Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For thequarterly period ended September 26, 2009**

** **

**or**

** **

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

** **

**For thetransition periodfrom              to              .**

 

**Commissionfile number 333-142188**

 

**DJO Finance LLC**

(Exact name of Registrant asspecified in its charter)

 

| **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

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas 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 reportingcompany. See the definitions of “large accelerated filer”, “accelerated filer”,and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

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 October 29, 2009, 100% of the issuer’s membership interestswere owned by DJO Holdings LLC.

 

 

 

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**DJO FINANCE LLC**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| ** **    | ** ** | ** **                                                                                                                                               | ** ** | **Page  No.** |
|---------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|
|          |       | **PART I—Financial  Information**                                                                                                              |       |          |
| Item 1.  |       | Unaudited  Condensed Consolidated Balance Sheets as of September 26, 2009 and December 31,  2008                                               |       | 3             |
|          |       | Unaudited  Condensed Consolidated Statements of Operations for the three and nine months  ended September 26, 2009 and September 27, 2008 |       | 4             |
|          |       | Unaudited  Condensed Consolidated Statements of Cash Flows for the nine months ended  September 26, 2009 and September 27, 2008                |       | 5             |
|          |       | Notes to  Unaudited Condensed Consolidated Financial Statements                                                                                          |       | 6             |
| Item 2.  |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                                              |       | 31            |
| Item 3.  |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                                              |       | 45            |
| Item 4.  |       | Controls and  Procedures                                                                                                                                 |       | 46            |
|          |       | **PART II—Other  Information**                                                                                                                 |       |          |
| Item 1.  |       | Legal Proceedings                                                                                                                                        |       | 46            |
| Item 1A. |       | Risk Factors                                                                                                                                             |       | 47            |
| Item 6.  |       | Exhibits                                                                                                                                                 |       | 48            |
| SIGNATURES    |       | 49                                                                                                                                                       |

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**DJOFinance LLC**

 

**Unaudited Condensed Consolidated Balance Sheets**

 

**(inthousands)**

 
| ** **                                                 | ** ** | **September 26,  2009** | ** ** | **December 31,  2008** | ** ** |
|------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                 |       |                         |       |                        |       |
| Current assets:                                            |       |                         |       |                        |       |
| Cash and cash equivalents                                  |       | $                            | 51,279     |                        | $          | 30,483 |   |
| Accounts receivable, net                                   |       | 160,442                      |       | 164,618                     |       |
| Inventories, net                                           |       | 97,112                       |       | 103,166                     |       |
| Deferred tax assets, net                                   |       | 37,561                       |       | 34,039                      |       |
| Prepaid expenses and other current assets                  |       | 18,120                       |       | 16,923                      |       |
| Total current assets                                       |       | 364,514                      |       | 349,229                     |       |
| Property and equipment, net                                |       | 84,721                       |       | 86,262                      |       |
| Goodwill                                                   |       | 1,193,044                    |       | 1,191,566                   |       |
| Intangible assets, net                                     |       | 1,214,554                    |       | 1,260,472                   |       |
| Other non-current assets                                   |       | 45,250                       |       | 52,601                      |       |
| Total assets                                               |       | $                            | 2,902,083  |                        | $          | 2,940,130 |   |
|                                                       |       |                         |       |                        |       |
| **Liabilities and Membership  Equity**                     |       |                         |       |                        |       |
| Current liabilities:                                       |       |                         |       |                        |       |
| Accounts payable                                           |       | $                            | 40,789     |                        | $          | 42,752 |   |
| Accrued interest                                           |       | 42,175                       |       | 10,966                      |       |
| Long-term debt and capital leases, current portion         |       | 11,294                       |       | 11,549                      |       |
| Other current liabilities                                  |       | 102,907                      |       | 104,401                     |       |
| Total current liabilities                                  |       | 197,165                      |       | 169,668                     |       |
| Long-term debt and capital leases, net of current  portion |       | 1,803,889                    |       | 1,832,044                   |       |
| Deferred tax liabilities, net                              |       | 319,845                      |       | 329,503                     |       |
| Other non-current liabilities                              |       | 14,331                       |       | 8,806                       |       |
| Total liabilities                                          |       | 2,335,230                    |       | 2,340,021                   |       |
|                                                       |       |                         |       |                        |       |
| Commitments and contingencies                              |       |                         |       |                        |       |
|                                                       |       |                         |       |                        |       |
| Membership equity:                                         |       |                         |       |                        |       |
| Additional paid-in capital                                 |       | 826,570                      |       | 824,235                     |       |
| Accumulated deficit                                        |       | (260,609                     | )          | (221,842                    | )          |
| Accumulated other comprehensive loss                       |       | (1,323                       | )          | (4,027                      | )          |
| DJO Finance LLC membership equity                          |       | 564,638                      |       | 598,366                     |       |
| Noncontrolling interests                                   |       | 2,215                        |       | 1,743                       |       |
| Total membership equity                                    |       | 566,853                      |       | 600,109                     |       |
| Total liabilities and membership equity                    |       | $                            | 2,902,083  |                        | $          | 2,940,130 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJOFinance LLC**

 

**Unaudited Condensed Consolidated Statements of Operations**

 

**(inthousands)**

 
| ** **                                                 | ** ** | **Three Months Ended**             | ** ** | **Nine Months Ended**              | ** ** |
|------------------------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                                                 | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** |
| Net  sales                                                 |       | $                                  | 236,186    |                               | $          | 235,515 |   | $ | 688,951 |   | $ | 708,902 |   |
| Cost  of sales                                             |       | 86,039                             |       | 86,946                             |       | 247,195 |   | 262,246 |   |
| Gross  profit                                              |       | 150,147                            |       | 148,569                            |       | 441,756 |   | 446,656 |   |
| Operating  expenses:                                       |       |                               |       |                               |       |   |   |   |   |
| Selling,  general and administrative                       |       | 101,413                            |       | 103,778                            |       | 310,618 |   | 327,722 |   |
| Research  and development                                  |       | 5,616                              |       | 6,773                              |       | 17,581 |   | 20,679 |   |
| Amortization  of acquired intangibles                      |       | 19,560                             |       | 19,159                             |       | 57,862 |   | 57,415 |   |
| Operating  income                                          |       | 23,558                             |       | 18,859                             |       | 55,695 |   | 40,840 |   |
| Other  income (expense):                                   |       |                               |       |                               |       |   |   |   |   |
| Interest  income                                           |       | 211                                |       | 336                                |       | 749 |   | 1,186 |   |
| Interest  expense                                          |       | (39,173                            | )          | (42,073                            | )          | (117,319 | ) | (129,755 | ) |
| Other  income (loss), net                                  |       | 1,422                              |       | (2,597                             | )          | 3,009 |   | (966 | ) |
| Loss  from continuing operations before income taxes       |       | (13,982                            | )          | (25,475                            | )          | (57,866 | ) | (88,695 | ) |
| Benefit  for income taxes                                  |       | (2,969                             | )          | (11,030                            | )          | (19,901 | ) | (28,966 | ) |
| Loss  from continuing operations                           |       | (11,013                            | )          | (14,445                            | )          | (37,965 | ) | (59,729 | ) |
| Income  (loss) from discontinued operations, net of tax    |       | (267                               | )          | 314                                |       | (434 | ) | 1,133 |   |
| Net  loss                                                  |       | (11,280                            | )          | (14,131                            | )          | (38,399 | ) | (58,596 | ) |
| Less:  Net income attributable to noncontrolling interests |       | 94                                 |       | 298                                |       | 368 |   | 793 |   |
| Net  loss attributable to DJO Finance LLC                  |       | $                                  | (11,374    | )                                  | $          | (14,429 | ) | $ | (38,767 | ) | $ | (59,389 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJOFinance LLC**

 

**Unaudited Condensed Consolidated Statements of Cash Flows**

 

**(inthousands)**

 
| ** **                                                                                                 | ** ** | **Nine Months Ended**        | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                 | ** ** | **September 26,  2009** | ** ** | **September 27,  2008** | ** ** |
| **OPERATING ACTIVITIES:**                                                                                  |       |                         |       |   |   |
| Net loss                                                                                                   |       | $                            | (38,399    | ) | $ | (58,596 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities:                 |       |                         |       |   |   |
| Depreciation                                                                                               |       | 20,572                       |       | 17,432 |   |
| Amortization of intangibles                                                                                |       | 57,862                       |       | 57,415 |   |
| Amortization of debt issuance costs                                                                        |       | 9,597                        |       | 9,857 |   |
| Stock-based compensation                                                                                   |       | 2,335                        |       | 1,204 |   |
| Asset impairments and loss on disposal of assets                                                           |       | 465                          |       | 1,361 |   |
| Deferred income taxes                                                                                      |       | (22,574                      | )          | (18,767 | ) |
| Provision for doubtful accounts and sales returns                                                          |       | 25,433                       |       | 15,411 |   |
| Inventory reserves                                                                                         |       | 6,296                        |       | 4,540 |   |
| Gain on disposal of discontinued operations                                                                |       | (393                         | )          | — |   |
| Changes in operating assets and liabilities, net of  acquired assets and liabilities:                      |       |                         |       |   |   |
| Accounts receivable                                                                                        |       | (19,423                      | )          | (33,919 | ) |
| Inventories                                                                                                |       | (1,164                       | )          | 4,360 |   |
| Prepaid expenses, other assets and liabilities                                                             |       | (36                          | )          | (4,904 | ) |
| Accrued interest                                                                                           |       | (31,209                      | )          | 33,701 |   |
| Accounts payable and other current liabilities                                                             |       | 53,205                       |       | (13,427 | ) |
| Net cash provided by operating activities                                                                  |       | 62,567                       |       | 15,668 |   |
| **INVESTING ACTIVITIES:**                                                                                  |       |                         |       |   |   |
| Acquisition of businesses, net of cash acquired                                                            |       | (12,846                      | )          | (3,879 | ) |
| Acquisition of intangible assets                                                                           |       | (154                         | )          | (1,216 | ) |
| Purchases of property and equipment                                                                        |       | (19,133                      | )          | (19,099 | ) |
| Proceeds from sale of discontinued operations                                                              |       | 21,846                       |       | — |   |
| Other, net                                                                                                 |       | 78                           |       | 1,214 |   |
| Net cash used in investing activities                                                                      |       | (10,209                      | )          | (22,980 | ) |
| **FINANCING ACTIVITIES:**                                                                                  |       |                         |       |   |   |
| Proceeds from debt and revolving line of credit                                                            |       | 65,173                       |       | 12,000 |   |
| Payments of revolving line of credit                                                                       |       | (94,834                      | )          | (21,551 | ) |
| Net cash used in  financing activities                                                                     |       | (29,661                      | )          | (9,551 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                                              |       | (1,901                       | )          | (236 | ) |
| **Net increase (decrease) in cash  and cash equivalents**                                                  |       | 20,796                       |       | (17,099 | ) |
| Cash and cash equivalents at beginning of period                                                           |       | 30,483                       |       | 63,471 |   |
| **Cash and cash equivalents at  end of period**                                                            |       | $                            | 51,279     |   | $ | 46,372 |   |
| **Supplemental disclosures of  cash flow information:**                                                    |       |                         |       |   |   |
| Cash paid for interest                                                                                     |       | $                            | 76,366     |   | $ | 86,135 |   |
| Cash paid for income taxes                                                                                 |       | $                            | 1,859      |   | $ | 1,603 |   |
| **Non-cash investing and  financing activities:**                                                          |       |                         |       |   |   |
| Increases in property and equipment and in other  liabilities in connection with capitalizedsoftware costs |       | $                            | 3,568      |   | $ | — |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO Finance LLC**

 

**Notes to Unaudited Condensed Consolidated FinancialStatements**

 

**1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES**

 

**Basis of Presentation and Principles of Consolidation.**  We are a global provider of high-quality,orthopedic devices, with a broad range of products used for rehabilitation,pain management and physical therapy. We also develop, manufacture anddistribute a broad range of surgical reconstructive implant products. We offerhealthcare professionals and patients a diverse range of orthopedicrehabilitation products addressing the complete spectrum of preventative,pre-operative, post-operative, clinical and home rehabilitation care. Our productsare used by orthopedic specialists, spine surgeons, 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 devices and related accessories are used by athletes andpatients for injury prevention and at-home physical therapy treatment.

 

In the first quarter of 2009, we changed how we report our segmentedfinancial information in accordance with the Financial Accounting Standards Board’s (“FASB”)Accounting Standards Codification (“ASC”) 280-10-50 (formerlyFinancial Accounting Standards Statement (“SFAS”) No.131, “Disclosures aboutSegments of an Enterprise and Related Information”).  Prior to 2009, we included the internationalcomponents of the Surgical, Chattanooga, and Empi businesses in either theSurgical or Domestic Rehabilitation segments, as their operations were manageddomestically.  During the fourth quarterof 2008, we effected an operational reorganization which resulted in thenon-U.S. components of all of our businesses being managed abroad.  Our restated segment information now reflectsthe international components of all of our businesses within our Internationalsegment.

 

We market and distribute our products through three operating segments,Domestic Rehabilitation, International, and Domestic Surgical Implant. OurDomestic Rehabilitation Segment offers to customers in the United States,non-invasive medical products that are used before and after surgery to assistin the repair and rehabilitation of soft tissue and bone, and to protectagainst further injury; electrotherapy devices and accessories used to treatpain and restore muscle function; iontophoretic devices and accessories used todeliver medication; clinical therapy tables, traction equipment and otherclinical therapy equipment; orthotic devices used to treat joint and spineconditions; orthopedic soft goods; rigid knee braces; and vascular systemswhich include products intended to prevent deep vein thrombosis followingsurgery. Our Domestic Surgical Implant Segment offers a comprehensive suite ofreconstructive joint products to customers in the United States.  Our International segment offers all of ourproducts to customers outside the United States.

 

Except as otherwise indicated, references to “us”, “we”, “our”, “DJO”,or “our Company”, refers to DJO Finance LLC and its consolidated subsidiaries.

 

Noncontrolling interests reflect the 50% separate ownership ofMedireha GmbH (“Medireha”) not owned by us, which we have consolidated dueto our controlling interest. Our controlling interest consists of our 50%ownership and our control of one of the two director seats, our rights toprohibit certain business activities that are not consistent with our plans forthe business and our exclusive distribution rights for products manufactured byMedireha. All significant intercompany balances and transactions have beeneliminated in consolidation.

 

The accompanying unaudited condensed consolidated financial statementsas of September 26, 2009 and for the three and nine months ended September 26,2009 and September 27, 2008 have been prepared in accordance withaccounting principles generally accepted in the United States for interimfinancial information. Accordingly, they do not include all of the informationand disclosures required by accounting principles generally accepted in theUnited States for complete financial statements. These consolidated financialstatements should be read in conjunction with the audited consolidatedfinancial statements of the Company and the notes thereto included in theCompany’s Annual Report on Form 10-K for the year ended December 31,2008. The accompanying unaudited condensed consolidated financial statements asof September 26, 2009 and for the three and nine months ended September 26,2009 and September 27, 2008 have been prepared on the same basis as theaudited consolidated financial statements and include all adjustmentsconsisting of normal recurring accruals which, in the opinion of management,are necessary for a fair presentation of the financial position, operatingresults and cash flows for the interim date and interim periods presented.Results for the interim periods are not necessarily indicative of the resultsto be achieved for the entire year or future periods.  At October 29, 2009, there are no materialsubsequent events requiring additional disclosure in, or amendment to, ourfinancial statements.

 

**Use of Estimates.**  The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make certain estimates and assumptions thataffect the reported amounts of assets and liabilities, the disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of 

 

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revenuesand expenses during the reporting period. On an ongoing basis, managementevaluates its estimates, including those related to contractual allowances,doubtful accounts, inventories, rebates, product returns, warranty obligations,self insurance, income taxes, goodwill and intangible assets and stock-basedcompensation. We base our estimates on historical experience and on variousother assumptions that we believe are reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results could differ from those estimates.

 

**Cash and Cash Equivalents.**  Cash consists of deposits with financialinstitutions. We consider all short-term, highly liquid investments andinvestments in money market funds and commercial paper with original maturitiesof less than three months at the time of purchase to be cash equivalents. Whileour cash and cash equivalents are on deposit with high-quality institutions,such deposits exceed Federal Deposit Insurance Corporation insured limits.

 

**Computer Software Costs. **Software is stated at cost less accumulated amortization and isamortized using the straight-line method over its estimated useful life rangingfrom three to seven years.  In accordancewith ASC 350-40-25 (formerly American Institute of Certified Public AccountantsStatement of Position (“SOP”) 98-1, “Accounting for  the Costs of Computer software Developed orObtained for Internal Use”), we capitalize costs of internally developedsoftware during the development stage. Additionally, we capitalize related costs including external consultingcosts, cost of software licenses, and internal payroll and payroll-relatedcosts for employees who are directly associated with a software project.  Software assets are reviewed for impairmentwhen events or circumstances indicate that the carrying value may not berecoverable over the remaining lives of the assets. Upgrades and enhancementsare capitalized if they result in added functionality.  Recently we began implementing a new ERPsystem resulting in approximately $7.8 million of capitalized software costs asof September 26, 2009.

 

**Derivative Financial Instruments.**  We account for derivatives pursuant to ASC815-20 (formerly SFAS No. 133, “Accounting for Derivative Instruments andHedging”), which requires that all derivative instruments be recognized in thefinancial statements and measured at fair value regardless of the purpose orintent for holding them.

