conditions.

*GelBased Orthopedic Products.**  *We offer gel-based products for the treatment ofcommon orthopedic and footcare conditions. These products include digitcareproducts, diabetes management products, pressure, friction, and shear forceabsorption products, products that protect the hands and wrists, and gelsheeting products for various applications. In all of these products, the gelinterfaces with the skin to provide moisturization and relief from friction,irritation and pain while aiding in healing of problem areas.

*GelBased Prosthetic Products.**  *We offer a line of products that are utilized in thefabrication of a prosthetic device. For example, we offer sheaths and linersthat incorporate a gel interface between the amputee’s skin and socket,providing protection for patients who are subject to significant pressurebetween their skin and prosthesis. We also offer liners and sleeves which areused as part of prosthetic suspension systems to maintain a secure fit whilenot limiting flexibility and motion. These products are designed to allow amputeesto maintain more active lifestyles while providing protection from irritationand infection.

*PPTand Other Materials.**  *PPTis a medical grade soft tissue cushioning material with a high density,open-celled urethane foam structure, which provides protection against forcesof pressure, shock and shear. In addition to utilizing PPT in the manufactureof custom orthotics, we have developed and sell a variety of productsfabricated from PPT, including molded insoles, components for orthotic devicesand laminated sheets. Besides podiatric use, we believe PPT is suitable forother orthopedic and medical-related uses such as liners for braces andartificial limbs, as shock absorbers and generally in devices used in sportsand physical therapy.

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*DistributedProducts.**  *Weoffer a range of distributed products such as prefabricated rehabilitationproducts, compression hose, socks, therapeutic shoes, resting splints, walkers,and other products for the lower extremities. All of these products aremanufactured by third parties, using the Langer or manufacturer’s brand name.

*Skincare Products.**  *We offer a range of products fortwo primary uses. First, we offer scar management products that utilize mineraloil-based gel sheeting to moisturize the skin and reduce the appearance ofvisible scars developed as a result of procedures such as Cesarean section,abdominoplasty, breast reduction and reconstruction. We also offer a line ofmoisturizing gloves and socks developed for the cosmetics industry utilizingour proprietary gel technologies. These products are sold under our proprietaryNouveaDerm® brand and also offered to specialty retailers,spas, health clubs, and catalogs for private label programs.

**Sales, Marketing and Distribution**

Our sales, marketing anddistribution is managed through a combination of account managers, productmanagers, inside sales representatives, and outside sales representatives whoare regionally and nationally based. We employ international sales andmarketing representatives who represent us in the United Kingdom, Europe, Asiaand Australia. We also utilize educational seminars to educate medicalprofessionals about our product offerings, followed up with telemarketingefforts. Our custom and prefabricated orthotics, custom sandals, AFO’s, anddistributed products have historically been sold to health care practitioners.Our PPT and materials products have historically been sold to practitioners,manufacturers, and shoe fabricators, as well as medical distributors, and ourgel-based products have been sold primarily to medical distributors. As wecontinue to integrate our recent Silipos acquisition, we intend to manage oursales and marketing efforts in a unified effort, and we plan to take advantageof opportunities to leverage relationships to increase sales and utilizeresources most effectively to increase the exposure of our product lines. In2005, we were able to create efficiencies and cost savings in our sales andmarketing efforts relative to historic expenditures.

*Health CarePractitioners*

We utilize a network of regional sales representativesto target multi-practitioner practices and individual facilities. Inaddition, we use trade shows, advertising, direct mail, educational seminars,public relations and customer visits to market and distribute products. Weemphasize customer service by maintaining a staff of customer servicerepresentatives.

We provide orthotic and prosthetic education andtraining for healthcare professionals who treat biomechanical problems of thelower extremity through seminars and in-service programs. We offer healthcareprofessionals a comprehensive program in biomechanics, gait analysis,prosthetic componentry, and the cost-effectiveness of orthotic therapy.

We promote awareness oforthotics to medical professionals through marketing and operationalinitiatives. We maintain a volume incentive program and offer practice buildingassistance to help healthcare professionals expand the ancillary productsportion of their practices. We believe these medical practitioner assistanceprograms strengthen our relationships with our existing or potential customerbase.

*MedicalDistributors*

Within our gel-basedorthopedic and prosthetic product lines, we distribute through approximately 70distributors and dealers including national distribution companies, regionaldistributors and catalog companies. National distributors typically focus onseveral medical specialties and have broad distribution throughout the UnitedStates either through direct marketing via catalogs or through a direct salesforce. 

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Regionaldistribution companies typically focus on specific medical specialties withindefined geographic regions and may sometimes inventory product on behalf ofmanufacturers.

*Skincare*

For our skincare productlines, our account representatives interact directly with specialty retailers,cosmetics companies, health clubs and spas, and catalog companies. We willsometimes ship product to customers in bulk for their own packaging pursuant toprivate label programs. In other cases, we will package the product ourselvesand sell under our own proprietary brands.

**Manufacturing and Sourcing**

*Manufacturing*

We manufacture a large portion of our customorthotics, including custom sandals and Ankle-Foot Orthoses, in our fabricationfacility in Deer Park, New York with the remainder produced in facilities inAnaheim, California, Montreal, Canada and Stoke-on-Trent, England. In ourmanufacturing process, medical practitioners will send plaster casts, foamimpressions, or digital images of the patient’s foot. Our advancedmanufacturing operation allows plaster models to be digitized, creating anelectronic three-dimensional image of the patient’s foot. These imagesare then transmitted to milling machines that transform the digital image intoa cast, and the orthotic is molded over the cast. The increased usage ofcomputer-aided design/computer-aided manufacturing processes hasincreased the efficiency of our fabricating operation and decreased theturnaround time for orders.

We manufacture mineraloil-based gel and then utilize that gel in our Niagara Falls, New York facilityto manufacture gel-based orthopedic products, including orthotic and prostheticproducts, and skincare products. This manufacturing process includes themolding of the gels into specific shapes and sometimes the application of gelsto textiles. Our Niagara Falls facility has obtained ISO 9001 certification,which permits the marketing of our products in certain foreign markets.

*Sourcing*

We source our products from a variety of suppliers. Wepurchase our therapeutic shoes from shoe manufacturers such as Apex and NewBalance, each of which either manufacture shoes themselves or outsource theproduct manufacturing. Our prefabricated rehabilitation soft goods productssuch as walkers, resting splints and ankle braces are sourced from contractmanufacturers, some of whom are located in China.

Although there are suppliers that supply products ormaterials that are material to our business, none of them supply us withproducts or materials that we believe could not otherwise be readily purchasedor substituted for from other sources without significant additional expense tous.

We did not renew oursupply agreement with Poly-Gel (when it expired in October of 2004), whichwas prior to our acquisition of Silipos, the principal supplier of mineral oilbased gels used in Silipos’ gel-based products, and we started manufacturingthe gels on our own. If we were to fail to produce sufficient quantities ofhigh quality gels, it would hurt our reputation and cause customers to cancelorders for our gel-based products.

**Competition**

The markets for our products are highly competitive,and we compete with a variety of companies ranging from small businesses tolarge corporations. We believe the markets for foot orthotics and off-the-shelffootcare products are highly fragmented and regional (and in many instanceslocal) in nature. Although a few licensed medical practitioners produce footorthotics in-house, the custom orthotic market 

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is serviced primarily bythird-party laboratories. Competitors sell nationally in the UnitedStates under such brands as Bergmann Orthotic Laboratory, Foot Levelers,Footmaxx Holdings, KLM Orthotic Laboratories, Allied OSI Labs, ProLab Orthoticsand PAL Health Systems. Included in the markets for off-the-shelf footcareproducts are participants such as Dr. Scholls, Implus, Spenco and ProFoot.The market for soft tissue products such as PPT includes brand name products suchas Spenco®,Sorbothane® and Poron®.

The broadly defined skincare market’s products includelotions, creams, water-based gels, oil-based gels, ointments and othertypes of products that transmit moisture, vitamins, minerals, and comfortagents to the skin. The market for high-end skincare products is dominated by anumber of large multinational companies that sell under brands such asShiseido, LVMH Moet Hennessy Louis Vuitton, Clarins and Revlon. In addition, anumber of specialty retailers and catalog companies that focus on the skincaremarket, such as The Body Shop and L’Occitaine, are vertically integrated andmanufacture their own products.

In each of our targetmarkets, the principal competitive factors are product design, innovation andperformance, efficiencies of scale, quality of engineering, brand recognition,reputation in the industry, production capability and capacity, and price andcustomer relations.

**Patents and Trademarks**

We hold a variety ofpatents, trademarks and copyrights in several countries, including the UnitedStates. We hold approximately 35 patents and patent applications in the U.S.and certain foreign jurisdictions and a number of trademarks for technologiesand brands related to our product offerings. In addition we have (i) a nonexclusive, paid up (except for certain administrative fees) license withApplied Elastomerics, Incorporated, dated as of November 30, 2001, asamended (the “AEI License”), to manufacture and sell certain products usingmineral oil based gels which are manufactured using certain patents; thelicense terminates upon the expiration of the patents, which expire between November 16,2010 and December 3, 2017, and (ii) a license with Gerald Zookeffective as of January 1, 1997, to manufacture and sell certain productsusing mineral oil based gels under certain patents and know how in exchange forsales based royalty payments; the license is exclusive as to certain productsand non-exclusive as to other products, and terminates upon expiration of theunderlying patents, which expire between June 27, 2006 and March 12,2013. We also have exclusive licenses to three types of orthotic devices whichare patented in the United States and several foreign countries. Other than theAEI License and the Zook license, we believe that none of our active patents orlicenses is essential to the successful operation of our business as a whole,although the loss of any patent protection that we have could allow competitorsto utilize techniques developed by us or our licensors. We believe ourtrademarks and trade names, including LangerTM, SporthoticsTM, PPTTM, SiliposTM,Explorer Gel LinerTM, SilolinerTM, DuraGelTM, and SilopadTM, contributesignificantly to brand recognition for our products, and the inability to useone or more of these names could have a material adverse effect on ourbusiness. For the year ended December 31, 2005, revenues generated by theproducts incorporating in the technology licensed under the AEI Licenseaccounted for approximately 40.2% of our revenues.

**Employees**

As of March 1, 2006,we have 335 employees, of which 130 were located in Deer Park, New York, 81were located in Niagara Falls, New York, 29 were located in Anaheim,California, 38 were located in Montreal, Canada, 5 were located in Markham,Ontario, 38 were located in Stoke-on-Trent, England, 8 were located in NewYork, New York, and 6 are outside salespeople. None of our employees arerepresented by unions or covered by any collective bargaining agreements. Wehave not experienced any work stoppages or employee-relatedslowdowns and believe that our relationship with employees is satisfactory.

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**Government Regulation**

*Medical DeviceRegulation*

*UnitedStates.**  *Ourproducts and operations are subject to regulation by the Food and DrugAdministration, or FDA, the Federal Trade Commission, or FTC, state authoritiesand comparable authorities in foreign jurisdictions. The FDA regulates theresearch, testing, manufacturing, safety, labeling, storage, recordkeeping,premarket clearance or approval, promotion, distribution and production ofmedical devices in the United States to ensure that medical productsdistributed domestically are safe and effective for their intended uses. Inaddition, the FDA regulates the export of medical devices manufactured in theUnited States to international markets. Under the Federal Food, Drug, andCosmetic Act, or FFDCA, medical devices are classified into one of threeclasses—Class I, Class II or Class III (described below)—dependingon the degree of risk associated with each medical device and the extent ofcontrol needed to ensure safety and effectiveness. Our products are generally Class Idevices, with the exception of certain gel sheeting and prosthetic deviceswhich are Class II devices. The FTC regulates product advertising to helpensure that claims are truthful and non-misleading.

Class I devices are subject to the lowest degreeof regulatory scrutiny because they are considered low risk devices. FDArequires Class I devices to comply with its General Controls, whichinclude compliance with the applicable portions of the FDA’s Quality SystemRegulation, or QSR, facility registration and product listing, reporting ofadverse medical events, and appropriate, truthful and non-misleading labeling,advertising, and promotional materials. Most Class I devices are notrequired to submit 510(k) premarket notifications, but all are subject toFDA’s general misbranding and adulteration prohibitions.

Class II devices are subject to the GeneralControls as well as certain Special Controls such as performance standards,post-market surveillance, and patient registries to assure the device’s safetyand effectiveness. Class II devices also typically require the submissionand clearance of a 510(k) premarket notification prior to marketing.Unless a specific exemption applies, 510(k) premarket notificationsubmissions are subject to user fees. When a 510(k) premarket notificationis required, the manufacturer must submit information to the FDA demonstratingthat the device is “substantially equivalent” to a “predicate device” which iseither a device that was legally marketed prior to May 28, 1976 (the dateupon which the Medical Device Amendments of 1976 were enacted) or anothercommercially available, similar device that was subsequently cleared throughthe 510(k) process.

If the FDA agrees that the device is substantiallyequivalent, it will grant a clearance order to allow the commercial marketingof the device in the U.S. By statute, the FDA is required to clear a510(k) premarket notification within 90 days of submission of theapplication. As a practical matter, clearance often takes longer. If the FDAdetermines that the device, or its intended use, is not “substantiallyequivalent” to a previously-cleared device or use, the FDA will place thedevice, or the particular use of the device, into Class III, and thedevice sponsor must then fulfill more rigorous premarketing requirements whichmay include the submission of a premarket approval application or thesubmission of a reclassification petition seeking de novo review of the deviceand placement into Class I or Class II. There can be no assurancethat we will receive 510(k) clearances within 90 days of submissionor that we will be successful in obtaining future 510(k) clearances forany of our products, which could have a materially adverse effect on us.

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Class III devices aresubject to the highest level of regulatory scrutiny and typically include lifesupport and life sustaining devices and implants as well as devices with a newintended use or technological characteristics that are not substantially equivalentto a use or technology currently being legally marketed. A premarket approvalapplication, or “PMA,” must be submitted and approved by FDA before marketingin the U.S.

The FDA will grant a PMAapproval if it finds that the safety and effectiveness of the product have beensufficiently demonstrated and that the product complies with all applicableregulations and standards. The FDA may require further clinical evaluation ofthe product, terminate the clinical trials, grant premarket approval but restrictthe number of devices distributed, or require additional patient follow-up foran indefinite period of time. There can be no assurance that we will besuccessful in obtaining a PMA for any Class III products, which isnecessary before marketing a Class III product in the U.S. Delays inobtaining marketing approvals and clearances in the U.S. could have a materialadverse effect on us. Unless an exemption applies, PMA submissions also aresubject to user fees.

The FDA, by statute and byregulation, has 180-days to review a PMA that has been accepted forfiling, although the review of an application more often occurs over asignificantly longer period of time, and can take several years. In approving aPMA application or clearing a 510(k) premarket notification application,the FDA may also require some form of post-market surveillance when the agencydetermines it to be necessary to protect the public health or to provideadditional safety and effectiveness data for the device. In such cases, themanufacturer might be required to follow certain patient groups for a number ofyears and to make periodic reports to the FDA on the clinical status of thosepatients. Medical devices can be marketed only for the indications for whichthey are cleared or approved. Modifications to a previously cleared or approveddevice that could significantly affect its safety or effectiveness or thatwould constitute a major change in its intended use, design or manufacturerequire the submission of a new 510(k) premarket notification, a premarketapproval supplement or a new premarket approval application. We have modifiedvarious aspects of our devices in the past and determined that new approvals,clearances or supplements were not required or we filed a new 510(k) or aPMA supplement. Nonetheless, the FDA may disagree with our conclusion thatclearances or approvals were not required for particular products and mayrequire approval or clearances for such past or any future modifications or toobtain new indications for our existing products. Such submissions may requirethe submission of additional clinical or preclinical data and may be timeconsuming and costly, and may not ultimately be cleared or approved by the FDA.

Our manufacturingprocesses are required to comply with the applicable portions of the QSR, whichcovers the methods and documentation of the design, testing, production,processes, controls, quality assurance, labeling, packaging and shipping of ourproducts. The QSR also, among other things, requires maintenance of a devicemaster record, device history record, and complaint files. Our domesticfacility records and manufacturing processes are subject to periodicunscheduled inspections by the FDA to assure compliance with the FFDCA and theregulations thereunder. Based on internal audits of our domestic facilities, webelieve that our facilities are in substantial compliance with the applicableQSR regulations. We also are required to report to the FDA if our productscause or contribute to a death or serious injury or malfunction in a way thatwould likely cause or contribute to death or serious injury were themalfunction to recur. Although medical device reports have been submitted inthe past 5 years, none have resulted in a recall of our products or otherregulatory action by the FDA. The FDA and authorities in other countries canrequire the recall of products in the event of material defects or deficienciesin design or manufacturing. The FDA can also withdraw or limit our productapprovals or clearances in the event of serious, unanticipated health or safetyconcerns. We may also be required to submit reports to FDA of corrections andremovals. Separately, we may on our own choose to conduct a voluntary marketwithdrawal in situations that do not require a recall, correction or removal.FDA could disagree with this characterization and require the reporting of acorrection or removal.

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The FDA has broadregulatory and enforcement powers. If the FDA determines that we have failed tocomply with applicable regulatory requirements, it can impose a variety ofenforcement actions from public warning letters, fines, injunctions, consentdecrees and civil penalties to suspension or delayed issuance of approvals,seizure or recall of our products, total or partial shutdown of production,withdrawal of approvals or clearances already granted, and criminalprosecution. The FDA can also require us to repair, replace or refund the costof devices that we manufactured or distributed. If any of these events were tooccur, it could materially adversely affect us.

Legal restrictions on theexport from the United States of any medical device that is legally distributedin the United States are limited. However, there are restrictions under U.S.law on the export from the United States of medical devices that cannot belegally distributed in the United States. If a Class I or Class IIdevice does not have 510(k) clearance, and the manufacturer reasonablybelieves that the device could obtain 510(k) clearance in the UnitedStates, then the device can be exported to a foreign country for commercialmarketing without the submission of any type of export request or prior FDAapproval, if it satisfies certain limited criteria relating primarily tospecifications of the foreign purchaser and compliance with the laws of thecountry to which it is being exported (Importing Country Criteria). We believethat all of our current products which are exported to foreign countriescurrently comply with these restrictions.

*International.**  *In many of the foreign countries inwhich we market our products, we are subject to similar regulatory requirementsconcerning the marketing of new medical devices. The regulations affect, amongother things, product standards, packaging requirements, labeling requirements,import restrictions, tariff regulations, duties and tax requirements. Theregulation of our products in Europe falls primarily within the EuropeanEconomic Area, which consists of the fifteen member states of the EuropeanUnion as well as Iceland, Lichtenstein and Norway. The legislative bodies ofthe European Union have adopted three directives in order to harmonize nationalprovisions regulating the design, manufacture, clinical trials, labeling andadverse event reporting for medical devices: the Council Directives 90/385/EEC(Actives Implantables Directive); 93/42/EEC (Medical Device Directive); and98/79/EC (In-Vitro-Diagnostics Directive). The member states of theEuropean Economic Area have implemented the directives into their respectivenational law. Medical devices that comply with the essential requirements ofthe national provisions and the directives will be entitled to bear a CEmarking. Unless an exemption applies, only medical devices which bear a CEmarking may be marketed within the European Economic Area. There can be noassurance that we will be successful in obtaining CE marks for our products ina timely manner, if at all, which could have a material adverse effect on themarket price of our common stock and our business, financial condition andresults of operations.

The EuropeanStandardization Committees have adopted numerous harmonized standards forspecific types of medical devices. Compliance with relevant standardsestablishes the presumption of conformity with the essential requirements for aCE marking and we are subject to conformity audits at any time.

Post market surveillanceof medical devices in the European Economic Area is generally conducted on acountry-by-country basis. The requirement within the member states of theEuropean Economic Area vary. Due to the movement towards harmonization ofstandards in the European Union and the expansion of the European Union, weexpect a changing regulatory environment in Europe characterized by a shiftfrom a country-by-country regulatory system to a European Union-wide singleregulatory system. The timing of this harmonization and its effect on us cannotcurrently be predicted.

In Canada, the MedicalDevices Regulations of the Medical Device Bureau, Therapeutic Products Directorateof Health Canada (“TPD”), set out the requirements governing the sale,importation and advertisement of medical devices. The regulations are intendedto ensure that medical devices distributed in Canada are both safe andeffective. The Canadian medical device classification system is broadly similarto the classification systems in place in the European Union and the UnitedStates and is based on a Class I to Class IV risk-basedclassification system, with Class I being the lowest risk and Class IVbeing 

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thehighest. The TPD has provided a comprehensive set of rules determining theclassification of a device, and, ultimately, the responsibility ofclassification lies with the manufacturer or importer. The TPD has provided adatabase of common devices and their risk classifications for reference.Devices that are Class II, III and IV are required to have a devicelicense. Class I devices are not so required. Device licenses must beobtained from the TPD before the sale of the device, effectively creating apremarket approval regime for these categories. Many non-invasive areclassified as Class I devices requiring only an establishment license,while manufacturers of Class II, III and IV devices do not. EffectiveJanuary 1, 2003, new Canadian regulatory quality systems requirements formedical devices took effect applying established quality standards to allCanadian and foreign manufacturers holding Class II, III and IVmedical device licenses, and all Canadian and foreign manufacturing applyingfor Class II, III and IV medical licenses. These quality systemregulations require Class II medical devices to be manufactured underCAN/CSA ISO 13488-1998, and Class III and IV medical devices to bedesigned and manufactured under CAN/CSA ISO 13485-1998. There are noregulatory quality system requirements for Class I medical devices.

*Skincare Product Regulation*

Our Skincare products aresubject to regulation by the FDA, FTC, and various other federal, state, andforeign governmental authorities. Depending upon product claims andformulation, skincare products may be regulated as cosmetics, drugs or devices.Our skincare products are primarily regulated as cosmetics, with the exceptionof the scar management gel sheeting which are medical devices because of theirmode of use.

There are fewer regulatoryrequirements for cosmetic products than for drugs or medical devices. Cosmeticsmarketed in the United States must comply with the FFDCA, the Fair Packagingand Labeling Act, and the FDA’s implementing regulations. Cosmetics must alsocomply with FDA’s ingredient, quality, and labeling requirements and the FTC’srequirements pertaining to truthful and non-misleading advertising. FDA or FTCcould disagree with our characterization of our skincare products or productclaims. This could result in a variety of enforcement actions which couldrequire the reformulation or relabeling of our products, the submission ofinformation in support of the products’ claims or the safety and effectivenessof our products, or more punitive action, all of which could have a materialadverse effect on the market price of our common stock and our business,financial condition and results of operations.

*Federal Privacy and Transaction Law and Regulations*

Other federal legislationrequires major changes in the transmission and retention of health informationby us. The Health Insurance Portability and Accountability Act of 1996, orHIPAA, mandates, among other things, the adoption of standards for theelectronic exchange of health information that may require significant andcostly changes to current practices. Sanctions for failure to comply with HIPAAinclude civil penalties of $100 per violation (up to $25,000 per year) andcriminal penalties of up to $250,000 and 10 years in jail. The United StatesDepartment of Health and Human Services, or HHS, has released rules mandatingthe use of new standards with respect to certain healthcare transactions andhealth information.

*Third-Party Reimbursement*

Some of our products areprescribed by physicians or other health care service providers and areeligible for third-party reimbursement. An important consideration forour business is whether third-party payment amounts will be adequate,since this is a factor in our customers’ selection of our products. We believethat third-party payers will continue to focus on measures to contain orreduce their costs through managed care and other efforts. Medicare policiesare important to our business because third-party payers often modeltheir policies after the Medicare program’s coverage and reimbursementpolicies.

Healthcare reformlegislation in the Medicare area has focused on containing healthcare spending.On December 8, 2003, the Medicare Prescription Drug, Improvement andModernization Act of 2003, or 

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ModernizationAct, was enacted, which provides for revisions to payment methodologies andother standards for items of durable medical equipment and orthotic devicesunder the Medicare program. First, beginning in 2004 through 2008, the paymentamounts for orthotic devices (2004 through 2006) and durable medical equipment(2004 through 2008) will no longer be increased on an annual basis. Second,beginning in 2007, a competitive bidding program will be phased in to replacethe existing fee schedule payment methodology. Off-the-shelf orthotic devicesand other non-Class III devices are subject to the program. Thecompetitive bidding program will begin in ten high population metropolitanstatistical areas and in 2009 will be expanded to 80 metropolitan statisticalareas (and additional areas thereafter). Payments in regions not subject tocompetitive bidding may also be adjusted using payment information from regionssubject to competitive bidding. Third, supplier quality standards are to beestablished which will be applied by independent accreditation organizations.Fourth, clinical conditions for payment will be established for certainproducts.

In recent years, effortsto control Medicare costs have included the heightened scrutiny ofreimbursement codes and payment methodologies. Under Medicare, certain devicesused by outpatients are classified using reimbursement codes, which in turnform the basis for each device’s Medicare payment levels. Changes to thereimbursement codes describing our products can result in reduced paymentlevels or the breadth of products for which reimbursement can be sought underrecognized codes.

On February 11, 2003,the Centers for Medicare and Medicaid Services, or CMS, made effective aninterim final regulation implementing “inherent reasonableness” authority,which allows the agency and contractors to adjust payment amounts by up to 15%per year for certain items and services when the existing payment amount isdetermined to be grossly excessive or grossly deficient. The regulation listsfactors that may be used by CMS and its contractors to determine whether anexisting reimbursement rate is grossly excessive or grossly deficient and todetermine a realistic and equitable payment amount. CMS may make a largeradjustment each year if it undertakes prescribed procedures. The regulationremains in effect after the Modernization Act, although the use of inherentreasonableness authority is precluded for devices provided under competitivebidding. We do not know what impact inherent reasonableness and competitivebidding would have on us or the reimbursement of our products.

Beyond changes inreimbursement codes and payment methodologies, the movement, both domesticallyand in foreign countries, toward healthcare reform and managed care maycontinue to result in downward pressure on product pricing.

*Fraud and Abuse*

We are subject to variousfederal and state laws pertaining to healthcare fraud and abuse, includinganti-kickback laws and physician self-referral laws. Violations of these lawsare punishable by criminal and civil sanctions, including, in some instances,exclusion from participation in federal and state healthcare programs,including Medicare, Medicaid, Veterans Administration health programs andTRICARE. We believe that our operations are in material compliance with suchlaws. However, because of the far-reaching nature of these laws, there can beno assurance that we would not be required to alter one or more of ourpractices to be deemed to be in compliance with these laws. In addition, therecan be no assurance that the occurrence of one or more violations of these lawsor regulations would not result in a material adverse effect on our financialcondition and results of operations.

*Anti-kickback and Fraud Laws*

Our operations are subjectto federal and state anti-kickback laws. Certain provisions of the SocialSecurity Act, which are commonly known collectively as the Medicare Fraud andAbuse Statute, prohibit persons from knowingly and willfully soliciting,receiving, offering or providing remuneration directly or indirectly to induceeither the referral of an individual, or the furnishing, recommending, orarranging for a good or service, for which payment may be made under a federalhealthcare program such as Medicare and Medicaid. The definition of “remuneration”has been broadly interpreted to include anything of value, 

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includingsuch items as gifts, discounts, waiver of payments, and providing anything atless than its fair market value. HHS has issued regulations, commonly known assafe harbors that set forth certain provisions which, if fully met, will assurehealthcare providers and other parties that they will not be prosecuted underthe Medicare Fraud and Abuse Statute. Although full compliance with theseprovisions ensures against prosecution under the Medicare Fraud and AbuseStatute, the failure of a transaction or arrangement to fit within a specificsafe harbor does not necessarily mean that the transaction or arrangement isillegal or that prosecution under the Medicare Fraud and Abuse Statute will bepursued. The penalties for violating the Medicare Fraud and Abuse Statuteinclude imprisonment for up to five years, fines of up to $25,000 per violationand possible exclusion from federal healthcare programs such as Medicare andMedicaid. Many states have adopted prohibitions similar to the Medicare Fraudand Abuse Statute, some of which apply to the referral of patients forhealthcare services reimbursed by any source, not only by the Medicare andMedicaid programs.

HIPAA created two newfederal crimes: healthcare fraud and false statements relating to healthcarematters. The healthcare fraud statute prohibits knowingly and willfullyexecuting or attempting to execute a scheme or artifice to defraud anyhealthcare benefit program, including private payers. The false statementsstatute prohibits knowingly and willfully falsifying, concealing or covering upa material fact or making any materially false, fictitious or fraudulentstatement or representation in connection with the delivery of or payment forhealthcare benefits, items or services. This statute applies to any healthbenefit plan, not just Medicare and Medicaid. Additionally, HIPAA grantedexpanded enforcement authority to HHS and the United States Department ofJustice, or DOJ, and provided enhanced resources to support the activities andresponsibilities of the OIG and DOJ by authorizing large increases in fundingfor investigating fraud and abuse violations relating to healthcare deliveryand payment.

*Physician Self-Referral Laws*

We are also subject tofederal and state physician self-referral laws. Federal physician self-referrallegislation (commonly known as the Stark Law) prohibits, subject to certainexceptions, physician referrals of Medicare and Medicaid patients to an entityproviding certain “designated health services” if the physician or an immediatefamily member has any financial relationship with the entity. The Stark Lawalso prohibits the entity receiving the referral from billing any good orservice furnished pursuant to an unlawful referral, and any person collectingany amounts in connection with an unlawful referral is obligated to refund suchamounts. A person who engages in a scheme to circumvent the Stark Law’sreferral prohibition may be fined up to $100,000 for each such arrangement orscheme. The penalties for violating the Stark Law also include civil monetarypenalties of up to $15,000 per service and possible exclusion from federalhealthcare programs such as Medicare and Medicaid. Various states havecorollary laws to the Stark Law, including laws that require physicians todisclose any financial interest they may have with a healthcare provider totheir patients when referring patients to that provider. Both the scope andexceptions for such laws vary from state to state.

*False Claims Laws*

Under separate statutes,submission of claims for payment that are “not provided as claimed” may lead tocivil money penalties, criminal fines and imprisonment, and/or exclusion fromparticipation in Medicare, Medicaid and other federally funded state healthprograms. These false claims statutes include the federal False Claims Act,which prohibits the knowing filing of a false claim or the knowing use of falsestatements to obtain payment from the federal government. When an entity isdetermined to have violated the False Claims Act, it must pay three times theactual damages sustained by the government, plus mandatory civil penalties ofbetween $5,000 and $10,000 for each separate false claim. Suits filed under theFalse Claims Act, known as “qui tam” actions, can be brought by any individualon behalf of the government and such individuals (known as “relators” or, morecommonly, as “whistleblowers”) may share in any amounts paid by the entity to thegovernment in fines or settlement. In addition, certain states have 

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enactedlaws modeled after the federal False Claims Act. Qui tam actions have increasedsignificantly in recent years, causing greater numbers of healthcare companiesto have to defend a false claim action, pay fines or be excluded from theMedicare, Medicaid or other federal or state healthcare programs as a result ofan investigation arising out of such action.

**Seasonality**

Revenue derived from oursales of orthotic devices in North America has historically been significantlyhigher in the warmer months of the year, while sales of orthotic devices by ourUnited Kingdom subsidiary have historically not evidenced any seasonality.Other factors which can result in quarterly variations include the timing andamount of new business generated by us, the timing of new productintroductions, our revenue mix, the timimg of additional selling, general andadministrative expenses to support the anticipated growth and development ofnew business units and the competitive and fluctuating economic conditions inthe orthopedic and skincare industries.

**Inflation**

We have in the past beenable to increase the prices of our products or reduce overhead costssufficiently to offset the effects of inflation on wages, materials and otherexpenses.

***SpecialNote Regarding Forward-looking Statements***

Information contained orincorporated by reference in this Annual Report on Form 10-K, inother SEC filings by the Company, in press releases, and in presentations by theCompany or its management, contains “forward-looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995 which canbe identified by the use of forward-looking terminology such as “believes,”“expects,” “plans,” “intends,” “estimates,” “projects,” “could,” “may,” “will,”“should,” or “anticipates” or the negatives thereof, other variations thereonor comparable terminology, or by discussions of strategy. No assurance can begiven that future results covered by the forward-looking statements willbe achieved, and other factors could also cause actual results to varymaterially from the future results covered in such forward-lookingstatements. Such forward-looking statements include, but are not limitedto, those relating to the Company’s financial and operating prospects, futureopportunities, ability to retain existing customers and attract new ones, theCompany’s acquisition strategy and ability to integrate acquired companies andassets, outlook of customers, reception of new products and technologies, andstrength of competition and pricing. In addition, such forward-lookingstatements involve known and unknown risks, uncertainties, and other factorswhich may cause the actual results, performance or achievements of the Companyto be materially different from any future results expressed or implied by suchforward-looking statements. Also, the Company’s business could bematerially adversely affected and the trading price of the Company’s commonstock could decline if any such risks and uncertainties develop into actualevents. The Company undertakes no obligation to publicly update or reviseforward-looking statements to reflect events or circumstances after thedate of this Form 10-K or to reflect the occurrence of unanticipatedevents.

**ITEM 1A.**        RISKFACTORS

In addition to otherinformation in this Annual Report on the Form 10-K, the followingrisk factors should be carefully considered in evaluating our business, becausesuch factors may have a significant impact on our business, operating results,liquidity and financial condition. As a result of the risk factors set forthbelow, actual results could differ materially from those mentioned in anyforward-looking statements. Additional risks and uncertainties notpresently known to us, or that we currently consider to be immaterial, may alsoimpact our business, operating results, liquidity and financial condition. Ifany of the following risks occur, our business, operating results, liquidityand financial condition, and the price of our common stock, could be materiallyadversely affected.

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**RisksRelated to Our Operations**

**Wehave a history of net losses and may incur additional losses in the future.**

We have a history of netlosses. In order for us to achieve and maintain consistent profitability fromour operations, we must continue to achieve product revenue at or above currentlevels. We may increase our operating expenses as we attempt to expand ourproduct lines and acquire other businesses and products. As a result, we mayneed to increase our revenues significantly to achieve sustainableprofitability. We cannot assure you that we will be able to obtain sustainableprofitability. Any such failure could have a material adverse effect on themarket price of our common stock and our business, financial condition andresults of operations.

**Ourbusiness plan relies on certain assumptions for the market for our productswhich, if incorrect, may adversely affect our profitability.**

Webelieve that various demographics and industry-specific trends will helpdrive growth in the orthopedic, orthotic, prosthetic and skincare markets,including:

·       anaging population with broad medical coverage, increased disposable income andlonger life expectancy;

·       agrowing emphasis on physical fitness, leisure sports and conditioning, whichwill continue to lead to increased injuries; and

·       increasingawareness and use of non-invasive devices for prevention, treatment andrehabilitation purposes.

These demographics andtrends are uncertain. The projected demand for our products could materiallydiffer from actual demand if our assumptions regarding these factors prove tobe incorrect or do not materialize, or if alternative treatments to thoseoffered by our products gain widespread acceptance.

**Thereare significant risks associated with our strategy of acquiring and integratingbusinesses.**

A keyelement of our strategy is the acquisition of businesses and assets that willcomplement our current business, increase size, expand our geographic scope ofoperations, and otherwise offer growth opportunities. We may not be able tosuccessfully identify attractive acquisition opportunities, obtain financingfor acquisitions, make acquisitions on satisfactory terms, or successfullyacquire and/or integrate identified targets. Additionally, competition foracquisition opportunities in our industry may escalate, which would increasethe costs to us of completing acquisitions or prevent us from makingacquisitions. Our ability to implement our acquisition strategy is also subjectto other risks and costs, including:

·       lossof key employees, customers or suppliers of acquired businesses;

·       diversionof management’s time and attention from our core businesses;

·       adverseeffects on existing business relationships with suppliers and customers;

·       ourability to realize operating efficiencies, synergies, or other benefitsexpected from an acquisition;

·       risksassociated with entering markets in which we have limited or no experience; and

·       assumptionof contingent or undisclosed liabilities of acquisition targets.

In addition, in connectionwith our recent acquisition of Silipos, we face the risk of incurring potentialliabilities of Silipos which may not be covered by the limited indemnificationin the Silipos Purchase Agreement, as defined later in this document.

The above risks could havea material adverse effect on the market price of our common stock and ourbusiness, financial condition and results of operations.

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**Wemay not be able to adequately manage our growth.**

We have expanded, and areseeking to continue to expand, our business. This growth has placed significantdemands on our management, administrative, operating and financial resources.The continued growth of our customer base, the types of products offered andthe geographic markets served can be expected to continue to place asignificant strain on our resources. Personnel qualified in the production andmarketing of our products are difficult to find and hire, and enhancements ofinformation technology systems to support growth are difficult to implement.Our future performance and profitability will depend in large part on ourability to attract and retain additional management and other key personnel. Inaddition, although we have recently implemented a new information technologyplatform, we cannot assure you that the new system will be effective inaccommodating our growing accounting, financial and information needs. Anyfailure to adequately manage our growth could have a material adverse effect onthe market price of our common stock and our business, financial condition andresults of operations.

**Awrite-off of intangible assets would adversely affect our results ofoperations.**

Our total assets includesubstantial intangible assets, including goodwill acquired in connection withthe acquisitions of Benefoot, Bi-Op and Silipos representing the excess of costover the fair value of the identifiable assets acquired. We expect to incuradditional goodwill in connection with other acquisitions we make in thefuture. We evaluate on a regular basis whether events and circumstances haveoccurred that indicate that all or a portion of the carrying amount of thegoodwill or other intangible assets may no longer be recoverable, in which casea charge to earnings would be required. In the year ended December 31,2005, we recorded a provision for impairment totalling $2,102,000 with respectto certain identifiable intangible assets. Any determination requiring anotherwrite-off of a significant portion of other unamortized intangible assets wouldbe expected to have a material adverse effect on our business, financialcondition, results of operations and the market price of our common stock.

**Ourbusiness is highly competitive. If we fail to compete successfully, our salesand operating results may be negatively affected and we may not achieve futuregrowth.**

The orthopedic, orthotic,prosthetic and skincare markets are highly competitive. Certain of ourcompetitors in these markets have more resources and experience as well as morerecognizable trademarks for products similar to those sold by us. In addition,the market for orthopedic devices and related products is characterized by newproduct development and corresponding obsolescence of existing products. Ourcompetitors may develop new techniques, therapeutic procedures or alternativeproducts that are more effective than our current technology or products orthat render our technology or products obsolete or uncompetitive, which couldcause a decrease in orders for our custom orthotic products. Such decreaseswould have a material adverse effect on the market price of our common stockand our business, financial condition and results of operations.

We may not be able todevelop successful new products or enhance existing products, obtain regulatoryclearances and approval of such products, market such products in acommercially viable manner or gain market acceptance for such products. Failureto develop, license or market new products and product enhancements couldmaterially and adversely affect our competitive position, which could cause asignificant decline in our sales and profitability.

We expect that the levelof competition faced by us may increase in the future. Some competitors havesubstantially greater financial, marketing, research and technical resourcesthan us. There can be no assurance that we will be able to continue to competesuccessfully in the orthopedic, orthotic, prosthetic and skincare markets. Anysuch failure could have a material adverse effect on the market price of ourcommon stock and our business, financial condition and results of operations.

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**Wemay not be able to raise adequate financing to fund our operations and growthprospects.**

Our acquisition andproduct expansion programs, debt servicing requirements, and existing operationswill require substantial capital resources. Currently, we do not have a workingcapital facility or revolving line of credit with a financial institution foradditional borrowings. Accordingly, we cannot assure you that we will be ableto generate sufficient operating cash flow or obtain sufficient additionalfinancing to meet these requirements. If we do not have adequate resources andcannot obtain additional capital on terms acceptable to us or at all, we may berequired to reduce operating costs by altering and delaying our business planor otherwise radically altering our business practices. Failure to meet ourfuture capital requirements could have a material adverse effect on the marketprice of our common stock and our business, financial condition and results ofoperations.

**Wemay be adversely affected by legal actions or proceedings.**

On April 21, 2005,Thermo-Ply, Inc., a Florida corporation, filed an action in the UnitedStates District Court for the Middle District of Florida (Tampa Division)against Silipos and four other defendants. The action asserts a claim foralleged infringement of U.S. Patent No. 6,231,617. Although notspecifically identified by the claim, we believe that the claim, insofar as itrelates to us, may be directed towards the Explorer Gel Liners manufactured,distributed and sold by Silipos. We are currently investigating the validity ofthis claim. Should the plaintiff be successful in pressing this claim, Siliposcould be enjoined from making, using or selling the accused products and couldalso be assessed damages for the alleged infringement, which damages could beincreased up to three times in the event the infringement is found to bewillful, together with attorney fees and certain costs. The parties arecurrently discussing a settlement of the action, although no assurance can begiven that such discussions will lead to a settlement favorable to the Company.Pursuant to the Silipos stock purchase agreement, SSL has agreed to fund anyobligations resulting from the settlement over $150,000, which we had accruedor paid as of December 31, 2005.

In addition, in connectionwith our acquisition of Silipos, we could become subject to certain claims oractions brought by Poly-Gel, L.L.C. (“Poly-Gel”), Silipos’ formersupplier of mineral oil based gels, although no such claims have been broughtto date. These claims may arise, for example, out of the supply agreementbetween Silipos and Poly-Gel dated August 20, 1999, the manufacture,marketing or sale of products made from gel not purchased from Poly-Gel,alleged misappropriation of trade secrets or other confidential information(including gel formulations) of Poly-Gel, as well as any other allegedviolations of the supply agreement (the “Potential Poly-Gel Claims”). Forany of these potential claims, SSL, the seller of Silipos, has agreed toindemnify us for losses up to $2.0 million, after which we would be liablefor any such claims. Furthermore, we have assumed responsibility for the first$150,000 of any other liability in connection with our acquisition of Silipos,and SSL’s maximum liability for total indemnification related to ouracquisition of Silipos is between $5,000,000 and $7,000,000. Thus, if the totalamount of all claims arising from the acquisition exceed this maximum, whetheror not related to Poly-Gel, we would be liable for amounts in excess of themaximum. For claims arising out of conduct that occurs after the closing of theSilipos transaction on September 30, 2004, we have agreed to indemnify SSLagainst losses. We would expect to vigorously defend against any claims broughtby Poly-Gel or any other third party. However, if such claims werebrought, we may not ultimately prevail.

On or about February 13, 2006, Dr. Gerald P.Zook filed a demand for arbitration with the American Arbitration Association,naming the Company and Silipos as 2 of the 16 respondents. (Four of the otherrespondents are the former owners of Silipos and its affiliates, and the other10 respondents are unknown entities.) The demand for arbitration alleges that the Company and Silipos are indefault of obligations to pay royalties in accordance with the terms of alicense agreement between Dr. Zook and Silipos dated as of January 1,1997, with respect to seven patents owned by Dr. Zook and licensed toSilipos. Silipos has paid royalties to Dr. Zook, but Dr. Zook claimsthat greater royalties are owed. The demand for arbitration 

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seeks an award of $400,000and reserves the right to seek a higher award after completion of discovery.The Company and Silipos intend to vigorously defend the claim.

On or aboutFebruary 23, 2006, Silipos commenced an action in New York State SupremeCourt, New York County, against Mr. Peter D. Bickel, who was the executivevice president of Silipos, Inc., until January 11, 2006. In theaction, Silipos seeks, among other things, a declaratory judgment thatMr. Bickel is not entitled to severance pay or other benefits, on accountof his breach of various provisions of his employment agreement with Siliposand his non-disclosure agreement with Silipos, and that his termination bySilipos was for “cause” as defined in the employment agreement. Silipos is alsoseeking an aggregate of $12 million in compensatory and punitive damages forbreaches of the employment agreement, breach of the non-disclosure agreement,breach of fiduciary duties, misappropriation of trade secrets, and tortiousinterference with business relationships. No assurance can be given thatSilipos will be successful in recovering all or any portion of this amount. Onor about March 22, 2006, Mr. Bickel removed the lawsuit to the UnitedStates District Court for the Southern District of New York and filed an answerdenying the material allegations of the complaint and counterclaims seeking adeclaratory judgment that his non-disclosure agreement is unenforceable andthat he is entitled to $500,000, representing two years’ base salary, inseverance compensation, on the ground that Silipos did not have “cause” toterminate his employment. Silipos intends to vigorously defend thesecounterclaims.

