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** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly periodended October 2, 2010**

 

**or**

 

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

 

**For the transition periodfrom              to               **

 

**Commission File Number:333-142188**

 

**DJO FinanceLLC**

(Exact name of Registrant asspecified in its charter)

 

| **State of Delaware**                                           | ** ** | **20-5653965**                          |
|-----------------------------------------------------------------|------------|-----------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification Number) |
|                                                            |       |                                    |
| **1430 Decision Street  Vista, California**                | ** ** | **92081**                               |
| (Address of principal executive offices)                        |       | (Zip Code)                              |

 

Registrant’s telephonenumber, including area code:

**(800) 336-5690**

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  Yes o No o

 

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

 

| Large accelerated filer o                     |   | Accelerated filer o         |
|-----------------------------------------------|--------|-----------------------------|
|                                          |   |                        |
| Non-accelerated filer x                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                        |

 

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

 

As of November 4, 2010, 100% of the issuer’s membership interestswere owned by DJO Holdings, LLC.

 

 

 

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**DJO FinanceLLC**

 

**INDEX**

 
| ** **                                 | ** **                                                                                                                                                 | **Page  Number** |
|--------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------|
| **PART I—FINANCIAL INFORMATION** |                                                                                                                                                       |
|                                       |                                                                                                                                                       |             |
| Item  1.                                   | Financial  Statements                                                                                                                                      |             |
|                                       | Unaudited Condensed Consolidated Balance Sheets as of  October 2, 2010 and December 31, 2009                                                | 1                |
|                                       | Unaudited Condensed Consolidated Statements of  Operations for the three and nine months ended October 2, 2010 and  September 26, 2009 | 2                |
|                                       | Unaudited Condensed Consolidated Statements of Cash  Flows for the nine months ended October 2, 2010 and  September 26, 2009           | 3                |
|                                       | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                                            | 4                |
| Item 2.                                    | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                | 30               |
| Item 3.                                    | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                | 43               |
| Item 4.                                    | Controls and  Procedures                                                                                                                                   | 43               |
| **PART II—OTHER  INFORMATION**   |                                                                                                                                                       |
|                                       |                                                                                                                                                       |             |
| Item 1.                                    | Legal Proceedings                                                                                                                                          | 44               |
| Item 1A.                                   | Risk Factors                                                                                                                                               | 46               |
| Item 6.                                    | Exhibits                                                                                                                                                   | 53               |

 

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**DJO FinanceLLC**

**Unaudited Condensed Consolidated Balance Sheets**

**(in thousands)**

 
| ** **                                             | ** ** | **October 2,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|-----------------------------|------------|
| **Assets**                                             |       |                      |       |                        |       |
| Current assets:                                        |       |                      |       |                        |       |
| Cash and cash equivalents                              |       | $                         | 50,244     |                        | $          | 44,611 |   |
| Accounts receivable, net                               |       | 141,664                   |       | 146,212                     |       |
| Inventories, net                                       |       | 108,888                   |       | 95,880                      |       |
| Deferred tax assets, net                               |       | 39,552                    |       | 40,448                      |       |
| Prepaid expenses and other current assets              |       | 26,221                    |       | 14,725                      |       |
| Total current assets                                   |       | 366,569                   |       | 341,876                     |       |
| Property and equipment, net                            |       | 83,866                    |       | 86,714                      |       |
| Goodwill                                               |       | 1,190,694                 |       | 1,191,497                   |       |
| Intangible assets, net                                 |       | 1,130,778                 |       | 1,187,677                   |       |
| Other assets                                           |       | 37,404                    |       | 42,415                      |       |
| Total assets                                           |       | $                         | 2,809,311  |                        | $          | 2,850,179 |   |
|                                                   |       |                      |       |                        |       |
| **Liabilities and Equity**                             |       |                      |       |                        |       |
| Current liabilities:                                   |       |                      |       |                        |       |
| Accounts payable                                       |       | $                         | 53,036     |                        | $          | 42,144 |   |
| Accrued interest                                       |       | 36,740                    |       | 10,968                      |       |
| Current portion of debt and capital lease  obligations |       | 9,634                     |       | 15,926                      |       |
| Other current liabilities                              |       | 85,662                    |       | 90,608                      |       |
| Total current liabilities                              |       | 185,072                   |       | 159,646                     |       |
| Long-term debt and capital lease obligations           |       | 1,795,754                 |       | 1,796,944                   |       |
| Deferred tax liabilities, net                          |       | 298,006                   |       | 321,131                     |       |
| Other long-term liabilities                            |       | 12,654                    |       | 14,089                      |       |
| Total liabilities                                      |       | 2,291,486                 |       | 2,291,810                   |       |
|                                                   |       |                      |       |                        |       |
| Commitments and contingencies                          |       |                      |       |                        |       |
|                                                   |       |                      |       |                        |       |
| Equity:                                                |       |                      |       |                        |       |
| DJO Finance LLC membership equity:                     |       |                      |       |                        |       |
| Member capital                                         |       | 830,315                   |       | 827,617                     |       |
| Accumulated deficit                                    |       | (313,405                  | )          | (272,275                    | )          |
| Accumulated other comprehensive income (loss)          |       | (1,833                    | )          | 518                         |       |
| Total membership equity                                |       | 515,077                   |       | 555,860                     |       |
| Noncontrolling interests                               |       | 2,748                     |       | 2,509                       |       |
| Total equity                                           |       | 517,825                   |       | 558,369                     |       |
| Total liabilities and equity                           |       | $                         | 2,809,311  |                        | $          | 2,850,179 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO FinanceLLC**

**Unaudited Condensed Consolidated Statements of Operations**

**(in thousands)**

 
| ** **                                                                                                                                                                                                                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**    | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                   | ** ** | **October 2,********2010**  | ** ** | **September 26,********2009** | ** ** | **October 2,********2010** | ** ** | **September 26,********2009** | ** ** |
|                                                                                                                                                                                                                                                         |       |                             |       |                               |       |   |   |   |   |
| Net sales                                                                                                                                                                                                                                                    |       | $                                | 233,559    |                               | $          | 236,186 |   | $ | 716,162 |   | $ | 688,951 |   |
| Cost of sales (exclusive  of amortization of intangible assets of $9,230 and $27,211 for  the three and nine months ended October 2, 2010 and $9,495 and  $28,499 for the three and nine months ended September 26, 2009,  respectively) |       | 84,147                           |       | 86,039                             |       | 256,066 |   | 247,195 |   |
| Gross profit                                                                                                                                                                                                                                                 |       | 149,412                          |       | 150,147                            |       | 460,096 |   | 441,756 |   |
|                                                                                                                                                                                                                                                         |       |                             |       |                               |       |   |   |   |   |
| Operating expenses:                                                                                                                                                                                                                                          |       |                             |       |                               |       |   |   |   |   |
| Selling, general and  administrative (SG&A)                                                                                                                                                                                                              |       | 102,672                          |       | 101,413                            |       | 328,913 |   | 310,618 |   |
| Research and development                                                                                                                                                                                                                                     |       | 5,892                            |       | 5,616                              |       | 16,923 |   | 17,581 |   |
| Amortization of  intangible assets                                                                                                                                                                                                                           |       | 19,403                           |       | 19,560                             |       | 58,128 |   | 57,862 |   |
| Impairment of assets  held for sale                                                                                                                                                                                                                          |       | —                           |       | —                             |       | 1,147 |   | — |   |
|                                                                                                                                                                                                                                                         |       | 127,967                          |       | 126,589                            |       | 405,111 |   | 386,061 |   |
| Operating income                                                                                                                                                                                                                                             |       | 21,445                           |       | 23,558                             |       | 54,985 |   | 55,695 |   |
|                                                                                                                                                                                                                                                         |       |                             |       |                               |       |   |   |   |   |
| Other income (expense):                                                                                                                                                                                                                                      |       |                             |       |                               |       |   |   |   |   |
| Interest expense                                                                                                                                                                                                                                             |       | (37,240                          | )          | (39,173                            | )          | (114,867 | ) | (117,319 | ) |
| Interest income                                                                                                                                                                                                                                              |       | 92                               |       | 211                                |       | 232 |   | 749 |   |
| Other income, net                                                                                                                                                                                                                                            |       | 4,981                            |       | 1,422                              |       | 1,364 |   | 3,009 |   |
|                                                                                                                                                                                                                                                         |       | (32,167                          | )          | (37,540                            | )          | (113,271 | ) | (113,561 | ) |
| Loss from continuing  operations before income taxes                                                                                                                                                                                                         |       | (10,722                          | )          | (13,982                            | )          | (58,286 | ) | (57,866 | ) |
| Income tax benefit                                                                                                                                                                                                                                           |       | 3,191                            |       | 2,969                              |       | 17,983 |   | 19,901 |   |
| Loss from continuing  operations                                                                                                                                                                                                                             |       | (7,531                           | )          | (11,013                            | )          | (40,303 | ) | (37,965 | ) |
| Loss from discontinued  operations, net of tax                                                                                                                                                                                                               |       | —                           |       | (267                               | )          | — |   | (434 | ) |
| Net loss                                                                                                                                                                                                                                                     |       | (7,531                           | )          | (11,280                            | )          | (40,303 | ) | (38,399 | ) |
| Net income attributable  to noncontrolling interests                                                                                                                                                                                                         |       | (184                             | )          | (94                                | )          | (827 | ) | (368 | ) |
| Net loss attributable to  DJO Finance LLC                                                                                                                                                                                                                    |       | $                                | (7,715     | )                                  | $          | (11,374 | ) | $ | (41,130 | ) | $ | (38,767 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO Finance LLC**

**Unaudited Condensed Consolidated Statements of Cash Flows**

**(in thousands)**

 
| ** **                                                                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                          | ** ** | **October 2,  2010**       | ** ** | **September 26,  2009** | ** ** |
| **OPERATING ACTIVITIES:**                                                                           |       |                            |       |   |   |
| Net loss                                                                                            |       | $                               | (40,303    | ) | $ | (38,399 | ) |
|                                                                                                |       |                            |       |   |   |
| Adjustments to reconcile net loss to net cash  provided by operating activities:                    |       |                            |       |   |   |
| Depreciation                                                                                        |       | 19,626                          |       | 20,572 |   |
| Amortization of intangible assets                                                                   |       | 58,128                          |       | 57,862 |   |
| Amortization of debt issuance costs and non-cash  interest expense                                  |       | 9,137                           |       | 9,597 |   |
| Stock-based compensation expense                                                                    |       | 1,309                           |       | 2,335 |   |
| Loss on disposal of assets, net                                                                     |       | 839                             |       | 465 |   |
| Deferred income tax benefit                                                                         |       | (21,417                         | )          | (22,574 | ) |
| Provision for doubtful accounts and sales returns                                                   |       | 25,549                          |       | 25,433 |   |
| Inventory reserves                                                                                  |       | 4,602                           |       | 6,296 |   |
| Impairment of assets held for sale                                                                  |       | 1,147                           |       | — |   |
| Gain on disposal of discontinued operations                                                         |       | —                          |       | (393 | ) |
| Changes in operating assets and liabilities, net  of acquired assets and liabilities:               |       |                            |       |   |   |
| Accounts receivable                                                                                 |       | (21,428                         | )          | (19,423 | ) |
| Inventories                                                                                         |       | (17,452                         | )          | (1,164 | ) |
| Prepaid expenses and other assets                                                                   |       | (12,593                         | )          | (36 | ) |
| Accrued interest                                                                                    |       | 25,772                          |       | 31,209 |   |
| Accounts payable and other current liabilities                                                      |       | 8,716                           |       | (9,213 | ) |
| Net cash provided by operating activities                                                           |       | 41,632                          |       | 62,567 |   |
|                                                                                                |       |                            |       |   |   |
| **INVESTING ACTIVITIES:**                                                                           |       |                            |       |   |   |
| Purchases of property and equipment                                                                 |       | (20,277                         | )          | (19,133 | ) |
| Cash paid in connection with acquisitions, net of  cash acquired                                    |       | (2,045                          | )          | (12,846 | ) |
| Proceeds received upon disposition of discontinued  operations, net                                 |       | —                          |       | 21,846 |   |
| Other investing activities, net                                                                     |       | (717                            | )          | (76 | ) |
| Net cash used in investing activities                                                               |       | (23,039                         | )          | (10,209 | ) |
|                                                                                                |       |                            |       |   |   |
| **FINANCING ACTIVITIES:**                                                                           |       |                            |       |   |   |
| Proceeds from issuance of debt                                                                      |       | 127,130                         |       | 65,173 |   |
| Repayments of debt and capital lease obligations                                                    |       | (136,161                        | )          | (94,834 | ) |
| Payment of debt issuance costs                                                                      |       | (3,454                          | )          | — |   |
| Investment by parent                                                                                |       | 1,389                           |       | — |   |
| Dividend paid by subsidiary to owners of noncontrolling  interests                                  |       | (557                            | )          | — |   |
| Net cash used in financing  activities                                                              |       | (11,653                         | )          | (29,661 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                                       |       | (1,307                          | )          | (1,901 | ) |
| **Net increase in cash and cash  equivalents**                                                      |       | 5,633                           |       | 20,796 |   |
| Cash and cash equivalents at beginning of period                                                    |       | 44,611                          |       | 30,483 |   |
| **Cash and cash equivalents at  end of period**                                                     |       | $                               | 50,244     |   | $ | 51,279 |   |
|                                                                                                |       |                            |       |   |   |
| **Supplemental disclosures of  cash flow information:**                                             |       |                            |       |   |   |
| Cash paid for interest                                                                              |       | $                               | 81,834     |   | $ | 76,366 |   |
| Cash paid for taxes, net                                                                            |       | $                               | 3,614      |   | $ | 1,859 |   |
| **Non-cash investing and  financing activities:**                                                   |       |                            |       |   |   |
| Increases in property and equipment and other  liabilities in connection with capitalized ERP costs |       | $                               | 1,069      |   | $ | 3,568 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO Finance LLC**

**Notes toUnaudited Condensed Consolidated Financial Statements**

 

**1.  BASIS OFPRESENTATION**

 

We are a global provider of high-quality orthopedic devices, with abroad range of products used for rehabilitation, pain management and physicaltherapy. We also develop, manufacture and distribute a broad range of surgicalreconstructive implant products. We believe that we offer healthcareprofessionals and patients a diverse range of orthopedic rehabilitationproducts addressing the complete spectrum of preventative, pre-operative,post-operative, clinical and home rehabilitation care. Our products are used byorthopedic specialists, primary care physicians, pain management specialists,physical therapists, podiatrists, chiropractors, athletic trainers and otherhealthcare professionals to treat patients with musculoskeletal conditionsresulting from degenerative diseases, deformities, traumatic events and sports-relatedinjuries. In addition, many of our non-surgical medical devices and relatedaccessories are used by athletes and patients for injury prevention and at-homephysical therapy treatment.

 

Our current business activities are the result of a combination ofReAble Therapeutics, Inc. (ReAble), which was acquired by an affiliate ofBlackstone Capital Partners V L.P. (Blackstone), and DJO OpcoHoldings, Inc. (DJO Opco), formerly named DJO Incorporated. OnNovember 20, 2007, ReAble acquired DJO Opco through a merger transaction(the DJO Merger). ReAble then changed its name to DJO Incorporated andcontinues to be owned primarily by affiliates of Blackstone. As a result of theDJO Merger, DJO Opco (which on December 31, 2009, was merged into DJO, LLC) becamea subsidiary of DJO Finance LLC (DJOFL), the entity filing this QuarterlyReport on Form 10-Q, which is itself a subsidiary of DJO Incorporated.Except as otherwise indicated, references to “us”, “we”, “our”, or “our Company”,refers to DJOFL and its consolidated subsidiaries.

 

On June 12, 2009, we sold our EmpiTherapy Solutions (ETS) catalog business, formerly known as Rehab MedicalEquipment, or RME, to Patterson Medical Supply, Inc. for approximately$21.8 million. As such, results of the ETS business for the three and ninemonth periods ended September 26, 2009 have been presented as discontinuedoperations in our unaudited condensed consolidated financial statements.

 

In the second quarter of 2010, we changed how we report our segmentfinancial information to senior management. Prior to the second quarter of2010, our Bracing and Supports and Recovery Sciences businesses were reportedtogether within the Domestic Rehabilitation Segment. During the second quarter,as a result of our recent sales and marketing leadership reorganization, thesebusinesses are now separately evaluated and managed. Segment information forall periods presented has been restated to reflect this change.

 

We market and distribute ourproducts through four operating segments, Bracing and Supports, RecoverySciences, Surgical Implant, and International. Our Bracing and Supports Segmentoffers to customers in the United States, orthopedic soft goods; rigid kneebraces; cold therapy devices and vascular systems which include productsintended to prevent deep vein thrombosis following surgery. Our RecoverySciences Segment offers to customers in the United States, non-invasive medicalproducts that are used before and after surgery to assist in the repair andrehabilitation of soft tissue and bone, and to protect against further injury;electrotherapy devices and accessories used to treat pain and restore musclefunction; iontophoretic devices and accessories used to deliver medication;clinical therapy tables, traction equipment and other clinical therapyequipment; and orthotic devices used to treat joint and spine conditions. OurSurgical Implant Segment offers a comprehensive suite of reconstructive jointproducts to customers in the United States. Our International segment offersall of our products to customers outside the United States.

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States (GAAP) requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities at the date of the financial statements and the reportedamounts of revenue and expenses during the reporting period. Estimates andassumptions are used in accounting for, among other things, contractual allowances,rebates, product returns, warranty obligations, allowances for doubtfulaccounts, valuation of inventories, self-insurance reserves, income taxes, losscontingencies, fair values of derivative instruments, fair values of long-livedassets and any related impairments, capitalization of costs associated withinternally developed software, and stock-based compensation. Actual resultscould differ from those estimates.

 

The accompanyingunaudited condensed consolidated financial statements include our accounts andall voting interest entities where we exercise a controlling financial interestthrough the ownership of a direct or indirect majority voting interest. All significantintercompany accounts and transactions have been eliminated in consolidation.

 

Our unaudited condensed consolidated financial statements have beenprepared in accordance with GAAP and with the instructions to Form 10-Qand Article 10 of Regulation S-X for interim financial information.Accordingly, these financial statements do not include all of the informationrequired by GAAP or Securities and Exchange Commission rules and regulationsfor complete financial statements. In the opinion of management, thesefinancial statements reflect all adjustments (consisting of normal recurringadjustments) necessary for a fair presentation of the results of operations forthe interim periods presented. The results of operations for any interim periodare not necessarily indicative of results for the full year. These unauditedcondensed consolidated financial statements should be read in conjunction withour consolidated financial statements and notes thereto included in our AnnualReport on Form 10-K for the year ended December 31, 2009.

 

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Certain prior period amounts have been reclassified to conform to thecurrent year presentation.

 

We operate our business on a manufacturing calendar, with our fiscalyear always ending on December 31. Each quarter is 13 weeks, consisting oftwo four-week periods and one five-week period. Our first and fourth quartersmay have more or fewer shipping days from year to year based on the days of theweek on which holidays and December 31 fall. The three months endedOctober 2, 2010 and September 26, 2009 each included 63 shipping days. The ninemonths ended October 2, 2010 and September 26, 2009 included 192 and 188shipping days, respectively.

 

**2.  RECENT ACCOUNTINGPRONOUNCEMENTS**

 

InJanuary 2010, we adopted the provisions of the Improvement to FinancialReporting by Enterprises Involved with Variable Interest Entities Topic of theFinancial Accounting Standards Board (FASB) Codification. This Topic requires aqualitative approach to identifying a controlling interest financial interestin a variable interest entity (VIE), and requires ongoing assessment of whetheran entity is a VIE, and whether an interest in a VIE makes the holder theprimary beneficiary of the VIE. The adoption of this Topic had no impact on ourconsolidated financial statements.

 

InJanuary 2010, we adopted the provisions of the FASB Codification which, amongother matters, removes the concept of a qualifying special-purpose entity;creates more stringent conditions for reporting a transfer of a portion of afinancial asset as a sale; establishes conditions for reporting a transfer of aportion of a financial asset as a sale; and changes the initial measurement ofa transferor’s interest in transferred financial assets. The adoption of thisTopic had no impact on our consolidated financial statements.

 

InSeptember 2009, the FASB issued guidance concerning the determination ofwhether an arrangement involving multiple deliverables contains more than oneunit of accounting and the manner in which consideration should be measured andallocated to the separate units of accounting in the multiple-elementarrangement. This guidance is effective for fiscal years beginning on or afterJune 15, 2010. We are currently evaluating the impact, if any, this issuewill have on our consolidated financial statements. However, we do not expectthat this issue will have a material effect on our financial position, resultsof operations, or cash flows.

 

**3.  ACCOUNTS RECEIVABLE RESERVES**

 

A summary of activity in our accounts receivable reserves for doubtfulaccounts and sales returns is presented below (in thousands):

 
| ** **                                        | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **October 2,  2010**       | ** ** | **September 26,   2009** | ** ** |
| Balance, beginning of period                      |       | $                               | 48,306     |   | $ | 36,521 |   |
| Provision for doubtful accounts and sales returns |       | 25,549                          |       | 25,433 |   |
| Write-offs, net of recoveries                     |       | (21,400                         | )          | (16,334 | ) |
| Balance, end of period                            |       | $                               | 52,455     |   | $ | 45,620 |   |

 

**4.  INVENTORIES**

 

Inventoriesconsist of the following (in thousands):

 
| ** **                    | ** ** | **October 2,  2010** | ** **    | **December 31,  2009** | ** ** |
|-------------------------------|------------|---------------------------|---------------|-----------------------------|------------|
| Components and raw materials  |       | $                         |  28,949  |                        | $          |  29,967 |   |
| Work in process               |       | 6,154                     |          | 3,745                       |       |
| Finished goods                |       | 64,044                    |          | 51,110                      |       |
| Inventory held on consignment |       | 22,428                    |          | 24,121                      |       |
|                          |       | 121,575                   |          | 108,943                     |       |
| Less inventory reserves       |       | (12,687                   | )             | (13,063                     | )          |
|                          |       | $                         |  108,888 |                        | $          |  95,880 |   |

 

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A summary of the activity in our reserves for estimated slow moving,excess, obsolete and otherwise impaired inventory is presented below (inthousands):

 
| ** **                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **October 2,  2010**       | ** ** | **September 26,  2009** | ** ** |
| Balance, beginning of period       |       | $                               | 13,063     |   | $ | 17,798 |   |
| Provision charged to cost of sales |       | 4,602                           |       | 6,296 |   |
| Write-offs, net of recoveries      |       | (4,978                          | )          | (6,895 | ) |
| Balance, end of period             |       | $                               | 12,687     |   | $ | 17,199 |   |

 

The write-offs to the reserve were primarily related to the dispositionof fully reserved inventory.

 

**5.  LONG-LIVED ASSETS**

 

***Goodwill***

 

Changes in the carrying amount of our goodwill for the nine monthsended October 2, 2010 are set forth below (in thousands):

 
| Balance, beginning of period |   | $    | 1,191,497 |   |
|------------------------------|--------|------|-----------|--------|
| Acquisition (1)              |   | 113  |      |
| Translation adjustments      |   | (916 | )         |
| Balance, end of period       |   | $    | 1,190,694 |   |

 

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(1)          On September 20, 2010 we acquired certain assets andcontractual rights from our South African distributor for total considerationof $1.9 million, which included (i) a cash payment of $1.2 million on theclosing date, (ii) forgiveness of $0.4 million of accounts receivable fromthe distributor and (iii) holdbacks of $0.3 million related primarily topotential indemnification claims, which will be paid in September 2011 if thereare no such claims. Our primary reason for this acquisition was to improve theprofitability of our sales in South Africa and expand the range of our productssold in this market, which will be aided by participating directly in the market,instead of through an independent distributor. The purchase price was allocatedto the acquired tangible and identifiable intangible assets consisting of $0.4million of inventory, $0.3 million of fixed assets and $1.1 million offinite-lived intangible assets. The $0.1 million excess of the purchase priceover the fair value of these identifiable assets was recorded as goodwill.

 

***Intangible assets, net***

 

Identifiableintangible assets consisted of the following as of October 2, 2010 (inthousands):

 
| ** **                                 | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Intangible assets subject to amortization: |       |                        |       |                          |       |                      |       |
| Technology-based                           |       | $                           | 447,456    |                          | $          | (110,865                  | )          | $ | 336,591 |   |
| Customer-based                             |       | 485,533                     |       | (120,829                      | )          | 364,704                   |       |
|                                       |       | $                           | 932,989    |                          | $          | (231,694                  | )          | 701,295 |   |
| Indefinite-lived intangible assets:        |       |                        |       |                          |       |                      |       |
| Trademarks and trade names                 |       |                        |       |                          |       | 429,483                   |       |
|                                       |       |                        |       |                          |       | $                         | 1,130,778  |   |

 

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Identifiableintangible assets consisted of the following as of December 31, 2009 (inthousands):

 
| ** **                                 | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Intangible assets subject to amortization: |       |                        |       |                          |       |                      |       |
| Technology-based                           |       | $                           | 458,732    |                          | $          | (94,346                   | )          | $ | 364,386 |   |
| Customer-based                             |       | 490,589                     |       | (97,067                       | )          | 393,522                   |       |
|                                       |       | $                           | 949,321    |                          | $          | (191,413                  | )          | 757,908 |   |
| Indefinite-lived intangible assets:        |       |                        |       |                          |       |                      |       |
| Trademarks and trade names                 |       |                        |       |                          |       | 429,769                   |       |
|                                       |       |                        |       |                          |       | $                         | 1,187,677  |   |

 

Our intangible assets with finite useful lives are being amortizedusing the straight-line method over their estimated useful lives ranging fromone to 20 years. Based on our amortizable intangible asset balance as ofOctober 2, 2010, we estimate that amortization expense will be as follows forthe next five years and thereafter (in thousands):

 
| Remaining 2010 |   | $       | 19,390  |   |
|----------------|--------|---------|---------|--------|
| 2011           |   | 76,975  |    |
| 2012           |   | 75,659  |    |
| 2013           |   | 69,719  |    |
| 2014           |   | 68,148  |    |
| Thereafter     |   | 391,404 |    |
|           |   | $       | 701,295 |   |

 

**6.  OTHERCURRENT LIABILITIES**

 

Other current liabilities consist of the following (in thousands):

 
| ** **                     | ** ** | **October 2,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------|------------|---------------------------|------------|-----------------------------|------------|
| Wages and related expenses     |       | $                         | 25,008     |                        | $          | 20,668 |   |
| Commissions and royalties      |       | 11,758                    |       | 12,953                      |       |
| Interest rate swap derivatives |       | 8,113                     |       | 9,701                       |       |
| Other accrued liabilities      |       | 40,783                    |       | 47,286                      |       |
|                           |       | $                         | 85,662     |                        | $          | 90,608 |   |

 

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**7.  DERIVATIVEINSTRUMENTS**

 

We use derivative financial instruments to manage interest rate riskrelated to our variable rate credit facilities and risk related to foreigncurrency exchange rates. Our objective is to reduce the risk to earnings andcash flows associated with changes in interest rates and changes in foreigncurrency exchange rates. Before acquiring a derivative instrument to hedge aspecific risk, we evaluate potential natural hedges. Factors considered in thedecision to hedge an underlying market exposure include the materiality of therisk, the volatility of the market, the duration of the hedge, and theavailability, effectiveness and cost of derivative instruments. We do not usederivative instruments for speculative or trading purposes.