 

*Foreign Exchange Forward Contracts*

 

We use foreign exchange forward contracts to hedge expense commitmentsthat are denominated in currencies other than the U.S. dollar. The purpose ofour foreign currency hedging activities is to fix the dollar value of specificcommitments and payments to foreign vendors. Before acquiring a derivativeinstrument to hedge a specific risk, potential natural hedges areevaluated.  While our foreign exchangecontracts act as economic hedges, we have not designated such instruments ashedges under ASC 815-30 (formerly SFAS No. 133, “Accounting for DerivativeInstruments and Hedging”).  We accountfor our foreign forward contracts in accordance with ASC 815-20-25 (formerlySFAS No. 157, “Fair Value Measurement”). 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. The change in fair value of the ineffectiveportion of a hedge, and changes in the fair values of the derivative arerecorded in other comprehensive income and are subsequently recognized in earningswhen the hedged item affects earnings.  At September 26, 2009, the fair value of our foreign exchangeforward contracts was a gain of $11.4 million and was determined through theuse of models that consider various assumptions, including time value, yieldcurves, as well as other relevant economic measures, which are inputs that areclassified as Level 2 in the valuation hierarchy.

 

*Interest Rate Swap Agreements*

 

We make use of debt financing as a source of funds and are thereforeexposed to interest rate fluctuations in the normal course of business. Ourcredit facilities are subject to floating interest rates. We manage the risk ofunfavorable movements in interest rates by hedging a portion of the outstandingloan balance, thereby locking in a fixed rate on a portion of the principal,reducing the effect of possible rising interest rates and making interestexpense more predictable.  We havedesignated these interest rate swap agreements as cash flow hedges and accountfor our interest rate swap agreements in accordance with ASC 815-20.  At September 26, 2009, the fair value ofour interest rate swap agreements was a loss of $18.6 million and wasdetermined through the use of models that consider various assumptions,including time value, yield curves, as well as other relevant economicmeasures, which are inputs that are classified as Level 2 in the valuationhierarchy.

 

**Foreign Currency Translation.**  The financial statements of our internationalsubsidiaries, where the local currency is the functional currency, aretranslated into U.S. dollars using period-end exchange rates for assets andliabilities and average exchange rates during the period for revenues andexpenses. Cumulative translation gains and losses are excluded from results ofoperations and recorded as a separate component of consolidated membershipequity. Gains and losses resulting from foreign currency transactions(transactions denominated in a currency other than the entity’s local currency)are included in the condensed consolidated statements of operations.

 

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Comprehensive loss consists of the following for the three and ninemonths ended September 26, 2009 (in thousands):

 
| ** **                                                         | ** ** | **Three Months**       | ** ** | **Nine Months**                         | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|
| ** **                                                         | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** |
| Net income (loss), as reported                                     |       | $                      | (11,374    | )                                       | $          | 94 |   | $ | (11,280 | ) | $ | (38,767 | ) | $ | 368 |   | $ | (38,399 | ) |
| Foreign currency  translation adjustments                          |       | 4,499                  |       | —                                  |       | 4,499 |   | 6,152 |   | — |   | 6,152 |   |
| Change in fair value of  interest rate swap agreements, net of tax |       | 454                    |       | —                                  |       | 454 |   | (3,448 | ) | — |   | (3,448 | ) |
| Comprehensive income (loss)                                        |       | $                      | (6,421     | )                                       | $          | 94 |   | $ | (6,327 | ) | $ | (36,063 | ) | $ | 368 |   | $ | (35,695 | ) |

 

Comprehensiveloss consists of the following for the three and nine months ended September 27,2008 (in thousands):

 
| ** **                                                         | ** ** | **Three Months**       | ** ** | **Nine Months**                         | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|
| ** **                                                         | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** |
| Net income (loss), as reported                                     |       | $                      | (14,429    | )                                       | $          | 298 |   | $ | (14,131 | ) | $ | (59,389 | ) | $ | 793 |   | $ | (58,596 | ) |
| Foreign currency  translation adjustments                          |       | (5,476                 | )          | —                                  |       | (5,476 | ) | (1,424 | ) | — |   | (1,424 | ) |
| Change in fair value of  interest rate swap agreements, net of tax |       | 804                    |       | —                                  |       | 804 |   | (1,904 | ) | — |   | (1,904 | ) |
| Comprehensive income (loss)                                        |       | $                      | (19,101    | )                                       | $          | 298 |   | $ | (18,803 | ) | $ | (62,717 | ) | $ | 793 |   | $ | (61,924 | ) |

 

**Reclassifications.**  The condensed consolidated financialstatements and accompanying footnotes reflect certain reclassifications toprior year consolidated financial statements to conform to the current yearpresentation.

 

**Discontinued Operations**.  In determining whether a group of assetsdisposed of (or to be disposed of) should be presented as a discontinued operation,we make a determination of whether the group of assets being disposed ofcomprises a component of the entity; that is, whether it has historicoperations and cash flows that can be clearly distinguished (both operationallyand for financial reporting purposes). We also determine whether the cash flowsassociated with the group of assets have been significantly (or will besignificantly) eliminated from our ongoing operations as a result of thedisposal transaction and whether we have no significant continuing involvementin the operations of the group of assets after the disposal transaction. Ifthese determinations can be made affirmatively, the results of operations ofthe group of assets being disposed of (as well as any gain or loss on the disposaltransaction) are aggregated for separate presentation apart from our continuingoperating results in our condensed consolidated financial statements. SeeNote 3 for a summary of discontinued operations.

 

**Recent Accounting Pronouncements.**  As of September 2009, we have adopted ASC 105-10 (formerly SFAS No. 168, “TheFASB Accounting Standards Codification and the Hierarchy of Generally AcceptedAccounting Principles”), which makes the Codification the source ofauthoritative US Generally Accepted Accounting Principles recognized by theFASB and applied to non-governmental entities. ASC 105-10 does not changepreviously issued Accounting Standards, but reorganizes the AccountingStandards into Topics. In circumstances where previous Accounting Standards requirea revision, FASB will issue an Accounting Standards Update (“ASU”) on theTopic.

 

InSeptember 2009, the FASB issued ASU 2009-13, which amends ASC 605-25 (formerly EITF IssueNo. 08-1, “Revenue Arrangements with Multiple Deliverables.”). ASU 2009-13provides guidance concerning (1) the determination of whether an arrangement involvingmultiple deliverables contains more than one unit of accounting, and (2) themanner in which consideration should be measured and allocated to the separateunits of accounting in the multiple-element arrangement and is effective forfiscal years beginning on or after June 15, 2010. We are currently evaluatingthe impact, if any, this issue will have on its consolidated financialstatements. However, we do not expect that this issue will result in a changein current practice.

 

InJune 2009, the FASBissued SFAS No. 167, “Amendments to FASB Interpretation No. 46 (R)”(“SFAS 167”) which amends certain requirements of FASB Interpretation No. 46,“Consolidation of Variable Interest entities” (“FIN 46”), including theaddition of entities previously considered qualifying special-purposeentities.  As of September 26, 2009,this statement has not been transitioned into the ASC Codification, but iseffective for fiscal years beginning after November 15, 2009.  We will adopt this statement as of thebeginning of 2010 and are currently assessing the potential impact of adoption.

 

In June 2009, theFASB issued SFAS No. 166, “Accounting for the Transfers of FinancialAssets as amendment of FASB Statement No. 140” (“SFAS 166”) which amendsSFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets”(“SFAS 140”).  SFAS 166 makes thefollowing amendments to SFAS 140: 1) removes concept of qualifyingspecial-purpose entities from SFAS 140; 2) modifies the financial componentsapproach used and limits the circumstances in which a transferor has nottransferred the original financial asset to an entity that is not consolidatedwith the transferor in the financial statements; 3) establishes conditions forreporting a transfer of a portion of a financial asset as a sale; 4) redefinesa participating interest; 5) clarifies that an entity must consider allarrangements or agreements made contemporaneously with, or in contemplation of,a transfer, even if not entered into at the time of the transfer; 6) clarifiesthat the transferor must evaluate whether it, its consolidated affiliatesincluded in the financial statements being presented, or its agency effectivelycontrol the transferred financial asset directly or indirectly; 7) requiresthat the transferor recognize and initially measure at fair value all assetsobtained and liabilities incurred as a result of the a transfer of an entireasset or group of financial assets accounted for as a sale; 8) removes specialprovisions for guaranteed mortgage securitizations to require them to betreated that same as any other transfer of financial assets; 9) Removes fairvalue practicability 

 

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exception from measuringthe proceeds received by a transferor in a transfer that meet the conditionsfor sale accounting at fair value; and 10) requires enhanced disclosures.  As of September 26, 2009, this statementhas not been transitioned into the ASC Codification, but is effective forfiscal years beginning after November 15, 2009.  We will adopt this statement as of thebeginning of 2010 and are currently assessing the potential impact of adoption.

 

In May 2009, theFASB issued, and we adopted, ASC 855-10 (formerly SFAS No. 165, “SubsequentEvents”), which requires entities to disclose certain events that occur afterthe balance sheet date but before the financial statements are issued.  In addition, ASC 855-10 requires entities todisclose the date through which the entity evaluated subsequent events and thebasis for such date.

 

As of January 1, 2009, we adopted ASC 815-10-65 (formerly SFAS No. 161,“Disclosures about Derivative Instruments and Hedging Activities”), whichrequires entities to disclose the fair values of derivative instruments andtheir gains and losses in a tabular format and to provide enhanced disclosuresabout (a) how and why they use derivative instruments, (b) howderivative instruments and related hedged items are accounted for under ASC815-20 and its related interpretations, and (c) how derivative instrumentsand related hedged items affect their financial performance, and cash flows.  Except for adding the required disclosures(see Note 15) the adoption of ASC 815-10-65 had no impact on our consolidatedfinancial statements.

 

We have adopted ASC 810-10 (formerly SFAS No. 160, “Non-controllingInterests in Consolidated Financial Statements-an amendment of ARB No. 51,Consolidated Financial Statements”) which amends Accounting Research Bulletin No. 51,“Consolidated Financial Statements”, to establish accounting and reportingstandards for the noncontrolling interest in a subsidiary.  This standard defines a noncontrollinginterest, previously called a minority interest, as the portion of equity in asubsidiary not attributable, directly or indirectly, to a parent.  ASC 810-10 requires, among other items, thata noncontrolling interest be included in the consolidated statement offinancial position within equity separate from the parent’s equity;consolidated net income to be reported at amounts inclusive of both the parent’sand noncontrolling interest’s shares; and if a subsidiary is deconsolidated,any retained noncontrolling equity investment in the former subsidiary bemeasured at fair value and a gain or loss be recognized in net income based onsuch fair value.  We have applied thepresentation and disclosure requirements of ASC 810-10 retrospectively.

 

We have adopted ASC 805-10 (formerly SFAS No. 141R, “BusinessCombinations”) as of January 1, 2009, which requires the acquiring entityin a business combination to recognize all the assets acquired and liabilitiesassumed in the transaction; establishes the acquisition-date fair value as themeasurement objective for all assets acquired and liabilities assumed; andrequires the acquirer to disclose to investors and other users all of theinformation they need to evaluate and understand the nature and financialeffect of the business combination (see Note 2).

 

**2. ACQUISITIONS**

 

We account for acquisitions in accordance with ASC 805-10, with theresults of operations attributable to each acquisition included in thecondensed consolidated financial statements from the date of acquisition.

 

***Acquisition of Chattanooga GroupInc.***

 

OnAugust 4, 2009 we acquired Chattanooga Group Inc., a Canadian distributorof certain of our products (“Chattanooga Canada”), for $7.2 million.  Our primary reason for the acquisition ofChattanooga Canada was to move from an indirect sales model (i.e., sales todistributors at a discount) to a direct sales model, resulting in increasedgross profit and operating income. Pursuant to the terms of the acquisition agreement and included withinthe purchase price, is a $1.4 million holdback and a $1.4 million promissorynote.  The holdback provides security forpotential indemnification claims and, if not used for such, indemnificationclaims will be paid to the sellers.  Theholdback also provides for the accrual of interest at an annual rate of 2.5%for the first 18 months and a variable rate thereafter.  Fifty percent of the holdback with interest isdue in January 2011 and the remainder of the balance with interest is duein three years, upon expiration of the tax statute of limitations period.  The note provides for the accrual of interestat an annual rate of 6% with the principal and interest due in August 2010.

 

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Thefair values of the assets acquired and the liabilities assumed were estimatedin accordance with ASC 805-10.  Thepurchase price was allocated as follows to the fair values of the net tangibleand intangible asset acquired:

 
| ** **             | ** ** | **Chattanooga  Canada** | ** ** |
|------------------------|------------|-------------------------|------------|
| Cash                   |       | $                       | 59         |   |
| Accounts receivable    |       | 423                     |       |
| Inventories            |       | 261                     |       |
| Liabilities assumed    |       | (475                    | )          |
| Intangible assets      |       | 5,311                   |       |
| Deferred tax liability |       | (1,779                  | )          |
| Goodwill               |       | 3,369                   |       |
| Total purchase price   |       | $                       | 7,169      |   |

 

Thepurchase price allocation of the Chattanooga Canada acquisition includedapproximately $5.0 million assigned to intangible assets related to certaincustomer relationships existing on the acquisition date and $0.3 million assignedto intangible assets related to a 5-year noncompetition agreement with theseller. The value of the customer relationships was based upon an estimate ofthe future discounted cash flows that would be derived from sales to thosecustomers.  The value of thenoncompetition agreement was based on an estimate of the future discounted cashflows that compares scenarios with and without the noncompetition agreement inplace.

 

Goodwillrepresents the excess of the purchase price over the fair value of tangible andidentifiable intangible assets acquired and liabilities assumed. For theChattanooga Canada acquisition, a value of approximately $3.4 million,representing the difference between the total purchase price and the aggregatefair value assigned to the net tangible assets acquired and the liabilitiesassumed and the identifiable intangible assets acquired, was assigned togoodwill. The remainder of the goodwill balance is related to estimatedsynergies in the purchase price. As a result of the acquisition, we anticipate costsavings driven by operating efficiencies.

 

***Acquisition of Empi Canada Inc.***

 

OnAugust 4, 2009 we acquired Empi Canada Inc., a Canadian distributor ofcertain of our products (“Empi Canada”), for $7.4 million.  Our primary reason for the acquisition ofEmpi Canada was to move from an indirect sales model (i.e., sales todistributors at a discount) to a direct sales model, resulting in increasedgross profit and operating income. Pursuant to the terms of the acquisition agreement and included withinthe purchase price, is a $1.4 million holdback and a $1.4 million promissorynote.  The holdback provides security forpotential indemnification claims and, if not used for such, indemnification claimswill be paid to the sellers.  The holdbackalso provides for the accrual of interest at an annual rate of 2.5% for thefirst 18 months and a variable rate thereafter.  Fifty percent of the holdback with interest isdue in January 2011 and the remainder of the balance with interest is duein three years, upon expiration of the tax statute of limitations period.  The note provides for the accrual of interestat an annual rate of 6% with the principal and interest due in August 2010.

 

Thefair values of the assets acquired and the liabilities assumed were estimatedin accordance with ASC 805-10.  Thepurchase price was allocated as follows to the fair values of the net tangibleand intangible asset acquired:

 
| ** **             | ** ** | **Empi Canada** | ** ** |
|------------------------|------------|-----------------|------------|
| Cash                   |       | $               | 29         |   |
| Accounts receivable    |       | 300             |       |
| Inventories            |       | 536             |       |
| Other assets           |       | 19              |       |
| Liabilities assumed    |       | (133            | )          |
| Intangible assets      |       | 2,686           |       |
| Deferred tax liability |       | (900            | )          |
| Goodwill               |       | 4,869           |       |
| Total purchase price   |       | $               | 7,406      |   |

 

Thepurchase price allocation of the Empi Canada acquisition included approximately$2.5 million assigned to intangible assets related to certain customerrelationships existing on the acquisition date and $0.2 million assigned tointangible assets related to a 5-year noncompetition agreement with theseller.  This value of the customerrelationships was based upon an estimate of the future discounted cash flowsthat would be derived from sales to those customers.  The value of the noncompetition agreement wasbased on an estimate of the future discounted cash flows that comparesscenarios with and without the noncompetition agreement in place.

 

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Goodwillrepresents the excess of the purchase price over the fair value of tangible andidentifiable intangible assets acquired and liabilities assumed. For the EmpiCanada acquisition, a value of approximately $4.9 million, representing thedifference between the total purchase price and the aggregate fair valueassigned to the net tangible assets acquired and the liabilities assumed andthe identifiable intangible assets acquired, was assigned to goodwill. Theremainder of the goodwill balance is related to estimated synergies in thepurchase price. As a result of the acquisition, we anticipate cost savingsdriven by operating efficiencies.

 

***Acquisition of DonJoy OrthopaedicsPty., Ltd.***

 

OnFebruary 3, 2009 we acquired DonJoy Orthopaedics Pty., Ltd. an Australiandistributor of certain of our products (“DJO Australia”), for $3.7million.  Our primary reason for theacquisition of DJO Australia was to move from an indirect sales model (i.e.,sales to distributors at a discount) to a direct sales model, resulting inincreased gross profit and operating income. Pursuant to the terms of the acquisition agreement and included withinthe purchase price at fair value, is an additional amount of up to $0.5 millionpayable to the selling shareholder of DJO Australia if certain revenue targetsare met by December 31, 2009.

 

Thefair values of the assets acquired and the liabilities assumed were estimatedin accordance with ASC 805-10.  Thepurchase price was allocated as follows to the fair values of the net tangibleand intangible asset acquired:

 

| ** **             | ** ** | **DJO Australia** | ** ** |
|------------------------|------------|-------------------|------------|
| Cash                   |       | $                 | 912        |   |
| Accounts receivable    |       | 397               |       |
| Inventories            |       | 725               |       |
| Other assets           |       | 12                |       |
| Liabilities assumed    |       | (636              | )          |
| Intangible assets      |       | 1,614             |       |
| Deferred tax liability |       | (484              | )          |
| Goodwill               |       | 899               |       |
| Total purchase price   |       | $                 | 3,439      |   |

 

Thepurchase price allocation of the DJO Australia acquisition includedapproximately $1.6 million assigned to intangible assets related to certain customerrelationships existing on the acquisition date. This value was based upon anestimate of the future discounted cash flows that would be derived from thosecustomers.