Additionally, in thenormal course of business, we may be subject to claims and litigation in theareas of general liability, including claims of employees, and claims,litigation or other liabilities as a result of acquisitions we have completed.The results of legal proceedings are difficult to predict and we cannot provideyou with any assurance that an action or proceeding will not be commencedagainst us, or that we will prevail in any such action or proceeding. Anunfavorable outcome of the arbitration proceeding commenced by Dr. GeraldP. Zook against us and Silipos, may adversely affect our rights to manufactureand/or sell certain products or raise the royalty costs of those certainproducts.

An unfavorable resolutionof any legal action or proceeding could materially adversely affect the marketprice of our common stock and our business, results of operations, liquidity orfinancial condition.

**Ourexisting purchasing arrangements may be adversely affected if we are unable tomaintain good relations with our suppliers.**

Our ability to sustain ourgross margins has been and will continue to be dependent, in part, on ourability to maintain satisfactory terms with the third-party manufacturersof certain raw materials. These terms may be adversely impacted by changes inour suppliers’ strategies or changes in our relationship with our suppliers. Wecannot assure you that we will continue to maintain satisfactory terms with oursuppliers. Our inability to maintain such terms, the loss of any of our keysuppliers, or any other interruption or delay in the supply of our requiredmaterials. or our inability to obtain these materials at acceptable prices orwithin a reasonable amount of time could impair our ability to meet scheduledproduct deliveries to our customers and could hurt our reputation and causecustomers to cancel orders.

**Werely heavily on our relationships with healthcare practitioners, agents anddistributors for marketing our products, and our failure to maintain theserelationships could adversely affect our business.**

The sales of our productsdepend significantly on the prescription or recommendation of such products bypodiatrists, orthopedists, orthopedic surgeons, dermatologists, cosmetic andplastic surgeons, occupational and physical rehabilitation professionals,prosthetists, orthotists and other healthcare professionals. Failure of ourproducts to retain the support of these surgeons and other specialists, or thefailure of our products to secure and retain similar support from leadingsurgeons and other specialists, could have a material adverse effect on themarket price of our common stock and our business, financial condition andresults of operation.

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Our marketing success alsodepends largely upon arrangements with agents and distributors. Our successdepends upon our agents’ and distributors’ sales and service expertise andtheir relationships with the customers in the marketplace. Our failure tomaintain relationships with our agents and distributors for marketing ourproducts could have an adverse effect on the market price of our common stockand our business, financial condition and results of operations.

**Thenature of our business could subject us to potential product liability andother claims.**

The sale of orthotic andprosthetic products and other biomechanical devices as well as skincareproducts entails the potential risk of physical injury to patients and otherend users and an inherent risk of product liability, lawsuits and productrecalls. We currently maintain product liability insurance with coverage limitsof $10 million per occurrence and an annual aggregate maximum of$10 million subject to a deductible of $25,000. However, we cannot assureyou that this coverage would be sufficient to cover the payment of anypotential claim. In addition, we cannot assure you that this or any otherinsurance coverage will continue to be available or, if available, will beobtainable at a reasonable cost. Our existing product liability insurancecoverage may be inadequate to protect us from any liabilities we might incur,and we will continue to be exposed to the risk that our claims may be excludedand that our insurers may become insolvent. A product liability claim or seriesof claims brought against us for uninsured liabilities or liabilities in excessof our insurance coverage could have a material adverse effect on the marketprice of our common stock and our business, financial condition and results ofoperations. In addition, as a result of a product liability claim, ourreputation could be harmed and we may have to recall some of our products,which could result in significant costs to us and have a material adverseeffect on the market price of our common stock and our business, financialcondition and results of operations.

**Healthcare regulations or health care reform initiatives could materially adverselyaffect the market price of our common stock and our business, financialcondition and results of operations.**

We are subject togovernmental regulation and supervision in the United States—at the federal andstate levels—and abroad. These regulations include FDA regulations and thoseregarding Medicare, Medicaid and physician self-referrals. These regulationsare far-reaching, and we may be required to alter one or more of our practicesto be in compliance with these laws. For example, we may be required to obtainregulatory approvals and otherwise comply with regulations regarding safety,quality and efficacy standards. If we fail to obtain such approvals and otherwisecomply with applicable regulatory requirements that could result in governmentauthorities taking punitive actions against us, including, among other things,imposing fines and penalties on us or preventing us from manufacturing orselling our products. Health care fraud and abuse regulations are complex, andeven minor, inadvertent irregularities in submissions can potentially give riseto claims that the statute has been violated. Any violations of these lawscould result in a material adverse effect on the market price of our commonstock and our business, financial condition and results of operations. Wecannot assure you that these laws and regulations will not change or beinterpreted in the future in a manner which restricts or adversely affects ourbusiness activities or relationships with providers of orthotic andbiomechanical products.

**Changesin government and other third-party payor reimbursement levels couldadversely affect our revenues and profitability.**

Our products are sold byus through our network of national, regional, independent and internationaldistributors, hospitals, doctors and other healthcare providers, many of whomare reimbursed for the healthcare services provided to their patients by third-partypayors, such as government programs, including Medicare and Medicaid, privateinsurance plans and managed care programs. Many of these programs set maximumreimbursement levels for certain of the products sold by us in the UnitedStates. We may be unable to sell our products through our distribution channelson a profitable basis if third-party payors deny coverage or reduce theircurrent levels of reimbursement, or if our costs of production increase fasterthan increases in reimbursement levels. The percentage of our sales dependenton 

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Medicareor other insurance programs may increase as the portion of the United Statespopulation over age 65 continues to grow, making us more vulnerable toreimbursement level reductions by these organizations. Reduced governmentreimbursement levels could result in reduced private payor reimbursement levelsbecause of indexing of Medicare fee schedules by certain third-partypayors. Furthermore, the healthcare industry is experiencing a trend towardscost containment as government and private insurers seek to contain healthcarecosts by imposing lower reimbursement rates and negotiating reduced contractrates with service providers.

Outside the United States,reimbursement systems vary significantly by country. Many foreign markets havegovernment-managed health care systems that govern reimbursement for newdevices and procedures. The ability of hospitals supported by such systems topurchase our products is dependent, in part, upon public budgetary constraints.Canada and some European countries, for example, have tightened reimbursementrates. If adequate levels of reimbursement from third-party payorsoutside of the United States are not obtained, international sales of ourproducts may decline, which could adversely affect our net sales and could havea material adverse effect on the market price of our common stock and ourbusiness, financial condition and results of operations.

**Ourbusiness is subject to substantial government regulation relating to medicalproducts that could have a material adverse effect on our business.**

Government regulation inthe United States and other countries is a significant factor affecting theresearch, development, formulation, manufacture and marketing of our products.In the United States, the FDA has broad authority to regulate the design,manufacture, formulation, marketing and sale of medical devices, skincare, andother medical products, and the FTC has broad authority over productadvertising. Overseas, these activities are subject to foreign governmental regulation,which is in many respects similar to regulation in the United States but whichvary from country to country. United States and foreign regulation continues toevolve, which could result in additional burdens on our operations. If we failto comply with applicable regulations we may be subject to, among other things,fines, suspension or withdrawal of regulatory approvals, product recalls,operating restrictions, and criminal prosecution. Additionally, the cost ofmaintaining personnel and systems necessary to comply with applicableregulations is substantial and increasing.

Some of our products mayrequire or will require regulatory approval prior to being marketed. Theprocess of obtaining these approvals can be lengthy and expensive. We may notbe able to obtain or maintain necessary approvals for testing or marketing ourproducts. Moreover, regulatory approvals, if granted, may include significantlimitations on the indicated uses for which our products may be marketed orother restrictions or requirements that reduce the value to us of the products.Regulatory authorities may also withdraw product approvals if we fail to complywith regulatory standards or if any problems related to our products developfollowing initial marketing. We are also subject to strict regulation withrespect to our manufacturing operations. This regulation includes testing,control and documentation requirements, and compliance with current goodmanufacturing practices, which is monitored through inspections by regulatoryauthorities.

Our profitability depends,in part, upon our and our distributors’ ability to obtain and maintain allnecessary certificates, permits, approvals and clearances from United Statesand foreign regulatory authorities and to operate in compliance with applicableregulations. Delays in the receipt of, or failure to receive necessaryapprovals, the loss of previously obtained approvals, or failure to comply withexisting or future regulatory requirements could have a material adverse effecton the market price of our common stock and our business, financial conditionand results of operations.

**Modificationsto our marketed devices may require FDA regulatory clearances or approvals andmay require us to cease marketing or recall the modified devices until suchclearances or approvals are obtained.**

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When required, the products we market in the UnitedStates have been subjected to Pre-market Notification requirements under Section 510(k) ofthe Federal Food Drug & Cosmetics Act or were exempt from the 510(k) Pre-marketNotification process. We have modified some of our products and productlabeling since obtaining 510(k) clearance. If the FDA requires us tosubmit a new 510(k) Pre-market Notification for modifications to ourexisting products, we may be the subject of enforcement actions by the FDA andbe required to stop marketing the products while the FDA reviews the 510(k) Pre-marketNotification. If the FDA requires us to go through a lengthier, more rigorousexamination than we expect, our product introductions or modifications could bedelayed or canceled, which could cause our sales to decline or otherwiseadversely impact our growth. In addition, the FDA may determine that futureproducts will be subject to the more costly, lengthy and uncertain Pre-marketApproval, or PMA, process. Products that are approved through the PMA processgenerally need FDA approval before they may be modified.

**Ourproducts may be subject to product recalls even after receiving clearance orapproval, which would harm our reputation and our business.**

The FDA and foreignregulatory authorities have the authority to request and, in some cases,require the recall of products in the event of material deficiencies, designdefects or manufacturing defects. A government-mandated or voluntaryrecall by us could occur as a result of component failures, manufacturingerrors, design defects, or any other incidents related to our medical devices,including, but not limited to, adverse event recalls, cease and desistcommunications and any other product liability issues related to our medicaldevices. Any product recall would divert managerial and financial resources andharm our reputation with customers and our business.

**If wefail to comply with the FDA’s Quality System Regulation, our manufacturingcould be delayed, and our product sales and profitability could suffer.**

Our manufacturingprocesses are required to comply with the FDA’s Quality System Regulation,which covers the procedures concerning (and documentation of) the design, testing,production processes, controls, quality assurance, labeling, packaging, storageand shipping of our devices. We also are subject to state requirements andlicenses applicable to manufacturers of medical devices. In addition, we mustengage in extensive recordkeeping and reporting and must make available ourmanufacturing facilities and records for periodic unscheduled inspections bygovernmental agencies, including the FDA, state authorities and comparableagencies in other countries. Moreover, failure to pass a Quality SystemRegulation inspection or to comply with these and other applicable regulatoryrequirements could result in disruption of our operations and manufacturingdelays. Failure to take adequate corrective action could result in, among otherthings, significant fines, suspension of approvals, seizures or recalls ofproducts, operating restrictions and criminal prosecutions. We cannot assureyou that the FDA or other governmental authorities would agree with ourinterpretation of applicable regulatory requirements or that we have in allinstances fully complied with all applicable requirements. Any failure tocomply with applicable requirements could adversely affect our product salesand profitability.

**Lossof the services of key management personnel could adversely affect ourbusiness.**

Our operations aredependent upon the skill, experience and performance of a relatively smallgroup of key management and technical personnel, including our Chairman and ourPresident and Chief Executive Officer. The unexpected loss of the services ofone or more of key management and technical personnel could have a materialadverse effect on the market price of our common stock and our business,financial condition and results of operations.

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**Ourbusiness, operating results and financial condition could be adversely affectedif we become involved in litigation regarding our patents or other intellectualproperty rights.**

Theorthopedic, orthotic, prosthetics and skincare product industries haveexperienced extensive litigation regarding patents and other intellectualproperty rights, and companies in this industry have used intellectual propertylitigation in an attempt to gain a competitive advantage. Our products maybecome subject to patent infringement claims or litigation or interferenceproceedings declared by the United States Patent and Trademark Office, orUSPTO, or the foreign equivalents thereto to determine the priority ofinventions, by competitors or other companies. The defense and prosecution of intellectualproperty suits, USPTO interference proceedings or the foreign equivalentsthereto and related legal and administrative proceedings are both costly andtime consuming. An adverse determination in litigation or interferenceproceedings to which we may become a party could:

·       subjectus to significant liabilities to third-parties;

·       requiredisputed rights to be licensed from a third-party for royalties that maybe substantial;

·       require us to ceasemanufacturing, using or selling such products or technology; or

·       resultin the invalidation or loss of our patent rights.

Any one of these outcomescould have a material adverse effect on the market price of our common stockand our business, financial condition and results of operations. Furthermore, wemay not be able to obtain necessary licenses on satisfactory terms, if at all.Even if we are able to enter into licensing arrangements, costs associated withthese transactions may be substantial and could include the long-term paymentof royalties. Accordingly, adverse determinations in a judicial oradministrative proceeding or our failure to obtain necessary licenses couldprevent us from manufacturing and selling our products, or from using certainprocesses to make our products which would have a material adverse effect onthe market price of our common stock and our business, operating results andfinancial condition. Moreover, even if we are successful in such litigation,the expense of defending such claims could be material.

In addition, we may in thefuture need to litigate to enforce our patents, to protect our trade secrets orknow-how or to determine the enforceability, scope and validity of theproprietary rights of others. Such enforcement of our intellectual propertyrights could involve counterclaims against us. Any future litigation orinterference proceedings may result in substantial expense to us andsignificant diversion of effort by our technical and management personnel.

Intellectual propertylitigation relating to our products could also cause our customers or potentialcustomers to defer or limit their purchases of our products, or causehealthcare professionals, agents and distributors to cease or lessen theirsupport and marketing of our products.

In addition, in connectionwith our acquisition of Silipos, we may be subject to the Potential Poly-GelClaims discussed under “Risk Factors—We may be adversely affected by legalactions or proceedings,” including intellectual property claims, brought byPoly-Gel. For any of these potential claims, SSL has generally agreed toindemnify us for losses up to $2.0 million, after which we would be liablefor any such claims. For claims arising out of conduct that occurs after theclosing of the Silipos transaction on September 30, 2004, we have agreedto indemnify SSL against losses. We would expect to vigorously defend againstany claims brought by Poly-Gel. However, if such claims were brought, we maynot ultimately prevail.

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**We may not be ableto maintain the confidentiality, or assure the protection, of our proprietarytechnology.**

We hold a variety of patents, trademarks andcopyrights in several countries, including the United States, that we aredependent on, including approximately 35 patents and patent applications in theU.S. and certain foreign jurisdictions and a number of trademarks fortechnologies and brands related to our product offerings. The ownership of apatent or an interest in a patent does not always provide significantprotection, and the patents and patent applications in which we have aninterest may be challenged as to their validity or enforceability. Others mayindependently develop similar technologies or design around the patentedaspects of our technology. Challenges may result in potentially significantharm to our business. We are also dependent upon a variety of methods andtechnologies that we regard as proprietary trade secrets. In addition, we have(i) a non-exclusive, paid up (except for certain administrative fees)license with Applied Elastomerics, Incorporated (the “AEI License”) dated as ofNovember 30, 2001, as amended, to manufacture and sell certain productsusing mineral oil based gels under certain patents, during the life of suchpatents, and (ii) a license with Gerald Zook (the “Zook License”),effective as of January 1, 1997, to manufacture and sell certain productsusing mineral oil based gels under certain patents and know how, during thelife of such patents, in exchange for sales based royalty payments, that isexclusive as to certain products but is non-exclusive as to others. We alsohave exclusive licenses to three types of orthotic devices which are patentedin the United States and several foreign countries. We believe our trademarksand trade names, including LangerTM, SporthoticsTM, PPTTM, SiliposTM, Explorer GelLinerTM, SilolinerTM, and SilopadTM, contribute significantly to brand recognitionfor our products, and the inability to use one or more of these names couldhave a material adverse affect on our business. For the years endedDecember 31, 2005 and 2004, revenues generated by the productsincorporating the technology licensed under the AEI License accounted forapproximately 40.2% and 42.6% of our revenues. For the years endedDecember 31, 2005 and 2004, revenues generated by products covered by theZook License, as we understand the Zook License, accounted for approximately23.9% and 17.0% of our revenues. Dr. Gerald P. Zook, the licensor of theZook License, has commenced an arbitration proceeding alleging that a broaderrange of products sold by us are covered by the Zook License and that morelicense fees are payable by us under the Zook License. See Item 3, “LegalProceedings.”

Werely on a combination of trade secret, copyright, patent, trademark, unfaircompetition and other intellectual property laws as well as contractualagreements to protect our rights to such intellectual property. Due to thedifficulty of monitoring unauthorized use of and access to intellectualproperty, however, such measures may not provide adequate protection. There canbe no assurance that courts will always uphold our intellectual propertyrights, or enforce the contractual arrangements that we have entered into toprotect our proprietary technology and trade secrets.

Further, although we seek to protect our tradesecrets, know-how and other unpatented proprietary technology, in part, withconfidentiality agreements with certain of our employees and consultants, wecannot assure you that:

·       these confidentialityagreements will not be breached;

·       we will have adequateremedies for any breach;

·       we will not be required todisclose such information to the FDA or other governmental agency in order for us to have the right to market aproduct; or

·       trade secrets, know-how andother unpatented proprietary technology will not otherwise become known to or independently developed by ourcompetitors.

Anyfinding of unenforceability, invalidity, non-infringement, or misappropriationof our intellectual property could have a material adverse effect on the marketprice of our common stock and our business, financial condition and results ofoperations. In addition, if we bring or become subject to litigation to defendagainst claimed infringement of our rights or of the rights of others or todetermine the scope and 

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validity of our intellectual property rights, suchlitigation could result in substantial costs and diversion of our resources.Unfavorable results in such litigation could also result in the loss orcompromise of our proprietary rights, subject us to significant liabilities,require us to seek licenses from third parties, or prevent us from selling ourproducts, which could have a material adverse effect on the market price of ourcommon stock and our business, financial condition and results of operations.

In addition, our licenses, including the AEI Licenseand the Zook License, could be terminated under a variety of circumstancesincluding for material breach of the license agreements or in the event of thebankruptcy or insolvency of the licensor. Any such termination could have amaterial adverse effect on the market price of our common stock and ourbusiness, financial condition and results of operations.

**Aportion of our revenues and expenditures is subject to exchange rate fluctuationsthat could adversely affect our reported results of operations.**

While a majority of our business is denominated inUnited States dollars, we maintain operations in foreign countries, primarilythe United Kingdom and Canada that require payments in the local currency andpayments received from customers for goods sold in these countries aretypically in the local currency. Consequently, fluctuations in the rate ofexchange between the United States dollar and certain other currencies mayaffect our results of operations and period-to-period comparisons of ouroperating results. For example, the value of the U.S. dollar has fallen overthe last year relative to the British pound and the Canadian dollar (which arethe principal foreign currencies material to our business) causing an increasein our reported revenues when we convert the higher valued foreign currenciesinto U.S. dollars. If the value of the U.S. dollar were to increase in relationto those currencies in the future, there could be a negative effect on thevalue of our sales in those markets when we convert amounts to dollars when weprepare our financial statements. We do not engage in hedging or similartransactions to reduce these risks.

**We may be liable for contamination or other harmcaused by hazardous materials that we use.**

Our research and development and manufacturingprocesses involve the use of hazardous materials. We are subject to federal,state and local regulation governing the use, manufacture, handling, storageand disposal of hazardous materials or waste. We cannot completely eliminatethe risk of contamination or injury resulting from hazardous materials orwaste, and we may incur liability as a result of any contamination or injury.In addition, under some environmental laws and regulations, we could also beheld responsible for all of the costs relating to any contamination at our pastor present facilities and at third-party waste disposal sites even ifsuch contamination was not caused by us. We may incur significant expenses inthe future relating to any failure to comply with environmental laws. Any suchfuture expenses or liability could have a significant negative impact on ourbusiness, financial condition and results of operations.

**Our quarterly operating results are subject tofluctuations.**

Ourrevenue and operating results have fluctuated and may continue to fluctuatefrom quarter to quarter due to seasonal factors and for other reasons. Revenuesderived from our sales of orthotic devices has historically been significantlyhigher in North America in the warmer months of the year, while sales oforthotic devices in the United Kingdom has not historically experiencedseasonality. We believe that this seasonality in North America results from theportion of our orthotics sales comprised of custom sandals which tend to behigher in the spring and summer months. Our experience has also been thatphysical activities in general tend to increase in warmer weather and that manypatients of our customers in the healthcare profession tend to defer healthcarepurchases until the spring months. Other factors which can result in quarterlyvariations include the timing and amount of new business generated by us, thetiming of new product introductions, our revenue mix, acquisitions, the timingof additional selling and general and administrative expenses to support theanticipated growth and development of new business units and the competitiveand fluctuating economic conditions in the orthopedic industry.

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Quarter-to-quarter comparisons of our operatingresults are not necessarily meaningful and should not be relied upon asindications of likely future performance or annual operating results.Reductions in revenues or net income between quarters could result in adecrease in the market price of our common stock.

**We may be unable to realize the benefits of our netoperating loss (“NOL”) carryforwards.**

NOLsmay be carried forward to offset federal and state taxable income in futureyears and eliminate income taxes otherwise payable on such taxable income,subject to certain adjustments. Based on current federal corporate income taxrates, our NOL could provide a benefit to us, if fully utilized, of significantfuture tax savings. However, our ability to use these tax benefits in futureyears will depend upon the amount of our otherwise taxable income. If we do nothave sufficient taxable income in future years to use the tax benefits beforethey expire, we will lose the benefit of these NOL carryforwards permanently.Additionally, future utilization of net operating losses will be limited underexisting tax law due to the change in control of Langer in 2001 and may befurther limited as a result of pending or future offerings of our common stock.

The amount of NOL carryforwards that we have claimedto date of approximately $6,400,000 has not been audited or otherwise validatedby the U.S. Internal Revenue Service (the “IRS”). The IRS could challenge ourcalculation of the amount of our NOL or any deductions or losses included insuch calculation, and provisions of the Internal Revenue Code may limit ourability to carry forward our NOL to offset taxable income in future years. Ifthe IRS were successful with respect to any challenge in respect of the amountof our NOL, the potential tax benefit of the NOL carryforwards to us could besubstantially reduced.

**Therecent changes in accounting standards regarding stock option plans could limitthe desirability of granting stock options, which could harm our ability toattract and retain employees, and could also negatively impact our results ofoperations.**

A recent change in accounting standards is requiringall public companies to treat the fair value of stock options granted toemployees as an expense effective as of the beginning of the first fiscal yearbeginning after June 15, 2005. When this change becomes mandatory, we andother companies will be required to record a compensation expense equal to thefair value of each stock option granted. Currently, we are generally notrequired to record compensation expense in connection with stock option grants.When we are required to expense the fair value of stock option grants, it mayreduce the attractiveness to us of granting stock options because of theadditional expense associated with these grants, which would negatively impactour reported results of operations. For example, had we been required toexpense stock option grants by applying the measurement provisions of Statementof Financial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation,” our recorded net loss for the year ended December 31, 2005of approximately $4,557,000 would have been increased by approximately$2,837,000 (of which approximately $766,000 would have represented periodicexpense relating to employee stock options granted and $2,071,000 would have representedexpenses relating to the acceleration of the vesting of certain options (SeeNote 10 to the Consolidated Financial Statements, “Stock Options”), to a netloss of approximately $7,394,000, and our recorded net income for the yearended December 31, 2004 of approximately $375,000 would have been reducedby approximately $521,000, to a net loss of approximately $146,000, and ourrecorded net loss for the year ended December 31, 2003 of approximately$5,000 would have been increased by approximately $147,000, to a net loss ofapproximately $152,000, net of tax. Nevertheless, stock options are animportant employee recruitment and retention tool, and we may not be able toattract and retain key personnel if we reduce the scope of our employee stockoption program. Accordingly, when we are required to expense stock optiongrants, our future results of operations will be negatively impacted, as couldour willingness to use stock options as an employee recruitment and retentiontool.

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**Risks Related to Our Common Stock**

**Onestockholder has the ability to significantly influence the election of ourdirectors and the outcome of corporate action requiring stockholder approval.**

As of March 27, 2006, Warren B. Kanders, ourChairman of the Board of Directors, in his capacity as sole manager and votingmember of Langer Partners, LLC (“Langer Partners”) and the sole stockholder ofKanders & Company, Inc., may be deemed to be the beneficial ownerof 2,913,523 shares, or approximately 26.5% of our outstanding common stock.

As of March 27, 2006, current executive officersand directors, including Mr. Kanders, beneficially own an aggregate of 4,026,002shares, or approximately 30.3% of our outstanding common stock, which excludes1,077,580 shares beneficially owned by Andrew H. Meyers, who ceased to be anofficer on December 31, 2005 and a director on March 24, 2006.

Consequently, Mr. Kanders, acting alone ortogether with our other officers and directors, has the ability tosignificantly influence all matters requiring stockholder approval, includingthe election of our directors and the outcome of corporate actions requiringstockholder approval, such as a change in control.

Langer Partners is partyto an agreement with Oracle Investment Management, Inc. (“Oracle”), thebeneficial owner of some of our outstanding 4% convertible subordinated notesdue August 31, 2006. Pursuant to the agreement, Langer Partners agreed notto, without the prior written consent of Oracle, sell, assign, pledge orotherwise transfer any shares of our common stock owned by Langer Partnersuntil such time as Oracle sells or otherwise transfers one-third or more of the4% convertible subordinated notes held by it, or shares of common stockreceived upon conversion of the notes. Oracle has not converted or transferredany of the 4% convertible subordinated notes to date. Oracle is considered tobeneficially own 6.3% of our outstanding common stock. Langer Partners furtheragreed with Oracle to vote all shares of Common Stock owned by Langer Partnersin favor of so many nominees of Oracle to our Board of Directors as is equal,on a percentage basis, to the aggregate percentage of our common stock owned byOracle on a fully diluted basis. Under this arrangement, we believe Oraclewould be currently entitled to designate one Board nominee pursuant to thisright. However, Oracle has not to date nominated a director.

**Theprice of our common stock has been and is expected to continue to be volatile,which could affect a stockholder’s return on investment.**

There has been significantvolatility in the stock market and in particular in the market price andtrading volume of securities of orthopedic and other health care companies,which has often been unrelated to the performance of the companies. The marketprice of our common stock has been subject to significant fluctuations, and weexpect it to continue to be subject to such fluctuations for the foreseeablefuture. We believe the reasons for these fluctuations include, in addition togeneral market volatility, the relatively thin level of trading in our stock,and the relatively low public float. Therefore, variations in financialresults, announcements of material events, technological innovations or newproducts by us or our competitors, our quarterly operating results, changes ingeneral conditions in the economy or the health care industry, otherdevelopments affecting us or our competitors or general price and volumefluctuations in the market are among the many factors that could cause themarket price of our common stock to fluctuate substantially.

**Sharesof our common stock have been thinly traded in the past.**

Although a trading marketfor our common stock exists, the trading volume has not been significant andthere can be no assurance that an active trading market for our common stockwill develop or, if developed, be sustained in the future. As a result of thethin trading market or “float” for our stock, the 

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marketprice for our common stock may fluctuate significantly more than the stockmarket as a whole. Without a large float, our common stock is less liquid thanthe stock of companies with broader public ownership and, as a result, thetrading prices of our common stock may be more volatile. In the absence of anactive public trading market, an investor may be unable to liquidate hisinvestment in our common stock. Trading of a relatively small volume of ourcommon stock may have a greater impact on the trading price for our stock thanwould be the case if our public float were larger. We cannot predict the pricesat which our common stock will trade in the future. Our common stock iscurrently traded on The Nasdaq National Market.

**Wemay issue a substantial amount of our common stock in the future which couldcause dilution to investors and otherwise adversely affect our stock price.**

A key element of ourgrowth strategy is to make acquisitions. As part of our acquisition strategy,we may issue additional shares of common stock as consideration for suchacquisitions. These issuances could be significant. To the extent that we makeacquisitions and issue our shares of common stock as consideration stockholder’sinterest may be diluted. Any such issuance will also increase the number ofoutstanding shares of common stock that will be eligible for sale in thefuture. Persons receiving shares of our common stock in connection with theseacquisitions may be more likely to sell off their common stock than otherinvestors, which may influence the price of our common stock. In addition, thepotential issuance of additional shares in connection with anticipatedacquisitions could lessen demand for our common stock and result in a lowerprice than might otherwise be obtained. We may issue common stock in the futurefor other purposes as well, including in connection with financings, forcompensation purposes, in connection with strategic transactions or for otherpurposes.

**Wehave a significant amount of convertible indebtedness outstanding and may issuea substantial amount of our common stock in connection with these and otheroutstanding securities and in connection with future acquisitions and ourgrowth plans; any such issuances of additional shares could adversely affectour stock price.**

On October 31, 2001, we sold $14,589,000 of our4% convertible subordinated notes due August 31, 2006 (the “ConvertibleNotes”) in a private placement. In June 2005, $150,000 of the ConvertibleNotes were converted into 25,000 shares of our common stock leaving a balanceof $14,439,000 outstanding. The remaining Convertible Notes are convertible atany time into approximately 2,406,500 shares of our common stock, at aconversion price of $6.00 per share, subject to adjustment in certaincircumstances. The conversion of our Convertible Notes could result in dilutionin the value of the shares of our outstanding stock and the voting powerrepresented thereby. The effect of the conversion of all of our outstanding ConvertibleNotes due August 31, 2006 would be to increase outstanding shares anddilute current shareholders by approximately 19.5% at December 31, 2005.In addition, the conversion price of our Convertible Notes may be lowered underthe conversion price adjustment provisions of the notes in certaincircumstances, including if we issue common stock at a net price per share lessthan the conversion price then in effect or if we issue rights, warrants oroptions entitling the recipients to subscribe for or purchase shares of ourcommon stock at a price per share less than the conversion price (after takinginto account any consideration we received for such rights, warrants oroptions). A reduction in the conversion price may result in the issuance of anadditional number of shares upon the conversion of our Convertible Notes. Wealso have a significant number of stock options and warrants outstanding.

We anticipate issuingadditional shares of our common stock and may also issue additional securitiesconvertible into or exercisable or exchangeable for common stock to financeacquisitions or for other reasons in the future. The number of outstandingshares of our common stock that will be eligible for sale in the future is,therefore, likely to increase substantially. Persons receiving shares of ourcommon stock in connection with these acquisitions or financings may be morelikely to sell large quantities of their 

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commonstock, which may adversely affect the price of our common stock. In addition,the potential issuance of additional shares in connection with anticipatedacquisitions could lessen demand for our common stock and result in a lowerprice than would otherwise be obtained. If our security holders sellsubstantial amounts of our common stock in the public market following thisoffering, the market price of our common stock could fall. These sales mightmake it more difficult for us to sell equity or equity-related securitiesin the future at a time and price that we deem appropriate and may require usto issue greater amounts of our common stock to finance acquisitions.Additional shares sold to finance acquisitions and conversions, exercises andexchanges of other securities for common stock may also dilute our earnings pershare.

**Ourcertificate of incorporation, our bylaws and Delaware law contain provisionsthat could discourage, delay or prevent a takeover attempt.**

We are subject to the anti-takeover provisions of Section 203of the Delaware General Corporation Law. In general, Section 203 prohibitspublicly-held Delaware corporations to which it applies from engaging in a “businesscombination” (generally including mergers, consolidations and sales of 10% ormore of the corporation’s assets) with an “interested stockholder” (generallydefined as a person owning 15% or more of the outstanding voting stock of thecorporation, subject to certain exceptions) for a period of three years afterthe date of the transaction in which the person became an interestedstockholder, unless the business combination is approved in a prescribedmanner. This provision could discourage others from bidding for our shares andcould, as a result, reduce the likelihood of an increase in our stock pricethat would otherwise occur if a bidder sought to buy our stock.

It could also discourage, delay or prevent anothercompany from merging with us or acquiring us, even if our stockholders were toconsider such a merger or acquisition to be favorable.

Additionally, our Board ofDirectors has the authority to issue up to 250,000 shares of preferred stock,and to determine the price, rights, preferences and restrictions, includingvoting and conversion rights, of those shares without any further action orvote by the stockholders. The rights of the holders of common stock will besubject to, and may be adversely affected by, the rights of the holders ofpreferred stock that may be issued in the future. Such provisions couldadversely affect the holders of common stock in a variety of ways, including bypotentially discouraging, delaying or preventing a takeover of us and bydiluting our earnings per share.

**We donot expect to pay dividends in the foreseeable future.**

We currently do not intendto pay any dividends on our common stock. We currently intend to retain anyearnings for working capital, repayment of indebtedness, capital expendituresand general corporate purposes.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

Not applicable

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**ITEM 2.**                PROPERTIES

We areheadquartered in Deer Park, New York and operate manufacturing facilities inDeer Park, New York, Niagara Falls, New York, Anaheim, California, Montreal,Canada and Stoke-on-Trent, England. We also have sales offices in New York Cityand Markham, Ontario (Canada). The following table sets forth information aboutour real properties where our manufacturing, warehouse, sales and office spaceare located: 

| Location                 | ** ** | ** **                      | ** ** | **Use** | ** ** | **2006  Annual  Rent** | ** ** | **Owned/  Leased** | ** **              | **Lease  Termination  Date** | ** ** | **Size  (Square  Feet)** | ** ** |
|--------------------------|------------|---------------------------------|------------|---------|------------|------------------------|------------|--------------------|-------------------------|------------------------------|------------|--------------------------|------------|
| Deer Park, New York      |       | Corporate headquarters,    |       |    |       |                   |       |               |                    |                         |       |                     |       |
|                          |       | manufacturing  and distribution |       | $       | 348,960    |                   | Leased     |               | July 31, 2009      | (1)                          |       | 44,500                   |       |   |
| Deer Park, New York      |       | Warehouse                       |       | $       | 27,075     |                   | Leased     |               | March 31,  2007    |                         |       | 3,500                    |       |   |
| Anaheim, California      |       | Manufacturing and distribution  |       | $       | 69,120     | (2)                    | Leased     |               | December 31,  2007 |                         |       | 8,000                    |       |   |
| Stoke-on-Trent, England  |       | Manufacturing and distribution  |       | $       | 63,725     | (3)                    | Leased     |               | June 30, 2009      |                         |       | 15,000                   |       |   |
| Montreal, Canada         |       | Manufacturing and distribution  |       | —  |       | Owned                  |       | Not Applicable     |                    |                         | 7,800      |                     |       |
| Niagara Falls, New York  |       | Manufacturing and distribution  |       | $       | 411,504    | (4)                    | Leased     |               | December 31,  2018 |                         |       | 40,000                   |       |   |
| New York, New York       |       | Sales                           |       | $       | 154,611    |                   | Leased     |               | December 31,  2007 |                         |       | 4,600                    |       |   |
| Niagara Falls, New York. |       | Manufacturing                   |       | $       | 30,179     |                   | Leased     |               | January 31,  2007  |                         |       | 5,250                    |       |   |
| New York, New York.      |       | Sales and administration        |       | $       | 13,500     | (5)                    | Leased     |               | April 30,  2017    | (7)                          |       | 13,500                   |       |   |
| Markham, Ontario.        |       | Sales and  administration       |       | $       | 11,987     | (6)                    | Leased     |               | April 30, 2008     | (6)                          |       | 1,933                    |       |   |

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(1)           In January 2005, we exercised our option to extendthe lease to July 31, 2009. The rent under the lease increases 4% annuallycommencing with each August payment.

(2)           Lease commenced January 1, 2005. The annual rentincreases to $71,040 in 2007. The table above reflects the 2006 annual rentpayments due for this lease.

(3)           Assumes a conversion rate of 1.82 U.S. Dollars to 1.00British pound sterling.

(4)           Reflects the annual rent due in 2006. The rentincreases each year throughout the lease.

(5)           On December 19, 2005, we entered into a lease (astenant) with 41 Madison, L.P. (the “Landlord”) of certain space, for use assales, marketing and executive offices. The lease will run for 10 years, 8months, commencing upon the completion of the build-out of the space.

(6)           Assumes a conversion rate of .83 U.S. dollars to 1.00Canadian dollar.

(7)           Estimated date based upon build-out schedule.

We believe that ourmanufacturing, warehouse and office facilities are suitable and adequate andafford sufficient capacity for our current and reasonably foreseeable futureneeds. We believe we have adequate insurance coverage for our properties andtheir contents.

**ITEM 3.**                LEGALPROCEEDINGS

On April 21, 2005, Thermo-Ply, Inc., aFlorida corporation, filed an action in the United States District Court forthe Middle District of Florida (Tampa Division) against Silipos and four otherdefendants. The action asserts a claim for alleged infringement of U.S. PatentNo. 6,231,617. Although not specifically identified by the claim, theCompany believes that the claim, insofar as it relates to the Company, may bedirected towards the Explorer Gel Liners manufactured, distributed and sold bySilipos. The Company is currently investigating the validity of this claim.Should the plaintiff be successful in 

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pressing this claim,Silipos could be enjoined from making, using or selling the accused productsand could also be assessed damages for the alleged infringement, which damagescould be increased up to three times in the event the infringement is found tobe willful, together with attorney fees and certain costs. The parties arediscussing a settlement of the action although no assurance can be given thatsuch discussions will lead to a settlement favorable to the Company. Pursuantto the Silipos stock purchase agreement, SSL has agreed to fund any of theCompany’s obligations resulting from the settlement over $150,000, which theCompany had accrued or paid as of December 31, 2005.

In addition, in connection with the Company’sacquisition of Silipos, the Company could become subject to certain claims oractions brought by Poly-Gel, although no such claims have been brought to date.These claims may arise, for example, out of the supply agreement betweenSilipos and Poly-Gel dated August 20, 1999, the manufacture, marketing orsale of products made from gel not purchased from Poly-Gel, allegedmisappropriation of trade secrets or other confidential information (includinggel formulations) of Poly-Gel, as well as any other alleged violations of thesupply agreement (the “Potential Poly-Gel Claims”). For any of these potentialclaims, SSL has agreed to indemnify the Company for losses up to $2.0 million,after which the Company would be liable for any such claims. Furthermore, theCompany has assumed responsibility for the first $150,000 of such liability inconnection with the Company’s acquisition of Silipos, and SSL’s maximumliability for total indemnification related to the Company’s acquisition ofSilipos is between $5,000,000 and $7,000,000. Thus, if the total amount of allclaims arising from the acquisition exceed this maximum, whether or not relatedto Poly-Gel, the Company would be liable for amounts in excess of the maximum.For claims arising out of conduct that occurs after the closing of the Silipostransaction on September 30, 2004, the Company has agreed to indemnify SSLagainst losses. The Company would expect to vigorously defend against anyclaims brought by Poly-Gel or any other third party.

On or about February 13, 2006, Dr. Gerald P.Zook filed a demand for arbitration with the American Arbitration Association,naming the Company and Silipos as 2 of the 16 respondents. (Four of the otherrespondents are the former owners of Silipos and its affiliates, and the other10 respondents are unknown entities.) The demand for arbitration alleges that the Company and Silipos are indefault of obligations to pay royalties in accordance with the terms of alicense agreement between Dr. Zook and Silipos dated as of January 1,1997, with respect to seven patents owned by Dr. Zook and licensed toSilipos. Silipos has paid royalties to Dr. Zook, but Dr. Zook claimsthat greater royalties are owed. The demand for arbitration seeks an award of$400,000 and reserves the right to seek a higher award after completion ofdiscovery. The Company and Silipos intend to vigorously defend the claim.

On or about February 23, 2006, Silipos commencedan action in New York State Supreme Court, New York County, againstMr. Peter D. Bickel, who was the executive vice president ofSilipos, Inc., until January 11, 2006. In the action, Silipos seeks,among other things, a declaratory judgment that Mr. Bickel is not entitledto severance pay or other benefits, on account of his breach of variousprovisions of his employment agreement with Silipos and his non-disclosureagreement with Silipos, and that his termination by Silipos was for “cause” asdefined in the employment agreement. Silipos is also seeking an aggregate of$12 million in compensatory and punitive damages for breaches of the employmentagreement, breach of the non-disclosure agreement, breach of fiduciary duties,misappropriation of trade secrets, and tortious interference with businessrelationships. No assurance can be given that Silipos will be successful inrecovering all or any portion of this amount. On or about March 22, 2006,Mr. Bickel removed the lawsuit to the United States District Court for theSouthern District of New York and filed an answer denying the materialallegations of the complaint and counterclaims seeking a declaratory judgmentthat his non-disclosure agreement is unenforceable and that he is entitled to$500,000, representing two years’ base salary, in severance compensation, onthe ground that Silipos did not have “cause” to terminate his employment.Silipos intends to vigorously defend these counterclaims.

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Additionally, in thenormal course of business, we may be subject to claims and litigation in theareas of general liability, including claims of employees, and claims,litigation or other liabilities as a result of acquisitions we have completed.The results of legal proceedings are difficult to predict and we cannot provideyou with any assurance that an action or proceeding will not be commencedagainst us, or that we will prevail in any such action or proceeding. Anunfavorable outcome of the arbitration proceeding commenced by Dr. GeraldP. Zook against us and Silipos, may adversely affect our rights to manufactureand/or sell certain products or raise the royalty costs of those certainproducts.

An unfavorable resolutionof any legal action or proceeding could materially adversely affect the marketprice of our common stock and our business, results of operations, liquidity orfinancial condition.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matterssubmitted to a vote of security holders during the fourth quarter of the fiscalyear covered by this Annual Report.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**Price Range of Common Stock**

Our common stock, par value $0.02 per share, has beentraded on The Nasdaq National Market since August 23, 2005 under thesymbol “GAIT”. For more then two years prior thereto, our common stock wastraded on the Nasdaq Small Cap Market. The following table sets forth the highand low bid prices for the common stock as reported on The Nasdaq Small CapMarket for the specified periods prior to August 23, 2005 and on theNasdaq National Market on and after August 23, 2005.

Thelast reported sale price on March 15, 2006, was $4.00. On such date, therewere approximately 229 holders of record of our common stock. This figureexcludes all owners whose stock is held beneficially or in “street” name.

| **Year ended December 31, 2005** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                                        |       | $          | 8.24       |     | $          | 6.53    |       |
| Second Quarter                                       |       | $          | 8.00       |     | $          | 6.18    |       |
| Third Quarter                                        |       | $          | 6.96       |     | $          | 4.33    |       |
| Fourth Quarter                                       |       | $          | 5.49       |     | $          | 4.25    |       |

 

| **Year ended December 31, 2004** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                                        |       | $          | 7.49       |     | $          | 3.48    |       |
| Second Quarter                                       |       | $          | 9.20       |     | $          | 5.43    |       |
| Third Quarter                                        |       | $          | 7.15       |     | $          | 5.41    |       |
| Fourth Quarter                                       |       | $          | 8.15       |     | $          | 5.50    |       |

 

**Dividend Policy**

We have not declared anycash dividends on our common stock in the past, and we do not presentlyanticipate declaring or paying any cash dividends in the foreseeable future. Wecurrently anticipate that we will retain all future earnings for use in ourbusiness. The payment of dividends in the future will be at the discretion ofour Board of Directors and will depend upon, among other things, our results ofoperations, capital requirements, general business conditions, contractualrestrictions on payment of dividends, if any, legal and regulatory restrictionson payment of dividends, and other factors our Board of Directors deemsrelevant.

**RecentSales of Unregistered Securities**

On October 1, 2005, we issued 901 shares of ourcommon stock as consideration for certain consulting services. The shares ofcommon stock were issued pursuant to an exemption provided by Section 4(2) ofthe Securities Act of 1933.

On November 12, 2004, the Board of Directorsapproved a grant of 100,000 shares of restricted stock to Kanders &Company subject to certain performance conditions, which were satisfied in June2005, provided Mr. Kanders has not resigned from the Board of Directors,all of which were originally scheduled to vest on November 12, 2007 andwhich would accelerate upon the death of Mr. Kanders, or the change of controlof the Company. On December 20, 2005, the Board of Directors acceleratedthe vesting of the stock award subject to lock-up, confidentiality andnon-competition agreements.