 

All derivatives, whether designated as hedging relationships or not,are recorded on the balance sheet at fair value. The fair value of ourderivatives is determined through the use of models that consider variousassumptions, including time value, yield curves and other relevant economicmeasures which are inputs that are classified as Level 2 in the valuationhierarchy. The classification of gains and losses resulting from changes in thefair values of derivatives is dependent on the intended use of the derivativeand its resulting designation. Our interest rate swap agreements are designatedas cash flow hedges, and accordingly, effective portions of changes in the fairvalue of the derivatives are recorded in accumulated other comprehensive income(loss) and subsequently reclassified into our consolidated statement ofoperations when the hedged forecasted transaction affects income (loss).Ineffective portions of changes in the fair value of cash flow hedges arerecognized in income (loss). Our foreign exchange contracts have not beendesignated as hedges, and accordingly, changes in the fair value of thederivatives are recorded in income (loss).

 

*Interest Rate Swap Agreements*.  Our senior secured credit facilities aresubject to floating interest rates. We manage the risk of unfavorable movementsin interest rates by hedging a portion of the outstanding loan balance, therebylocking in a fixed rate on a portion of the principal, reducing the effect ofpossible rising interest rates and making interest expense more predictable overthe term of the credit facilities. We have five interest rate swap agreementswhich we have designated as cash flow hedges for accounting purposes, and thehedges are considered effective. As such, the effective portion of the gain orloss on the derivative instrument is reported as a component of accumulatedother comprehensive income (loss) and is reclassified into interest expense inour unaudited condensed consolidated statement of operations in the period inwhich it affects income (loss).

 

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Information regarding our interest rate swap agreements as of October 2,2010 is presented below (in thousands):

 
| **Maturity Date (1)**        | ** ** | **Notional  Amount** | ** ** | **Pay  Fixed** | ** ** | **Receive  Floating** | ** **    | **Estimated loss  expected to be  reclassified into  earnings within the  next twelve months** | ** ** |
|----------------------------------------|------------|----------------------|------------|----------------|------------|-----------------------|---------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|
| December 2010                     |       | $                    | 750,000    |           | 1.88%      |                  | 1 month LIBOR |                                                                                                                                   | $          | 3,086 |   |
| January - December 2011 |       | 75,000               |       | 2.55%          |       | 1 month LIBOR         |          | 1,238                                                                                                                                  |       |
| January -  December 2011     |       | 75,000               |       | 2.60%          |       | 1 month LIBOR         |          | 1,267                                                                                                                                  |       |
| January -  December 2011     |       | 75,000               |       | 2.585%         |       | 1 month LIBOR         |          | 1,258                                                                                                                                  |       |
| January -  December 2011     |       | 75,000               |       | 2.595%         |       | 1 month LIBOR         |          | 1,264                                                                                                                                  |       |
|                                   |       |                 |       |           |       |                  |          | $                                                                                                                                      | 8,113      |   |
|                                        |            |                      |            |                |            |                       |               |                                                                                                                                        |            |  |  |

 

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(1)          Forderivative instruments that were in effect as of October 2, 2010, wepresent a single date that represents the applicable final maturity date. Forderivative instruments that become effective subsequent to October 2,2010, we present a range of dates that represent the period covered by theapplicable derivative instrument.

 

*Foreign Exchange Rate Contracts*.  We utilize Mexican Peso (MXP) foreignexchange forward contracts to hedge a portion of our exposure to fluctuationsin foreign exchange rates, as our Mexico-based manufacturing operations incurcosts that are largely denominated in MXP. These foreign exchange forwardcontracts expire weekly throughout fiscal year 2010.While our foreign exchangeforward contracts act as economic hedges, we have not designated suchinstruments as hedges for accounting purposes. Therefore, gains and lossesresulting from changes in the fair values of these derivative instruments arerecorded in other income, net, in our unaudited condensed consolidatedstatements of operations.

 

Information regarding the notional and fair value of our foreignexchange forward contracts as of October 2, 2010 and December 31,2009 is presented in the table below (in thousands):

 
| **October 2, 2010** | ** ** | **December 31, 2009** | ** ** |
|-------------------------------|------------|---------------------------------|------------|
| **Notional Value  MXP**  | ** ** | **Notional Value  USD**    | ** ** | **Fair Value  USD** | ** ** | **Notional Value  MXP** | ** ** | **Notional Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| 143,400                       |       | $                               | 10,759     |   | $ | 11,279 |   | 190,745 |   | $ | 14,242 |   | $ | 14,331 |   |
|                               |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The following table summarizes the fair value of derivative instrumentsin our unaudited condensed consolidated balance sheets (in thousands): 

 
| ** **                                                                         | ** ** | **Balance Sheet Location** | ** ** | **October 2,  2010** | ** ** | **December 31,  2009** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------|------------|-----------------------------|------------|
| **Derivative assets:**                                                             | ** ** | ** **                           | ** ** | ** **                | ** ** | ** **                  | ** ** |
| Foreign exchange forward contracts not designated  as hedges                       |       | Other  current assets                |       | $                         | 520        |                        | $          | 89 |   |
| ** **                                                                         | ** ** | ** **                           | ** ** | ** **                | ** ** | ** **                  | ** ** |
| **Derivative liabilities:**                                                        | ** ** | ** **                           | ** ** | ** **                | ** ** | ** **                  | ** ** |
| Current portion of interest rate swap agreements  designated as cash flow hedges   |       | Other  current liabilities           |       | $                         | 8,113      |                        | $          | 9,701 |   |
| Long-term portion of interest rate swap agreements  designated as cash flow hedges |       | Other  long-term liabilities         |       | 1,570                     |       | 1,543                       |       |
|                                                                               |       |                                 |       | $                         | 9,683      |                        | $          | 11,244 |   |

 

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The following table summarizes the effect of derivative instruments onour unaudited condensed consolidated statements of operations (in thousands):

 
| ** **                                                    | ** ** | ** **                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**    | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|----------------------------------|------------|------------------------------------|------------|
| ** **                                                    | ** ** | **Location of gain (loss)** | ** ** | **October 2,********2010**  | ** ** | **September 26,********2009** | ** ** | **October 2,********2010** | ** ** | **September 26,********2009** | ** ** |
| Interest rate swap agreements designated as cash  flow hedges |       | Interest  expense (1)                      |       | $                                | (2,988     | )                                  | $          | (5,001 | ) | $ | (9,181 | ) | $ | (12,629 | ) |
| Foreign exchange forward contracts not designated  as hedges  |       | Other income, net                          |       | 407                              |       | 427                                |       | 431 |   | (2,945 | ) |
|                                                          |       |                                       |       | $                                | (2,581     | )                                  | $          | (4,574 | ) | $ | (8,750 | ) | $ | (15,574 | ) |

 

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(1)          Represents theloss on derivative instruments designated as cash flow hedges, which has beenreclassified from accumulated other comprehensive income (loss) into interestexpense during the periods presented.

 

The pre-tax loss onderivative instruments designated as cash flow hedges recognized in accumulatedother comprehensive income (loss) is presented below (in thousands):

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**    | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|------------------------------------|------------|
| ** **                                         | ** ** | **October 2,********2010**  | ** ** | **September 26,********2009** | ** ** | **October 2,********2010** | ** ** | **September 26,********2009** | ** ** |
| Interest rate swaps designated as cash flow hedges |       | $                                | 1,750      |                               | $          | 5,748 |   | $ | 7,619 |   | $ | 17,957 |   |
|                                                    |            |                                  |            |                                    |            |  |  |  |  |  |  |  |  |

 

**8.  FAIR VALUEMEASUREMENTS**

 

Financial assets and liabilities are classified based on the lowestlevel of input that is significant to the fair value measurements. Ourassessment of the significance of a particular input to the fair valuemeasurements requires judgment, and may affect the valuation of the assets andliabilities being measured and their placement within the fair value hierarchy.The following tables present the balances of assets and liabilities measured atfair value on a recurring basis (in thousands):

 
| **As of October 2, 2010**                 | ** ** | **Level 1 (1)** | ** ** | **Level 2 (2)** | ** ** | **Level 3 (3)** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|-----------|------------|
| **Total Assets:**                                             |       |                      |       |                      |       |                      |       |      |       |
| Foreign exchange forward contracts not designated  as hedges  |       | $                         | —     |                      | $          | 520                       |       | $         | —     |   | $ | 520 |   |
|                                                          |       |                      |       |                      |       |                      |       |      |       |
| **Total Liabilities:**                                        |       |                      |       |                      |       |                      |       |      |       |
| Interest rate swap agreements designated as cash  flow hedges |       | $                         | —     |                      | $          | 9,683                     |       | $         | —     |   | $ | 9,683 |   |

 
| **As of December 31, 2009**               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Total Assets:**                                             |       |       |       |       |       |       |       |       |       |
| Foreign exchange forward contracts not designated  as hedges  |       | $          | —     |       | $          | 89         |       | $          | —     |   | $ | 89 |   |
|                                                          |       |       |       |       |       |       |       |       |       |
| **Total Liabilities:**                                        |       |       |       |       |       |       |       |       |       |
| Interest rate swap agreements designated as cash  flow hedges |       | $          | —     |       | $          | 11,244     |       | $          | —     |   | $ | 11,244 |   |

 

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(1)   Fair value measurements based on quotedprices in active markets for identical assets or liabilities.

(2)   Fair value measurements based on observableinputs other than quoted prices in active markets for identical assets andliabilities.

(3)   No observable valuation inputs in the market.

 

**9.  DEBT AND CAPITALLEASE OBLIGATIONS**

 

Debt and capital lease obligations consists of the following (inthousands):

 
| ** **                                                                                                               | ** ** | **October 2,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-----------------------------|------------|
| Senior Secured Credit Facility:                                                                           |       |                      |       |                        |       |
| $100.0 million revolving credit facility                                                                                 |       | $                         | —     |                        | $          | — |   |
| Term loan facility, net of unamortized original  issue discount ($7.2 million  and $9.3 million, respectively) |       | 925,840                   |       | 1,034,427                   |       |
| 10.875% Senior Notes, including unamortized  original issue premium ($4.5 million  as of October 2, 2010)      |       | 679,456                   |       | 575,000                     |       |
| 11.75% Senior Subordinated Notes (see Note 18)                                                                           |       | 200,000                   |       | 200,000                     |       |
| Notes payable for acquisitions                                                                                           |       | —                    |       | 2,860                       |       |
| Capital lease obligations                                                                                                |       | 92                        |       | 228                         |       |
| Other                                                                                                                    |       | —                    |       | 355                         |       |
| Total debt and capital lease obligations                                                                                 |       | 1,805,388                 |       | 1,812,870                   |       |
| Current maturities                                                                                                       |       | (9,634                    | )          | (15,926                     | )          |
| Long-term debt and capital lease obligations                                                                             |       | $                         | 1,795,754  |                        | $          | 1,796,944 |   |

 

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***Senior Secured Credit Facility***

 

On November 20, 2007, we entered into the Senior Secured CreditFacility consisting of a $1,065.0 million term loan facility maturingMay 2014 and a $100.0 million revolving credit facility maturingNovember 2013. We issued the term loan facility at a 1.2% discount,resulting in net proceeds of $1,052.4 million. We are amortizing the$12.6 million discount using the effective interest method, therebyincreasing the reported outstanding balance through the maturity date of theterm loan facility.

 

On January 14, 2010, we entered into Amendment No. 1 to theSenior Secured Credit Facility, which permitted us to issue up to an additional$150.0 million in aggregate principal amount of new 10.875% Notes on or priorto March 1, 2010, as long as the net cash proceeds were used to make avoluntary prepayment of the term loans. In connection with this amendment, weincurred $1.1 million of arrangement and lender consent fees, which weexpensed during the first quarter of 2010. On January 20, 2010, we issued$100.0 million of new 10.875% Notes, as described below, and made a $101.5million voluntary prepayment of the term loans in accordance with the terms ofAmendment No. 1 to the Senior Secured Credit Facility. In addition,pursuant to the excess cash flow provisions of the Senior Secured CreditFacility, as described below, we also made a $2.0 million prepayment of theterm loans during March 2010. In connection with these prepayments, weaccelerated $0.8 million of amortization of the then remaining unamortizedoriginal issue discount during the first quarter of 2010. Additionally, werecognized a non-cash loss of $1.9 million attributable to the write off of thethen remaining unamortized debt issuance costs related to the portion of the termloans that were repaid.

 

As of October 2, 2010, the market value of our term loan facilitywas $898.0 million. Wedetermine market value using trading prices for our term loan on or near thatdate.

 

*Interest Rates.*  Borrowings under the Senior Secured CreditFacility bear interest at a rate equal to an applicable margin plus, at ouroption, either (a) a base rate determined by reference to the higher of(1) the prime rate, as defined and (2) the federal funds rate plus0.50% or (b) the Eurodollar rate determined by reference to the costs offunds for deposits in U.S. dollars for the interest period relevant to eachborrowing adjusted for required reserves. The initial applicable margin forborrowings under the term loan facility and the revolving credit facility is2.00% with respect to base rate borrowings and 3.00% with respect to Eurodollarborrowings. The applicable margin for borrowings under the term loan facilityand the revolving credit facility may be reduced subject to our attainingcertain leverage ratios. We use interest rate swap agreements in an effort tohedge our exposure to fluctuating interest rates related to a portion of ourSenior Secured Credit Facility (See Note 7).

 

*Fees.*  In addition to paying interest on outstandingprincipal under the Senior Secured Credit Facility, we are required to pay acommitment fee to the lenders under the revolving credit facility with respectto the unutilized commitments thereunder. The current commitment fee rate is0.50% per annum. The commitment fee rate may be reduced subject to ourattaining certain leverage ratios. We must also pay customary letter of creditfees.

 

*Principal Payments.*  We are required to pay annual payments inequal quarterly installments on the term loan facility in an amount equal to1.00% of the funded total principal amount through February 2014, with anyremaining amount payable in full at maturity in May 2014.

 

*Prepayments.*  The Senior Secured Credit Facility requiresus to prepay outstanding term loans, subject to certain exceptions, with(1) 50% (which percentage can be reduced to 25% or 0% upon our attainingcertain leverage ratios) of our annual excess cash flow, as defined;(2) 100% of the net cash proceeds above an annual amount of $25.0 millionfrom non-ordinary course asset sales (including insurance and condemnationproceeds) by DJOFL and its restricted subsidiaries, subject to certainexceptions to be agreed upon, including a 100% reinvestment right if reinvestedor committed to reinvest within 15 months of such sale or disposition solong as reinvestment is completed within 180 days thereafter; and(3) 100% of the net cash proceeds from issuance or incurrence of debt byDJOFL and its restricted subsidiaries, other than proceeds from debt permittedto be incurred under the Senior Secured Credit Facility and related amendments.Any mandatory prepayments are applied to the term loan facility in direct orderof maturity. We reinvested the net proceeds from our 2009 asset sales and, assuch, our calculation of 2009 excess cash flows excluded those net proceeds. Wemay voluntarily prepay outstanding loans under the Senior Secured CreditFacility at any time without premium or penalty, provided that voluntaryprepayments of Eurodollar loans made on a date other than the last day of aninterest period applicable thereto shall be subject to customary breakagecosts.

 

*Guarantee and Security.*  All obligations under the Senior SecuredCredit Facility are unconditionally guaranteed by DJO Holdings LLC (DJOHoldings) and each existing and future direct and indirect wholly-owneddomestic subsidiary of DJOFL other than immaterial subsidiaries, unrestrictedsubsidiaries and subsidiaries that are precluded by law or regulation fromguaranteeing the obligations (collectively, the Guarantors).

 

All obligations under the Senior Secured Credit Facility, and theguarantees of those obligations, are secured by pledges of 100% of the capitalstock of DJOFL, 100% of the capital stock of each wholly owned domesticsubsidiary and 65% of the capital stock of each wholly owned foreign subsidiarythat is, in each case, directly owned by DJOFL or one of the Guarantors; and asecurity interest in, and mortgages on, substantially all tangible andintangible assets of DJO Holdings, DJOFL and each Guarantor.

 

*Certain Covenants and Events of Default.*  The Senior Secured Credit Facility containscovenants that, among other things, restrict, subject to certain exceptions,our and our subsidiaries’ ability to:

 

·                  incur additionalindebtedness,

·                  create liens on assets,

·                  change fiscal years,

·                  enter into sale andleaseback transactions,

·                  engage in mergers orconsolidations,

·                  sell assets,

·                  pay dividends and otherrestricted payments,

·                  make investments, loans oradvances,

 

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·                  repay subordinatedindebtedness,

·                  make certain acquisitions,

·                  engage in certaintransactions with affiliates,

·                  restrict the ability ofrestricted subsidiaries that are not Guarantors to pay dividends or makedistributions,

·                  amend material agreementsgoverning our subordinated indebtedness, and

·                  change our lines ofbusiness.

 

In addition, the Senior Secured Credit Facility requires us to maintaina maximum senior secured leverage ratio of 3.75:1 for the trailing twelvemonths ended October 2, 2010, stepping down to 3.25:1 beginning with thetrailing twelve months ended December 31, 2011. The Senior Secured CreditFacility also contains certain customary affirmative covenants and events ofdefault. As of October 2, 2010, our maximum senior secured leverage ratiowas within the covenant level, and we were in compliance with all otherapplicable covenants.

 

***10.875% Senior Notes***

 

On November 20, 2007, DJOFL and DJO Finance Corporation (DJOFinco) (collectively, the Issuers) issued $575.0 million aggregateprincipal amount of 10.875% Senior Notes (the 10.875% Notes) due 2014, under anagreement dated as of November 20, 2007 (the 10.875% Indenture) among theIssuers, the guarantors party thereto and The Bank of New York Mellon (formerlyknown as The Bank of New York), as trustee.

 

On January 20, 2010, the Issuers issued $100.0 million aggregateprincipal amount of new 10.875% Notes, pursuant to the 10.875% Indenture thatgoverns our existing 10.875% Notes due 2014. We issued the new 10.875% Notes ata 5.0% premium, resulting in gross proceeds of $105.0 million. We areamortizing the premium over the term of the new 10.875% Notes using the effectiveinterest method, thereby decreasing the reported outstanding balance throughthe maturity date. Net proceeds from the issuance (excluding approximately $2.0million of interest accrued from November 15, 2009 toJanuary 19, 2010, which was included in the interest payment we madeto holders of the new 10.875% Notes on May 15, 2010), along with cash onhand, were used to repay $101.5 million of existing term loans under the SeniorSecured Credit Facility. The 10.875% Notes require semi-annual interest paymentsof approximately $36.7 million each May 15 and November 15 and aredue November 15, 2014.

 

As of October 2, 2010, the market value of the 10.875% Notes was$730.7 million. We determine market value using trading prices for the10.875% Notes on or near that date. We believe the trading prices as of October 2,2010 reflect certain differences between prevailing market terms and conditionsand the actual terms of our 10.875% Notes.

 

*Optional Redemption.*  Under the 10.875% Indenture, prior toNovember 15, 2011, the Issuers have the option to redeem some or all ofthe 10.875% Notes for cash at a redemption price equal to 100% of the thenoutstanding principal balance plus an applicable make-whole premium plusaccrued and unpaid interest. Beginning on November 15, 2011, the Issuersmay redeem some or all of the 10.875% Notes at a redemption price of 105.438%of the then outstanding principal balance plus accrued and unpaid interest. Theredemption price decreases to 102.719% and 100% of the then outstanding principalbalance at November 2012 and November 2013, respectively.Additionally, from time to time, before November 15, 2010, the Issuers mayredeem up to 35% of the 10.875% Notes at a redemption price equal to 110.875%of the principal amount then outstanding, in each case, with proceeds we raise,or a direct or indirect parent company raises, in certain offerings of equityof DJOFL or its direct or indirect parent companies, as long as at least 65% ofthe aggregate principal amount of the notes issued remains outstanding.

 

*Change of Control.*  Upon the occurrence of a change of control,unless DJOFL has previously sent or concurrently sends a notice exercising itsoptional redemption rights with respect to all of the then-outstanding 10.875%Notes, DJOFL will be required to make an offer to repurchase all of thethen-outstanding 10.875% Notes at 101% of their principal amount, plus accruedand unpaid interest.

 

*Covenants.*  The 10.875% Indenture contains covenantslimiting, among other things, our and our restricted subsidiaries’ ability toincur additional indebtedness or issue certain preferred and convertibleshares, pay dividends on, redeem, repurchase or make distributions in respectof the capital stock of DJO, or make other restricted payments, make certaininvestments, sell certain assets, create liens on certain assets to securedebt, consolidate, merge, sell or otherwise dispose of all or substantially allof our assets, enter into certain transactions with affiliates, and designateour subsidiaries as unrestricted subsidiaries. As of October 2, 2010, wewere in compliance with all applicable covenants.

 

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***11.75% Senior Subordinated Notes***

 

The Issuers issued $200.0 million aggregate principal amount of11.75% Senior Subordinated Notes in November 2006 (the 11.75% Notes). The11.75% Notes required semi-annual interest payments of approximately$11.8 million each May 15 and November 15.

 

As of October 2, 2010, the market value of the 11.75% Notes wasapproximately $212.5 million. We determine market value using trading pricesfor the 11.75% Notes on or near that date.

 

The 11.75% Notes contained provisions similar to the 10.875% Notes withrespect to change of control and covenant requirements. Under the Indenturegoverning the 11.75% Notes (the 11.75% Indenture), prior to November 15,2010, the Issuers had the option to redeem some or all of the 11.75% Notes forcash at a redemption price equal to 100% of the then outstanding principalbalance plus an applicable make-whole premium plus accrued and unpaid interest.

 

On October 18, 2010, we issued $300.0 million of new 9.75% SeniorSubordinated Notes (9.75% Notes), and used a portion of the proceeds torepurchase $199.85 million aggregate principal amount of the 11.75% Notes fortotal consideration of $213.0 million plus $9.8 million of accrued interestthrough the settlement date. We intend to redeem the remaining $150,000aggregate principal amount of the 11.75% Notes during November 2010 at aredemption price of 105.875% (see Note 18 for additional information).

 

Our ability to continue to meet the covenants related to ourindebtedness specified above and in Note 18, in future periods will depend, inpart, on events beyond our control, and we may not continue to meet thoseratios. A breach of any of these covenants in the future could result in adefault under the Senior Secured Credit Facility, the 10.875% Indenture, andthe Indenture which governs the 9.75% Notes issued on October 18, 2010(collectively, the Indentures), at which time the lenders could elect todeclare all amounts outstanding under the Senior Secured Credit Facility to beimmediately due and payable. Any such acceleration would also result in adefault under the Indentures.

 

***Debt Issuance Costs***

 

As of October 2, 2010 and December 31, 2009, we had $34.8million and $38.9 million, respectively, of unamortized debt issuance costswhich were included in other non-current assets in our unaudited condensedconsolidated balance sheets. We incurred $0.1 million, and $3.5 million of debtissuance costs which were capitalized, during the three and nine months endedOctober 2, 2010, respectively, in connection with the sale of the new10.875% Notes and the registered exchange offer of the notes, which wascompleted in April 2010. For the three and nine months ended October 2,2010, amortization of debt issuance costs was $1.7 million and $7.6 million,respectively. For the three and nine months ended September 26, 2009,amortization of debt issuance costs was $2.7 million and $8.4 million,respectively.

 

**10.  INCOMETAXES**

 

Income taxes for the interim periods presented have been included inour unaudited condensed consolidated financial statements on the basis of anestimated annual effective tax rate, adjusted for discrete items. The incometax benefit for these periods differed from the amount which would have beenrecorded using the U.S. statutory tax rate due primarily to the impact of nondeductibleexpenses, foreign taxes, deferred taxes on the assumed repatriation of foreignearnings, and the existence of valuation allowances in foreign jurisdictions.

 

For the three and nine months ended October 2, 2010, we recordedincome tax benefits of approximately $3.2 million and $18.0 million,respectively, on pre-tax losses of approximately $10.7 million and $58.3million, resulting in effective tax rates of 29.8% and 30.9%, respectively. Forthe three and nine months ended September 26, 2009, we recorded an incometax benefit of approximately $3.0 million and $19.9 million, respectively, onpre-tax losses of approximately $14.0 million and $57.9 million, respectively,resulting in effective tax rates of 20.8% and 34.3%, respectively.

 

We and our subsidiaries file income tax returns in the U.S. federaljurisdiction and various states and foreign jurisdictions. With few exceptions,we are no longer subject to U.S. federal, state and local, or non-U.S. incometax examinations by tax authorities for years before 2006. The Internal RevenueService (IRS) completed its field examination of the 2005 and 2006 tax yearsduring the first half of 2010. The IRS has proposed material adjustmentsrelated to transaction cost, stock option, and bad debt deductions included inour 2006 tax return. We intend to appeal each of the proposed adjustmentsvigorously through the IRS appeals process. However, should the IRS’ proposedadjustments be upheld in appeals, a material reduction in our currentlyunreserved net operating losses could result. At December 31, 2009, ourgross unrecognized tax benefits were $19.1 million. For the nine months ended October 2,2010, we increased our gross unrecognized tax benefits by $0.5 million. As of October 2,2010, our total gross unrecognized tax benefits were $19.6 million, including acumulative $2.1 million related to interest and penalties. There is areasonable possibility that the closing of the IRS appeals process could resultin a material reduction of our unrecognized tax benefits within the next twelvemonths. Due to the fact that the appeals process has not been finalized, theamount of the unrecognized tax benefits that may be reduced cannot bereasonably estimated. All unrecognized tax benefits will impact our effectivetax rate upon recognition. We believe that it is reasonably possible that anincrease of $0.4 million in unrecognized tax benefits related to variousimmaterial state exposures may be necessary within the next twelve months.

 

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**11.  RESTRUCTURING ANDRELATED CHARGES**

 

In June 2009, we announced our plans to close our Chattanoogamanufacturing and distribution facility, located in Hixson, Tennessee, and tointegrate the operations of the Chattanooga site into our other existing sites.The transition of Chattanooga activities to our existing facilities wascompleted during the first half of 2010. A summary of the activity relating tothe restructuring for the nine months ended October 2, 2010 is as follows(in thousands):

 
| ** **                           | ** ** | **Severance &  Employee  Retention** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|-----------|------------|-----------|------------|
| Balance at December 31, 2009    |       | 4,049                                         |       | 405       |       | 4,454     |       |
| Expensed during period               |       | 1,111                                         |       | 123       |       | 1,234     |       |
| Payments made during period          |       | (4,896                                        | )          | (502      | )          | (5,398    | )          |
| Adjustments to restructuring accrual |       | (130                                          | )          | (13       | )          | (143      | )          |
| Balance at October 2, 2010      |       | $                                             | 134        |      | $          | 13        |       | $ | 147 |   |
|                                      |            |                                               |            |           |            |           |            |  |  |  |

 

Total severance and employee retentionrelated expenses incurred to date as a result of the transition of ourChattanooga activities are $6.6million, and are included in our unaudited condensed consolidated statements ofoperations. We do not expect to incur additional material severance andemployee retention expenses in conjunction with the Chattanooga integration.