 

Goodwillrepresents the excess of the purchase price over the fair value of tangible andidentifiable intangible assets acquired and liabilities assumed. For the DJOAustralia acquisition, a value of approximately $0.9 million, representing thedifference between the total purchase price and the aggregate fair valueassigned to the net tangible assets acquired and the liabilities assumed andthe identifiable intangible assets acquired, was assigned to goodwill.

 

**3. DISCONTINUED OPERATIONS**

 

On June 12, 2009 wesold our Empi Therapy Solutions (“ETS”) catalog business, formerly known asRehab Medical Equipment, or RME, to Patterson Medical Supply, Inc. forapproximately $21.0 million plus an additional payment related to the retentionby DJO of certain outstanding liabilities. Our ETS business, which was included within our Domestic RehabilitationSegment, sold a wide range of proprietary and third party rehabilitationproducts to physical therapists and chiropractors through printed catalog andan on-line e-commerce site.  Financialdata for the three and nine months ended September 26, 2009 and September 27,2008 related to discontinued operations includes the following (in thousands):

 
| ** **                     | ** ** | **Three Months Ended**             | ** ** | **Nine Months Ended**              | ** ** |
|--------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                     | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** |
| Total revenues                 |       | $                                  | —     |                               | $          | 8,122 |   | $ | 13,450 |   | $ | 24,264 |   |
|                           |       |                               |       |                               |       |   |   |   |   |
| Pre-tax income (loss)          |       | $                                  | (504       | )                                  | $          | 515 |   | $ | 6,390 |   | $ | 1,872 |   |
| Income tax provision (benefit) |       | (237                               | )          | 201                                |       | 6,824 |   | 739 |   |
| Net income (loss)              |       | $                                  | (267       | )                                  | $          | 314 |   | $ | (434 | ) | $ | 1,133 |   |

 

Included withindiscontinued operations for the three and nine months ended September 26,2009 is a pre-tax gain on disposal of discontinued operations of $6.5 million.The effective tax rate of the discontinued operations for the nine months endedSeptember 26, 2009 is 107%, and differs from the amount which would havebeen recorded using the US statutory tax rate due primarily to a largedifference in the book and tax basis of goodwill.

 

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**4. 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**         | ** ** |
|---------------------------------------------------|------------|-------------------------------|------------|
| ** **                                        | ** ** | **September 26,   2009** | ** ** | **September 27,  2008** | ** ** |
| Balance, beginning of period                      |       | $                             | 36,521     |   | $ | 32,417 |   |
| Provision for doubtful accounts and sales returns |       | 25,433                        |       | 15,411 |   |
| Write-offs, net of recoveries                     |       | (16,334                       | )          | (19,124 | ) |
| Balance, end of period                            |       | $                             | 45,620     |   | $ | 28,704 |   |

 

**5. INVENTORIES**

 

Inventories consist of the following (in thousands):

 
| ** **                    | ** ** | **September 26,  2009** | ** ** | **December 31,   2008** | ** ** |
|-------------------------------|------------|------------------------------|------------|------------------------------|------------|
| Components and raw materials  |       | $                            | 28,349     |                         | $          | 34,015 |   |
|                          |       |                         |       |                         |       |
| Work in process               |       | 4,236                        |       | 5,310                        |       |
| Finished goods                |       | 56,997                       |       | 59,835                       |       |
| Inventory held on consignment |       | 24,729                       |       | 21,804                       |       |
|                          |       | 114,311                      |       | 120,964                      |       |
| Less—inventory reserves  |       | (17,199                      | )          | (17,798                      | )          |
|                          |       | $                            | 97,112     |                         | $          | 103,166 |   |

 

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**        | ** ** |
|------------------------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **September 26,  2009** | ** ** | **September 27,  2008** | ** ** |
| Balance, beginning of period       |       | $                            | 17,798     |   | $ | 18,996 |   |
| Provision charged to cost of sales |       | 6,296                        |       | 4,540 |   |
| Write-offs, net of recoveries      |       | (6,895                       | )          | (7,458 | ) |
|                               |       |                         |       |   |   |
| Balance, end of period             |       | $                            | 17,199     |   | $ | 16,078 |   |

 

The write-offs to the reserve were principally related to thedisposition of fully reserved inventory.

 

**6. GOODWILL AND INTANGIBLE ASSETS**

 

A summary of adjustments to our goodwill balance for the nine monthsended September 26, 2009 is as follows (in thousands):

 

| Balance, beginning of period |   | $       | 1,191,566 |   |
|------------------------------|--------|---------|-----------|--------|
| Sale of a business           |   | (11,986 | )         |
| Foreign currency translation |   | 4,327   |      |
| Acquisitions (See Note 2)    |   | 9,137   |      |
| Balance, end of period       |   | $       | 1,193,044 |   |

 

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Identifiable intangible assets consisted of the following as of September 26,2009 (in thousands):

 
| ** **                                            | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Intangible Assets,  Net** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| Amortizable intangible assets:                        |       |                       |       |                          |       |                        |       |
| Technology-based                                      |       | $                          | 458,763    |                          | $          | (85,000                     | )          | $ | 373,763 |   |
| Customer-based                                        |       | 487,998                    |       | (86,900                       | )          | 401,098                     |       |
|                                                  |       | $                          | 946,761    |                          | $          | (171,900                    | )          | 774,861 |   |
| Indefinite-lived intangible assets:                   |       |                       |       |                          |       |                        |       |
| Trademarks                                            |       |                       |       |                          |       | 435,267                     |       |
| Accumulated foreign currency translation  adjustments |       |                       |       |                          |       | 4,426                       |       |
| Net identifiable intangible assets                    |       |                       |       |                          |       | $                           | 1,214,554  |   |

 

Identifiable intangible assets consisted of the following as of December 31,2008 (in thousands):

 
| ** **                                            | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Intangible Assets,  Net** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| Amortizable intangible assets:                        |       |                       |       |                          |       |                        |       |
| Technology-based                                      |       | $                          | 458,612    |                          | $          | (56,501                     | )          | $ | 402,111 |   |
| Customer-based                                        |       | 478,387                    |       | (57,537                       | )          | 420,850                     |       |
|                                                  |       | $                          | 936,999    |                          | $          | (114,038                    | )          | 822,961 |   |
| Indefinite-lived intangible assets:                   |       |                       |       |                          |       |                        |       |
| Trademarks                                            |       |                       |       |                          |       | 435,267                     |       |
| Accumulated foreign currency translation  adjustments |       |                       |       |                          |       | 2,244                       |       |
| Net identifiable intangible assets                    |       |                       |       |                          |       | $                           | 1,260,472  |   |

 

Our amortizable intangible assets are being amortized over theestimated useful lives of 10 and nine years on a weighted average basis fortechnology-based and customer-based intangible assets, respectively.

 

Estimated amortization expense related to identifiable intangibleassets for the next five years and thereafter is as follows (in thousands):

 
| Remaining 2009 |   | $       | 19,588  |   |
|----------------|--------|---------|---------|--------|
| 2010           |   | 77,081  |    |
| 2011           |   | 75,674  |    |
| 2012           |   | 74,256  |    |
| 2013           |   | 69,399  |    |
| Thereafter     |   | 458,863 |    |
|           |   | $       | 774,861 |   |

 

**7. OTHER CURRENT LIABILITIES**

 

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

 
| ** **                     | ** ** | **September 26,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Wages and related expenses     |       | $                            | 23,004     |                        | $          | 21,695 |   |
| Commissions and royalties      |       | 12,206                       |       | 13,799                      |       |
| Taxes                          |       | 4,451                        |       | 4,943                       |       |
| Professional fees              |       | 5,477                        |       | 2,453                       |       |
| Rebates                        |       | 3,791                        |       | 4,812                       |       |
| Accrued ERP costs              |       | 6,309                        |       | 6,763                       |       |
| Interest rate swap derivatives |       | 16,029                       |       | 13,272                      |       |
| Restructuring costs            |       | 5,156                        |       | 2,505                       |       |
| Other accrued liabilities      |       | 26,484                       |       | 34,159                      |       |
|                           |       | $                            | 102,907    |                        | $          | 104,401 |   |

 

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**8. LONG-TERM DEBT AND CAPITAL LEASES**

 

Long-term debt (including capital lease obligations) consists of thefollowing (in thousands):

 
| ** **                                                                                                                                                                                             | ** ** | **September 26,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Term loan under Senior Secured Credit Facility, net  of unamortized original issue discount ($9.7 million and $10.9 million  at September 26, 2009 and December 31, 2008, respectively) |       | $                            | 1,039,320  |                        | $          | 1,043,404 |   |
| Revolving loans outstanding under Senior Secured  Credit Facility                                                                                                                                      |       | —                       |       | 24,000                      |       |
| 10.875% Senior notes                                                                                                                                                                                   |       | 575,000                      |       | 575,000                     |       |
| 11.75% Senior subordinated notes                                                                                                                                                                       |       | 200,000                      |       | 200,000                     |       |
| Loans and revolving credit facilities at various  European banks                                                                                                                                       |       | 597                          |       | 891                         |       |
| Capital lease obligations and other                                                                                                                                                                    |       | 266                          |       | 298                         |       |
|                                                                                                                                                                                                   |       | 1,815,183                    |       | 1,843,593                   |       |
| Less current portion                                                                                                                                                                                   |       | (11,294                      | )          | (11,549                     | )          |
| Long-term debt and capital leases, net of current  portion                                                                                                                                             |       | $                            | 1,803,889  |                        | $          | 1,832,044 |   |

 

*Senior Secured Credit Facility*

 

On November 20, 2007, we entered into the Senior Secured CreditFacility which consists of a $1,065.0 million term loan facility maturing May 2014and a $100.0 million revolving credit facility maturing November 2013.We issued the term loan facility at a 1.2% discount, resulting in net proceedsof $1,052.4 million. The original $12.6 million discount is beingamortized as additional interest expense over the term of the term loanfacility and increases the reported outstanding balance accordingly. The marketvalue of our term loan facility was approximately $1,001.8 million as of September 26,2009 and was determined using trading prices for our term loan on or near thatdate. As of September 26, 2009, no amounts were drawn related to ourrevolving 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) theprime rate of Credit Suisse and (2) the federal funds rate plus 0.50% or (b) theEurodollar rate determined by reference to the costs of funds for deposits inU.S. dollars for the interest period relevant to each borrowing adjusted forrequired reserves. The initial applicable margin for borrowings under the termloan facility and the revolving credit facility is 2.00% with respect to baserate borrowings and 3.00% with respect to Eurodollar borrowings. The applicablemargin for borrowings under the term loan facility and the revolving creditfacility may be reduced subject to us attaining certain 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 15).  On November 20,2007, we entered into an interest rate swap agreement for a notional amount of$515.0 million at a fixed LIBOR rate of 4.205%. This swap agreement amortizesthrough December 2009. As of September 26, 2009, the remainingnotional amount of the swap was $435.0 million. In February 2009, weentered into two additional non-amortizing interest rate swap agreements. Thefirst is for a notional amount of $550.0 million at a fixed LIBOR rate of 1.04%beginning February 2009 through December 2009 (with a notional amountof $550.0 million as of September 26, 2009). The second is for a notionalamount of $750.0 million at a fixed LIBOR rate of 1.88% beginning January 2010through December 2010.  In August 2009,we entered into four new non-amortizing interest swap agreements with notionalamounts aggregating $300.0 million.  Eachof the four agreements has a term beginning January 2011 through December 2011.The four agreements are at a weighted average fixed LIBOR rate of 2.5825%.   As of September 26, 2009, our weightedaverage interest rate for all borrowings under the Senior Secured CreditFacility was 5.3%.

 

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 with respect to the unutilizedcommitments thereunder. The current commitment fee rate is 0.50% per annum. Thecommitment fee rate may be reduced subject to us attaining certain leverageratios. We must also pay customary letter of credit fees.

 

*Principal Payments.*  We are required to pay annual payments inequal quarterly installments on the loans under the term loan facility in anamount equal to 1.00% of the funded total principal amount through February 2014,with any remaining amount payable in May 2014. Principal amountsoutstanding under the revolving credit facility are due and payable in full atmaturity.

 

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*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 attaining certainleverage ratios) of our annual excess cash flow, as defined; (2) 100% ofthe net cash proceeds above an annual amount of $25.0 million from non-ordinarycourse asset sales (including insurance and condemnation proceeds) by DJOFinance LLC (“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 issuances or incurrences of debt by DJOFL and itsrestricted subsidiaries, other than proceeds from debt permitted to be incurredunder the Senior Secured Credit Agreement. The foregoing mandatory prepaymentswill be applied to the term loan facilities in direct order of maturity.  We have not been required to make anymandatory pre-payments through September 26, 2009.  We may voluntarily prepay outstanding loansunder the Senior Secured Credit Facility at any time without premium orpenalty, provided that voluntary prepayments of Eurodollar loans made on a dateother than the last day of an interest period applicable thereto shall besubject to customary breakage costs.

 

*Guarantee and Security.*  All obligations under the Senior SecuredCredit Facility are unconditionally guaranteed by DJO Holdings LLC (“Holdings”)and each existing and future direct and indirect wholly-owned domesticsubsidiary 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 Holdings, DJOFL and each Guarantor.

 

*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 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.

 

In addition, the Senior Secured Credit Facility requires us to maintaina maximum senior secured leverage ratio of 4.50:1 as of the twelve months endedSeptember 26, 2009, stepping down over time to 3.25:1 by the end of 2011.The Senior Secured Credit Facility also contains certain customary affirmativecovenants and events of default. Our maximum senior secured leverage ratio waswithin the covenant level as of September 26, 2009.

 

*10.875% Senior Notes Payable*

 

On November 20, 2007, DJOFL and DJO Finance Corporation (“Finco”)(collectively, the “Issuers”) issued $575.0 million aggregate principalamount of 10.875% Notes under an agreement dated as of November 20, 2007(the “10.875% Indenture”) among the Issuers, the guarantors party thereto andThe Bank of New York Mellon (formerly known as The Bank of New York), astrustee.

 

The 10.875% Notes require semi-annual interest payments ofapproximately $31.3 million each May 15 and November 15 and aredue November 15, 2014. The market value of the 10.875% Notes wasapproximately $582.2 million as of September 26, 2009 and was determinedusing trading prices for the 10.875% Notes on or near that date. We believe thetrading prices reflect certain differences between prevailing market terms andconditions and the actual terms of our 10.875% Notes.

 

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*Optional Redemption.*  Under the 10.875% Indenture, prior to November 15,2011, the Issuers have the option to redeem some or all of the 10.875% Notesfor cash at a redemption price equal to 100% of the then outstanding principalbalance plus an applicable make-whole premium plus accrued and unpaid interest.Beginning on November 15, 2011, the Issuers may redeem some or all of the10.875% Notes at a redemption price of 105.438% of the then outstandingprincipal balance plus accrued and unpaid interest. The redemption pricedecreases to 102.719% and 100% of the then outstanding principal balance at November 2012and November 2013, respectively. Additionally, from time to time, before November 15,2010, the Issuers may redeem up to 35% of the 10.875% Notes at a redemptionprice 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, incertain offerings of equity of DJOFL or its direct or indirect parentcompanies, as long as at least 65% of the aggregate principal amount of thenotes 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 September 26, 2009,we were in compliance with all applicable covenants.

 

*11.75% Senior Subordinated Notes Payable*

 

The Issuers issued $200.0 million aggregate principal amount of11.75% senior subordinated notes in November 2006 (the “11.75% Notes”).The 11.75% Notes require semi-annual interest payments of approximately$11.0 million each May 15 and November 15 and are due November 15,2014.

 

The market value of the 11.75% Notes was approximately $185.0 millionas of September 26, 2009 and was determined using trading prices for the11.75% Notes on or near that date. We believe the trading prices reflectcertain differences between prevailing market terms and conditions and theactual terms of our 11.75% Notes.

 

The 11.75% Notes contain similar provisions as 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 have 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.Beginning on November 15, 2010, the Issuers may redeem some or all of the11.75% Notes at a redemption price of 105.875% of the then outstandingprincipal balance plus accrued and unpaid interest on the 11.75% Notes. Theredemption price decreases to 102.938% and 100% of the then outstandingprincipal balance at November 2011 and November 2012, respectively.Additionally, from time to time, before November 15, 2009, the Issuers mayredeem up to 35% of the 11.75% Notes at a redemption price equal to 111.75% ofthe principal amount then outstanding, in each case, with proceeds we raise, ora direct or indirect parent company raises, in certain offerings of equity ofDJOFL or its direct or indirect parent companies, as long as at least 65% ofthe aggregate principal amount of the notes issued remains outstanding.

 

Our ability to continue to meet the covenants related to ourindebtedness specified above in future periods will depend, in part, on eventsbeyond our control, and we may not continue to meet those ratios. A breach ofany of these covenants in the future could result in a default under the SeniorSecured Credit Facility, the 11.75% Indenture and the 10.875% Indenture(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 Issue Costs*

 

We incurred $30.7 million, $24.5 million, and $10.2 million of debtissue costs in connection with the Senior Secured Credit Facility, the 10.875%Notes, and the 11.75% Notes, respectively. These costs have been capitalizedand are included in other non-current assets in the condensed consolidatedbalance sheets at September 26, 2009 and December 31, 2008. Debtissue costs are being amortized over the terms of the respective debtinstruments through November 2014.