On December 20, 2005,the Company accelerated the vesting of a certain restricted stock award to W. GrayHudkins originally granted in November 2004, subject to certain lock-up,confidentiality and non-

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competitionagreements. Mr. Hudkins surrendered 17,200 shares of such restricted stockto the Company to satisfy his obligation to reimburse the Company for withholdingtaxes payable by the Company on behalf of Mr. Hudkins.

**ITEM6.**                SELECTED FINANCIALDATA

Theselected consolidated financial data set forth below should be read inconjunction with our consolidated financial statements and the related notesthereto in Item 8 and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” in Item 7. We derived theconsolidated statements of operations data for the ten months ended December 31,2001 and the year ended December 31, 2002, and the consolidated balancesheet data as of December 31, 2001, December 31, 2002 and December 31,2003 from our audited financial statements not included in this Annual Report.We derived the consolidated statements of operations data for the years ended December 31,2003, 2004 and 2005 and the consolidated balance sheet data as of December 31,2004 and 2005 from our audited financial statements. The historical results arenot necessarily indicative of the operating results to be expected in thefuture. 

| ** **                                 | ** ** | **Year ended  Dec. 31, 2005**                       | ** ** | **Year ended  Dec. 31, 2004** | ** ** | **Year ended  Dec. 31, 2003** | ** ** | **Year ended  Dec. 31, 2002** | ** ** | **Ten months  ended  Dec. 31, 2001** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                 | ** ** | **(in thousands, except per share data)** | ** ** |
| Consolidated  Statements of Operations:    |       |                                                               |       |                                         |       |                                         |       |                                         |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Net sales                                  |       |                                                               | $          | 40,141                                       |       |                                         |       | $                                            | 30,127     |                                                |       |   | $ | 24,721 |   |   |   | $ | 18,677 |   |   |   | $ | 10,936 |   |   |
| Operating (loss) income                    |       |                                                               | (4,313     | )                                            |       |                                         | 1,177      |                                         |       |                                                | 764        |   |   |   | (470 | ) |   |   | 139 |   |   |
| Change in fair value of Put Option         |       |                                                               | 1,750      |                                         |       |                                         | 605        |                                         |       |                                                | —     |   |   |   | — |   |   |   | — |   |   |
| Change in fair value of Protection Payment |       |                                                               | —     |                                         |       |                                         | (223       | )                                            |       |                                                | —     |   |   |   | — |   |   |   | — |   |   |
| (Loss) income before income taxes          |       |                                                               | (4,758     | )                                            |       |                                         | 532        |                                         |       |                                                | 161        |   |   |   | (998 | ) |   |   | 73 |   |   |
| Net (loss) income                          |       |                                                               | (4,557     | )                                            |       |                                         | 375        |                                         |       |                                                | (5         | ) |   |   | (1,106 | ) |   |   | 70 |   |   |
| Net (loss) income per common share:        |       |                                                               |       |                                         |       |                                         |       |                                         |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                      |       |                                                               | (0.63      | )                                            |       |                                         | 0.09       |                                         |       |                                                | —     |   |   |   | (0.26 | ) |   |   | 0.02 |   |   |
| Diluted                                    |       |                                                               | (0.63      | )                                            |       |                                         | 0.08       |                                         |       |                                                | —     |   |   |   | (0.26 | ) |   |   | 0.02 |   |   |
| Weighted average number of common shares:  |       |                                                               |       |                                         |       |                                         |       |                                         |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                      |       |                                                               | 7,277      |                                         |       |                                         | 4,395      |                                         |       |                                                | 4,374      |   |   |   | 4,246 |   |   |   | 3,860 |   |   |
| Diluted                                    |       |                                                               | 7,277      |                                         |       |                                         | 4,793      |                                         |       |                                                | 4,374      |   |   |   | 4,246 |   |   |   | 4,307 |   |   |
|                                            |            |                                                                    |            |                                              |            |                                              |            |                                              |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                    | ** ** | **Dec. 31, 2005** | ** ** | **Dec. 31, 2004** | ** ** | **Dec. 31, 2003** | ** ** | **Dec. 31, 2002** | ** ** | **Dec. 31, 2001** | ** ** |
|-------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Consolidated  Balance Sheets: |       |                        |       |                        |       |                        |       |                        |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Working capital               |       |                        | $          | 9,204                       |       |                        |       | $                           | 1,387      |                        |       |   | $ | 7,434 |   |   |   | $ | 10,569 |   |   |   | $ | 16,655 |   |   |
| Total assets                  |       |                        | 57,172     |                        |       |                        | 47,807     |                        |       |                        | 24,023     |   |   |   | 23,810 |   |   |   | 20,700 |   |   |
| Long-term debt                |       |                        | 2,700      |                        |       |                        | 24,847     |                        |       |                        | 14,589     |   |   |   | 15,389 |   |   |   | 14,589 |   |   |
| Stockholders’ equity     |       |                        | 33,181     |                        |       |                        | 5,215      |                        |       |                        | 3,775      |   |   |   | 3,112 |   |   |   | 3,866 |   |   |
|                               |            |                             |            |                             |            |                             |            |                             |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As set forth in Item 1,Business, “Acquisition History”, we have completed three acquisitions since May 6,2002. See Item 7, Management’s Discussion and Analysis of Financial Conditionand Results of Operations, “Overview” and “Results of Operations,” forinformation regarding the effect of acquisitions on our results of operations.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*Thediscussion in this Item 7 should be read in conjunction with our consolidatedfinancial statements and the related notes to those statements includedelsewhere in this Annual Report. In addition to historical consolidatedfinancial information, the following discussion and analysis contains forward-lookingstatements that involve risks, uncertainties and assumptions. Our actualresults and timing of specific events may differ materially from thoseanticipated in these forward-looking statements as a result of manyfactors, including, but not limited to, those discussed in Item 1A, RiskFactors, and elsewhere in this Annual Report.*

**Overview**

We design, manufacture anddistribute a range of medical products targeting the orthopedic, orthotic andprosthetic markets. We also offer a diverse line of skincare products for themedical, therapeutic and retail markets. We sell our products primarily in theUnited States and Canada, as well as in more than 30 other countries, tonational, regional, international and independent medical distributors anddirectly to healthcare professionals.

Our broad range of over500 orthopedic products, including custom foot and ankle orthotic devices,pre-fabricated foot products, rehabilitation products, and gel-based orthopedicand prosthetics products, are designed to correct, protect, heal and providecomfort for the patient. Our line of over 50 skincare products, which includescar management products and gel-based therapeutic gloves and socks, isdesigned to improve skin appearance and transmit moisture agents, vitamins andnutrients to the skin.

Since February 2001,we have consummated the following three acquisitions:

·       *Silipos.* On September 30, 2004, weacquired Silipos, Inc., our largest acquisition to date, from SSL. Siliposis a leading designer, manufacturer and marketer of gel-based products focusingon the orthopedic, orthotic, prosthetic, and skincare markets. We acquired Silipos because of its distribution channels andproprietary products, and to enable us to expand into additional product linesthat are part of our market focus. The aggregate consideration paid by us inconnection with this acquisition was approximately $17.3 million,including transaction costs of approximately $2.0 million, paid in cashand notes.

·       *Bi-Op.* On January 13, 2003, weacquired Bi-Op Laboratories, Inc., which is engaged in the design,manufacture and sale of footwear and foot orthotic devices as well as orthoticand prosthetic services. We acquired Bi-Op to gain access to additional marketsand complementary product lines. The aggregate consideration, includingtransaction costs, was approximately $2.2 million, of which approximately$1.8 million was paid in cash, and the remaining portion was paid throughthe issuance of 107,611 shares of our common stock.

·       *Benefoot.* On May 6, 2002, we acquiredthe net assets of Benefoot, Inc., and Benefoot Professional Products, Inc.(together, “Benefoot”). Benefoot designs, manufactures and distributes customorthotics, custom Birkenstock® sandals,therapeutic shoes, and prefabricated orthotic devices to healthcareprofessionals. We acquired Benefoot to gain additional scale in our core customorthotics business as well as to gain access to complementary product lines.The aggregate consideration, including transaction costs, was approximately$7.9 million, of which approximately $5.6 million was paid in cash,$1.8 million was paid through the issuance of 4% promissory notes, andapproximately $0.5 million was paid through the issuance of 61,805 sharesof common stock. In connection with this acquisition, we also assumed certainliabilities of Benefoot, including approximately $0.3 million of long-termindebtedness which was paid at closing.

We sell our productsdirectly to health care professionals and also to wholesale distributors.Custom orthotic products are primarily sold directly to health careprofessionals. Other products sold in our orthopedic business are sold bothdirectly to health care professionals and to distributors. Products sold in 

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ourskincare business are sold primarily to wholesale distributors. Revenue fromproduct sales is recognized at the time of shipment. Our most significantexpense is cost of sales. Cost of sales consists of materials, direct labor andoverhead, and related shipping costs. General and administrative expensesconsist of executive, accounting and administrative salaries and related expenses,insurance, pension expenses, bank service charges, stockholder relations andamortization of identifiable intangible assets with definite lives. Sellingexpenses consist of advertising, promotions, commissions, conventions, postage,travel and entertainment, sales and marketing salaries and related expenses.

For the year ended December 31,2005, we derived approximately 89% of our revenue from North America andapproximately 11% of our revenue from outside North America. For each of theyears ended December 31, 2004 and 2003, we derived approximately 90% ofour revenue from North America, and approximately 10% of our revenue fromoutside North America. Of our revenue derived from North America for the yearended December 31, 2005, approximately 93% was generated in the UnitedStates and approximately 7% was generated from Canada. Of our revenue derivedfrom North America for each of the years ended December 31, 2004 and 2003,approximately 92% and 93%, respectively, was generated in the United States andapproximately 8% and 7%, respectively, was generated from Canada. On a proforma basis, giving effect to our acquisition of Silipos as if it had occurredon the first day of the period, approximately 84% of our revenue for each ofthe years ended December 31, 2004 and 2003 would have been derived fromNorth America, and approximately 16% of our revenue for each of these years,would have been derived from outside North America. On a pro forma basis,giving effect to our acquisition of Silipos as if had occurred on the first dayof the period, for the years ended December 31, 2004 and 2003,approximately 79% and 80%, respectively, of our revenue would have been derivedin the United States, and approximately 5% and 4%, respectively, would havebeen derived from Canada.

For the year ended December 31,2005, we had a net loss of approximately $4,557,000, as compared to net incomefor the year ended December 31, 2004 of approximately $375,000. Theprincipal reasons for the net loss were the non-cash stock award and stockoption compensation expense recorded in 2005 of approximately $3,045,000(including approximately $1,313,000 relating to the acceleration of vesting ofcertain stock options and stock awards in the fourth quarter of 2005), ascompared to approximately $23,000 in 2004, the provision for impairment of$2,102,000 provided with respect to certain identifiable intangible assetsrecorded in 2005, and the increase in interest expense to approximately$2,692,000 in 2005, as compared to approximately $1,219,000 in 2004. The netloss for 2005 was partially offset by the non-cash gain on the expiration ofthe Put Option (as defined below) of $1,750,000 recorded in 2005, as comparedto the non-cash gain on the change in the fair value of the Put Option of$605,000 recorded in 2004.

From January 1, 2002to September 30, 2004, we had two reportable segments, custom orthoticsand distributed products. As a result of the Silipos acquisition, beginningwith the fourth quarter of 2004, we are reporting custom orthotics anddistributed products as a single segment called orthopedics, and are reportinga new second segment called skincare. The orthopedics segment includes theorthopedic products of Silipos.

On a pro forma basisgiving effect to our acquisition of Silipos as of the beginning of the relevantyears, approximately 86% and 87% of our revenue, respectively, for the yearsended December 31, 2004 and 2003 would have been derived from ourorthopedics segment, and approximately 14% and 13% of our revenue,respectively, for these periods would have been derived from our new skincaresegment.

**CriticalAccounting Policies and Estimates**

Our accounting policiesare more fully described in Note 1 of the Notes to Consolidated FinancialStatements. The preparation of financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the 

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date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Future events and their effects cannot bedetermined with absolute certainty. Therefore, the determination of estimatesrequires the exercise of judgment. Actual results may differ from theseestimates under different assumptions or conditions.

*Accounting Estimates.**  *We believe the most significantaccounting estimates inherent in the preparation of our consolidated financialstatements include estimates associated with our determination of liabilitiesrelated to warranty activity and estimates associated with our reserves withrespect to collectibility of accounts receivable, allowances for sales returns,inventory valuations, valuation allowance for deferred tax assets andimpairment of goodwill and identifiable intangible assets. Various assumptionsand other factors underlie the determination of these significant estimates.The process of determining significant estimates is fact specific and takesinto account factors such as historical experience, current and expectedeconomic conditions, and product mix. We constantly re-evaluate thesesignificant factors and make adjustments where facts and circumstances dictate.Historically, actual results have not significantly deviated from thosedetermined using the estimates described above.

*Warranty Reserve.**  *Warranty reserves represent ourestimate of future costs associated with our warranty of fabricated productsand are based upon historical experience. The warranty reserve at December 31,2002 was approximately $70,000. During the year ended December 31, 2003,we added approximately $405,000 to the reserve and charged the same amountagainst the reserve for costs incurred to complete warranty repairs. Thewarranty reserve at December 31, 2003 was $70,000. During the year ended December 31,2004, we added approximately $332,000 to the reserve and charged approximately$332,000 against the reserve for costs incurred to complete warranty repairs.The warranty reserve at December 31, 2004 was $70,000. During the yearended December 31, 2005, we added approximately $290,000 to the reserveand charged $290,000. The warranty reserve at December 31, 2005 was$70,000. If future costs incurred were to differ from our estimates, we mayneed to increase or decrease our reserve.

*Revenue Recognition.**  *Revenue from the sale of ourproducts is recognized upon shipment. We generally do not have anypost-shipment obligations to customers other than for product warranties. Wegenerally warrant our products against defects in materials and workmanship fora period of 6 months. We record provision for estimated future costsassociated with our warranties of fabricated products/custom orthotics when weship such products, based on historical experience. We also offer extendedwarranty contracts which we record as deferred revenue and recognize over thelives of the contracts (24 months) on a straight-line basis. See *“Warranty Reserve,”* above. Revenue fromshipping and handling fees is included in net sales in the consolidatedstatements of operations. Costs incurred for shipping and handling is includedin the cost of sales in the consolidated statements of operations.

*Allowance for Doubtful Accounts.**  *Our allowance for doubtful accountswas 7.6% of accounts receivable at December 31, 2005 as compared to 5.1%of accounts receivable at December 31, 2004. Management believes that theoverall allowance, as a percentage of accounts receivable at December 31,2005 is appropriate based upon the consolidated collection and write-offhistory as well as the average age of the consolidated accounts receivable. Theallowance for doubtful accounts at December 31, 2002 was approximately$125,000. During the year ended December 31, 2003, we added approximately$118,000 to the allowance based upon increased net sales and our review of theaccounts receivable aging. We wrote off, net of recoveries, approximately$18,000 against the allowance. The allowance for doubtful accounts atDecember 31, 2003 was approximately $225,000. During the year endedDecember 31, 2004, we added approximately $172,000 to the allowance andwrote off, net of recoveries, approximately $17,000 against the allowance. Asof December 31, 2004, the allowance for doubtful accounts wasapproximately $380,000. During the year ended December 31, 2005, we addedapproximately $151,000 to the allowance and wrote off approximately $101,000.At December 31, 2005, the allowance for doubtful accounts was approximately$430,000. If future payments by our customers were different from ourestimates, we may need to increase or decrease our allowance for doubtfulaccounts.

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*Other Allowances.**  *The sales returns and allowances atDecember 31, 2002 were $28,000. In 2003, we added $40,000 to theallowance. The sales returns and allowances at each of December 31, 2005,2004 and 2003 were $68,000. If actual sales returns and allowances were todiffer from our estimates, we may need to increase or decrease our sales returnand allowance.

*Inventory Reserve.**  *At December 31, 2002, theinventory reserve for excess or obsolete inventory was approximately $220,000. In2003, we provided approximately $129,000 as an additional reserve and chargedapproximately $39,000 to the reserve. The inventory reserve for excess orobsolete inventory at December 31, 2003 was approximately $310,000. Duringthe year ended December 31, 2004, we added approximately $214,000 ofadditional reserves and wrote off approximately $155,000 in excess or obsoleteinventory which was disposed of during the year. During 2004, we reviewed ourinventory levels and aging relative to current and expected usage and determinedthe requirement for additions to the reserve. The inventory reserve forobsolete inventory at December 31, 2004 was approximately $369,000. Duringthe year ended December 31, 2005, we added $453,000 of additional reservesand wrote off approximately $258,000 in excess or obsolete inventory which wasdisposed of during the year. The reserve for obsolete inventory wasapproximately $564,000 at December 31, 2005. If the inventory quality orusage relative to quantities held were to deteriorate or improve in the future,we may need to increase or decrease our reserve for excess or obsoleteinventory. Inventory write-downs represent the estimated loss of value ofcertain slow-moving inventory or inventory that has been damaged or spoiled.Inventory usage is analyzed using turnover analysis, and an allowance forobsolescence is provided when inventory quantity exceeds its normal cycle. Thepercentage of allowance is based upon actual usage, historical data andexperience. Most of these reserves are associated with raw materials used inthe fabrication process and either represent items no longer utilized in theprocess or significant excess inventory. Inventory for which a reserve has beenprovided was approximately $992,000 and approximately $1,175,000, on anoriginal cost basis, at December 31, 2004 and December 31, 2005,respectively. Certain of the raw material inventory for which a reserve wasprovided has subsequently been used in fabrication, with the related reservebeing reversed. However, we re-evaluate the reserve as of the end of eachreporting period based upon the age of the existing inventory and the usageanalysis..

*Valuation Allowance—DeferredTax Assets.**  *Thevaluation allowance relating to deferred tax assets was approximately$2,408,000 at December 31, 2002, which represented a full allowanceagainst all net deferred tax assets except approximately $6,000 related to analternative minimum tax carryforward. During the year ended December 31,2003, the valuation allowance increased by approximately $17,000 toapproximately $2,425,000 at December 31, 2003. During 2004, the valuationallowance was increased by approximately $143,000 to approximately $2,568,000. During2005, the valuation allowance was increased by approximately $2,112,000 toapproximately $4,680,000. We believe this valuation allowance is requiredbecause it is more likely than not that these deferred tax assets will not berealized.

*Goodwill and IdentifiableIntangible Assets.**  *Goodwillrepresents the excess of purchase price over fair value of identifiable netassets of acquired businesses. Identifiable intangible assets primarilyrepresent allocations of purchase price to identifiable intangible assets ofacquired businesses. Because of our strategy of growth through acquisitions,goodwill and other identifiable intangible assets comprise a substantialportion (36.2% as of December 31, 2005 and 47.4% as of December 31,2004) of our total assets.

Wehad no goodwill or other intangible assets prior to 2002. In June 2001,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 142 “Goodwill and Other IntangibleAssets.”  We adopted SFAS No. 142effective January 1, 2002. As a result of the adoption of this standard,amortization of goodwill and certain intangible assets with indefinite liveshas been discontinued. Instead, we review these assets for impairment on anannual basis.

During2003, 2004 and 2005, impairment tests of goodwill and indefinite-lived identifiableintangible assets were performed in accordance with SFAS No. 142 and anevaluation of identifiable intangible assets 

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with definite lives pursuant to SFAS No. 144. As theresult of the impairment test completed as of October 1, 2005 inaccordance with SFAS No. 142, we recognized a loss on impairment ofidentifiable intangibles with indefinite lives of $1,600,000 and recorded aloss on impairment of $502,000 with respect to identifiable intangible assetswith definitive lives in accordance with SFAS No. 144.

Goodwilland identifiable intangible assets, net, at December 31, 2002 wereapproximately $3,186,000 and approximately $3,313,000, respectively. During theyear ended December 31, 2003, goodwill increased by approximately$1,350,000, which represented goodwill of approximately $820,000 created by theBi-Op acquisition and approximately $530,000 resulting from performance-basedcontingent consideration pursuant to the Benefoot acquisition. During 2003, weadded $900,000 of identifiable intangible assets with definite lives, all ofwhich related to the Bi-Op acquisition and recorded amortization expense ofapproximately $253,000. Goodwill and identifiable intangible assets, net, at December 31,2003 were approximately $4,536,000 and approximately $3,960,000, respectively.

During2004, goodwill increased by approximately $8,785,000, which represented thegoodwill resulting from the Silipos acquisition of approximately $8,621,000 andthe final payment of deferred performance based contingent consideration withrespect to the Benefoot acquisition of approximately $164,000. Additionally,during 2004, we added $5,732,000 of identifiable intangible assets as a resultof the Silipos acquisition and recorded amortization expense of approximately$349,000. Goodwill and identifiable intangible assets, net at December 31,2004, were approximately $13,321,000 and approximately $9,343,000,respectively.

During the year ended December 31, 2005, goodwillincreased by approximately $798,000. The increase was due to the payment of$900,000 as the full settlement of our obligation under the Silipos stockpurchase agreement to pay SSL Holdings, Inc., $1 million if we did notacquire Poly-Gel by March 31, 2006, and which was accounted for under SFASNo. 141, “Business Combinations.” The payment was made on July 15,2005. Additionally, we recorded professional fees of approximately $67,000 withrespect to the acquisition, and a reduction to certain deferred assets andproperty and equipment totalling approximately $63,000. Goodwill decreased dueto a $232,000 reduction in the purchase price paid by us to SSL because Siliposdid not satisfy certain minimum working capital requirements as of the closingdate of the acquisition pursuant to the Silipos purchase agreement. Thereduction to the purchase price was satisfied by decreasing the $7,500,000principal amount of 5.5% secured promissory note due March 31, 2006 issuedto SSL (the “$7.5 Million Note”), and which is reflected herein. Goodwill andidentifiable intangible assets, net, at December 31, 2005 wereapproximately $14,119,000 and approximately $6,604,000, respectively.

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**Results of Operations**

Thefollowing tables present (i) selected consolidated statements ofoperations data, and (ii) selected consolidated statements of operationsdata as a percentage of net sales:

| ** **                                                            | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                            | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| ***Consolidated Statements of Operations Data:*** |       |                                        |       |   |   |   |   |
| Net sales                                                             |       | $                                           | 24,720,515 |   | $ | 30,126,759 |   | $ | 40,141,498 |   |
| Cost of sales                                                         |       | 16,049,790                                  |       | 18,022,532 |   | 22,222,934 |   |
| Gross profit                                                          |       | 8,670,725                                   |       | 12,104,227 |   | 17,918,564 |   |
| General and  administrative expenses                                  |       | 4,775,142                                   |       | 5,927,808 |   | 12,257,046 |   |
| Selling expenses                                                      |       | 3,131,197                                   |       | 4,950,947 |   | 7,402,843 |   |
| Research and  development expenses                                    |       | —                                      |       | 48,694 |   | 469,971 |   |
| Provision for  impairment of identifiable intangible assets           |       | —                                      |       | — |   | 2,102,000 |   |
| Operating (loss)  income                                              |       | 764,386                                     |       | 1,176,778 |   | (4,313,296 | ) |
| Other income  (expense):                                              |       |                                        |       |   |   |   |   |
| Interest income                                                       |       | 157,522                                     |       | 174,261 |   | 443,996 |   |
| Interest expense                                                      |       | (836,273                                    | )          | (1,219,427 | ) | (2,692,209 | ) |
| Change in fair  value of Put Option                                   |       | —                                      |       | 605,000 |   | 1,750,000 |   |
| Change in fair  value of Protection Payment                           |       | —                                      |       | (223,000 | ) | — |   |
| Other                                                                 |       | 75,798                                      |       | 18,859 |   | 53,081 |   |
| Other expense,  net                                                   |       | (602,953                                    | )          | (644,307 | ) | (445,132 | ) |
| (Loss) income  before income taxes                                    |       | 161,433                                     |       | 532,471 |   | (4,758,428 | ) |
| Provision for  (benefit from) income taxes                            |       | 166,904                                     |       | 157,683 |   | (201,160 | ) |
| Net (loss) income                                                     |       | $                                           | (5,471     | ) | $ | 374,788 |   | $ | (4,557,268 | ) |

 

| ** **                                                  | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                  | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| ***Consolidated  Statements of Operations Data:***          |       |                                        |       |   |   |   |   |
| Net sales                                                   |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
| Cost of sales                                               |       | 64.9                                        |       | 59.8 |   | 55.4 |   |
| Gross Profit                                                |       | 35.1                                        |       | 40.2 |   | 44.6 |   |
| General and  administrative expenses                        |       | 19.3                                        |       | 19.7 |   | 30.5 |   |
| Selling expenses                                            |       | 12.7                                        |       | 16.4 |   | 18.4 |   |
| Research and  development expenses                          |       | —                                      |       | .2 |   | 1.2 |   |
| Provision for  impairment of identifiable intangible assets |       | —                                      |       | — |   | 5.2 |   |
| Operating (loss)  income                                    |       | 3.1                                         |       | 3.9 |   | (10.7 | ) |
| Other income  (expense):                                    |       |                                        |       |   |   |   |   |
| Interest income                                             |       | .6                                          |       | .6 |   | 1.1 |   |
| Interest expense                                            |       | (3.4                                        | )          | (4.0 | ) | (6.7 | ) |
| Change in fair  value of Put Option                         |       | —                                      |       | 2.0 |   | 4.4 |   |
| Change in fair  value of Protection Payment                 |       | —                                      |       | (.7 | ) | — |   |
| Other                                                       |       | .3                                          |       | .1 |   | .1 |   |
| Other expense,  net                                         |       | (2.4                                        | )          | (2.1 | ) | (1.1 | ) |
| (Loss) income  before income taxes                          |       | .7                                          |       | 1.8 |   | (11.9 | ) |
| Provision for  (benefit from) income taxes                  |       | .7                                          |       | .5 |   | (.5 | ) |
| Net (loss) income                                           |       | —                                      | %          | 1.2 | % | (11.4 | )% |

 

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***Years Ended December 31, 2005 and 2004***

Net loss for the year ended December 31, 2005 wasapproximately $(4,557,000), or $(.63) per share on a fully diluted basis, ascompared to net income of approximately $375,000, or $.08 per share on a fullydiluted basis for the year ended December 31, 2004. The principal reasonsfor the net loss were the impairment with respect to certain identifiableintangible assets with indefinite lives totalling $1,600,000, and theimpairment of certain identifiable intangible assets with definite lives of$502,000. Additionally, we realized non-cash compensation expense with respectto certain stock awards (approximately $742,000) and stock options(approximately $2,303,000) granted totalling approximately $3,045,000,approximately $1,313,000 of which was attributable to our acceleration ofvesting of such stock awards and stock options. These items were partiallyoffset by the non-recurring non-cash gain of $1,750,000 from the change in thefair value of the Put Option (as hereinafter defined) that we assumed inconnection with our acquisition of Silipos. The Put Option is contained in thesupply agreement between Silipos and Poly-Gel, L.L.C. (“Poly-Gel”) dated August 20,1999, which we assumed in connection with the Silipos acquisition. The supplyagreement provided that Poly-Gel had the option (the “Put Option”) to causeSilipos to purchase the assets or shares of Poly-Gel at a purchase price,payable in cash, of 1.5 times Poly-Gel’s revenues in the 12-month periodprior to the exercise of the Put Option. At September 30, 2004, the fairvalue of the Put Option was $2,355,000. At December 31, 2004, the fairvalue of the Put Option was $1,750,000. The Put Option expired unexercised on February 16,2005 in accordance with its terms. In late 2004, we engaged in discussions withPoly-Gel regarding our possible acquisition of Poly-Gel. However, thesediscussions were terminated and we did not acquire Poly-Gel. We recorded thereduction in the estimated fair value of the Put Option obligation of $605,000at December 31, 2004, as a non-cash gain from the change in the estimatedfair value of the Put Option in the consolidated statement of operations forthe year ended December 31, 2004, and as described above, we recorded theexpiration of the Put Option as an additional non-cash gain of $1,750,000during the three months ended March 31, 2005. The results for the yearended December 31, 2005 also reflect the impact of the following events onour historic business resulting from our acquisition and integration ofSilipos: interest expense incurred with respect to debt issued in connectionwith the Silipos acquisition of approximately $842,000 (including amortizationof debt discount associated with warrants issued, amortization of debtplacement costs, and the amortization of interest cost related to theincreasing-rate debt and the Protection Payment, net of the realization of theRefund Provision, as described below) in the $7.5 Million Note. Additionally,the results were impacted by  an increasein professional fees of approximately $1,245,000; an increase of approximately$719,000 associated with stock-based compensation (stock award) (includingapproximately $431,000 relating to the acceleration of the vesting of the stockawards); an increase in severance compensation and related legal reserves of$372,000; an increase in stock option compensation of approximately $2,303,000,approximately $1,257,000 of which related to stock options for consultingservices and approximately $1,046,000 of which related to a modification to astock option agreement, (including approximately $882,000 relating to theacceleration of the vesting of the stock options for consulting services); anincrease in amortization expense of approximately $288,000 associated with theidentifiable intangible assets with definite lives acquired in the Siliposacquisition; and an increase of approximately $141,000 of depreciation.Additionally, during the year ended December 31, 2005, we recordedapproximately $572,000 as the write-off of the unamortized debt discount inconnection with the repayment of the $5,500,000 principal amount of 7% seniorsubordinated notes due September 30, 2007 (the “Subordinated Notes”), andapproximately $58,000 as the write-off of the related debt placement fees (bothof which were included in interest expense in the consolidated statements ofoperations).

We reported our operations in two segments, customorthotics and distributed products, through September 30, 2004. Beginning October 1,2004, we are reporting operations in two segments, orthopedics and skincare.Both our historic custom orthotics business and the distributed productsbusiness are now included in the orthopedic segment for reporting purposes, asare orthotics and prosthetic products sold by Silipos. Silipos products areprimarily sold through distributors.

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Net sales for the year ended December 31, 2005were approximately $40,141,000, as compared to approximately $30,127,000 forthe year ended December 31, 2004, an increase of approximately$10,014,000, or approximately 33.2%. The principal reason for the increase wasthe net sales of approximately $17,505,000 in 2005 generated by Silipos, ascompared to $5,558,000 generated by Silipos in 2004 (which was acquired on September 30,2004 and thus only contributed to the 2004 results for one quarter), partiallyoffset by a decline in net sales of approximately $1,933,000 in our historicbusiness. The decline was attributable to several factors described below.

Net sales of orthopedics were approximately$35,641,000 in the year ended December 31, 2005, as compared toapproximately $27,947,000 in the year ended December 31, 2004, an increaseof approximately $7,694,000, or approximately 27.5%. This increase was due tothe net sales increase of approximately $9,627,000 from the orthopedic segmentof Silipos, offset by a reduction in net sales in our historic business ofapproximately $1,933,000.

Within the orthopedic segment, net sales of customorthotics for the year ended December 31, 2005 were approximately$17,347,000, as compared to approximately $18,836,000 for the year ended December 31,2004, a decrease of approximately $1,489,000. Net sales of ankle-foot orthoses(“AFO’s”) increased from approximately $1,571,000 in the year ended December 31,2004, to approximately $1,696,000 in the year ended December 31, 2005.However, these increases were more than offset by a decrease in our othercustom foot orthotic sales (exclusive of revenue from AFO’s) of approximately$1,614,000, from approximately $17,265,000 in the year ended December 31,2004, to approximately $15,651,000 in the year ended December 31, 2005.

Net sales of historic distributed products for theyear ended December 31, 2005 were approximately $5,289,000, as compared toapproximately $5,733,000 for the year ended December 31, 2004, a decreaseof approximately $444,000, or approximately 7.7%. This decrease wasattributable to a decrease in sales of certain distributed products, includingshoes and PPT®,a proprietary shock absorption cushion product used, among other things, in thefabrication of insoles, and shoes.

Net sales of Silipos branded orthopedic products wereapproximately $13,005,000 in the year ended December 31, 2005, as comparedto approximately $3,378,000 in the year ended December 31, 2004. The 2005sales represents the full year effect of the Silipos acquisition whereas the2004 net sales represent only sales of Silipos following our acquisition ofSilipos on September 30, 2004.

Through Silipos, we generated net sales ofapproximately $4,500,000 in our skincare segment in the year endedDecember 31, 2005, as compared to $2,180,000 in the year endedDecember 31, 2004. We had skincare sales in the year endedDecember 31, 2004 for only the last three months of the year, followingour acquisition of Silipos on September 30, 2004. Net sales in theskincare segment represented approximately 25.7% of Silipos’ sales for the yearended December 31, 2005, and represented approximately 11.2% of our totalnet sales for the year ended December 31, 2005. The cost of salesassociated with skincare was approximately $1,880,000, or approximately 41.8%of net sales in our skincare segment, resulting in a gross profit ofapproximately 58.2%.

Cost of sales, on a consolidated basis, increasedapproximately $4,200,000, to approximately $22,223,000 in the year endedDecember 31, 2005, as compared to approximately $18,023,000 in the yearended December 31, 2004. This increase was primarily attributable to theincrease in cost of sales incurred by Silipos of approximately $4,558,000 inthe year ended December 31, 2005, offset by a decrease in cost of sales inour historic business of approximately $358,000, which was attributable to adecrease in net sales, partially offset by an increase in overhead and certainmaterial costs.

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Cost of sales in the orthopedic segment wasapproximately $20,343,000, or approximately 57.1% of orthopedic net sales inthe year ended December 31, 2005, as compared to approximately$17,129,000, or approximately 61.3% of orthopedic net sales in the year ended December 31,2004. The reason for the increase in the cost of sales was the cost of salesrelated to the Silipos’ products, which nevertheless generated higher grossprofit.

Cost of sales for custom orthotics were approximately$12,359,000, or approximately 71.2% of net sales of custom orthotics for theyear ended December 31, 2005, as compared to approximately $12,346,000, orapproximately 65.5% of net sales of custom orthotics for the year ended December 31,2004. Cost of sales of historic distributed products were approximately$3,175,000, or approximately 60.0% of net sales of distributed products in thehistoric business for the year ended December 31, 2005, as compared toapproximately $3,546,000, or approximately 61.9% of net sales of distributedproducts in the historic business for the year ended December 31, 2004.

Cost of sales for Silipos branded orthopedic productswere approximately $4,809,000, or approximately 37.0% of net sales of Siliposbranded orthopedic products of approximately $13,005,000 in the year ended December 31,2005, as compared to approximately $1,237,000, or approximately 36.6% of netsales of Silipos branded orthopedic products of approximately $3,378,000 in theyear ended December 31, 2004.

Cost of sales for skincare products were approximately$1,880,000, or approximately 41.8% of net sales of skincare products ofapproximately $4,500,000 in the year ended December 31, 2005, as comparedto approximately $894,000, or approximately 41.0% of net sales of skincareproducts of approximately $2,180,000 in the year ended December 31, 2004.

Consolidated gross profit increased approximately$5,814,000, or approximately 48%, to approximately $17,918,000 for the yearended December 31, 2005, as compared to approximately $12,104,000 for theyear ended December 31, 2004. Consolidated gross profit as a percentage ofnet sales for the year ended December 31, 2005 was approximately 44.6%, ascompared to approximately 40.2% for the year ended December 31, 2004. Theprincipal reason for the increase in consolidated gross profit was the grossprofit contribution from Silipos of approximately $10,816,000 for the yearended December 31, 2005. Silipos’ consolidated gross profit as apercentage of its net sales for the year ended December 31, 2005 wasapproximately 61.8%, which includes both orthopedics and skincare. ExcludingSilipos, our gross profit as a percentage of net sales was approximately 31.4%for the year ended December 31, 2005, reflecting a decrease from a grossprofit of approximately 35.3% for the year ended December 31, 2004.

Gross profit for the orthopedic segment wasapproximately $15,298,000, or approximately 42.9% of net sales of theorthopedic segment in the year ended December 31, 2005, as compared toapproximately $10,818,000, or approximately 38.7% of net sales of theorthopedic segment in the year ended December 31, 2004.

Gross profit for custom orthotics was approximately$4,988,000, or approximately 28.8% of net sales of custom orthotics for theyear ended December 31, 2005, as compared to approximately $6,490,000, orapproximately 34.5% of net sales of custom orthotics for the year ended December 31,2004. Gross profit for our historic distributed products was approximately$2,114,000, or approximately 40.0% of net sales of distributed products in thehistoric business for the year ended December 31, 2005, as compared toapproximately $2,187,000, or approximately 38.1% of net sales of distributedproducts in the historic business for the year ended December 31, 2004.The decrease in gross profit in custom orthotics was attributable to increasesin certain overhead expenses, as well as a slight increase in certain materialprices. The slight decrease in gross profit in distributed products from ourhistorical business was attributable to a decrease in the net sales of historicdistributed products.

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Gross profit generated by Silipos’ branded orthopedicsales was approximately $8,196,000, or approximately 63.0% of net sales ofSilipos’ branded orthopedic products, as compared to $2,141,000, orapproximately 63.4% of net sales of Silipos’ branded orthopedic products forthe year ended December 31, 2004. The gross profit was enhanced by ourdecision to manufacture our own gel products used in production. Such productswere previously purchased from Poly-Gel pursuant to the supply agreementbetween Silipos and Poly-Gel.

Gross profit generated by our skincare segment wasapproximately $2,620,000, or approximately 58.2% of net sales in the skincaresegment for the year ended December 31, 2005, as compared to $1,286,000,or approximately 59.0% of net sales in the skincare segment for the year ended December 31,2004.

General and administrative expenses for the year endedDecember 31, 2005 were approximately $12,257,000, or approximately 30.5%of net sales, as compared to approximately $5,928,000, or approximately 19.7%of net sales for the year ended December 31, 2004, representing anincrease of approximately $6,329,000. Silipos generated approximately$1,539,000 of general and administrative expenses in the year ended December 31,2005, which included legal fees totalling $333,000 ($150,000 with respect tothe Thermo-Ply litigation), as compared to $307,000 in the year ended December 31,2004, which represents the full year effect of Silipos’ operations in 2005. Theprincipal reason for the remaining increase of $5,145,000 was due to anincrease in stock option compensation (approximately $2,303,000, approximately$1,257,000 of which related to stock options for consulting services and approximately$1,046,000 of which related to a modification to a stock option agreement), anincrease in stock-based compensation (approximately $719,000), an increase inseverance and related legal reserves ($372,000), an increase in professionalfees (approximately $1,245,000), an increase in amortization expense associatedwith the identifiable intangible assets with definite lives acquired in theSilipos acquisition (approximately $288,000), an increase in depreciationexpense (approximately $141,000), and a write off of certain other assetstotalling $166,000.

Selling expenses increased approximately $2,452,000,or approximately 49.5%, to approximately $7,403,000 for the year ended December 31,2005, as compared to approximately $4,951,000 for the year ended December 31,2004. Selling expenses as a percentage of net sales were approximately 18.4 %and 16.4% for the years ended December 31, 2005 and 2004, respectively.Silipos incurred approximately $4,005,000 of selling expenses in the year endedDecember 31, 2005, as compared to approximately $1,816,000 of sellingexpenses for the year ended December 31, 2004, and selling expenses in ourhistoric business increased by approximately $263,000, from approximately$3,135,000 in the year ended December 31, 2004, to approximately$3,398,000 in the year ended December 31, 2005. Silipos, which sellsprimarily to distributors, allocates more resources, both in absolute amountsand as a percentage of net sales, into sales, marketing, and sales-relatedexpenses, including royalties and sales commissions, than our historicbusiness. We intend to continue to closely monitor selling expenses in ourhistoric custom orthotics and distributed products businesses. Additionally, weexpect to continue to monitor and review the selling expenses of Silipos inorder to focus such expenditures on growth areas and products.

Research and development expense was approximately$470,000 in the year ended December 31, 2005, compared to approximately$49,000 in the year ended December 31, 2004. This was attributableprimarily to the fact that all of the research and development expense isincurred by Silipos, which we owned for only one quarter in 2004. Additionally,we, through Silipos, undertook several initiatives in 2005 that were not inplace in 2004.

During 2003, 2004 and 2005, the Company performedimpairment tests of goodwill and indefinite-lived intangible assets inaccordance with SFAS No. 142, and evaluation of the useful lives ofacquired intangible assets subject to amortization were performed in accordancewith SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets.”  As a result of theimpairment test 

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completed as of October 1,2005, we recognized a loss on impairment of identifiable intangible assets withindefinite lives of $1,600,000 and recorded a loss on impairment of $502,000with respect to identifiable intangible assets with definitive lives.

Interest expense was approximately $2,692,000 for theyear ended December 31, 2005, as compared to approximately $1,219,000 forthe year ended December 31, 2004, an increase of approximately $1,473,000.The principal reasons for the increase in 2005 were:

(i)            Nominal interestexpense of approximately $547,000 in the year ended December 31, 2005associated with the various components of the acquisition indebtedness incurredin connection with the Silipos acquisition, which closed on September 30,2004, of which $5.5 million was repaid in June 2005 and $10.5 millionwas repaid in July 2005, as compared to $242,000 in the year ended December 31,2004;

(ii)        Interest recorded withrespect to a capital lease assumed in the Silipos acquisition, which     totaled approximately $443,000 in the yearended December 31, 2005, as compared to $111,000 in the year ended December 31,2004;

(iii)    Interest amortization of theestimated fair value of the warrants (debt discount) issued in connection withthe Subordinated Notes, which aggregated approximately $106,000, and theamortization of the related debt placement costs of approximately $12,000 inthe year ended December 31, 2005, as compared to $57,000 and $6,000,respectively for the year ended December 31, 2004;

(iv)      Amortization of interestexpense of approximately $677,000 (net of the $100,000 discount provided aspart of the settlement) associated with the increasing-rate debt and interestcosts related to the Protection Payment included in the $7.5 Million Note (seeNote 7, “Long-term Debt”); and

(v)          The write-off ofapproximately $572,000 of unamortized debt discount and the write-off ofapproximately $58,000 of the related debt placement costs, discussed in (iii) above,in connection with the repayment of the Subordinated Notes.

These amounts were partially offset by the realizationof the call option of $500,000, which was recorded as a reduction in interestexpense for the year ended December 31, 2005.

These amounts were further offset by a reduction ininterest expense associated with the $800,000 principal amount of 4% promissorynotes issued by us in 2002 in connection with our acquisition of Benefoot (the “BenefootNotes”), which were outstanding for part of the 2004 period, and which wererepaid in May 2004.

We recorded a reduction in the estimated fair value ofthe Put Option obligation of $605,000 at December 31, 2004 from September 30,2004 as a non-cash gain from the change in the estimated fair value of the PutOption in the consolidated statement of operations for the year ended December 31,2004. We recorded the expiration of the Put Option on February 16, 2005 asan additional non-cash gain of $1,750,000 from the change in the estimated fairvalue of the Put Option in the three months ended March 31, 2005 which wasincluded in the statement of operations for the year ended December 31,2005.

The (benefit from)provision for income taxes was approximately $(201,000) in the year ended December 31,2005, as compared to $158,000 in the year ended December 31, 2004. In2005, we provided for current foreign income taxes of approximately $113,000and a deferred income tax benefit totalling approximately $314,000(approximately $22,000 of which relates to foreign taxes). In the year ended December 31,2004, we provided deferred income expense of $154,000 and a foreign tax provisionof $4,000.