 

Asa result of our integration of the operations of our Chattanooga division, weexited facilities in Hixson, and listed the buildings for sale during the firsthalf of 2010.  Based on the currentestimated fair market value of the buildings, we recorded an impairment chargeof $1.1 million during the first half of 2010, which has been reflected asimpairment of assets held for sale in our unaudited condensed consolidatedstatement of operations. The fair market value of the buildings held for saleis estimated to be approximately $2.8 million, and is included in other currentassets in our unaudited condensed consolidated balance sheet at October 2,2010.

 

**12.  STOCK OPTION PLANSAND STOCK-BASED COMPENSATION**

 

We have one active equity compensation plan,the DJO Incorporated 2007 Incentive Stock Plan (the 2007 Stock Option Plan),under which we are authorized to grant awards of stock, options, and otherstock-based awards for up to 7,500,000 shares of Common Stock of our indirectparent, DJO Incorporated, subject to adjustment in certain events.

 

Options issued under the 2007 Stock OptionPlan can be either incentive stock options or non-qualified stock options. Theexercise price of stock options granted will not be less than 100% of the fairmarket value of the underlying shares on the date of grant, and will expire nomore than ten years from the date of grant. We adopted a form of non-statutorystock option agreement (the DJO Form Option Agreement) for employee stockoption awards under the 2007 Stock Option Plan. Under the DJO Form OptionAgreement, one-third of stock options will vest over a specified period of time(typically five years) from the date of grant contingent solely upon theawardees’ continued employment with us (the Time-Based Tranche). As initiallyadopted, another one-third of stock options were to vest over a specifiedperformance period (typically five years) from the date of grant upon theachievement of certain pre-determined annual performance targets based on AdjustedEBITDA and free cash flow, as defined (the Performance-Based Tranche). Asamended in March 2009, the final one-third of stock options will vestbased upon achieving a minimum internal rate of return (IRR) and a minimumreturn of money on invested capital (MOIC), as defined; each measured withrespect to Blackstone’s aggregate investment in DJO Incorporated capital stock,to be achieved by Blackstone following a liquidation of all or a portion of itsinvestment in DJO Incorporated capital stock (the Enhanced Market-ReturnTranche).

 

In March 2010, the Compensation Committee approved furthermodifications to the terms of the outstanding options and the DJO Form OptionAgreement. The vesting terms of the Time-Based Tranche and EnhancedMarket-Return Tranche remain the same as discussed above. As modified, thefinancial performance targets for future years of the Performance-Based Tranchewere replaced by new IRR and MOIC targets, similar to the EnhancedMarket-Return Tranche, each measured with respect to Blackstone’s aggregateinvestment in DJO Incorporated capital stock, to be achieved by Blackstonefollowing a liquidation of all or a portion of its investment in DJOIncorporated capital stock (referred to hereafter as the Market-ReturnTranche). As a result of this modification, the Market-Return Tranche has botha performance component and a market condition component.

 

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Options granted under the 2007 Stock Option Plan containchange-in-control provisions that would result in accelerated vesting of theTime-Based Tranche upon the occurrence of a change-in-control. Specifically,the Time-Based Tranche would become immediately exercisable upon the occurrenceof a change-in-control if the optionee remains in continuous employment of theCompany until the consummation of the change-in-control. However, thischange-in-control provision does not apply to the Market-Return or the EnhancedMarket-Return Tranches.

 

During the three months ended October 2,2010 we granted 107,500 stock options, including 5,000 to non-employeedistributors, with a weighted average grant date fair value of $6.46 per sharefor the Time-Based Tranche, and an exercise price of $16.46 per share. Wegranted 138,150 stock options, including 24,000 to non-employee distributors,with a weighted average grant date fair value of $6.40 per share for theTime-Based Tranche, and an exercise price of $16.46 per share during the threemonths ended September 26, 2009.

 

During the nine months ended October 2,2010 we granted 592,250 stock options, including 6,200 to non-employeedistributors, with a weighted average grant date fair value of $6.66 per sharefor the Time-Based Tranche, and an exercise price of $16.46 per share. Wegranted 733,732 stock options, including 24,800 to non-employee distributors, witha weighted average grant date fair value of $6.31 per share for the Time-BasedTranche, and an exercise price of $16.46 per share during the nine months endedSeptember 26, 2009.

 

The following table summarizes certain assumptions we used to estimatethe fair value of the Time-Based Tranche of stock options granted during theperiods presented:

 
| ** **                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                    | ** ** | **October 2,  2010**        | ** ** | **September 26,  2009**    | ** ** | **October 2,  2010** | ** ** | **September 26,  2009** | ** ** |
| Expected volatility           |       | 34.3                             | %          | 34.7                            | %          | 34.2 – 34.5 | % | 34.4 – 34.7 | % |
| Risk-free interest rate       |       | 2.0                              | %          | 2.8                             | %          | 2.0 - 3.0 | % | 2.3 – 2.8 | % |
| Expected years until exercise |       | 6.9                              |       | 6.1                             |       | 6.4 - 7.0 |   | 6.1 – 6.3 |   |
| Expected dividend yield       |       | 0.0                              | %          | 0.0                             | %          | 0.0 | % | 0.0 | % |

 

We recorded non-cash stock-based compensationexpense of $0.4 million and $1.3 million for the three and nine months ended October 2,2010, respectively. We recorded non-cash compensation expense of $0.9 millionand $2.3 million for the three and nine months ended September 26, 2009, respectively.For the each of the three and nine months periods ended October 2, 2010and September 26, 2009, we only recognized non-cash compensation expensefor options in the Time-Based Tranche, as the performance and market componentsof the Market-Return and Enhanced Market-Return Tranches are not deemedprobable at this time.

 

**13.  EQUITY**

 

During the three and nine months ended October 2, 2010, DJOIncorporated sold 24,304 and 87,052 shares of its Common Stock, respectively,at $16.46 per share in an offering to certain accredited investors comprised ofemployees, directors and independent sales agents, subject to the execution ofa stockholders agreement including certain rights and restrictions. Net proceedsfrom this offering during the three and nine months ended October 2, 2010were approximately $0.4 million and $1.4 million, respectively. These proceedswere contributed by DJO Incorporated to us and have been included in membercapital in our unaudited condensed consolidated balance sheet as of October 2,2010. The proceeds will be used for working capital purposes.

 

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Comprehensive loss consists of the following for the periods presented(in thousands):

 
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**    | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------------|------------|
| ** **                                                                       | ** ** | **October 2,********2010**  | ** ** | **September 26,********2009** | ** ** | **October 2,********2010** | ** ** | **September 26,********2009** | ** ** |
|                                                                             |       |                             |       |                               |       |   |   |   |   |
| Net loss                                                                         |       | $                                | (7,531     | )                                  | $          | (11,280 | ) | $ | (40,303 | ) | $ | (38,399 | ) |
|                                                                             |       |                             |       |                               |       |   |   |   |   |
| Other comprehensive  income (loss), net of taxes:                                |       |                             |       |                               |       |   |   |   |   |
| Foreign currency  translation adjustments                                        |       | 6,723                            |       | 5,499                              |       | (3,333 | ) | 6,052 |   |
| Unrealized losses on  cash flow hedges                                           |       | (1,066                           | )          | (3,500                             | )          | (4,640 | ) | (10,935 | ) |
| Reclassification  adjustment for losses on cash flow hedges included in net loss |       | 1,819                            |       | 3,046                              |       | 5,591 |   | 7,691 |   |
| Other comprehensive  income (loss)                                               |       | 7,476                            |       | 5,045                              |       | (2,382 | ) | 2,808 |   |
| Comprehensive loss                                                               |       | (55                              | )          | (6,235                             | )          | (42,685 | ) | (35,591 | ) |
| Comprehensive income  attributable to noncontrolling interests                   |       | (444                             | )          | (186                               | )          | (796 | ) | (472 | ) |
| Comprehensive loss  attributable to DJO Finance LLC                              |       | $                                | (499       | )                                  | $          | (6,421 | ) | $ | (43,481 | ) | $ | (36,063 | ) |

 

**14.  RELATEDPARTY TRANSACTIONS**

 

Blackstone Management Partners V L.L.C. (BMP), an affiliate of ourmajor shareholder, provides certain monitoring, advisory and consultingservices to us for an annual monitoring fee equal to the greater of$7.0 million or 2% of consolidated EBITDA as defined in the Transactionand Monitoring Fee Agreement, payable in the first quarter of each year. Themonitoring fee agreement will continue until the earlier of November 2019,or such date as DJOFL and BMP may mutually determine. DJOFL has agreed toindemnify BMP and its affiliates, directors, officers, employees, agents andrepresentatives from and against all liabilities relating to the servicescontemplated by the Transaction and Monitoring Fee Agreement and the engagementof BMP pursuant to, and the performance of BMP and its affiliates of theservices contemplated by, the Transaction and Monitoring Fee Agreement. At anytime in connection with or in anticipation of a change of control of DJOFL, asale of all or substantially all of DJOFL’s assets or an initial publicoffering of common stock of DJOFL, BMP may elect to receive, in lieu ofremaining annual monitoring fee payments, a single lump sum cash payment equalto the then-present value of all then-current and future annual monitoring feespayable under the Transaction and Monitoring Fee Agreement, assuming a hypotheticaltermination date of the agreement to be November 2019. For each of thethree and nine month periods presented, we recognized $1.75 million and $5.25million, respectively, related to the annual monitoring fee, which is recordedas a component of SG&A expense in our unaudited condensed consolidatedstatements of operations.

 

**15.  COMMITMENTS ANDCONTINGENCIES**

 

From time to time, we are plaintiffs or defendants in variouslitigation matters in the ordinary course of our business, some of which involveclaims for damages that are substantial in amount. We believe that thedisposition of claims currently pending will not have a material adverse effecton our financial position or results of operations.

 

Themanufacture and sale of orthopedic devices and related products exposes us to asignificant risk of product liability claims. From time to time, we have been,and we are currently, subject to a number of product liability claims allegingthat the use of our products resulted in adverse effects. Even if we aresuccessful in defending against any liability claims, such claims couldnevertheless distract our management, result in substantial costs, harm ourreputation, adversely affect the sales of all our products and otherwise harmour business. If there is a significant increase in the number of productliability claims, our business could be adversely affected.

 

We are currently named asone of several defendants in approximately 100 product liability cases,including a lawsuit in Canada seeking class action status, related to adisposable drug infusion pump (pain pump) product manufactured by two thirdparty manufacturers that we distributed through our Bracing and Supportssegment. We discontinued our sale of these products in the second quarter of 2009.These cases have been brought against the manufacturers and certaindistributors of these pumps, and in some cases, the manufacturers of theanesthetics used in these pumps. All of these lawsuits allege that the use ofthese pumps with certain anesthetics in certain shoulder surgeries overprolonged periods have resulted in cartilage damage to the plaintiffs. We havesought indemnity and tendered the defense of these cases to the twomanufacturers who supplied these pumps to us, to their products liabilitycarriers and to our products liability carriers. These lawsuits are aboutequally divided between the two manufacturers. Both manufacturers have rejectedour tenders of indemnity. Until early 2010, the base policy for one of themanufacturers was paying for our defense, but that policy has been exhausted bydefense costs of the Company and the manufacturer and by settlements, and asecond policy has been significantly eroded by defense costs of the Company andthe manufacturer and is expected to be exhausted by 

 

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settlements in the nearfuture. This manufacturer has ceased operations, has little assets and noadditional insurance coverage. The Company has asserted indemnification rightsagainst the successor to this manufacturer and intends to pursue its claimsappropriately. The base policy for the other manufacturer has been exhaustedand the excess liability carriers for that manufacturer have not acceptedcoverage for the Company, and are not expected to provide for its defense. TheCompany and this manufacturer have been cooperating in jointly negotiatingsettlements of those lawsuits in which both parties are named. Our productsliability carriers have accepted coverage of these cases, subject to areservation of the right to deny coverage for customary matters, includingpunitive damages and off-label promotion. In August 2010, one of ourexcess carriers for the period ending July 1, 2010 and for thesupplemental extended reporting period (SERP) discussed below, which isinsuring $10 million in excess of $25 million, informed us that it has reservedits right to rescind the policy based on an alleged failure by us and ourinsurance broker to disclose material information. We disagree with thisallegation and are seeking to resolve the issue with this carrier. The lawsuitsallege damages ranging from unspecified amounts to claims between $1.0 millionand $10.0 million. We could be exposed to material liabilities if our insurancecoverage is not available or inadequate and the resources of the twomanufacturers, including their respective products liability insurancepolicies, are unavailable or insufficient to pay the defense costs andsettlements or judgments in these cases.

 

In mid-2010, we were namedin three multi-plaintiff lawsuits alleging that the plaintiffs had been injuredfollowing use of certain cold therapy products manufactured by the Company. Theselawsuits are in their early stages and were brought by 16, 11 and 19plaintiffs, respectively. The complaints are not specific as to the nature ofthe injuries, but allege various product liability theories, includinginadequate warnings regarding the risks associated with the use of cold therapyand failure to incorporate certain safety features into the design. No specificdollar amounts of damages are alleged. We could be exposed to materialliabilities if our insurance coverage is not available or inadequate to pay thedefense costs and settlements or judgments in these cases.

 

On August 2, 2010, wewere served with a subpoena under the Health Insurance Portability andAccountability Act (HIPAA) seeking numerous documents related to our activitiesinvolving the pain pumps discussed above. The subpoena which was issued by theUnited States Attorney’s Office, Central District of California, refers to anofficial investigation by the U.S. Department of Justice (DOJ) and the U.S.Food and Drug Administration (FDA) of Federal healthcare offenses. We areproducing documents that are responsive to the subpoena. We believe that ouractions related to our prior distribution of these pain pumps have been incompliance with applicable legal standards. We can make no assurance as to theresources that will be needed to respond to the subpoena or the final outcomeof any investigation or further action.

 

We maintain product liability insurance that is subject to annualrenewal. Our current policy covers claims reported between July 1, 2010and June 30, 2011. No carriers were prepared to cover claims for thisreporting period related to the pain pump products described above andtherefore our current policies exclude coverage for those products. For the currentpolicy year, we maintain coverage limits (together with excess policies) of upto $50 million, with self-insured retentions of $500,000 per claim for claimsrelating to our cold therapy units, $500,000 per claim for claims relating toinvasive products, $75,000 per claim for claims relating to non-invasiveproducts other than our cold therapy products, and an aggregate self-insuredretention of $2.25 million. We purchased SERP coverage for our $80 millionlimit product liability program that expired on June 30, 2010, and thissupplemental coverage is limited to pain pump claims. Except for the additionalexcess coverage mentioned below, this SERP coverage does not provide additionallimits to the aggregate $80 million limit on the expiring program but does providethat the existing limits of the expiring program will remain available forclaims reported for an extended period of time. Specifically, pain pump claimsmay be reported under the $10 million base policy for an indefinite period oftime and for a period of five years under the excess layers. We also purchasedadditional coverage of $25 million excess of $80 million with a five yearreporting period. Thus, the SERP coverage has a total limit of $105 million(less amounts paid for claims reported under the expiring program). Thiscoverage is subject to a self-insured retention of $500,000 per claim forclaims related to pain pumps, with an aggregate self-insured retention of $1.0million for all product liability claims under either the expiring program or theSERP program. In addition, the layer of $25 million excess over $55 million hasa separate self-insured retention of $50,000 per claim. Our two productliability programs prior to the program that expired on June 30, 2010cover claims reported between July 1, 2007 and February 15, 2008 andbetween February 15, 2008 and July 1, 2009, respectively. The2007-2008 policy provides for coverage (together with excess policies) of up toa limit of $20 million and the 2008-2009 policy provides for coverage (togetherwith excess policies) of up to a limit of $25 million. Certain of the pain pumpcases described above were reported under and are covered by these two policiesas well as the expiring program.

 

If a products liability claim or series of claims is brought against usfor uninsured liabilities or in excess of our insurance coverage, our businesscould suffer materially. In addition, in certain instances, a productsliability claim could also result in our having to recall some of our products,which could result in significant costs to us. Our condensed consolidatedbalance sheets as of October 2, 2010 (unaudited) and December 31,2009, include accrued liabilities of approximately $1.7 million and $2.0million, respectively, for expenses related to products liability claims forproducts other than our pain pump products. The amounts accrued are based uponprevious claims experience in part due to the fact that in 2003 we exceeded thecoverage limits in effect at that time for certain historical product liabilityclaims involving one of our discontinued surgical implant products and suchproducts are excluded from coverage under our current policies.

 

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On April 15, 2009, webecame aware of a *qui tam*actionfiled in Federal Court in Boston, Massachusetts in March 2005 and amendedin December 2007 that names us as a defendant along with each of the othercompanies that manufactures and sells external bone growth stimulators, as wellas our principal stockholder, The Blackstone Group, and the principalstockholder of one of the other companies in the bone growth stimulationbusiness. This case is captioned United States *exrel.*Beirman v. Orthofix International, N.V., *et al.*, Civil Action No. 05-10557 (D.Mass.). The case was sealed when originally filed and unsealed inMarch 2009. The plaintiff, or relator, alleges that the defendants haveengaged in Medicare fraud and violated Federal and state false claims acts fromthe time of the original introduction of the devices by each defendant to thepresent by seeking reimbursement for bone growth stimulators as a purchaseditem rather than a rental item. The relator also alleges that the defendantsare engaged in other marketing practices constituting violations of the Federaland various state anti-kickback statutes. On December 4, 2009, we filed amotion to dismiss the relator’s complaint. The relator filed a second amendedcomplaint in May 2010 that, among other things, dropped The BlackstoneGroup as a defendant. We have filed another motion to dismiss directed at thesecond amended complaint. Shortly before becoming aware of the *qui**tam*action, we were advised that our bone growth stimulator business wasthe subject of an investigation by the DOJ, and on April 10, 2009, we wereserved with a subpoena under HIPAA seeking numerous documents relating to themarketing and sale by us of bone growth stimulators. On September 21, 2009,we were served with a second HIPAA subpoena related to this DOJ investigationseeking additional documents relating to the marketing and sale by us of bonegrowth stimulators. We believe that these subpoenas are related to the DOJ’sinvestigation of the allegations in the *quitam*action, although the DOJ has decided not to intervene in the *qui tam*action at this time. We believethat our marketing practices in the bone growth stimulation business are incompliance with applicable legal standards and we intend to defend this caseand investigation vigorously. We can make no assurance as to the resources thatwill be needed to respond to these matters or the final outcome of such action.

 

**16. SEGMENT AND GEOGRAPHIC INFORMATION**

 

We provide a broad array of orthopedic rehabilitation and regenerationproducts, as well as surgical implants to customers in the United States andabroad. In the second quarter of 2010, we changed how we report our segmentfinancial information to senior management. Prior to the second quarter of2010, our Bracing and Supports and Recovery Sciences businesses were reportedtogether within the Domestic Rehabilitation Segment. During the second quarter,as a result of our recent sales and marketing leadership reorganization, thesebusinesses are now separately evaluated and managed. Segment information forall periods presented has been restated to reflect this change. We currentlydevelop, manufacture and distribute our products through the following fouroperating segments:

 

***Bracing and Supports Segment***

 

Our Bracing and Supports Segment, which generates its revenues in theUnited States, offers our DonJoy, ProCare and Aircast products, including rigidknee bracing, orthopedic soft goods, cold therapy products, and vascularsystems. This segment also includes our OfficeCare business, through which wemaintain an inventory of soft goods and other products at healthcarefacilities, primarily orthopedic practices, for immediate distribution topatients.

 

***Recovery Sciences Segment***

 

Our Recovery Sciences Segment, which generates its revenues in theUnited States, is divided into four main businesses:

 

·                  *Empi.*  Our Empi business unit offers our homeelectrotherapy, iontophoresis, and home traction products. We primarily sellthese products directly to patients or to physical therapy clinics. Forproducts sold to patients, we arrange billing to the patients and their thirdparty payors.

 

·                  *Regeneration*.  Our Regeneration business unit primarilysells our bone growth stimulation products. We sell these products eitherdirectly to patients or to independent distributors. For products sold topatients, we arrange billing to the patients and their third party payors.

 

·                  *Chattanooga.*  Our Chattanooga businessunit offers products in the clinical rehabilitation market in the categories ofclinical electrotherapy devices, clinical traction devices, and other clinicalproducts and supplies such as treatment tables, continuous passive motion (CPM)devices and dry heat therapy.

 

·                  *AthleteDirect.*  Our Athlete Direct businessunit offers consumers ranging from fitness enthusiasts to competitive athletesour Compex electrostimulation device, which is used in athletic trainingprograms to aid muscle development and to accelerate muscle recovery aftertraining sessions. 

 

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***Surgical Implant Segment***

 

Our Surgical Implant Segment, which generates its revenues in theUnited States, develops, manufactures and markets a wide variety of knee, hipand shoulder implant products that serve the orthopedic reconstructive jointimplant market.

 

***International Segment***

 

Our International Segment, which generates most of its revenues inEurope, sells all of our products and certain third party products through acombination of direct sales representatives and independent distributors.

 

Information regarding our reportable business segments is presentedbelow (in thousands). Segment results exclude the impact of certain generalcorporate expenses and charges related to various integration activities, asdefined. All prior periods presented have been restated to reflect our currentreportable segments.

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**    | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|------------------------------------|------------|
| ** **                                           | ** ** | **October 2,********2010**  | ** ** | **September 26,********2009** | ** ** | **October 2,********2010** | ** ** | **September 26,********2009** | ** ** |
| **Net sales:**                                       |       |                             |       |                               |       |   |   |   |   |
| Bracing and Supports                                 |       | $                                | 78,156     |                               | $          | 76,388 |   | $ | 232,087 |   | $ | 219,224 |   |
| Recovery Sciences                                    |       | 85,884                           |       | 85,794                             |       | 257,361 |   | 249,767 |   |
| Surgical Implant                                     |       | 14,559                           |       | 15,416                             |       | 46,735 |   | 47,097 |   |
| International                                        |       | 54,960                           |       | 58,588                             |       | 179,979 |   | 172,863 |   |
|                                                 |       | $                                | 233,559    |                               | $          | 236,186 |   | $ | 716,162 |   | $ | 688,951 |   |
|                                                 |       |                             |       |                               |       |   |   |   |   |
| **Gross profit:**                                    |       |                             |       |                               |       |   |   |   |   |
| Bracing and Supports                                 |       | $                                | 42,521     |                               | $          | 44,146 |   | $ | 127,865 |   | $ | 122,748 |   |
| Recovery Sciences                                    |       | 66,753                           |       | 64,377                             |       | 195,773 |   | 188,162 |   |
| Surgical Implant                                     |       | 10,258                           |       | 11,779                             |       | 34,533 |   | 36,541 |   |
| International                                        |       | 30,697                           |       | 32,434                             |       | 106,097 |   | 98,645 |   |
| Expenses not allocated to segments and  eliminations |       | (817                             | )          | (2,589                             | )          | (4,172 | ) | (4,340 | ) |
|                                                 |       | $                                | 149,412    |                               | $          | 150,147 |   | $ | 460,096 |   | $ | 441,756 |   |
|                                                 |       |                             |       |                               |       |   |   |   |   |
| **Operating income:**                                |       |                             |       |                               |       |   |   |   |   |
| Bracing and Supports                                 |       | $                                | 17,188     |                               | $          | 20,687 |   | $ | 50,428 |   | $ | 51,577 |   |
| Recovery Sciences                                    |       | 30,962                           |       | 27,715                             |       | 85,441 |   | 75,962 |   |
| Surgical Implant                                     |       | 401                              |       | 2,805                              |       | 4,545 |   | 8,982 |   |
| International                                        |       | 9,752                            |       | 10,625                             |       | 40,787 |   | 33,556 |   |
| Expenses not allocated to segments and  eliminations |       | (36,858                          | )          | (38,274                            | )          | (126,216 | ) | (114,382 | ) |
|                                                 |       | $                                | 21,445     |                               | $          | 23,558 |   | $ | 54,985 |   | $ | 55,695 |   |

 

The accounting policies of the reportable segments are the same as theaccounting policies of the Company. We allocate resources and evaluate theperformance of segments based on net sales, gross profit, operating income andother non-GAAP measures as defined. We do not allocate assets to reportablesegments because a significant portion of our assets are shared by segments.

 

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**Geographic Area**

 

Following are our net sales by geographic area, based on location ofcustomer (in thousands):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**    | ** ** |
|--------------------------------------|------------|----------------------------------|------------|------------------------------------|------------|
| ** **                           | ** ** | **October 2,********2010**  | ** ** | **September 26,********2009** | ** ** | **October 2,********2010** | ** ** | **September 26,********2009** | ** ** |
| **Net sales:**                       |       |                             |       |                               |       |   |   |   |   |
| United States                        |       | $                                | 185,530    |                               | $          | 177,598 |   | $ | 533,274 |   | $ | 516,088 |   |
| Germany                              |       | 15,998                           |       | 18,612                             |       | 55,319 |   | 53,312 |   |
| Other Europe, Middle East and Africa |       | 16,623                           |       | 25,528                             |       | 68,225 |   | 81,174 |   |
| Asia Pacific                         |       | 3,764                            |       | 3,429                              |       | 16,911 |   | 10,277 |   |
| Other                                |       | 11,644                           |       | 11,019                             |       | 42,433 |   | 28,100 |   |
|                                 |       | $                                | 233,559    |                               | $          | 236,186 |   | $ | 716,162 |   | $ | 688,951 |   |

 

**17. SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS**

 

DJOFL and its direct wholly-owned subsidiary, DJO Finco, issued the10.875% Notes with aggregate principal amounts of $575.0 million and$100.0 million on November 20, 2007 and January 20, 2010,respectively. On November 3, 2006, DJOFL and DJO Finco issued the 11.75%Notes with an aggregate principal amount of $200.0 million. DJO Finco wasformed solely to act as a co-issuer of the notes, has only nominal assets anddoes not conduct any operations. The Indentures generally prohibit DJO Fincofrom holding any assets, becoming liable for any obligations, or engaging in anybusiness activity. The 10.875% Notes are jointly and severally, fully andunconditionally guaranteed, on an unsecured senior basis by all of the DJOFL’sdomestic subsidiaries (other than DJO Finco) that are 100% owned, directly orindirectly, by DJOFL (the Guarantors). The 11.75% Notes, redeemed in October 2010upon issuance of our 9.75% Notes (see Note 18), were jointly and severally,fully and unconditionally guaranteed, on an unsecured senior subordinated basisby the Guarantors. Our foreign subsidiaries (the Non-Guarantors) do notguarantee these notes. The Guarantors also unconditionally guarantee the SeniorSecured Credit Facility.