 

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**9. STOCK OPTION PLANS AND STOCK-BASED COMPENSATION**

 

*2007 Stock Incentive Plan*

 

We have one active equityplan, the DJO Incorporated 2007 Incentive Stock Plan (the “2007 Plan”), whichis authorized to grant options up to 7,500,000 shares, subject to adjustment incertain events. Options issued under the 2007 Plan can be either incentivestock options or non-qualified stock options. The exercise price of stockoptions granted will not be less than 100% of the fair market value of theunderlying shares on the date of grant, and will expire no more than ten yearsfrom the date of grant. In addition, we adopted a form of non-statutory stockoption agreement (the “DJO Form Option Agreement”) for employee stockoption awards under the 2007 Plan. Under the DJO Form Option Agreement,one-third of stock options will vest over a specified period of time (typicallyfive years) contingent solely upon the awardees’ continued employment with us (“Time-BasedTranche”). Another one-third of stock options will vest over a specifiedperformance period (typically four to five years) from the date of grant uponthe achievement of certain pre-determined performance targets based on AdjustedEBITDA and free cash flow on an annual basis (“Performance-Based Tranche”), asdefined in the DJO Form Option Agreement. The final one-third of stock options was originally determined to vestbased upon achieving enhanced pre-determined performance targets based onAdjusted EBITDA and free cash flow (“Enhanced Performance-Based Tranche”), buthas been modified as described herein. The DJO Form Option Agreementincludes certain forfeiture provisions upon an awardees’ separation fromservice with us.

 

During March 2009, we made modifications to the terms of theoutstanding options and the 2007 Plan. The Time-Based Tranche terms remain thesame as discussed above. The performance conditions for the portion of theoptions within the Performance-Based Tranche that vest based on 2009 financialperformance were modified to require achievement of the levels of AdjustedEBITDA and free cash flow that were established in connection with our 2009budget process. As with the original terms of such options, the optionees mayearn 80% or more of such portion of options upon achievement of at least aminimum threshold amount of the budgeted Adjusted EBITDA and of the free cashflow targets for 2009. The financial targets for the Performance-Based Tranchesfor the years 2010-2012 remain unchanged and we added financial targets for2013-2015. The vesting provisions of the Performance-Based Tranche weremodified to provide that upon achievement of the annual target for a given year,the annual portion of the tranche associated with all prior years will alsovest to the extent not previously vested. The financial performance targets forthe entire Enhanced Performance-Based Tranche were replaced by targets withdifferent financial metrics. These new targets require achievement of a minimuminternal rate of return (“IRR”) and multiple of invested capital (“MOIC”), eachmeasured with respect to Blackstone’s aggregate investment in our capitalstock, to be achieved by Blackstone following a liquidation of all or a portionof its investment in our capital stock. As a result of this modification, theEnhanced Performance-Based Tranche has both a performance component and amarket condition component.

 

Options granted under the 2007 Plan contain change-in-controlprovisions that cause the vesting of a portion of the tranches upon theoccurrence of a change-in-control, as follows: 1) the option shares in theTime-Based Tranche will become immediately exercisable upon the occurrence of achange-in-control if the optionee remains in continuous employment of theCompany until the consummation of the change-in-control and 2) the optionshares of the Performance-Based Tranche for the year in which suchchange-in-control is consummated and for any subsequent performance periodswill become immediately exercisable if the optionee remains in continuousemployment of the Company until the consummation of the change-in-control. Thisprovision does not operate to vest the Enhanced Performance-Based Tranche whichrequires the achievement of the IRR and MOIC targets by Blackstone on itsequity investment in us.

 

*Employee Stock Options*

 

During the nine months ended September 26, 2009 we granted 708,932stock options under the 2007 Plan to our executive officers, senior management,and certain other employees.

 

For the three and nine months ended September 26, 2009, werecorded non-cash compensation expense of approximately $0.9 million and $2.2million, respectively, associated with stock options issued under the 2007Plan.  During the first half of 2008, theachievement of 2008 targets was deemed probable and we recorded non-cashcompensation expense of approximately $0.4 million. At September 27, 2008,the Company reassessed the probability of achieving 2008 targets and determinedthat achievement of such targets was no longer probable.  As such, for the three months ended September 27,2008, we recorded a net reversal of non-cash compensation expense ofapproximately $22,000.  For the ninemonths ended September 27, 2008, we recorded non-cash compensation expenseof approximately $1.2 million associated with stock options under the 2007Plan.

 

The fair value of each option award is estimated on the date of grant,or modification, using the Black-Scholes-Merton option pricing model forservice and performance based awards, and a binomial model for market basedawards. In estimating fair value for new options issued under the 2007 Plan,expected volatility was based completely on historical volatility of comparablepublicly-traded companies. As our historical share option exercise experiencedoes not provide a reasonable basis upon which to estimate the 

 

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expectedterm, we used the simplified approach to calculate the expected term. Expectedlife is calculated in two tranches based on the employment level defined asexecutive or employee. The risk-free rate used in calculating fair value ofservice and performance-based stock options for periods within the expectedterm of the option is based on the U.S. Treasury yield bond curve in effect atthe time of grant.

 

We record expense for awards with a performance condition only to theextent deemed probable of achievement, with the exception of market-basedoptions previously modified during the first quarter of 2008 and reallocated tothe Time-Based and Performance-Based Tranches. The expense related to the previously modified options is recognizedratably over the expected term of the stock options using the originalgrant-date fair value regardless of the probability of achieving theperformance conditions.  We are requiredto reassess at each reporting period whether the achievement of any performancecondition is probable, at which time we would recognize the relatedcompensation expense over the remaining performance or service period, if any.During 2008 we did not recognize compensation expense associated with our Performance-BasedTranche as the performance targets under the original grant were notachieved.  As a result of themodification of the 2009 targets and our actual results for the nine monthsended September 26, 2009, we now believe that it is probable that we willachieve the 2009 performance targets.  As such, for the nine months ended September 26,2009, we recognized compensation expense for the modified options and theannual portion of the tranche associated with the 2008 options that were notpreviously vested.  To date, noamount has been recorded for the Enhanced Performance-Based Tranche, asachievement of the performance component is not deemed probable at this time.

 

As a result of the 2009 modification, we will no longer use theoriginal grant date fair value to measure compensation cost and havere-assessed the assumptions used to determine the fair value of options at thedate of modification and at subsequent grant dates. The following tablepresents the assumptions we used in calculating the fair value of employeestock options for the nine months ended September 26, 2009 and September 27,2008:

 
| ** **               | ** ** | **Nine Months Ended**        | ** ** |
|--------------------------|------------|------------------------------|------------|
| ** **               | ** ** | **September 26,  2009** | ** ** | **September 27,  2008** | ** ** |
| Expected dividends       |       | 0.0%                         |       | 0.0% |   |
| Expected volatility      |       | 34.4 – 34.7%            |       | 27.4% – 60.0% |   |
| Risk-free rate           |       | 2.30 – 2.79%            |       | 3.21% – 4.70% |   |
| Expected term (in years) |       | 6.1 – 6.3 years         |       | 4.7 – 7.1 years |   |

 

*Non-Employee Stock Options*

 

During the nine months ended September 26, 2009 we granted 24,800stock options under the 2007 Plan to non-employees (“non-employee options”).The non-statutory stock option agreement for the non-employees states that theoptions have an exercise price of $16.46 per share, which was equal to 100% ofthe estimated fair market value of the stock and will become effective upon thedefined effective date and expire ten years from that date. A number of sharesequal to 25% of the options granted become vested and exercisable at the end ofeach of the first four years subsequent to the effective date, provided theoptionee is still affiliated with and providing services to the Company. Thenon-employee option agreement does not include any performance requirements onthe optionee’s part in order to vest in the options granted.  Non-employee options are accounted for inaccordance with ASC 505-50 (formerly Emerging Issues Task Force Issue No. 96-18,“Accounting for Equity Instruments That are Issued to Other Than Employees forAcquiring, or in Counjunction with Selling Goods or Services”) which statesthat the fair value of each option will be re-measured at the end of eachreporting period until vested, when the final fair value of the vesting of theoption is determined.

 

**10. SEGMENT AND GEOGRAPHIC INFORMATION**

 

Weprovide a broad array of orthopedic rehabilitation and regeneration products,as well as implants to customers in the United States and abroad.  In the first quarter of 2009, we changed howwe report financial information to the Chief Operating Decision Maker.  Prior to 2009, we included the internationalcomponents of the Surgical, Chattanooga, and Empi businesses in either theSurgical or Domestic Rehabilitation segments, as their operations were manageddomestically.  During the fourth quarterof 2008, we effected an operational reorganization which resulted in thenon-U.S. components of all of our businesses being managed abroad.  As a result, the segment financial data forthe three and nine months ended September 26, 2009 reflects this newsegmentation and the data for the three and nine months ended September 27,2008, as noted below, has been restated to reflect this change.  We currently develop, manufacture anddistribute our products through the following three operating segments.

 

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***Domestic Rehabilitation Segment***

 

Our Domestic Rehabilitation Segment, which generates its revenues inthe United States, is divided into five main businesses:

 

·                  *Bracingand Supports. *Our Bracing andSupports business unit offers our DonJoy, ProCare and Aircast products,including rigid knee bracing, orthopedic soft goods, cold therapy products, andvascular systems.  This business unitalso includes our OfficeCare business, through which we maintain an inventoryof soft goods and other products at healthcare facilities, primarily orthopedicpractices, for immediate distribution to patients.

 

·                  *Empi. *Our Empi business unitoffers products in the categories of home electrotherapy, iontophoresis, andhome traction.

 

·                  *Regeneration*.  Our Regeneration business unit primarilysells our bone growth stimulation products. These products are sold through a combination of certain DonJoy salesrepresentatives and additional independent and employed sales representativesdedicated to selling these products either directly to patients or independentdistributors.  We arrange billing tothese third party payors or patients for products directly sold to thepatients.

 

·                  *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 business unit offers our Compexelectrostimulation device to consumers, ranging from people interested inimproving their fitness to competitive athletes, to assist in athletic trainingprograms through muscle development and to accelerate muscle recovery aftertraining sessions.

 

***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.

 

***Domestic Surgical Implant Segment***

 

Our Domestic Surgical Implant Segment develops, manufactures andmarkets a wide variety of knee, hip and shoulder implant products that servethe orthopedic reconstructive joint implant market in the United States.

 

Information regarding our reportable business segments is presentedbelow (in thousands). This information excludes the impact of certain expensesnot allocated to segments, primarily general corporate expenses andnon-recurring charges related to our integration activities. All prior periodspresented have been restated to reflect our current reportable segments.

 
| ** **                                      | ** ** | **Three Months Ended**             | ** ** | **Nine Months Ended**              | ** ** |
|-------------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                                      | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** |
| **Net sales:**                                  |       |                               |       |                               |       |   |   |   |   |
| Domestic Rehabilitation Segment                 |       | $                                  | 162,182    |                               | $          | 162,521 |   | $ | 468,991 |   | $ | 468,104 |   |
| International Segment                           |       | 58,588                             |       | 58,485                             |       | 172,863 |   | 194,794 |   |
| Domestic Surgical Implant Segment               |       | 15,416                             |       | 14,509                             |       | 47,097 |   | 46,004 |   |
| Consolidated net sales                          |       | $                                  | 236,186    |                               | $          | 235,515 |   | $ | 688,951 |   | $ | 708,902 |   |
| ** **                                      |       |                               |       |                               |       |   |   |   |   |
| **Gross profit:**                               |       |                               |       |                               |       |   |   |   |   |
| Domestic Rehabilitation Segment                 |       | $                                  | 108,523    |                               | $          | 101,127 |   | $ | 310,910 |   | $ | 296,606 |   |
| International Segment                           |       | 32,434                             |       | 35,669                             |       | 98,645 |   | 117,726 |   |
| Domestic Surgical Implant Segment               |       | 11,779                             |       | 11,888                             |       | 36,541 |   | 37,864 |   |
| Expenses not allocated to segments/Eliminations |       | (2,589                             | )          | (115                               | )          | (4,340 | ) | (5,540 | ) |
| Consolidated gross profit                       |       | $                                  | 150,147    |                               | $          | 148,569 |   | $ | 441,756 |   | $ | 446,656 |   |
| ** **                                      |       |                               |       |                               |       |   |   |   |   |
| **Operating income:**                           |       |                               |       |                               |       |   |   |   |   |
| Domestic Rehabilitation Segment                 |       | $                                  | 48,402     |                               | $          | 36,903 |   | $ | 127,539 |   | $ | 100,936 |   |
| International Segment                           |       | 10,625                             |       | 12,239                             |       | 33,556 |   | 43,803 |   |
| Domestic Surgical Implant Segment               |       | 2,805                              |       | 2,767                              |       | 8,982 |   | 8,983 |   |
| Expenses not allocated to segments/Eliminations |       | (38,274                            | )          | (33,050                            | )          | (114,382 | ) | (112,882 | ) |
| Consolidated operating income                   |       | $                                  | 23,558     |                               | $          | 18,859 |   | $ | 55,695 |   | $ | 40,840 |   |

 

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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. Moreover, we do not allocate assets toreportable segments because a significant portion of assets are shared by thesegments.

 

**Geographic Area**

 

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

 
| ** **                                   | ** ** | **Three Months Ended**             | ** ** | **Nine Months Ended**              | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                                   | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** |
| **Net sales:**                               |       |                               |       |                               |       |   |   |   |   |
| United States                                |       | $                                  | 177,598    |                               | $          | 177,030 |   | $ | 516,088 |   | $ | 514,108 |   |
| Germany                                      |       | 18,612                             |       | 6,692                              |       | 53,312 |   | 47,912 |   |
| Other Europe, Middle East, & Africa |       | 25,528                             |       | 40,586                             |       | 81,174 |   | 114,271 |   |
| Asia Pacific                                 |       | 3,429                              |       | 3,678                              |       | 10,277 |   | 10,196 |   |
| Other                                        |       | 11,019                             |       | 7,529                              |       | 28,100 |   | 22,415 |   |
|                                         |       | $                                  | 236,186    |                               | $          | 235,515 |   | $ | 688,951 |   | $ | 708,902 |   |

 

**11. INCOME TAXES**

 

Income taxes for the interim periods presented have been included inthe accompanying unaudited condensed consolidated financial statements on thebasis of an estimated annual effective tax rate, adjusted for discrete items.The tax benefit for these periods differed from the amount which would havebeen recorded using the U.S. statutory tax rate due primarily to the impact offoreign taxes, including favorable adjustments related to prior year foreigntaxes, unfavorable adjustments related to deferred foreign exchange gains, deferredtaxes on the assumed repatriation of foreign earnings and the favorable impactof new California legislation discussed below.

 

For the three and nine months ended September 26, 2009, werecorded an income tax benefit of approximately $3.0 million and $19.9 million,respectively, on pre-tax losses of approximately $13.9 million and $57.8million, respectively.  For the three andnine months ended September 27, 2008, we recorded an income tax benefit ofapproximately $11.0 million and $29.0 million, respectively, on pre-tax lossesof approximately $25.5 million and $88.7 million, respectively.

 

During the first quarter of 2009, the state of California enactedlegislation which will allow corporate taxpayers to elect to use a single salesfactor apportionment formula to apportion business income to California for taxyears beginning on or after January 1, 2011. We anticipate making thiselection in fiscal year 2011 and thereafter. In the first quarter of 2009, werecorded a tax benefit of $3.8 million related to the enactment of thislegislation which represents a reduction in our net deferred tax liabilitiesdue to a lower effective state tax rate.

 

Weand our subsidiaries file income tax returns in the U.S. federal jurisdiction,various states and foreign jurisdictions. With few exceptions, we are no longersubject to U.S. federal, state and local, or non-U.S. income tax examinationsby tax authorities for years before 2005. At December 31, 2008, our grossunrecognized tax benefits were $15.4 million. For the three and nine months ended September 26, 2009, weincreased our gross unrecognized tax benefits by $0.4 million and $0.7 million,respectively, due to additions and settlements of unrecognized tax benefitsrelated to tax positions of prior years. For the three and nine months ended September 26, 2009, werecognized an additional $0.1 million and $0.4 million, respectively, ininterest and penalties.  Our total grossunrecognized tax benefits were $16.1 million at September 26, 2009,including $1.6 million related to interest and penalties.  We do not anticipate a decrease in any grossuncertain tax positions within the next twelve months.  Due to the adoption of ASC 805-740 (formerlySFAS No. 141R, “Business Combinations”) on January 1, 2009, all of our unrecognized tax benefits will impactour effective tax rate upon recognition. We believe that it is reasonablypossible that an increase of $0.4 million in unrecognized tax benefits relatedto various immaterial state exposures may be necessary within the next twelvemonths.

 

**12. RESTRUCTURING AND RELATED CHARGES**

 

In June 2009, we announced our plans to close ourChattanooga manufacturing and distribution facility, located in Hixson,Tennessee, and to integrate the operations of the Chattanooga site into ourother existing sites. The transition of our Chattanooga activities is expectedto take approximately nine to 12 months to complete. As a result of thistransition, we expect to incur approximately $6.0 million to $8.0 million ofcash expenses, mainly related to one-time termination benefits and employeeretention.

 

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A summary of the activity relating to therestructuring for the period from June 1, 2009 through September 26,2009 is as follows (in thousands):

 
| ** **                         | ** ** | **Severance &   Employee  Retention** | ** ** | **Other** | ** ** | **Total** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|-----------|------------|-----------|------------|
| Balance, beginning of period       |       | $                                              | —     |      | $          | —    |       | $ | — |   |
| Expensed during period             |       | 985                                            |       | —    |       | 985       |       |
| Payments made during period        |       | (25                                            | )          | —    |       | (25       | )          |
| Balance at June 27, 2009      |       | 960                                            |       | —    |       | 960       |       |
| Expensed during period             |       | 2,171                                          |       | 305       |       | 2,476     |       |
| Payments made during period        |       | (391                                           | )          | (31       | )          | (422      | )          |
| Balance at September 26, 2009 |       | $                                              | 2,740      |      | $          | 274       |       | $ | 3,014 |   |

 

Expenses incurred related to the transitionof our Chattanooga activities are recorded within selling, general andadministrative expense on our statement of operations.