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***Years ended December 31, 2004 and 2003***

Net income for the year ended December 31, 2004,was approximately $375,000, or $.08 per share on a fully diluted basis, ascompared to a net loss of approximately $(5,000), or $(.00) per share on a fullydiluted basis for the year ended December 31, 2003, an increase ofapproximately $380,000. The principal reason for the increase in net income wasthe contribution from Silipos in the fourth quarter of approximately $1,337,000of pretax income which included the non-cash gain of $605,000 from the changein the fair value of the Put Option (as hereinafter defined) we assumed inconnection with our acquisition of Silipos. We became liable under anobligation in the supply agreement between Silipos and Poly-Gel dated August 20,1999, under which Poly-Gel had the option (the “Put Option”) to cause Siliposto purchase the assets or shares of Poly-Gel at a purchase price, payable incash, of 1.5 times Poly-Gel’s revenues over the 12 month period prior tothe exercise of the Put Option. At September 30, 2004, the fair value ofthe Put Option was approximately $2,355,000. At December 31, 2004, thefair value of the Put Option was approximately $1,750,000. The Put Optionexpired unexercised on February 16, 2005 in accordance with its terms, andwe have terminated all discussions with Poly-Gel regarding our possibleacquisition of Poly-Gel, and we do not expect to acquire Poly-Gel.We recorded the reduction in the estimated fair value of the Put Optionobligation of $605,000 as a gain from the change in estimated fair value of thePut Option in the consolidated statement of operations for the year ended December 31,2004. Our historic business generated a pretax loss of approximately $805,000in 2004, as compared to pretax income of approximately $161,000 in 2003. Theprincipal reason for the net loss in our historic business was a decrease innet sales and corresponding gross profit, partially offset by cost containmentmeasures undertaken in 2004, as compared to 2003, all of which is discussedbelow. Additionally, the 2004 operating results for the historic businessreflect the change in the fair value of the protection payment associated withthe $7.5 Million Note and the $3.0 Million Note issued to SSL in connectionwith the Silipos acquisition, which resulted in an expense of $223,000, theinterest expense incurred with respect to debt issued in connection with theSilipos acquisition of approximately $305,000 (including related warrants anddebt placement cost amortization), and the increase in amortization expense ofapproximately $96,000 associated with the identifiable intangible assets withdefinite lives acquired in the Silipos acquisition.

We reported our operations in two segments, customorthotics and distributed products through September 30, 2004. Beginning October 1,2004, we are reporting our operations in two segments, orthopedics andskincare. Both the custom orthotics business and the distributed productsbusiness are now included in the orthopedic segment for reporting purposes.

Net sales for the year ended December 31, 2004were approximately $30,127,000, as compared to approximately $24,721,000 forthe year ended December 31, 2003, an increase of approximately $5,406,000or approximately 21.9%. The principal reason for the increase was the net salesof approximately $5,558,000 generated by Silipos (which was acquired as of September 30,2004) in the fourth quarter of 2004, partially offset by a decline in net salesof approximately $152,000 in our historic business. The decline wasattributable to several factors described below.

Net sales of orthopedics were approximately$27,947,000 for the year ended December 31, 2004, as compared toapproximately $24,721,000 for the year ended December 31, 2003, anincrease of approximately $3,226,000, or approximately 13.0%. This increase wasdue to approximately $3,378,000 of net sales generated by the orthopedicsegment of Silipos, offset by a reduction in net sales in our historic businessof approximately $152,000.

Within the orthopedic segment, net sales of customorthotics for the year ended December 31, 2004 were approximately$18,836,000, as compared to approximately $19,031,000 for the year ended December 31,2003, a decrease of approximately $195,000. Shipping revenue related to oursales of custom orthotics increased due to a domestic initiative to pass thecost of shipping to the customers. As a result of the domestic shippinginitiative, we generated shipping revenue on orthotics of approximately $938,000in 

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2004, as compared toapproximately $725,000 in 2003. Net sales of AFO’s also increased fromapproximately $1,290,000 in 2003, to approximately $1,571,000 in 2004, and netsales of our First ChoiceÔline of orthotics increased from approximately $889,000 in 2003, toapproximately $1,234,000 in 2004. However, these increases were more thanoffset by a decrease in our other custom foot orthotic sales (exclusive ofrevenues from shipping, AFO’s and First Choice) of approximately $1,034,000,from approximately $16,127,000 in 2003, to approximately $15,093,000 in 2004.In 2004, we raised custom foot orthotic prices by approximately 5% (includingshipping); however, we had a loss in sales unit volume of approximately 11% asa result of the price increase.

Net sales of distributed products for the year ended December 31,2004 were approximately $5,733,000, as compared to approximately $5,690,000 forthe year ended December 31, 2003, an increase of approximately $43,000, orapproximately 0.8%. The increase was due to an increase in sales of certaindistributed products including PPT (which increased approximately $279,000(excluding related shipping revenue) or approximately 24.5%), which waspartially offset by a reduction in the sale of therapeutic shoes. This decreasewas primarily due to a 10% price decrease for therapeutic shoes, which wasintended to stimulate sales; however, there was an approximate 5% reduction insales unit volume due to continued competitive pressure and an approximate 6%reduction in sales unit volume due to a discontinuation of a direct-to-consumershoe program in early 2004.

Net sales of Silipos branded orthopedic products wereapproximately $3,378,000 in the fourth quarter of 2004. Related cost of saleswere approximately $1,237,000, or approximately 36.6%, resulting in a grossprofit of approximately 63.4%.

We, through Silipos, generated net sales ofapproximately $2,180,000 in its skincare segment. Such net sales wereapproximately 39.2% of Silipos’ sales for the period we owned Silipos, andrepresented 18.9% of our total net sales since we acquired Silipos. The cost ofsales associated with skincare was approximately $894,000, or approximately41.0% of net sales in our skincare segment, resulting in a gross profit ofapproximately 59.0%.

Cost of sales increased approximately $1,973,000, toapproximately $18,023,000 for the year ended December 31, 2004, ascompared to approximately $16,050,000 for the year ended December 31,2003. This increase was primarily attributable to the cost of sales contributedby Silipos of approximately $2,131,000 in the fourth quarter of 2004, offset bya decrease in cost of sales in the historic business of approximately $158,000,which was attributable to a decrease in net sales and our focus on cost containmentmeasures.

Cost of sales in the orthopedic segment wereapproximately $17,129,000, or approximately 61.3% of orthopedic net sales inthe year ended December 31, 2004, as compared to approximately$16,050,000, or approximately 64.9% of orthopedic net sales in the year ended December 31,2003. The reason for the increase in the cost of sales was the cost of salesrelated to the Silipos’ products.

Costs of sales for custom orthotics were approximately$12,346,000, or approximately 65.5% of net sales of custom orthotics for theyear ended December 31, 2004, as compared to approximately $12,910,000, orapproximately 67.8% of net sales of custom orthotics for the year ended December 31,2003. Cost of sales of distributed products were approximately $3,546,000, orapproximately 61.9% of net sales of distributed products in the historicbusiness for the year ended December 31, 2004, as compared toapproximately $3,140,000, or approximately 55.2% of net sales of distributedproducts in the historic business for the year ended December 31, 2003.

Cost of sales for Silipos’ branded orthopedic productswere approximately $1,237,000, or approximately 36.6% of net sales of Silipos’branded orthopedic products of approximately $3,378,000.

Cost of sales for skincare products were approximately$894,000, or approximately 41.0% of net sales of skincare products ofapproximately $2,180,000.

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Gross profit increased approximately $3,433,000, orapproximately 39.6%, to approximately $12,104,000 for the year ended December 31,2004, as compared to approximately $8,671,000 in 2003. Gross profit as apercentage of net sales for the year ended December 31, 2004 wasapproximately 40.2%, as compared to approximately 35.1% for the year ended December 31,2003. The principal reason for the increase in gross profit was theapproximately $3,427,000 gross profit contribution of Silipos. Silipos’ grossprofit as a percentage of its net sales for the period during which we ownedSilipos was approximately 61.7%, which includes both orthopedics and skincare.Excluding Silipos, our gross profit as a percentage of net sales wasapproximately 35.3%, reflecting a slight increase over a gross profit ofapproximately 35.1% in 2003.

Gross profit for the orthopedic segment wasapproximately $10,818,000, or approximately 38.7% of net sales of theorthopedic segment in the year ended December 31, 2004, as compared toapproximately $8,671,000, or approximately 35.1% of net sales in the year endedDecember 31, 2003.

Gross profit for custom orthotics was approximately$6,490,000 during the year ended December 31, 2004, as compared toapproximately $6,121,000 for the year ended December 31, 2003. Grossprofit for distributed products was approximately $2,187,000 for the year endedDecember 31, 2004, as compared to approximately $2,550,000 for the yearended December 31, 2003. The increase in gross profit as a percentage innet sales of custom orthotics from approximately 32.2% in 2003, toapproximately 34.5% in 2004, was attributable to an approximate 5% price increasein custom orthotics (including shipping charges), and an increase in the saleof ankle-foot orthotics, which have a higher gross profit than other customorthotics, offset by an approximate 11% reduction in the sales unit volume ofcustom orthotics. The sales unit volume declined due to the price increase. Thedecrease in gross profit percentage in distributed products from our historicalbusiness, from approximately 44.8% in 2003, to approximately 38.1% in 2004, wasattributable to an approximate 10% price decrease in the therapeutic shoeprogram and an approximate 8% reduction in the sales unit volume, partiallyoffset by an increase in the sale of other distributed products, which includePPT, which has a higher profit margin, but lower unit sales volume, than thetherapeutic shoe program. The price decrease for the therapeutic shoe programwas designed to stimulate sales; however, there was an approximate 5% reductionin sales unit volume due to continued competitive pressure and an approximate6% reduction in sales unit volume due to the discontinuation of adirect-to-consumer shoe program in early 2004. Additionally, in the aggregate,gross profit as a percentage of net sales increased principally due to lowerlabor costs and lower manufacturing overhead, partially offset by increases incertain product costs. The lower labor costs and lower manufacturing overhead,resulting in a higher gross profit percentage, which we expect to benefit fromin the future, was the result of cost containment measures undertaken in 2004and described in the cost-of-sales analysis above. The cost containmentmeasures included a reduction in staff of approximately 6%, and a decrease inovertime required, which was consistent with the reduction in sales unit volumein the custom orthotics segment.

Gross profit generated by Silipos’ branded orthopedicsales was approximately $2,141,000, or approximately 63.4% of net sales ofSilipos’ branded orthopedic products. The gross profit was enhanced by ourdecision to manufacture its own gel products used in production. Such productswere previously purchased from an unrelated supplier.

Gross profit generated by our skincare segment wasapproximately $1,286,000, or approximately 59.0% of net sales in the skincaresegment. The gross profit was in line with our expectations when we acquiredSilipos.

General and administrative expenses for the year endedDecember 31, 2004 were approximately $5,928,000, or approximately 19.7% ofnet sales, as compared to approximately $4,775,000, or approximately 19.3% ofnet sales for the year ended December 31, 2003, representing an increaseof approximately $1,153,000. Silipos generated approximately $307,000 ofgeneral and administrative 

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expenses in the fourthquarter of 2004. Additionally, in 2004, we took a charge of approximately$292,000 with respect to transaction costs associated with the abandonedacquisition of Poly-Gel. Further, we incurred a charge of approximately$65,000 for capital-based franchise taxes as a result of the acquisitionof Silipos. We recognized approximately $96,000 of amortization in connectionwith identifiable intangible assets with definitive lives acquired in theSilipos transaction. Finally, we incurred increased costs (depreciation ofapproximately $148,000) associated with the acquisition and implementation of anew information technology platform, as well as increases in professional fees(approximately $75,000) and insurance expense (approximately $49,000) inconnection with compliance with the Sarbanes Oxley Act of 2002, and the revisedlisting requirements of The Nasdaq Stock Market, which costs are expected toremain at such levels.

Selling expenses increased approximately $1,820,000,or approximately 58.1%, to approximately $4,951,000, for the year ended December 31,2004, as compared to approximately $3,131,000 for the year ended December 31,2003. Selling expenses as a percentage of net sales were approximately 16.4%for the year ended December 31, 2004, as compared to approximately 12.7%for the year ended December 31, 2003. Silipos contributed approximately$1,816,000 of selling expenses in the fourth quarter of 2004, which comprisedsubstantially all of the increase in selling expenses for the year ended December 31,2004 over the year ended December 31, 2003. Silipos, which sells todistributors, allocates more resources, both in absolute amounts and as apercentage of net sales, into sales, marketing, and sales-relatedexpenses, including royalties and sales commissions, than our historicbusiness. We will continue to closely monitor selling expenses in our historicbusiness, *i.e.*, custom orthoticsand distributed products business. Additionally, we expect to rationalize theselling expenses of Silipos in order to focus such expenditures on growth areasand products.

Interest expensewas approximately $1,219,000 for the year ended December 31, 2004, ascompared to approximately $836,000 for the year ended December 31, 2003,an increase of approximately $383,000, or approximately 45.8%. The principalreasons for the increase in 2004 were:

(i)            The interest expenseof approximately $242,000 associated with the acquisition indebtedness incurredin connection with the Silipos acquisition, which closed on September 30,2004;

(ii)        The interest recorded withrespect to the capital lease assumed in the Silipos acquisition, which totaledapproximately $111,000 in 2004; and

(iii)    The interest amortization ofthe estimated fair value of the warrants issued in connection with theSubordinated Notes, which aggregated approximately $57,000 and the amortizationof the related debt placement costs of approximately $6,000.

These amounts were partially offset by the finalrepayment in May 2004 of $800,000 outstanding under our 4% promissorynotes issued in 2002 in connection with our acquisition of Benefoot (the“Benefoot Notes”), which were outstanding for only part of the year.

At September 30, 2004, the fair value of the PutOption was approximately $2,355,000. At December 31, 2004, the fair valueof the Put Option was approximately $1,750,000. The Put Option expiredunexercised on February 16, 2005. We recorded the reduction in theestimated fair value of the Put Option obligation of $605,000 as a gain fromthe change in estimated fair value of the Put Option in the consolidated statementof operations for the year ended December 31, 2004. We will record theexpiration of the Put Option in the first quarter of 2005 as an additional gainof $1,750,000 from the change in the estimated fair value of the Put Option.

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Additionally, we recorded $223,000 as additionalexpense to reflect a change in the fair value of our obligation under the$7.5 Million Note and $3.0 Million Note to pay a $500,000 yieldenhancement on March 31, 2005 or increase, effective April 1, 2005, by$1,000,000 the principal amount of $7.5 Million Note issued to SSL inconnection with the Silipos acquisition (the $500,000 yield enhancement or the$1,000,000 increase in principal are each referred to as the “ProtectionPayment”). See “—Long-term Debt”.

The provision for incometaxes decreased to approximately $158,000 in 2004 from approximately $167,000in 2003. Prior to the adoption of SFAS No. 142, we would not have needed avaluation allowance for the portion of the net operating losses equal to theamount of tax-deductible goodwill and trade names amortization expected tooccur during the carryforward period of the net operating losses based on thetiming of the reversal of these taxable temporary differences. As a result ofthe adoption of SFAS No. 142, the reversal will not occur during thecarryforward period of the net operating losses. Therefore, we recorded adeferred income tax expense of approximately $154,000 and approximately$158,000 during the years ended December 31, 2004 and 2003, respectively.The deferred income tax expense recorded in 2003 was partially offset by therecognition of a deferred tax benefit of approximately $6,000 related to analternative minimum tax carryforward. Additionally, our foreign tax provisionincreased to approximately $4,000 in 2004 from $119 in 2003 because we hadpre-tax income from foreign operations in 2004.

**Liquidity and Capital Resources**

Working capital as of December 31, 2005 wasapproximately $9,204,000, as compared to approximately $1,387,000 as of December 31,2004. Cash balances at December 31, 2005 were approximately $18,829,000,an increase of approximately $14,919,000, from approximately $3,910,000 at December 31,2004. The increase in working capital at December 31, 2005 is attributableto the receipt of the proceeds from the underwritten public offering of stocktotalling approximately $33,975,000, less expenses paid to date ofapproximately $4,665,000, the repayment of the $7.5 Million Note and the $3.0Million Note plus interest (including the Protection Payment, net of the RefundProvision), the payment of $900,000 to satisfy our obligation under the Silipospurchase agreement, and cash payments for purchases of property and equipmentof approximately $990,000. The increase in cash at December 31, 2005, ascompared to December 31, 2004, is primarily attributable to the remainingnet proceeds from the public offering.

Net cash provided by operating activities wasapproximately $3,867,000 for the year ended December 31, 2005. Net cashprovided by operating activities was approximately $648,000 in the year ended December 31,2004. Net cash provided by operations in the year ended December 31, 2005resulted from decreases in accounts receivable, inventory and prepaid expenses,and an increase in accounts payable and other current liabilities. The net cashused in operating activities in the year ended December 31, 2004 resultedprimarily from increases in inventory levels, and prepaid expenses and othercurrent assets, and increases in accounts receivable and a decrease in accountspayable and other current liabilities.

Net cash used in investing activities in the yearended December 31, 2005 was approximately $2,328,000. Net cash used ininvesting activities was approximately $6,994,000 in the year ended December 31,2004. Net cash used in investing activities in the year ended December 31,2005 reflects the cash payment for amounts related to the acquisition ofSilipos of approximately $1,277,000, of which $900,000  represents the settlement of the obligationunder the Silipos stock purchase agreement to pay SSL $1 million if we did notacquire Poly-Gel before March 31, 2006, and purchases of property and equipment of approximately $990,000,principally the investment in our new information technology platform,partially offset by the sale of certain property and equipment of approximately$70,000. Net cash used in investing activities in the year ended December 31,2004 represented the cash utilized to purchase Silipos (net of cash acquired)of $5,331,000, the investment in property and equipment of approximately 

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$1,198,000, principallyour new information technology platform, and approximately $466,000, whichrepresented the payment of certain deferred contingent consideration withrespect to the Benefoot transaction.

We generated cash flows from financing activities ofapproximately $13,406,000, which represents the gross proceeds from the publicoffering of common stock of approximately $33,975,000, less expenses paidthrough December 31, 2005 of approximately $4,665,000, less the repaymentof the Subordinated Notes ($5.5 million) plus interest, the $7.5 Million Noteplus interest, and the $3.0 Million Note plus interest. Net cash from financingactivities was approximately $4,702,000 in the year ended December 31,2004 which reflects the proceeds from the issuance of the Subordinated Notes,$1,600 received from the exercise of stock options, and the repayment of the$800,000 promissory notes issued in connection with the Benefoot acquisition inMay 2004.

Our ability to fund working capital requirements andmake acquisitions and anticipated capital expenditures and satisfy our debtobligations will depend on our future performance, which is subject to generaleconomic, financial and other factors, some of which are beyond our control, aswell as the availability to us of other sources of liquidity. We believe thatbased on current levels of operations and anticipated growth, our cash flowfrom operations will be adequate for at least the next twelve months to fundour working capital requirements, and anticipated capital expenditures.

Pursuant to the terms of our outstanding $7.5 MillionNote, on March 15, 2005 we notified SSL, the holder of the $7.5 MillionNote, of our election to increase the principal amount of such note, effectiveas of April 1, 2005, by $1,000,000 rather than make an additional paymentof $500,000 by March 31, 2005. On March 31, 2005, we entered into aSettlement Agreement and limited release with SSL, pursuant to which the purchaseprice of Silipos was reduced by $232,000. The reduction in the purchase pricewas satisfied by a reduction in the principal balance of the $7.5 Million Note.The $7.5 Million Note, which had a revised face value of $8,268,000, wasscheduled to mature on March 31, 2006.

The Silipos purchase agreement provides that if weacquire Poly-Gel for less than $4,500,000 prior to March 31, 2006, andliabilities and damages relating to claims brought by Poly-Gel, Silipos’  former supplier of mineral based gels, arisingout of the supply agreement between Silipos and Poly-Gel dated August 20,1999, the manufacture, marketing or sale of products made from gel notpurchased from Poly-Gel, alleged misappropriation of trade secrets orother confidential information (including gel formulation) of Poly-Gel, as wellas any other alleged violations of the supply agreement (the “PotentialPoly-Gel Claims”), do not exceed $2,000,000, we are obligated, pursuant to theterms of the Silipos purchase agreement, to pay SSL an additional amount of$4,500,000 less the purchase price paid for Poly-Gel which could resultin a payment to SSL of up to $4.5 million. Our aggregate liability to SSL underthis provision of the Silipos purchase agreement could be as high as $4.5million.

Under the terms of the Silipos stock purchaseagreement, if we do not acquire Poly-Gel prior to March 31, 2006, and theamount of any liabilities for Potential Poly-Gel Claims does not exceed$2,500,000, we were obligated to pay SSL $1,000,000, plus an amount not toexceed $500,000, for certain costs, if incurred by SSL, in defense of any suchPotential Poly-Gel Claims. As part of the settlement of the $7.5 Million Noteand the $3.0 Million Note, we recorded and paid $900,000 as full settlement ofthe $1.0 million obligation. SSL remains obligated under the Silipos stockpurchase agreement for certain Potential Poly-Gel Claims, if any.

In June 2005, we reached a further settlementwith SSL to repay the acquisition indebtedness incurred and certain otherobligations due under the Silipos stock purchase agreement. Additionally, weagreed to satisfy our obligations under the Silipos stock purchase agreement topay SSL Holdings, Inc. $1.0 million by March 31, 2006 if we did notacquire Poly-Gel by such date.

On July 15, 2005, we consummated the settlementwith SSL to repay the acquisition indebtedness incurred and certain otherobligations due under the Silipos stock purchase agreement. We paid off the 

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$7.5 Million Note, whichhad a face value of $8.268 million, plus accrued interest of approximately$248,000 ($224,000 through June 30, 2005), the $3.0 Million Note plusaccrued interest of approximately $75,000 ($69,000 through June 30, 2005)less the recoupment of the Refund Provision (as defined in Note 7 to the ConsolidatedFinancial Statements, “Long Term Debt”) of $0.5 million. In consideration ofour earlier than scheduled repayment to SSL of the $7.5 Million Note, the $3.0Million Note and the $1.0 million payment, SSL provided us with a $100,000discount with respect to the $7.5 Million Note and a $100,000 discount withrespect to the $1.0 million payment.

In the year ended December 31,2005, we generated a net loss after income taxes of approximately $4,557,000,which included loss on impairment of certain identifiable intangible assetstotalling $2,102,000. Additionally, we incurred compensation charges for stockawards, stock options granted to consultants, modifications to stock optionagreements and acceleration of vesting of certain stock awards and optionswhich in the aggregate were approximately $3,045,000. These charges werepartially offset by the non-cash gain of $1,750,000 for the change in theestimated fair value of the Put Option. In the year ended December 31,2004, we generated earnings after taxes of approximately $375,000, whichincluded a non-cash gain of $605,000 for the change in the estimated fair valueof the Put Option. In the year ended December 31, 2003, we did not haveearnings after taxes. There can be no assurance that our business will generatecash flow from operations sufficient to enable us to fund our liquidity needs,which include the Convertible Notes in the principal amount of $14,439,000 thatmature in August 2006. In such event, we would likely need to raiseadditional funds through public or private equity, borrowings from banks orother institutional lenders or debt financings. In addition, our growthstrategy contemplates our making acquisitions, and we may need to raiseadditional funds for this purpose. We may finance acquisitions of othercompanies or product lines in the future from existing cash balances, throughborrowings from banks or other institutional lenders, and/or the public orprivate offerings of debt or equity securities. We cannot assure you that anysuch funds will be available to us on favorable terms, or at all.

***Changes in Significant Balance Sheet Accounts—December 31,2005***

Accounts receivable, net, decreased from approximately$7,056,000 at December 31, 2004, to approximately $5,182,000 at December 31,2005, a decrease of approximately $1,874,000. The decrease is primarilyattributable to a decrease in accounts receivable relating to Silipos fromapproximately $3,324,000, net at December 31, 2004 to approximately$1,856,000, net at December 31, 2005, and an increase in provision fordoubtful accounts from approximately $380,000 at December 31, 2004, to$430,000 at December 31, 2005. The difference in accounts receivablebalances relating to Silipos is attributable to the decrease in fourth quartersales, which were approximately $3,863,000 in 2005, as compared toapproximately $5,558,000 in the fourth quarter of 2004, due partially to theloss of certain orthopedic customers in the 2005 quarter, as well as thereduction in the skincare sales in the three months ended December 31,2005, as compared to the three months ended December 31, 2004 whichreflected very strong skincare sales.

Inventories, net, decreased from approximately$4,846,000 at December 31, 2004, to approximately $4,123,000 at December 31,2005, a decrease of approximately $723,000, which was attributable partially tothe net increase in the reserve for excess or obsolete inventory fromapproximately $369,000 at December 31, 2004 to approximately $564,000 at December 31,2005 and partly to our focus to reduce certain excess inventory levels,principally in the distributed products group of our orthopedic segment.

Prepaid expenses and other current assets decreasedfrom approximately $1,388,000 at December 31, 2004, to approximately$820,000 at December 31, 2005. The 2004 balances included $418,000incurred in connection with the registration statement of our underwrittenpublic offering which were charged to additional paid in capital upon thecompletion of the offering. This was partially offset by prepaid rent, suppliesand prepaid conventions totalling $118,000.

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Property and equipment, net, decreased fromapproximately $7,181,000 at December 31, 2004, to approximately $7,035,000at December 31, 2005, a decrease of approximately $146,000. The change wasprimarily attributable to the investment in property and equipment ofapproximately $990,000, offset by depreciation expense of approximately$1,011,000 in the year ended December 31, 2005, and the sale ofcertain property and equipment that had a net book value of approximately$60,000. We do not currently anticipate significant additions to property andequipment in 2006 for our existing business, other than items purchased for eitherproduction or administrative purposes in the normal course of business.

Identifiable intangible assets, net, decreased fromapproximately $9,343,000 at December 31, 2004, to approximately $6,604,000at December 31, 2005, a decrease of approximately $2,739,000, $637,000 ofwhich was attributable to amortization expense recorded for the year ended December 31,2005 and $2,102,000 of which was attributable to the provision for impairmentin connection with certain identifiable intangible assets.

Other assets decreased from approximately $762,000 at December 31,2004, to approximately $460,000 at December 31, 2005, a decrease ofapproximately $302,000. The change was primarily attributable to theamortization of deferred debt acquisition costs of approximately $193,000, andthe write-off of the unamortized portion of debt placement costs ofapproximately $58,000 and the write-off of certain other assets totalling$166,000 for the year ended December 31, 2005, partially offset bydeposits of approximately $100,000 with an investment banking firm engaged tofind acquisition targets.

Goodwill increased from approximately $13,321,000 at December 31,2004, to approximately $14,119,000 at December 31, 2005, an increase ofapproximately $798,000. The increase was attributable to the payment of$900,000 as the full settlement of our obligation under the Silipos stockpurchase agreement to pay SSL Holdings, Inc., $1 million if we did notacquire Poly-Gel by March 31, 2006, and which was accounted for under SFASNo. 141. The settlement agreement was consummated and payment was made on July 15,2005. Additionally, we recorded professional fees of approximately$66,000 with respect to the acquisition and a write-down totallingapproximately $64,000 of certain deferred tax assets and property and equipmentto their fair value. These increases were partially offset by a $232,000reduction in the purchase price paid by us to SSL because Silipos did notsatisfy certain minimum working capital requirements as of the closing date ofthe acquisition pursuant to the Silipos purchase agreement.

Accounts payable increased from approximately$1,140,000 at December 31, 2004, to approximately $1,281,000 at December 31,2005, an increase of approximately $141,000 which was consistent with our levelof operation.

Other current liabilities decreased from approximately$4,265,000 at December 31, 2004, to approximately $3,675,000 at December 31,2005, a decrease of approximately $590,000. The change was primarilyattributable to the payment of certain accrued liabilities that existed at December 31,2004 related to the acquisition of Silipos (approximately $373,000) and ourunderwritten public offering (approximately $403,000) and accrued interest withrespect to Silipos-related debt (approximately $144,000). Additionally, accruedliabilities for Silipos decreased by approximately $453,000, accrued bonusesdecreased by approximately $95,000, accrued franchise taxes decreased byapproximately $50,000 and accrued shipping decreased by approximately $65,000; these decreases were partiallyoffset by increases in certain accrued liabilities such as professional fees(approximately $494,000) and accrued severance (approximately $335,000).

Deferred income taxespayable decreased by approximately $315,000, from approximately $1,640,000 at December 31,2004, to approximately $1,325,000 at December 31, 2005. The decrease wasprimarily attributable to the income tax effect of the excess of amortizationrecorded for financial statement purposes over amortization deducted for incometax purposes plus the deferred tax effect (benefit) of the provision forimpairment of certain identifiable intangible assets recorded for financialstatement purposes.

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***Changes in Significant Balance Sheet Accounts—December 31,2004***

Accounts receivable, net, increased from approximately$3,628,000 at December 31, 2003 to approximately $7,056,000 at December 31,2004, an increase of approximately $3,428,000. The increase is primarilyattributable to the accounts receivable acquired in the Silipos acquisition ofapproximately $3,366,000, (approximately $3,324,000 at December 31, 2004),as well as a slight increase in accounts receivable from our other business,due mostly to lower collections in the year ended December 31, 2004.

Inventories, net, increased from approximately$2,497,000 at December 31, 2003 to approximately $4,846,000 at December 31,2004, an increase of approximately $2,349,000. Inventory acquired in theSilipos acquisition of approximately $2,111,000 (approximately $1,973,000 at December 31,2004) accounted for most of the increase with the balance being attributable toincreased purchases of distributed products (including shoes) to take advantageof volume pricing and to build inventory levels for flexibility.

Prepaid expenses and other increased fromapproximately $495,000 at December 31, 2003 to approximately $1,388,000 atDecember 31, 2004, an increase of approximately $893,000. The increase wasprimarily attributable to prepaid expenses of Silipos of $327,000 atacquisition (approximately $349,000 at December 31, 2004), as well ascertain costs associated with the registration statement filed by us for theproposed offering of common stock.

Property and equipment, net, increased fromapproximately $2,496,000 at December 31, 2003 to approximately $7,181,000at December 31, 2004, an increase of approximately $4,685,000. Theincrease was attributable to property and equipment acquired in the Silipostransaction of approximately $4,059,000 (approximately $3,995,000 at December 31,2004), plus investment in property and equipment in the year ended December 31,2004 of approximately $1,198,000 primarily attributable to the investment inour new technology platform, partially offset by depreciation expense ofapproximately $604,000 in 2004.

Identifiable intangible assets, net, increased fromapproximately $3,960,000 at December 31, 2003 to approximately $9,343,000at December 31, 2004, an increase of approximately $5,383,000. Thisincrease was comprised of identifiable intangible assets of approximately$5,732,000 recorded with respect to the acquisition of Silipos, offset byamortization expense of approximately $349,000 recorded for the year ended December 31,2004.

Other assets decreased from approximately $877,000 at December 31,2003 to approximately $762,000 at December 31, 2004, a decrease ofapproximately $115,000. The change was primarily attributable to amortizationof deferred debt acquisition costs of approximately $199,000, partially offsetby the debt acquisition costs capitalized in connection with the sale of the SubordinatedNotes of approximately $76,000.

Goodwill increased from approximately $4,536,000 at December 31,2003 to approximately $13,321,000 at December 31, 2004, an increase ofapproximately $8,785,000, of which approximately $8,621,000 was associated withthe Silipos acquisition and approximately $164,000 was associated with theperformance-based contingent consideration related to the Benefoottransaction.

Accounts payable increased from approximately$1,133,000 at December 31, 2003, to approximately $1,140,000 at December 31,2004, an increase of approximately $7,000, which represented the net effect ofthe accounts payable assumed in the Silipos acquisition of approximately$595,000 (approximately $304,000 at December 31, 2004), partially offsetby a decrease in accounts payable of approximately $588,000 (includingSilipos), which was primarily the result of our taking advantage of certaindiscounts for early payments.

Other current liabilities increased from approximately$2,114,000 at December 31, 2003 to approximately $4,265,000 at December 31,2004, an increase of approximately $2,151,000. The change was primarilyattributable to accrued liabilities associated with Silipos of approximately$1,419,000 

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(approximately $1,498,000at December 31, 2004) plus accrued transaction costs relating to theSilipos acquisition, the cost of approximately $776,000 relating to the filingof a registration statement in connection with our proposed offering of commonstock, and accrued interest of approximately $144,000, partially offset by therepayment of deferred contingent consideration of approximately $302,000 at December 31,2003, and a reduction of accrued rebates of approximately $52,000 at December 31,2004, compared to December 31, 2003.

Deferred income taxespayable increased by approximately $1,139,000 at December 31, 2004 ascompared to December 31, 2003, from approximately $501,000 toapproximately $1,640,000, primarily as the result of deferred income taxesassociated with intangible assets primarily relating to the acquisition ofSilipos.

***Contractual Obligations***

Certainof our facilities and equipment are leased under noncancelable operating andcapital leases. Additionally, as discussed below, we have certain long-term andshort-term indebtedness. The following is a schedule, by fiscal year, of futureminimum rental payments required under current operating and capital leases anddebt repayment requirements as of December 31, 2005 measured from the endof our fiscal year (December 31): 

| ** **                             | ** ** | **Payments due By Period (In thousands)** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|
| **Contractual Obligations**       | ** ** | ** **                                                         | ** ** | **Total** | ** ** | **Less than    Year** | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **More than  5 Years** | ** ** |
| Operating Lease  Obligations           |       | $                                                                  | 8,688      |   |   | $ | 767 |   |   | $ | 2,317 |   | $ | 1,448 |   |   | $ | 4,156 |   |   |
| Capital Lease  Obligations             |       | 6,316                                                              |       |   | 412 |   |   | 854 |   | 896 |   |   | 4,154 |   |   |
| Interest on  Long-term Debt            |       | 385                                                                |       |   | 385 |   |   | — |   | — |   |   | — |   |   |
| Convertible Notes  due August 31, 2006 |       | 14,439                                                             |       |   | 14,439 |   |   | — |   | — |   |   | — |   |   |
| Severance  Obligations                 |       | 335                                                                |       |   | 335 |   |   | — |   | — |   |   | — |   |   |
| Pension  Obligations                   |       | 40                                                                 |       |   | 40 |   |   | — |   | — |   |   | — |   |   |
| Total                                  |       | $                                                                  | 30,203     |   |   | $ | 16,378 |   |   | $ | 3,171 |   | $ | 2,344 |   |   | $ | 8,310 |   |   |
|                                        |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Long-term Debt***

On October 31,2001, we completed the sale of $14,589,000 principal amount of our 4%convertible subordinated notes due August 31, 2006 (the “Convertible Notes”),in a private placement. Langer Partners, whose sole manager and voting memberis Warren B. Kanders, our Chairman of the Board of Directors since November 12,2004, holds $2,500,000 principal amount of these Convertible Notes. TheConvertible Notes are convertible into shares of our common stock at aconversion price of $6.00 per share (equal to the market value of our stock on October 31,2001), subject to anti-dilution protections in the event that, among otherthings, we issue common stock or equity securities convertible into orexchangeable for common stock at a price below the conversion price of theConvertible Notes, and are subordinated to existing or future seniorindebtedness of the Company. Among other provisions, we may, at our option,call, prepay, redeem, repurchase, convert or otherwise acquire (collectively, “Call”)the Convertible Notes, in whole or in part after August 31, 2003. If weelect to Call any of the Convertible Notes, the holders of the ConvertibleNotes may elect to convert the Convertible Notes into our common stock.Interest is payable semi-annually on the last day of June and December. OnJune 20, 2005, $150,000 of the Convertible Notes were converted into25,000 shares of common stock in accordance with their terms. Interest expenseon the Convertible Notes for years ended December 31, 2005, 2004 and 2003was $580,377, $583,560 and $583,560, respectively.

Wereceived net proceeds of $13,668,067 from the offering of the ConvertibleNotes. The cost of raising these proceeds was $920,933, which is beingamortized over the life of the Convertible Notes. The amortization of thesecosts for the years December 31, 2005 and 2004 were approximately $193,000and 

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approximately $194,000, respectively, and wereincluded in interest expense in the related consolidated statements ofoperations.

Weissued $1,800,000 in promissory notes in connection with the acquisition ofBenefoot. $1,000,000 of the notes were repaid on May 6, 2003 and thebalance was repaid on May 6, 2004. Related interest expense for the yearended December 31, 2004 was $11,111.

On September 30, 2004, we completed theacquisition of all of the outstanding stock of Silipos (see Note 2(c)—”Acquisitionof Silipos” of the our financial statements included in Item 8 below). Inconnection with the acquisition of Silipos, we issued:

·       the Subordinated Notes inthe principal amount of $5,500,000 to ten accredited investors;

·       the $7.5 Million Note, aspreviously defined; and

·       the $3.0 Million Note, aspreviously defined.

TheSubordinated Notes were issued to fund the cash portion of the purchase pricefor Silipos. Langer Partners held $750,000 principal amount of theseSubordinated Notes. As part of such issuance, we also issued warrants topurchase 110,000 shares of our common stock at an exercise price of $0.02 pershare, subject to adjustments under certain circumstances, which warrants areexercisable until September 30, 2009, commencing on September 30,2005. The fair value of the warrants at September 30, 2004 was determinedto be $735,900, using the Black-Scholes pricing model and the followingassumptions: risk free interest rate of 2.89%, dividend of 0%, volatility of83%, and an expected life of three years and was recorded as debt discount.Such amount was originally being amortized over the term of the SubordinatedNotes, and recorded as an additional interest expense. Additionally, we issued10,000 warrants, under the same terms as described above, to anunaffiliated third party for placing the Subordinated Notes, which warrantshave a fair value of $75,800, using the Black-Scholes pricing model and thesame assumptions used to value the other warrants. We recognized amortizationexpense of $106,386 and $12,252 with respect to the debt discount (warrants)and debt placement fees for the year ended December 31, 2005,respectively, which was included in interest expense in the consolidatedstatement of operations, all of which was recognized in the six months ended June 30,2005. There were no such amounts in the prior year periods. We incurredinterest expense of $175,389 with respect to the Subordinated Notes, all ofwhich was recorded as of June 30, 2005. We repaid the Subordinated Notesplus accrued interest, which totalled $5,675,389, on June 15, 2005, with aportion of the net proceeds from our public offering of common stock (see Note 6,“Public Offering”). Accordingly, as of June 30, 2005, we recognized$572,116 with respect to the unamortized debt discount (fair value of thewarrants) and the unamortized debt placement fees of $57,973, which is includedin interest expense on the consolidated statement of operations for the yearended December 31, 2005.

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The $7.5 Million Note was secured by the pledge of thestock of Silipos and was subject to increase pursuant to a Protection Paymentas defined in Note 1 (b). Both the $7.5 Million Note and the $3.0 Million Noteprovided for semi-annual payments of interest at the rate of 5.5% per annumwith the first payments due and paid February 1, 2005. The interest rateon the $7.5 Million Note increased from 5.5% to 7.5% on April 1, 2005. Werecorded the $7.5 Million Note and the $3.0 Million Note at their face value,which represented the fair value of the notes on their date of issuance (September 30,2004). We adjusted the carrying value of the $7.5 Million Note and the $3.0Million Note to $7.986 million and $2.737 million, respectively, at December 31,2004, and further adjusted the carrying value of the notes as of January 1,2005 to $7.723 million and $3.0 million, respectively, upon our determinationto follow EITF No. 86-15 with respect to the $7.5 Million Note (seeNote 1 (b)). On March 31, 2005, we entered into a settlement agreement(the “Settlement Agreement”) and limited release among the parties to theSilipos purchase agreement. Under the terms of the Settlement Agreement, theparties exchanged mutual releases and agreed to a $232,000 reduction in the purchaseprice previously paid by us to SSL because Silipos did not satisfy certainminimum working capital requirements as of the closing date of the acquisitionpursuant to the Silipos purchase agreement. The reduction to the purchase pricewas satisfied by amending and restating the $7.5 Million Note, which wasoriginally due on March 31, 2006 to reflect the reduction in the purchaseprice of $232,000. In addition, the $7.5 Million Note was amended and restatedto reflect our election on March 15, 2005, in accordance with its terms,to increase the principal amount effective, April 1, 2005, by the$1,000,000 Protection Payment rather than to make an additional cash payment of$500,000 by March 31, 2005. As amended and restated and effective as of April 1,2005, the face value of the $7.5 Million Note was $8,268,000. Additionally,under the terms of the Settlement Agreement, the parties also agreed to amendand restate the $3.0 Million Note, which was originally due on December 31,2009. The $3.0 Million Note was amended and restated to provide that it was tobe reduced by $500,000 if the $7.5 Million Note was repaid in full on or beforeMay 31, 2005, and would be further reduced by an additional $500,000 ifboth the $3.0 Million Note and the $7.5 Million Note have been repaid in fullon or before March 31, 2006. We determined that the Protection Paymentrepresented a term-extending option that did not meet the criteria forbifurcation under SFAS No. 133 in that there is no provision for netsettlement. We followed the guidance of EITF No. 86-15 whichaddresses the calculation of interest cost on increasing-rate debt and requiresthat interest costs should be determined using the interest method based on theestimated outstanding term of the debt (12 months from issuance). Accordingly,we recorded additional interest expense of approximately $677,000 (in excess ofthe initial coupon rate of 5.5%, 7.5% after April 1, 2005), net of the$100,000 discount negotiated as part of the settlement, discussed below, toincrease the carrying value of the $7.5 Million Note to the payoff amount of$8,168,000 at June 30, 2005, which is reflected as interest expense in theconsolidated statement of operations for the year ended December 31, 2005.

Under its original terms, the $3.0 Million Note wouldbe reduced by half of any Protection Payment actually made pursuant to the $7.5Million Note if both the $7.5 Million Note and the $3.0 Million Note are repaidprior to March 31, 2006. We determined that the right to reduce the $3.0Million Note by 50% of the Protection Payment made on the $7.5 Million Note ifboth the $7.5 Million Note and the $3.0 Million Note were repaid in fullby March 31, 2006, represented a call option (“Refund Provision”) that isan embedded derivative that met the criteria under SFAS No. 133 forbifurcation and separate accounting treatment. The exercise price pursuant tothe call option under the $3.0 Million Note is equal to the principal amount ofthe $3.0 Million Note less any refund we are entitled to under the RefundProvision, based upon whether or not the $7.5 Million Note has been repaid andthe date of exercise. We concluded that the Refund Provision embedded in the$3.0 Million Note is not clearly and closely related to the $3.0 Million Note becausethe $3.0 Million Note could be settled in such a way that the holder of suchnote would not recover substantially all of its investment. After reaching thisdetermination, we followed the guidance of DIG B-16, which concludes thatcall options embedded in debt that are not considered clearly and closelyrelated to the debt itself are net settleable and thus require bifurcation. 

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Accordingly, the RefundProvision was recorded at fair value at issuance date (September 30,2004), and was subsequently marked to market through earnings. The fair valueof the Refund Provision embedded in the $3.0 Million Note was determined to bede minimis and accordingly, no asset was recorded at September 30, 2004.Based upon a fair market value analysis to an unrelated third party marketparticipant, the Refund Provision was valued at $500,000 at June 30, 2005and was recorded as a current asset (call option) and a non-cash gain on thechange in the fair value of a call option. In making this determination,consideration was given primarily to the fact that we had completed ourunderwritten public offering of common stock on June 15, 2005, had raisedsufficient equity, after related expenses, to repay both the $7.5 Million Noteand the $3.0 Million Note prior to March 31, 2006, and reached anagreement in principal with SSL (discussed below) to repay the notes. Werealized $500,000 with respect to the Refund Provision upon the repayment ofthe $7.5 Million Note and the $3.0 Million Note in July 2005, which wasrecorded as a reduction in interest expense in the consolidated statement ofoperations for the year ended December 31, 2005, which was offset by thereversal of the non-cash gain on the change in the fair value of the calloption previously recorded.

We incurred interest expense of approximately $959,000(inclusive of approximately $677,000 of additional interest expense in excessof the initial coupon rate of 5.5% (7.5% after April 1, 2005)) and $89,000with respect to the $7.5 Million Note and the $3.0 Million Note, respectively,for the year ended December 31, 2005.

In June 2005, wereached a further settlement with SSL to repay the acquisition indebtednessincurred and certain other obligations we have under the Silipos stock purchaseagreement. Additionally, we agreed to satisfy our obligations under the Siliposstock purchase agreement to pay SSL Holdings, Inc. $1.0 million by March 31,2006 if we did not acquire Poly-Gel by such date. In consideration of ourearlier than scheduled repayment of the $7.5 Million Note, the $3.0 MillionNote, the $1.0 million payment, SSL provided us with a $100,000 discount withrespect to the $7.5 Million Note and a $100,000 discount with respect to the$1.0 million payment. The agreement was consummated and payment was made on July 15,2005.