 

The following tables present the financial position, results ofoperations and cash flows of DJOFL, the Guarantors, the Non-Guarantors andcertain eliminations for the periods presented.

 

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**DJO FinanceLLC**

**UnauditedCondensed Consolidating Balance Sheets**

**As of October 2,2010**

(inthousands)

 
| ** **                                             | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non —  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------|------------|-----------|------------|----------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                             |       |      |       |           |       |                            |       |             |       |             |       |
| Current assets:                                        |       |      |       |           |       |                            |       |             |       |             |       |
| Cash and cash equivalents                              |       | $         | 7,442      |           | $          | 22,802                          |       | $                | 20,000     |             | $          | — |   | $ | 50,244 |   |
| Accounts receivable, net                               |       | —    |       | 110,067        |       | 31,507                          |       | 90               |       | 141,664          |       |
| Inventories, net                                       |       | —    |       | 90,925         |       | 27,308                          |       | (9,345           | )          | 108,888          |       |
| Deferred tax assets, net                               |       | —    |       | 35,472         |       | 4,226                           |       | (146             | )          | 39,552           |       |
| Prepaid expenses and other current assets              |       | 29        |       | 20,594         |       | 2,972                           |       | 2,626            |       | 26,221           |       |
| Total current assets                                   |       | 7,471     |       | 279,860        |       | 86,013                          |       | (6,775           | )          | 366,569          |       |
| Property and equipment, net                            |       | —    |       | 75,062         |       | 13,665                          |       | (4,861           | )          | 83,866           |       |
| Goodwill                                               |       | —    |       | 1,108,702      |       | 112,437                         |       | (30,445          | )          | 1,190,694        |       |
| Intangible assets, net                                 |       | —    |       | 1,092,720      |       | 36,937                          |       | 1,121            |       | 1,130,778        |       |
| Investment in subsidiaries                             |       | 1,297,701 |       | 1,660,184      |       | 69,621                          |       | (3,027,506       | )          | —           |       |
| Intercompany receivables                               |       | 1,026,793 |       | —         |       | —                          |       | (1,026,793       | )          | —           |       |
| Other non-current assets                               |       | 34,827    |       | 530            |       | 2,010                           |       | 37               |       | 37,404           |       |
| Total assets                                           |       | $         | 2,366,792  |           | $          | 4,217,058                       |       | $                | 320,683    |             | $          | (4,095,222 | ) | $ | 2,809,311 |   |
|                                                   |       |      |       |           |       |                            |       |             |       |             |       |
| **Liabilities and Equity**                             |       |      |       |           |       |                            |       |             |       |             |       |
| Current liabilities:                                   |       |      |       |           |       |                            |       |             |       |             |       |
| Accounts payable                                       |       | $         | —     |           | $          | 46,747                          |       | $                | 6,011      |             | $          | 278 |   | $ | 53,036 |   |
| Current portion of debt and capital lease  obligations |       | 9,594     |       | 40             |       | —                          |       | —           |       | 9,634            |       |
| Other current liabilities                              |       | 44,849    |       | 54,196         |       | 20,719                          |       | 2,638            |       | 122,402          |       |
| Total current liabilities                              |       | 54,443    |       | 100,983        |       | 26,730                          |       | 2,916            |       | 185,072          |       |
| Long-term debt and capital lease obligations           |       | 1,795,702 |       | 52             |       | —                          |       | —           |       | 1,795,754        |       |
| Deferred tax liabilities, net                          |       | —    |       | 283,187        |       | 14,819                          |       | —           |       | 298,006          |       |
| Intercompany payables, net                             |       | —    |       | 894,280        |       | 132,513                         |       | (1,026,793       | )          | —           |       |
| Other long-term liabilities                            |       | 1,570     |       | 9,558          |       | 1,526                           |       | —           |       | 12,654           |       |
| Total liabilities                                      |       | 1,851,715 |       | 1,288,060      |       | 175,588                         |       | (1,023,877       | )          | 2,291,486        |       |
| Noncontrolling interests                               |       | —    |       | —         |       | 2,748                           |       | —           |       | 2,748            |       |
| Total membership equity                                |       | 515,077   |       | 2,928,998      |       | 142,347                         |       | (3,071,345       | )          | 515,077          |       |
| Total liabilities and equity                           |       | $         | 2,366,792  |           | $          | 4,217,058                       |       | $                | 320,683    |             | $          | (4,095,222 | ) | $ | 2,809,311 |   |

 

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**DJO FinanceLLC**

**UnauditedCondensed Consolidating Statements of Operations**

**For theThree Months Ended October 2, 2010**

(inthousands)

 
| ** **                                                                | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
|                                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Net sales                                                                 |       | $         | —     |           | $          | 201,837              |       | $                | 43,453     |             | $          | (11,731 | ) | $ | 233,559 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $9,230) |       | —    |       | 71,429         |       | 23,654               |       | (10,936          | )          | 84,147           |       |
| Gross profit                                                              |       | —    |       | 130,408        |       | 19,799               |       | (795             | )          | 149,412          |       |
|                                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Operating expenses:                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                       |       | —    |       | 83,231         |       | 19,391               |       | 50               |       | 102,672          |       |
| Research and development                                                  |       | —    |       | 4,870          |       | 1,022                |       | —           |       | 5,892            |       |
| Amortization of intangible assets                                         |       | —    |       | 18,436         |       | 960                  |       | 7                |       | 19,403           |       |
|                                                                      |       | —    |       | 106,537        |       | 21,373               |       | 57               |       | 127,967          |       |
| Operating income (loss)                                                   |       | —    |       | 23,871         |       | (1,574               | )          | (852             | )          | 21,445           |       |
|                                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Other income (expense):                                                   |       |      |       |           |       |                 |       |             |       |             |       |
| Interest expense                                                          |       | (37,160   | )          | (10,702        | )          | (886                 | )          | 11,508           |       | (37,240          | )          |
| Interest income                                                           |       | 6,922     |       | 4,531          |       | 147                  |       | (11,508          | )          | 92               |       |
| Other income, net                                                         |       | 22,523    |       | 2,647          |       | 2,327                |       | (22,516          | )          | 4,981            |       |
|                                                                      |       | (7,715    | )          | (3,524         | )          | 1,588                |       | (22,516          | )          | (32,167          | )          |
| Income (loss) before income taxes                                         |       | (7,715    | )          | 20,347         |       | 14                   |       | (23,368          | )          | (10,722          | )          |
| Income tax benefit (expense)                                              |       | —    |       | 3,589          |       | (398                 | )          | —           |       | 3,191            |       |
| Net income (loss)                                                         |       | (7,715    | )          | 23,936         |       | (384                 | )          | (23,368          | )          | (7,531           | )          |
| Net income attributable to noncontrolling  interests                      |       | —    |       | —         |       | (184                 | )          | —           |       | (184             | )          |
| Net income (loss) attributable to DJO Finance LLC                         |       | $         | (7,715     | )              | $          | 23,936               |       | $                | (568       | )                | $          | (23,368 | ) | $ | (7,715 | ) |

 

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**DJO FinanceLLC**

**UnauditedCondensed Consolidating Statements of Operations**

**For theNine Months Ended October 2, 2010**

(inthousands)

 
| ** **                                                                 | ** ** | **DJOFL**  | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                 | ** ** | ** ** | ** ** | ** **     | ** ** | ** **           | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net sales                                                                  |       | $          | —     |           | $          | 617,701              |       | $                | 146,567    |             | $          | (48,106 | ) | $ | 716,162 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $27,211) |       | —     |       | 229,725        |       | 74,622               |       | (48,281          | )          | 256,066          |       |
| Gross profit                                                               |       | —     |       | 387,976        |       | 71,945               |       | 175              |       | 460,096          |       |
|                                                                       |       |       |       |           |       |                 |       |             |       |             |       |
| Operating expenses:                                                        |       |       |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                        |       | —     |       | 269,378        |       | 59,485               |       | 50               |       | 328,913          |       |
| Research and development                                                   |       | —     |       | 14,144         |       | 2,779                |       | —           |       | 16,923           |       |
| Amortization of intangible assets                                          |       | —     |       | 55,229         |       | 2,892                |       | 7                |       | 58,128           |       |
| Impairment of assets held for sale                                         |       | —     |       | 1,147          |       | —               |       | —           |       | 1,147            |       |
|                                                                       |       |       |       | 339,898        |       | 65,156               |       | 57               |       | 405,111          |       |
| Operating income                                                           |       | —     |       | 48,078         |       | 6,789                |       | 118              |       | 54,985           |       |
|                                                                       |       |       |       |           |       |                 |       |             |       |             |       |
| Other income (expense):                                                    |       |       |       |           |       |                 |       |             |       |             |       |
| Interest expense                                                           |       | (114,626   | )          | (31,953        | )          | (2,682               | )          | 34,394           |       | (114,867         | )          |
| Interest income                                                            |       | 26,877     |       | 7,304          |       | 445                  |       | (34,394          | )          | 232              |       |
| Other income (expense), net                                                |       | 46,619     |       | (18,178        | )          | (615                 | )          | (26,462          | )          | 1,364            |       |
|                                                                       |       | (41,130    | )          | (42,827        | )          | (2,852               | )          | (26,462          | )          | (113,271         | )          |
| Income (loss) before income taxes                                          |       | (41,130    | )          | 5,251          |       | 3,937                |       | (26,344          | )          | (58,286          | )          |
| Income tax benefit (expense)                                               |       | —     |       | 20,668         |       | (2,685               | )          | —           |       | 17,983           |       |
| Net income (loss)                                                          |       | (41,130    | )          | 25,919         |       | 1,252                |       | (26,344          | )          | (40,303          | )          |
| Net income attributable to noncontrolling  interests                       |       | —     |       | —         |       | (827                 | )          | —           |       | (827             | )          |
| Net income (loss) attributable to DJO Finance LLC                          |       | $          | (41,130    | )              | $          | 25,919               |       | $                | 425        |             | $          | (26,344 | ) | $ | (41,130 | ) |

 

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**DJO Finance LLC**

**UnauditedCondensed Consolidating Statements of Cash Flows**

**For theNine Months Ended October 2, 2010**

(inthousands)

 
| ** **                                                                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                             |       | $         | (41,130    | )              | $          | 25,919               |       | $                | 1,252      |             | $          | (26,344 | ) | $ | (40,303 | ) |
| ** **                                                                                                    |       |      |       |           |       |                 |       |             |       |             |       |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                                  |       | —    |       | 16,131         |       | 3,559                |       | (64              | )          | 19,626           |       |
| Amortization of intangible assets                                                                             |       | —    |       | 55,228         |       | 2,893                |       | 7                |       | 58,128           |       |
| Amortization of debt issuance costs and non-cash  interest expense                                            |       | 9,137     |       | —         |       | —               |       | —           |       | 9,137            |       |
| Stock-based compensation expense                                                                              |       | —    |       | 1,309          |       | —               |       | —           |       | 1,309            |       |
| Loss on disposal of assets, net                                                                               |       | —    |       | 720            |       | 423                  |       | (304             | )          | 839              |       |
| Deferred income tax benefit (expense)                                                                         |       | —    |       | (79,209        | )          | 57,792               |       | —           |       | (21,417          | )          |
| Non-cash income (loss) from subsidiaries                                                                      |       | (43,854   | )          | 512,494        |       | 20,880               |       | (489,520         | )          | —           |       |
| Provision for doubtful accounts and sales returns                                                             |       | —    |       | 24,987         |       | 562                  |       | —           |       | 25,549           |       |
| Inventory reserves                                                                                            |       | —    |       | 3,980          |       | 622                  |       | —           |       | 4,602            |       |
| Impairment of assets held for sale                                                                            |       | —    |       | 1,147          |       | —               |       | —           |       | 1,147            |       |
|                                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Changes in operating assets and liabilities:                                                                  |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                           |       | —    |       | (22,130        | )          | 789                  |       | (87              | )          | (21,428          | )          |
| Inventories                                                                                                   |       | —    |       | (10,322        | )          | (4,417               | )          | (2,713           | )          | (17,452          | )          |
| Prepaid expenses and other assets                                                                             |       | 132       |       | 13,933         |       | (24,033              | )          | (2,625           | )          | (12,593          | )          |
| Accounts payable and other current liabilities                                                                |       | 25,205    |       | 5,996          |       | 641                  |       | 2,646            |       | 34,488           |       |
| Net cash provided by (used in)  operating activities                                                     |       | (50,510   | )          | 550,183        |       | 60,963               |       | (519,004         | )          | 41,632           |       |
|                                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| **INVESTING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Purchases of property and equipment                                                                           |       | —    |       | (18,991        | )          | (3,854               | )          | 2,568            |       | (20,277          | )          |
| Cash paid in connection with acquisitions, net of  cash acquired                                              |       | —    |       | (810           | )          | —               |       | (1,235           | )          | (2,045           | )          |
| Other investing activities, net                                                                               |       | —    |       | 531            |       | (1,248               | )          | —           |       | (717             | )          |
| Net cash used in investing activities                                                                    |       | —    |       | (19,270        | )          | (5,102               | )          | 1,333            |       | (23,039          | )          |
| ** **                                                                                                    |       |      |       |           |       |                 |       |             |       |             |       |
| **FINANCING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                  |       | 60,102    |       | (524,172       | )          | (53,601              | )          | 517,671          |       | —           |       |
| Proceeds from issuance of debt                                                                                |       | 127,000   |       | —         |       | 130                  |       | —           |       | 127,130          |       |
| Repayments of debt and capital lease obligations                                                              |       | (132,695  | )          | (2,717         | )          | (749                 | )          | —           |       | (136,161         | )          |
| Payment of debt issuance costs                                                                                |       | (3,454    | )          | —         |       | —               |       | —           |       | (3,454           | )          |
| Investment by parent                                                                                          |       | —    |       | 1,389          |       | —               |       | —           |       | 1,389            |       |
| Dividend paid by subsidiary to owners of noncontrolling  interests                                            |       | —    |       | —         |       | (557                 | )          | —           |       | (557             | )          |
| Net cash provided by (used in) financing  activities                                                          |       | 50,953    |       | (525,500       | )          | (54,777              | )          | 517,671          |       | (11,653          | )          |
| Effect of exchange rate changes on cash  and cash equivalents                                            |       | —    |       | —         |       | (1,307               | )          | —           |       | (1,307           | )          |
| **Net increase (decrease) in cash  and cash equivalents**                                                     |       | 443       |       | 5,413          |       | (223                 | )          | —           |       | 5,633            |       |
| Cash and cash equivalents at beginning of period                                                              |       | 6,999     |       | 17,389         |       | 20,223               |       | —           |       | 44,611           |       |
| Cash and cash equivalents at end of period                                                                    |       | $         | 7,442      |           | $          | 22,802               |       | $                | 20,000     |             | $          | — |   | $ | 50,244 |   |

 

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**DJO Finance LLC**

**CondensedConsolidating Balance Sheets**

**As ofDecember 31, 2009**

(inthousands)

 
| ** **                                             | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                             |       |      |       |           |       |                 |       |             |       |             |       |
| Current assets:                                        |       |      |       |           |       |                 |       |             |       |             |       |
| Cash and cash equivalents                              |       | $         | 6,999      |           | $          | 17,389               |       | $                | 20,223     |             | $          | — |   | $ | 44,611 |   |
| Accounts receivable, net                               |       | —    |       | 113,258        |       | 32,954               |       | —           |       | 146,212          |       |
| Inventories, net                                       |       | —    |       | 80,491         |       | 23,705               |       | (8,316           | )          | 95,880           |       |
| Deferred tax assets, net                               |       | —    |       | 40,474         |       | 993                  |       | (1,019           | )          | 40,448           |       |
| Prepaid expenses and other current assets              |       | 162       |       | 11,368         |       | 3,195                |       | —           |       | 14,725           |       |
| Total current assets                                   |       | 7,161     |       | 262,980        |       | 81,070               |       | (9,335           | )          | 341,876          |       |
| Property and equipment, net                            |       | —    |       | 76,883         |       | 12,811               |       | (2,980           | )          | 86,714           |       |
| Goodwill                                               |       | —    |       | 1,108,703      |       | 82,794               |       | —           |       | 1,191,497        |       |
| Intangible assets, net                                 |       | —    |       | 1,147,504      |       | 40,173               |       | —           |       | 1,187,677        |       |
| Investment in subsidiaries                             |       | 1,275,652 |       | 2,362,165      |       | 71,566               |       | (3,709,383       | )          | —           |       |
| Intercompany receivables                               |       | 1,065,693 |       | —         |       | —               |       | (1,065,693       | )          | —           |       |
| Other non-current assets                               |       | 38,946    |       | (1,913         | )          | 5,382                |       | —           |       | 42,415           |       |
| Total assets                                           |       | $         | 2,387,452  |           | $          | 4,956,322            |       | $                | 293,796    |             | $          | (4,787,391 | ) | $ | 2,850,179 |   |
|                                                   |       |      |       |           |       |                 |       |             |       |             |       |
| **Liabilities and Equity**                             |       |      |       |           |       |                 |       |             |       |             |       |
| Current liabilities:                                   |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts payable                                       |       | $         | —     |           | $          | 34,750               |       | $                | 7,393      |             | $          | 1 |   | $ | 42,144 |   |
| Current portion of debt and capital lease  obligations |       | 12,568    |       | 140            |       | 3,218                |       | —           |       | 15,926           |       |
| Other current liabilities                              |       | 22,165    |       | 60,992         |       | 18,419               |       | —           |       | 101,576          |       |
| Total current liabilities                              |       | 34,733    |       | 95,882         |       | 29,030               |       | 1                |       | 159,646          |       |
| Long-term debt and capital lease obligations           |       | 1,796,859 |       | 83             |       | 2                    |       | —           |       | 1,796,944        |       |
| Deferred tax liabilities, net                          |       | —    |       | 302,870        |       | 15,272               |       | 2,989            |       | 321,131          |       |
| Intercompany payables, net                             |       | —    |       | 960,790        |       | 104,903              |       | (1,065,693       | )          | —           |       |
| Other non-current liabilities                          |       | —    |       | 11,162         |       | 2,927                |       | —           |       | 14,089           |       |
| Total liabilities                                      |       | 1,831,592 |       | 1,370,787      |       | 152,134              |       | (1,062,703       | )          | 2,291,810        |       |
| Noncontrolling interests                               |       | —    |       | —         |       | 2,509                |       | —           |       | 2,509            |       |
| Total membership equity                                |       | 555,860   |       | 3,585,535      |       | 139,153              |       | (3,724,688       | )          | 555,860          |       |
| Total liabilities and equity                           |       | $         | 2,387,452  |           | $          | 4,956,322            |       | $                | 293,796    |             | $          | (4,787,391 | ) | $ | 2,850,179 |   |

 

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** **

**DJOFinance LLC**

**UnauditedCondensed Consolidating Statements of Operations**

**For theThree Months Ended September 26, 2009**

(inthousands)

 
| ** **                                                                | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                 |       | $         | —     |           | $          | 208,258              |       | $                | 63,491     |             | $          | (35,563 | ) | $ | 236,186 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $9,495) |       | —    |       | 74,148         |       | 42,564               |       | (30,673          | )          | 86,039           |       |
| Gross profit                                                              |       | —    |       | 134,110        |       | 20,927               |       | (4,890           | )          | 150,147          |       |
|                                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Operating expenses:                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                       |       | —    |       | 82,853         |       | 18,560               |       | —           |       | 101,413          |       |
| Research and development                                                  |       | —    |       | 5,049          |       | 567                  |       | —           |       | 5,616            |       |
| Amortization of intangible assets                                         |       | —    |       | 18,639         |       | 921                  |       | —           |       | 19,560           |       |
|                                                                      |       | —    |       | 106,541        |       | 20,048               |       | —           |       | 126,589          |       |
| Operating income                                                          |       | —    |       | 27,569         |       | 879                  |       | (4,890           | )          | 23,558           |       |
|                                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Other income (expense):                                                   |       |      |       |           |       |                 |       |             |       |             |       |
| Interest expense                                                          |       | (38,978   | )          | (4,370         | )          | (885                 | )          | 5,060            |       | (39,173          | )          |
| Interest income                                                           |       | 4,351     |       | 753            |       | 175                  |       | (5,068           | )          | 211              |       |
| Other income (expense), net                                               |       | 23,253    |       | (56,348        | )          | 1,418                |       | 33,099           |       | 1,422            |       |
|                                                                      |       | (11,374   | )          | (59,965        | )          | 708                  |       | 33,091           |       | (37,540          | )          |
| Income (loss) from continuing operations before  income taxes        |       | (11,374   | )          | (32,396        | )          | 1,587                |       | 28,201           |       | (13,982          | )          |
| Income tax benefit (expense)                                              |       | —    |       | 3,895          |       | (926                 | )          | —           |       | 2,969            |       |
| Loss from discontinued operations, net                                    |       | —    |       | (267           | )          | —               |       | —           |       | (267             | )          |
| Net income (loss)                                                         |       | (11,374   | )          | (28,768        | )          | 661                  |       | 28,201           |       | (11,280          | )          |
| Net income attributable to noncontrolling  interests                      |       | —    |       | —         |       | (94                  | )          | —           |       | (94              | )          |
| Net income (loss) attributable to DJO Finance LLC                         |       | $         | (11,374    | )              | $          | (28,768              | )          | $                | 567        |             | $          | 28,201 |   | $ | (11,374 | ) |

 

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** **

**DJOFinance LLC**

**UnauditedCondensed Consolidating Statements of Operations**

**For theNine Months Ended September 26, 2009**

(inthousands)

 
| ** **                                                                 | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                  |       | $         | —     |           | $          | 589,554              |       | $                | 192,241    |             | $          | (92,844 | ) | $ | 688,951 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $28,499) |       | —    |       | 212,781        |       | 126,963              |       | (92,549          | )          | 247,195          |       |
| Gross profit                                                               |       | —    |       | 376,773        |       | 65,278               |       | (295             | )          | 441,756          |       |
|                                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Operating expenses:                                                        |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                        |       | —    |       | 252,494        |       | 58,124               |       | —           |       | 310,618          |       |
| Research and development                                                   |       | —    |       | 15,539         |       | 2,042                |       | —           |       | 17,581           |       |
| Amortization of intangible assets                                          |       | —    |       | 55,917         |       | 1,945                |       | —           |       | 57,862           |       |
|                                                                       |       | —    |       | 323,950        |       | 62,111               |       | —           |       | 386,061          |       |
| Operating income                                                           |       | —    |       | 52,823         |       | 3,167                |       | (295             | )          | 55,695           |       |
|                                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Other income (expense):                                                    |       |      |       |           |       |                 |       |             |       |             |       |
| Interest expense                                                           |       | (116,818  | )          | (13,835        | )          | (2,489               | )          | 15,823           |       | (117,319         | )          |
| Interest income                                                            |       | 13,737    |       | 2,190          |       | 656                  |       | (15,834          | )          | 749              |       |
| Other income (expense), net                                                |       | 64,314    |       | (47,719        | )          | 1,860                |       | (15,446          | )          | 3,009            |       |
|                                                                       |       | (38,767   | )          | (59,364        | )          | 27                   |       | (15,457          | )          | (113,561         | )          |
| Income (loss) from continuing operations before  income taxes         |       | (38,767   | )          | (6,541         | )          | 3,194                |       | (15,752          | )          | (57,866          | )          |
| Income tax benefit (expense)                                               |       | —    |       | 21,385         |       | (1,484               | )          | —           |       | 19,901           |       |
| Loss from discontinued operations, net                                     |       | —    |       | (434           | )          | —               |       | —           |       | (434             | )          |
| Net income (loss)                                                          |       | (38,767   | )          | 14,410         |       | 1,710                |       | (15,752          | )          | (38,399          | )          |
| Net income attributable to noncontrolling  interests                       |       | —    |       | —         |       | (368                 | )          | —           |       | (368             | )          |
| Net income (loss) attributable to DJO Finance LLC                          |       | $         | (38,767    | )              | $          | 14,410               |       | $                | 1,342      |             | $          | (15,752 | ) | $ | (38,767 | ) |

 

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**DJOFinance LLC**

**UnauditedCondensed Consolidating Statements of Cash Flows**

**For theNine Months Ended September 26, 2009**

(inthousands)

 
| ** **                                                                                                         | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                                  |       | $         | (38,767    | )              | $          | 14,410               |       | $                | 1,710      |             | $          | (15,752 | ) | $ | (38,399 | ) |
|                                                                                                               |       |      |       |           |       |                 |       |             |       |             |       |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                                       |       | —    |       | 17,253         |       | 3,711                |       | (392             | )          | 20,572           |       |
| Amortization of intangible assets                                                                                  |       | —    |       | 55,917         |       | 1,945                |       | —           |       | 57,862           |       |
| Amortization of debt issuance costs and non-cash  interest expense                                                 |       | 9,597     |       | —         |       | —               |       | —           |       | 9,597            |       |
| Stock-based compensation expense                                                                                   |       | —    |       | 2,335          |       | —               |       | —           |       | 2,335            |       |
| Loss on disposal of assets, net                                                                                    |       | —    |       | 270            |       | 270                  |       | (75              | )          | 465              |       |
| Gain on disposal of discontinued operations                                                                        |       | —    |       | (496           | )          | —               |       | —           |       | (393             | )          |
| Deferred income tax benefit                                                                                        |       | —    |       | (24,012        | )          | (711                 | )          | 2,149            |       | (22,574          | )          |
| Non-cash income (loss) from subsidiaries                                                                           |       | (64,314   | )          | 86,249         |       | —               |       | (21,935          | )          | —           |       |
| Provision for doubtful accounts and sales returns                                                                  |       | —    |       | 24,728         |       | 705                  |       | —           |       | 25,433           |       |
| Inventory reserves                                                                                                 |       | —    |       | 5,449          |       | 847                  |       | —           |       | 6,296            |       |
|                                                                                                               |       |      |       |           |       |                 |       |             |       |             |       |
| Changes in operating assets and liabilities,  net of acquired assets and liabilities:                         |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                                |       | —    |       | (18,154        | )          | (1,269               | )          | —           |       | (19,423          | )          |
| Inventories                                                                                                        |       | —    |       | (3,404         | )          | (1,762               | )          | 4,002            |       | (1,164           | )          |
| Prepaid expenses and other assets                                                                                  |       | 273       |       | (4,826         | )          | 4,855                |       | (338             | )          | (36              | )          |
| Accounts payable and other current liabilities                                                                     |       | 31,190    |       | (8,856         | )          | (591                 | )          | 253              |       | 21,996           |       |
| Net cash provided by (used in) operating  activities                                                               |       | (62,021   | )          | 146,863        |       | 9,710                |       | (31,985          | )          | 62,567           |       |
|                                                                                                               |       |      |       |           |       |                 |       |             |       |             |       |
| **INVESTING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Purchases of property and equipment                                                                                |       | —    |       | (15,558        | )          | (4,129               | )          | 554              |       | (19,133          | )          |
| Cash paid in connection with acquisitions, net of  cash acquired                                                   |       | —    |       | (2,417         | )          | (10,429              | )          | —           |       | (12,846          | )          |
| Proceeds received upon disposition of discontinued  operations, net                                                |       | —    |       | 21,846         |       | —               |       | —           |       | 21,846           |       |
| Other investing activities, net                                                                                    |       | —    |       | (25            | )          | (51                  | )          | —           |       | (76              | )          |
| Net cash provided by (used in) investing  activities                                                               |       | —    |       | 3,846          |       | (14,609              | )          | 554              |       | (10,209          | )          |
|                                                                                                               |       |      |       |           |       |                 |       |             |       |             |       |
| **FINANCING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                       |       | 94,878    |       | (136,731       | )          | 10,422               |       | 31,431           |       | —           |       |
| Proceeds from issuance of debt and revolving line  of credit                                                       |       | 65,000    |       | (3             | )          | 176                  |       | —           |       | 65,173           |       |
| Repayments of debt and capital lease obligations                                                                   |       | (94,325   | )          | (26            | )          | (483                 | )          | —           |       | (94,834          | )          |
| Net cash provided by (used in) financing  activities                                                               |       | 65,553    |       | (136,760       | )          | 10,115               |       | 31,431           |       | (29,661          | )          |
| Effect of exchange rate changes on cash and cash  equivalents                                                      |       | —    |       | —         |       | (1,901               | )          | —           |       | (1,901           | )          |
| **Net increase in cash and cash  equivalents**                                                                     |       | 3,532     |       | 13,949         |       | 3,315                |       | —           |       | 20,796           |       |
| Cash and cash equivalents at beginning of period                                                                   |       | —    |       | 14,373         |       | 16,110               |       | —           |       | 30,483           |       |
| Cash and cash equivalents at end of period                                                                         |       | $         | 3,532      |           | $          | 28,322               |       | $                | 19,425     |             | $          | — |   | $ | 51,279 |   |

 

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**18.  SUBSEQUENTEVENTS**

 

On October 1, 2010, we commenced a cash tender offer for any andall of our $200 million of outstanding 11.75% Notes (see Note 9) due 2014 witha final tender expiration date of October 29, 2010. The total tender offerconsideration of $1,065 for each $1,000 principal amount of 11.75% Notesvalidly tendered included an early tender premium of $30 per $1,000 principalamount of 11.75% Notes validly tendered by October 15, 2010. Inaddition, holders who validly tendered their 11.75% Notes were entitled toreceive accrued interest from and including the last interest payment datethrough the applicable settlement date.