 

**13. COMMITMENTS AND CONTINGENCIES**

 

The manufacture and sale of orthopedic devices and related productsexposes us to significant risks of product liability claims, lawsuits andproduct recalls. From time to time, we have been, and we are currently, thesubject of a number of product liability claims and lawsuits relating to ourproducts. We are currently defendants in approximately 80 product liabilitycases related to a disposable drug infusion pump product manufactured by twothird party manufacturers that we distributed through our Bracing and Supportsbusiness unit of our Domestic Rehabilitation segment. We discontinued our saleof these products in the second quarter of 2009. These cases have been broughtagainst the manufacturers and certain distributors of these pumps, and in somecases, the manufacturers of the anesthetics used in these pumps. All of theselawsuits allege that the use of these pumps with certain anesthetics in certainshoulder surgeries over prolonged periods have resulted in cartilage damage tothe plaintiffs. We have sought indemnity and tendered the defense of thesecases to the two manufacturers who supplied these pumps to us, to theirproducts liability carrier and to our product liability carrier. The productliability carrier for both of the two manufacturers has accepted coverage forour defense of these claims; however, both manufacturers have rejected ourtenders of indemnity.  Our productliability carrier has also accepted coverage of these cases, subject to customaryreservations, and was providing us with the defense until the carrier for themanufacturers began providing a defense. The lawsuits allege damages rangingfrom unspecified amounts to claims between $1.0 million and$10.0 million. These cases are in varying stages of discovery.

 

We maintain product liability insurance which is subject to annualrenewal and our recently renewed policy (together with excess policies)provides for coverage of up to a limit of $25.0 million, subject to aself-insured retention of $50,000 on non-invasive products (other than ourIceMan cold therapy product), a self-insured retention of $250,000 on invasiveproducts (other than our pain pump products) and a self-insured retention of$500,000 for pain pumps and the IceMan cold therapy product, with an aggregateself-insured retention of $1.0 million for all product liability claims. Webelieve our current product liability insurance coverage is adequate. However,if a product liability claim or series of claims is brought against us foruninsured liabilities or in excess of our insurance coverage, our businesscould suffer materially. In addition, in certain instances, a product liabilityclaim could also result in our having to recall some of our products, whichcould result in significant costs to us. As of September 26, 2009 and December 31,2008, we have accrued approximately $2.0 million and $1.8 million,respectively, for product liability claims expenses based upon previous claimexperience in part due to the fact that in 2003 we exceeded the coverage limitsin effect at that time for certain historical product liability claimsinvolving one of our discontinued surgical implant products and such productsare excluded from coverage under our current policies.

 

Dueto the nature of our business, we are subject to a variety of audits bygovernment agencies and other private interests.  In the first quarter of 2008, we received aU.S. Food and Drug Administration (“FDA”) Form 483 “InspectionalObservations” in connection with an FDA audit of the Chattanooga business unitof our Domestic Rehabilitation Segment, stating that we failed to reportcertain customer complaints claiming that our muscle stimulator devicesmalfunctioned, and that we did not adequately implement corrective andpreventive action to prevent recurrence of potential product failures relatingto our muscle stimulator devices. The FDA auditor also recommended that werecall a series of ultrasound devices that had experienced operating issues in2005, and we are implementing such a recall. We received a warning letter fromthe FDA in June 2008 relating to reporting issues on the muscle stimulatordevice complaints and requesting software verification and validation plans andreports regarding the correction of problems associated with the ultrasoundproduct. We believe that we have addressed these areas of concern adequately.In a recent FDA audit of our Chattanooga facility, as a follow-up to thewarning letter we received in June 2008, the FDA issued no Form 483 “InspectionalObservations.”  However, we cannot assureyou that the FDA will not take further action along these lines in the future.

 

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In the third quarter of 2009, we received an FDA Form 483“Inspectional Observations” in connection with an FDA audit of our DomesticSurgical Implant Segment, stating that we failed to follow our standardoperating procedures to ensure that the designs of certain products werecorrectly transferred into production; we failed to adequately analyze certainquality data to identify existing and potential causes of nonconforming productand quality problems, resulting in disposal or reworking of certainnonconforming parts in the later stages of our production processes; ourcomplaint handling procedures were not well defined to ensure that allcomplaints are processed in a uniform and timely manner; and we failed tofollow our standard operating procedures related to procurement to minimizereceipt of nonconforming materials from suppliers. We are reviewing theseinspectional observations to determine the appropriate remedial action. Wecannot assure you that the FDA will not take further action in the future,including issuing a warning letter related to these observations.

 

OnApril 15, 2009, we became aware of a *Qui Tam* actionfiled in Federal Court in Boston, Massachusetts in March 2005 and amendedin December 2007 that names us as defendants 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.  The case was sealed whenoriginally filed and unsealed in March 2009.  The plaintiff, or relator, alleges that thedefendants have engaged in Medicare fraud and violated Federal and state falseclaims acts from the time of the original introduction of the devices by eachdefendant to the present by seeking reimbursement for bone growth stimulatorsas a purchased item rather than a rental item. The relator also alleges that the defendants are engaged in othermarketing practices constituting violations of the Federal and various stateantikickback statutes.  Shortly beforebecoming aware of the *Qui Tam* action,we were advised that our bone growth stimulator business was the subject of aninvestigation by the Department of Justice (“DOJ”), and on April 10, 2009,we were served with a subpoena under the Health Insurance Portability and Accountability Act seekingnumerous documents relating to the marketing and sale by us of bone growthstimulators.  We believe that thissubpoena is related to the DOJ’s investigation of the allegations in the *Qui Tam* action, although the DOJ has decided not tointervene in the *Qui Tam* action at this time.  The Company believes that its marketingpractices in the bone growth stimulation business are in compliance withapplicable legal standards and intends to defend this case vigorously.

 

**14. RELATED PARTY TRANSACTIONS**

 

Blackstone Management Partners V L.L.C. (“BMP”), an affiliate of ourmajor shareholder, provides certain monitoring, advisory and consulting servicesto us for an annual monitoring fee equal to the greater of $7.0 million or2% of consolidated EBITDA as defined in the Transaction and Monitoring FeeAgreement, payable in the first quarter of each year. At any time in connectionwith or in anticipation of a change of control of DJOFL, a sale of all orsubstantially all of DJOFL’s assets or an initial public offering of commonstock of DJOFL, BMP may elect to receive, in lieu of remaining annualmonitoring fee payments, a single lump sum cash payment equal to thethen-present value of all then-current and future annual monitoring feespayable under the transaction and monitoring fee agreement, assuming ahypothetical termination date of the agreement to be the twelfth anniversary ofsuch election. The monitoring fee agreement will continue until the earlier ofthe twelfth anniversary of the date of the agreement or such date as DJOFL andBMP may mutually determine. DJOFL will agree to indemnify BMP and itsaffiliates, directors, officers, employees, agents and representatives from andagainst all liabilities relating to the services contemplated by thetransaction and monitoring fee agreement and the engagement of BMP pursuant to,and the performance of BMP and its affiliates of the services contemplated by,the transaction and monitoring fee agreement. For each of the three and ninemonth periods ended September 26, 2009 and September 27, 2008, werecognized $1.75 million and $5.25 million, respectively, related to themonitoring fee, which is recorded as a component of selling, general andadministrative expense in the unaudited condensed consolidated statements ofoperations.

 

**15. DERIVATIVE INSTRUMENTS**

 

We operate internationally and are therefore exposed to foreigncurrency exchange rate fluctuations in the normal course of our business, inparticular to changes in the Mexican Peso due to our Mexico-based manufacturingoperations that incur costs that are largely denominated in Mexican Pesos. Aspart of our risk management strategy, we use derivative instruments to hedgeportions of our exposure. While our foreign exchange contracts act as economichedges, we have not designated such instruments as hedges under ASC815-20.  Before acquiring a derivativeinstrument to hedge a specific risk, potential natural hedges are evaluated.Derivative instruments are only utilized to manage underlying exposures thatarise from our business operations. Factors considered in the decision to hedgean underlying market exposure include the materiality of the risk, thevolatility of the market, the duration of the hedge, and the availability,effectiveness and cost of derivative instruments.  At September 26, 2009, we had 53 foreignexchange forward contracts, with a notional amount of $10.9 million and anaggregate fair market value of approximately $11.4 million. These foreignexchange forward contracts expire weekly throughout the fiscal year 2009.

 

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Additionally, we make use of debt financing as a source of funds andare therefore exposed to interest rate fluctuations in the normal course ofbusiness. Our credit facilities are subject to floating interest rates. Wemanage the risk of unfavorable movements in interest rates by hedging a portionof the outstanding loan balance, thereby locking in a fixed rate on a portionof the principal, reducing the effect of possible rising interest rates andmaking interest expense more predictable. On November 20, 2007, we entered into an interest rate swapagreement related to the Senior Secured Credit Facility for a notional amountof $515.0 million at a fixed LIBOR rate of 4.205% amortizing through anexpiration date in December 2009 (the notional amount was $435.0 millionas of September 26, 2009).  In February 2009,we entered into two new non-amortizing interest rate swap agreements.  The first agreement is for a notional amountof $550.0 million at a fixed LIBOR rate of 1.04% beginning February 2009amortizing through December 2009 (the notional amount was $550.0 millionas of September 26, 2009).  Thesecond agreement is for a notional amount of $750.0 million at a fixed LIBORrate of 1.88% with a term beginning January 2010 through December 2010.  In August 2009, we entered into four newnon-amortizing interest swap agreements with notional amounts aggregating$300.0 million.  Each of the fouragreements has a term beginning January 2011 through December 2011.The four agreements are at a weighted average fixed LIBOR rate of 2.5825%.  We have designated these interest rate swapagreements as cash flow hedges under ASC 815-20.

 

In accordance with ASC 820-10-35 (formerly SFAS No. 157, “FairValue Measurements”), we follow the three levels of the fair value hierarchyfor disclosure of the inputs to valuation. This hierarchy prioritizes theinputs into three broad levels as follows. Level 1 inputs are quotedprices (unadjusted) in active markets for identical assets or liabilities. Level 2inputs are quoted prices for similar assets and liabilities in active marketsor inputs that are observable for the asset or liability, either directly orindirectly through market corroboration, for substantially the full term of thefinancial instrument. Level 3 inputs are unobservable inputs based on ourown assumptions used to measure assets and liabilities at fair value. Afinancial asset or liability’s classification within the hierarchy isdetermined based on the lowest level input that is significant to the fairvalue measurement. At September 26, 2009, the fair value of our interestrate swap agreements and our foreign currency exchange forward contracts weredetermined through the use of models that consider various assumptions,including time value, yield curves, as well as other relevant economicmeasures, which are inputs that are classified as Level 2 in the valuationhierarchy.

 

The following table summarizes our derivative instruments, which, sincethe fair values reflect gains and losses are, included within our assets andother current and non-current liabilities, respectively, in our condensedconsolidated balance sheets (in thousands):

 

| ** **                   | ** ** | **September 26,  2009** | ** ** | **December 31,  2008** | ** ** |
|------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets:**                  | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Foreign exchange contracts   |       | $                            | 427        |                        | $          | — |   |
| Total derivative assets      |       | $                            | 427        |                        | $          | — |   |
| ** **                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **Liabilities:**             | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Foreign exchange contracts   |       | $                            | —     |                        | $          | 4,162 |   |
| Interest rate swaps          |       | 18,599                       |       | 13,272                      |       |
| Total derivative liabilities |       | $                            | 18,599     |                        | $          | 17,434 |   |

 

The following table summarizes the effect our derivative instrumentshave on our condensed consolidated statements of operations (in thousands):

 
| ** **                 | ** ** | ** **                       | ** ** | **Three Months Ended**             | ** ** | **Nine Months Ended**              | ** ** |
|----------------------------|------------|----------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                 | ** ** | **Location of Gain or   (Loss)** | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** |
|                       | ** ** | ** **                       | ** ** | ** **                         | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Foreign exchange contracts |       | Other income (expense), net      |       | $                                  | 427        |                               | $          | 163 |   | $ | (2,945 | ) | $ | 914 |   |
| Interest rate swaps        |       | Interest expense                 |       | (5,001                             | )          | (1,741                             | )          | (12,629 | ) | (2,823 | ) |
| Total net loss             |       |                             |       | $                                  | (4,574     | )                                  | $          | (1,578 | ) | $ | (15,574 | ) | $ | (1,909 | ) |

 

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**16. SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATINGFINANCIAL STATEMENTS**

 

On November 20, 2007, DJOFL and its direct wholly-ownedsubsidiary, Finco, issued the 10.875% Notes with an aggregate principal amountof $575.0 million. On November 3, 2006, DJOFL and Finco issued the11.75% Notes with an aggregate principal amount of $200.0 million. Fincowas formed solely to act as a co-issuer of the notes, has only nominal assetsand does not conduct any operations. The Indentures generally prohibit Fincofrom holding any assets, becoming liable for any obligations, or engaging inany business 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 the co-issuer) that are 100% owned, directlyor indirectly, by DJOFL (the “Guarantors”). The 11.75% Notes are jointly andseverally, fully and unconditionally guaranteed, on an unsecured seniorsubordinated basis by the Guarantors. Our foreign subsidiaries (the “Non-Guarantors”)do not guarantee the notes. The Guarantors also unconditionally guarantee theSenior Secured Credit Facility.

 

The following tables present the financial position, results ofoperations and cash flows of DJOFL, the Guarantors, the Non-Guarantors andcertain eliminations as of September 26, 2009 and December 31, 2008and for the three and nine months ended September 26, 2009 and September 27,2008, respectively.

 

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**DJO Finance LLC**

** **

**UnauditedCondensed Consolidating Balance Sheets**

**As of September 26,2009**

**(inthousands)**

 
| ** **                                                      | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Current assets:                                                 |       |      |       |           |       |                 |       |             |       |             |       |
| Cash and cash equivalents                                       |       | $         | 3,532      |           | $          | 28,322               |       | $                | 19,425     |             | $          | — |   | $ | 51,279 |   |
| Accounts receivable, net                                        |       | —    |       | 122,899        |       | 37,543               |       | —           |       | 160,442          |       |
| Inventories, net                                                |       | —    |       | 81,587         |       | 24,806               |       | (9,281           | )          | 97,112           |       |
| Deferred tax assets, net                                        |       | —    |       | 37,759         |       | 1,022                |       | (1,220           | )          | 37,561           |       |
| Prepaid expenses and other current assets                       |       | 29        |       | 15,892         |       | 2,199                |       | —           |       | 18,120           |       |
| Total current assets                                            |       | 3,561     |       | 286,459        |       | 84,995               |       | (10,501          | )          | 364,514          |       |
| Property and equipment, net                                     |       | —    |       | 73,913         |       | 12,825               |       | (2,017           | )          | 84,721           |       |
| Goodwill                                                        |       | —    |       | 1,108,703      |       | 84,341               |       | —           |       | 1,193,044        |       |
| Intangible assets, net                                          |       | —    |       | 1,173,055      |       | 41,499               |       | —           |       | 1,214,554        |       |
| Investment in subsidiaries                                      |       | 1,242,942 |       | 2,262,373      |       | 70,344               |       | (3,575,659       | )          | —           |       |
| Intercompany receivable                                         |       | 1,151,653 |       | —         |       | —               |       | (1,151,653       | )          | —           |       |
| Other non-current assets                                        |       | 41,597    |       | 887            |       | 2,766                |       | —           |       | 45,250           |       |
| Total assets                                                    |       | $         | 2,439,753  |           | $          | 4,905,390            |       | $                | 296,770    |             | $          | (4,739,830 | ) | $ | 2,902,083 |   |
| **Liabilities and Membership  Equity**                          |       |      |       |           |       |                 |       |             |       |             |       |
| Current liabilities:                                            |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts payable                                                |       | $         | —     |           | $          | 34,782               |       | $                | 6,008      |             | $          | (1 | ) | $ | 40,789 |   |
| Long-term debt and capital leases, current portion              |       | 10,650    |       | 175            |       | 469                  |       | —           |       | 11,294           |       |
| Other current liabilities                                       |       | 60,795    |       | 57,280         |       | 27,007               |       | —           |       | 145,082          |       |
| Total current liabilities                                       |       | 71,445    |       | 92,237         |       | 33,484               |       | (1               | )          | 197,165          |       |
| Long-term debt and capital leases, net of  current portion |       | 1,803,670 |       | 82             |       | 137                  |       | —           |       | 1,803,889        |       |
| Deferred tax liabilities, net                                   |       | —    |       | 305,761        |       | 15,158               |       | (1,074           | )          | 319,845          |       |
| Intercompany payable, net                                       |       | —    |       | 1,019,878      |       | 131,775              |       | (1,151,653       | )          | —           |       |
| Other non-current liabilities                                   |       | —    |       | 11,458         |       | 2,873                |       | —           |       | 14,331           |       |
| Total liabilities                                               |       | 1,875,115 |       | 1,429,416      |       | 183,427              |       | (1,152,728       | )          | 2,335,230        |       |
| Total membership equity                                         |       | 564,638   |       | 3,475,974      |       | 113,343              |       | (3,587,102       | )          | 566,853          |       |
| Total liabilities and membership equity                         |       | $         | 2,439,753  |           | $          | 4,905,390            |       | $                | 296,770    |             | $          | (4,739,830 | ) | $ | 2,902,083 |   |

 

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**DJOFinance LLC**

 