**Seasonality**

Revenue derived from oursales of orthotic devices in North America has historically been significantlyhigher in the warmer months of the year, while sales of orthotic devices by ourUnited Kingdom subsidiary have historically not evidenced any seasonality.Other factors which can result in quarterly variations include the timing andamount of new business generated by us, the timing of new productintroductions, our revenue mix, the timing of additional selling, general andadministrative expenses to support the anticipated growth and development ofnew business units and the competitive and fluctuating economic conditions inthe orthopedic and skincare industries.

**Inflation**

We have in the past beenable to increase the prices of our products or reduce overhead costssufficiently to offset the effects of inflation on wages, materials and otherexpenses, and anticipate that we will be able to continue to do so in thefuture.

**RecentlyIssued Accounting Pronouncements**

In November 2004, FASB issued SFAS No. 151, “InventoryCosts.”  SFAS No. 151 amends theguidance in Chapter 4 of Accounting Research Bulletin No. 43, “InventoryPricing,” to clarify the accounting for amounts of idle facility expense,freight, handling costs and wasted material. SFAS No. 151 requires thatthese types of items be recognized as current period charges as they occur. Theprovisions of SFAS No. 151 are effective for inventory costs incurredduring fiscal years beginning after June 15, 2005. 

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We are currently still evaluatingthe impact of adoption of SFAS No. 151 on our consolidated financialstatements. The adoption of this new accounting pronouncement is not expectedto have a material impact on our consolidated financial statements.

In December 2004, the FASB issued SFAS No. 123(R),“Share-Based Payment,” revising SFAS No. 123, “Accounting for Stock-BasedCompensation,” and superceding Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees.” This statement focuses primarily onaccounting for transactions in which an entity obtains employee services inshare-based payment transactions. SFAS No. 123(R) requires that thefair value of such equity instruments be recognized as expense in thehistorical financial statements as services are performed. Prior to SFAS No. 123(R),only certain pro-forma disclosures of fair value were required. As a result ofthe Securities and Exchange Commission’s April 2005 extension of thecompliance date for SFAS No. 123(R), SFAS No. 123(R) will beeffective for us as of the beginning of the 2006 fiscal year. The adoption ofthis new accounting pronouncement is expected to have a material impact on ourconsolidated financial statements when we grant stock options and stock awardsin the future.

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections,” whichchanges the requirements for the accounting and reporting of a change inaccounting principle and error corrections. SFAS No. 154 applies to allvoluntary changes in accounting principle, as well as to changes required by anaccounting pronouncement that does not include specific transition provisions.SFAS No. 154 is effective for accounting changes and corrections of errorsmade in fiscal years beginning after December 15, 2005. Starting in 2006,we will apply the provisions of SFAS No. 154 on a prospective basis whenapplicable.

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**Unaudited Quarterly Financial Data**

Setforth below is certain unaudited quarterly financial data for each of the ourlast eight quarters, and such data expressed as a percentage of our revenue forthe respective quarters. The information has been derived from unauditedfinancial statements that, in the opinion of management, include alladjustments (consisting only of normal recurring adjustments) necessary tofairly present such quarterly information in accordance with generally acceptedaccounting principles. The operating results for any quarter are notnecessarily indicative of the results to be expected for any future period.

| ** **                                                  | ** ** | **Mar. 31,  2004** | ** ** | **June 30,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Dec. 31,  2004(1)** | ** ** | **Mar. 31,  2005** | ** ** | **June 30,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **Dec. 31,  2005(2)** | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------|------------|----------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------|------------|----------------------------|------------|
| Sales                                                       |       |                    | $          | 5,764                   |       |                     |       | $                          | 6,547      |                    |       |                    | $          | 6,285                    |       |                       | $          | 11,530 |   | $ | 10,397 |   | $ | 10,052 |   |   | $ | 10,531 |   |   | $ | 9,162 |   |
| Cost of sales                                               |       |                    | 3,791      |                    |       |                     | 4,160      |                       |       |                    | 4,007      |                    |       | 6,065                    |       | 5,502                      |       | 5,486 |   |   | 5,758 |   |   | 5,477 |   |
| Gross profit                                                |       |                    | 1,973      |                    |       |                     | 2,387      |                       |       |                    | 2,278      |                    |       | 5,465                    |       | 4,895                      |       | 4,566 |   |   | 4,773 |   |   | 3,685 |   |
| Operating expenses:                                         |       |                    |       |                    |       |                     |       |                       |       |                    |       |                    |       |                     |       |                       |       |   |   |   |   |   |   |   |   |
| Provision for  impairment of identifiable intangible assets |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       | —                   |       | —                     |       | — |   |   | — |   |   | 2,102 |   |
| Selling                                                     |       |                    | 807        |                    |       |                     | 786        |                       |       |                    | 790        |                    |       | 2,567                    |       | 1,939                      |       | 2,015 |   |   | 1,747 |   |   | 1,702 |   |
| General and  administrative                                 |       |                    | 1,174      |                    |       |                     | 1,344      |                       |       |                    | 1,259      |                    |       | 2,150                    |       | 2,265                      |       | 2,582 |   |   | 2,421 |   |   | 4,990 |   |
| Research and  development.                                  |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       | 49                       |       | 130                        |       | 110 |   |   | 112 |   |   | 117 |   |
| Total operating expenses                                    |       |                    | 1,981      |                    |       |                     | 2,130      |                       |       |                    | 2,049      |                    |       | 4,766                    |       | 4,334                      |       | 4,707 |   |   | 4,280 |   |   | 8,911 |   |
| (Loss) income from  operations                              |       |                    | (8         | )                       |       |                     | 257        |                       |       |                    | 229        |                    |       | 699                      |       | 561                        |       | (141 | ) |   | 493 |   |   | (5,226 | ) |
| Interest and other  income (expense)                        |       |                    | (161       | )                       |       |                     | (155       | )                          |       |                    | (147       | )                       |       | (563                     | )          | (827                       | )          | (1,569 | ) |   | (174 | ) |   | (125 | ) |
| Change in fair  value of Put Option.                        |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       | 605                      |       | 1,750                      |       | — |   |   | — |   |   | — |   |
| Change in fair  value of Call Option.                       |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       | —                   |       | —                     |       | 500 |   |   | — |   |   | — |   |
| Change in fair  value of Protection Payment                 |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       | (223                     | )          | —                     |       | — |   |   | — |   |   | — |   |
| (Loss) income before taxes                                  |       |                    | (169       | )                       |       |                     | 102        |                       |       |                    | 82         |                    |       | 518                      |       | 1,484                      |       | (1,210 | ) |   | 319 |   |   | (5,351 | ) |
| Provision for (benefit from) income taxes                   |       |                    | 50         |                    |       |                     | 25         |                       |       |                    | 38         |                    |       | 45                       |       | 39                         |       | 48 |   |   | 83 |   |   | (371 | ) |
| Net (loss) income                                           |       |                    | $          | (219                    | )          |                     |       | $                          | 77         |                    |       |                    | $          | 44                       |       |                       | $          | 473 |   | $ | 1,445 |   | $ | (1,258 | ) |   | $ | 236 |   |   | $ | (4,980 | ) |
| Net (loss) income per share                                 |       |                    |       |                    |       |                     |       |                       |       |                    |       |                    |       |                     |       |                       |       |   |   |   |   |   |   |   |   |
| Basic                                                       |       |                    | $          | (.05                    | )          |                     |       | $                          | .02        |                    |       |                    | $          | .01                      |       |                       | $          | .11 |   | $ | .33 |   | $ | (.24 | ) |   | $ | .02 |   |   | $ | (.51 | ) |
| Diluted                                                     |       |                    | $          | (.05                    | )          |                     |       | $                          | .02        |                    |       |                    | $          | .01                      |       |                       | $          | .10 |   | $ | .22 |   | $ | (.24 | ) |   | $ | .02 |   |   | $ | (.51 | ) |

 

59

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| ** **                                                  | ** ** | **Mar. 31,  2004** | ** ** | **June 30,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Dec. 31,  2004(1)** | ** ** | **Mar. 31,  2005** | ** ** | **June 30,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **Dec. 31,  2005(2)** | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------|------------|----------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------|------------|----------------------------|------------|
| Sales                                                       |       |                    | 100.0      | %                       |       |                     | 100.0      | %                          |       |                    | 100.0      | %                       |       |                     | 100.0      | %                          |       |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |
| Cost of sales                                               |       |                    | 65.8       |                    |       |                     | 63.5       |                       |       |                    | 63.8       |                    |       |                     | 52.6       |                       |       |   | 52.9 |   |   |   | 54.6 |   |   |   | 54.7 |   |   |   | 59.8 |   |   |
| Gross profit                                                |       |                    | 34.2       |                    |       |                     | 36.5       |                       |       |                    | 36.2       |                    |       |                     | 47.4       |                       |       |   | 47.1 |   |   |   | 45.4 |   |   |   | 45.3 |   |   |   | 40.2 |   |   |
| Operating  expenses:                                        |       |                    |       |                    |       |                     |       |                       |       |                    |       |                    |       |                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Provision for  impairment of identifiable intangible assets |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       |                     | —     |                       |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 22.9 |   |   |
| Selling                                                     |       |                    | 14.0       |                    |       |                     | 12.0       |                       |       |                    | 12.6       |                    |       |                     | 22.3       |                       |       |   | 18.6 |   |   |   | 20.0 |   |   |   | 16.6 |   |   |   | 18.6 |   |   |
| General and  administrative                                 |       |                    | 20.3       |                    |       |                     | 20.5       |                       |       |                    | 20.0       |                    |       |                     | 18.7       |                       |       |   | 21.8 |   |   |   | 25.7 |   |   |   | 23.0 |   |   |   | 54.5 |   |   |
| Research and  development.                                  |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       |                     | 0.4        |                       |       |   | 1.3 |   |   |   | 1.1 |   |   |   | 1.1 |   |   |   | 1.3 |   |   |
| Total operating expenses                                    |       |                    | 34.3       |                    |       |                     | 32.5       |                       |       |                    | 32.6       |                    |       |                     | 41.3       |                       |       |   | 41.7 |   |   |   | 46.8 |   |   |   | 40.6 |   |   |   | 97.2 |   |   |
| (Loss) income from  operations                         |       |                    | (0.1       | )                       |       |                     | 4.0        |                       |       |                    | 3.6        |                    |       |                     | 6.1        |                       |       |   | 5.4 |   |   |   | (1.4 | ) |   |   | 4.7 |   |   |   | (57.0 | ) |   |
| Interest and other  income (expense)                        |       |                    | (2.8       | )                       |       |                     | (2.4       | )                          |       |                    | (2.3       | )                       |       |                     | (4.9       | )                          |       |   | (8.0 | ) |   |   | (15.6 | ) |   |   | (1.7 | ) |   |   | (1.4 | ) |   |
| Change in fair  value of Put Option.                   |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       |                     | 5.2        |                       |       |   | 16.8 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Change in fair  value of Call Option.                  |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       |                     | —     |                       |       |   | — |   |   |   | 5.0 |   |   |   | — |   |   |   | — |   |   |
| Change in fair  value of Protection Payment                 |       |                    | —     |                    |       |                     | —     |                       |       |                    | —     |                    |       |                     | (1.9       | )                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| (Loss) income before taxes                                  |       |                    | (2.9       | )                       |       |                     | 1.6        |                       |       |                    | 1.3        |                    |       |                     | 4.5        |                       |       |   | 14.3 |   |   |   | (12.0 | ) |   |   | 3.0 |   |   |   | (58.4 | ) |   |
| Provision for (benefit from) income taxes                   |       |                    | 0.9        |                    |       |                     | 0.4        |                       |       |                    | 0.6        |                    |       |                     | 0.4        |                       |       |   | 0.4 |   |   |   | 0.5 |   |   |   | 0.8 |   |   |   | (4.0 | ) |   |
| Net (loss) income                                           |       |                    | (3.8       | )%                      |       |                     | 1.2        | %                          |       |                    | 0.7        | %                       |       |                     | 4.1        | %                          |       |   | 13.9 | % |   |   | (12.5 | )% |   |   | 2.2 | % |   |   | (54.4 | )% |   |

----

(1)           Includes a full quarter of results of operations ofSilipos, which was acquired on September 30, 2004.

(2)           Included in the operating results for the quarter endedDecember 31, 2005 were:

(a)          a provision for impairment of certain identifiableintangible assets totalling $2,102,000; and

(b)          stock award and stock option compensation expensetotalling approximately $2,398,000, of which approximately $1,313,000 relatedto the acceleration of vesting of certain stock options and stock awards.

60

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**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion about our market riskinvolves forward-looking statements. Actual results could differmaterially from those projected in the forward-looking statements.

In general, business enterprises can be exposed to market risks,including fluctuation in commodity and raw materials prices, foreign n currencyexchange rates, and interest rates that can adversely affect the cost andresults of operating, investing, and financing. In seeking to minimize therisks and/or costs associated with such activities, the Company managesexposure to changes in commodities and raw material prices, interest rates andforeign currency exchange rates through its regular operating and financing activities.The Company does not utilize financial instruments for trading or otherspeculative purposes, nor does the Company utilize leveraged financialinstruments or other derivatives. In the Silipos acquisition, the Companyacquired the Put Option (as defined in Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” in the subsectionheaded “Results of Operations—Years Ended December 31, 2005 and 2004”),and under the Silipos Purchase Agreement and the $7.5 Million Note, the Companybecame obligated to make the Protection Payment (as defined in Item 7 in thesubsection headed “Results of Operations—Years Ended December 31, 2004 and2003”). The Put Option expired unexercised in accordance with its terms in thethree months ended March 31, 2005. The Protection Payment was accountedfor under EITF No. 86-15. (see Notes 1(b), 2(c) and 7 of the Notes tothe Consolidated Financial Statements, in Item 8 of this Annual Report).

The Company’s exposure to market rate risk for changesin interest rates relates primarily to the Company’s short-term monetaryinvestments. There is a market rate risk for changes in interest rates earnedon short-term money market instruments. There is inherent rollover risk in theshort-term money market instruments as they mature and are renewed at currentmarket rates. The extent of this risk is not quantifiable or predictablebecause of the variability of future interest rates and business financingrequirements. However, there is no risk of loss of principal in the short-termmoney market instruments, only a risk related to a potential reduction infuture interest income. Derivative instruments are not presently used to adjustthe Company’s interest rate risk profile.

The majority of the Company’s business is denominatedin United States dollars. There are costs associated with the Company’soperations in foreign countries, primarily the United Kingdom and Canada, whichrequire payments in the local currency, and payments received from customersfor goods sold in these countries are typically in the local currency. TheCompany partially manages its foreign currency risk related to those paymentsby maintaining operating accounts in these foreign countries and by havingcustomers pay the Company in those same currencies.

61

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**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**LANGER, INC.AND SUBSIDIARIESIndex to Consolidated Financial Statements**

|                                                          | ** ** | **Page** | ** ** |
|----------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm |       |     | 63         |   |   |
| Report of Independent Registered Public Accounting  Firm |       |     | 64         |   |   |
| *Consolidated  Financial Statements:*                    |       |     |       |   |   |
| Consolidated Balance Sheets                              |       |     | 65         |   |   |
| Consolidated Statements of Operations                    |       |     | 66         |   |   |
| Consolidated Statements of Stockholders’ Equity     |       |     | 67         |   |   |
| Consolidated Statements of Cash Flows                    |       |     | 68         |   |   |
| Notes to Consolidated Financial Statements               |       |     | 69         |   |   |

 

62

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**Reportof Independent Registered Public Accounting Firm**

Board of Directors and StockholdersLanger, Inc. and SubsidiariesDeer Park, New York

We have audited the accompanying consolidated balancesheet of Langer, Inc. and Subsidiaries (the “Company”) as of December 31,2005 and the related consolidated statements of operations, stockholders’equity, and cash flows for the year then ended. We have also audited theschedules for the year ended December 31, 2005 listed in the Index at Item15. These financial statements and schedules are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial statements and schedules based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements and schedules are free ofmaterial misstatement. The Company is not required to have, nor were we engagedto perform, an audit of its internal control over financial reporting. Ouraudit included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements andschedules, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall presentation of thefinancial statements and schedules. We believe that our audit provides areasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Langer, Inc. and Subsidiaries at December 31, 2005, and theresults of their operations and their cash flows for the year then ended, inconformity with accounting principles generally accepted in the United Statesof America.

Also, in our opinion, the schedules present fairly, inall material respects, the information set forth therein for the year ended December 31,2005.

(Signed BDO Seidman, LLP)

Melville, New York

March 21, 2006

63

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofLanger, Inc.Deer Park, New York

We have audited the accompanying consolidated balancesheet of Langer, Inc. and subsidiaries (the “Company”) as of December 31,2004, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the two years in the period endedDecember 31, 2004. Our audits also included the financial statementschedule listed in the Index at Item 15. These consolidated financialstatements and financial statement schedule are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theconsolidated financial statements and financial statement schedule based on ouraudits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of Langer, Inc. and subsidiaries as of December 31,2004, and the results of their operations and their cash flows for each of thetwo years in the period ended December 31, 2004, in conformity withaccounting principles generally accepted in the United States of America. Alsoin our opinion, such financial statement schedule of Langer, Inc. andsubsidiaries as of December 31, 2004 and for the two years in the periodended December 31, 2004, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

/s/ Deloitte & Touche LLPJericho, New YorkMarch 17, 2005

64

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**LANGER, INC.AND SUBSIDIARIESConsolidated Balance Sheets**

| ** **                                                                                                                                | ** ** | **December 31, 2005** | ** **  | **December 31, 2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|-------------|---------------------------------|------------|
| **Assets**                                                                                                                                | ** ** |                            | ** **  | ** **                      |       |   | ** ** | ** ** |   |
| Current assets:                                                                                                                           |       |                            |        |                            |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                 |       |                            | $           | 18,828,989                      |       |   |   | $ | 3,909,849 |   |   |
| Accounts receivable, net  of allowances for doubtful accounts and returns and allowances aggregating  $498,073 and $447,657, respectively |       |                            | 5,182,368   |                            |       |   | 7,055,505 |   |   |
| Inventories, net                                                                                                                          |       |                            | 4,122,998   |                            |       |   | 4,846,083 |   |   |
| Prepaid expenses and  other                                                                                                               |       |                            | 819,757     |                            |       |   | 1,387,800 |   |   |
| Total current assets                                                                                                                      |       |                            | 28,954,112  |                            |       |   | 17,199,237 |   |   |
| Property and equipment,  net                                                                                                              |       |                            | 7,034,885   |                            |       |   | 7,181,277 |   |   |
| Identifiable intangible  assets, net                                                                                                      |       |                            | 6,604,015   |                            |       |   | 9,342,898 |   |   |
| Goodwill                                                                                                                                  |       |                            | 14,119,213  |                            |       |   | 13,321,151 |   |   |
| Other assets                                                                                                                              |       |                            | 460,151     |                            |       |   | 762,013 |   |   |
| Total assets                                                                                                                              |       |                            | $           | 57,172,376                      |       |   |   | $ | 47,806,576 |   |   |
| **Liabilities and Stockholders’ Equity**                                                                                             | ** ** |                            | ** **  | ** **                      |       |   | ** ** | ** ** |   |
| Current liabilities:                                                                                                                      |       |                            |        |                            |       |   |   |   |   |
| Convertible notes                                                                                                                         |       |                            | $           | 14,439,000                      |       |   |   | $ | — |   |   |
| Accounts payable                                                                                                                          |       |                            | 1,070,152   |                            |       |   | 1,139,953 |   |   |
| Unearned revenue                                                                                                                          |       |                            | 565,744     |                            |       |   | 670,513 |   |   |
| Other current liabilities                                                                                                                 |       |                            | 3,674,947   |                            |       |   | 4,265,345 |   |   |
| Secured promissory note  payable                                                                                                          |       |                            | —      |                            |       |   | 7,986,000 |   |   |
| Obligation under Put  Option                                                                                                              |       |                            | —      |                            |       |   | 1,750,000 |   |   |
| Total current liabilities                                                                                                                 |       |                            | 19,749,843  |                            |       |   | 15,811,811 |   |   |
| Non current liabilities:                                                                                                                  |       |                            |        |                            |       |   |   |   |   |
| Long-term debt:                                                                                                                           |       |                            |        |                            |       |   |   |   |   |
| Obligation under capital  lease                                                                                                           |       |                            | 2,700,000   |                            |       |   | 2,700,000 |   |   |
| Convertible notes                                                                                                                         |       |                            | —      |                            |       |   | 14,589,000 |   |   |
| Promissory note payable                                                                                                                   |       |                            | —      |                            |       |   | 2,737,000 |   |   |
| Senior subordinated notes  payable                                                                                                        |       |                            | —      |                            |       |   | 4,821,498 |   |   |
| Unearned revenue                                                                                                                          |       |                            | 106,713     |                            |       |   | 116,000 |   |   |
| Accrued pension expense                                                                                                                   |       |                            | 40,388      |                            |       |   | 94,445 |   |   |
| Deferred income taxes  payable                                                                                                            |       |                            | 1,324,932   |                            |       |   | 1,639,610 |   |   |
| Other liabilities                                                                                                                         |       |                            | 69,989      |                            |       |   | 82,519 |   |   |
| Total liabilities                                                                                                                         |       |                            | 23,991,865  |                            |       |   | 42,591,883 |   |   |
| Commitments and contingencies                                                                                                             |       |                            |        |                            |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                |       |                            |        |                            |       |   |   |   |   |
| Preferred stock, $1.00  par value; authorized 250,000 shares; no shares issued                                                       |       |                            | —      |                            |       |   | — |   |   |
| Common stock, $.02 par  value; authorized 50,000,000 shares; issued 9,992,923 and 4,505,033,  respectively                                |       |                            | 199,859     |                            |       |   | 90,101 |   |   |
| Additional paid-in  capital                                                                                                               |       |                            | 46,722,004  |                            |       |   | 14,441,541 |   |   |
| Unearned stock  compensation                                                                                                              |       |                            | —      |                            |       |   | (277,083 | ) |   |
| Accumulated deficit                                                                                                                       |       |                            | (13,341,620 | )                               |       |   | (8,784,352 | ) |   |
| Accumulated other  comprehensive loss                                                                                                     |       |                            | (203,091    | )                               |       |   | (140,057 | ) |   |
|                                                                                                                                      |       |                            | 33,377,152  |                            |       |   | 5,330,150 |   |   |
| Treasury stock at cost,  84,300 and 67,100 shares, respectively                                                                           |       |                            | (196,641    | )                               |       |   | (115,457 | ) |   |
| Total stockholders’  equity                                                                                                          |       |                            | 33,180,511  |                            |       |   | 5,214,693 |   |   |
| Total liabilities and  stockholders’ equity                                                                                          |       |                            | $           | 57,172,376                      |       |   |   | $ | 47,806,576 |   |   |

 

See accompanying notes to consolidated financial statements.

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**LANGER, INC.AND SUBSIDIARIESConsolidated Statements of Operations**

| ** **                                                                                    | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                                                                     |       | $                                                             | 40,141,498 |   | $ | 30,126,759 |   | $ | 24,720,515 |   |
| Cost of sales                                                                                 |       | 22,222,934                                                    |       | 18,022,532 |   | 16,049,790 |   |
| Gross profit                                                                                  |       | 17,918,564                                                    |       | 12,104,227 |   | 8,670,725 |   |
| General and  administrative expenses                                                          |       | 12,257,046                                                    |       | 5,927,808 |   | 4,775,142 |   |
| Selling expenses                                                                              |       | 7,402,843                                                     |       | 4,950,947 |   | 3,131,197 |   |
| Research and  development expenses                                                            |       | 469,971                                                       |       | 48,694 |   | — |   |
| Provision for  impairment of identifiable intangible assets                                   |       | 2,102,000                                                     |       | — |   | — |   |
| Operating (loss) income                                                                       |       | (4,313,296                                                    | )          | 1,176,778 |   | 764,386 |   |
| Other income (expense):                                                                       |       |                                                          |       |   |   |   |   |
| Interest income                                                                               |       | 443,996                                                       |       | 174,261 |   | 157,522 |   |
| Interest expense                                                                              |       | (2,692,209                                                    | )          | (1,219,427 | ) | (836,273 | ) |
| Change in fair value of Put Option                                                            |       | 1,750,000                                                     |       | 605,000 |   | — |   |
| Change in fair value of Protection Payment                                                    |       | —                                                        |       | (223,000 | ) | — |   |
| Other                                                                                         |       | 53,081                                                        |       | 18,859 |   | 75,798 |   |
| Other expense, net                                                                            |       | (445,132                                                      | )          | (644,307 | ) | (602,953 | ) |
| (Loss) income before income taxes                                                             |       | (4,758,428                                                    | )          | 532,471 |   | 161,433 |   |
| Provision for  (benefit from) income taxes (Note 13)                                          |       | (201,160                                                      | )          | 157,683 |   | 166,904 |   |
| Net (loss) income                                                                             |       | $                                                             | (4,557,268 | ) | $ | 374,788 |   | $ | (5,471 | ) |
| Net (loss) income per  common share:                                                          |       |                                                          |       |   |   |   |   |
| Basic                                                                                         |       | $                                                             | (.63       | ) | $ | .09 |   | $ | (.00 | ) |
| Diluted                                                                                       |       | $                                                             | (.63       | ) | $ | .08 |   | $ | (.00 | ) |
| Weighted average  number of common shares used in computation of net (loss) income per share: |       |                                                          |       |   |   |   |   |
| Basic                                                                                         |       | 7,277,240                                                     |       | 4,395,180 |   | 4,374,396 |   |
| Diluted                                                                                       |       | 7,277,240                                                     |       | 4,793,439 |   | 4,374,396 |   |

 

See accompanying notes to consolidated financial statements.

66

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**LANGER, INC.AND SUBSIDIARIESConsolidated Statements of Stockholders’ Equity**

| ** **                                                    | ** ** | ** **            | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | **Accumulated Other  Comprehensive Income (Loss)** | ** ** | ** **      | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|------------|------------|------------------|------------|-----------------|------------|-------------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                    | ** ** | ** **            | ** ** | ** **   | ** ** | ** ** | ** ** | **Unearned**     | ** ** | **Additional**  | ** ** | ** **                                                        | ** ** | **Foreign**     | ** ** | **Minimum** | ** ** | ** ** | ** ** | **Total** | ** ** |
| ** **                                                    | ** ** | **Common Stock** | ** ** | **Treasury** | ** ** | **stock**  | ** ** | **paid-in**      | ** ** | **Accumulated** | ** ** | **currency**                                                      | ** ** | **pension**     | ** ** | **Comprehensive** | ** ** | **stockholders’** | ** ** |
| ** **                                                    | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **stock**  | ** ** | **compensation** | ** ** | **capital**     | ** ** | **deficit**                                                       | ** ** | **translation** | ** ** | **liability** | ** ** | **income** | ** ** | **equity** | ** ** |
| Balance at  January 1, 2003                              |       | 4,336,744             |       | $            | 86,735     |       | $          | (115,457         | )          |            | $          | —                                                            |       |            | $          | 12,825,237 |   |   | $ | (9,153,669 | ) |   |   | $ | (26,217 | ) |   |   | $ | (504,415 | ) |   |   |   |   |   |   | $ | 3,112,214 |   |   |
| Net loss                                                      |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            | (5,471     | ) |   |   |   |   |   |   |   |   |   |   | $ | (5,471 | ) |   |   |   |   |   |
| Foreign currency  adjustment                                  |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   | 238,038 |   |   |   |   |   |   |   | 238,038 |   |   |   |   |   |   |
| Minimum pension  liability adjustment, net of tax             |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   | 51,306 |   |   |   | 51,306 |   |   |   |   |   |   |
| Total  comprehensive income                                   |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   |   |   |   |   | $ | 283,873 |   |   |   | 283,873 |   |   |
| Issuance of stock  to purchase business                       |       | 107,611               |       | 2,152        |       |       |       |             |       |            |       | 366,954                                                           |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 369,106 |   |   |
| Issuance of stock  options for consulting services            |       | 3,096                 |       | 62           |       |       |       |             |       |            |       | 9,938                                                             |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 10,000 |   |   |
| Balance at  December 31, 2003                            |       | 4,447,451             |       | 88,949       |       | (115,457   | )          |             | —     |            |       | 13,202,129                                                        |       |            | (9,159,140 | ) |   |   | 211,821 |   |   |   | (453,109 | ) |   |   |   |   |   |   | 3,775,193 |   |   |
| Net income                                                    |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            | 374,788    |   |   |   |   |   |   |   |   |   |   |   | $ | 374,788 |   |   |   |   |   |   |
| Foreign currency  adjustment                                  |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   | 82,330 |   |   |   |   |   |   |   | 82,330 |   |   |   |   |   |   |
| Minimum pension  liability adjustment, net of tax             |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   | 18,901 |   |   |   | 18,901 |   |   |   |   |   |   |
| Total  comprehensive income                                   |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   |   |   |   |   | $ | 476,019 |   |   |   | 476,019 |   |   |
| Exercise of stock  options                                    |       | 500                   |       | 10           |       |       |       |             |       |            |       | 1,590                                                             |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 1,600 |   |   |
| Stock issued for  services                                    |       | 17,082                |       | 342          |       |       |       |             |       |            |       | 126,922                                                           |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 127,264 |   |   |
| Common stock  issued for restricted stock grants              |       | 40,000                |       | 800          |       |       |       |             | (300,000   | )               |       | 299,200                                                           |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Amortization of  unearned stock compensation                  |       |                  |       |         |       |       |       |             | 22,917     |            |       |                                                              |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 22,917 |   |   |
| Issuance of  warrants                                         |       |                  |       |         |       |       |       |             |       |            |       | 811,700                                                           |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 811,700 |   |   |
| Balance at  December 31, 2004                            |       | 4,505,033             |       | 90,101       |       | (115,457   | )          |             | (277,083   | )               |       | 14,441,541                                                        |       |            | (8,784,352 | ) |   |   | 294,151 |   |   |   | (434,208 | ) |   |   |   |   |   |   | 5,214,693 |   |   |
| Net loss                                                      |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            | (4,557,268 | ) |   |   |   |   |   |   |   |   |   |   | $ | (4,557,268 | ) |   |   |   |   |   |
| Foreign currency  adjustment                                  |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   | (67,383 | ) |   |   |   |   |   |   | (67,383 | ) |   |   |   |   |   |
| Minimum pension  liability adjustment, net of tax             |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   | 4,349 |   |   |   | 4,349 |   |   |   |   |   |   |
| Total  comprehensive loss                                     |       |                  |       |         |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   |   |   |   |   | $ | (4,620,302 | ) |   |   | (4,620,302 | ) |   |
| Stock grant for  consulting services                          |       | 901                   |       | 18           |       |       |       |             |       |            |       | 4,982                                                             |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 5,000 |   |   |
| Common stock  issued for restricted stock grants              |       | 100,000               |       | 2,000        |       |       |       |             | (465,000   | )               |       | 463,000                                                           |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Amortization of  unearned stock compensation                  |       |                  |       |         |       |       |       |             | 742,083    |            |       |                                                              |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 742,083 |   |   |
| Effect of stock  options issued for compensation for services |       |                  |       |         |       |       |       |             |       |            |       | 1,256,988                                                         |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 1,256,988 |   |   |
| Sale of stock in  public offering                             |       | 5,226,989             |       | 104,540      |       |       |       |             |       |            |       | 33,870,889                                                        |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 33,975,429 |   |   |
| Expenses of public  offering, including sales commissions     |       |                  |       |         |       |       |       |             |       |            |       | (4,673,686                                                        | )          |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (4,673,686 | ) |   |
| Stock returned to  treasury in settlement of obligations      |       |                  |       |         |       | (81,184    | )          |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (81,184 | ) |   |
| Effect of  modification to stock option agreement             |       |                  |       |         |       |       |       |             |       |            |       | 1,045,625                                                         |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 1,045,625 |   |   |
| Conversion of Convertible  Note to common stock, net          |       | 25,000                |       | 500          |       |       |       |             |       |            |       | 147,115                                                           |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 147,615 |   |   |
| Exercise of stock  options                                    |       | 110,000               |       | 2,200        |       |       |       |             |       |            |       | 165,550                                                           |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 167,750 |   |   |
| Exercise of  warrants                                         |       | 25,000                |       | 500          |       |       |       |             |       |            |       |                                                              |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 500 |   |   |
| Balance at  December 31, 2005                            |       | 9,992,923             |       | $            | 199,859    |       | $          | (196,641         | )          |            | $          | —                                                            |       |            | $          | 46,722,004 |   |   | $ | (13,341,620 | ) |   |   | $ | 226,768 |   |   |   | $ | (429,859 | ) |   |   |   |   |   |   | $ | 33,180,511 |   |   |

 

See accompanying notes to consolidated financial statements.

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**LANGER, INC.AND SUBSIDIARIESConsolidated Statements of Cash Flows**

| ** **                                                                                                                      | ** ** | **For the years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                      | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash Flows From Operating Activities:                                                                                           |       |                                                          |       |   |   |   |   |
| Net (loss) income                                                                                                               |       | $                                                             | (4,557,268 | ) | $ | 374,788 |   | $ | (5,471 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities:                        |       |                                                          |       |   |   |   |   |
| Depreciation of  property and equipment and amortization of identifiable intangible assets                                 |       | 1,647,680                                                     |       | 953,222 |   | 651,209 |   |
| Gain on sale of  property and equipment                                                                                         |       | (10,402                                                       | )          | — |   | — |   |
| Provision for  impairment of identifiable intangible assets                                                                     |       | 2,102,000                                                     |       | — |   | — |   |
| Change in fair  value of Put Option                                                                                             |       | (1,750,000                                                    | )          | (605,000 | ) | — |   |
| Change in fair  value of Protection Payment                                                                                     |       | —                                                        |       | 223,000 |   | — |   |
| Amortization of  debt acquisition costs                                                                                         |       | 262,940                                                       |       | 199,346 |   | 193,772 |   |
| Amortization of  debt discount                                                                                                  |       | 678,502                                                       |       | 57,398 |   | — |   |
| Amortization of  unearned stock compensation                                                                                    |       | 742,083                                                       |       | 22,917 |   | — |   |
| Compensation  expense for options issued for services and option modification                                                   |       | 2,302,613                                                     |       | — |   | — |   |
| Provision for doubtful  accounts receivable                                                                                     |       | 151,066                                                       |       | 172,295 |   | 117,993 |   |
| Deferred income  tax (benefit) provision                                                                                        |       | (314,678                                                      | )          | 131,988 |   | 135,500 |   |
| Issuance of stock  for services                                                                                                 |       | 5,000                                                         |       | 66,132 |   | 10,000 |   |
| Changes in operating assets and liabilities:                                                                                    |       |                                                          |       |   |   |   |   |
| Accounts receivable                                                                                                             |       | 1,698,594                                                     |       | (206,165 | ) | (512,078 | ) |
| Inventories                                                                                                                     |       | 708,627                                                       |       | (216,305 | ) | 33,901 |   |
| Prepaid expenses                                                                                                                |       | 145,471                                                       |       | (78,718 | ) | 403,361 |   |
| Accounts payable  and other current liabilities                                                                                 |       | 60,250                                                        |       | (387,236 | ) | (377,345 | ) |
| Other assets                                                                                                                    |       | 167,512                                                       |       | — |   | — |   |
| Unearned revenue  and other liabilities                                                                                         |       | (172,835                                                      | )          | (59,690 | ) | (200,723 | ) |
| Net cash provided  by operating activities                                                                                      |       | 3,867,155                                                     |       | 647,972 |   | 450,119 |   |
| Cash Flows From Investing Activities:                                                                                           |       |                                                          |       |   |   |   |   |
| Deposits                                                                                                                        |       | (130,975                                                      | )          | — |   | — |   |
| Proceeds from sale  of property and equipment                                                                                   |       | 70,000                                                        |       | — |   | — |   |
| Purchase of  businesses, net of cash acquired                                                                                   |       | (1,277,194                                                    | )          | (5,796,534 | ) | (1,897,328 | ) |
| Purchase of  property and equipment                                                                                             |       | (989,881                                                      | )          | (1,197,845 | ) | (1,402,336 | ) |
| Net cash used in  investing activities                                                                                          |       | (2,328,050                                                    | )          | (6,994,379 | ) | (3,299,664 | ) |
| Cash Flows From Financing Activities:                                                                                           |       |                                                          |       |   |   |   |   |
| Sale of stock in  public offering                                                                                               |       | 33,975,429                                                    |       | — |   | — |   |
| Offering expense  paid, including sales commission                                                                              |       | (4,665,383                                                    | )          | — |   | — |   |
| Repayment of  promissory notes                                                                                                  |       | (10,491,000                                                   | )          | — |   | — |   |
| Repayment of  senior subordinated notes payable                                                                                 |       | (5,500,000                                                    | )          | — |   | — |   |
| Proceeds from the  exercise of stock options                                                                                    |       | 167,750                                                       |       | 1,600 |   | — |   |
| Cash paid to  settle withholding obligation                                                                                     |       | (81,184                                                       | )          | — |   | — |   |
| Proceeds from the  exercise of warrants                                                                                         |       | 500                                                           |       | — |   | — |   |
| Proceeds from issuance  of debt                                                                                                 |       | —                                                        |       | 5,500,000 |   | — |   |
| Payments of  promissory notes                                                                                                   |       | —                                                        |       | (800,000 | ) | (1,000,000 | ) |
| Net cash provided  by (used in) financing activities                                                                            |       | 13,406,112                                                    |       | 4,701,600 |   | (1,000,000 | ) |
| Effect of exchange  rate changes on cash                                                                                        |       | (26,077                                                       | )          | 20,710 |   | (28,219 | ) |
| Net increase  (decrease) in cash and cash equivalents                                                                           |       | 14,919,140                                                    |       | (1,624,097 | ) | (3,877,764 | ) |
| Cash and cash  equivalents at beginning of year                                                                                 |       | 3,909,849                                                     |       | 5,533,946 |   | 9,411,710 |   |
| Cash and cash  equivalents at end of year                                                                                       |       | $                                                             | 18,828,989 |   | $ | 3,909,849 |   | $ | 5,533,946 |   |
| Supplemental Disclosures of Investing Activities:                                                                               |       |                                                          |       |   |   |   |   |
| Reduction in  purchase price of business acquired satisfied by the reduction of the  principal balance of the $7.5 Million Note |       | $                                                             | 232,000    |   |   |   |   |   |
| Supplemental Disclosures of Non-Cash Financing  Activities:                                                                     |       |                                                          |       |   |   |   |   |
| Conversion of Convertible  Note to common stock, net                                                                            |       | $                                                             | 147,615    |   |   |   |   |   |
| Issuance of  promissory notes in purchase of business                                                                           |       |                                                          |       | $ | 10,500,000 |   |   |   |
| Obligation under  the Put Option                                                                                                |       |                                                          |       | $ | 1,750,000 |   |   |   |
| Warrants issued in  connection with senior subordinated note payable                                                            |       |                                                          |       | $ | 735,900 |   |   |   |
| Warrants issued  for debt placement fee                                                                                         |       |                                                          |       | $ | 75,800 |   |   |   |
| Increase in  accounts payable relating to expenses of public offering                                                           |       | $                                                             | 8,303      |   | $ | 403,064 |   |   |   |
| Stock returned to  treasury from stock award to satisfy withholding obligation                                                  |       | $                                                             | 81,184     |   |   |   |   |   |
| Increase in  accounts payable relating to property and equipment acquired                                                       |       | $                                                             | 7,887      |   | $ | 58,953 |   | $ | 95,798 |   |
| Increase in  accounts payable relating to purchase of business                                                                  |       |                                                          |       | $ | 372,857 |   | $ | 302,036 |   |
| Supplemental Disclosures of Cash Flow Information:                                                                              |       |                                                          |       |   |   |   |   |
| Cash paid during the period for:                                                                                                |       |                                                          |       |   |   |   |   |
| Interest                                                                                                                        |       | $                                                             | 1,959,481  |   | $ | 804,792 |   | $ | 642,501 |   |
| Income taxes                                                                                                                    |       | $                                                             | 100,669    |   | $ | 6,284 |   | $ | 33,288 |   |

 

See accompanying notes to consolidated financial statements.

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**LANGER, INC.AND SUBSIDIARIESNotes to Consolidated Financial Statements**

**(1)   Summaryof Significant Accounting Policies**

**(a) Principlesof Consolidation**

The accompanyingconsolidated financial statements include the accounts of Langer, Inc. andits subsidiaries (the “Company” or “Langer”). All significant intercompanytransactions and balances have been eliminated in consolidation.

**(b) DerivativeFinancial Instruments**

In the consolidated financial statements for the yearended December 31, 2004, the Company accounted for its option to make acash payment of $500,000 on March 31, 2005, or increase the principalamount of the Company’s $7.5 million secured promissory note due March 31,2006 (the “$7.5 Million Note”) by $1 million effective April 1, 2005(either payment a “Protection Payment”) if the Company did not prepay the $7.5Million Note by March 31, 2005, as an embedded derivative which requiredbifurcation under Statement of Financial Accounting Standards (“SFAS”) No. 133,“Accounting for Derivative Financial Instruments and Hedging Activities.”Additionally, the Company accounted for the option embedded in its $3.0 millionpromissory note due December 31, 2009 (the “$3.0 Million Note”) to receivea payment equal to one half of the actual Protection Payment made under the$7.5 Million Note if the $3.0 Million Note is prepaid by March 31,2006, as an embedded derivative which requires bifurcation under SFAS No. 133.For the year ended December 31, 2004, the embedded derivative instrumentsin the $7.5 Million Note and the $3.0 Million Note were recorded at their fairvalue using the discounted cash flow method.

During the three months ended March 31, 2005, theCompany determined that it should have accounted for the $7.5 Million Note asincreasing-rate debt with a term-extending option under the provisions ofEmerging Issues Task Force (“EITF”) Issue No. 86-15, “Increasing-RateDebt.” Additionally, the Company determined that it should have accounted forthe $3.0 Million Note as debt with an embedded call option, which requiresbifurcation under SFAS No. 133. The embedded derivative instrument in the$3.0 Million Note should have been recorded at its fair value to an unrelatedthird party market participant. The Company has determined that the change inaccounting treatment did not have a material impact on its financial positionor results of operations as of or for the year ended December 31, 2004, orits results of operations as of or for the three months ended March 31,2005 and, accordingly, this change has been reflected in its consolidatedfinancial statements for the year ended December 31, 2005. Note 7, “Long-TermDebt” to the consolidated financial statements further describes the Company’scurrent accounting with respect to the $7.5 Million Note and the $3.0 MillionNote. The notes were repaid in July 2005, and there are no derivatives asof December 31, 2005.

In accordance with SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities,” as amended, theCompany recognizes all derivative financial instruments in the consolidatedfinancial statements at fair value regardless of the purpose or intent forholding the instrument. Changes in the fair value of derivative financialinstruments are either recognized periodically in income or in stockholders’equity as a component of accumulated other comprehensive income (loss)depending on whether the derivative financial instrument qualifies for hedgeaccounting or, if so, whether it qualifies as a fair value or cash flow hedge.Generally, the changes in the fair value of derivatives accounted for as fairvalue hedges are recorded in income along with the portions of the changes inthe fair value of the hedged item that relate to the hedged risks. Changes inthe fair value of derivatives accounted for as cash flow hedges, to the 

69

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extentthey are effective as hedges, are recorded in accumulated other comprehensiveincome (loss), net of deferred taxes. Changes in fair values of derivatives notqualifying as hedges are reported in income.

**(c) Descriptionof the Business**

The Company is anorthopedics products company specializing in the designing, manufacturing,distributing and marketing of high quality foot and gait-related biomechanicalproducts. The Company’s diversified range of products is comprised of (i) customorthotic devices ordered by healthcare professionals, and (ii) pre-fabricatedorthopedic rehabilitation and recovery devices and related devices distributedby the Company to healthcare professionals for use by their patients. On September 30,2004, the Company acquired Silipos, Inc. and subsidiary, a designermanufacturer and distributor of gel-based products that target orthopedics(including prosthetics) and skincare (see Note 2 (c), “Acquisition ofSilipos” and Note 11).