 

On October 5, 2010, we entered into Amendment No. 2 to theSenior Secured Credit Facility, which permitted us to (1) issue$300.0 million in aggregate principal amount of new subordinated notes tobe co-issued by DJOFL and DJO Finco; (2) use the proceeds from theoffering to repurchase or redeem all of our existing 11.75% Notes due 2014; (3) prepaya portion of the term loans under our Senior Secured Credit Facility; and (4) payrelated premiums, fees and expenses, all without utilizing existing debtincurrence capacity under our Senior Secured Credit Facility. In connectionwith this amendment, we incurred $0.7 million of fees and expenses, whichwill be expensed during the fourth quarter of 2010.

 

OnOctober 18, 2010, we issued $300.0 million aggregate principal amount ofnew 9.75% Senior Subordinated Notes (9.75% Notes) maturing onOctober 15, 2017, realizing net proceeds of $293.2 million afterdeducting $6.8 million of debt issuance costs, which were capitalized and willbe amortized using the effective interest method through the maturity data.Semi-annual interest of approximately $14.6 million, related to the 9.75% Noteswill be payable in cash on April 15 and October 15 of each year,commencing on April 15, 2011, and will accrue from and including October 18,2010. The 9.75% Notes are guaranteed jointly and severally and on an unsecuredsenior basis by each of DJOFL’s existing and future direct and indirect whollyowned domestic subsidiaries that guarantee any of DJOFL’s indebtedness or anyindebtedness of DJOFL’s domestic subsidiaries or is an obligor under DJOFL’sSenior Secured Credit Facility.

 

OnOctober 18, 2010, we used a portion of the proceeds from the issuance ofthe 9.75% Notes to repurchase $199.85 million aggregate principal amountof our 11.75% Notes for total consideration of $222.8 million, which includesapplicable premiums and accrued interest from the last interest payment date tothe settlement date. We intend to redeem the remaining $150,000 aggregateprincipal amount of the 11.75% Notes, and expect to do so during November 2010,at a redemption price of 105.875%. In connection with the repayment of the11.75% Notes we incurred $0.6 million of fees, which will be expensed duringthe fourth quarter of 2010.

 

DuringOctober 2010, we prepaid a total $79.0 million of term loans under ourSenior Secured Credit Facility. In connection with this prepayment, during thefourth quarter we expect to (1) accelerate $0.6 million ofamortization of the unamortized original issue discount as of the prepaymentdate and (2) recognize a non-cash loss of $1.2 million attributable to thewrite off of unamortized debt issuance costs as of the prepayment date relatingto the portion of the term loans that were repaid.

 

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Introduction**

 

This management’s discussion and analysis of financial condition andresults of operations is intended to provide an understanding of our results ofoperations, financial condition and where appropriate, factors that may affectfuture performance.

 

The following discussion should be read in conjunction with theunaudited condensed consolidated financial statements and related notes theretoas well as the other financial data included elsewhere in this Form 10-Q.

 

**Forward Looking Statements**

 

The following management’s discussion and analysis contains “forwardlooking statements” within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended, that represent our expectations or beliefs concerning futureevents, including, but not limited to, statements regarding growth in sales ofour products, profit margins and the sufficiency of our cash flow for futureliquidity and capital resource needs. These forward-looking statements arefurther qualified by important factors that could cause actual results todiffer materially from those in the forward-looking statements. The sectionentitled “Risk Factors” in Part II, Item 1A of this report and in our2009 Annual Report on Form 10-K filed with the Securities andExchange Commission (SEC) on March 5, 2010, describes these and otherimportant risk factors that may affect our business, financial condition,results of operations, and/or liquidity. Results actually achieved may differmaterially from expected results included in these statements as a result ofthese or other factors.

 

**Overview of Business**

 

We are a global provider ofhigh-quality orthopedic devices, with a broad range of products used forrehabilitation, pain management and physical therapy. We also develop,manufacture and distribute a broad range of surgical reconstructive implantproducts. We are one of the largest non-surgical orthopedic rehabilitationdevice companies in the world, as measured by revenues. Many of our productshave leading market positions. We believe that our strong brand names,comprehensive range of products, focus on quality, innovation and customerservice, extensive distribution network, and our strong relationships withorthopedic and physical therapy professionals have contributed to our leadingmarket positions. We believe that we are one of only a few orthopedic devicecompanies that offer healthcare professionals and patients a diverse range oforthopedic rehabilitation products addressing the complete spectrum ofpreventative, pre-operative, post-operative, clinical and home rehabilitationcare. Our products are used by orthopedic specialists, primary care physicians,pain management specialists, physical therapists, podiatrists, chiropractors,athletic trainers and other healthcare professionals to treat patients withmusculoskeletal conditions resulting from degenerative diseases, deformities,traumatic events and sports-related injuries. In addition, many of ournon-surgical medical devicesandrelated accessories are used by athletes and patients for injury prevention andat-home physical therapy treatment

 

On June 12, 2009, we sold our EmpiTherapy Solutions (ETS) catalog business, formerly known as Rehab MedicalEquipment, or RME, to Patterson Medical Supply, Inc. for approximately$21.8 million. As such, results of the ETS business for the three and ninemonth periods ended September 26, 2009 have been presented as discontinuedoperations in our unaudited condensed consolidated financial statements.

 

We provide a broad array of orthopedicrehabilitation and regeneration products, as well as surgical implants tocustomers in the United States and abroad. In the second quarter of 2010, wechanged how we report financial information to senior management. Prior to thesecond quarter of 2010, our Bracing and Supports and Recovery Sciencesbusinesses were reported together within the Domestic Rehabilitation Segment.During the second quarter, as a result of our recent sales and marketingleadership reorganization, these businesses are now separately evaluated andmanaged. Segment information for all periods presented has been restated toreflect this change. We currently develop, manufacture and distribute ourproducts through four operating segments.

 

***Bracing and Supports Segment***

 

Our Bracing and Supports Segment, which generates its revenues in theUnited States, offers our DonJoy, ProCare and Aircast products, including rigidknee bracing, orthopedic soft goods, cold therapy products, and vascularsystems. This segment also includes our OfficeCare business, through which wemaintain an inventory of soft goods and other products at healthcarefacilities, primarily orthopedic practices, for immediate distribution topatients.

 

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***Recovery Sciences Segment***

 

Our Recovery Sciences Segment, which generates its revenues in theUnited States, is divided into four main businesses:

 

·                  *Empi.*Our Empibusiness unit offers our home electrotherapy, iontophoresis, and home tractionproducts. We primarily sell these products directly to patients or to physicaltherapy clinics. For products sold to patients, we arrange billing to thepatients and their third party payors.

 

·                  *Regeneration*. OurRegeneration business unit sells our bone growth stimulation products. We sellthese products either directly to patients or to independent distributors. Forproducts sold to patients, we arrange billing to the patients and their thirdparty payors.

 

·*                 **Chattanooga.*Our Chattanooga business unit offers products in the clinicalrehabilitation market in the category of clinical electrotherapy devices,clinical traction devices, and other clinical products and supplies such astreatment tables, continuous passive motion (CPM) devices and dry heat therapy.

 

·                  *AthleteDirect.*Our Athlete Direct business unit offers consumersranging from fitness enthusiasts to competitive athletes our Compexelectrostimulation device, which is used in athletic training programs to aidmuscle development and to accelerate muscle recovery after training sessions. 

 

***Surgical Implant Segment***

 

Our Surgical Implant Segment, which generates its revenues in theUnited States, develops, manufactures and markets a wide variety of knee, hipand shoulder implant products that serve the orthopedic reconstructive jointimplant market.

 

***International Segment***

 

Our International Segment, which generates most of its revenues inEurope, sells all of our products and certain third party products through acombination of direct sales representatives and independent distributors.

 

Our four operating segments enable us to reach a diverse customer basethrough multiple distribution channels and give us the opportunity to provide awide range of medical devices and related products to orthopedic specialists andother healthcare professionals operating in a variety of patient treatmentsettings. These four segments constitute our reportable segments. SeeNote 16 to our unaudited condensed consolidated financial statements foradditional information regarding our segments.

 

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The tables below present financial information forour reportable segments for the periods presented. Segment results exclude theimpact of certain general corporate expenses and charges related to variousintegration activities, as defined. All prior periods presented have beenrestated to reflect our current reportable segments.

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **($ in thousands)**                           | ** ** | **October 2,  2010**        | ** ** | **September 26,  2009**    | ** ** | **October 2,  2010** | ** ** | **September 26,  2009** | ** ** |
|                                                     |       |                             |       |                            |       |   |   |   |   |
| **Bracing and Supports:**                                |       |                             |       |                            |       |   |   |   |   |
| Net sales                                                |       | $                                | 78,156     |                            | $          | 76,388 |   | $ | 232,087 |   | $ | 219,224 |   |
| Gross profit                                             |       | $                                | 42,521     |                            | $          | 44,146 |   | $ | 127,865 |   | $ | 122,748 |   |
| Gross profit margin                                      |       | 54.4                             | %          | 57.8                            | %          | 55.1 | % | 56.0 | % |
| Operating income                                         |       | $                                | 17,188     |                            | $          | 20,687 |   | $ | 50,428 |   | $ | 51,577 |   |
| Operating income as a percent of net  segment sales |       | 22.0                             | %          | 27.1                            | %          | 21.7 | % | 23.5 | % |
|                                                     |       |                             |       |                            |       |   |   |   |   |
| **Recovery Sciences:**                                   |       |                             |       |                            |       |   |   |   |   |
| Net sales                                                |       | $                                | 85,884     |                            | $          | 85,794 |   | $ | 257,361 |   | $ | 249,767 |   |
| Gross profit                                             |       | $                                | 66,753     |                            | $          | 64,377 |   | $ | 195,773 |   | $ | 188,162 |   |
| Gross profit margin                                      |       | 77.7                             | %          | 75.0                            | %          | 76.1 | % | 75.3 | % |
| Operating income                                         |       | $                                | 30,962     |                            | $          | 27,715 |   | $ | 85,441 |   | $ | 75,962 |   |
| Operating income as a percent of net  segment sales |       | 36.1                             | %          | 32.3                            | %          | 33.2 | % | 30.4 | % |
|                                                     |       |                             |       |                            |       |   |   |   |   |
| **Surgical Implant:**                                    |       |                             |       |                            |       |   |   |   |   |
| Net sales                                                |       | $                                | 14,559     |                            | $          | 15,416 |   | $ | 46,735 |   | $ | 47,097 |   |
| Gross profit                                             |       | $                                | 10,258     |                            | $          | 11,779 |   | $ | 34,533 |   | $ | 36,541 |   |
| Gross profit margin                                      |       | 70.5                             | %          | 76.4                            | %          | 73.9 | % | 77.6 | % |
| Operating income                                         |       | $                                | 401        |                            | $          | 2,805 |   | $ | 4,545 |   | $ | 8,982 |   |
| Operating income as a percent of net  segment sales |       | 2.8                              | %          | 18.2                            | %          | 9.7 | % | 19.1 | % |
|                                                     |       |                             |       |                            |       |   |   |   |   |
| **International:**                                       |       |                             |       |                            |       |   |   |   |   |
| Net sales                                                |       | $                                | 54,960     |                            | $          | 58,588 |   | $ | 179,979 |   | $ | 172,863 |   |
| Gross profit                                             |       | $                                | 30,697     |                            | $          | 32,434 |   | $ | 106,097 |   | $ | 98,645 |   |
| Gross profit margin                                      |       | 55.9                             | %          | 55.4                            | %          | 58.9 | % | 57.1 | % |
| Operating income                                         |       | $                                | 9,752      |                            | $          | 10,625 |   | $ | 40,787 |   | $ | 33,556 |   |
| Operating income as a percent of net  segment sales |       | 17.7                             | %          | 18.1                            | %          | 22.7 | % | 19.4 | % |

 

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**Results of Operations**

 

We operate our business on a manufacturing calendar, with our fiscalyear always ending on December 31. Each quarter is 13 weeks, consisting oftwo four-week periods and one five-week period. Our first and fourth quartersmay have more or fewer shipping days from year to year based on the days of theweek on which holidays and December 31 fall. The quarters ended October 2,2010 and September 26, 2009 each included 63 shipping days. The ninemonths ended October 2, 2010 and September 26, 2009 included 192 and188 shipping days, respectively.

 

The following table presents results of operations as a percentage ofnet sales for the periods presented ($ in thousands):

 
|                                                                |   | **Three Months Ended** | ** ** | **Nine Months Ended** |       |
|---------------------------------------------------------------------|--------|----------------------------------|------------|---------------------------------|------------|
|                                                                |   | **October 2,  2010**        | ** ** | **September 26,  2009**    | ** ** | **October 2,  2010** | ** ** | **September 26,  2009** |   |
| Net sales                                                           |   | $                                | 233,559    |                            | 100.0      | % | $ | 236,186 |   | 100.0 | % | $ | 716,162 |   | 100.0 | % | $ | 688,951 |   | 100.0 | % |
| Cost of sales (exclusive of amortization of  intangible assets (1)) |   | 84,147                           |       | 36.0                            |       | 86,039 |   | 36.4 |   | 256,066 |   | 35.8 |   | 247,195 |   | 35.9 |   |
| Gross profit                                                        |   | 149,412                          |       | 64.0                            |       | 150,147 |   | 63.6 |   | 460,096 |   | 64.2 |   | 441,756 |   | 64.1 |   |
|                                                                |   |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating expenses:                                                 |   |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative                                 |   | 102,672                          |       | 44.0                            |       | 101,413 |   | 42.9 |   | 328,913 |   | 45.9 |   | 310,618 |   | 45.1 |   |
| Research and development                                            |   | 5,892                            |       | 2.5                             |       | 5,616 |   | 2.4 |   | 16,923 |   | 2.4 |   | 17,581 |   | 2.6 |   |
| Amortization of intangible assets                                   |   | 19,403                           |       | 8.3                             |       | 19,560 |   | 8.3 |   | 58,128 |   | 8.1 |   | 57,862 |   | 8.4 |   |
| Impairment of assets held for sale                                  |   | —                           |       | —                          |       | — |   | — |   | 1,147 |   | 0.2 |   | — |   | — |   |
|                                                                |   | 127,967                          |       | 54.8                            |       | 126,589 |   | 53.6 |   | 405,111 |   | 56.5 |   | 386,061 |   | 56.0 |   |
| Operating income                                                    |   | 21,445                           |       | 9.2                             |       | 23,558 |   | 10.0 |   | 54,985 |   | 7.7 |   | 55,695 |   | 8.1 |   |
|                                                                |   |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Other income (expense):                                             |   |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense                                                    |   | (37,240                          | )          | (15.9                           | )          | (39,173 | ) | (16.6 | ) | (114,867 | ) | (16.0 | ) | (117,319 | ) | (17.0 | ) |
| Interest income                                                     |   | 92                               |       | 0.0                             |       | 211 |   | 0.1 |   | 232 |   | 0.0 |   | 749 |   | 0.1 |   |
| Other income, net                                                   |   | 4,981                            |       | 2.1                             |       | 1,422 |   | 0.6 |   | 1,364 |   | 0.2 |   | 3,009 |   | 0.4 |   |
|                                                                |   | (32,167                          | )          | (13.8                           | )          | (37,540 | ) | (15.9 | ) | (113,271 | ) | (15.8 | ) | (113,561 | ) | (16.5 | ) |
| Loss from continuing operations before income  taxes                |   | (10,722                          | )          | (4.6                            | )          | (13,982 | ) | (5.9 | ) | (58,286 | ) | (8.1 | ) | (57,866 | ) | (8.4 | ) |
| Income tax benefit                                                  |   | 3,191                            |       | 1.4                             |       | 2,969 |   | 1.3 |   | 17,983 |   | 2.5 |   | 19,901 |   | 2.9 |   |
| Loss from discontinued operations, net                              |   | —                           |       | —                          |       | (267 | ) | (0.1 | ) | — |   | — |   | (434 | ) | (0.1 | ) |
| Net loss                                                            |   | (7,531                           | )          | (3.2                            | )          | (11,280 | ) | (4.8 | ) | (40,303 | ) | (5.6 | ) | (38,399 | ) | (5.6 | ) |
| Net income attributable to noncontrolling  interests                |   | (184                             | )          | (0.1                            | )          | (94 | ) | (0.0 | ) | (827 | ) | (0.1 | ) | (368 | ) | (0.0 | ) |
| Net loss attributable to DJO Finance LLC                       |   | $                                | (7,715     | )                               | (3.3       | )% | $ | (11,374 | ) | (4.8 | )% | $ | (41,130 | ) | (5.7 | )% | $ | (38,767 | ) | (5.6 | )% |

 

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(1)          Cost of sales is exclusiveof amortization of intangible assets of $9,230 and $27,211 for the three andnine months ended October 2, 2010, respectively, and $9,495 and $28,499for the three and nine months ended September 26, 2009, respectively.

 

***Three Months Ended October 2,2010 compared to Three Months Ended September 26, 2009***

 

*Net Sales.*  Our net sales for the three months ended October 2,2010 were $233.6 million as compared to $236.2 million for the three monthsended September 26, 2009, representing a 1.1% decrease. This decrease wasdriven primarily by a $3.3 million impact from unfavorable changes in foreigncurrency exchange rates in effect for the three months ended October 2,2010, as compared to rates in effect for the three months ended September 26,2009, the impact of the sale or discontinuation of certain product lines in2009, which were included in revenue during the three months ended September 26,2009 in the amount of approximately $2.3 million, and a decrease in salesin our Surgical Implant Segment. These decreases were partially offset by anincrease in sales in our Bracing and Supports Segment.

 

For the three months ended October 2, 2010, we generated 23.5% ofour net sales from customers outside the United States as compared to 24.8% forthe three months ended September 26, 2009.

 

Sales of new products, which include products that have been on themarket less than one year, were $4.0 million for the three months ended October 2,2010 compared to new product sales of $5.1 million for the three months ended September 26,2009.

 

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The following table sets forth the mix of our net sales for the threemonths ended October 2, 2010 compared to the three months ended September 26,2009 ($ in thousands):

 
| ** **           | ** ** | **Three Months Ended** | ** ** | ** **                    | ** ** | ** **                   | ** ** |
|----------------------|------------|----------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| ** **           | ** ** | **October 2,  2010**        | ** ** | **% of Net  Sales** | ** ** | **September 26,  2009** | ** ** | **% of Net  Sales** | ** ** | **Increase (decrease)** | ** ** |
| Bracing and Supports |       | $                                | 78,156     |                          | 33.5       | %                            | $          | 76,388 |   | 32.4 | % | $ | 1,768 |   | 2.3 | % |
| Recovery Sciences    |       | 85,884                           |       | 36.8                          |       | 85,794                       |       | 36.3 |   | 90 |   | 0.1 |   |
| Surgical Implant     |       | 14,559                           |       | 6.2                           |       | 15,416                       |       | 6.5 |   | (857 | ) | (5.6 | ) |
| International        |       | 54,960                           |       | 23.5                          |       | 58,588                       |       | 24.8 |   | (3,628 | ) | (6.2 | ) |
|                 |       | $                                | 233,559    |                          | 100.0      | %                            | $          | 236,186 |   | 100.0 | % | $ | (2,627 | ) | (1.1 | )% |

 

Net sales in our Bracing and Supports Segment of $78.2 million for thethree months ended October 2, 2010, increased $1.8 million, or 2.3%,as compared to the three months ended September 26, 2009. The increase wasdriven primarily by increased unit sales across most product lines, andincreased revenue under our new soft goods contract with the Novation grouppurchasing organization. Partially offsetting these gains, growth in ourBracing and Supports segment was impacted by the conversion of certain unitspreviously billed to insurance at higher average selling prices to units soldat reduced average selling prices to clinics choosing to do their own insurancebilling.

 

Net sales in our Recovery Sciences Segment were $85.9 million for thethree months ended October 2, 2010, essentially flat compared to net salesfor the three months ended September 26, 2009 of $85.8 million. Increasesin sales of new products in our Empi business unit were offset by decreases insales of our Chattanooga products, and the impact of discontinuing certainChattanooga products which contributed revenue of $0.9 million in the threemonths ended September 26, 2009.

 

Net sales in our Surgical Implant Segment decreased to$14.6 million for the three months ended October 2, 2010 from$15.4 million for the three months ended September 26, 2009,representing a 5.6% decrease over the same period in the prior year. Thedecrease was primarily due to the loss of a few key customers resulting in decreasedsales of our hip and knee products, and the impact of the sale of a non-corespine product line which contributed revenue of $0.5 million in the threemonths ended September 26, 2009. These decreases were partially offset byincreased sales of our shoulder products.

 

Net sales in our International Segment for the three months ended October 2,2010 were $55.0 million, a decrease of 6.2% from net sales of $58.6 million forthe three months ended September 26, 2009. The decrease is primarilyattributable to unfavorable changes in foreign exchange rates compared to ratesin effect for the three months ended September 26, 2009, which impactednet sales by $3.3 million. Excluding the impact of foreign exchange rates, netsales in our International Segment were essentially flat compared to the sameperiod in the prior year, as strong sales of our Bracing and Supports productsand continued improvement in sales of our Chattanooga products were offset bythe impact of the discontinuation of certain Chattanooga products sold ininternational markets, which contributed revenue of $0.9 million in the threemonths ended September 26, 2009.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales was 64.0%, for the three months ended October 2, 2010, comparedto 63.6% for the three months ended September 26, 2009. Our gross profitmargin for the three months ended October 2, 2010 was favorablyimpacted by cost savings achieved in connection with various integrationactivities, partially offset by unfavorable changes in foreign currencyexchange rates compared to the rates in effect for the prior year.

 

Gross profit in our Bracing and Supports Segment as a percentage of netsales was 54.4% for the three months ended October 2, 2010 as compared to57.8% for the three months ended September 26, 2009. The decrease wasprimarily due to a lower margin mix of products sold.

 

Gross profit in our Recovery Sciences Segment as a percentage of netsales increased to 77.7% for the three months ended October 2, 2010 from75.0% for the three months ended September 26, 2009. The increase wasprimarily driven by cost savings resulting from the integration of ourChattanooga business operations.

 

Gross profit in our Surgical Implant Segment as a percentage of netsales decreased to 70.5% for the three months ended October 2, 2010 from76.4% for the three months ended September 26, 2009. The decrease wasprimarily driven by lower sales volume and the unfavorable impact of certainnon-recurring inventory adjustments.

 

Gross profit in our International Segment as a percentage of net salesincreased slightly to 55.9% for the three months ended October 2, 2010from 55.4% for the three months ended September 26, 2009. The increase wasprimarily driven by a more favorable mix of products sold, and cost savingsachieved in connection with the integration of our Chattanooga businessoperations, partially offset by unfavorable changes in foreign exchange rates.

 

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*Selling, General and Administrative (SG&A).*  Our SG&A increased to $102.7 million forthe three months ended October 2, 2010 from $101.4 million for the threemonths ended September 26, 2009. Our SG&A expenses were impacted bysignificant non-recurring integration charges and other adjustments related toongoing restructuring activities and acquisitions. We incurred the followingSG&A expenses in connection with such activities during the periodspresented (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **October 2,  2010**        | ** ** | **September 26,  2009** | ** ** |
| Integration charges:                              |       |                             |       |   |   |
| Employee severance and relocation                 |       | $                                | 270        |   | $ | 2,649 |   |
| U.S commercial sales and marketing reorganization |       | 2,540                            |       | — |   |
| Chattanooga integration                           |       | 10                               |       | 1,959 |   |
| DJO Merger and other integration                  |       | 943                              |       | 2,344 |   |
| International integration                         |       | 16                               |       | 415 |   |
| Litigation costs and settlements, net             |       | 1,982                            |       | 78 |   |
| ERP implementation                                |       | 4,676                            |       | 2,740 |   |
|                                              |       | $                                | 10,437     |   | $ | 10,185 |   |

 

*Research and Development.*  Our research and development expenseincreased to $5.9 million for the three months ended October 2, 2010 from$5.6 million for the three months ended September 26, 2009. As apercentage of net sales, research and development expense increased slightly to2.5% for the three months ended October 2, 2010 from 2.4% in the threemonths ended September 26, 2009.

 

*Amortization of Intangible Assets.* Amortizationof intangible assets was $19.4 million and $19.6 million for the three monthsended October 2, 2010 and September 26, 2009, respectively.

 

*Interest Expense.*  Our interest expense decreased to $37.2million for the three months ended October 2, 2010 from $39.2 millionfor the three months ended September 26, 2009, primarily due to lowerweighted average interest rates on our outstanding debt.