**UnauditedCondensed Consolidating Balance Sheets**

**As of December 31,2008**

**(inthousands)**

 
| ** **                                                      | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Current assets:                                                 |       |      |       |           |       |                 |       |             |       |             |       |
| Cash and cash equivalents                                       |       | $         | —     |           | $          | 14,373               |       | $                | 16,110     |             | $          | — |   | $ | 30,483 |   |
| Accounts receivable, net                                        |       | —    |       | 130,151        |       | 34,467               |       | —           |       | 164,618          |       |
| Inventories, net                                                |       | —    |       | 86,533         |       | 21,183               |       | (4,550           | )          | 103,166          |       |
| Deferred tax assets, net                                        |       | —    |       | 34,756         |       | —               |       | (717             | )          | 34,039           |       |
| Prepaid expenses and other current assets                       |       | 303       |       | 13,516         |       | 1,388                |       | 1,716            |       | 16,923           |       |
| Total current assets                                            |       | 303       |       | 279,329        |       | 73,148               |       | (3,551           | )          | 349,229          |       |
| Property and equipment, net                                     |       | —    |       | 75,875         |       | 12,316               |       | (1,929           | )          | 86,262           |       |
| Goodwill                                                        |       | —    |       | 1,120,690      |       | 70,876               |       | —           |       | 1,191,566        |       |
| Intangible assets, net                                          |       | —    |       | 1,228,872      |       | 31,600               |       | —           |       | 1,260,472        |       |
| Investment in subsidiaries                                      |       | 1,119,504 |       | 1,119,058      |       | 52,461               |       | (2,291,023       | )          | —           |       |
| Intercompany receivable                                         |       | 1,295,225 |       | —         |       | —               |       | (1,295,225       | )          | —           |       |
| Other non-current assets                                        |       | 49,951    |       | 2,173          |       | 477                  |       | —           |       | 52,601           |       |
| Total assets                                                    |       | $         | 2,464,983  |           | $          | 3,825,997            |       | $                | 240,878    |             | $          | (3,591,728 | ) | $ | 2,940,130 |   |
| **Liabilities and Membership  Equity**                          |       |      |       |           |       |                 |       |             |       |             |       |
| Current liabilities:                                            |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts payable                                                |       | $         | —     |           | $          | 33,566               |       | $                | 9,100      |             | $          | 86 |   | $ | 42,752 |   |
| Long-term debt and capital leases, current portion              |       | 10,650    |       | 187            |       | 712                  |       | —           |       | 11,549           |       |
| Other current liabilities                                       |       | 24,213    |       | 69,249         |       | 22,243               |       | (338             | )          | 115,367          |       |
| Total current liabilities                                       |       | 34,863    |       | 103,002        |       | 32,055               |       | (252             | )          | 169,668          |       |
| Long-term debt and capital leases, net of  current portion |       | 1,831,754 |       | 100            |       | 190                  |       | —           |       | 1,832,044        |       |
| Deferred tax liabilities, net                                   |       | —    |       | 318,826        |       | 9,195                |       | 1,482            |       | 329,503          |       |
| Intercompany payable                                            |       | —    |       | 1,209,321      |       | 85,904               |       | (1,295,225       | )          | —           |       |
| Other non-current liabilities                                   |       | —    |       | 8,716          |       | 90                   |       | —           |       | 8,806            |       |
| Total liabilities                                               |       | 1,866,617 |       | 1,639,965      |       | 127,434              |       | (1,293,995       | )          | 2,340,021        |       |
| Total membership equity                                         |       | 598,366   |       | 2,186,032      |       | 113,444              |       | (2,297,733       | )          | 600,109          |       |
| Total liabilities and membership equity                         |       | $         | 2,464,983  |           | $          | 3,825,997            |       | $                | 240,878    |             | $          | (3,591,728 | ) | $ | 2,940,130 |   |

 

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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                                                |       | —    |       | 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 acquired intangibles                         |       | —    |       | 18,639         |       | 921                  |       | —           |       | 19,560           |       |
| Operating income                                             |       | —    |       | 27,569         |       | 879                  |       | (4,890           | )          | 23,558           |       |
| Other income (expense):                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                              |       | 4,351     |       | 753            |       | 175                  |       | (5,068           | )          | 211              |       |
| Interest expense                                             |       | (38,978   | )          | (4,370         | )          | (885                 | )          | 5,060            |       | (39,173          | )          |
| Other income, net                                            |       | 23,253    |       | (56,348        | )          | 1,418                |       | 33,099           |       | 1,422            |       |
| Income (loss)from continuing operations before  income taxes |       | (11,374   | )          | (32,396        | )          | 1,587                |       | 28,201           |       | (13,982          | )          |
| Provision (benefit) for income taxes                         |       | —    |       | (3,895         | )          | 926                  |       | —           |       | (2,969           | )          |
| Income (loss) from discontinued operations, net              |       | —    |       | (267           | )          | —               |       | —           |       | (267             | )          |
| Net income (loss)                                            |       | (11,374   | )          | (28,768        | )          | 661                  |       | 28,201           |       | (11,280          | )          |
| Noncontrolling interests                                     |       | —    |       | —         |       | 94                   |       | —           |       | 94               |       |
| Net income (loss) attributable to DJO Finance LLC            |       | $         | (11,374    | )              | $          | (28,768              | )          | $                | 567        |             | $          | 28,201 |   | $ | (11,374 | ) |

 

**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                                                |       | —    |       | 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 acquired intangibles                         |       | —    |       | 55,917         |       | 1,945                |       | —           |       | 57,862           |       |
| Operating income                                             |       | —    |       | 52,823         |       | 3,167                |       | (295             | )          | 55,695           |       |
| Other income (expense):                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                              |       | 13,737    |       | 2,190          |       | 656                  |       | (15,834          | )          | 749              |       |
| Interest expense                                             |       | (116,818  | )          | (13,835        | )          | (2,489               | )          | 15,823           |       | (117,319         | )          |
| Other income (expense), net                                  |       | 64,314    |       | (47,719        | )          | 1,860                |       | (15,446          | )          | 3,009            |       |
| Income (loss)from continuing operations before  income taxes |       | (38,767   | )          | (6,541         | )          | 3,194                |       | (15,752          | )          | (57,866          | )          |
| Provision (benefit) for income taxes                         |       | —    |       | (21,385        | )          | 1,484                |       | —           |       | (19,901          | )          |
| Income (loss) from discontinued operations, net              |       | —    |       | (434           | )          | —               |       | —           |       | (434             | )          |
| Net income (loss)                                            |       | (38,767   | )          | 14,410         |       | 1,710                |       | (15,752          | )          | (38,399          | )          |
| 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 Operations**

**For theThree Months Ended September 27, 2008**

**(inthousands)**

 
| ** **                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                     |       | $         | —     |           | $          | 196,680              |       | $                | 61,320     |             | $          | (22,485 | ) | $ | 235,515 |   |
| Cost of sales                                                 |       | —    |       | 75,806         |       | 35,734               |       | (24,594          | )          | 86,946           |       |
| Gross profit                                                  |       | —    |       | 120,874        |       | 25,586               |       | 2,109            |       | 148,569          |       |
| Operating expenses:                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                           |       | —    |       | 84,749         |       | 19,030               |       | (1               | )          | 103,778          |       |
| Research and development                                      |       | —    |       | 5,947          |       | 826                  |       | —           |       | 6,773            |       |
| Amortization of acquired intangibles                          |       | —    |       | 18,629         |       | 530                  |       | —           |       | 19,159           |       |
| Operating income                                              |       | —    |       | 11,549         |       | 5,200                |       | 2,110            |       | 18,859           |       |
| Other income (expense):                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                               |       | 10,534    |       | 921            |       | 219                  |       | (11,338          | )          | 336              |       |
| Interest expense                                              |       | (41,848   | )          | (10,577        | )          | (986                 | )          | 11,338           |       | (42,073          | )          |
| Other income (expense), net                                   |       | 16,885    |       | (862           | )          | (1,739               | )          | (16,881          | )          | (2,597           | )          |
| Income (loss) from continuing operations before  income taxes |       | (14,429   | )          | 1,031          |       | 2,694                |       | (14,771          | )          | (25,475          | )          |
| Provision (benefit) for income taxes                          |       | —    |       | (12,897        | )          | 1,208                |       | 659              |       | (11,030          | )          |
| Income (loss) from discontinued operations, net               |       | —    |       | 314            |       | —               |       | —           |       | 314              |       |
| Net (loss) income                                             |       | (14,429   | )          | 14,242         |       | 1,486                |       | (15,430          | )          | (14,131          | )          |
| Noncontrolling interests                                      |       | —    |       | —         |       | 298                  |       | —           |       | 298              |       |
| Net income (loss) attributable to DJO Finance LLC             |       | $         | (14,429    | )              | $          | 14,242               |       | $                | 1,188      |             | $          | (15,430 | ) | $ | (14,429 | ) |

 

**DJOFinance LLC**

 

**UnauditedCondensed Consolidating Statements of Operations**

**For theNine Months Ended September 27, 2008**

**(inthousands)**

 
| ** **                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                     |       | $         | —     |           | $          | 581,192              |       | $                | 196,647    |             | $          | (68,937 | ) | $ | 708,902 |   |
| Cost of sales                                                 |       | —    |       | 221,185        |       | 112,369              |       | (71,308          | )          | 262,246          |       |
| Gross profit                                                  |       | —    |       | 360,007        |       | 84,278               |       | 2,371            |       | 446,656          |       |
| Operating expenses:                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                           |       | —    |       | 262,055        |       | 65,674               |       | (7               | )          | 327,722          |       |
| Research and development                                      |       | —    |       | 18,431         |       | 2,248                |       | —           |       | 20,679           |       |
| Amortization of acquired intangibles                          |       | —    |       | 55,809         |       | 1,606                |       | —           |       | 57,415           |       |
| Operating income                                              |       | —    |       | 23,712         |       | 14,750               |       | 2,378            |       | 40,840           |       |
| Other income (expense):                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                               |       | 36,855    |       | 3,343          |       | 566                  |       | (39,578          | )          | 1,186            |       |
| Interest expense                                              |       | (129,153  | )          | (37,108        | )          | (3,058               | )          | 39,564           |       | (129,755         | )          |
| Other income (expense), net                                   |       | 32,909    |       | (21            | )          | (950                 | )          | (32,904          | )          | (966             | )          |
| Income (loss) from continuing operations before  income taxes |       | (59,389   | )          | (10,074        | )          | 11,308               |       | (30,540          | )          | (88,695          | )          |
| Provision (benefit) for income taxes                          |       | —    |       | (32,837        | )          | 3,212                |       | 659              |       | (28,966          | )          |
| Income (loss) from discontinued operations, net               |       | —    |       | 1,133          |       | —               |       | —           |       | 1,133            |       |
| Net (loss) income                                             |       | (59,389   | )          | 23,896         |       | 8,096                |       | (31,199          | )          | (58,596          | )          |
| Noncontrolling interests                                      |       | —    |       | —         |       | 793                  |       | —           |       | 793              |       |
| Net income (loss) attributable to DJO Finance LLC             |       | $         | (59,389    | )              | $          | 23,896               |       | $                | 7,303      |             | $          | (31,199 | ) | $ | (59,389 | ) |

 

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**DJO Finance LLC**

 

**UnauditedCondensed Consolidating Statements of Cash Flows**

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

**(inthousands)**

 
| ** **                                                                                                         | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Net loss (income)                                                                                                  |       | $         | (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 intangibles                                                                                        |       | —    |       | 55,917         |       | 1,945                |       | —           |       | 57,862           |       |
| Amortization of debt issuance costs                                                                                |       | 9,597     |       | —         |       | —               |       | —           |       | 9,597            |       |
| Stock-based compensation                                                                                           |       | —    |       | 2,335          |       | —               |       | —           |       | 2,335            |       |
| Loss on disposal of assets                                                                                         |       | —    |       | 270            |       | 270                  |       | (75              | )          | 465              |       |
| Gain on disposal of discontinued operations                                                                        |       | —    |       | (496           | )          | —               |       | 103              |       | (393             | )          |
| Deferred income taxes                                                                                              |       | —    |       | (24,012        | )          | (711                 | )          | 2,149            |       | (22,574          | )          |
| Non-cash income 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, other assets and liabilities                                                                     |       | 273       |       | (4,826         | )          | 4,855                |       | (338             | )          | (36              | )          |
| Accounts payable and other current liabilities                                                                     |       | 31,190    |       | (8,856         | )          | (591                 | )          | 253              |       | 21,996           |       |
| Net cash (used in) provided by operating   activities                                                         |       | (62,021   | )          | 146,863        |       | 9,710                |       | (31,985          | )          | 62,567           |       |
| **INVESTING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net cash acquired                                                                       |       | —    |       | (2,417         | )          | (10,429              | )          | —           |       | (12,846          | )          |
| Acquisition of intangibles                                                                                         |       | —    |       | (103           | )          | (51                  | )          | —           |       | (154             | )          |
| Purchases of property and equipment                                                                                |       | —    |       | (15,558        | )          | (4,129               | )          | 554              |       | (19,133          | )          |
| Proceeds from sale of discontinued operations                                                                      |       | —    |       | 21,846         |       | —               |       | —           |       | 21,846           |       |
| Other, net                                                                                                         |       | —    |       | 78             |       | —               |       | —           |       | 78               |       |
| Net cash (used in) provided by investing   activities                                                         |       | —    |       | 3,846          |       | (14,609              | )          | 554              |       | (10,209          | )          |
| **FINANCING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                       |       | 94,878    |       | (136,731       | )          | 10,422               |       | 31,431           |       | —           |       |
| Payments on revolving line of credit                                                                               |       | (94,325   | )          | (26            | )          | (483                 | )          | —           |       | (94,834          | )          |
| Proceeds from debt and revolving line of credit                                                                    |       | 65,000    |       | (3             | )          | 176                  |       | —           |       | 65,173           |       |
| Net cash (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 (decrease) 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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**DJOFinance LLC**

 

**UnauditedCondensed Consolidating Statements of Cash Flows**

**For theNine Months Ended September 27, 2008**

**(inthousands)**

 
| ** **                                                                                                         | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Net loss (income)                                                                                                  |       | $         | (59,389    | )              | $          | 23,896               |       | $                | 8,096      |             | $          | (31,199 | ) | $ | (58,596 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                                       |       | —    |       | 14,568         |       | 3,459                |       | (595             | )          | 17,432           |       |
| Amortization of intangibles                                                                                        |       | —    |       | 55,809         |       | 1,606                |       | —           |       | 57,415           |       |
| Amortization of debt issuance costs                                                                                |       | 9,857     |       | —         |       | —               |       | —           |       | 9,857            |       |
| Stock-based compensation                                                                                           |       | —    |       | 1,204          |       | —               |       | —           |       | 1,204            |       |
| Asset impairments and loss on disposal  of assets                                                             |       | —    |       | 1,046          |       | 380                  |       | (65              | )          | 1,361            |       |
| Deferred income taxes                                                                                              |       | —    |       | (19,096        | )          | (330                 | )          | 659              |       | (18,767          | )          |
| Non-cash income from subsidiaries                                                                                  |       | (32,908   | )          | (9             | )          | —               |       | 32,917           |       | —           |       |
| Provision for doubtful accounts and sales returns                                                                  |       | —    |       | 15,026         |       | 385                  |       | —           |       | 15,411           |       |
| Inventory reserves                                                                                                 |       | —    |       | 4,118          |       | 422                  |       | —           |       | 4,540            |       |
| Changes in operating assets and liabilities,  net of acquired assets and liabilities:                         |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                                |       | —    |       | (30,702        | )          | (3,217               | )          | —           |       | (33,919          | )          |
| Inventories                                                                                                        |       | —    |       | 5,114          |       | 1,603                |       | (2,357           | )          | 4,360            |       |
| Prepaid expenses, other assets and liabilities                                                                     |       | 9         |       | (7,045         | )          | 2,221                |       | (89              | )          | (4,904           | )          |
| Accounts payable and other current liabilities                                                                     |       | 33,642    |       | (14,582        | )          | 1,125                |       | 89               |       | 20,274           |       |
| Net cash (used in) provided by  operating activities                                                          |       | (48,789   | )          | 49,347         |       | 15,750               |       | (640             | )          | 15,668           |       |
| **INVESTING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net of cash acquired                                                                    |       | —    |       | (1,170         | )          | (46                  | )          | —           |       | (1,216           | )          |
| Acquisition of intangible assets                                                                                   |       | —    |       | (2,062         | )          | (1,817               | )          | —           |       | (3,879           | )          |
| Purchases of property and equipment                                                                                |       | —    |       | (16,385        | )          | (3,354               | )          | 640              |       | (19,099          | )          |
| Other, net                                                                                                         |       | —    |       | 1,214          |       | —               |       | —           |       | 1,214            |       |
| Net cash (used in) provided by investing activities                                                                |       | —    |       | (18,403        | )          | (5,217               | )          | 640              |       | (22,980          | )          |
| **FINANCING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                       |       | 53,595    |       | (45,976        | )          | (7,619               | )          | —           |       | —           |       |
| Proceeds from debt and revolving line of credit                                                                    |       | 12,000    |       | —         |       | —               |       | —           |       | 12,000           |       |
| Payments on debt and revolving line of credit                                                                      |       | (17,325   | )          | (683           | )          | (3,543               | )          | —           |       | (21,551          | )          |
| Net cash provided by (used in)  financing activities                                                          |       | 48,270    |       | (46,659        | )          | (11,162              | )          | —           |       | (9,551           | )          |
| Effect of exchange rate changes on cash and  cash equivalents                                                 |       | —    |       | —         |       | (236                 | )          | —           |       | (236             | )          |
| **Net decrease in cash and  cash equivalents**                                                                |       | (519      | )          | (15,715        | )          | (865                 | )          | —           |       | (17,099          | )          |
| Cash and cash equivalents at beginning of period                                                                   |       | 519       |       | 44,694         |       | 18,258               |       | —           |       | 63,471           |       |
| Cash and cash equivalents at end of period                                                                         |       | $         | —     |           | $          | 28,979               |       | $                | 17,393     |             | $          | — |   | $ | 46,372 |   |

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Forward Looking Statements**

 

The following management’s discussion and analysis contains “forwardlooking statements” within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934 thatrepresent our expectations or beliefs concerning future events, including, butnot limited to, statements regarding growth in sales of our products, profitmargins and the sufficiency of our cash flow for future liquidity and capitalresource needs. These forward-looking statements are further qualified byimportant factors that could cause actual results to differ materially fromthose in the forward-looking statements. Some of these factors are describedunder the heading “Risk Factors” below. The section entitled “Risk Factors”contained in Part II, Item 1A of this report, and similar discussionsin our other SEC filings including our 2008 Annual Report on Form 10-Kfiled with the Commission on March 11, 2009, describe some important riskfactors that may affect our business, financial condition, results ofoperations, and/or liquidity. Results actually achieved may differ materiallyfrom expected results included in these statements as a result of these orother factors.