**(d) Revenue Recognition**

Revenue from the sale ofthe Company’s products is recognized upon shipment. The Company generally doesnot have any post-shipment obligations to customers other than for productwarranties. The Company generally warrants its products against defects inmaterials and workmanship for a period of 6 months. The Company records aprovision for estimated future costs associated with its warranties offabricated products/custom orthotics as warranty reserves upon shipment, basedupon historical experience. The Company offers extended warranty contractswhich are recorded as deferred revenue and recognized over the lives of thecontracts (24 months) on a straight-line basis. Revenue from shipping andhandling fees is included in net sales in the consolidated statements ofoperations. Costs incurred for shipping and handling are included in cost ofsales in the consolidated statements of operations.

**(e) Advertisingand Promotion Expenses**

Advertising and promotion costs are expensed asincurred. Advertising and promotion expenses were approximately $1,098,000,$553,000 and $326,000 for the years ended December 31, 2005, 2004 and2003, respectively.

The Company accounts forsales and incentives which include discounts, coupons, co-operative advertisingand free products or services in accordance with Emerging Issues Task ForceIssue No. 01-09, “*Accounting forConsideration Given by a Vendor to a Customer”.* Generally, cashconsideration is to be classified as a reduction of net sales, unless specificcriteria are met regarding goods or services that a vendor may receive inreturn for this consideration. The Company’s consideration given to customersdoes not meet these conditions and, accordingly is classified as a reduction torevenue.

**(f) CashEquivalents**

The Company considers allshort-term, highly liquid investments purchased with a maturity of three monthsor less to be cash equivalents consisting primarily of money market funds.

**(g) Inventories**

Inventories are stated atthe lower of cost or market. Cost is determined using the first-in, first-out(FIFO) method.

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**(h) Propertyand Equipment**

Propertyand equipment is stated at cost less accumulated depreciation and amortization.Depreciation and amortization are calculated using the straight-line method.The lives on which depreciation and amortization are computed are as follows:

| Building and  improvements       |   | 20 years                                |   |
|----------------------------------|--------|----------------------------------------------|--------|
| Office furniture  and equipment  |   | 3-10 years                              |   |
| Computer  equipment and software |   | 3-10 years                              |   |
| Machinery and  equipment         |   | 5-15 years                              |   |
| Leasehold  improvements          |   | 5-10 years  or term of lease if shorter |   |
| Automobiles                      |   | 3-5 years                               |   |

 

The Company reviewslong-lived assets and certain identifiable intangibles whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. If the sum of expected future cash flows (undiscounted andwithout interest charges) is less than the carrying value of the asset, animpairment loss is recognized. Otherwise, an impairment loss is not recognized.If an impairment loss is required, the amount of such loss is equal to theexcess of the carrying value of the impaired asset over its fair value. Basedupon the Company’s review of long-lived assets pursuant to SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” the Company recorded aprovision for impairment of $502,000 in the year ended December 31, 2005. Theprovision was determined based upon expected undiscounted cash flow andrecoverability.

**(i) Goodwilland Identifiable Intangible Assets with Indefinite Lives**

In accordance with theprovisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” theCompany no longer amortizes goodwill and identifiable intangible assets withindefinite lives (trade names). Instead these assets are reviewed forimpairment on an annual basis (October 1). Based upon the review ofimpairment, the Company recorded a provision for impairment of $1,600,000 withrespect to the Benefoot trademark because the fair value of the trademark wasde minimus based upon management’s determination that it will no longer rely onor use such trademark in the marketplace.

**(j) IncomeTaxes**

The Company accounts forincome taxes in accordance with SFAS No. 109, “Accounting for IncomeTaxes.” Under this method, deferred tax assets and liabilities are determinedbased on differences between financial reporting and tax bases of assets andliabilities and are measured using the enacted tax rates and laws that will bein effect when the differences are expected to reverse.

**(k) Net Income(Loss) Per Share**

Basic income (loss) pershare is based on the weighted average number of shares of common stockoutstanding during the period. Diluted income (loss) per share is based on theweighted average number of shares of common stock and common stock equivalents(options, warrants, stock awards and convertible subordinated notes)outstanding during the period, except where the effect would be antidilutive.

**(l) Foreign CurrencyTranslation**

Assets and liabilities ofthe foreign subsidiaries that are denominated in local currencies have beentranslated at year-end exchange rates, while revenues and expenses have beentranslated at average exchange rates in effect during the year. Resultingcumulative translation adjustments have been recorded as a separate componentof accumulated other comprehensive income (loss) in stockholders’ equity.

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**(m) Use ofEstimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

**(n) Fair Valueof Financial Instruments**

At December 31, 2005and 2004, the carrying amount of the Company’s financial instruments, includingcash and cash equivalents, accounts receivable, accounts payable and accruedliabilities, approximated fair value because of their short-term maturity. Thecarrying value of long-term debt at December 31, 2005 and 2004 also approximatedfair value based on borrowing rates currently available to the Company for debtwith similar terms.

**(o) InternalUse Software**

In accordance withStatement of Position 98-1, “Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use”, the Company capitalizesinternal-use software costs upon the completion of the preliminary projectstage and ceases capitalization when the software project is substantiallycomplete and ready for its intended use. Capitalized costs are amortized on astraight-line basis over the estimated useful life of the software.

**(p) StockOptions**

At December 31,2005, the Company had three stock-based employee compensation plans,which are described more fully in Note 10. The Company accounts for thoseplans under the recognition and measurement principles of Accounting PrinciplesBoard Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,”and related Interpretations. No stock-based employee compensation cost isreflected in net income (loss), as all options granted under those plans had anexercise price equal to market value of the underlying common stock on the dateof grant. The following table illustrates the effect on net (loss) income and(loss) earnings per share if the Company had applied the fair value recognitionprovisions of SFAS No. 123, “Accounting for Stock-BasedCompensation,” to stock-based employee compensation.

| ** **                                                                                                                                               | ** ** | **For the years ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                                               | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net (loss)  income—as reported                                                                                                                      |       | $                                                             | (4,557,268 | ) | $ | 374,788 |   | $ | (5,471 | ) |
| Deduct: Total  stock-based employee compensation expense determined under fair value  basis method for all awards, net of tax                       |       | (3,882,026                                                    | )          | (520,656 | ) | (146,594 | ) |
| Add: Total  stock-based employee compensation expense determined under the intrinsic  value method, net of tax, reflected in the statement of operations |       | 1,045,625                                                     |       | — |   | — |   |
| Pro forma net loss:                                                                                                                                      |       | $                                                             | (7,393,669 | ) | $ | (145,868 | ) | $ | (152,065 | ) |
| (Loss) Earnings per  share:                                                                                                                              |       |                                                          |       |   |   |   |   |
| Basic—as reported                                                                                                                                   |       | $                                                             | (.63       | ) | $ | .09 |   | $ | (.00 | ) |
| Basic—pro forma                                                                                                                                     |       | $                                                             | (1.02      | ) | $ | (.03 | ) | $ | (.03 | ) |
| Diluted—as reported                                                                                                                                 |       | $                                                             | (.63       | ) | $ | .08 |   | $ | (.00 | ) |
| Diluted—pro forma                                                                                                                                   |       | $                                                             | (1.02      | ) | $ | (.03 | ) | $ | (.03 | ) |

 

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On September 8, 2005,the Company determined not to extend Andrew H. Meyer’s employmentcontract, and in accordance with its terms, the contract expiredDecember 31, 2005 (except for certain covenants by Mr. Meyers infavor of the Company). In accordance with a modification of the employmentcontract on November 12, 2004, which extended his right to exercise175,000 vested options from 90 days to one year beyond termination, the Companyrecorded a non-cash charge equal to the intrinsic value of the options on thedate the option agreement was modified, or approximately $1,046,000 atDecember 31, 2005.****Additionally,the Company issued certain stock options for consulting services. In connectionwith such options, the Company recorded non-cash compensation expense totalling$1,257,000 during the year ended December 31, 2005, which includes theeffect of accelerating the vesting of certain stock options (see Note 15, “RelatedParty Transactions”).

**(q) Concentration of Credit Risk**

Financial instruments which potentially expose theCompany to concentration of credit risk consist primarily of cash investmentsand accounts receivable. The Company places its cash investments withhigh-credit quality financial institutions and currently invests primarily inmoney market accounts. Accounts receivable are generally diversified due to thenumber of healthcare professionals comprising the Company’s customer base. Asof December 31, 2005 and 2004, the Company’s allowance for doubtfulaccounts was approximately $430,000 and $380,000. The Company believes nosignificant concentration of credit risk exists with respect to these cashinvestments and accounts receivable. The carrying amounts of these financialinstruments are reasonable estimates of their fair value.

**(r) Recently IssuedAccounting Pronouncements**

In November 2004,FASB issued SFAS No. 151, “Inventory Costs.” SFAS No. 151 amends theguidance in Chapter 4 of Accounting Research Bulletin No. 43, “InventoryPricing,” to clarify the accounting for amounts of idle facility expense,freight, handling costs and wasted material. SFAS No. 151 requires thatthese types of items be recognized as current period charges as they occur. Theprovisions of SFAS No. 151 are effective for inventory costs incurredduring fiscal years beginning after June 15, 2005. The Company iscurrently still evaluating the impact of adoption of SFAS No. 151 on itsconsolidated financial statements. The adoption of this new accountingpronouncement is not expected to have a material impact on our consolidatedfinancial statements.

In December 2004,the FASB issued SFAS No. 123(R), “Share-Based Payment,” revising SFAS No. 123and superceding APB No. 25, “Accounting for Stock Issued to Employees.”This statement focuses primarily on accounting for transactions in which anentity obtains employee services in share-based payment transactions. SFAS No. 123(R) requiresthat the fair value of such equity instruments be recognized as expense in thehistorical financial statements as services are performed. Prior to SFAS No. 123(R),only certain pro-forma disclosures of fair value were required. As a result ofthe Securities and Exchange Commission’s April 2005 extension of thecompliance date for SFAS No. 123(R), SFAS No. 123(R) will beeffective for us as of the beginning of the 2006 fiscal year. OnDecember 20, 2005, in order to lessen the impact in future periods, theCompany accelerated the vesting of certain stock options and awards (seeNote 10). The adoption of this new accounting pronouncement is expected tohave a material impact on our consolidated financial statements when we grantstock options and stock awards in the future.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections,” which changes the requirements for theaccounting and reporting of a change in accounting principle and errorcorrections. SFAS No. 154 applies to all voluntary changes in accountingprinciple, as well as to changes required by an accounting pronouncement thatdoes not include specific transition provisions. SFAS No. 154 is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. Starting in 2006, we will apply the provisions ofSFAS No. 154 on a prospective basis when applicable.

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**(2)  **Acquisitions

**(a) *Bi-Op Laboratories, Inc.***

EffectiveJanuary 1, 2003, the Company, through a wholly-owned subsidiary,acquired all of the issued and outstanding stock of Bi-Op Laboratories, Inc.(“Bi-Op”) pursuant to the terms of a Stock Purchase Agreement dated as of January 13,2003 (the “Stock Purchase Agreement”). Bi-Op was purchased principally toexpand Langer’s global presence and to take over fabrication of certain customorthotics for Canadian customers of Langer. The purchase price for Bi-Op wasdetermined by arms’-length negotiations between the Company and theseller and was based in part upon analyses and due diligence which the Companyperformed on the financial records of Bi-Op, focusing on enterprise value,historic cash flows and expected future cash flow to determine valuation. Theresults of operations of Bi-Op have been included in the Company’s consolidatedfinancial statements since January 1, 2003.

Inconnection with the acquisition, the Company paid consideration in Canadiandollars, determined through arms-length negotiation of the parties. Whenconverted to U.S. dollars the total purchase price approximated$2.2 million, of which approximately $1.8 million (including$0.5 million for transaction costs) was paid in cash and approximately$0.4 million was paid by issuing 107,611 shares of the Company’s commonstock (the “Shares”). The purchase price was funded by using a portion of theproceeds remaining from the sale of the Company’s 4% convertible subordinatednotes due August 31, 2006 (the “Convertible Notes”). The Shares werevalued based upon the average of the market price of the Company’s common stocktwo days before, two days after, and on the date the acquisition was announced.

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In connection with the Stock Purchase Agreement, theCompany entered into an employment agreement with Raynald Henry, Bi-Op’s formerprincipal owner, having a term of three years and providing for an annual basesalary of $75,000 CDN and benefits, including certain severance payments. In December 2005,Mr. Henry agreed to a two year extension of his contract which now expiresat the end of December 2007. The allocation of the purchase price amongthe assets and liabilities was based upon the Company’s valuation of the fairvalue of assets and liabilities of Bi-Op.

Thefollowing table sets forth the components of the purchase price:

| Cash  consideration   |   | $       | 1,368,756 |   |
|-----------------------|--------|---------|-----------|--------|
| Common stock  issued  |   | 369,106 |      |
| Transaction costs     |   | 495,383 |      |
| Total purchase  price |   | $       | 2,233,245 |   |

 

Thefollowing table provides the allocation of the purchase price:

| **Assets:**                                                                                                        |   |      |      |
|--------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|
| Cash and cash  equivalents                                                                                         |   | $         | 194,531   |   |
| Accounts  receivables                                                                                              |   | 212,593   |      |
| Inventories                                                                                                        |   | 109,572   |      |
| Prepaid expenses  and other                                                                                        |   | 232,394   |      |
| Property and  equipment                                                                                            |   | 437,148   |      |
| Goodwill                                                                                                           |   | 820,056   |      |
| Identifiable  intangible assets (non-competition agreement of $400,000 and repeat  customer base of $500,000) |   | 900,000   |      |
| Other assets                                                                                                       |   | 41,802    |      |
|                                                                                                               |   | 2,948,096 |      |
| **Liabilities:**                                                                                                   |   |      |      |
| Accounts payable                                                                                                   |   | 117,809   |      |
| Other current  liabilities                                                                                         |   | 140,217   |      |
| Deferred income  taxes                                                                                             |   | 270,000   |      |
| Long-term  debt and other liabilities                                                                              |   | 186,825   |      |
|                                                                                                               |   | 714,851   |      |
| Total purchase  price                                                                                              |   | $         | 2,233,245 |   |

 

Thevalue allocated to goodwill in the purchase of Bi-Op is not deductible forincome tax purposes.

**(b) *Benefoot, Inc. and Benefoot Professional Products, Inc.***

On May 6, 2002, the Company, through a wholly-ownedsubsidiary, acquired substantially all of the assets and liabilities of each ofBenefoot, Inc. and Benefoot Professional Products, Inc. (collectively,“Benefoot”), pursuant to the terms of an asset purchase agreement (the “AssetPurchase Agreement”). The assets acquired include machinery and equipment,other fixed assets, inventory, receivables, contract rights, and intangibleassets. Benefoot was acquired to strengthen the Company’s core business ofcustom orthotics and provide it with new products (distributed products),including therapeutic shoes and custom sandals, thereby broadening the productselection for customers. The purchase price for Benefoot was determined by arms’-lengthnegotiations between the Company and the seller and was based in part uponanalyses and due diligence which the Company performed on the financial recordsof Benefoot, focusing on enterprise value, historic cash flows and expectedfuture cash flow to determine valuation.

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In connection with the acquisition, the Company paidconsideration of $6.1 million, of which $3.8 million was paid incash, $1.8 million was paid through the issuance of 4% promissory notes(the “Promissory Notes”) and $0.5 million was paid by issuing 61,805shares of common stock (the “Shares”), together with certain registrationrights. The Shares were valued based upon the average of the market price ofthe Company’s common stock two days before, two days after and on the date theacquisition was announced. $1.0 million of the Promissory Notes wererepaid on May 6, 2003 and the balance of $0.8 million, plus interestwas repaid on May 6, 2004. The Company also assumed certain liabilities ofBenefoot, including approximately $0.3 million of long-term indebtednesswhich was paid at closing. The Company also agreed to pay Benefoot up to anadditional $1 million (“Performance-based Consideration”) uponachievement of certain performance targets on or prior to May 6, 2004measured at various intervals. During the year ended December 31, 2004,the Company recorded $163,952 of such Performance-based Consideration asadditional goodwill. As of May 6, 2004, the final measurement date forsuch performance targets, the Company had incurred a total of $767,190 withrespect to such Performance-based Consideration. Such amount was recordedas an adjustment to the purchase price as it was not related to the employmentof the selling shareholders and was based solely on the achievement of certainperformance targets. The Company funded the entire cash portion of the purchaseprice with proceeds from the prior sale of the Company’s Convertible Notes.

In connection with the Asset Purchase Agreement, theCompany entered into an employment agreement with each of two shareholders ofBenefoot, each having a term of two years and providing for an annual basesalary of $150,000 and benefits, including certain severance arrangements. Oneof these shareholders subsequently terminated his employment agreement with theCompany and the second contract expired in the second quarter of 2004. Theallocation of the purchase price among the assets acquired and liabilitiesassumed is based on the Company’s valuation of the fair value of the assets andliabilities of Benefoot.

Thefollowing table sets forth the components of the purchase price:

| Cash  consideration                         |   | $         | 3,800,351 |   |
|---------------------------------------------|--------|-----------|-----------|--------|
| Benefoot long-term  debt paid at closing    |   | 307,211   |      |
| Total cash paid  at closing                 |   | 4,107,562 |      |
| Promissory note  issued                     |   | 1,800,000 |      |
| Common stock  issued                        |   | 529,512   |      |
| Transaction costs                           |   | 680,228   |      |
| Performance-based  contingent consideration |   | 767,190   |      |
| Total purchase  price                       |   | $         | 7,884,492 |   |

 

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Thefollowing table provides the allocation of the purchase price:

| **Assets:**                                                                                                                                                       |   |      |      |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|
| Cash and cash  equivalents                                                                                                                                        |   | $         | 225,953   |   |
| Accounts receivables                                                                                                                                              |   | 806,370   |      |
| Inventories                                                                                                                                                       |   | 660,559   |      |
| Prepaid expenses and  other                                                                                                                                       |   | 76,973    |      |
| Property and equipment                                                                                                                                            |   | 155,110   |      |
| Goodwill                                                                                                                                                          |   | 3,880,094 |      |
| Identifiable intangible  assets (trade names of $1,600,000, non-competition agreements of  $230,000, and license agreements and related technology of $1,600,000) |   | 3,430,000 |      |
| Other assets                                                                                                                                                      |   | 6,163     |      |
|                                                                                                                                                              |   | 9,241,222 |      |
| **Liabilities:**                                                                                                                                                  |   |      |      |
| Accounts Payable                                                                                                                                                  |   | 647,873   |      |
| Other accrued  liabilities                                                                                                                                        |   | 389,400   |      |
| Unearned revenue                                                                                                                                                  |   | 210,355   |      |
| Long-term debt and  other liabilities                                                                                                                             |   | 109,102   |      |
|                                                                                                                                                              |   | 1,356,730 |      |
| Total purchase price                                                                                                                                              |   | $         | 7,884,492 |   |

 

In accordance with theprovisions of SFAS No. 142, the Company will not amortize goodwill andintangible assets with indefinite lives (trade names with an estimated fairvalue of $1,600,000). As a result of the Company’s review of goodwill andlong-lived assets with indefinite lives in accordance with SFAS No. 142,the Company provided an allowance for impairment of $1,600,000 with respect to theBenefoot trademark in the statement of operations for the year endedDecember 31, 2005 because the fair value of the trademark was de minimusbased upon management’s determination that it will no longer rely on or use thetrademark in the marketplace. The value allocated to goodwill in the purchaseof Benefoot is deductible for income tax purposes.

**(c)** *Acquisition of Silipos.*

On September 30,2004, the Company acquired all of the outstanding stock of Silipos, Inc.(“Silipos”) from SSL International plc (“SSL”). Silipos is a manufacturer ofgel-based products for the orthopedic, prosthetic and skincare markets, andoperates out of a 40,000 square-foot manufacturing facility in Niagara Falls,New York, and a sales and marketing office in New York City. Silipos wasacquired because of its distribution channels and its proprietary products. Thepurchase price for Silipos was determined by arm’s-length negotiationsbetween the Company and SSL and was based in part upon analyses and duediligence, which the Company performed on the financial records of Silipos,focusing on enterprise value, historic cash flows and expected future cash flowto determine valuation. The results of operations of Silipos sinceSeptember 30, 2004 (the date of acquisition) have been included in theCompany’s consolidated financial statements.

The original purchaseprice paid was $15.5 million, plus transaction costs of approximately$2.0 million (including $0.9 million with respect to contingentconsideration pursuant to an obligation under the Silipos stock purchaseagreement described below), and was comprised of $5.0 million of cash paid atclosing, the $7.5 Million Note and the $3.0 Million Note. (See Note 5, “LongTerm Debt,” for a description of the notes). On March 31, 2005, theCompany entered into a settlement agreement and limited release with SSL,pursuant to which the purchase price for Silipos was reduced by approximately$0.2 million. (See Note 5, “Long-term Debt” for the description of theSettlement Agreement).

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Silipos was a party to a supply agreement withPoly-Gel, L.L.C. (“Poly-Gel”), Silipos’ former supplier of mineral based gels,under which the owners of Poly-Gel had the option to require Silipos topurchase Poly-Gel at a purchase price equal to 1.5 times Poly-Gel’s revenue forthe twelve month period ending immediately prior to the exercise of the option(the “Put Option”). The fair value of the obligation under the Put Option was$2,355,000 at September 30, 2004. The fair value of the obligation underthe Put Option was $1,750,000 at December 31, 2004. The Company recordedthe reduction in the fair value of the obligation under the Put Option of$605,000 as a non-cash gain on change in the fair value of the Put Option inthe consolidated statement of operations for the year ended December 31,2004. The Put Option expired unexercised on February 16, 2005, and theCompany did not otherwise acquire Poly-Gel. The Company recorded the expirationof the Put Option as an additional non-cash gain of $1,750,000 during the threemonths ended March 31, 2005.

The Silipos purchase agreement provides that if theCompany acquires Poly-Gel prior to March 31, 2006, for less than$4,500,000, and liabilities and damages relating to claims brought by Poly-Gelarising out of the supply agreement between Silipos and Poly-Gel datedAugust 20, 1999, the manufacture, marketing or sale of products made fromgel not purchased from Poly-Gel, alleged misappropriation of trade secrets orother confidential information (including gel formulation) of Poly-Gel, as wellas any other alleged violations of the supply agreement (the “PotentialPoly-Gel Claims”), do not exceed $2,000,000, the Company is obligated, pursuantto the terms of the Silipos purchase agreement, to pay SSL an additional amountof $4,500,000 less the purchase price paid for Poly-Gel, which could result ina payment to SSL of up to $4.5 million. The Company’s aggregate liability underthis provision of the Silipos purchase agreement could be as high as $4.5million.

If the Company does not acquire Poly-Gel prior to March 31,2006, and the amount of any liabilities for Potential Poly-Gel Claims, asdefined in the Silipos purchase agreement, do not exceed $2,500,000, then theCompany was obligated, under the Silipos purchase agreement, to pay SSL$1,000,000, plus an amount not to exceed $500,000, for certain costs, ifincurred by SSL, in defense of any such Potential Poly-Gel Claims.

In June 2005, the Company reached an agreementwith SSL to repay the $7.5 Million Note and the $3.0 Million Note and to settlethe $1.0 million obligation under the Silipos stock purchase agreement. Inconsideration for making these payments, SSL provided the Company with a$100,000 discount with respect to the $7.5 Million Note and $100,000 discountwith respect to the $1.0 million payment. The payments were made on July 15,2005. The Company recorded the $900,000 obligation under the Silipos stockpurchase agreement as contingent consideration at June 30, 2005, underSFAS No. 141, “Business Combinations,” as additional goodwill and willrecord any amount due as payment for costs incurred by SSL up to $500,000 inthe consolidated statement of operations when incurred. Additionally, theCompany recorded approximately $292,000 as transaction expenses associated witha possible acquisition of Poly-Gel that was abandoned, which was included ingeneral and administrative expenses in the consolidated statement of operationsfor the year ended December 31, 2004.

Allocation of Silipos’ purchase price among the assetsacquired and liabilities assumed is based on the Company’s evaluation of thefair value of the assets and liabilities of Silipos.

Thefollowing table sets forth the components of the purchase price:

| Total cash  consideration |   | $          | 5,000,000  |   |
|---------------------------|--------|------------|------------|--------|
| Promissory notes  issued  |   | 10,268,000 | (1)        |
| Transaction costs  paid   |   | 1,986,005  | (2)        |
| Total purchase price      |   | $          | 17,254,005 |   |

 

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(1)          On March 31, 2005,the Company entered into a settlement agreement and limited release among theparties to the Silipos purchase agreement. Under the terms of the settlementagreement, the parties exchanged mutual releases and agreed to a $232,000 reductionin the purchase price previously paid by the Company to SSL because Silipos didnot satisfy certain minimum working capital requirements as of the closing dateof the acquisition pursuant to the Silipos purchase agreement. The reduction tothe purchase price was satisfied by decreasing the principal amount of the $7.5Million Note, which was originally due on March 31, 2006, and is reflectedabove. (See Note 7, “Long-term Debt,” for discussion of the $7.5 Million Note.)

(2)          This amount includes$900,000 paid to SSL pursuant to the Silipos stock purchase agreement.

Thefollowing table provides the final allocation of the purchase price based uponthe fair value of the assets acquired and liabilities assumed at September 30,2004 based upon a third-party appraisal:

| **Assets:**                                                                                                                                                                   |   |       |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|------------|
| Cash and cash  equivalents                                                                                                                                                    |   | $          | 378,264    |   |
| Accounts receivable                                                                                                                                                           |   | 3,365,847  |       |
| Inventories                                                                                                                                                                   |   | 2,111,511  |       |
| Other current assets                                                                                                                                                          |   | 326,996    |       |
| Property and equipment                                                                                                                                                        |   | 4,045,617  |       |
| Goodwill                                                                                                                                                                      |   | 9,419,063  |       |
| Identifiable intangible  assets (trade name of $2,688,000, repeat customer base  of $1,680,000, and licensing agreement and related technology of  $1,364,000) |   | 5,732,000  |       |
| Deferred income tax  assets                                                                                                                                                   |   | 642,047    |       |
|                                                                                                                                                                          |   | 26,021,345 |       |
| **Liabilities:**                                                                                                                                                              |   |       |       |
| Accounts payable                                                                                                                                                              |   | 594,982    |       |
| Obligation under Put  Option                                                                                                                                                  |   | 2,355,000  |       |
| Accrued liabilities                                                                                                                                                           |   | 1,418,762  |       |
| Capital lease obligation                                                                                                                                                      |   | 2,700,000  |       |
| Deferred income taxes  payable                                                                                                                                                |   | 1,698,596  |       |
|                                                                                                                                                                          |   | 8,767,340  |       |
| Total purchase price                                                                                                                                                          |   | $          | 17,254,005 |   |

 

In accordance with theprovisions of SFAS No. 142, the Company will not amortize goodwill andintangible assets with indefinite lives. The value allocated to goodwill in thepurchase of Silipos is not deductible for income tax purposes.

Summaryunaudited pro forma condensed results of operations for the year ended December 31,2004 and 2003, assuming the Silipos acquisition had occurred at the beginningof the earliest period presented are as follows:

| ** **             | ** ** | **For the years ended December 31,** | ** ** |
|------------------------|------------|---------------------------------------------------------------|------------|
| ** **             | ** ** | **2004**                                                      | ** ** | **2003** | ** ** |
| Net sales              |       | $                                                             | 44,608,253 |   | $ | 45,558,684 |   |
| Loss before income tax |       | (11,185,474                                                   | )          | (7,709,072 | ) |
| Net loss               |       | (11,343,157                                                   | )          | (8,494,633 | ) |
| Net loss per share     |       | (2.58                                                         | )          | (1.94 | ) |
|                        |            |                                                               |            |  |  |  |  |

 

These pro forma resultsare not necessarily indicative of what would have occurred if the acquisitionhad been in effect for the period presented, and they may not be indicative ofresults expected in the future.

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**(d) Identifiable IntangibleAssets**

Identifiableintangible assets at December 31, 2005 consisted of:

| **Assets**                                               | ** ** | ** **      | ** ** | **Estimated  Useful Life  from  Acquisition Date  unless noted** | ** ** | **Original  Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Allowance  for Impairment** | ** ** | **Net Carrying  Value** | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|------------------------------------------------------------------|------------|--------------------|------------|-------------------------------|------------|------------------------------------|------------|------------------------------|------------|
| Trade names—Benefoot                                |       | Indefinite      |       | $                                                                | 1,600,000  |               |       | $                             | —     |                               |       |                         | $          | 1,600,000 |   |   |   | $ | — |   |   |
| Non-competition  agreements—Benefoot/Bi-Op          |       | 4 Years(1)      |       | 630,000                                                          |       |               | 270,051    |                          |       |                               | 58,000     |                         |       |   | 301,949 |   |   |
| License agreements and  related technology—Benefoot |       | 5 to 8 Years(1) |       | 1,600,000                                                        |       |               | 531,460    |                          |       |                               | 444,000    |                         |       |   | 624,540 |   |   |
| Repeat customer  base—Bi-Op                         |       | 7 Years(1)      |       | 500,000                                                          |       |               | 75,000     |                          |       |                               | —     |                         |       |   | 425,000 |   |   |
| Trade Names—Silipos                                 |       | Indefinite      |       | 2,688,000                                                        |       |               | —     |                          |       |                               | —     |                         |       |   | 2,688,000 |   |   |
| Repeat customer  base—Silipos                       |       | 7 Years         |       | 1,680,000                                                        |       |               | 300,000    |                          |       |                               | —     |                         |       |   | 1,380,000 |   |   |
| License agreements and  related technology—Silipos  |       | 9.5 Years       |       | 1,364,000                                                        |       |               | 179,474    |                          |       |                               | —     |                         |       |   | 1,184,526 |   |   |
|                                                     |       |            |       | $                                                                | 10,062,000 |               |       | $                             | 1,355,985  |                               |       |                         | $          | 2,102,000 |   |   |   | $ | 6,604,015 |   |   |

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(1)          Asa result of the Company’s review of goodwill and long-lived assets withindefinite lives in accordance with SFAS No. 142, the Company provided anallowance for impairment of $1,600,000 with respect to certain of theidentifiable intangible assets. Additionally, based upon its SFAS No. 144 analysis,the Company recorded a provision of impairment of $502,000 with respect tocertain of the identifiable intangible assets with definitive lives, as it wasdetermined, based upon the review of estimated related cashflows, that thecarrying value of certain of the identifiable intangible assets with indefinitelives exceeded the fair value. Further, based upon the analysis as ofOctober 1, 2005, it was determined that the estimated useful lives ofcertain of the identifiable intangible assets with definite lives needed to bereduced, and the Company prospectively reduced the estimated useful lives ofcertain identifiable intangible assets for Non-competition agreements—Benefoot/Bi-Opfrom 7 to 8 years to 4 years, License agreements and related technology—Benefootfrom 11 years to 5 to 8 years and Repeat customer base—Bi-Op from 20 yearsto 7 years.

Identifiableintangible assets at December 31, 2004 consisted of:

| **Assets**                                               | ** ** | ** **   | ** ** | **Original  Useful Life  from  Acquisition Date** | ** ** | **Original  Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Value** | ** ** |
|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------|------------|--------------------|------------|-------------------------------|------------|--------------------------|------------|
| Trade names—Benefoot                                |       | Indefinite   |       | $                                                 | 1,600,000  |               |       | $                             | —     |                     |       | $ | 1,600,000 |   |
| Non-competition  agreements—Benefoot/Bi-Op          |       | 7 to 8 Years |       | 630,000                                           |       |               | 187,197    |                          |       | 442,803                  |       |
| License agreements and  related technology—Benefoot |       | 11 Years     |       | 1,600,000                                         |       |               | 386,010    |                          |       | 1,213,990                |       |
| Repeat customer  base—Bi-Op                         |       | 20 Years     |       | 500,000                                           |       |               | 50,000     |                          |       | 450,000                  |       |
| Trade Names—Silipos                                 |       | Indefinite   |       | 2,688,000                                         |       |               | —     |                          |       | 2,688,000                |       |
| Repeat customer  base—Silipos                       |       | 7 Years      |       | 1,680,000                                         |       |               | 60,000     |                          |       | 1,620,000                |       |
| License agreements and  related technology—Silipos  |       | 9.5 Years    |       | 1,364,000                                         |       |               | 35,895     |                          |       | 1,328,105                |       |
|                                                     |       |         |       | $                                                 | 10,062,000 |               |       | $                             | 719,102    |                     |       | $ | 9,342,898 |   |

 

Aggregate amortization expense relating to the aboveidentifiable intangible assets for the years ended December 31, 2005, 2004and 2003, was $636,883, $349,207, and $253,308, respectively. As of December 31,2005, the estimated future amortization expense is approximately $643,000 perannum for 2006 - 2008, and $623,000 for 2009, approximately $540,000for 2010 and approximately $823,000 thereafter. The effect of the change inestimated useful lives for certain of the identifiable intangible assets is toincrease amortization by approximately $84,000 per year in 2006 to 2008 andapproximately $74,000 in 2009, and to reduce amortization by approximately $4,000in 2010, approximately $23,000 in 2011, approximately $39,000 in 2012,approximately $35,000 in 2013 and approximately $25,000 per year in 2014 to2022.

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**(e)   Goodwill**

Changesin goodwill for the years ended December 31, 2003, 2004 and 2005 are asfollows:

| ** **                                                                             | ** ** | **Orthopedics** | ** ** | **Skincare** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------|------------|--------------|------------|------------|------------|
| Balance,  January 1, 2003                                                         |       | $               | 3,186,386  |         | $          | —     |       | $ | 3,186,386 |   |
| Purchase price  adjustments related to achievement of milestones and acquisition costs |       | 529,756         |       | —       |       | 529,756    |       |
| Acquisition of Bi-Op                                                                   |       | 820,056         |       | —       |       | 820,056    |       |
| Balance,  December 31, 2003                                                       |       | 4,536,198       |       | —       |       | 4,536,198  |       |
| Purchase price  adjustments related to achievement of milestones                  |       | 163,952         |       | —       |       | 163,952    |       |
| Acquisition of  Silipos                                                                |       | 6,034,701       |       | 2,586,300    |       | 8,621,001  |       |
| Balance,  December 31, 2004                                                       |       | 10,734,851      |       | 2,586,300    |       | 13,321,151 |       |
| Purchase price  adjustments related to Silipos                                         |       | 558,643         |       | 239,419      |       | 798,062    |       |
| Balance,  December 31, 2005                                                       |       | $               | 11,293,494 |         | $          | 2,825,719  |       | $ | 14,119,213 |   |

 

**(3)   Inventories,net**

Inventories,net, consisted of the following: 

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Raw materials                                |       | $                     | 2,648,238  |   | $ | 2,621,930 |   |
| Work-in-process                              |       | 265,204               |       | 466,980 |   |
| Finished goods                               |       | 1,773,825             |       | 2,126,417 |   |
|                                         |       | 4,687,267             |       | 5,215,327 |   |
| Less: Allowance  for excess and obsolescence |       | 564,269               |       | 369,244 |   |
|                                         |       | $                     | 4,122,998  |   | $ | 4,846,083 |   |

 

**(4)   Property and Equipment, net**

Property and equipment, net, is comprised of thefollowing: 

| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Land, building  and improvements (see Note 7)    |       | $                     | 2,557,687  |   | $ | 2,542,203 |   |
| Office furniture  and equipment                  |       | 1,096,082             |       | 1,060,232 |   |
| Computer  equipment and software                 |       | 3,693,872             |       | 3,222,660 |   |
| Machinery and  equipment                         |       | 2,664,482             |       | 2,460,732 |   |
| Leasehold  improvements                          |       | 897,221               |       | 784,259 |   |
|                                             |       | 10,909,344            |       | 10,070,086 |   |
| Less: Accumulated  depreciation and amortization |       | 3,874,459             |       | 2,888,809 |   |
|                                             |       | $                     | 7,034,885  |   | $ | 7,181,277 |   |

 

Depreciation andamortization expense relating to property and equipment was $1,010,797,$604,015 and $397,901 for the years ended December 31, 2005, 2004 and2003, respectively.

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**(5)   OtherCurrent Liabilities**

Othercurrent liabilities consisted of the following: 

| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Accrued payroll  and related payroll taxes |       | $                     | 610,098    |   | $ | 633,191 |   |
| Accrued  professional fees                 |       | 878,392               |       | 384,711 |   |
| Deferred  interest—capital lease      |       | 560,178               |       | 518,125 |   |
| Accrued severance  and severance related   |       | 335,208               |       | — |   |
| Accrued bonuses                            |       | 315,647               |       | 410,775 |   |
| Credits due  customers                     |       | 210,625               |       | 161,668 |   |
| Accrued rent                               |       | 73,214                |       | 67,429 |   |
| Accrued warranty                           |       | 70,000                |       | 70,000 |   |
| Accrued  transaction costs                 |       | —                |       | 775,921 |   |
| Accrued interest                           |       | —                |       | 144,375 |   |
| Other                                      |       | 621,585               |       | 1,099,150 |   |
|                                       |       | $                     | 3,674,947  |   | $ | 4,265,345 |   |

 

Thefollowing is a summary of the activity related to the Company’s warrantyreserve:

| ** **                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Balance at the  beginning of the year |       | $                                           | 70,000     |   | $ | 70,000 |   | $ | 70,000 |   |
| Acquired                              |       | —                                      |       | — |   | — |   |
| Provisions for  warranty              |       | 290,146                                     |       | 332,343 |   | 404,538 |   |
| Warranty utilized                     |       | (290,146                                    | )          | (332,343 | ) | (404,538 | ) |
| Balance at the  end of the year       |       | $                                           | 70,000     |   | $ | 70,000 |   | $ | 70,000 |   |

 

**(6)**   Public Offering

On June 15, 2005, theCompany closed upon an underwritten public offering of common stock, resultingin a sale of 5,000,000 shares of common stock at $6.50 per share or $32,500,000of gross proceeds. On July 13, 2005, the underwriters exercised a portionof their overallotment option and purchased an additional 226,989 shares ofcommon stock at $6.50 per share resulting in gross proceeds of $1,475,429. TheCompany used a portion of the net proceeds totalling $5,675,389 to repay the$5,500,000 principal amount of 7% senior subordinated notes dueSeptember 30, 2007 (the “Subordinated Notes”), plus accrued interest of$175,389 on June 15, 2005. In July 2005, the Company used $11,891,000of the proceeds to repay the $7.5 Million Note, the $3.0 Million Note, plusrelated accrued interest (including the portion attributable to increasing-ratedebt) of approximately $591,000, and the obligation under the Silipos stockpurchase agreement of $900,000. The Company incurred underwriting discounts andoffering expenses totalling $4,673,686 in connection with the sale of theaggregate 5,226,989 shares.

**(7)**   Long-term Debt

On October 31, 2001, the Company completed thesale of $14,589,000 principal amount of its 4% convertible subordinated notesdue August 31, 2006 (the “Convertible Notes”), in a private placement.Langer Partners, LLC (“Langer Partners”), whose sole manager and voting memberis Warren B. Kanders, the Company’s Chairman of the Board of Directors sinceNovember 12, 2004, holds $2,500,000 principal amount of these ConvertibleNotes. The Convertible Notes are convertible into shares of the Company’scommon stock at a conversion price of $6.00 per share (equal to the marketvalue of the Company’s stock on October 31, 2001), subject toanti-dilution protections in the event that, among other things, the Companyissues common stock or equity securities convertible into or exchangeable forcommon stock at a 

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price below the conversionprice of the Convertible Notes, and are subordinated to existing or futuresenior indebtedness of the Company. Among other provisions, the Company may, atits option, call, prepay, redeem, repurchase, convert or otherwise acquire(collectively, “Call”) the Convertible Notes, in whole or in part afterAugust 31, 2003. If the Company elects to Call any of the ConvertibleNotes, the holders of the Convertible Notes may elect to convert theConvertible Notes into the Company’s common stock. On June 20, 2005,$150,000 of the Convertible Notes were converted into 25,000 shares of commonstock in accordance with their terms. Interest is payable semi-annually on thelast day of June and December. Interest expense on the Convertible Notesfor the years ended December 31, 2005, 2004 and 2003 were $580,377 and$583,560, and $583,560, respectively.

The Company received net proceeds of $13,668,067 fromthe offering of the Convertible Notes. The cost of raising these proceeds was$920,933, which is being amortized over the life of the Convertible Notes. Theamortization of these costs for the years ended December 31, 2005, 2004and 2003 were $192,715, $193,772 and $193,772, respectively, and were includedin interest expense in the related consolidated statements of operations.

The Company issued $1,800,000 in promissory notes inconnection with the acquisition of Benefoot. $1,000,000 of the notes wererepaid on May 6, 2003 and the balance was repaid on May 6, 2004.Related interest expense for the years ended December 31, 2004 and 2003were $11,111 and $45,932, respectively.

On September 30, 2004, the Company completed theacquisition of all of the outstanding stock of Silipos (see Note 2 (c)—“Acquisitionof Silipos”). In connection with the acquisition of Silipos, the Company issued:

(i)            the Subordinated Notesin the principal amount of $5,500,000 to ten accredited investors;

(ii)        the $7.5 Million Note, aspreviously defined; and

(iii)    the $3.0 Million Note, aspreviously defined.

The Subordinated Notes were issued to fund the cashportion of the purchase price for Silipos. Langer Partners, held $750,000principal amount of these Subordinated Notes. As part of such issuance, theCompany also issued warrants to purchase an aggregate of 110,000 shares of theCompany’s common stock at an exercise price of $0.02 per share, subject toadjustments under certain circumstances, which warrants are exercisable until September 30,2009, commencing on September 30, 2005. The fair value of the warrants at September 30,2004 was determined to be $735,900, using the Black-Scholes pricing model andthe following assumptions: risk free interest rate of 2.89%, dividend of 0%,volatility of 83%, and an expected life of three years and was recorded as debtdiscount. Such amount was originally being amortized over the term of theSubordinated Notes, and recorded as an additional interest expense.Additionally, the Company issued 10,000 warrants, under the same terms asdescribed above, to an unaffiliated third party for placing the Subordinated Notes,which warrants have a fair value of $75,800, using the Black-Scholes pricingmodel and the same assumptions used to value the other warrants. In the yearended December 31, 2005, the Company recognized amortization expense of$106,386 and $12,252 with respect to the debt discount (warrants) and debtplacement fees, respectively, which was included in interest expense in theconsolidated statement of operations, all of which was recognized in the sixmonths ended June 30, 2005. There were no such amounts in the prior yearperiods. Additionally, during the year ended December 31, 2005, theCompany incurred interest expense of $175,389 with respect to theSubordinated Notes, all of which was recorded as of June 30, 2005. TheCompany repaid the Subordinated Notes plus accrued interest, which totalled$5,675,389, on June 15, 2005, with a portion of the net proceeds from itspublic offering of common stock (see Note 6, “Public Offering”). Accordingly,as of June 30, 2005, the Company recognized $572,116 with respect to theunamortized debt discount (fair value of the warrants) and the unamortized debtplacement fees of $57,973, which is included in interest expense on theconsolidated statement of operations for the year ended December 31, 2005.