 

*Other Income, Net.*  Other income, net, was $5.0 million and $1.4million for the three months ended October 2, 2010 and September 26,2009, respectively. Results for both periods were primarily associated with netrealized and unrealized foreign currency transaction gains.

 

*Income Tax Benefit.*  For the three months ended October 2,2010, we recorded an income tax benefit of approximately $3.2 million on apre-tax loss of approximately $10.7 million, resulting in a 29.8% effective taxrate. For the three months ended September 26, 2009, we recorded an incometax benefit of approximately $3.0 million on a pre-tax loss of approximately$14.0 million, resulting in a 21.2% effective tax rate.

 

***Nine Months Ended October 2,2010 compared to Nine Months Ended September 26, 2009***

 

*Net Sales.*  Our net sales for the nine months ended October 2,2010 were $716.2 million, representing an increase of 3.9% from net sales of$689.0 million for the nine months ended September 26, 2009. This increasewas driven by increased sales across most business units, as well as thebenefit of four additional shipping days as compared to the nine months ended September 26,2009. These increases were partially offset by a $0.9 million impact fromunfavorable changes in foreign exchange rates in effect for the nine monthsended October 2, 2010 as compared to rates in effect for the nine monthsended September 26, 2009, and the impact of the sale or discontinuation ofcertain product lines in 2009, which were included in revenue during the ninemonths ended September 26, 2009 in the amount of approximately $7.3million.

 

For the nine months ended October 2, 2010, we generated 25.1% ofour net sales from customers outside the United States as compared to 25.1% forthe nine months ended September 26, 2009.

 

Sales of new products, which include products that have been on the marketless than one year, were $15.4 million for the nine months ended October 3,2010 compared to new product sales of $12.4 million for the nine months ended September 26,2009.

 

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The following table sets forth the mix of our net sales for the ninemonths ended October 2, 2010 compared to the nine months ended September 26,2009 ($ in thousands):

 
| ** **           | ** ** | **Nine Months Ended** | ** ** | ** **                    | ** ** | ** **                   | ** ** |
|----------------------|------------|---------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| ** **           | ** ** | **October 2,  2010**       | ** ** | **% of Net  Sales** | ** ** | **September 26,  2009** | ** ** | **% of Net  Sales** | ** ** | **Increase (decrease)** | ** ** |
| Bracing and Supports |       | $                               | 232,087    |                          | 32.4       | %                            | $          | 219,224 |   | 31.9 | % | $ | 12,863 |   | 5.9 | % |
| Recovery Sciences    |       | 257,361                         |       | 35.9                          |       | 249,767                      |       | 36.2 |   | 7,594 |   | 3.0 |   |
| Surgical Implant     |       | 46,735                          |       | 6.5                           |       | 47,097                       |       | 6.8 |   | (362 | ) | (0.8 | ) |
| International        |       | 179,979                         |       | 25.1                          |       | 172,863                      |       | 25.1 |   | 7,116 |   | 4.1 |   |
|                 |       | $                               | 716,162    |                          | 100.0      | %                            | $          | 688,951 |   | 100.0 | % | $ | 27,211 |   | 3.9 | % |

 

Net sales in our Bracing and Supports Segment were $232.1 million forthe nine months ended October 2, 2010, reflecting an increase of $12.9million, or 5.9% from net sales of $219.2 million for the nine months ended September 26,2009. The increase was driven primarily by increased unit sales, which werefavorably impacted by the benefit of four additional shipping days in the ninemonths ended October 2, 2010 as compared to the nine months ended September 26,2009, as well as our new soft goods contract with the Novation group purchasingorganization. Partially offsetting these gains, growth in our Bracing andSupports segment was impacted by the conversion of certain units previouslybilled to insurance at higher average selling prices to units sold at reducedaverage selling prices to clinics choosing to do their own insurance billing.

 

Net sales in our Recovery Sciences Segment increased to$257.4 million for the nine months ended October 2, 2010 from $249.8million for the nine months ended September 26, 2009, representing a 3.0%increase over the same period in the prior year. The increase is primarily dueto continued improvement in sales in our Chattanooga business unit, sales ofnew products in our Empi business unit, and the benefit of four additionalshipping days in the nine months ended October 2, 2010 as compared to thenine months ended September 26, 2009. These increases were partiallyoffset by the impact of discontinuing certain Chattanooga products whichcontributed revenue of $2.9 million in the nine months ended September 26,2009.

 

Net sales in our Surgical Implant Segment were $46.7 million forthe nine months ended October 2, 2010, a slight decrease from net sales of$47.1 million for the nine months ended September 26, 2009. The decreasewas driven primarily by the loss of a few key customers resulting in decreasedsales of our hip and knee products, and the impact of the sale of a non-corespine product line which contributed revenue of $1.4 million in the nine monthsended September 26, 2009. These decreases were partially offset byincreased sales of our shoulder products, and the benefit of four additionalshipping days in the nine months ended October 2, 2010 as compared to thenine months ended September 26, 2009.

 

Net sales in our International Segment for the nine months endedOctober 2, 2010 were $180.0 million, reflecting an increase of 4.1% fromnet sales of $172.9 million for the nine months ended September 26, 2009.The increase was driven primarily by strong sales of our bracing and supportsproducts, improving sales of our Chattanooga products, and the benefit of fouradditional shipping days in the nine months ended October 2, 2010 ascompared to the nine months ended September 26, 2009. The increases werepartially offset by $0.9 million of unfavorable changes in foreign exchangerates compared to rates in effect for the nine months ended September 26,2009, and the impact of discontinuing certain Chattanooga products whichcontributed revenue in 2009.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales was 64.2%, for the nine months ended October 2, 2010 as comparedto 64.1% for the nine months ended September 26, 2009. Our gross profitmargin for the nine months ended October 2, 2010 is consistent withthe prior year period as cost savings resulting from integration activity wereoffset by certain other non-recurring integration related costs, andunfavorable changes in foreign exchange rates compared to rates in effect forthe nine months ended September 26, 2009.

 

Gross profit in our Bracing and Supports Segment as a percentage of netsales was 55.1% for the nine months ended October 2, 2010 compared to56.0% for the nine months ended September 26, 2009. The decrease wasprimarily driven by a lower margin mix of products sold.

 

Gross profit in our Recovery Sciences Segment as a percentage of netsales was 76.1% for the nine months ended October 2, 2010 compared to75.3% for the nine months ended September 26, 2009. The decrease wasprimarily driven by a lower margin mix of products sold, partially offset bycost savings achieved in connection with the integration of our Chattanoogabusiness operations.

 

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Gross profit in our Surgical Implant Segment as a percentage of netsales decreased to 73.9% for the nine months ended October 2, 2010 from77.6% for the nine months ended September 26, 2009. The decrease wasprimarily driven by lower sales volume and certain non recurring inventoryadjustments.

 

Gross profit in our International Segment as a percentage of net salesincreased to 58.9% for the nine months ended October 2, 2010 from 57.1%for the nine months ended September 26, 2009. The increase was primarilydriven by the impact of a more favorable mix of products sold, and cost savingsachieved in connection with the integration of our Chattanooga businessoperations. These increases were partially offset by unfavorable changes inforeign currency exchange rates compared to rates in effect for the nine monthsended September 26, 2009.

 

*Selling, General and Administrative (SG&A).*  Our SG&A expenses increased to $328.9million for the nine months ended October 2, 2010 from $310.6 million forthe nine months ended September 26, 2009. Our SG&A expenses wereimpacted by significant non-recurring integration charges and other adjustmentsrelated to ongoing restructuring activities and acquisitions. We incurred thefollowing SG&A expenses in connection with such activities during theperiods presented (in thousands):

 
| ** **                                        | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **October 2,  2010**       | ** ** | **September 26,  2009** | ** ** |
| Integration charges:                              |       |                            |       |   |   |
| Employee severance and relocation                 |       | $                               | 2,411      |   | $ | 5,771 |   |
| U.S commercial sales and marketing reorganization |       | 7,877                           |       | — |   |
| Chattanooga integration                           |       | 3,614                           |       | 21 |   |
| DJO Merger and other integration                  |       | 2,967                           |       | 10,590 |   |
| International integration                         |       | 79                              |       | 4,357 |   |
| Litigation costs and settlements, net             |       | 4,496                           |       | 78 |   |
| Additional product liability insurance premiums   |       | 11,138                          |       | — |   |
| ERP implementation                                |       | 11,682                          |       | 14,822 |   |
|                                              |       | $                               | 44,264     |   | $ | 35,639 |   |

 

During the nine months endedOctober 2, 2010, we incurred $11.1 million of expenses related toadditional product liability insurance premiums, which were primarilyattributable to supplemental extended reporting period coverage for productliability claims related to our discontinued pain pump products, for whichannual insurance coverage was otherwise unavailable when our existing coverageexpired on June 30, 2010.

 

*Research and Development.*  Our research and development expensedecreased to $16.9 million for the nine months ended October 2, 2010 from$17.6 million for the nine months ended September 26, 2009. As apercentage of net sales, research and development expense decreased slightly to2.4% for the nine months ended October 2, 2010 from 2.6% in the nine monthsended September 26, 2009.

 

*Amortization of Intangible Assets.* Ouramortization of intangible assets was $58.1 million and $57.9 million for thenine months ended October 2, 2010 and September 26, 2009,respectively.

 

*Interest Expense.*  Our interest expense was $114.9 million and$117.3 million for the nine months ended October 2, 2010 and September 26,2009, respectively. Lower weighted average interest rates on our outstandingdebt in the nine months ended October 2, 2010 were offset by acceleratedamortization of original issue discount and deferred financing costs inconnection with the prepayments of our Senior Secured Credit Facility duringthe first quarter of 2010.

 

*Other Income, Net.*  Other income, net, was $1.4 million and $3.0million for the nine months ended October 2, and September 26,2009 respectively. Results for both periods were primarily attributable to netrealized and unrealized foreign currency transaction gains.

 

*Income Tax Benefit.* For the nine months endedOctober 2, 2010, we recorded an income tax benefit of approximately$18.0 million on a pre-tax loss of approximately $58.3 million,resulting in a 30.9% effective tax rate. For the nine months endedSeptember 26, 2009, we recorded an income tax benefit of $19.9 millionon a pre-tax loss of $57.8 million, resulting in a 34.4% effective taxrate.

 

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** **

**Liquidity and Capital Resources**

 

As of October 2, 2010, our primary source of liquidity consistedof cash and cash equivalents totaling $50.2 million and $100.0 million ofavailable borrowings under our revolving credit facility. Working capital at October 2,2010 was $181.5 million. We believe that our existing cash, plus the amounts weexpect to generate from operations and amounts available through our revolvingcredit facility, will be sufficient to meet our operating needs for the nexttwelve months, including working capital requirements, capital expenditures,and debt repayment and interest obligations. While we currently believe that wewill be able to meet all of our financial covenants imposed by our SeniorSecured Credit Facility, there is no assurance that we will in fact be able todo so or that, if we do not, we would be able to obtain waivers of default oramendments to the Senior Secured Credit Facility in the future. We and oursubsidiaries, affiliates or significant shareholders (including Blackstone andits affiliates) may from time to time, in our or their sole discretion,purchase, repay, redeem or retire any of our outstanding debt or equitysecurities (including any publicly issued debt securities), in privatelynegotiated or open market transactions, by tender offer or otherwise.

 

A summary of the changes in our cash and cash equivalents for the ninemonths ended October 2, 2010 and September 26, 2009 is asfollows:

 
| ** **                                                    | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                    | ** ** | **October 2,  2010**       | ** ** | **September 26,  2009** | ** ** |
| Cash provided by operating activities                         |       | $                               | 41,632     |   | $ | 62,567 |   |
| Cash used in investing activities                             |       | (23,039                         | )          | (10,209 | ) |
| Cash used in financing activities                             |       | (11,653                         | )          | (29,661 | ) |
| Effect of exchange rate changes on cash and cash  equivalents |       | (1,307                          | )          | (1,901 | ) |
| Net increase in cash and cash equivalents                     |       | $                               | 5,633      |   | $ | 20,796 |   |

 

***Cash Flows***

 

Operatingactivities provided cash of $41.6 million and $62.6 million for the nine monthsended October 2, 2010 and September 26, 2009, respectively. Cashprovided by operating activities for the nine months ended October 2, 2010primarily reflected our net loss excluding $98.9 million of non-cash items, andan unfavorable change in operating assets of $17.0 million. Cash provided byoperating activities for the nine months ended September 26, 2009consisted of our net loss excluding $99.6 million of non-cash items, and afavorable change in operating assets of $1.4 million.

 

Investing activities used$23.0 million of cash for the nine months ended October 2, 2010 and$10.2 million for the nine months ended September 26, 2009. Cash usedin investing activities for the nine months ended October 2, 2010primarily consisted of $20.3 million of purchases of property and equipment,including $11.6 million for our new ERP system, $1.2 million for theacquisition of our South African distributor, and a $0.8 million paymentrelated to an earn-out provision associated with the 2009 acquisition of ourAustralian distributor. Cash used in investing activities for the nine monthsended September 26, 2009 primarily consisted of $21.8 million of proceedsfrom the sales of assets, partially offset by purchases of property andequipment totaling $19.3 million, including $4.3 million for our new ERPsystem, and the acquisition of businesses for a total of $12.9 million, net ofcash acquired.

 

We used $11.7 million and$29.7 million of cash for financing activities during the nine months ended October 2, 2010and September 26, 2009, respectively. Cash used in financing activitiesfor the nine months ended October 2, 2010 was primarily related to netpayments on long-term debt of $9.0 million and the payment of $3.5 million ofdebt issuance costs incurred in connection with the issuance of our new 10.875%Senior Notes in January 2010. In addition, during the nine months ended October 2,2010, we received an investment of approximately $1.4 million from our indirectparent, from the issuance of DJO Incorporated common stock to certainaccredited investors. Cash used in financing activities for the nine monthsended September 26, 2009 represented net payments on long-term debt andrevolving lines of credit.

 

For the remainder of 2010, we expect to spend total cash ofapproximately $58.5 million for the following:

 

· $13.2 million forscheduled principal and estimated interest payments on our senior securedcredit facility,

· $36.7 million for scheduledinterest payments on our 10.875% senior notes, and

· $8.6 million forcapital expenditures, including $3.3 million for our ERP system.

 

Inaddition, we expect to incur additional costs implementing our new ERP system overthe remainder of the project, which will be expensed as incurred in ourconsolidated statements of operations.

 

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OnOctober 18, 2010, we issued $300.0 million aggregate principal amount ofnew 9.75% Senior Subordinated Notes. We used proceeds from the issuance of the9.75% Notes, along with cash on hand, to repurchase $199.85 millionaggregate principal amount of our 11.75% Notes for total consideration of$222.8 million (which includes applicable premiums and accrued interest fromthe last interest payment date to the settlement date), prepay a total $79.0million of term loans under our Senior Secured Credit Facility, and pay relatedfees and expenses (see Note 18 to our unaudited condensed consolidatingfinancial statements).

 

***Indebtedness***

 

As of October 2, 2010, we had approximately $1,805.4 million inaggregate indebtedness outstanding.

 

*Senior Secured Credit Facility*

 

*Overview.*  The Senior Secured Credit Facility originallyprovided senior secured financing of $1,165.0 million, consisting of a$1,065.0 million term loan facility, of which $933.0 million remainsoutstanding as of October 2, 2010, and a $100.0 million revolvingcredit facility. We issued the term loan facility at a 1.2% discount, resultingin net proceeds of $1,052.4 million. In addition, we are permitted, subjectto receipt of additional commitments from participating lenders and certainother conditions, to incur up to an additional $150.0 million ofborrowings under the Senior Secured Credit Facility.

 

*Interest Rate and Fees.*  Borrowings under the Senior Secured CreditFacility bear interest at a rate equal to an applicable margin plus, at ouroption, either (a) a base rate determined by reference to the higher of(1) the prime rate as defined, and (2) the federal funds rate plus0.50% or (b) the Eurodollar rate determined by reference to the costs offunds for deposits in U.S. dollars for the interest period relevant to eachborrowing adjusted for required reserves. The initial applicable margins forborrowings under the term loan facility and the revolving credit facility is2.00% with respect to base rate borrowings and 3.00% with respect to Eurodollarborrowings. The applicable margin for borrowings under the term loan facilityand the revolving credit facility may be reduced subject to us attainingcertain leverage ratios.

 

We use interest rate swap agreements in an effort to hedge our exposureto fluctuating interest rates related to a portion of our Senior Secured CreditFacility (see Note 7 to our unaudited condensed consolidated financialstatements). As of October 2, 2010, our weighted average interest rate forall borrowings under the Senior Secured Credit Facility was 4.56%.

 

In addition to paying interest on outstanding principal under theSenior Secured Credit Facility, we are required to pay a commitment fee to thelenders under the revolving credit facility in respect of the unutilizedcommitments there under. The initial commitment fee rate is 0.50% per annum.The commitment fee rate may be reduced subject to us attaining certain leverageratios. We must also pay customary letter of credit fees.

 

*Amortization.*  We are required to pay annual amortization(payable in equal quarterly installments) on the loans under the term loanfacility in an amount equal to 1.00% of the funded total principal amountthrough February 2014 with the remaining amount payable in May 2014.Principal amounts outstanding under the revolving credit facility are due andpayable in full at maturity, which is six years from the date of the closing ofthe Senior Secured Credit Facility.

 

*Certain Covenants and Events of Default.*  The Senior Secured Credit Facility contains anumber of covenants that, among other things, restrict, subject to certainexceptions, our and our subsidiaries’ ability to:

 

·                  incur additionalindebtedness,

·                  create liens on assets,

·                  change fiscal years,

·                  enter into sale andleaseback transactions,

·                  engage in mergers orconsolidations,

·                  sell assets,

·                  pay dividends and make otherrestricted payments,

·                  make investments, loans oradvances,

·                  repay subordinatedindebtedness,

·                  make certain acquisitions,

·                  engage in certaintransactions with affiliates,

·                  restrict the ability ofrestricted subsidiaries that are not Guarantors to pay dividends or makedistributions,

·                  amend material agreementsgoverning our subordinated indebtedness, and

·                  change our lines ofbusiness.

 

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Pursuant to the terms of the credit agreement relating to the SeniorSecured Credit Facility, we are required to maintain a maximum senior securedleverage ratio consolidated senior debt to Adjusted EBITDA, of 3.75:1 for thetrailing 12 months ended October 2, 2010, stepping down over time to3.25:1 by the end of 2011. Adjusted EBITDA is defined as net income (loss)attributable to DJO Finance LLC plus(income) loss from discontinuedoperations,  interest expense, net,provision (benefit) for income taxes and depreciation and amortization, furtheradjusted for certain non-cash items, non-recurring items and other adjustmentitems, including the addition of pre-acquisition EBITDA from businessesacquired during the period and certain future cost savings expected to beachieved related to acquisitions, all as permitted in calculating covenantcompliance under our Senior Secured Credit Facility and the Indentures(Adjusted EBITDA). As of October 2, 2010 our actual senior securedleverage ratio was within the required ratio at 3.32:1.

 

*10.875% Senior Notes and 11.75% Senior SubordinatedNotes*

 

The Indentures governing the $675.0 million principal amount of10.875% Notes and the $200.0 million principal amount of 11.75% Noteslimit our (and most or all of our subsidiaries’) ability to:

 

·                  incur additional debt orissue certain preferred shares,

·                  pay dividends on or makeother distributions in respect of our capital stock or make other restrictedpayments,

·                  make certain investments,

·                  sell certain assets,

·                  create liens on certainassets to secure debt,

·                  consolidate, merge, sell orotherwise dispose of all or substantially all of our assets,

·                  enter into certaintransactions with our affiliates, and

·                  designate our subsidiariesas unrestricted subsidiaries.

 

Under the Indentures governing our 10.875% Notes and our 11.75% Notes,our ability to incur additional debt, subject to specified exceptions, is tiedto improving our ratio of Adjusted EBITDA to fixed charges, as defined, orhaving a ratio of at least 2.00:1 on a pro forma basis after giving effect tosuch incurrence. Additionally, our ability to make certain restricted paymentsis also tied to having a ratio of Adjusted EBITDA to fixed charges of at least2.00:1 on a pro forma basis, as defined. Our ratio of Adjusted EBITDA to fixedcharges for the twelve months ended October 2, 2010, measured on that dateon a pro forma basis giving effect to our January 2010 issuance of $100million principal amount of 10.875% Notes and the use of proceeds there from,as if those transactions had occurred at the beginning of such twelve monthperiod, was 1.82:1. Notwithstanding these limitations, the aggregate amount ofterm loan increases and revolving commitment increases shall not exceed thegreater of (i) $150.0 million and (ii) the additional aggregateamount of secured indebtedness which would be permitted to be incurred as ofany date of determination (assuming for this purpose that the full amount ofany revolving credit increase had been utilized as of such date) such that, aftergiving pro forma effect to such incurrence (and any other transactionsconsummated on such date), the senior secured leverage ratio for theimmediately preceding test period would not be greater than 4.00:1. Fixedcharges is defined in the Indentures as consolidated interest expense plus allcash dividends or other distributions paid on any series of preferred stock ofany restricted subsidiary and all dividends or other distributions accrued onany series of disqualified stock.

 

*Covenant Compliance*

 

The following is a summary of our covenantrequirement ratios as of October 2, 2010:

 
| ** **                                                                                                                  | ** ** | **Covenant  Requirements** | ** ** | **Actual  Ratios** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **Senior Secured Credit Facility**                                                                                          |       |                       |       |               |       |
| Maximum ratio of consolidated net senior secured  debt to Adjusted EBITDA                                              |       | 3.75:1                     |       | 3.32:1             |       |
| **10.875% Senior Notes and 11.75%  Senior Subordinated Notes**                                                              |       |                       |       |               |       |
| Minimum ratio of Adjusted EBITDA to fixed charges  required to incur additional debt pursuant to ratio provision, pro forma |       | 2.00:1                     |       | 1.82:1             |       |

 

As described above, our Senior Secured Credit Facility consisting of aterm loan facility of $933.0 million as of October 2, 2010 and a$100.0 million revolving credit facility, along with the Indenturesgoverning the $675.0 million of senior notes and the $200.0 millionof senior subordinated notes represent significant components of our capitalstructure. Under our Senior Secured Credit Facility, we are required tomaintain specified senior secured leverage ratios, which become morerestrictive over time, and which are determined based on our Adjusted EBITDA.If we fail to comply with the senior secured leverage ratio under our SeniorSecured Credit Facility, we would be in default. Upon the occurrence of anevent of default under the Senior Secured Credit Facility, the lenders couldelect to declare all amounts outstanding under the Senior Secured CreditFacility to be immediately due and payable and terminate all commitments toextend further credit. If we were unable to repay those amounts, the lendersunder the 

 

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SeniorSecured Credit Facility could proceed against the collateral granted to them tosecure that indebtedness. We have pledged a significant portion of our assetsas collateral under the Senior Secured Credit Facility. Any acceleration underthe Senior Secured Credit Facility would also result in a default under theIndentures governing the notes, which could lead to the note holders electingto declare the principal, premium, if any, and interest on the then outstandingnotes immediately due and payable. In addition, under the Indentures governingthe notes, our ability to engage in activities such as incurring additionalindebtedness, making investments, refinancing subordinated indebtedness, payingdividends and entering into certain merger transactions is governed, in part,by our ability to satisfy tests based on Adjusted EBITDA.

 

Adjusted EBITDA is defined as net income (loss) attributable to DJOFinance LLC, plus income (loss) from discontinued operations, interest expense,net, provision (benefit) for income taxes and depreciation and amortization,further adjusted for certain non-cash items, non-recurring items and otheradjustment items, including the addition ofpre-acquisition EBITDA from businesses acquired during the period and certainfuture cost savings expected to be achieved related to acquisitions, all as permittedin calculating covenant compliance under our Senior Secured Credit Facility andIndentures. We believe that the presentation of Adjusted EBITDA is appropriateto provide additional information to investors about the calculation of, andcompliance with, certain financial covenants in our Senior Secured Credit Facilityand the Indentures. Adjusted EBITDA is a material component of these covenants.

 

Adjusted EBITDA should not be considered as an alternative to netincome or other performance measures presented in accordance with GAAP, or asan alternative to cash flow from operations as a measure of our liquidity.Adjusted EBITDA does not represent net loss or cash flow from operations asthose terms are defined by GAAP and does not necessarily indicate whether cashflows will be sufficient to fund cash needs. In particular, the definition ofAdjusted EBITDA in the Indentures and our Senior Secured Credit Facility allowsus to add back certain non-cash, extraordinary, unusual or non-recurringcharges that are deducted in calculating net loss. However, these are expenses thatmay recur, vary greatly and are difficult to predict. While Adjusted EBITDA andsimilar measures are frequently used as measures of operations and the abilityto meet debt service requirements, Adjusted EBITDA is not necessarilycomparable to other similarly titled captions of other companies due to thepotential inconsistencies in the method of calculation.

 

Our ability to meet the covenants specified above will depend on futureevents, many of which are beyond our control, and we cannot assure you that wewill meet those covenants. A breach of any of these covenants in the futurecould result in a default under our Senior Secured Credit Facility and theIndentures, at which time the lenders could elect to declare all amountsoutstanding under our Senior Secured Credit Facility to be immediately due andpayable. Any such acceleration would also result in a default under theIndentures.

 

The following table provides a reconciliation from our net loss toAdjusted EBITDA for the three and twelve months ended October 2, 2010 (inthousands). The terms and related calculations are defined in the creditagreement relating to our Senior Secured Credit Facility and the Indentures.

 
| ** **                                           | ** ** | **Three Months  Ended  October 2, 2010** | ** ** | **Twelve Months   Ended  October 2, 2010** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------------------|------------|
|                                                 |       |                                                    |       |                                                           |       |
| Net loss attributable to DJO Finance LLC             |       | $                                                       | (7,715     | )                                                              | $          | (52,796 | ) |
| Net income from discontinued operations, net of  tax |       | —                                                  |       | (115                                                           | )          |
| Interest expense, net                                |       | 37,148                                                  |       | 154,064                                                        |       |
| Income tax benefit                                   |       | (3,191                                                  | )          | (19,760                                                        | )          |
| Depreciation and amortization                        |       | 25,924                                                  |       | 111,468                                                        |       |
| Non-cash charges (a)                                 |       | 659                                                     |       | 3,885                                                          |       |
| Non-recurring and restructuring charges (b)          |       | 11,406                                                  |       | 62,509                                                         |       |
| Other adjustment items (c)                           |       | (2,971                                                  | )          | 4,454                                                          |       |
| Adjusted EBITDA                                      |       | $                                                       | 61,260     |                                                           | $          | 263,709 |   |

 

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(a)          Non-cash charges arecomprised of the following (in thousands):

 
| ** **                             | ** ** | **Three Months  Ended  October 2, 2010** | ** ** | **Twelve Months  Ended  October 2, 2010** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------------|------------|
|                                   |       |                                                    |       |                                                     |       |
| Impairment of assets held for sale (1) |       | $                                                       | —     |                                                     | $          | 1,147 |   |
| Stock compensation expense             |       | 444                                                     |       | 2,356                                                    |       |
| Losses on disposal of assets, net      |       | 215                                                     |       | 382                                                      |       |
| Total non-cash charges                 |       | $                                                       | 659        |                                                     | $          | 3,885 |   |

 

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(1)        As a result of ourintegration of the operations of our Chattanooga division, we exited facilitiesin Hixson, Tennessee and listed the buildings for sale during the nine monthsended October 2, 2010. Based on the current estimated fair market value ofthe buildings, we recorded a $1.1 million non-cash charge during the ninemonths ended October 2, 2010, which has been reflected as impairment ofassets held for sale.