 

**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 thecondensed consolidated financial statements and related notes to thosefinancial statements as well as the other financial data included elsewhere inthis Form 10-Q.

 

**Overview of Business**

 

We are a leading global provider of high-quality, orthopedic devices,with a broad range of products used for rehabilitation, pain management andphysical therapy. We also develop, manufacture and distribute a broad range ofsurgical reconstructive implant products. We are the largest non-surgicalorthopedic rehabilitation device company in the United States and among thelargest globally, as measured by revenues. Many of our products have leadingmarket positions. We believe that our strong brand names, comprehensive rangeof products, focus on quality, innovation and customer service, extensivedistribution network, and our strong relationships with orthopedic and physicaltherapy professionals have contributed to our leading market positions. Webelieve that we are one of only a few orthopedic device companies that offerhealthcare professionals and patients a diverse range of orthopedicrehabilitation products addressing the complete spectrum of preventative,pre-operative, post-operative, clinical and home rehabilitation care. Ourproducts are used by orthopedic specialists, spine surgeons, primary carephysicians, pain management specialists, physical therapists, podiatrists,chiropractors, athletic trainers and other healthcare professionals to treatpatients with musculoskeletal conditions resulting from degenerative diseases,deformities, traumatic events and sports-related injuries. In addition, many ofour non-surgical medical devices and related accessories are used by athletesand patients for injury prevention and at-home physical therapy treatment.

 

On June 12, 2009 we sold our ETS catalog business to PattersonMedical Supply, Inc. for approximately $21.0 million plus an additionalpayment related to the retention by DJO of certain outstanding liabilities. Assuch, results of the ETS business for periods prior to the date of sale havebeen presented as discontinued operations.

 

We provide a broad array of orthopedic rehabilitation and regenerationproducts, as well as implants to customers in the United States andabroad.  In the first quarter of 2009, wechanged how we report financial information to the Chief Operating DecisionMaker.  Prior to 2009, we included theinternational components of the Surgical, Chattanooga, and Empi businesses ineither the Surgical or Domestic Rehabilitation segments, as their operationswere managed domestically.  During thefourth quarter of 2008, we effected an operational reorganization whichresulted in the non-U.S. components of all of our businesses being managedabroad.  As a result, the segmentfinancial data for the three and nine months ended September 26, 2009 reflectsthis new segmentation and the data for the three and nine months ended September 27,2008, as noted below, has been restated to reflect this change.  We currently develop, manufacture anddistribute our products through the following three operating segments:

 

***Domestic Rehabilitation Segment***

 

Our Domestic Rehabilitation Segment, which generates its revenues inthe United States, is divided into five main businesses:

 

·                  *Bracingand Supports. *Our Bracing andSupports business unit offers our DonJoy, ProCare and Aircast products,including rigid knee bracing, orthopedic soft goods, cold therapy products, andvascular systems.  This business unitalso includes our OfficeCare business, through which we maintain an inventoryof soft goods and other products at healthcare facilities, primarily orthopedicpractices, for immediate distribution to patients.

 

·                  *Empi. *Our Empi business unitoffers products in the category of home electrotherapy, iontophoresis, and hometraction.

 

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·                  *Regeneration*.  Our Regeneration business unit sells our bonegrowth stimulation products.  Theseproducts are sold through a combination of certain DonJoy sales representativesand additional independent and employed sales representatives dedicated toselling these products either directly to patients or independentdistributors.  We arrange billing tothese third party payors or patients for products directly sold to thepatients.

 

·                  *Chattanooga. *Our Chattanooga businessunit offers products in the clinical rehabilitation market in the category 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 business unit offers our Compexelectrostimulation device to consumers, ranging from people interested inimproving their fitness to competitive athletes, to assist in athletic trainingprograms through muscle development and to accelerate muscle recovery aftertraining sessions.

 

***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.

 

***Domestic Surgical Implant Segment***

 

Our Domestic Surgical Implant Segment develops, manufactures andmarkets a wide variety of knee, hip and shoulder implant products that servethe orthopedic reconstructive joint implant market in the United States.

 

Our three operating segments enable us to reach a diverse customer basethrough multiple distribution channels and give us the opportunity to provide awide range of orthopedic devices and related products to orthopedic specialistsoperating in a variety of patient treatment settings. These three segmentsconstitute our three reportable segments. See Note 10 to our unauditedcondensed consolidated financial statements for additional informationregarding our segments.

 

Set forth below is net revenue, gross profit and operating incomeinformation for our reporting segments for the three and nine months ended September 26,2009 and September 27, 2008, respectively. This information excludesintersegment and certain expenses not allocated to segments (which areprimarily comprised of general corporate expenses, certain non-recurringcharges, and adjustments related to the DJO Merger and certain other smalleracquisitions for all periods presented). All prior periods presented have beenrestated to reflect our current reportable segments.

 
| ** **                                         | ** ** | **Three Months Ended**             | ** ** | **Nine Months Ended**              | ** ** |
|----------------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| **($ in thousands)**                          | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** | **September 26,********2009** | ** ** | **September 27,********2008** | ** ** |
| **Domestic Rehabilitation:**                       |       |                               |       |                               |       |   |   |   |   |
| Net sales                                          |       | $                                  | 162,182    |                               | $          | 162,521 |   | $ | 468,991 |   | $ | 468,104 |   |
| Gross profit                                       |       | $                                  | 108,523    |                               | $          | 101,127 |   | $ | 310,910 |   | $ | 296,606 |   |
| Gross profit margin                                |       | 66.9                               | %          | 62.2                               | %          | 66.3 | % | 63.4 | % |
| Operating income                                   |       | $                                  | 48,402     |                               | $          | 36,903 |   | $ | 127,539 |   | $ | 100,936 |   |
| Operating income as a percent of net segment sales |       | 29.8                               | %          | 22.7                               | %          | 27.2 | % | 21.6 | % |
| **International:**                                 |       |                               |       |                               |       |   |   |   |   |
| Net sales                                          |       | $                                  | 58,588     |                               | $          | 58,485 |   | $ | 172,863 |   | $ | 194,794 |   |
| Gross profit                                       |       | $                                  | 32,434     |                               | $          | 35,669 |   | $ | 98,645 |   | $ | 117,726 |   |
| Gross profit margin                                |       | 55.4                               | %          | 61.0                               | %          | 57.1 | % | 60.4 | % |
| Operating income                                   |       | $                                  | 10,625     |                               | $          | 12,239 |   | $ | 33,556 |   | $ | 43,803 |   |
| Operating income as a percent of net segment sales |       | 18.1                               | %          | 20.9                               | %          | 19.4 | % | 22.5 | % |
| **Domestic Surgical Implant:**                     |       |                               |       |                               |       |   |   |   |   |
| Net sales                                          |       | $                                  | 15,416     |                               | $          | 14,509 |   | $ | 47,097 |   | $ | 46,004 |   |
| Gross profit                                       |       | $                                  | 11,779     |                               | $          | 11,888 |   | $ | 36,541 |   | $ | 37,864 |   |
| Gross profit margin                                |       | 76.4                               | %          | 81.9                               | %          | 77.6 | % | 82.3 | % |
| Operating income                                   |       | $                                  | 2,805      |                               | $          | 2,767 |   | $ | 8,982 |   | $ | 8,983 |   |
| Operating income as a percent of net segment sales |       | 18.2                               | %          | 19.1                               | %          | 19.1 | % | 19.5 | % |

 

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***Acquisition of Chattanooga GroupInc.***

 

OnAugust 4, 2009 we acquired Chattanooga Group Inc., a Canadian distributorof certain of our products (“Chattanooga Canada”), for $7.2 million.  Pursuant to the terms of the acquisitionagreement and included within the purchase price, is a $1.4 million holdbackand a $1.4 million promissory note.  Theholdback provides security for potential indemnification claims and, if notused for such, indemnification claims will be paid to the sellers.  The holdback also provides for the accrual ofinterest at an annual rate of 2.5% for the first 18 months and a variable ratethereafter.  Fifty percent of theholdback with interest is due in January 2011 and the remainder of thebalance with interest is due in three years, upon expiration of the tax statuteof limitations period.  The note providesfor the accrual of interest at an annual rate of 6% with the principal andinterest due in August 2010.  Thefair values of the assets acquired and the liabilities assumed were estimatedin accordance with ASC 805-10.

 

***Acquisition of Empi Canada Inc.***

 

OnAugust 4, 2009 we acquired Empi Canada Inc., a Canadian distributor ofcertain of our products (“Empi Canada “), for $7.4 million.  Pursuant to the terms of the acquisitionagreement and included within the purchase price, is a $1.4 million holdbackand a $1.4 million promissory note.  Theholdback provides security for potential indemnification claims and, if notused for such, indemnification claims will be paid to the sellers.  The holdback also provides for the accrual ofinterest at an annual rate of 2.5% for the first 18 months and a variable rate thereafter. Fifty percent of the holdback withinterest is due in January 2011 and the remainder of the balance withinterest is due in three years, upon expiration of the tax statute oflimitations period.  The note providesfor the accrual of interest at an annual rate of 6% with the principal andinterest due in August 2010.  Thefair values of the assets acquired and the liabilities assumed were estimatedin accordance with ASC 805-10.

 

***Acquisition of DonJoy OrthopaedicsPty. Ltd.***

 

OnFebruary 3, 2009 we acquired DonJoy Orthopaedics Pty., Ltd., an Australiandistributor of certain of our products (“DJO Australia”), for $3.7million.  Pursuant to the terms of theacquisition agreement and included within the purchase price, is an additionalamount of up to $0.5 million payable to the selling shareholder of DJOAustralia if certain revenue targets are met by December 31, 2009.  The fair values of the assets acquired andthe liabilities assumed were estimated in accordance with ASC 805-10.

 

**Results of Operations**

 

The following table sets forth our statements of operations as apercentage of sales for the periods indicated:

 
| ** **                                                | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended**       | ** ** |
|-----------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                | ** ** | **September 26, 2009** | ** ** | **September 27, 2008** | ** ** | **September 26, 2009** | ** ** | **September 27, 2008** | ** ** |
| Net  sales                                                |       | $                           | 236,186    |                        | 100.0      | % | $ | 235,515 |   | 100.0 | % | $ | 688,951 |   | 100.0 | % | $ | 708,902 |   | 100.0 | % |
| Cost of sales                                             |       | 86,039                      |       | 36.4                        |       | 86,946 |   | 36.9 |   | 247,195 |   | 35.9 |   | 262,246 |   | 37.0 |   |
| Gross profit                                              |       | 150,147                     |       | 63.6                        |       | 148,569 |   | 63.1 |   | 441,756 |   | 64.1 |   | 446,656 |   | 63.0 |   |
| Operating  expenses:                                      |       |                        |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and  administrative                      |       | 101,413                     |       | 42.9                        |       | 103,778 |   | 44.1 |   | 310,618 |   | 45.1 |   | 327,722 |   | 46.2 |   |
| Research and development                                  |       | 5,616                       |       | 2.4                         |       | 6,773 |   | 2.9 |   | 17,581 |   | 2.6 |   | 20,679 |   | 2.9 |   |
| Amortization of acquired  intangibles                     |       | 19,560                      |       | 8.3                         |       | 19,159 |   | 8.1 |   | 57,862 |   | 8.4 |   | 57,415 |   | 8.1 |   |
| Operating income                                          |       | 23,558                      |       | 10.0                        |       | 18,859 |   | 8.0 |   | 55,695 |   | 8.1 |   | 40,840 |   | 5.8 |   |
| Other  income (expense):                                  |       |                        |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                           |       | 211                         |       | 0.1                         |       | 336 |   | 0.1 |   | 749 |   | 0.1 |   | 1,186 |   | 0.2 |   |
| Interest  expense                                         |       | (39,173                     | )          | (16.6                       | )          | (42,073 | ) | (17.9 | ) | (117,319 | ) | (17.0 | ) | (129,755 | ) | (18.3 | ) |
| Other income (expense),  net                              |       | 1,422                       |       | 0.6                         |       | (2,597 | ) | (1.1 | ) | 3,009 |   | 0.4 |   | (966 | ) | (0.1 | ) |
| Loss  from continuing operations before income taxes |       | (13,982                     | )          | (5.9                        | )          | (25,475 | ) | (10.8 | ) | (57,866 | ) | (8.4 | ) | (88,695 | ) | (12.5 | ) |
| Benefit  for income taxes                                 |       | (2,969                      | )          | (1.3                        | )          | (11,030 | ) | (4.7 | ) | (19,901 | ) | (2.9 | ) | (28,966 | ) | (4.1 | ) |
| Income (loss) from  discontinued operations, net     |       | (267                        | )          | (0.1                        | )          | 314 |   | 0.1 |   | (434 | ) | (0.1 | ) | 1,133 |   | 0.2 |   |
| Net  loss                                                 |       | (11,280                     | )          | (4.8                        | )          | (14,131 | ) | (6.0 | ) | (38,399 | ) | (5.6 | ) | (58,596 | ) | (8.3 | ) |
| Noncontrolling interests                                  |       | 94                          |       | 0.0                         |       | 298 |   | 0.1 |   | 368 |   | 0.1 |   | 793 |   | 0.1 |   |
| Net  loss attributable to DJO Finance LLC                 |       | $                           | (11,374    | )                           | (4.8       | )% | $ | (14,429 | ) | (6.1 | )% | $ | (38,767 | ) | (5.6 | )% | $ | (59,389 | ) | (8.4 | )% |

 

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***Three Months Ended September 26,2009 compared to Three Months Ended September 27, 2008***

 

*Net Sales.*  Our netsales for the three months ended September 26, 2009 were $236.2 million,representing an increase of 0.3% from net sales of $235.5 million for the threemonths ended September 27, 2008. This increase was primarily driven by higher sales in each of ourdomestic business units, except Chattanooga as well as increasing sales in ourinternational segments on the basis of constant currency rates, offset by $3.4million of unfavorable changes in foreign exchange rates compared to rates ineffect for the three months ended September 27, 2008.

 

For the three months ended September 26, 2009 and September 27,2008, we generated 24.8% of our net sales from customers outside the UnitedStates. Additionally, sales of new products, which include products that havebeen on the market less than one year, were $5.1 million for the three monthsended September 26, 2009, compared to new product sales of $16.7 millionfor the three months ended September 27, 2008.

 

The following table sets forth the mix of our net sales for the threemonths ended September 26, 2009 compared to the three months ended September 27,2008:

 
| ** **                        | ** ** | **Three Months Ended**       | ** ** | ** **             | ** ** | ** **                         | ** ** |
|-----------------------------------|------------|------------------------------|------------|------------------------|------------|------------------------------------|------------|
| **($ in thousands)**         | ** ** | **September 26,  2009** | ** ** | **% of Net  Revenues** | ** ** | **September 27,********2008** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Domestic Rehabilitation Segment   |       | $                            | 162,182    |                   | 68.7       | %                                  | $          | 162,521 |   | 69.0 | % | $ | (339 | ) | (0.2 | )% |
| International Segment             |       | 58,588                       |       | 24.8                   |       | 58,485                             |       | 24.8 |   | 103 |   | 0.2 |   |
| Domestic Surgical Implant Segment |       | 15,416                       |       | 6.5                    |       | 14,509                             |       | 6.2 |   | 907 |   | 6.3 |   |
| **Consolidated net sales**        |       | $                            | 236,186    |                   | 100.0      | %                                  | $          | 235,515 |   | 100.0 | % | $ | 671 |   | 0.3 | % |

 

Net sales in our Domestic Rehabilitation Segment were $162.2 millionfor the three months ended September 26, 2009, reflecting a decrease of0.2% from net sales of $162.5 million for the three months ended September 27,2008. The decrease was driven primarily by declines in revenues in ourChattanooga business due to the economic downturn and constraints in the creditmarkets which have compelled customers to slow purchases of capital equipmentitems supplied by Chattanooga.

 

Net sales in our International Segment for the three months ended September 26,2009 were $58.6 million, reflecting an increase of 0.2% from net sales of $58.5million for the three months ended September 27, 2008. The increase wasdriven primarily by higher sales across the majority of the territories, offsetby $3.4 million of unfavorable changes in foreign exchange rates compared torates in effect for the three months ended September 27, 2008 and lowersales in certain territories due to the economic downturn.  On the basis of constant currency rates, salesin our International Segment grew 5.9% in the three months ended September 26,2009 compared to the prior year period.

 

Net sales in our Domestic Surgical Implant Segment increased to $15.4million from $14.5 million for the three months ended September 26, 2008,representing a 6.3% increase over the same period in the prior year. Theincrease was driven primarily by an increase in sales of our shoulder products.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales increased to 63.6% for the three months ended September 26, 2009from 63.1% for the three months ended September 27, 2008. The increase inour gross profit margin is primarily attributable to cost improvementinitiatives implemented in the past year and the benefits of a more favorablemix of products sold, partially offset by unfavorable changes in foreignexchange rates of approximately $2.5 million and a $1.9 million non-recurringreserve of certain inventory in our Chattanooga business.

 

Gross profit in our Domestic Rehabilitation Segment as a percentage ofnet sales increased to 66.9% for the three months ended September 26, 2009from 62.2% for the three months ended September 27, 2008. The increase wasprimarily driven by cost improvement initiatives and the benefits of a morefavorable mix of products sold, partially offset by a $1.9 millionnon-recurring reserve of certain inventory in our Chattanooga business.

 

Gross profit in our International Segment as a percentage of net salesdecreased to 55.4% for the three months ended September 26, 2009 from61.0% for the three months ended September 27, 2008.  The decrease was primarily driven byunfavorable changes in foreign exchange rates of approximately $2.5 million andthe impact of a less favorable mix of products sold.