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The $7.5 Million Note was secured by the pledge of thestock of Silipos and was subject to increase pursuant to a Protection Paymentas defined in Note 1 (b). Both the $7.5 Million Note and the $3.0 Million Noteprovided for semi-annual payments of interest at the rate of 5.5% per annumwith the first payments due and paid February 1, 2005. The interest rateon the $7.5 Million Note increased from 5.5% to 7.5% on April 1, 2005. TheCompany recorded the $7.5 Million Note and the $3.0 Million Note at their facevalue, which represented the fair value of the notes on their date of issuance(September 30, 2004). The Company adjusted the carrying value of the $7.5Million Note and the $3.0 Million Note to $7.986 million and$2.737 million, respectively, at December 31, 2004, and furtheradjusted the carrying value of the notes as of January 1, 2005 to $7.723million and $3.0 million, respectively, upon the Company’s determination tofollow EITF No. 86-15 with respect to the $7.5 Million Note (seeNote 1 (b)). On March 31, 2005, the Company entered into a settlementagreement (the “Settlement Agreement”) and limited release among the parties tothe Silipos purchase agreement. Under the terms of the Settlement Agreement,the parties exchanged mutual releases and agreed to a $232,000 reduction in thepurchase price previously paid by the Company to SSL because Silipos did notsatisfy certain minimum working capital requirements as of the closing date ofthe acquisition pursuant to the Silipos purchase agreement. The reduction tothe purchase price was satisfied by amending and restating the $7.5 MillionNote, which was originally due on March 31, 2006 to reflect the reductionin the purchase price of $232,000. In addition, the $7.5 Million Note wasamended and restated to reflect the Company’s election on March 15, 2005,in accordance with its terms, to increase the principal amount effective, April 1,2005, by the $1,000,000 Protection Payment rather than to make an additionalcash payment of $500,000 by March 31, 2005. As amended and restated andeffective as of April 1, 2005, the face value of the $7.5 Million Note was$8,268,000. Additionally, under the terms of the Settlement Agreement, theparties also agreed to amend and restate the $3.0 Million Note, which wasoriginally due on December 31, 2009. The $3.0 Million Note was amended andrestated to provide that the $3.0 Million Note was to be reduced by$500,000 if the $7.5 Million Note was repaid in full on or before May 31,2005, and would be further reduced by an additional $500,000 if both the $3.0Million Note and the $7.5 Million Note have been repaid in full on or before March 31,2006. The Company determined that the Protection Payment represented aterm-extending option that did not meet the criteria for bifurcation under SFASNo. 133 in that there is no provision for net settlement. The Companyfollowed the guidance of EITF No. 86-15, which addresses thecalculation of interest cost on increasing-rate debt and requires that interestcosts should be determined using the interest method based on the estimatedoutstanding term of the debt (12 months from issuance). Accordingly, theCompany recorded additional interest expense of approximately $677,000 (inexcess of the initial coupon rate of 5.5%, 7.5% after April 1, 2005), netof the $100,000 discount negotiated as part of the settlement discussed below,to increase the carrying value of the $7.5 Million Note to the payoff amount of$8,168,000 at June 30, 2005, which is reflected as interest expense in theconsolidated statement of operations for the year ended December 31, 2005.

Under its original terms, the $3.0 Million Note wouldbe reduced by half of any Protection Payment actually made pursuant to the $7.5Million Note if both the $7.5 Million Note and the $3.0 Million Note are repaidprior to March 31, 2006. The Company determined that the right to reducethe $3.0 Million Note by 50% of the Protection Payment made on the $7.5 MillionNote if both the $7.5 Million Note and the $3.0 Million Note were repaid infull by March 31, 2006, represented a call option (“Refund Provision”)that is an embedded derivative that met the criteria under SFAS No. 133for bifurcation and separate accounting treatment. The exercise price pursuantto the call option under the $3.0 Million Note is equal to the principal amountof the $3.0 Million Note less any refund the Company is entitled to under theRefund Provision, based upon whether or not the $7.5 Million Note has beenrepaid and the date of exercise. The Company concluded that the Refund Provisionembedded in the $3.0 Million Note is not clearly and closely related to the$3.0 Million Note because the $3.0 Million Note could be settled in such a waythat the holder of such note would not recover substantially all of itsinvestment. After reaching this determination, the Company followed theguidance of DIG B-16, which concludes that call options embedded in debtthat are not considered clearly and closely related to the debt itself are netsettleable 

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and thus requirebifurcation. Accordingly, the Refund Provision was recorded at fair value atissuance date (September 30, 2004), and was subsequently marked to marketthrough earnings. The fair value of the Refund Provision embedded in the $3.0Million Note was determined to be de minimis and accordingly, no asset wasrecorded at September 30, 2004. Based upon a fair market value analysis toan unrelated third party market participant, the Refund Provision was valued at$500,000 at June 30, 2005 and was recorded as a current asset (calloption) and a non-cash gain on the change in the fair value of a call option.In making this determination, consideration was given primarily to the factthat the Company had completed its underwritten public offering of common stockon June 15, 2005, had raised sufficient equity, after related expenses, torepay both the $7.5 Million Note and the $3.0 Million Note prior to March 31,2006, and reached an agreement in principal with SSL (discussed below) to repaythe notes. The Company realized $500,000 with respect to the Refund Provisionupon the repayment of the $7.5 Million Note and the $3.0 Million Note in July 2005,which was recorded as a reduction in interest expense in the consolidatedstatement of operations for the three and nine months ended September 30,2005, which was offset by the reversal of the non-cash gain on the change inthe fair value of the call option previously recorded.

The Company incurred interest expense of approximately$959,000 (inclusive of approximately $677,000 of additional interest expense inexcess of the initial coupon rate of 5.5% (7.5% after April 1, 2005)) andapproximately $89,000 with respect to the $7.5 Million Note and the $3.0Million Note, respectively, for the year ended December 31, 2005.

In June 2005, the Company reached a furthersettlement with SSL to repay the acquisition indebtedness incurred and certainother obligations due under the Silipos stock purchase agreement. Additionally,the Company agreed to satisfy its obligations under the Silipos stock purchaseagreement to pay SSL Holdings, Inc. $1.0 million by March 31, 2006 ifthe Company did not acquire Poly-Gel by such date. In consideration of theCompany’s earlier than scheduled repayment of the $7.5 Million Note, the $3.0Million Note, and the $1.0 million payment, SSL provided the Company with a$100,000 discount with respect to the $7.5 Million Note and a $100,000 discountwith respect to the $1.0 million payment. The agreement was consummated andpayment was made on July 15, 2005.

Pursuant to the acquisition of Silipos, the Company isobligated under a capital lease covering the land and building at the Siliposfacility in Niagara Falls, N.Y. that expires in 2018. This lease also containstwo five-year renewal options. As of December 31, 2005, the Company’sobligation under capital lease, excluding current installments, is $2,700,000.

Annualfuture minimum capital lease payments are as follows:

| **Years ending December 31:**                    | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                                            |       | $          | 411,504    |       |
| 2007                                                            |       | 422,052    |       |
| 2008                                                            |       | 432,516    |       |
| 2009                                                            |       | 443,016    |       |
| 2010                                                            |       | 453,512    |       |
| Later years  through 2018                                       |       | 4,153,712  |       |
| Total minimum lease payments                                    |       | 6,316,312  |       |
| Less: Amount  representing interest                             |       | 3,616,312  |       |
| Present value of net minimum capital lease payments             |       | 2,700,000  |       |
| Less: Current  installments of obligations under capital lease  |       | —     |       |
| Obligations under  capital lease, excluding current installment |       | $          | 2,700,000  |       |

 

Additionally, the Company has accrued interest of$560,178 and $518,125 at December 31, 2005 and 2004, respectively, withrespect to the capital lease which is included in other current liabilities atthe respective balance sheet dates.

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AtDecember 31, 2005 and 2004, the gross amount of land and building andrelated accumulated depreciation recorded under the capital lease was asfollows: 

| ** **                      | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Land                            |       | $                     | 278,153    |   | $ | 278,153 |   |
| Building                        |       | 1,654,930             |       | 1,654,930 |   |
|                            |       | 1,933,083             |       | 1,933,083 |   |
| Less: Accumulated  depreciation |       | 151,365               |       | 30,273 |   |
|                            |       | $1,781,718            |       | $ | 1,902,810 |   |
|                                 |            |                       |            |  |  |  |  |

 

**(8)**   Commitments andContingencies

**(a) Leases**

Certain of the Company’s facilities and equipment areleased under noncancelable operating leases. Rental expense amounted to$753,553, $580,895, and $519,094 for the years ended December 31, 2005,2004 and 2003, respectively.

Futureminimum rental payments required under current operating leases are:

| **Years ending December 31:** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                         |       | $          | 766,939    |       |
| 2007                                         |       | 1,273,421  |       |
| 2008                                         |       | 1,043,594  |       |
| 2009                                         |       | 849,160    |       |
| 2010                                         |       | 598,061    |       |
| Thereafter                                   |       | 4,156,580  |       |
|                                         |       | $          | 8,687,755  |       |

 

On December 19, 2005,we entered into a lease (as tenant) with 41 Madison, L.P. (the “Landlord”) ofcertain space, for use as sales, marketing and executive offices. The leasewill run for 10 years, 8 months, commencing upon the completion of thebuild-out of the space at the Landlord’s expense (up to $607,000, with theCompany responsible for the excess build-out cost, if any). The Company has aone-time right to renew the lease for a term of 5 years at a base rent equal tothe fair market value of the space at the time of renewal. The Company also hasa one-time right to terminate the lease as of the end of the 88th month, upon 12 months prior notice to theLandlord. The Company began recording rent expense on a straight line basiscommencing in December 2005 in accordance with FASB Staff Position SFAS No. 13-1,“Accounting for Rental Costs Incurred during a Construction Period.”

**(b) Royalties**

The Company has enteredinto several agreements with licensors, consultants and suppliers, whichrequire the Company to pay royalty fees relating to the sale of certainproducts. Royalties in the aggregate under these agreements totaled $506,360,$323,715, and $57,680 for the years ended December 31, 2005, 2004 and2003, respectively.

**(c) Letter ofCredit**

In connection withexecuting the lease of office space in New York City on December 19, 2005,described above in Note 8(a), the Company issued an irrevocable letter ofcredit in favor of the landlord in the amount of $368,672 to secure itsperformance under the terms, covenants and condition of the lease, with a termof one year, which term shall automatically renew for successive one yearperiods such that the 

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letterof credit will not expire less than 60 days beyond the expiration date of thelease. The Company incurred an issuance fee of $500 in connection with thisirrevocable letter of credit.

**(9)**   EmployeeRestricted Stock and Other Stock Issuances

In November 2004, the Company granted 40,000shares of restricted stock to a key employee of the Company which wasoriginally scheduled to vest in three annual tranches beginning in 2005.Unearned stock compensation of $300,000 was recorded based on the fair marketvalue of the Company’s common stock at the date of grant, or $7.50 per share.Unearned stock compensation is shown as a separate component of stockholders’equity and was originally being amortized to expense over the three-yearvesting period of the restricted stock. Amortization of unearned stockcompensation for the year ended December 31, 2004 was $22,917 and wasincluded in general and administrative expenses in the consolidated statement ofoperations. On December 20, 2005, the Board of Directors accelerated thevesting of the stock award subject to lock-up, confidentiality andnon-competition agreements. 17,200 shares were returned to the Company tosettle related tax obligations. The Company recorded $277,083 of compensationexpense with respect to the award in the statement of operations for the yearended December 31, 2005. The restricted stock has all the rights andprivileges of the Company’s common stock, subject to certain restrictions andforfeiture provisions.

During the years ended December 31, 2005, 2004,and 2003, the Company issued 901 shares, 17,082 shares, and 3,096 sharesof common stock with fair values of $5,000, $127,264 and $10,000, respectively,for consulting services.

On November 12, 2004,the Board of Directors approved a grant of 100,000 shares of restricted stockto Kanders & Company, Inc. (“Kanders & Company”), the sole stockholderof which is Warren B. Kanders, subject to certain performance conditions,provided Mr. Kanders has not resigned from the Board of Directors, all ofwhich were originally scheduled to vest on November 12, 2007 and whichwould accelerate upon the death of Mr. Kanders, or the change of controlof the Company. On December 20, 2005, the Board of Directors acceleratedthe vesting of the stock award, which remains subject to lock-up,confidentiality and non-competition agreements. The Company recorded acompensation charge of $465,000 with respect to such award in the statement ofoperations for the year ended December 31, 2005, of which approximately$317,000 relates to the acceleration of the vesting of such award.

**(10)**   Stock Options

The Company maintained a stock option plan foremployees, officers, directors, consultants and advisors of the Companycovering 550,000 shares of common stock (the “1992 Plan”). Outstanding optionsgranted under the 1992 Plan are exercisable for a period of ten years from dateof grant at an exercise price at least equal to 100 percent of the fairmarket value of the Company’s common stock at the date of grant. Pursuant tovesting schedules all of which is subject to the approval of the Board ofDirectors. The expiration date of the plan was July 26, 2002. AtDecember 31, 2005, there were 175,000 options outstanding under the 1992Plan. At the Company’s July 17, 2001 annual meeting, the shareholdersapproved and adopted a new stock incentive plan for a maximum of 1,500,000shares of common stock (the “2001 Plan”) with substantially the same terms asthe 1992 Plan. At December 31, 2005, there were 716,628 optionsoutstanding under the 2001 Plan. On June 23, 2005, the shareholdersapproved the Company’s 2005 Stock Incentive Plan, pursuant to which a maximum2,000,000 shares of commons stock are reserved for issuance and available forawards.

87

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Thefollowing is a summary of activity related to the Company’s qualified andnon-qualified stock options: 

| ** **                               | ** ** | **Number of  Shares** | ** ** | **Exercise price  range per  share** | ** **       | **Weighted  average  exercise price  per share** | ** ** |
|------------------------------------------|------------|----------------------------|------------|------------------------------------------------|------------------|------------------------------------------------------------|------------|
| Outstanding at  January 1, 2003     |       | 609,000                    |       | $                                              | 1.53 – 8.15 |                                                       |       | $ | 2.92 |   |   |
| Granted                                  |       | 32,330                     |       | 3.20 – 6.50                               |             |                                                       | 4.87       |   |   |
| Cancelled or  forfeited                  |       | (18,000                    | )          | 3.20 – 8.15                               |             |                                                       | 5.52       |   |   |
| Outstanding at  December 31, 2003   |       | 623,330                    |       | 1.53 – 8.07                               |             |                                                       | 2.95       |   |   |
| Granted                                  |       | 396,880                    |       | 5.94 – 7.50                               |             |                                                       | 7.19       |   |   |
| Granted subject  to shareholder approval |       | 300,000                    |       | 7.50                                           |             |                                                       | 7.50       |   |   |
| Exercised                                |       | (500                       | )          | 3.20                                           |             |                                                       | 3.20       |   |   |
| Cancelled or  forfeited                  |       | (126,206                   | )          | 3.20 – 8.07                               |             |                                                       | 7.67       |   |   |
| Outstanding at  December 31, 2004   |       | 1,193,504                  |       | 1.53 – 8.07                               |             |                                                       | 4.93       |   |   |
| Granted                                  |       | 1,231,000                  |       | 4.89 – 7.52                               |             |                                                       | 6.01       |   |   |
| Exercised                                |       | (110,000                   | )          | 1.53                                           |             |                                                       | 1.53       |   |   |
| Cancelled or  forfeited                  |       | (404,376                   | )          | 3.20 – 7.50                               |             |                                                       | 7.39       |   |   |
| Outstanding at  December 31, 2005   |       | 1,910,128                  |       | $                                              | 1.53 – 8.07 |                                                       |       | $ | 5.30 |   |   |

 

Thefollowing table summarizes information about options outstanding as of December 31,2005:

| **Exercise Prices** | ** ** | ** ** | ** ** | **Number  Outstanding** | ** ** | **Weighted Avg.  Remaining  Contractual  Life (Years)** | ** ** | **Number  Exercisable** | ** ** |
|--------------------------|------------|------------|------------|-------------------------|------------|-------------------------------------------------------------------|------------|-------------------------|------------|
| $1.53                    |       |       | 365,000    |                    |       |                                                              | 5.06       |                    |       | 365,000 |   |
| $5.34                    |       |       | 10,000     |                    |       |                                                              | 5.75       |                    |       | 10,000 |   |
| $8.07                    |       |       | 13,500     |                    |       |                                                              | 6.30       |                    |       | 13,500 |   |
| $3.20                    |       |       | 2,000      |                    |       |                                                              | 7.21       |                    |       | 2,000 |   |
| $5.94                    |       |       | 88,128     |                    |       |                                                              | 8.25       |                    |       | 88,128 |   |
| $6.28                    |       |       | 30,000     |                    |       |                                                              | 8.50       |                    |       | 30,000 |   |
| $7.50                    |       |       | 420,000    |                    |       |                                                              | 8.87       |                    |       | 420,000 |   |
| $6.52                    |       |       | 453,000    |                    |       |                                                              | 9.50       |                    |       | 378,000 |   |
| $4.89                    |       |       | 528,500    |                    |       |                                                              | 9.87       |                    |       | 528,500 |   |
|                     |       |       | 1,910,128  |                    |       |                                                              |       |                    |       | 1,835,128 |   |

 

At December 31, 2005, all 175,000 options wereexercisable and no options were available for issuance under the 1992 Plan. At December 31,2005, 641,628 options were exercisable, 75,000 options were unexercisable andno options were available under the 2001 Plan. At December 31, 2005, all768,500 issued under the 2005 Plan were exercisable under the 2005 Plan. Theoptions outstanding at December 31, 2005 under the 1992 Plan, the 2001Plan and the 2005 Plan had remaining lives ranging from approximately 5 yearsto almost 10 years, with a weighted-average life of approximately8.6 years.

On September 8, 2005, the Company determined notto extend Andrew H. Meyer’s employment contract, and in accordance withits terms, the contract expired December 31, 2005 (except for certaincovenants by Mr. Meyers in favor of the Company). In accordance with amodification of the employment contract on November 12, 2004, whichextended his right to exercise 175,000 vested options from 90 days to one yearbeyond termination, the Company recorded a non-cash charge equal to theintrinsic value of the options on the date the option agreement was modified,or approximately $1,046,000 at December 31, 2005. 

88

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The Company issued certain stock options forconsulting services. In connection with such options, the Company recordednon-cash compensation expense totaling $1,257,000, which includes the effect ofaccelerating the vesting of certain stock options in the year endedDecember 31, 2005 (see Note 15, “Related Party Transactions”).

On December 20, 2005, in order to lessen theimpact in future periods, the Company accelerated the vesting of (i) certainunvested stock options previously awarded to employees, officers, consultantsand directors of the Company under its 2005 Stock Incentive Plan and 2001 StockIncentive Plan, and (ii) all unvested restricted stock awards, subject ineach case to such optionees and restricted stock award holders entering intolock-up, confidentiality and non-competition agreements. As a result of thisaction, options to purchase 1,238,503 shares of common stock (387,500 shares ofwhich were consultant stock options and 851,003 shares of which were employeestock options) that would have vested over the next one to five years becamefully vested. None of these employee stock options were in the money on thisdate. Therefore, there was no compensation expense recognized with respect tothe acceleration of the 851,003 stock options. Outstanding unvested options(75,000) that were not accelerated will continue to vest on their currentschedules. The 75,000 unvested options were forfeited in the first quarter of2006.

The decision to accelerate the vesting of theseoptions and awards, which the Company believes to be in the interest of itsstockholders, was made primarily to reduce non-cash compensation that wouldhave been recorded in future periods following the Company’s application of theSFAS No. 123(R). The Company will be required to apply the expenserecognition provisions of SFAS No. 123(R) beginning January 1,2006. The acceleration of the vesting of the employees’ and directors’ optionsis expected to reduce the Company’s non-cash compensation expense related tothe options by approximately $2,071,000 (pre-tax) for the years 2006 - 2010.The acceleration of vesting of certain stock awards, and stock options issuedfor consulting services resulted in a charge to operations of approximately$1,313,000 (pre-tax) in the fourth quarter of 2005.

Thefollowing table sets forth the numbers of shares as to which the vesting ofstock options or restricted stock awards has been accelerated as a result ofthe foregoing changes for directors and executive officers, and for otherholders of options and/or restricted stock award:

| **Name and Position**                                    | ** ** | ** ** | ** ** | **Shares Acquirable  under Options** | ** ** | **Shares in Restricted  Stock Awards** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|------------------------------------------------|------------|-------------------------------------------------------|------------|
| Warren B.  Kanders, Chairman of the Board,  and stockholder        |       |       | 435,000    |                                           |       |                                                  | 100,000    |   |   |
| Joseph P.  Ciavarella, Vice President and  Chief Financial Officer |       |       | 143,334    |                                           |       |                                                  | —     |   |   |
| Burtt R. Ehrlich,  Director                                        |       |       | 47,500     |                                           |       |                                                  | —     |   |   |
| Arthur Goldstein,  Director                                        |       |       | 47,500     |                                           |       |                                                  | —     |   |   |
| Stuart P.  Greenspon, Director                                     |       |       | 37,500     |                                           |       |                                                  | —     |   |   |
| W. Gray Hudkins,  Chief Operating Officer(1)                       |       |       | 287,500    |                                           |       |                                                  | 26,666     |   |   |
| All other holders  of options and restricted  stock awards         |       |       | 240,169    |                                           |       |                                                  | —     |   |   |
| Totals                                                             |       |       | 1,238,503  |                                           |       |                                                  | 126,666    |   |   |

----

(1)          Became President andChief Executive Officer on January 1, 2006.

At December 31, 2005, there were 716,628 and175,000 shares of common stock reserved for issuance under the 2001 Plan and1992 Plan, respectively. Additionally, there are 768,500 shares of common stockreserved for issuance under the 2005 Plan and 1,130,599 shares of common stockavailable for future grants.

89

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In 2001, the Companyissued 100,000 options to Kanders & Company which are exercisable at aprice of $1.525 per share. (See Note 15, “Related Party Transactions” formore information.)

***Additional Stock Plan Information***

The Company continues to account for its stock-basedawards using the intrinsic value method in accordance with APB No. 25,“Accounting for Stock Issued to Employees”, and its related interpretations.Accordingly, no compensation expense has been recognized in the financialstatements for employee stock arrangements.

SFAS No. 123,“Accounting for Stock-Based Compensation,” requires the disclosure of proforma net income and net income per share had the Company adopted the fairvalue method as of the beginning of fiscal 1997 (see Note 1(p)). UnderSFAS No. 123, the fair value of stock-based awards to employees iscalculated through the use of option pricing models, even though such modelswere developed to estimate the fair value of freely tradable, fullytransferable options without vesting restrictions, which significantly differfrom the Company’s stock option awards. These models also require subjectiveassumptions, including future stock price volatility and expected time toexercise, which greatly affect the calculated values. The Company’scalculations were made using the Black-Scholes option pricing model withthe following weighted average assumptions: expected life, 60 monthsfollowing vesting; stock volatility of 57%, 63% and 62%, and risk free interestrates of 4.12%, 3.52%, and 2.57%, for the years ended December 31, 2005,2004, and 2003, respectively, and no dividends during the expected term. Duringthe years ended December 31, 2005, 2004 and 2003, the options granted had weightedfair values of $3.01, $4.04 and $1.43 per share, respectively. TheCompany’s calculations are on a multiple option valuation approach andforfeitures are recognized as they occur.

**(11)**   SegmentInformation

In the nine months ended September 30, 2004 andthe year ended December 31, 2003, the Company operated in two segments(custom orthotics and distributed products) principally in the design,development, manufacture and sale of foot and gait-related products.Intersegment net sales are recorded at cost.

BeginningOctober 1, 2004, following the acquisition of Silipos, the Companyoperated in two segments, orthopedic and skincare. The segment information forthe year ended December 31, 2005 is reported utilizing these segments, andthe information for the years ended December 31, 2004 and 2003 has beenrestated to reflect the current segment reporting structure. Segmentinformation for the years ended December 31, 2005, 2004 and 2003 issummarized as follows:

| **Year ended December 31, 2005**                                       | ** ** | ** ** | ** ** | **Orthopedic** | ** ** | **Skincare** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------|------------|----------------|------------|--------------|------------|-----------|------------|
| Net sales                                                                                  |       | $          | 35,641,988 |           | $          | 4,499,510    |       | $         | 40,141,498 |   |
| Operating loss                                                                             |       | (5,013,641 | )          | 700,345        |       | (4,313,296   | )          |
| Depreciation of  property and equipment and amortization of identifiable intangible assets |       | 1,404,523  |       | 243,157        |       | 1,647,680    |       |
| Long-lived assets                                                                          |       | 10,934,668 |       | 2,704,232      |       | 13,638,900   |       |
| Total assets                                                                               |       | 48,697,845 |       | 8,474,531      |       | 57,172,376   |       |
| Capital expenditures                                                                       |       | 858,868    |       | 79,947         |       | 938,815      |       |
|                                                                                            |            |            |            |                |            |              |            |           |            |  |  |  |

 

90

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| **Year ended December 31, 2004**                                       | ** ** | ** ** | ** ** | **Orthopedic** | ** ** | **Skincare** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------|------------|----------------|------------|--------------|------------|-----------|------------|
| Net sales                                                                                  |       | $          | 27,946,332 |           | $          | 2,180,427    |       | $         | 30,126,759 |   |
| Operating income                                                                           |       | 755,654    |       | 421,124        |       | 1,176,778    |       |
| Depreciation of  property and equipment and amortization of identifiable intangible assets |       | 888,380    |       | 64,842         |       | 953,222      |       |
| Total assets                                                                               |       | 40,269,829 |       | 7,536,747      |       | 47,806,576   |       |
| Capital expenditures                                                                       |       | 1,197,845  |       | —         |       | 1,197,845    |       |
|                                                                                            |            |            |            |                |            |              |            |           |            |  |  |  |

 

| **Year ended December 31, 2003**                                       | ** ** | ** ** | ** ** | **Orthopedic** | ** **                                                                | **Skincare** | ** ** | **Total**  | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------|------------|----------------|---------------------------------------------------------------------------|--------------|------------|------------|------------|
| Net sales                                                                                  |       | $          | 24,720,515 |           | $           — |         | $          | 24,720,515 |       |
| Operating income                                                                           |       | 764,386    |       | —         |                                                                      | 764,386      |       |
| Depreciation of  property and equipment and amortization of identifiable intangible assets |       | 651,209    |       | —         |                                                                      | 651,209      |       |
| Total assets                                                                               |       | 24,023,197 |       | —         |                                                                      | 24,023,197   |       |
| Capital expenditures                                                                       |       | 1,402,336  |       | —         |                                                                      | 1,402,336    |       |
|                                                                                            |            |            |            |                |                                                                           |              |            |            |            |  |  |

 

Geographicalsegment information is summarized as follows: 

| **Year ended December 31, 2005**                                       | ** ** | ** ** | ** ** | **United States** | ** ** | **Canada** | ** ** | **United  Kingdom** | ** ** | **Consolidated  Total** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------|------------|------------------------|------------|------------|------------|---------------------|------------|-------------------------|------------|
| Net sales to  external customers                                                           |       | $          | 33,448,447 |                   | $          | 2,460,496  |       | $                   | 4,232,555  |                    | $          | 40,141,498 |   |
| Intersegment net  sales                                                                    |       | 963,676    |       | —                 |       | —     |       | 963,676             |       |
| Gross profit                                                                               |       | 14,763,381 |       | 1,218,533              |       | 1,936,650  |       | 17,918,564          |       |
| Operating income  (loss)                                                                   |       | (4,519,738 | )          | 129,719                |       | 76,723     |       | (4,313,296          | )          |
| Depreciation of  property and equipment and amortization of identifiable intangible assets |       | 1,573,273  |       | 45,929                 |       | 28,478     |       | 1,647,680           |       |
| Long-lived assets                                                                          |       | 12,841,132 |       | 619,831                |       | 177,937    |       | 13,638,900          |       |
| Total assets                                                                               |       | 52,813,489 |       | 1,811,793              |       | 2,547,094  |       | 57,172,376          |       |
| Capital expenditures                                                                       |       | 871,554    |       | 47,353                 |       | 19,908     |       | 938,815             |       |
|                                                                                            |            |            |            |                        |            |            |            |                     |            |                         |            |  |  |  |  |

 

| **Year ended December 31, 2004**                                       | ** ** | ** ** | ** ** | **United States** | ** ** | **Canada** | ** ** | **United  Kingdom** | ** ** | **Consolidated  Total** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------|------------|------------------------|------------|------------|------------|---------------------|------------|-------------------------|------------|
| Net sales to  external customers                                                           |       | $          | 24,909,667 |                   | $          | 2,099,329  |       | $                   | 3,117,763  |                    | $          | 30,126,759 |   |
| Intersegment net  sales                                                                    |       | 344,877    |       | —                 |       | —     |       | 344,877             |       |
| Gross profit                                                                               |       | 9,759,521  |       | 1,099,134              |       | 1,245,572  |       | 12,104,227          |       |
| Operating income                                                                           |       | 996,259    |       | 134,763                |       | 45,756     |       | 1,176,778           |       |
| Depreciation of  property and equipment and amortization of identifiable intangible assets |       | 868,246    |       | 40,213                 |       | 44,763     |       | 953,222             |       |
| Total assets                                                                               |       | 44,023,302 |       | 1,717,155              |       | 2,066,119  |       | 47,806,576          |       |
| Capital  expenditures                                                                      |       | 1,080,007  |       | 101,243                |       | 16,595     |       | 1,197,845           |       |
|                                                                                            |            |            |            |                        |            |            |            |                     |            |                         |            |  |  |  |  |

 

91

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| **Year ended  December 31, 2003**                                                      | ** ** | ** ** | ** ** | **United States** | ** ** | **Canada** | ** ** | **United  Kingdom** | ** ** | **Consolidated  Total** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------|------------|-------------------|------------|------------|------------|---------------------|------------|-------------------------|------------|
| Net sales to  external customers                                                            |       | $          | 20,494,911 |              | $          | 1,644,438  |       | $                   | 2,581,166  |                    | $          | 24,720,515 |   |
| Intersegment net  sales                                                                     |       | 267,425    |       | —            |       | —     |       | 267,425             |       |
| Gross profit                                                                                |       | 6,932,015  |       | 735,844           |       | 1,002,866  |       | 8,670,725           |       |
| Operating income  (loss)                                                                    |       | 803,439    |       | (34,705           | )          | (4,348     | )          | 764,386             |       |
| Depreciation of  property and equipment and amortization of identifiable intangibles assets |       | 553,599    |       | 41,893            |       | 55,717     |       | 651,209             |       |
| Total assets                                                                                |       | 21,577,577 |       | 1,333,881         |       | 1,111,739  |       | 24,023,197          |       |
| Capital expenditures                                                                        |       | 1,354,666  |       | 10,295            |       | 37,375     |       | 1,402,336           |       |
|                                                                                             |            |            |            |                   |            |            |            |                     |            |                         |            |  |  |  |  |

 

Export sales from theCompany’s United States operations accounted for approximately 17%, 15%, and17% of net sales for each of the years ended December 31, 2005, 2004 and2003, respectively.

**(12)**   Pension Plan and401(k) Plan

Prior to July 30, 1986, the Company maintained anon-contributory defined benefit pension plan covering substantially allemployees. Effective July 30, 1986, the Company adopted an amendment tothe plan under which future benefit accruals to the plan ceased (freezing themaximum benefits available to employees as of July 30, 1986), other thanthose required by law. Previously accrued benefits remain in effect andcontinue to vest under the original terms of the plan.

92

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Thefollowing table sets forth the Company’s defined benefit plan status at December 31,2005 and December 31, 2004, determined by the plan’s actuary in accordancewith SFAS No. 87, “Employers’ Accounting for Pensions,” as amended by SFASNo. 132:

| ** **                                                             | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                             | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **CHANGE  IN BENEFIT OBLIGATION:**                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Benefit  obligation at beginning of year                               |       | $                     | (719,916   | ) | $ | (684,510 | ) |
| Interest cost                                                          |       | (35,706               | )          | (33,987 | ) |
| Benefits paid                                                          |       | 19,942                |       | 8,615 |   |
| Actuarial loss                                                         |       | (11,991               | )          | (10,034 | ) |
| Settlement                                                             |       | —                |       | — |   |
| Benefit obligation  at end of year                                     |       | $                     | (747,671   | ) | $ | (719,916 | ) |
| **CHANGE IN PLAN ASSETS:**                                             | ** ** | ** **            | ** ** | ** ** | ** ** |
| Fair value of  plan assets, beginning of year                          |       | $                     | 625,471    |   | $ | 512,617 |   |
| Actual return on  plan assets                                          |       | 44,758                |       | 49,390 |   |
| Employer  contribution                                                 |       | 56,996                |       | 72,079 |   |
| Benefits paid                                                          |       | (2,811                | )          | (8,615 | ) |
| Settlement                                                             |       | (17,131               | )          | — |   |
| Fair value of  plan assets, end of year                                |       | $                     | 707,283    |   | $ | 625,471 |   |
| Funded status                                                          |       | $                     | (40,388    | ) | $ | (94,445 | ) |
| Unrecognized  transition (asset)/obligation                            |       | 96,738                |       | 104,529 |   |
| Unrecognized net  (gain) loss                                          |       | 429,859               |       | 434,208 |   |
| Net Amount  Recognized                                                 |       | $                     | 486,209    |   | $ | 444,292 |   |
| **Amounts recognized in the consolidated balance  sheets consist of:** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accrued benefit  cost                                                  |       | $                     | (40,388    | ) | $ | (94,445 | ) |
| Intangible asset                                                       |       | 96,738                |       | 104,529 |   |
| Accumulated other  comprehensive income                                |       | 429,859               |       | 434,208 |   |
| Net Amount  Recognized                                                 |       | $                     | 486,209    |   | $ | 444,292 |   |

 

Theestimated future benefit payments payable by year are as follows: 

| 2006             |   | $      | 678,000 |   |
|------------------|--------|--------|---------|--------|
| 2007             |   | 2,800  |    |
| 2008             |   | 2,800  |    |
| 2009             |   | 2,800  |    |
| 2010             |   | 2,800  |    |
| 2011 – 2014 |   | 14,100 |    |
|             |   | $      | 703,300 |   |

 

| ** **                      | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Projected benefit  obligation   |       | $                     | 747,671    |   | $ | 719,916 |   |
| Accumulated  benefit obligation |       | 747,671               |       | 719,916 |   |
| Fair value of  plan assets      |       | 707,283               |       | 625,471 |   |
|                                 |            |                       |            |  |  |  |  |

 

93

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**Net periodic pension expense is comprised of thefollowing components:**

| ** **                                          | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Interest cost                                       |       | $                                           | 35,706     |   | $ | 33,987 |   | $ | 36,366 |   |
| Expected return  on plan assets                     |       | (47,482                                     | )          | (39,688 | ) | (35,090 | ) |
| Amortization of  unrecognized transition obligation |       | 7,791                                       |       | 7,791 |   | 7,791 |   |
| Amortization of  net loss                           |       | 19,064                                      |       | 19,233 |   | 23,126 |   |
| Settlement                                          |       | —                                      |       | — |   | 37,258 |   |
| Net periodic  pension expense                       |       | $                                           | 15,079     |   | $ | 21,323 |   | $ | 69,451 |   |

 

Thechange in minimum liability with respect to pension benefits included incomprehensive income (loss) is as follows:

| ** **                                                                        | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                        | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| (Decrease)  increase in minimum liability included in comprehensive income (loss) |       | $                                           | (4,349     | ) | $ | (18,901 | ) | $ | (51,306 | ) |
|                                                                                   |            |                                             |            |  |  |  |  |  |  |  |

 

**Assumptions**

**Weightedaverage assumptions used to determine benefit obligations at December 31:**

| ** **    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate |       | 5.0%     |       | 5.0%     |       | 5.0%     |       |

 

**Weightedaverage assumptions used to determine periodic benefit cost for years ended December 31:**

| ** **                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                                     |       | 5.0%     |       | 5.0%     |       | 5.0%     |       |
| Expected long-term  rate of return on plan assets |       | 7.5%     |       | 7.5%     |       | 7.5%     |       |

 

The discount rate is based upon applicable interestrates prescribed in the Plan for lump sum settlement payments.

The expected long-term rate of return is selectedbased upon the expected duration of the projected benefit obligation for theplan and the asset mix of the plan. There is no assumed increase incompensation levels since future benefit accruals have ceased, as discussedabove. The unrecognized transition liability and unrecognized net loss arebeing amortized over 30.4 and 18.2 years, respectively.

TheCompany’s pension plan weighted average asset allocations at December 31,2005 and 2004 by asset category are as follows:

| **Asset Category** | ** ** | ** ** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------|------------|------------|------------|----------|------------|----------|------------|
| Cash and money  markets |       | 9.23%      |       | 5.16%    |       |
| Equity securities       |       | 54.40%     |       | 47.72%   |       |
| Debt securities         |       | 29.90%     |       | 41.80%   |       |
| Other                   |       | 6.47%      |       | 5.32%    |       |
| Total                   |       | 100.00%    |       | 100.00%  |       |

 

The Company’s investment policy is to maximize thetotal rate of return (income and appreciation) with a view to the long-termfunding objectives of the pension plan. Therefore the plan assets are 

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diversified to the extentnecessary to minimize risk and to achieve optimal balance between risk andreturn and between income and growth of assets though capital appreciation.

In 2005 and 2004, none ofthe Company’s stock was included in the equity securities component.

**Cash flows**

The Company expects to contribute approximately$57,000 to the pension plan in 2006.

As required by Statement of Financial AccountingStandards No. 87, the Company recorded a pension liability of $40,388 at December 31,2005 (included in Accrued Pension Expense) to reflect the excess of accumulatedbenefits over the fair value of pension plan assets. Since the requiredadditional pension liability is in excess of the unrecognized prior servicecost (unrecognized transition obligation), an amount equal to the unrecognizedprior service cost has been recognized as an intangible asset in the amounts of$96,738 and $104,529 (included in “Other assets”) as of December 31, 2005and 2004, respectively. The remaining liability required to be recognized isreported as a separate component of stockholders’ equity.

The Company has a definedcontribution retirement and savings plan (the “401(k) Plan”) designed toqualify under Section 401(k) of the Internal Revenue Code (the “Code”).Eligible employees include those who are at least twenty-one years old and whohave worked at least 1,000 hours during any one year. The Company may makematching contributions in amounts that the Company determines at its discretionat the beginning of each year. In addition, the Company may make furtherdiscretionary contributions. Participating employees are immediately vested inamounts attributable to their own salary or wage reduction elections, and arevested in Company matching and discretionary contributions under a vestingschedule that provides for ratable vesting over the second through sixth yearsof service. The assets of the 40l (k) Plan are invested in stock, bond andmoney market mutual funds. For the years ended December 31, 2005, 2004,and 2003, and the Company made contributions totaling $73,430, $46,879 and$47,225, respectively, to the 401(k) Plan.

**(13)   IncomeTaxes**

Theprovision for (benefit from) income taxes is comprised of the following:

| ** ** | ** ** | **Years ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:   |       |                                        |       |   |   |   |   |
| Federal    |       | $                                           | —     |   | $ | — |   | $ | 5,910 |   |
| State      |       | —                                      |       | — |   | 2,875 |   |
| Foreign    |       | 113,518                                     |       | 25,695 |   | 22,619 |   |
|       |       | 113,518                                     |       | 25,695 |   | 31,404 |   |
| Deferred:  |       |                                        |       |   |   |   |   |
| Federal    |       | (254,779                                    | )          | 135,988 |   | 137,000 |   |
| State      |       | (37,399                                     | )          | 18,500 |   | 21,000 |   |
| Foreign    |       | (22,500                                     | )          | (22,500 | ) | (22,500 | ) |
|       |       | (314,678                                    | )          | 131,988 |   | 135,500 |   |
|       |       | $                                           | (201,160   | ) | $ | 157,683 |   | $ | 166,904 |   |

 

As of December 31, 2005, the Company has netFederal tax operating loss carryforwards of approximately $6,400,000, which maybe applied against future taxable income and expires from 2006 through 2024. Futureutilization of these net operating loss carryforwards will be limited underexisting tax 

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law due to the change incontrol of the Company in 2001. The Company also has available tax creditcarryforwards of approximately $141,000.

Thefollowing is a summary of deferred tax assets and liabilities: 

| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Current assets:                   |       |                  |       |   |   |
| Accounts  receivable              |       | $                     | 199,511    |   | $ | 185,241 |   |
| Stock options                     |       | 609,782               |       | 119,557 |   |
| Inventory  reserves               |       | 459,996               |       | 369,156 |   |
| Accrued expenses  and other       |       | 349,776               |       | 295,191 |   |
|                              |       | 1,619,065             |       | 969,145 |   |
| Non-current  assets:              |       |                  |       |   |   |
| Capital lease                     |       | 576,557               |       | 512,932 |   |
| Identifiable  intangible assets   |       | 388,998               |       | 57,669 |   |
| Net operating  loss carryforwards |       | 2,490,312             |       | 1,494,123 |   |
| Tax credit  carryforwards         |       | 141,000               |       | 141,000 |   |
|                              |       | 5,215,932             |       | 3,174,869 |   |
| Valuation  allowances             |       | (4,680,114            | )          | (2,568,330 | ) |
| Non-current  liabilities:         |       |                  |       |   |   |
| Goodwill and  trade names         |       | —                |       | (366,290 | ) |
| Property and  equipment           |       | (535,818              | )          | (465,148 | ) |
| Identifiable  intangible assets   |       | (1,324,932            | )          | (1,414,711 | ) |
|                              |       | (1,860,750            | )          | (2,246,149 | ) |
| Net deferred tax  liabilities     |       | $                     | (1,324,932 | ) | $ | (1,639,610 | ) |

 

The decrease in the net deferred liability reflectsthe effect of the provision for impairment recorded for financial statementpurposes relating to certain identifiable intangible assets with indefinitelives and certain identifiable intangible assets with definite livesaggregating $2,102,000.

Prior to the adoption of SFAS No. 142, theCompany would not have needed a valuation allowance for the portion of the netoperating losses equal to the amount of tax-deductible goodwill and trade namesamortization expected to occur during the carryforward period of the netoperating losses based on the timing of the reversal of these taxable temporarydifferences. As a result of the adoption of SFAS No. 142, thereversal may not occur during the carryforward period of the net operatinglosses because indefinite lived intangible assets and goodwill are notamortized for financial statement purposes. Accordingly, during 2004 and 2003,the Company recorded deferred income tax expense with respect to theseintangibles which were amortized for tax purposes but not for financialstatement purposes. During the year ended December 31, 2005, the Companyrecorded a provision for impairment of $1,600,000 with respect to identifiableintangible assets with indefinite lives, and a provision for impairment of$502,000 with respect to identifiable intangible assets with definite liveswhich exceeded the amortization deductions available for tax purposes. TheCompany recorded a deferred income tax (benefit) expense of approximately$(315,000), $154,000, and $158,000 during the years ended December 31,2005, 2004 and 2003, respectively, which would not have been required prior tothe adoption of SFAS No. 142.

The deferred income tax recorded in 2003 was partiallyoffset by the recognition of a deferred tax benefit of approximately $6,000related to an alternative minimum tax carryforward.

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Thefollowing is a summary of the domestic and foreign components of income (loss)before income taxes:

| ** ** | ** ** | **Years ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Domestic   |       | $                                           | (4,993,511 | ) | $ | 418,560 |   | $ | 317,081 |   |
| Foreign    |       | 235,083                                     |       | 113,911 |   | (155,648 | ) |
|       |       | $                                           | (4,758,428 | ) | $ | 532,471 |   | $ | 161,433 |   |

 

TheCompany’s effective provision for income taxes differs from the Federalstatutory rate. The reasons for such differences are as follows:

| ** **                                                        | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                        | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                        | ** ** | **Amount**                                  | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Provision at  Federal statutory rate                              |       | $                                           | (1,617,866 | ) | (34.0 | ) | $ | 181,040 |   | 34.0 |   | $ | 54,887 |   | 34.0 |   |
| Change in fair  value of Put Option                               |       | (595,000                                    | )          | (12.5 | ) | (205,700 | ) | (38.6 | ) | — |   | — |   |
| Compensation  expense from stock option modification              |       | 355,513                                     |       | 7.5 |   | — |   | — |   | — |   | — |   |
| Other Permanent  items                                            |       | (153,198                                    | )          | (3.2 | ) | 218,468 |   | 41.0 |   | 5,100 |   | 3.2 |   |
| Increase (decrease) in  taxes resulting from:                     |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| State income tax expense, net of federal benefit                  |       | (37,399                                     | )          | (0.8 | ) | 18,500 |   | 3.5 |   | 15,760 |   | 9.7 |   |
| Foreign (income) losses with no tax benefit  provided        |       | (79,928                                     | )          | (1.7 | ) | (38,730 | ) | (7.3 | ) | 52,920 |   | 32.8 |   |
| Foreign taxes                                                     |       | 91,018                                      |       | 1.9 |   | 3,195 |   | 0.6 |   | — |   | — |   |
| Change in valuation allowance                                     |       | 2,111,784                                   |       | 44.4 |   | — |   | — |   | 16,768 |   | 10.4 |   |
| State tax benefit included in the change in  valuation allowance. |       | (270,025                                    | )          | (5.7 | ) | — |   | — |   | — |   | — |   |
| Other                                                             |       | (6,059                                      | )          | (0.1 | ) | (19,090 | ) | (3.6 | ) | 21,469 |   | 13.3 |   |
| Effective tax rate                                                |       | $                                           | (201,160   | ) | (4.2 | )% | $ | 157,683 |   | 29.6 | % | $ | 166,904 |   | 103.4 | % |

 

The Company does notprovide for income taxes on the unremitted earnings of foreign subsidiarieswhere, in management’s opinion, such earnings have been indefinitely reinvestedin those operations or will be remitted as dividends with taxes substantiallyoffset by foreign tax credits, which are immaterial. It is not practical todetermine the amount of unrecognized deferred tax liabilities for temporarydifferences related to these investments.