 

(b)         Non-recurring and integration charges are comprisedof the following (in thousands):

 
| ** **                                            | ** ** | **Three Months  Ended  October 2, 2010** | ** ** | **Twelve Months  Ended  October 2, 2010** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------------|------------|
|                                                  |       |                                                    |       |                                                     |       |
| Integration charges:                                  |       |                                                    |       |                                                     |       |
| Employee severance and relocation                     |       | $                                                       | 270        |                                                     | $          | 4,847 |   |
| Chattanooga integration                               |       | 567                                                     |       | 7,837                                                    |       |
| DJO Merger and other integration                      |       | 1,355                                                   |       | 7,287                                                    |       |
| U.S Commercial Sales and Marketing reorganization     |       | 2,540                                                   |       | 7,877                                                    |       |
| International integration                             |       | 16                                                      |       | 1,237                                                    |       |
| Litigation costs and settlements, net                 |       | 1,982                                                   |       | 7,263                                                    |       |
| Additional products liability insurance premiums  (1) |       | —                                                  |       | 11,138                                                   |       |
| ERP implementation                                    |       | 4,676                                                   |       | 15,023                                                   |       |
| Total non-recurring and integration charges           |       | $                                                       | 11,406     |                                                     | $          | 62,509 |   |

 

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(1)        Primarily consists ofinsurance premiums related to a supplemental extended reporting period forproduct liability claims related to our discontinued pain pump products, forwhich annual insurance coverage was not renewed.

 

(c)                                  Otheradjustment items are comprised of the following (in thousands):

 
| ** **                          | ** ** | **Three Months  Ended  October 2, 2010** | ** ** | **Twelve Months  Ended  October 2, 2010** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------------|------------|
|                                |       |                                                    |       |                                                     |       |
| Blackstone monitoring fees          |       | $                                                       | 1,750      |                                                     | $          | 7,000 |   |
| Noncontrolling interests            |       | 184                                                     |       | 1,182                                                    |       |
| Pre-acquisition Adjusted EBITDA (1) |       | —                                                  |       | 443                                                      |       |
| Pre-disposition Adjusted EBITDA (2) |       | —                                                  |       | (100                                                     | )          |
| Other (3)                           |       | (4,905                                                  | )          | (4,071                                                   | )          |
| Total other adjustment items        |       | $                                                       | (2,971     | )                                                        | $          | 4,454 |   |

 

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(1)        Pre-acquisition AdjustedEBITDA for the twelve months ended October 2, 2010 related to theacquisition of the bracing and supports and vascular systems business of ourSouth African distributor.

 

(2)        Pre-disposition AdjustedEBITDA for the twelve months ended October 2, 2010 related to certainimmaterial product lines sold in fiscal year 2009.

 

(3)        Other adjustment itemsconsist primarily of net realized and unrealized foreign currency transactiongains. The twelve months ended October 2, 2010 also included a $3.1 milliongain related to the sale of certain product lines.

 

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**CriticalAccounting Policies and Estimates**

 

Wehave disclosed in our unaudited condensed consolidated financial statements andin “Item 7—Management’s Discussion and Analysis of Financial Condition andResults of Operations” included in our 2009 Annual Report on Form 10-K,those accounting policies that we consider to be significant in determining ourresults of operations and financial condition. There have been no material changesto those policies that we consider to be significant since the filing of our2009 Annual Report on Form 10-K. We believe that the accounting principlesutilized in preparing our unaudited condensed consolidated financial statementsconform in all material respects to GAAP.

 

**ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

We are exposed to certain market risks as part of our ongoing businessoperations, primarily risks from changing interest rates and foreign currencyexchange rates that could impact our financial condition, results ofoperations, and cash flows.

 

***Interest Rate Risk***

 

Our primary exposure is to changing interest rates. We havehistorically managed our interest rate risk by balancing the amounts of ourfixed and variable rate debt. For our fixed rate debt, interest rate changesmay affect the market value of the debt but do not impact our earnings or cashflow. Conversely, for our variable rate debt, interest rate changes generallydo not affect the fair market value of the debt but do impact future earningsand cash flow, assuming other factors are constant. Our senior notes of$875.0 million principal consist of fixed rate notes, while our borrowingsunder the Senior Secured Credit Facility bear interest at floating rates basedon LIBOR or the prime rate, as defined. As of October 2, 2010, we had$933.0 million of borrowings under the Senior Secured Credit Facility. We useinterest rate swap agreements in an effort to hedge our exposure to fluctuatinginterest rates related to a portion of our Senior Secured Credit Facility (seeNotes 7 and 9 to our unaudited condensed consolidated financial statements). Ahypothetical 1% increase in variable interest rates for the portion of theSenior Secured Credit Facility not covered by interest rate swap agreementswould have impacted our earnings and cash flow for the nine months ended October 2,2010, by approximately $1.4 million. We may use additional derivativefinancial instruments where appropriate to manage our interest rate risk.However, as a matter of policy, we do not enter into derivative or otherfinancial investments for trading or speculative purposes.

 

***Foreign Currency Risk***

 

Due to the global reach of our business, we are exposed to market riskfrom changes in foreign currency exchange rates, particularly with respect tothe U.S. dollar compared to the Euro and the Mexican Peso (MXP). Our whollyowned foreign subsidiaries are consolidated into our financial results and aresubject to risks typical of an international business including, but notlimited to, differing economic conditions, changes in political climate,differing tax structures, other regulations and restrictions and foreignexchange volatility. To date, we have not used international currencyderivatives to hedge against our investment in our European subsidiaries ortheir operating results, which are converted into U.S. Dollars at period-endand average foreign exchange rates, respectively. However, as we continue toexpand our business through acquisitions and organic growth, the sales of ourproducts that are denominated in foreign currencies has increased, as well asthe costs associated with our foreign subsidiaries which operate in currenciesother than the U.S. dollar. Accordingly, our future results could be materiallyimpacted by changes in these or other factors. For the three and nine monthsended October 2, 2010, sales denominated in foreign currencies accountedfor approximately 20.8% and 22.0% of our consolidated net sales, respectively,of which 15.1% and 16.5% respectively, were denominated in the Euro. Inaddition, our exposure to fluctuations in foreign currencies arises becausecertain of our subsidiaries enter into purchase or sale transactions using acurrency other than its functional currency. Accordingly, our future resultscould be materially impacted by changes in foreign exchange rates or other factors.Occasionally, we seek to reduce the potential impact of currency fluctuationson our business through hedging transactions. During the nine months ended October 2,2010, we utilized Mexican Peso (MXP) foreign exchange forward contracts tohedge a portion of our exposure to fluctuations in foreign exchange rates, asour Mexico-based manufacturing operations incur costs that are largelydenominated in MXP (see Note 7 to our unaudited condensed consolidatedfinancial statements). These foreign exchange forward contracts expire weeklythroughout fiscal year 2010.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

***Disclosure Controls and Procedures***

 

We maintain disclosure controls and procedures (as the term is definedin Rules 13a-15(e) and 15d-15(e) under the Securities ExchangeAct of 1934, as amended (the Exchange Act) that are designed to ensure thatinformation required to be disclosed in our Exchange Act reports is recorded,processed, summarized and reported within the time periods specified in theCommission’s rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure.

 

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Any controls and procedures, no matter how well designed and operated,can provide only reasonable assurance of achieving the desired controlobjectives. Under the supervision and with the participation of our management,including our Chief Executive Officer and our Chief Financial Officer, weconducted an evaluation of the effectiveness of our disclosure controls andprocedures as of the end of the quarter covered by this report. Based on thisevaluation and subject to the foregoing, our Chief Executive Officer and ourChief Financial Officer concluded that, as of the end of the quarter covered bythis report, the design and operation of our disclosure controls and procedureswere effective to accomplish their objectives at a reasonable assurance level.

 

***Changes in Internal Control overFinancial Reporting***

 

During the first quarter of 2010 we made changes to our internalcontrol over financial reporting in connection with the transition to the newERP system for our Surgical Implant business. This ongoing implementation hasmaterially changed how transactions are being processed and has also changedthe structure and operation of some internal controls. While the ERP changesmaterially affected our internal control over financial reporting during thefirst quarter of 2010, the implementation has proceeded to date withoutmaterial adverse effects on our internal control over financial reporting.Additionally, we established additional temporary compensating controls,including transactional validation and additional reconciliation procedures toensure the accuracy of the reported amounts. We expect to maintain certain ofthese additional temporary compensating controls for a period of time.

 

Except for those changes made in connection with the new ERP system,there were no other changes in the Company’s internal control over financialreporting (as that term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) during the quarter covered by thisreport that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**Part II.OTHER INFORMATION**

 

**ITEM1.  LEGAL PROCEEDINGS**

 

From time to time, we are plaintiffs or defendants in variouslitigation matters in the ordinary course of our business, some of whichinvolve claims for damages that are substantial in amount. We believe that thedisposition of claims currently pending will not have a material adverse effecton our financial position or results of operations.

 

Themanufacture and sale of orthopedic devices and related products exposes us to asignificant risk of product liability claims. From time to time, we have been,and we are currently, subject to a number of product liability claims allegingthat the use of our products resulted in adverse effects. Even if we aresuccessful in defending against any liability claims, such claims couldnevertheless distract our management, result in substantial costs, harm ourreputation, adversely affect the sales of all our products and otherwise harmour business. If there is a significant increase in the number of productliability claims, our business could be adversely affected.

 

We are currently named as oneof several defendants in approximately 100 product liability cases, including alawsuit in Canada seeking class action status, related to a disposable druginfusion pump product (pain pump) manufactured by two third party manufacturersthat we distributed through our Bracing and Supports segment. We discontinuedour sale of these products in the second quarter of 2009. These cases have beenbrought against the manufacturers and certain distributors of these pumps, andin some cases, the manufacturers of the anesthetics used in these pumps. All ofthese lawsuits allege that the use of these pumps with certain anesthetics incertain shoulder surgeries over prolonged periods have resulted in cartilagedamage to the plaintiffs. We have sought indemnity and tendered the defense ofthese cases to the two manufacturers who supplied these pumps to us, to theirproducts liability carriers and to our products liability carriers. Theselawsuits are about equally divided between the two manufacturers. Bothmanufacturers have rejected our tenders of indemnity. Until early 2010, thebase policy for one of the manufacturers was paying for our defense, but thatpolicy has been exhausted by defense costs of the company and the manufacturerand by settlements, and a second policy has been significantly eroded bydefense costs of the company and the manufacturer and is expected to beexhausted by settlements in the near future. This manufacturer has ceasedoperations, has little assets and no additional insurance coverage. The Companyhas asserted indemnification rights against the successor to this manufacturerand intends to pursue its claims appropriately. The base policy for the othermanufacturer has been exhausted and the excess liability carriers for thatmanufacturer have not accepted coverage for the Company and are not expected toprovide for its defense. The Company and this manufacturer have beencooperating in jointly negotiating settlements of those lawsuits in which bothparties are named. Our products liability carriers have accepted coverage ofthese cases, subject to a reservation of the right to deny coverage forcustomary matters, including punitive damages and off-label promotion. In August 2010,one of our excess carriers for the period ending July 1, 2010 and for thesupplemental extended reporting period (SERP) discussed below, which isinsuring $10 million in excess of $25 million, informed us that it has reservedits

 

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right to rescind the policybased on an alleged failure by us and our insurance broker to disclose materialinformation. We disagree with this allegation and are seeking to resolve theissue with this carrier. The lawsuits allege damages ranging from unspecifiedamounts to claims between $1 million and $10 million. We could be exposed tomaterial liabilities if our insurance coverage is not available or inadequateand the resources of the two manufacturers, including their respective productsliability insurance policies, are unavailable or insufficient to pay thedefense costs and settlements or judgments in these cases.

 

In mid-2010, we were namedin three multi-plaintiff lawsuits alleging that the plaintiffs had been injuredfollowing use of certain cold therapy products manufactured by the Company.These lawsuits are in their early stages and were brought by 16, 11 and 19plaintiffs, respectively. The complaints are not specific as to the nature ofthe injuries, but allege various product liability theories, includinginadequate warnings regarding the risks associated with the use of cold therapyand failure to incorporate certain safety features into the design. No specificdollar amounts of damages are alleged. We could be exposed to materialliabilities if our insurance coverage is not available or inadequate to pay thedefense costs and settlements or judgments in these cases.

 

On August 2, 2010, wewere served with a subpoena under the Health Insurance Portability andAccountability Act (HIPAA) seeking numerous documents related to our activitiesinvolving the pain pumps discussed above. The subpoena which was issued by theUnited States Attorney’s Office, Central District of California, refers to anofficial investigation by the U.S. Department of Justice (DOJ) and the U.S.Food and Drug Administration (FDA) of Federal health care offenses. We areproducing documents that are responsive to the subpoena. We believe that ouractions related to our prior distribution of these pain pumps have been incompliance with applicable legal standards. We can make no assurance as to theresources that will be needed to respond to the subpoena or the final outcomeof any investigation or further action.

 

We maintain product liability insurance that is subject to annualrenewal. Our current policy covers claims reported between July 1, 2010and June 30, 2011. No carriers were prepared to cover claims for thisreporting period related to the pain pump products described above andtherefore our current policies exclude coverage for those products. For thecurrent policy year, we maintain coverage limits (together with excesspolicies) of up to $50 million, with self-insured retentions of $500,000 perclaim for claims relating to our cold therapy units, $500,000 per claim forclaims relating to invasive products, $75,000 per claim for claims relating tonon-invasive products other than our cold therapy products, and an aggregateself-insured retention of $2.25 million. We purchased SERP coverage for our $80million limit product liability program that expired on June 30, 2010, andthis supplemental coverage is limited to pain pump claims. Except for theadditional excess coverage mentioned below, this SERP coverage does not provideadditional limits to the aggregate $80 million limit on the expiring programbut does provide that the existing limits of the expiring program will remainavailable for claims reported for an extended period of time. Specifically,pain pump claims may be reported under the $10 million base policy for anindefinite period of time and for a period of five years under the excesslayers. We also purchased additional coverage of $25 million excess of $80million with a five year reporting period. Thus, the SERP coverage has a totallimit of $105 million (less amounts paid for claims reported under the expiringprogram). This coverage is subject to a self-insured retention of $500,000 perclaim for claims related to pain pumps, with an aggregate self-insuredretention of $1.0 million for all products liability claims under either theexpiring program or the SERP program. In addition, the layer of $25 millionexcess over $55 million has a separate self-insured retention of $50,000 perclaim. Our two product liability programs prior to the program that expired on June 30,2010 cover claims reported between July 1, 2007 and February 15, 2008and between February 15, 2008 and July 1, 2009, respectively. The2007-2008 policy provides for coverage (together with excess policies) of up toa limit of $20 million and the 2008-2009 policy provides for coverage (togetherwith excess policies) of up to a limit of $25 million. Certain of the pain pumpcases described above were reported under and are covered by these two policiesas well as the expiring program.

 

If a products liability claim or series of claims is brought against usfor uninsured liabilities or in excess of our insurance coverage, our businesscould suffer materially. In addition, in certain instances, a productsliability claim could also result in our having to recall some of our products,which could result in significant costs to us. Our condensed consolidatedbalance sheets as of October 2, 2010 (unaudited) and December 31,2009, include accrued liabilities of approximately $1.7 million and $2.0million, respectively, for expenses related to products liability claims forproducts other than our pain pump products. The amounts accrued are based uponprevious claims experience in part due to the fact that in 2003 we exceeded thecoverage limits in effect at that time for certain historical product liabilityclaims involving one of our discontinued surgical implant products and suchproducts are excluded from coverage under our current policies.

 

On April 15, 2009, webecame aware of a *qui tam*actionfiled in Federal Court in Boston, Massachusetts in March 2005 and amendedin December 2007 that names us as a defendant along with each of the othercompanies that manufactures and sells external bone growth stimulators, as wellas our principal stockholder, The Blackstone Group, and the principalstockholder of one of the other companies in the bone growth stimulationbusiness. This case is captioned United States *exrel.*Beirman v. Orthofix International, N.V., *et al.*, Civil Action No. 05-10557 (D.Mass.). The case was sealed when originally filed and unsealed inMarch 2009. The plaintiff, or relator, alleges that the defendants haveengaged in Medicare fraud and violated Federal and state false claims acts fromthe time of the original introduction of the devices by each defendant to thepresent by seeking reimbursement for bone growth stimulators as a purchaseditem rather than a rental item. The relator also alleges that the defendantsare engaged in other marketing 

 

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practices constitutingviolations of the Federal and various state anti-kickback statutes. OnDecember 4, 2009, we filed a motion to dismiss the relator’s complaint.The relator filed a second amended complaint in May 2010 that, among otherthings, dropped The Blackstone Group as a defendant. We have filed anothermotion to dismiss directed at the second amended complaint. Shortly beforebecoming aware of the *qui**tam*action, we were advised that our bonegrowth stimulator business was the subject of an investigation by the DOJ, andon April 10, 2009, we were served with a subpoena under HIPAA seekingnumerous documents relating to the marketing and sale by us of bone growthstimulators. On September 21, 2009, we were served with a second HIPAAsubpoena related to this DOJ investigation seeking additional documentsrelating to the marketing and sale by us of bone growth stimulators. We believethat these subpoenas are related to the DOJ’s investigation of the allegationsin the *qui tam*action, althoughthe DOJ has decided not to intervene in the *quitam*action at this time. We believe that our marketing practices inthe bone growth stimulation business are in compliance with applicable legalstandards and we intend to defend this case and investigation vigorously. Wecan make no assurance as to the resources that will be needed to respond tothese matters or the final outcome of such action.

 

**ITEM1A.  RISK FACTORS**

 

For a discussion of theCompany’s potential risks or uncertainties, please seePart I, Item IA, of the Company’s Annual Report onForm 10-K for the fiscal year ended December 31, 2009 filed with theCommission on March 5, 2010. Except for the following factors, there havebeen no material changes to the risk factors disclosed in such Form 10-K.

 

**Risks Related to Our Business**

 

***Changes in Medicare coverage andreimbursement policies for our products could adversely affect our business andresults of operations.***

 

Inrecent years, Congress has enacted a number of laws that impact Medicarereimbursement for and coverage of durable medical equipment (DME), prosthetics,orthotics and supplies (DMEPOS). Such legislation has included temporaryfreezes or reductions in payments for DME and other payment reforms, newclinical conditions for payment, quality standards, enhanced supplier screeningmeasures, and other reforms.

 

TheMedicare Prescription Drug, Improvement and Modernization Act of 2003established a new competitive bidding program for DMEPOS, which eventuallycould impact prefabricated orthotic devices and other of our products. Undercompetitive bidding, Medicare will no longer reimburse for certain products andservices based on the Medicare fee schedule amount in designated competitivebidding areas. Instead, the Medicare program will provide reimbursement forthese items and services based on a competitive bidding process. Only thosesuppliers selected through a competitive bidding process within each designatedregion will be eligible to have their products reimbursed by Medicare. Biddingwas conducted in 2007 for the first phase of competitive bidding in tenmetropolitan statistical areas for ten product categories, none of whichincluded our products, and bid prices briefly went into effect on July 1,2008. The program was scheduled to be expanded to 70 additional areas in 2009,and additional areas thereafter. On July 15, 2008, Congress enacted theMedicare Improvements for Patients and Providers Act of 2008 (MIPPA), whichterminated round one contracts and required the Centers for Medicare &Medicaid Services (CMS) to rebid those areas in 2009. The legislation alsodelayed round two bidding until 2011 and made a series of changes to programrequirements. The delay in bidding was financed by nationwide reduction inMedicare DMEPOS fee schedule payments for 2009 for items that were subject tothe first round of bidding. CMS conducted the rebidding of the first round ofthe competitive bidding program in 2009, with the program scheduled to go intoeffect January 1, 2011. While none of our products are included in theinitial round of items subject to bidding, there is no assurance they will notbe included in the future, since the statute authorizes off-the-shelf orthoticsand transcutaneous electrical nerve stimulation (TENS) devices to be includedin the program. When it is eventually implemented, the competitive biddingprocess will reduce the number of suppliers providing certain items andservices to Medicare beneficiaries and the amounts paid for such items andservices within a given geographic area. Inclusion of any of our products inMedicare competitive bidding or other Medicare reimbursement or coveragereductions could result in such products being sold in lesser quantities or fora lower price. Further, CMS is required to use competitive bid pricinginformation to adjust the payment amounts otherwise in effect for an area thatis not a competitive acquisition area by 2016. Any of these developments couldhave a material adverse effect on our results of operations. In addition, if weare not selected to participate in the competitive bidding program in aparticular region, it could have a material adverse effect on our sales andprofitability.

 

OnMarch 23, 2010, the President signed into law the Patient Protection andAffordable Care Act, which was amended by a second bill signed into law on March 30,2010, known as the Health Care and Education Reconciliation Act (collectivelyreferred to as the Affordable Care Act or ACA). Among other things, the ACAeliminates the full inflation update to the DME fee schedule for the years 2011through 2014. In addition, beginning in 2011, the ACA reduces the inflationupdate for DMEPOS by a “productivity adjustment” factor intended to reflectproductivity gains in delivering health care services. The productivityadjustment is to be based on the change in the 10-year moving average ofchanges in annual economy-wide private nonfarm business multifactorproductivity, which CMS currently estimates will be 1.6 percent in 2011. TheACA also increases to 100 the number of geographic areas to be included inround two of the DMEPOS competitive bidding program.

 

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Governmentagencies, legislative bodies and the private sector continue to proposeinitiatives to limit the growth of healthcare costs, including price regulationand competitive pricing, in markets where we do business. We could experience anegative impact on our operating results due to increased pricing pressure inthe United States and certain other markets. Governments, hospitals and otherthird party payors could reduce the amount of approved payment for the company’sproducts. Reductions in reimbursement levels or coverage, or othercost-containment measures could unfavorably affect our future operating results.

 

***Federal and state health reform and costcontrol efforts include provisions that could adversely impact our business andresults of operations.***

 

TheACA is a sweeping measure designed to expand access to affordable healthinsurance, control health care spending, and improve health care quality.Several provisions of the ACA specifically impact the medical equipmentindustry. In addition to changes in Medicare DMEPOS reimbursement and anexpansion of the DMEPOS competitive bidding program, the ACA imposes a newannual federal excise tax on certain medical device manufacturers andimporters. Specifically, for sales on or after January 1, 2013,manufacturers, producers, and importers of taxable medical devices must pay asan excise tax 2.3% of the price for which the devices are sold. The ACA alsorequires medical supply and device manufacturers to report certain paymentsmade to physicians and other referral sources, effective March 31, 2013.The ACA also establishes new Medicare and Medicaid program integrityprovisions, including expanded documentation requirements for Medicare DMEPOSorders and more stringent procedures for screening Medicare and Medicaid DMEPOSsuppliers, along with broader expansion of federal fraud and abuse authorities.Although the eventual impact of the health reform provisions of the ACA arestill uncertain, it is possible that the legislation will have a materialadverse impact on our business.

 

Likewise,many states have adopted or are considering changes in state health carelegislative and regulatory policies as a result of state budgetary shortfalls.These changes have included reductions in provider and supplier reimbursementlevels under state Medicaid programs, including in some cases reducedreimbursement for DMEPOS items, and/or other Medicaid coverage restrictions. Asstates continue to face significant financial pressures, it is possible thatstate health policy changes will adversely affect our profitability.

 

***If we fail to meet Medicare accreditationand surety bond requirements or DMEPOS supplier standards, it could negativelyimpact our business operations.***

 

MedicareDMEPOS suppliers (other than certain exempted professionals) must be accreditedby an approved accreditation organization as meeting DMEPOS Quality Standardsadopted by CMS, including specific requirements for suppliers ofcustom-fabricated and custom-fitted orthoses and certain prosthetics. Medicaresuppliers also are required to meet surety bond requirements. We believe we arein compliance with current requirements in this area. CMS also recentlyclarified and expanded the requirements that DMEPOS suppliers must meet toestablish and maintain Medicare billing privileges. On August 27, 2010,CMS published a final rule that, among other things, prohibits suppliersfrom sharing a practice location in certain circumstances, imposes new physicalfacility requirements on suppliers, clarifies the prohibition on the directsolicitation of Medicare beneficiaries, generally prohibits suppliers fromcontracting with another individual to perform licensed services, and clarifiesa number of other supplier operational requirements. The rule generally iseffective September 27, 2010 (although there are separate deadlines forcompliance with the physical facility standards for existing suppliers withleases that expire after that date). We believe we are in compliance with therequirements of the new rule. If in the future we fail to maintain our Medicareaccreditation status and/or do not comply with Medicare surety bond or supplierstandard requirements, or if these requirements are expanded in the future, itcould adversely impact our profits and results of operation.

 

***The success of our surgical implantproducts depends on our relationships with leading surgeons who assist with thedevelopment and testing of our products.***

 

Akey aspect of the development and sale of our surgical implant products is theuse of designing and consulting arrangements with orthopedic surgeons who arewell recognized in the healthcare community. These surgeons assist in thedevelopment and clinical testing of new surgical implant products. They alsoparticipate in symposia and seminars introducing new surgical implant productsand assist in the training of healthcare professionals in using our newproducts. We may not be successful in maintaining or renewing our currentdesigning and consulting arrangements with these surgeons or in developingsimilar arrangements with new surgeons. In that event, our ability to develop,test and market new surgical implant products could be adversely affected.

 

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Inaddition, the ACA establishes new disclosure requirements regarding financialarrangements between medical device and supplies manufacturers and physicians,including physicians who serve as consultants, effective March 31, 2013. Anumber of states also have enacted specific marketing and payment disclosurerequirements and others may do so in the future. Likewise, voluntary industryguidelines have been adopted regarding device manufacturer financialarrangements with physicians and other health care professionals. We cannotdetermine at this time the impact, if any, of such requirements or voluntaryguidelines on our relationships with surgeons, but there can be no assurancesthat such requirements and guidelines would not impose additional costs on usand/or adversely impact our consulting and other arrangements with surgeons.

 

***Implementation of CMS’s “Consignment Closet”policy could require changes in our OfficeCare business model that couldadversely affect our business.***

 

OnAugust 7, 2009, CMS issued Transmittal 297 entitled “Compliance Standardsfor Consignment Closets and Stock and Bill Arrangements” (the Transmittal),requiring a change in procedures in stock and bill arrangements for Medicarebeneficiaries. When implemented, the Transmittal will require productsdispensed to a Medicare beneficiary from the inventory in our OfficeCareaccounts in physician office settings to be fitted and billed to Medicare bythe physician rather than by us. Title to the product must pass to thephysician at the time the product is dispensed to the patient. The effect ofthis change in most instances would be to convert a billing opportunity by usinto a sale to the physician at a wholesale price. The Transmittal wasoriginally scheduled to go into effect on September 8, 2009, but CMS firstdelayed the effective date until March 1, 2010, and on February 4,2010 CMS rescinded the Transmittal in order to consider other implementationdates. CMS has indicated that it would not enforce any policy on consignmentclosets without issuing a new transmittal. If the Transmittal goes into effectas written, it could adversely affect the revenue and, to a lesser extent,profitability of our OfficeCare business.

 

***Proposed laws that would limit the types oforthopedic professionals who can fit, sell or seek reimbursement for our productscould, if adopted, adversely affect our business.***

 

Inresponse to pressure from certain groups (mostly orthotists), the U.S. Congressand state legislatures have periodically considered proposals that limit thetypes of orthopedic professionals who can fit or sell our orthotic deviceproducts or who can seek reimbursement for them. Several states have adoptedlegislation which imposes certification or licensing requirements on themeasuring, fitting and adjusting of certain orthotic devices. Although most ofthese state laws exempt manufacturers’ representatives, other states’ lawssubject the activities of such representatives to certification or licensingrequirements. Additional states may be considering similar legislation. Suchlaws could reduce the number of potential customers by restricting theactivities of our sales representatives in those jurisdictions where suchlegislation or regulations are enacted. Furthermore, because the sales oforthotic devices are driven in part by the number of professionals who fit andsell them, laws that limit these activities could reduce demand for theseproducts. We may not be successful in opposing the adoption of such legislationor regulations and, therefore, such laws could have a material adverse effect onour business.

 

Inaddition, efforts have been made to establish similar requirements at thefederal level for the Medicare program. For example, in 2000, Congress passedthe Medicare, Medicaid and SCHIP Benefits Improvement and Protection Act of2000 (BIPA). BIPA contained a provision requiring, as a condition for paymentby the Medicare program, that certain certification or licensing requirementsbe met for individuals and suppliers furnishing certain, but not all,custom-fabricated orthotic devices. Although CMS has not implemented thisrequirement to date, Medicare follows state requirements in those states thatrequire the use of an orthotist or prosthetist for furnishing of orthotics orprosthetics. We cannot predict the effect that implementation of BIPA orimplementation of other such laws will have on our business and can provide noassurance that such laws will not have a material adverse impact on ourbusiness.

 

***If adequate levels of reimbursementcoverage from third party payors for our products are not obtained, healthcareproviders and patients may be reluctant to use our products, and our sales maydecline.***

 

Oursales depend largely on whether there is adequate reimbursement coverage bygovernment healthcare programs, such as Medicare and Medicaid, and by privatepayors. We believe that surgeons, hospitals, physical therapists and otherhealthcare providers may not use, purchase or prescribe our products andpatients may not purchase our products if these third party payors do notprovide satisfactory coverage of and reimbursement for the costs of ourproducts or the procedures involving the use of our products. Consequently, wemay be unable to sell our products on a profitable basis if third party payorsdeny coverage, reduce their current levels of reimbursement or fail to causetheir levels of reimbursement to rise quickly enough to cover cost increases.

 

Changesin the coverage of, and reimbursement for, our products by these third partypayors could have a material adverse effect on our results of operations. Thirdparty payors continue to review their coverage and reimbursement policiescarefully for existing and new therapies and can, without notice, decide not toreimburse for treatments that include the use of our products. For example, somethird party payors have ceased reimbursing us for one of our bone growthstimulators for certain indications. They may also attempt to control costs by (i) authorizingfewer elective surgical procedures, including joint reconstructive surgeries, (ii) requiringthe use of the least expensive product available or (iii) reducing thereimbursement for or limiting the number of authorized 

 

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visitsfor rehabilitation procedures. For example, in the United States, Congress andCMS frequently engage in efforts to contain costs, which may result inlimitations in Medicare coverage of, and/or reduced reimbursement for, ourproducts. Additionally, because many private payors model their coverage andreimbursement policies on Medicare policies, third party payors’ coverage ofand reimbursement for our products could be negatively impacted by legislative,regulatory or other measures that reduce Medicare coverage and reimbursementgenerally.

 

Ourinternational sales also depend in part upon the coverage and eligibility forreimbursement of our products through government-sponsored healthcare paymentsystems and third party payors, the amount of reimbursement and the costallocation of payments between the patient and government- sponsored healthcarepayment systems and third party payors. Coverage and reimbursement practicesvary significantly by country, with certain countries requiring products toundergo a lengthy regulatory review in order to be eligible for third partycoverage and reimbursement. In addition, healthcare cost containment effortssimilar to those we face in the United States are prevalent in many of the foreigncountries in which our products are sold, and these efforts are expected tocontinue in the future, possibly resulting in the adoption of more stringentreimbursement standards. For example, in Germany, our largest foreign countrymarket, new regulations generally require adult patients to pay a portion ofthe cost of each medical technical device purchased. This may adversely affectour sales and profitability by making it more difficult for patients in Germanyto pay for our products.

 

Anydevelopments in the United States or our foreign markets that eliminate, reduceor materially modify coverage of, and reimbursement rates for, our productscould have a material adverse effect on our ability to sell our products.

 

***Our success depends on receiving regulatoryapproval for our products, and failure to do so could adversely affect ourgrowth and operating results.***

 

Ourproducts are subject to extensive regulation in the United States by the FDAand by similar governmental authorities in the foreign countries where we dobusiness. The FDA regulates virtually all aspects of a medical device’sdevelopment, testing, manufacturing, labeling, promotion, distribution andmarketing. In general, unless an exemption applies, a medical device mustreceive either pre-market approval or pre-market clearance from the FDA beforeit can be marketed in the United States. While in the past we have receivedsuch approvals and clearances, we may not be successful in the future inreceiving such approvals and clearances in a timely manner or at all. The FDArecently asked the Institute of Medicine (IOM) to conduct a two-year study ofthe clearance process for devices under § 510(k) of the Food, Drug, andCosmetic Act, as amended, and to provide recommendations for changes, if necessary.In addition, the FDA completed an internal review of the clearance process andissued a 510(k) Preliminary Report and Recommendations on August 4,2010. Among other things, the FDA report recommends the development of a subsetof moderate-risk (Class II) devices called “Class IIb,” for whichclinical or manufacturing data typically would be necessary to support asubstantial equivalence determination required for clearance of a device. The510(k) Preliminary Report also recommends that FDA consider revisingregulations to explicitly require 510(k) submitters to provide a summaryof all scientific information known or that the submitter should reasonablyknow regarding the safety and effectiveness of the device under review. This isnot required now for 510(k) submissions. In addition, the IOM is expectedto complete its study in 2012, in which additional changes may be recommended.Many of our products are cleared for marketing under the 510(k) processthat the FDA and the IOM are reviewing and the FDA’s recommended changes wouldmake this process more onerous, time consuming and expensive. If we begin tohave significant difficulty obtaining such FDA approvals or clearances in atimely manner or at all, we could suffer a material adverse effect on our revenuesand growth.

 

***If we fail to obtain regulatory approvalfor the modification of, or new uses for, our products, or if safety concernsemerge for any of our marketed products, or if our any of our productclearances or approvals are withdrawn, our growth and operating results couldsuffer.***

 

Inorder to market modifications to our existing products or market our existingproducts for new indications, we may be required to obtain pre-marketapplication approvals, pre-market supplement approvals or pre-marketclearances. The FDA requires device manufacturers themselves to make anddocument a determination of whether or not a modification requires a newapproval or clearance; however, the FDA can review and disagree with amanufacturer’s decision. We may not be successful in receiving such approvalsor clearances or the FDA may not agree with our decisions not to seek approvalsor clearances for any particular device modification. The FDA may require anapproval or clearance for any past or future modification or a new indicationfor our existing products. The FDA may also require additional clinical orpreclinical data in such submissions, which may be time consuming and costly,and may not ultimately approve or clear one or more of our products for marketing.In addition, the FDA may require additional data after a device has beenapproved or cleared for marketing, or withdraw clearance or approval, if anynew safety concerns emerge after the product enters the market. If the FDArequires us to obtain pre-market approvals, pre-market supplement approvals,pre-market clearances for any modification to a previously cleared or approveddevice, or if the FDA requires us to obtain additional post-marketing data orwithdraws approval or clearance, we may be required to cease manufacturing andmarketing the modified device or to recall such modified device until we obtainFDA clearance or approval, and we may be subject to significant regulatoryfines or penalties. In addition, the FDA may not clear or approve such submissionsin a timely manner, if at all. Because a significant portion of our revenues isgenerated by products that are modified or used for new treatments, delays orfailures in obtaining such approvals could reduce our revenue and adverselyaffect our operating results.

 

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OnApril 5, 2010, the FDA proposed a rule titled, “Neurological andPhysical Medicine Devices, Designation of Special Controls for Certain Class IIDevices and Exemption from Premarket Notification,” that would, among otherthings, exempt certain class II neurological medical devices from 510(k) premarketnotification requirements. Included in this subset are “limited output” TENSdevices for pain relief, TENS devices for aesthetic purposes, neuromuscularelectrical nerve stimulation (NMES) devices for rehabilitation, and NMESdevices for muscle conditioning. We manufacture and market these types ofdevices. If the FDA decides to finalize the rule as proposed, there couldbe an influx of TENS and NMES devices into the market which would increasecompetition and which could have a material adverse effect on our business.

 

***We may fail to receive positive clinicalresults for our products in development that require clinical trials, and evenif we receive positive clinical results, we may still fail to receive thenecessary clearance or approvals to market our products.***

 

Inthe development of new products or new indications for, or modifications to,existing products, we may be required to conduct or sponsor clinical trials.Clinical trials are expensive and require significant investment of time andresources and may not generate the data we need to support a submission to theFDA. Clinical trials are subject to regulation by the FDA and, if federal fundsare involved or if an investigator or site has signed a federal assurance, wewill be subject to further regulation by the Office for Human ResearchProtections and the National Institutes of Health. Failure to comply with suchregulation, including, but not limited to, failure to obtain adequate consentof subjects, failure to adequately disclose financial conflicts or failure toreport data or adverse events accurately, could result in fines, penalties,suspension of trials and the inability to use the data to support an FDAsubmission. In addition, the American Recovery and Reinvestment Act expandsfederal efforts to compare the effectiveness of different medical treatments,which could include some element of explicit cost or cost effectivenesscomparisons; research supported by these efforts eventually could be used toguide public and private coverage and reimbursement policies. In the internationalmarket, we are subject to regulations for clinical studies in each respectivecountry.

 

***If the Department of Health and HumanServices (HHS), the Office of Inspector General (OIG), the FDA or anotherregulatory agency determines that we have promoted off-label use of ourproducts, we may be subject to various penalties, including civil or criminalpenalties, and the off-label use of our products may result in injuries thatlead to product liability suits, which could be costly to our business.***

 

TheOIG, the FDA and other regulatory agencies actively enforce regulationsprohibiting the promotion of a medical device for a use that has not beencleared or approved by the FDA. Use of a device outside its cleared or approvedindications is known as “off-label” use. Physicians may use our products foroff-label uses, as the FDA does not restrict or regulate a physician’s choiceof treatment within the practice of medicine. However, if the OIG or the FDA oranother regulatory agency determines that our promotional materials, trainingor activities constitutes improper promotion of an off-label use, it couldrequest that we modify our promotional materials, training or activities, orsubject us to regulatory enforcement actions, including the issuance of awarning letter, injunction, seizure, civil fine and criminal penalties.Although our policy is to refrain from statements and activities that could beconsidered off-label promotion of our products, the FDA, another regulatoryagency or the DOJ could disagree and conclude that we have engaged in off-labelpromotion and, potentially, aided and abetted in the submission of falseclaims. In addition, the off-label use of our products may increase the risk ofinjury to patients, and, in turn, the risk of product liability claims. Productliability claims are expensive to defend and could divert our management’sattention and result in substantial damage awards against us.

 

OnAugust 2, 2010, we were served with a subpoena under HIPAA seekingnumerous documents related to our activities involving the manufacture anddistribution of pain pumps. The subpoena, which was issued by the United StatesAttorney’s Office, Central District of California, refers to an officialinvestigation by the DOJ and the FDA of federal health care offenses. We areproducing documents that are responsive to the subpoena. We believe that ouractions related to our prior distribution of these pain pumps have been incompliance with applicable legal standards. We can make no assurance as to theresources that will be needed to respond to the subpoena or the final outcomeof any investigation or further action.

 

***Various federal and state agencies havebecome increasingly vigilant in recent years in their investigation of variousbusiness practices under various healthcare “fraud and abuse” laws with respectto our business arrangements, including our interactions with prescribingphysicians and other health care professionals.***

 

Weare directly, or indirectly through our customers, subject to various federaland state laws pertaining to healthcare fraud and abuse. These laws, whichdirectly or indirectly affect our ability to operate our business include, butare not limited to, the following:

 

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· the federal Anti-Kickback Statute, which prohibits persons fromknowingly and willfully soliciting, offering, receiving or providingremuneration, directly or indirectly, in cash or in kind, to induce either thereferral of an individual, or the furnishing or arranging for or recommendingof a good or service, for which payment may be made under federal healthcareprograms, such as Medicare and Medicaid, Veterans Administration healthprograms and TRICARE;

 

· several federal False Claims statutes, which impose civil and criminalliability on individuals and entities who submit, or cause to be submitted,false or fraudulent claims for payment to the government, or fail to returnamounts received from a government payor within 60 days of identifying the overpayment;

 

· HIPAA, which prohibits executing a scheme to defraud any healthcarebenefit program, and also prohibits false statements, defined as knowingly andwillfully falsifying, concealing or covering up a material fact or making anymaterially false statement in connection with the delivery of or payment forhealthcare benefits, items or services;

 

· the federal physician self-referral prohibition, commonly known as theStark Law, which, in the absence of a statutory or regulatory exception,prohibits the referral of Medicare and Medicaid patients by a physician to anentity for the provision of certain designated healthcare services, if thephysician or a member of the physician’s immediate family has a direct orindirect financial relationship, including an ownership interest in, or acompensation arrangement with, the entity and also prohibits that entity fromsubmitting a bill to a federal payor for services rendered pursuant to aprohibited referral; and

 

· state law equivalents to the Anti-Kickback Statute, the false claimsprovisions, the Stark Law and the physician self-referral prohibitions, some ofwhich may apply even more broadly than their federal counterparts because theyare not limited to government reimbursed items and include items or servicesreimbursed by any payor.

 

Thefederal government has significantly increased investigations of andenforcement activity involving medical device manufacturers with regard toalleged kickbacks and other forms of remuneration to physicians who use andprescribe their products. Such investigations often arise based on allegationsof violations of the federal Anti-Kickback Statute and sometimes allegeviolations of the civil False Claims Act, in connection with off-labelmarketing of products to physicians and others. We, like other companies in theorthopedic industry, are involved in ongoing governmental investigations, theresults of which may adversely impact our business and results of operations.Defendants determined to be liable under the False Claims Act may be requiredto pay three times the actual damages sustained by the government, plusmandatory civil penalties ranging between $5,500 and $11,000 for each falseclaim.

 

OnApril 15, 2009, we became aware of a *quitam*action filed in Federal Court in Boston, Massachusetts in March 2005and amended in December 2007 that names us as a defendant along with eachof the other companies that manufactures and sells external bone growthstimulators, as well as our principal stockholder, The Blackstone Group, andthe principal stockholder of one of the other companies in the bone growthstimulation business. This case is captioned United States *ex rel.*Beirman v. Orthofix International,N.V., *et al.*, Civil Action No. 05-10557(D. Mass.). The case was sealed when originally filed and unsealed in March 2009.The plaintiff, or relator, alleges that the defendants have engaged in Medicarefraud and violated Federal and state false claims acts from the time of theoriginal introduction of the devices by each defendant to the present byseeking reimbursement for bone growth stimulators as a purchased item ratherthan a rental item. The relator also alleges that the defendants are engaged inother marketing practices constituting violations of the Federal and variousstate anti-kickback statutes. On December 4, 2009, we filed a motion todismiss the relator’s complaint. The relator filed a second amended complaintin May 2010 that, among other things, dropped The Blackstone Group as adefendant. We have filed another motion to dismiss directed at the secondamended complaint. Shortly before becoming aware of the *qui tam*action, we were advised that ourbone growth stimulator business was the subject of an investigation by the DOJ,and on April 10, 2009, we were served with a subpoena under HIPAA seekingnumerous documents relating to the marketing and sale by us of bone growthstimulators. On September 21, 2009, we were served with a second HIPAAsubpoena related to this DOJ investigation seeking additional documentsrelating to the marketing and sale by us of bone growth stimulators. We believethat these subpoenas are related to the DOJ’s investigation of the allegationsin the *qui tam*action, althoughthe DOJ has decided not to intervene in the *quitam*action at this time. We believe that our marketing practices inthe bone growth stimulation business are in compliance with applicable legalstandards and we intend to defend this case and investigation vigorously. Wecan make no assurance as to the resources that will be needed to respond tothese matters or the final outcome of such action.

 

Thefraud and abuse laws and regulations are complex and even minor, inadvertentirregularities in submissions can potentially give rise to investigations andclaims that the law has been violated. Any violations of these laws orregulations could result in a material adverse effect on our business,financial condition and results of operations. If there is a change in law,regulation or administrative or judicial interpretations, we may have to changeone or more of our business practices to be in compliance with these laws.Required changes could be costly and time consuming. Any failure to makerequired changes could result in our losing business or our existing businesspractices being challenged as unlawful.

 

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*** ***

***Our activities are subject to FederalPrivacy and Transaction Law and Regulations, which could have an impact on ouroperations.***

 

HIPAAimpacts the transmission, maintenance, use and disclosure of certainindividually identifiable health information (referred to as protected healthinformation or PHI). Since HIPAA was enacted in 1996, numerous implementingregulations have been issued, including, but not limited to: (1) standardsfor the privacy of individually identifiable health information (the PrivacyRule), (2) security standards (the Security Rule), (3) standards forelectronic transactions (the Transactions Rule) and (4) standard uniquenational provider identifier (NPI Rule). We refer to these rules as theAdministrative Simplification Rules. CMS has also issued regulations governingthe enforcement of the Administrative Simplification Rules. Sanctions forviolation of HIPAA and /or the Administrative Simplification Rules includecriminal and civil penalties.

 

HIPAAapplies to “covered entities,” which includes certain health care providers whoconduct certain transactions electronically. As such, HIPAA and theAdministrative Simplification Rules apply to certain aspects of ourbusiness. The effective date for all of the Administrative Simplification Rules outlinedabove has passed, and, as such, all of the Administrative Simplification Rules arein effect. To the extent applicable to our operations, we believe we arecurrently in compliance with HIPAA and the applicable AdministrativeSimplification Rules. Any failure to comply with applicable requirements couldadversely affect our profitability.

 

OnFebruary 17, 2009, President Obama signed into law the Health InformationTechnology for Economic and Clinical Health Act (HITECH Act) as part of theAmerican Recovery and Reinvestment Act. This economic stimulus package includesmany health care policy provisions, including strengthened federal privacy andsecurity provisions to protect personally-identifiable health information, suchas notification requirements for health data security breaches. Many of thedetails of the new requirements are being implemented through regulations,including (1) an interim final rule published October 30, 2009,enhancing the enforcement provisions of the Administrative SimplificationRules, (2) an interim final rule published August 24, 2009,addressing the obligations associated with a breach of unsecured protectedhealth information committed by a “covered entity” or “business associate” and (3) aproposed rule published on July 14, 2010, modifying the HIPAAPrivacy, Security, and Enforcement Rules in furtherance of the associatedprivacy and security related provisions of the HITECH Act. We are reviewingthese new requirements to assess the potential impact on our operations. Anyfailure to comply with applicable requirements could adversely affect ourprofitability.

 

***Product liability claims may harm ourbusiness, particularly if the number of claims increases significantly or ourproduct liability insurance proves inadequate.***

 

Themanufacture and sale of orthopedic devices and related products exposes us to asignificant risk of product liability claims. From time to time, we have been,and we are currently, subject to a number of product liability claims allegingthat the use of our products resulted in adverse effects. Even if we aresuccessful in defending against any liability claims, such claims couldnevertheless distract our management, result in substantial costs, harm ourreputation, adversely affect the sales of all our products and otherwise harmour business. If there is a significant increase in the number of productliability claims, our business could be adversely affected.

 

Weare currently named as one of several defendants in approximately 100 productliability cases, including a lawsuit in Canada seeking class action status,related to a disposable drug infusion pump product (pain pump) manufactured bytwo third party manufacturers that we distributed through our Bracing andSupports segment. We discontinued our sale of these products in the secondquarter of 2009. These cases have been brought against the manufacturers andcertain distributors of these pumps, and in some cases, the manufacturers ofthe anesthetics used in these pumps. All of these lawsuits allege that the useof these pumps with certain anesthetics in certain shoulder surgeries overprolonged periods have resulted in cartilage damage to the plaintiffs. We havesought indemnity and tendered the defense of these cases to the twomanufacturers who supplied these pumps to us, to their products liabilitycarriers and to our products liability carriers. These lawsuits are aboutequally divided between the two manufacturers. Both manufacturers have rejectedour tenders of indemnity. Until early 2010, the base policy for one of the manufacturerswas paying for our defense, but that policy has been exhausted by defense costsof the company and the manufacturer and by settlements, and a second policy hasbeen significantly eroded by defense costs of the company and the manufacturerand is expected to be exhausted by settlements in the near future. Thismanufacturer has ceased operations, has little assets and no additionalinsurance coverage. The Company has asserted indemnification rights against thesuccessor to this manufacturer and intends to pursue its claims appropriately.The base policy for the other manufacturer has been exhausted and the excessliability carriers for that manufacturer have not accepted coverage for thecompany or provided for its defense. Our products liability carriers haveaccepted coverage of these cases, subject to a reservation of the right to denycoverage for customary matters, including punitive damages and off-labelpromotion. In August 2010, one of our excess carriers for the periodending July 1, 2010 and for the supplemental extended reporting period(SERP) discussed below, which is insuring $10 million in excess of $25 million,informed us that it has reserved its right to rescind the policy based on analleged failure by us and our insurance broker to disclose materialinformation. We disagree with this allegation and are

 

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seekingto resolve the issue with this carrier. The lawsuits allege damages rangingfrom unspecified amounts to claims between $1 million and $10 million. Thesecases are in varying stages from initial pleading and discovery to pre-trialpreparation. We could be exposed to material liabilities if our insurancecoverage is not available or inadequate and the resources of the twomanufacturers, including their respective products liability insurancepolicies, are unavailable or insufficient to pay the defense costs andsettlements or judgments in these cases.

 

Inmid-2010, we were named in three multi-plaintiff lawsuits alleging that theplaintiffs had been injured following use of certain cold therapy productsmanufactured by the Company. These lawsuits are in their early stages and werebrought by 16, 11 and 19 plaintiffs, respectively. The complaints are notspecific as to the nature of the injuries, but allege various product liabilitytheories, including inadequate warnings regarding the risks associated with theuse of cold therapy and failure to incorporate certain safety features into thedesign. No specific dollar amounts of damages are alleged. We could be exposedto material liabilities if our insurance coverage is not available orinadequate to pay the defense costs and settlements or judgments in thesecases.

 

Wemaintain product liability insurance that is subject to annual renewal. Ourcurrent policy covers claims reported between July 1, 2010 and June 30,2011. No carriers were prepared to cover claims for this reporting period relatedto the pain pump products described above and therefore our current policiesexclude coverage for those products. For the current policy year, we maintaincoverage limits (together with excess policies) of up to $50 million, withself-insured retentions of $500,000 per claim for claims relating to our coldtherapy units, $500,000 per claim for claims relating to invasive products,$75,000 per claim for claims relating to non-invasive products other than ourcold therapy products, and an aggregate self-insured retention of $2.25million. We purchased SERP coverage for our $80 million limit product liabilityprogram that expired on June 30, 2010, and this supplemental coverage islimited to pain pump claims. Except for the additional excess coverage mentionedbelow, this SERP coverage does not provide additional limits to the aggregate$80 million limit on the expiring program but does provide that the existinglimits of the expiring program will remain available for claims reported for anextended period of time. Specifically, pain pump claims may be reported underthe $10 million base policy for an indefinite period of time and for a periodof five years under the excess layers. We also purchased additional coverage of$25 million excess of $80 million with a five year reporting period. Thus, theSERP coverage has a total limit of $105 million (less amounts paid for claimsreported under the expiring program). This coverage is subject to aself-insured retention of $500,000 per claim for claims related to pain pumps,with an aggregate self-insured retention of $1.0 million for all productsliability claims under either the expiring program or the SERP program. Inaddition, the layer of $25 million excess over $55 million has a separateself-insured retention of $50,000 per claim. Our two products liabilityprograms prior to the program that expired on June 30, 2010 cover claimsreported between July 1, 2007 and February 15, 2008 and between February 15,2008 and July 1, 2009, respectively. The 2007-2008 policy provides forcoverage (together with excess policies) of up to a limit of $20 million andthe 2008-2009 policy provides for coverage (together with excess policies) ofup to a limit of $25 million. Certain of the pain pump cases described abovewere reported under and are covered by these two policies as well as theexpiring program. If our existing products liability insurance provesinsufficient to cover our existing or future claims, including those related tothe pain pump products discussed above, we could suffer a material adverseimpact to our business and results of operations.

 

**ITEM6.  EXHIBITS**

 

(a)*                   **Exhibits*

 
| 3.1   |   | Certificate  of Formation of DJOFL and amendments thereto (incorporated by reference to  Exhibit 3.1 to DJOFL’s Annual Report on Form 10-K for the fiscal  year ended December 31, 2007, filed on March 28, 2008). |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | Limited  Liability Company Agreement of DJOFL (incorporated by reference to  Exhibit 3.2 to DJOFL’s Registration Statement on Form S-4, filed  April 18, 2007 (File No. 333-142188)).                              |
| 31.1+ |   | Certification  (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Executive  Officer.                                                                                                                                         |
| 31.2+ |   | Certification  (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Financial  Officer.                                                                                                                                         |
| 32.1+ |   | Section 1350—Certification  (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief  Executive Officer.                                                                                                         |
| 32.2+ |   | Section 1350—Certification  (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief  Financial Officer.                                                                                                         |

 

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+          Filed herewith

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
| ** **                   | ** ** | **DJO FINANCE LLC** |
|------------------------------|------------|--------------------------|
|                         |       |                     |
| Date:  November 4, 2010 |       | By:                      | /s/  LESLIE H. CROSS |
|                         |       |                     | Leslie  H. Cross *President and Chief Executive Officer* |
|                         |       |                     |
| Date:  November 4, 2010 |       | By:                      | /s/  VICKIE L. CAPPS |
|                         |       |                     | Vickie  L. Capps *Executive Vice President, Chief Financial  Officer and Treasurer* |

 

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