**(14)   Reconciliationof Basic and Diluted Earnings Per Share**

Basic earnings per commonshare (“EPS”) are computed based on the weighted average number of commonshares outstanding during each period. Diluted earnings per common share arecomputed based on the weighted average number of common shares, after givingeffect to dilutive common stock equivalents outstanding during each period. Thediluted income (loss) per share computations for the years ended December 31,2005, 2004, and 2003 exclude approximately 1,910,000, 611,000, and 623,000 andshares, respectively, related to employee stock options because the effect ofincluding them would be anti-dilutive. The impact of the Convertible Notes onthe calculation of the fully-diluted earnings per share was anti-dilutiveand is therefore not included in the computation for the years ended December 31,2005, 2004 and 2003.

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Thefollowing table provides a reconciliation between basic and diluted earnings(loss) per share:

| ** **                               | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                               | ** ** | **Income**                                  | ** ** | **Shares** | ** ** | **Per  Share** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per  Share** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per  Share** | ** ** |
| *Basic EPS*                              |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                        |       | $                                           | (4,557,268 | ) | 7,277,240 |   |   | $ | (.63 | ) |   | $ | 374,788 |   | 4,395,180 |   |   | $ | .09 |   |   |   | $ | (5,471 | ) |   | 4,374,396 |   |   | $ | (.00 | ) |   |
| *Effect of Dilutive Securities*          |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock options, warrants and stock awards |       | —                                      |       | — |   |   | — |   |   | — |   | 398,259 |   |   | (.01 | ) |   |   | — |   |   | — |   |   | — |   |   |
| Diluted EPS                              |       | $                                           | (4,557,268 | ) | 7,277,240 |   |   | $ | (.63 | ) |   | $ | 374,788 |   | 4,793,439 |   |   | $ | .08 |   |   |   | $ | (5,471 | ) |   | 4,374,396 |   |   | $ | (.00 | ) |   |

 

**(15)   RelatedParty Transactions**

***Consulting Agreement with Kanders & Company, Inc.***   OnNovember 12, 2004, the Company entered into a consulting agreement (the “ConsultingAgreement”) with Kanders & Company, the sole stockholder of which isWarren B. Kanders, who on November 12, 2004, became the Company’s Chairmanof the Board of Directors, and who is the sole manager and voting member ofLanger Partners, LLC (“Langer Partners”), the Company’s largest stockholder.The Consulting Agreement provides that Kanders & Company will act asthe Company’s non-exclusive consultant to provide us with strategic consultingand corporate development services for a term of three years. Kanders &Company will receive, pursuant to the Consulting Agreement, an annual fee of$200,000 and may receive separate compensation for assistance, at the Company’srequest, with certain transactions or other matters to be determined by theboard from time to time. Additionally, through the Consulting Agreement,Kanders & Company was granted options to purchase 240,000 shares ofthe Company’s common stock at an exercise price of $7.50 per share (the marketprice of the stock on the date of the grant), vesting in three equal annualinstallments beginning on November 12, 2005. In November 2005, thegrant of the options for 240,000 shares to Kanders & Company wascancelled and the Company granted to Mr. Kanders the 240,000 options onthe same terms. The Company accounted for 15,000 of such options ascompensation for duties performed by Mr. Kanders in his capacity asChairman of the Board of Directors under APB No. 25 and accounted for225,000 of such options as being granted pursuant to the Consulting Agreementand accounted for in accordance with EITF No. 96-18, “Accounting forEquity Instruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods and Services.” In November 2005, Mr. Kanderswas granted 275,000 options at an exercise price of $4.89 (the market price atthe date of the grant) vesting in three equal annual installments beginning April 1,2008. The Company accounted for 37,500 of these options as compensation forduties performed in his capacity as Chairman of the Board of Directors and237,500 as options granted pursuant to the Consulting Agreement. Additionally,on December 20, 2005, the Board of Directors accelerated the vesting ofcertain options, including these, subject to lockup, confidentiality andnon-competition agreements. The Company recorded non-cash stock optioncompensation of approximately $1,257,000 for year ended December 31, 2005with respect to the consulting options of which approximately $882,000 relatesto the acceleration of the vesting of such options. The Company has also agreedto provide Kanders & Company with indemnification protection, whichsurvives the termination of the Consulting Agreement for six years, and extendsto any actual or wrongfully attempted breach of duty, neglect, error, ormisstatement by Kanders & Company alleged by any claimant. TheConsulting Agreement replaced a previous agreement for similar consultingservices, pursuant to which Kanders & Company received an annual feeof $100,000, options to purchase 100,000 shares of the Company’s common stockat an exercise price of $1.525 per share, and the indemnification protectiondescribed above. The Company expensed $200,000, $113,611 and $100,000 withrespect to the annual fee under the Consulting Agreement during the years endedDecember 31, 2005, 2004 and 2003, respectively.

On November 12, 2004,the Board of Directors approved a grant of 100,000 shares of restricted stockto Kanders & Company, subject to certain performance conditions,provided Mr. Kanders has not resigned 

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from theBoard of Directors, all of which were originally scheduled to vest on November 12,2007 and which would accelerate upon the death of Mr. Kanders, or thechange of control of the Company. On December 20, 2005, the Board ofDirectors accelerated the vesting of the stock award subject to lock-up,confidentiality and non-competition agreements. The Company recorded acompensation charge of $465,000 with respect to such award in the statement ofoperations for the year ended December 31, 2005, of which approximately$317,000 relates to the acceleration of the vesting of such award.

***Note and Warrant Purchase Agreement.******  ***On September 30,2004, the Company sold (a) the Subordinated Notes, and (b) warrantsto purchase an aggregate of 110,000 shares of the Company’s common stock at anexercise price of $0.02 per share (the “Warrants”) pursuant to a Note andWarrant Purchase Agreement dated September 30, 2004 by and among theCompany and ten accredited investors, including Langer Partners. TheSubordinated Notes and Warrants were sold by the Company to finance the cashportion of the Silipos acquisition. Langer Partners purchased $750,000principal amount of the Subordinated Notes and Warrants to purchase 15,000shares of the Company’s common stock. As permitted under the terms of the SubordinatedNotes, all the Subordinated Notes were prepaid with interest on June 15,2005. The Warrants became exercisable on September 30, 2005 and theyexpire September 30, 2009. The exercise price of the Warrants is subjectto adjustment in certain circumstances. The fair value of all 110,000 of theWarrants was determined to be $735,900 using the Black Scholes pricing model.This amount was recognized as a discount to the Subordinated Notes and is beingamortized over the term of the Company’s Subordinated Notes and recorded as anadditional interest expense. Under the Note and Warrant Purchase Agreement, theCompany filed a shelf registration statement covering resales of theshares underlying the Warrants by December 31, 2005, which becameeffective on January 13, 2006.

***4% Convertible Subordinated Notes.******  ***On October 31,2001, the Company sold $14,589,000 of the Company’s Convertible Notes due August 31,2006 in a private placement of which $150,000 was converted to 25,000 shares ofcommon stock in June 2005. The remaining notes are convertible intoapproximately 2,431,500 shares of the Company’s common stock at a conversionprice of $6.00 per share, subject to adjustment in certain circumstances.Langer Partners purchased and currently holds $2,500,000 principal amount ofthe Company’s Convertible Notes. Additionally, several persons and entitiesthat have family relationships with Warren Kanders purchased and currently holdan aggregate of $590,000 principal amount of these notes.

On October 31, 2001,Langer Partners entered into an agreement with Oracle Investment Management, Inc.(“Oracle”), pursuant to which Langer Partners agreed not to, without the priorwritten consent of Oracle, sell, assign, pledge, or otherwise transfer anyshares of all the Company’s common stock owned by Langer Partners until suchtime as Oracle sells or otherwise transfers one-third or more of the ConvertibleNotes acquired by it, or shares of common stock received upon conversion of thenotes. Oracle originally acquired and currently holds $4,000,000 in aggregateprincipal amount of the Convertible Notes. Neither Oracle nor its affiliateshave converted any of the Convertible Notes to date. If Oracle transfers lessthan one-third of its interest in the Convertible Notes acquired by it or theshares of the Company’s common stock it would receive upon conversion of thenotes, Langer Partners will be permitted to transfer a pro-rata percentage ofthe Company’s common stock owned by it. Langer Partners further agreed withOracle to vote all shares of common stock owned by Langer Partners in favor ofso many nominees of Oracle to the Company’s Board of Directors as is equal on apercentage basis to the aggregate percentage of the Company’s common stockowned by Oracle on a fully diluted basis. Oracle is currently entitled todesignate one Board nominee pursuant to this right. However, Oracle has not todate nominated a director.

***Tender Offer.******  ***In February 2001,an investor group and management team, including the Company’s current Chairmanof the Board of Directors Warren B. Kanders, the Company’s former President,Chief Executive Officer and director, Andrew H. Meyers, and the Company’sformer Board of Directors 

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member, Gregory R.Nelson, obtained a controlling interest in Langer, by purchasing 1,362,509shares of Langer at $1.525 per share, or approximately 51% of the thenoutstanding common stock of Langer, under the terms of a negotiated tenderoffer agreement with the Company. The aggregate purchase price paid by thegroup was $2,077,826. The investor group was also granted a 180 day optionto purchase up to 1,400,000 additional shares of Langer common stock, with aninitial exercise price of $1.525 per share, rising up to $1.60 per share. On May 14,2001, the option was exercised in full and the shares were purchased at a priceof $1.525 per share. As a result of the tender offer and option exercise, theinvestor group acquired approximately 57.8% of the outstanding common stock ofLanger (without giving effect to the options granted to Kanders &Company and Andrew H. Meyers, as discussed below) for an aggregateconsideration of $4,212,826. In connection with the tender offer, the Companyentered into an employment agreement with Mr. Meyers that provided that hewould serve as the Company’s President and Chief Executive Officer for athree-year term that would expire December 31, 2003 at a salary of$175,000 and granted him options to purchase 175,000 shares at an exerciseprice of $1.525. The Company also entered into a three year consultingagreement for financial advisory services with Kanders & Company, ofwhich Mr. Kanders is sole stockholder, providing for an annual fee of$100,000, an award of options for 100,000 shares at a price of $1.525 per share(which equaled the price paid in the tender offer), and a non-renewal fee of$100,000, which Kanders & Company waived when it entered into aconsulting agreement with the Company in November 2004.

***Loan to Steven Goldstein.******  ***In April 2002,the Company made a full-recourse secured two-year term loan to Mr. StevenGoldstein, who was then the Company’s Executive Vice President, in theprincipal sum of $21,000, which provided for interest at the rate of 4% peryear, compounded quarterly. The loan, along with applicable interest, wasrepaid in April 2004.

***Contract termination.******  ***On September 8,2005, the Company determined not to extend Andrew H. Meyer’semployment contract, and in accordance with its terms, the contract expired December 31,2005 (except for certain covenants by Mr. Meyers in favor of the Company).In accordance with a modification of the employment contract on November 12,2004, which extended his right to exercise 175,000 vested options from 90 daysto one year beyond termination, the Company recorded a non-cash charge equal tothe intrinsic value of the options on the date the option agreement wasmodified, or approximately $1,046,000 at December 31, 2005. Additionally,as of December 31, 2005, the Company accrued approximately $335,000 forseverance related expenses in accordance with the contract and a relatedseparation agreement.

***Other related party transactions.******  ***The Companyhas obtained certain technology related products and services from a companyowned by the brother-in-law of Andrew Meyers, who was, until December 31,2005, the Company’s President, Chief Executive Officer and who remained adirector of the Company until March 24, 2006. Costs incurred by theCompany for such products and services were approximately $37,000, $31,000, and$142,000 in the years ended December 31, 2005, 2004 and 2003,respectively. The Company also engaged a company owned by Steven Goldstein’sfather-in-law to provide certain promotional and marketing goods and servicesto the Company. Mr. Goldstein was Executive Vice President of the companyprior to September 30, 2005. Costs incurred with respect to such goods andservices for the years ended December 31, 2004 and 2003 were approximately$50,000, and $56,000, respectively. There was no such amount incurred in theyear ended December 31, 2005.

**(16)   Litigation**

From time to time, theCompany is subject to certain legal actions arising in the normal course ofbusiness. After taking into consideration legal counsel’s evaluation of suchactions, management is of the opinion that their final resolution will not havea material adverse effect on the Company’s consolidated financial statements.

On April 21, 2005, Thermo-Ply, Inc., aFlorida corporation, filed an action in the United States District Court forthe Middle District of Florida (Tampa Division) against Silipos and four other 

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defendants. The actionasserts a claim for alleged infringement of U.S. Patent No. 6,231,617.Although not specifically identified by the claim, the Company believes thatthe claim, insofar as it relates to the Company, may be directed towards theExplorer Gel Liners manufactured, distributed and sold by Silipos. The Companyis currently investigating the validity of this claim. Should the plaintiff besuccessful in pressing this claim, Silipos could be enjoined from making, usingor selling the accused products and could also be assessed damages for thealleged infringement, which damages could be increased up to three times in theevent the infringement is found to be willful, together with attorney fees andcertain costs. The parties are discussing a settlement of the action althoughno assurance can be given that such discussions will lead to a settlementfavorable to the Company. Pursuant to the Silipos stock purchase agreement, SSLhas agreed to fund any of the Company’s obligations resulting from thesettlement over $150,000, which the Company had accrued or paid as ofDecember 31, 2005.

In addition, in connectionwith the Company’s acquisition of Silipos, the Company could become subject tocertain claims or actions brought by Poly-Gel, although no such claims havebeen brought to date. These claims may arise, for example, out of the supplyagreement between Silipos and Poly-Gel dated August 20, 1999, themanufacture, marketing or sale of products made from gel not purchased fromPoly-Gel, alleged misappropriation of trade secrets or other confidentialinformation (including gel formulations) of Poly-Gel, as well as any otheralleged violations of the supply agreement (the “Potential Poly-Gel Claims”).For any of these potential claims, SSL has agreed to indemnify the Company forlosses up to $2.0 million, after which the Company would be liable for any suchclaims. Furthermore, the Company has assumed responsibility for the first$150,000 of such liability in connection with the Company’s acquisition ofSilipos, and SSL’s maximum liability for total indemnification related to theCompany’s acquisition of Silipos is between $5,000,000 and $7,000,000. Thus, ifthe total amount of all claims arising from the acquisition exceed thismaximum, whether or not related to Poly-Gel, the Company would be liable foramounts in excess of the maximum. For claims arising out of conduct that occursafter the closing of the Silipos transaction on September 30, 2004, theCompany has agreed to indemnify SSL against losses. The Company would expect tovigorously defend against any claims brought by Poly-Gel or any other thirdparty.

On or about February 13,2006, Dr. Gerald P. Zook filed a demand for arbitration with the AmericanArbitration Association, naming the Company and Silipos as 2 of the 16respondents. (Four of the other respondents are the former owners of Siliposand its affiliates, and the other 10 respondents are unknown entities.)  The demand for arbitration alleges that theCompany and Silipos are in default of obligations to pay royalties inaccordance with the terms of a license agreement between Dr. Zook andSilipos dated as of January 1, 1997, with respect to seven patents ownedby Dr. Zook and licensed to Silipos. Silipos has paid royalties to Dr. Zook,but Dr. Zook claims that greater royalties are owed. The demand forarbitration seeks an award of $400,000 and reserves the right to seek a higheraward after completion of discovery. The Company and Silipos intend tovigorously defend the claim.

On or about February 23,2006, Silipos commenced an action in New York State Supreme Court, New YorkCounty, against Mr. Peter D. Bickel, who was the executive vice presidentof Silipos, Inc., until January 11, 2006. In the action, Siliposseeks, among other things, a declaratory judgment that Mr. Bickel is notentitled to severance pay or other benefits, on account of his breach ofvarious provisions of his employment agreement with Silipos and hisnon-disclosure agreement with Silipos, and that his termination by Silipos wasfor “cause” as defined in the employment agreement. Silipos is also seeking anaggregate of $12 million in compensatory and punitive damages for breaches ofthe employment agreement, breach of the non-disclosure agreement, breach offiduciary duties, misappropriation of trade secrets, and tortious interferencewith business relationships. No assurance can be given that Silipos will besuccessful in recovering all or any portion of this amount. On or about March 22,2006, Mr. Bickel removed the lawsuit to the United States District Courtfor the Southern District of New York and filed an answer denying the materialallegations of the complaint and counterclaims seeking a declaratory judgmentthat his non-disclosure agreement is unenforceable and that he is entitled to$500,000, 

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representingtwo years’ base salary, in severance compensation, on the ground that Siliposdid not have “cause” to terminate his employment. Silipos intends to vigorouslydefend these counterclaims.

**(17)   QuarterlyOperating Results (Unaudited):**

| ** **                                                  | ** ** | **March 31,  2004**                                           | ** ** | **June 30,  2004** | ** ** | **September 30,  2004** | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005(1)** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|-----------------------------|------------|--------------------------|------------|-------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **(In thousands, except per share data)** | ** ** |
| Sales                                                       |       |                                                               | $          | 5,764                   |       |                         |       | $                           | 6,547      |                     |       |                    | $          | 6,285                        |       |                           |       | $ | 11,530 |   |   |   | $ | 10,397 |   |   |   | $ | 10,052 |   |   |   | $ | 10,531 |   |   |   | $ | 9,162 |   |   |
| Cost of sales                                               |       |                                                               | 3,791      |                    |       |                         | 4,160      |                        |       |                     | 4,007      |                    |       |                         | 6,065      |                           |       |   | 5,502 |   |   |   | 5,486 |   |   |   | 5,758 |   |   |   | 5,477 |   |   |
| Gross profit                                                |       |                                                               | 1,973      |                    |       |                         | 2,387      |                        |       |                     | 2,278      |                    |       |                         | 5,465      |                           |       |   | 4,895 |   |   |   | 4,566 |   |   |   | 4,773 |   |   |   | 3,685 |   |   |
| Operating expenses:                                         |       |                                                               |       |                    |       |                         |       |                        |       |                     |       |                    |       |                         |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Provision for impairment of identifiable intangible  assets |       |                                                               | —     |                    |       |                         | —     |                        |       |                     | —     |                    |       |                         | —     |                           |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,102 |   |   |
| Selling                                                     |       |                                                               | 807        |                    |       |                         | 786        |                        |       |                     | 790        |                    |       |                         | 2,567      |                           |       |   | 1,939 |   |   |   | 2,015 |   |   |   | 1,747 |   |   |   | 1,702 |   |   |
| General and administrative                                  |       |                                                               | 1,174      |                    |       |                         | 1,344      |                        |       |                     | 1,259      |                    |       |                         | 2,150      |                           |       |   | 2,265 |   |   |   | 2,582 |   |   |   | 2,421 |   |   |   | 4,990 |   |   |
| Research and development.                                   |       |                                                               | —     |                    |       |                         | —     |                        |       |                     | —     |                    |       |                         | 49         |                           |       |   | 130 |   |   |   | 110 |   |   |   | 112 |   |   |   | 117 |   |   |
| Total operating expenses                                    |       |                                                               | 1,981      |                    |       |                         | 2,130      |                        |       |                     | 2,049      |                    |       |                         | 4,766      |                           |       |   | 4,334 |   |   |   | 4,707 |   |   |   | 4,280 |   |   |   | 8,911 |   |   |
| Income (loss) from operations                               |       |                                                               | (8         | )                       |       |                         | 257        |                        |       |                     | 229        |                    |       |                         | 699        |                           |       |   | 561 |   |   |   | (141 | ) |   |   | 493 |   |   |   | (5,226 | ) |   |
| Interest and other income (expense)                         |       |                                                               | (161       | )                       |       |                         | (155       | )                           |       |                     | (147       | )                       |       |                         | (563       | )                              |       |   | (827 | ) |   |   | (1,569 | ) |   |   | (174 | ) |   |   | (125 | ) |   |
| Change in fair value of Put Option                          |       |                                                               | —     |                    |       |                         | —     |                        |       |                     | —     |                    |       |                         | 605        |                           |       |   | 1,750 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Change in fair value of Call Option                         |       |                                                               | —     |                    |       |                         | —     |                        |       |                     | —     |                    |       |                         | —     |                           |       |   | — |   |   |   | 500 |   |   |   | — |   |   |   | — |   |   |
| Change in fair value of Protection Payment                  |       |                                                               | —     |                    |       |                         | —     |                        |       |                     | —     |                    |       |                         | (223       | )                              |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Income (loss) before taxes                                  |       |                                                               | (169       | )                       |       |                         | 102        |                        |       |                     | 82         |                    |       |                         | 518        |                           |       |   | 1,484 |   |   |   | (1,210 | ) |   |   | 319 |   |   |   | (5,351 | ) |   |
| Provision for (benefit from) income taxes                   |       |                                                               | 50         |                    |       |                         | 25         |                        |       |                     | 38         |                    |       |                         | 45         |                           |       |   | 39 |   |   |   | 48 |   |   |   | 83 |   |   |   | (371 | ) |   |
| Net income (loss)                                           |       |                                                               | $          | (219                    | )          |                         |       | $                           | 77         |                     |       |                    | $          | 44                           |       |                           |       | $ | 473 |   |   |   | $ | 1,445 |   |   |   | $ | (1,258 | ) |   |   | $ | 236 |   |   |   | $ | (4,980 | ) |   |
| Net income (loss) per  share:                               |       |                                                               |       |                    |       |                         |       |                        |       |                     |       |                    |       |                         |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                       |       |                                                               | $          | (.05                    | )          |                         |       | $                           | .02        |                     |       |                    | $          | .01                          |       |                           |       | $ | .11 |   |   |   | $ | .33 |   |   |   | $ | (.24 | ) |   |   | $ | .02 |   |   |   | $ | (.51 | ) |   |
| Diluted                                                     |       |                                                               | $          | (.05                    | )          |                         |       | $                           | .02        |                     |       |                    | $          | .01                          |       |                           |       | $ | .10 |   |   |   | $ | .22 |   |   |   | $ | (.24 | ) |   |   | $ | .02 |   |   |   | $ | (.51 | ) |   |

----

(1)          Certainadjustments were recorded in the quarter ended December 31, 2005.

(a)          TheCompany’s annual test date under SFAS No. 142 is October 1, 2005, and as aresult of the analysis, the Company recorded an impairment of $1,600,000related to the Benefoot tradename. Furthermore, the Company recorded an SFASNo. 144 impairment of $502,000 with respect to other related identifiable intangibleassets.

(b)         Stockaward and stock option compensation expense totalling approximately $2,398,000,of which approximately $1,313,000 related to the acceleration of vesting ofcertain stock options and stock awards, which occurred at the end of the fourthquarter.

102

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**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

**ITEM 9A.**        CONTROLSAND PROCEDURES

**Evaluationof Disclosure Controls and Procedures**

The Company’s managementcarried out an evaluation, under the supervision and with the participation ofthe Company’s current Chief Executive Officer and Chief Financial Officer, whoare, respectively, its current principal executive officer and principalfinancial officer, of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (the “ExchangeAct”) as of December 31, 2005, pursuant to Exchange Act Rule 13a-15.

*Restatement ofPreviously Issued Financial Statements*

During 2005, the Company concluded that its condensedconsolidated financial statements in Form 10-Q for the quarterlyperiods ended March 31, 2005 and June 30, 2005 needed to be restated.The restatements were required as a result of the Company’s conclusion thatchanges to accounting for certain stock options and restricted stock grantswere required.

Management has concludedthat the controls in place relating to the accounting of stock options andrestricted stock were not effective during such period to provide reasonableassurance that these stock options would be properly recorded and disclosed inthe financial statements, and that this is a material weakness in internalcontrol over financial reporting.

*Remediation ofMaterial Weakness*

The Audit Committee of theCompany’s Board of Directors is continuing its review of the Company’s internalcontrols to determine how this material weakness occurred and how to implementcontrols designed to avoid the occurrence of this kind of problem in thefuture.

**Changes in Internal Controls**

**Therewas no change in the Company’s internal controls over financial reporting (asdefined in Rules 13a-15(f) of the Exchange Act) that occurred during thefourth quarter of fiscal 2005 that materially affected, or is reasonably likelyto materially affect, the Company’s internal controls over financial reporting.**

**ITEM 9B.**       OTHERINFORMATION

Not applicable.

103

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**PART III**

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS OF THE COMPANY

The information set forth under the caption “Electionof Directors” in the proxy statement to be distributed by the Board ofDirectors of the Company in connection with the 2006 Annual Meeting ofStockholders is incorporated herein by reference.

The Company has adopted acode of ethics that applies to its Chief Executive Officer and Chief FinancialOfficer, who are the Company’s principal executive officer and principalfinancial and accounting officer, and to all of its other officers, directorsand employees. The code of ethics may be accessed at www.langerinc.com, ourInternet website, at the tab “Investor Relations”. The Company intends todisclose future amendments to, or waivers from, certain provision of its codeof ethics, if any, on the above website within four business days following thedate of such amendment or waiver.

**ITEM 11.**         EXECUTIVECOMPENSATION

The information requiredby Item 11 appearing under the caption “Executive Compensation” of the Company’sproxy statement for the 2006 Annual Meeting of Stockholders is incorporatedherein by reference.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information requiredby Item 12 appearing under the caption “Security Ownership of CertainBeneficial Owners and Management” of the Company’s proxy statement for the 2006Annual Meeting of Stockholders is incorporated herein by reference.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

The information requiredby Item 13 appearing under the caption “Certain Relationships and RelatedTransactions” of the Company’s proxy statement for the 2006 Annual Meeting ofthe Stockholders is incorporated herein by reference.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES

The information requiredby Item 14 appearing under the caption “Principal Accounting Fees and Services”of the Company’s proxy statement for the 2006 annual meeting of thestockholders is incorporated herein by reference.

104

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**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

**1. Financial Statements**

For a list of thefinancial statements of the Company included in this report, please see the Indexto Consolidated Financial Statements appearing at the beginning of Item 8,Financial Statements and Supplementary Data.

**2. Financial Statement Schedules**

The following Financial Statement Schedule is filed aspart of this Form 10-K:

Schedule II—Valuationand Qualifying Accounts

**LANGER, INC. AND SUBSIDIARIESVALUATION AND QUALIFYINGACCOUNTSSCHEDULE II**

| ** **                 | ** ** | **Sales Returns  and Allowances** | ** ** | **Allowance for  Doubtful Accounts  Receivable** | ** ** | **Warranty  Reserve** | ** ** | **Inventory  Reserve** | ** ** | **Valuation  Allowance for  Deferred Tax  Assets** | ** ** |
|----------------------------|------------|---------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|--------------------------------------------------------------|------------|
| At  January 1, 2003   |       |                                        | $          | 28,000                                                     |       |                  |       | $                      | 124,935    |                                                         |       | $ | 70,000 |   | $ | 220,405 |   |   | $ | 2,408,241 |   |   |
| Additions                  |       |                                        | 40,000     |                                                       |       |                  | 117,993    |                   |       | 404,538                                                      |       | 129,063 |   |   | 16,768 |   |   |
| Deletions                  |       |                                        | —     |                                                       |       |                  | (18,203    | )                      |       | (404,538                                                     | )          | (39,468 | ) |   | — |   |   |
| At  December 31, 2003 |       |                                        | 68,000     |                                                       |       |                  | 224,725    |                   |       | 70,000                                                       |       | 310,000 |   |   | 2,425,009 |   |   |
| Additions                  |       |                                        | —     |                                                       |       |                  | 172,295    |                   |       | 332,343                                                      |       | 214,000 |   |   | 143,321 |   |   |
| Deletions                  |       |                                        | —     |                                                       |       |                  | (17,363    | )                      |       | (332,343                                                     | )          | (154,756 | ) |   | — |   |   |
| At  December 31, 2004 |       |                                        | 68,000     |                                                       |       |                  | 379,657    |                   |       | 70,000                                                       |       | 369,244 |   |   | 2,568,330 |   |   |
| Additions                  |       |                                        | —     |                                                       |       |                  | 151,066    |                   |       | 290,146                                                      |       | 453,027 |   |   | 2,111,784 |   |   |
| Deletions                  |       |                                        | —     |                                                       |       |                  | (100,650   | )                      |       | (290,146                                                     | )          | (258,003 | ) |   | — |   |   |
| At  December 31, 2005 |       |                                        | $          | 68,000                                                     |       |                  |       | $                      | 430,073    |                                                         |       | $ | 70,000 |   | $ | 564,268 |   |   | $ | 4,680,114 |   |   |

 

All other schedules havebeen omitted because they are not applicable, not required or the informationis disclosed in the consolidated financial statements, including the notesthereto.

**3. Exhibits**

| Exhibit No. | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                  |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Agreement and Plan of  Merger dated as of May 15, 2002, between Langer, Inc., a New York  corporation, and Langer, Inc., a Delaware corporation (the surviving  corporation), incorporated herein by reference to Appendix A of our  Definitive Proxy Statement for the Annual Meeting of Stockholders held on  June 27, 2002, filed with the Securities and Exchange Commission on  May 31, 2002. |
| 3.2              |       | Certificate of  Incorporation, incorporated herein by reference to Appendix B of our  Definitive Proxy Statement for the Annual Meeting of Stockholders held on  June 27, 2002, filed with the Securities and Exchange Commission on  May 31, 2002.                                                                                                                                                               |
| 3.3              |       | By-laws,  incorporated herein by reference to Appendix C of our Definitive Proxy  Statement for the Annual Meeting of Stockholders held on June 27, 2002,  filed with the Securities and Exchange Commission on May 31, 2002.                                                                                                                                                                                     |

105

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| 4.1   |   | Specimen of Common Stock  Certificate, incorporated herein by reference to our Registration Statement  of Form S-1 (File No. 2- 87183).                                                                                                                                                                       |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1  |   | Employment Agreement  between Langer, Inc. and Andrew H. Meyers, dated as of February 13,  2001, incorporated herein by reference to, Exhibit 10.6 of our Annual  Report on Form 10-K filed on May 29, 2001 (File No. 000-12991).+                                                        |
| 10.2  |   | Employment Agreement  between Langer, Inc. and Steven Goldstein, dated as of November 15,  2004.†+                                                                                                                                                                                                       |
| 10.3  |   | Consulting Agreement  between Langer, Inc. and Kanders & Company, Inc., dated  November 12, 2004.†+                                                                                                                                                                                        |
| 10.4  |   | Option Agreement between  Langer, Inc. and Kanders & Company, Inc., dated  February 13, 2001, incorporated herein by reference to  Exhibit (d)(1)(G) to the Schedule TO (File Number 005-36032).+                                                                                     |
| 10.5  |   | Registration Rights  Agreement between Langer, Inc. and Kanders &  Company, Inc., dated February 13, 2001, incorporated herein by  reference to Exhibit (d)(1)(I) to the Schedule TO (File Number 005-36032).                                                                         |
| 10.6  |   | Indemnification  Agreement between Langer, Inc. and Kanders &  Company, Inc., dated February 13, 2001, incorporated herein by  reference to Exhibit (d)(1)(J) to the Schedule TO (File Number 005-36032).                                                                             |
| 10.7  |   | Letter Agreement among  Langer, Inc., OrthoStrategies, OrthoStrategies Acquisition Corp, Steven  V. Ardia, Thomas I. Altholz, Justin Wernick, and Kenneth Granat, dated  December 28, 2000, incorporated herein by reference to  Exhibit (d)(1)(K) to the Schedule TO (File Number 005-36032). |
| 10.8  |   | Letter Agreement between  Langer, Inc. and Daniel Gorney, dated as of December 28, 2000,  incorporated herein by reference to Exhibit (d)(1)(O) to the  Schedule TO (File Number 005-36032).                                                                                                        |
| 10.9  |   | Letter Agreement between  Langer, Inc. and Thomas Archbold, dated as of December 28, 2000,  incorporated herein by reference to Exhibit (d)(1)(P) to the  Schedule TO (File Number 005-36032).                                                                                                      |
| 10.10 |   | Letter Agreement between  Langer, Inc. and Ronald J. Spinelli, dated as of December 28, 2000,  incorporated herein by reference to  Exhibit (d) (1) (Q) to the Schedule TO (File Number 005-36032).                                                                                       |
| 10.11 |   | The Company’s 2001 Stock  Incentive Plan incorporated herein by reference to Exhibit 10.18 of our  Annual Report on Form 10-K for the fiscal year ended  December 31, 2001.+                                                                                                                        |
| 10.12 |   | Langer Biomechanics  Group Retirement Plan, restated as of July 20, 1979 incorporated by  reference to our Registration Statement of Form S-1 (File  No. 2-87183).                                                                                                                                       |
| 10.13 |   | Agreement, dated  March 26, 1992, and effective as of March 1, 1992, relating to our  401(k) Tax Deferred Savings Plan incorporated by reference to our  Form 10-K for the fiscal year ended February 29, 1992.                                                                                |
| 10.14 |   | Consulting Agreement  between Langer, Inc. and Stephen V. Ardia, dated November 29, 2000  incorporated by reference to Exhibit 10.21 of our Annual Report on  Form 10-K for the fiscal year ended February 28, 2001.+                                                                          |

106

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| 10.16   |   | Form of  Indemnification Agreement for Langer, Inc.’s executive officers and  directors, incorporated by reference to Exhibit 10.23 of our Annual  Report on Form 10-K for the fiscal year ended February 28,  2001.                                                                                                                                 |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17   |   | Copy of Lease related to  Langer, Inc.’s Deer Park, NY facilities incorporated by reference to  Exhibit 10(f) of our Annual Report on Form 10-K for the  fiscal year ended February 28, 1993.                                                                                                                                                        |
| 10.17.1 |   | Copy of Amendment to  Lease of Langer, Inc.’s Deer Park, NY facility dated February 19,  1999.††                                                                                                                                                                                                                                                          |
| 10.18   |   | Asset Purchase  Agreement, dated May 6, 2002, by and among Langer, Inc., GoodFoot  Acquisition Co., Benefoot, Inc., Benefoot Professional  Products, Inc., Jason Kraus, and Paul Langer, incorporated herein by reference  to Exhibit 2.1 of our Current Report on Form 8-K filed with  the Securities and Exchange Commission on May 13, 2002. |
| 10.19   |   | Registration Rights  Agreement, dated May 6, 2002, among Langer, Inc.,  Benefoot, Inc., Benefoot Professional Products, Inc., and  Dr. Sheldon Langer, incorporated herein by reference to  Exhibit 10.1 of our Current Report on Form 8-K, filed with  the Securities and Exchange Commission on May 13, 2002.                            |
| 10.20   |   | Promissory Note, dated  May 6, 2002, made by Langer, Inc. in favor of Benefoot, Inc.,  incorporated herein by reference to Exhibit 10.2 of our Current Report  on Form 8-K, filed with the Securities and Exchange Commission on  May 13, 2002.                                                                                                      |
| 10.21   |   | Promissory Note, dated  May 6, 2002, made by Langer, Inc. in favor of Benefoot Professional  Products, Inc., incorporated herein by reference to Exhibit 10.3 of  our Current Report on Form 8-K, filed with the Securities and  Exchange Commission on May 13, 2002.                                                                                |
| 10.22   |   | Stock Purchase  Agreement, dated January 13, 2003, by and among Langer, Inc.,  Langer Canada Inc., Raynald Henry, Micheline Gadoury, 9117-3419 Quebec  Inc., Bi-Op Laboratories Inc., incorporated herein by reference to  Exhibit 2.1 of our Current Report on Form 8- K filed with the  Securities and Exchange Commission on January 13, 2003.         |
| 10.23   |   | Employment Agreement  between Langer, Inc. and Joseph Ciavarella dated as of February 16,  2004, incorporated herein by reference to Exhibit 10.33 of our Annual  Report on Form 10-K for the year ended December 31, 2003.+                                                                                                                              |
| 10.24   |   | Option Agreement between  Langer, Inc. and Joseph P. Ciavarella dated as of March 24, 2004,  incorporated herein by reference to Exhibit 10.34 of our Annual Report  on Form 10-K for the year ended December 31, 2003.+                                                                                                                                  |
| 10.25   |   | Stock Purchase  Agreement, dated as of September 22, 2004, by and among  Langer, Inc., LRC North America, Inc., SSL Holdings, Inc., and  Silipos, Inc., incorporated herein by reference to Exhibit 2.1 of  our Current Report on Form 8-K filed with the Securities and  Exchange Commission on October 6, 2004.                          |
| 10.26   |   | Stock Pledge and Agency  Agreement, dated September 30, 2004, by and among Langer, Inc., SSL  Holdings, Inc., and Pepper Hamilton LLP., incorporated herein by  reference to Exhibit 4.4 of our Current Report on Form 8-K  filed with the Securities and Exchange Commission on October 6, 2004.                                                    |
| 10.27   |   | $7,500,000 Secured  Promissory Note due March 31, 2006, incorporated herein by reference to  Exhibit 4.5 of our Current Report on Form 8-K filed with the  Securities and Exchange Commission on October 6, 2004.                                                                                                                                              |

107

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| 10.28 |   | $3,000,000 Promissory  Note due December 31, 2009, incorporated herein by reference to  Exhibit 4.6 of our Current Report on Form 8-K filed with the  Securities and Exchange Commission on October 6, 2004.                                                                                |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.29 |   | Note and Warrant  Purchase Agreement, dated September 30, 2004, by and among  Langer, Inc., and the investors named therein, incorporated herein by  reference to Exhibit 4.1 of our Current Report on Form 8-K  filed with the Securities and Exchange Commission on October 6, 2004. |
| 10.30 |   | Form of 7% Senior  Subordinated Note due September 30, 2007, incorporated herein by  reference to Exhibit 4.2 of our Current Report on Form 8-K  filed with the Securities and Exchange Commission on October 6, 2004.                                                                 |
| 10.31 |   | Form of Warrant to  purchase shares of the common stock of Langer, Inc., incorporated herein  by reference to Exhibit 4.3 of our Current Report on Form 8-K  filed with the Securities and Exchange Commission on October 6, 2004.                                                     |
| 10.32 |   | Supply Agreement, dated  as of August 20, 1999, by and between Silipos, Inc., and Poly-Gel,  L.L.C. incorporated by reference to Exhibit 10.1 to our Quarterly Report  on Form 10-Q for the nine months ended September 30, 2004.                                                      |
| 10.33 |   | Employment Agreement  between Langer, Inc. and W. Gray Hudkins, dated as of November 15,  2004.†+                                                                                                                                                                                                |
| 10.34 |   | Amendments dated as of  November 12, 2004, October 28, 2004, August 31, 2004,  May 28, 2004, March 30, 2004, January 30, 2004 and  December 1, 2003, to Employment Agreement dated as of February 13,  2001, between us and Andrew H. Meyers.†+                    |
| 10.35 |   | Stock Option Agreement  between Langer, Inc. and W. Gray Hudkins, dated November 12,  2004.†+                                                                                                                                                                                                    |
| 10.36 |   | Stock Option Agreement  between Langer, Inc. and Steven Goldstein, dated November 12,  2004.†+                                                                                                                                                                                                   |
| 10.37 |   | Restricted Stock  Agreement between Langer, Inc. and W. Gray Hudkins, dated  November 12, 2004.†+                                                                                                                                                                                                |
| 10.38 |   | Form of 4%  Convertible Subordinated Note due August 31, 2006, incorporated by  reference to Exhibit 99.3 of our Current Report on Form 8-K  Filed with the Securities and Exchange Commission on November 13, 2001.                                                                   |
| 10.39 |   | Letter Agreement dated  October 31, 2001, between Langer Partners, LLC and Oracle Management.†                                                                                                                                                                                                        |
| 10.40 |   | Stock Option Agreement  between Langer, Inc. and Kanders & Company, Inc. dated  November 12, 2004.†                                                                                                                                                                                |
| 10.41 |   | Patent License  Agreement, including amendment no. 1 thereto, between Applied  Elastomerics, Inc. and SSL Americas, Inc., dated effective  November 30, 2001.                                                                                                                                    |
| 10.42 |   | Assignment and  Assumption Agreement, dated as of September 30, 2004, by and between SSL  Americas, Inc. and Silipos, Inc.                                                                                                                                                                       |
| 10.43 |   | License Agreement, dated  as of January 1, 1997, by and between Silipos, Inc. and Gerald P.  Zook.                                                                                                                                                                                                    |

108

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| 10.44  |   | Copy of Lease between 366 Madison Inc. and  Silipos, Inc., dated April, 1995; Lease Modification and Extension  Agreement, dated November 1, 1995; and Second Lease Modification and  Extension Agreement, dated December 16, 1997.                                                                                                           |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.45  |   | Copy of Sublease between  Calamar Enterprises, Inc. and Silipos, Inc., dated May 21,  1998; First Amendment to Sublease between Calamar Enterprises, Inc. and  Silipos, Inc., dated July 15, 1998; and Second Amendment to  Sublease between Calamar Enterprises, Inc. and Silipos, Inc., dated  March 1, 1999. |
| 21.1   |   | Subsidiaries of the  Registrant.                                                                                                                                                                                                                                                                                                                             |
| 23.1   |   | Consent of BDO Seidman,  LLP.                                                                                                                                                                                                                                                                                                                                |
| 23.2   |   | Consent of  Deloitte & Touche LLP.                                                                                                                                                                                                                                                                                                                  |
| 31.1   |   | Rule 13a-14(a)/15d-14(a) Certification  by Principal Executive Officer.                                                                                                                                                                                                                                                                            |
| 31.2   |   | Rule 13a-14(a)/15d-14(a) Certification  by Principal Financial Officer.                                                                                                                                                                                                                                                                            |
| 32.1   |   | Section 1350  Certification by Principal Executive Officer.                                                                                                                                                                                                                                                                                             |
| 32.2   |   | Section 1350  Certification by Principal Financial Officer.                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                         |

----

†                    Incorporatedby reference to our Registration Statement on Form S-1 (File No. 333-120718)filed with the Securities and Exchange Commission on November 23, 2004.

††             Incorporated by referenceto Amendment No. 2, filed with the Securities and Exchange Commission on February 11,2005, of our Registration Statement on Form S-1 (File No. 333-120718).

+                This exhibitrepresents a management contract or compensation plan.

109

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**SIGNATURES**

Pursuantto the requirements of Section l3 or l5(d) of the Securities ExchangeAct of l934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|                           | ** ** | **LANGER, INC.** |
|---------------------------|------------|-----------------------|
|                      |       | By:                   |   | /s/ W. GRAY HUDKINS |
| Date: March 30, 2006 |       |                  |   | W. Gray Hudkins*President and Chief Executive Officer  (Principal Executive Officer)* |
|                      |       | By:                   |   | /s/ JOSEPH P. CIAVARELLA |
| Date: March 30, 2006 |       |                  |   | Joseph P. Ciavarella*Vice President and Chief Financial Officer  (Principal Accounting Officer)* |

 

Pursuantto the requirements of the Securities Exchange Act of l934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                            | By:    |   | /s/ WARREN B.  KANDERS        |
|----------------------------|--------|--------|-------------------------------|
| Date:  March 30, 2006 |   |   | Warren B. Kanders  Director   |
|                       | By:    |   | /s/ BURTT R. EHRLICH          |
| Date:  March 30, 2006 |   |   | Burtt R. Ehrlich  Director    |
|                       | By:    |   | /s/ ARTHUR GOLDSTEIN          |
| Date:  March 30, 2006 |   |   | Arthur Goldstein  Director    |
|                       | By:    |   | /s/ STUART P. GREENSPON       |
| Date:  March 30, 2006 |   |   | Stuart P. Greenspon  Director |

 

110

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