 

Gross profit in our Domestic Surgical Implant Segment as a percentageof gross sales decreased to 76.4% for the three months ended September 26,2009 from 81.9% for the three months ended September 27, 2008. Thedecrease was primarily driven by a lower margin mix of products sold and, to alesser extent, higher inventory obsolescence costs.

 

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*Selling, General and Administrative.*  Our selling, general and administrativeexpenses decreased to $101.4 million for the three months ended September 26,2009 from $103.8 million for the three months ended September 27, 2008 dueto overall cost savings initiatives, partially offset by $1.3 million of highernon-recurring costs as a result of our integration activities. The followingtable sets forth certain non-recurring costs associated with our integrationactivities and the implementation of our new global ERP system:

 

| ** **                                 | ** ** | **Three Months Ended**             | ** ** |
|--------------------------------------------|------------|------------------------------------|------------|
| **($ in thousands)**                  | ** ** | **September 26,********2009** | ** ** | **September 27,  2008** | ** ** |
| Employee severance and relocation expenses |       | $                                  | 156        |   | $ | 2,602 |   |
| Integration expenses                       |       | 8,058                              |       | 4,264 |   |
| ERP implementation                         |       | 2,658                              |       | 2,180 |   |
|                                       |       | $                                  | 10,872     |   | $ | 9,046 |   |

 

Employee severance and relocation for the three months ended September 26,2009 included severance in connection with integration activities following theDJO Merger and restructuring at our international locations.   Employee severance and relocation expensesfor the three months ended September 27, 2008 consisted of $2.2 million ofseverance in connection with the DJO Merger and $0.4 million of severance inconnection with other acquisitions. Integration expense for the three months ended September 26, 2009included $4.5 million of integration costs accrued in connection with theintegration of theoperations of the Chattanooga site into our other existing sites and $3.6million of integration costs in connection with the DJO merger and other smallacquisitions.  Integrationexpenses for the three months ended September 27, 2008 included $3.9million of integration costs accrued in connection with the DJO Merger and $0.4million of integration costs related to other acquisitions.

 

*Research and Development.*  Our research and development expensedecreased to $5.6 million for the three months ended September 26, 2009from $6.8 million for the three months ended September 27, 2008. As apercentage of net sales, research and development expense decreased slightly to2.4% from 2.9% in the three months ended September 27, 2008, primarilyreflecting cost savings initiatives.

 

*Amortization of Acquired Intangibles.*  Amortization of acquired intangibles includesamortization expense related to intangible assets acquired in connection withour acquisitions. The intangible assets are being amortized over the estimatedlives ranging from two to 20 years. Our amortization of acquired intangiblesincreased to $19.6 million for the three months ended September 26, 2009from $19.2 million for the three months ended September 27, 2008.

 

*Interest Expense.*  Our interest expense decreased to $39.2million for the three months ended September 26, 2009 from interestexpense of $42.1 million for the three months ended September 27,2008.  The decrease is primarily relatedto lower debt levels and reduced interest rates.

 

*Other Income (Expense).*  Net other income increased to $1.4 millionfor the three months ended September 26, 2009 from net other expense of$2.6 million for the three months ended September 27, 2008.  Both amounts primarily reflect net foreigncurrency transaction (losses) or gains.

 

*Benefit for Income Taxes.*  For the three months ended September 26,2009, we recorded $3.0 million of income tax benefit on a pre-tax loss of $13.9million.  For the three months ended September 27,2008, we recorded $11.0 million of income tax benefit on a pre-tax loss of$25.5 million.

 

***Nine Months Ended September 26,2009 compared to Nine Months Ended September 27, 2008***

 

*Net Sales*.  Our netsales for the nine months ended September 26, 2009 were $689.0 million,representing a decrease of 2.8% from net sales of $708.9 million for the ninemonths ended September 27, 2008. This decrease was primarily driven by $20.0 million of unfavorablechanges in foreign exchange rates compared to rates in effect for the ninemonths ended September 27, 2008.

 

For the nine months ended September 26, 2009, we generated 25.1%of our net sales from customers outside the United States as compared to 27.5%for the nine months ended September 27, 2008. Additionally, sales of newproducts, which include products that have been on the market less than oneyear, were $12.4 million for the nine months ended September 26, 2009,compared to new product sales of $28.4 million for the nine months ended September 27,2008.

 

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The following table sets forth the mix of our net sales for the ninemonths ended September 26, 2009 compared to the nine months ended September 27,2008:

 
| ** **                         | ** ** | **Nine Months Ended**        | ** ** | ** **             | ** ** | ** **                         | ** ** |
|------------------------------------|------------|------------------------------|------------|------------------------|------------|------------------------------------|------------|
| **($ in thousands)**          | ** ** | **September 26,  2009** | ** ** | **% of Net  Revenues** | ** ** | **September 27,********2008** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Domestic Rehabilitation Segments   |       | $                            | 468,991    |                   | 68.1       | %                                  | $          | 468,104 |   | 66.0 | % | $ | 887 |   | 0.2 | % |
| International Segments             |       | 172,863                      |       | 25.1                   |       | 194,794                            |       | 27.5 |   | (21,931 | ) | (11.3 | ) |
| Domestic Surgical Implant Segments |       | 47,097                       |       | 6.8                    |       | 46,004                             |       | 6.5 |   | 1,093 |   | 2.4 |   |
| **Consolidated net sales**         |       | $                            | 688,951    |                   | 100.0      | %                                  | $          | 708,902 |   | 100.0 | % | $ | (19,951 | ) | (2.8 | )% |

 

Net sales in our Domestic Rehabilitation Segment were $469.0 millionfor the nine months ended September 26, 2009, reflecting a slight increaseof 0.2% from net sales of $468.1 million for the nine months ended September 27,2008. The increase was driven primarily by second quarter growth across themajority of our product lines, mostly offset by declines in revenues in ourChattanooga business due to the economic downturn and constraints in the creditmarkets which have compelled customers to slow purchasing capital equipmentitems supplied by Chattanooga and a slowdown in certain customer purchasingduring the first quarter due to the overall global economic decline.

 

Net sales in our International Segment for the nine months ended September 26,2009 were $172.9 million, reflecting a decrease of 11.3% from net sales of$194.8 million for the nine months ended September 27, 2008. The decreasewas driven primarily by $20.0 million of unfavorable changes in foreignexchange rates compared to rates in effect for the nine months ended September 27,2008 and reduced sales of consumer products and clinical physicalequipment.  On the basis of constantcurrency rates, sales in our International Segment decreased 1.0% for the ninemonths ended September 26, 2009 compared to the nine months ended September 27,2008.

 

Net sales in our Domestic Surgical Implant Segment increased slightlyto $47.1 million from $46.0 million for the nine months ended September 26,2009, representing a 2.4% increase over the same period in the prior year. Theincrease was driven primarily by an increase in sales of our shoulder products.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales increased to 64.1% for the nine months ended September 26, 2009from 63.0% for the nine months ended September 27, 2008. The increase inour gross profit margin is primarily attributable to cost improvementinitiatives implemented in the past year and the benefits of a more favorablemix of products sold, partially offset by unfavorable changes in foreignexchange rates of approximately $14.5 million. Additionally, the increase in gross profit was driven by reducedamortization of purchased inventory fair value adjustments related to prioryear acquisitions of $4.7 million.

 

Gross profit in our Domestic Rehabilitation Segment as a percentage ofnet sales increased to 66.3% for the nine months ended September 26, 2009from 63.4% for the nine months ended September 27, 2008. The increase wasprimarily driven by cost improvements initiatives implemented in the past year,the benefits of a more favorable mix of products sold, and reduced amortizationof purchased inventory fair value adjustments related to prior yearacquisitions of $4.7 million.

 

Gross profit in our International Segment as a percentage of net salesdecreased to 57.1% for the nine months ended September 26, 2009 from 60.4%for the nine months ended September 27, 2008.  The decrease was primarily driven byunfavorable changes in foreign exchange rates of approximately $14.5 millionand the impact of a less favorable mix of products sold.

 

Gross profit in our Domestic Surgical Implant Segment as a percentageof gross sales decreased to 77.6% for the nine months ended September 26,2009 from 82.3% for the nine months ended September 27, 2008. The decreasewas primarily driven by lower margin mix of products sold and higher inventoryobsolescence costs.

 

*Selling, General and Administrative.*  Our selling, general and administrativeexpenses decreased to $310.6 million for the nine months ended September 26,2009 from $327.7 million for the nine months ended September 27, 2008 dueto overall cost savings initiatives and $9.4 million of lower non-recurringcosts as a result of our integration activities, partially offset by $12.2million of costs related to the implementation of our new global ERP system.The following table sets forth certain non-recurring costs associated with ourintegration activities and ERP implementation:

 

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| ** **                                 | ** ** | **Nine Months Ended**              | ** ** |
|--------------------------------------------|------------|------------------------------------|------------|
| **($ in thousands)**                  | ** ** | **September 26,********2009** | ** ** | **September 27,  2008** | ** ** |
| Employee severance and relocation expenses |       | 2,959                              |       | $ | 8,970 |   |
| Integration expenses                       |       | 22,843                             |       | 20,221 |   |
| Reversal of reimbursement claims           |       | (6,000                             | )          | — |   |
| ERP implementation                         |       | 14,735                             |       | 2,579 |   |
|                                       |       | $                                  | 34,537     |   | $ | 31,770 |   |
|                                            |            |                                    |            |  |  |  |  |

 

Employee severance and relocation expenses for the nine months ended September 26,2009 included $1.8 million of severance in connection with our recentcompany-wide headcount reduction and $1.2 million of severance in connectionwith integration activities following the DJO Merger and restructuring at ourinternational locations.  Employeeseverance and relocation expenses for the nine months ended September 27,2008 consisted of $5.0 million of severance related to the DJO Merger, $1.2million of severance in connection with other acquisitions and $2.8 million ofpayments and other expenses in connection with the termination of a formerexecutive officer.  Integration expensefor the nine months ended September 26, 2009 included $12.1 million, $5.3million and $5.4 million of integration costs accrued in connection with theDJO Merger, restructuring at our international locations and certain othersmaller acquisitions, and the integration of the operations of the Chattanoogasite into our other existing sites, respectively, partially offset by a $6.0million reversal of an accrual made in 2008 for alleged reimbursement claimsdue to the favorable settlement of the dispute.  Integration expenses for the nine months endedSeptember 27, 2008 included $17.2 million and $3.0 million of integrationcosts accrued in connection with the DJO Merger and other acquisitions,respectively.

 

*Research and Development.*  Our research and development expensedecreased to $17.6 million for the nine months ended September 26, 2009from $20.7 million for the nine months ended September 27, 2008. As apercentage of net sales, research and development expense decreased slightly to2.6% from 2.9% in the nine months ended September 27, 2008.

 

*Amortization of Acquired Intangibles.*  Amortization of acquired intangibles includesamortization expense related to intangible assets acquired in connection withour acquisitions. The intangible assets are being amortized over the estimatedlives ranging from two to twenty years. Our amortization of acquiredintangibles increased to $57.9 million for the nine months ended September 26,2009 from $57.4 million for the nine months ended September 27, 2008.

 

*Interest Expense.*  Our interest expense decreased to $117.3million for the nine months ended September 26, 2009 from interest expenseof $129.8 million for the nine months ended September 27, 2008.  The decrease is primarily related to lowerdebt levels and reduced interest rates.

 

*Other Income (Expense).*  Net other income increased to $3.0 millionfor the nine months ended September 26, 2009 from net other expense of$1.0 million for the nine months ended September 27, 2008.  Both amounts primarily reflect net foreigncurrency transaction (losses) or gains.

 

*Benefit for Income Taxes.*  For the nine months ended September 26,2009, we recorded $19.9 million of income tax benefit on a pre-tax loss of$57.8 million.  For the nine months endedSeptember 27, 2008, we recorded $29.0 million of income tax benefiton a pre-tax loss of $88.7 million.

 

During the first quarter of 2009, the state of California enactedlegislation which will allow corporate taxpayers to elect to use a single salesfactor apportionment formula to apportion business income to California for taxyears beginning on or after January 1, 2011. We anticipate making thiselection in fiscal year 2011 and thereafter. In the first quarter of 2009, werecorded a tax benefit of $3.8 million related to the enactment of thislegislation which represents a reduction in our net deferred tax liabilitiesdue to a lower effective state tax rate.

 

**Liquidity and Capital Resources**

 

As of September 26, 2009, our primary source of liquidityconsisted of cash and cash equivalents totaling $51.3 million and $100.0million of available borrowings under our revolving credit facility, describedbelow. Working capital at September 26, 2009 was $167.4 million. Webelieve that our existing cash, plus the amounts we expect to generate fromoperations and amounts available through our revolving credit facility, will besufficient to meet our operating needs for the next twelve months, includingworking capital requirements, capital expenditures, and debt and interestrepayment obligations. While we currently believe that we will be able to meetall of our financial covenants imposed by our Senior Secured Credit Facility,there is no assurance that we will in fact be able to do so or that, if we donot, we will be able to obtain from our lenders 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.

 

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A summary of the changes in our cash and cash equivalents for the ninemonths ended September 26, 2009 and September 27, 2008 is as follows:

 

| ** **                                                    | ** ** | **Nine Months Ended**        | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                    | ** ** | **September 26,  2009** | ** ** | **September 27,  2008** | ** ** |
| Cash provided by operating activities                         |       | $                            | 62,567     |   | $ | 15,668 |   |
| Cash used in investing activities                             |       | (10,209                      | )          | (22,980 | ) |
| Cash used in financing activities                             |       | (29,661                      | )          | (9,551 | ) |
| Effect of exchange rate changes on cash and cash  equivalents |       | (1,901                       | )          | (236 | ) |
| Net increase (decrease) in cash and cash  equivalents         |       | $                            | 20,796     |   | $ | (17,099 | ) |

 

***Cash Flows***

 

Operatingactivities provided cash of $62.6 million and $15.7 million for the nine monthsended September 26, 2009  and September 27,2008, respectively. Cash provided by operating activities for the nine monthsended September 26, 2009 primarily reflected our net income afteradjustment for non-cash charges and a favorable net change in operating assetsand liabilities. Cash provided by operating activities for the nine monthsended September 27, 2008 primarily reflected our net income after adjustmentfor non-cash charges partially offset by a slightly unfavorable net change inoperating assets and liabilities. Cash paid for interest was$76.4 million and $86.1 million for the nine months ended September 26,2009 and September 27, 2008, respectively.

 

Investing activities used $10.2 million and $23.0 million of cashfor the nine months ended September 26, 2009 and September 27, 2008,respectively. Cash used in investing activities for the nine months ended September 26,2009 primarily consisted of $19.1 million of purchases of property andequipment, including $4.3 million for our new ERP system, and the acquisition ofbusinesses for a total of $12.8 million, net of cash, partially offset by $21.8million of proceeds from the sales of assets, mainly ETS. Cash used ininvesting activities for the nine months ended September 27, 2008 wasprimarily used for purchases of property and equipment amounting to $19.1million, including $3.0 million for our new ERP system and the acquisition ofbusinesses for a total of $3.9 million.

 

Financing activities used $29.7 million and $9.6 million of cash forthe nine months ended September 26, 2009 and September 27, 2008,respectively. Cash used in financing activities for the nine months ended September 26,2009 and the nine months ended September, 2008 represented net payments onlong-term debt and revolving lines of credit.

 

For the remainder of 2009, we expect to spend total cash ofapproximately $79.8 million for the following:

 

· approximately $25.5 million for scheduledprincipal and estimated interest payments on our senior secured creditfacility;

 

· approximately $43.0million for scheduled interest payments on our senior notes; and

 

· approximately $11.3 million for capitalexpenditures, including $2.2 million for our ERP system.

 

Inaddition, we expect to spend up to an additional $22.3 million implementing our new ERP system capitalproject over approximately the next 15 months.

 

***Indebtedness***

 

As of September 26, 2009, we had approximately $1,815.2 million inaggregate indebtedness outstanding.

 

*Senior Secured Credit Facility*

 

*Overview.*  The Senior Secured Credit Facility providessenior secured financing of $1,165.0 million, consisting of a$1,065.0 million term loan facility 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,subject to receipt of additional commitments from participating lenders andcertain other conditions, to incur up to an additional $150.0 million ofborrowings under the Senior Secured Credit Facility.

 

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*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) theprime rate of Credit Suisse and (2) the federal funds rate plus 0.50% or (b) theEurodollar rate determined by reference to the costs of funds for deposits inU.S. dollars for the interest period relevant to each borrowing adjusted forrequired reserves. The initial applicable margins for borrowings under the termloan facility and the revolving credit facility is 2.00% with respect to baserate borrowings and 3.00% with respect to Eurodollar borrowings. The applicablemargin for borrowings under the term loan facility and the revolving creditfacility may be reduced subject to us attaining certain 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 8).  On November 20,2007, we entered into an interest rate swap agreement for a notional amount of$515.0 million at a fixed LIBOR rate of 4.205%.  This swap agreement amortizes through December 2009.As of September 26, 2009, the remaining notional amount of the swap was$435.0 million. In February 2009, we entered into two additionalnon-amortizing interest rate swap agreements. The first is for a notionalamount of $550.0 million at a fixed LIBOR rate of 1.04% beginning February 2009through December 2009 (with a remaining notional amount of $550.0 millionas of September 26, 2009). The second is for a notional amount of $750.0million at a fixed LIBOR rate of 1.88% beginning January 2010 through December 2010.  In August 2009, we entered into four newnon-amortizing interest swap agreements with notional amounts aggregating$300.0 million.  Each of the fouragreements has a term beginning January 2011 through December 2011.The four agreements are at a weighted average fixed LIBOR rate of 2.5825%.  As of September 26, 2009, our weightedaverage interest rate for all borrowings under the Senior Secured CreditFacility was 5.3%.

 

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 thereunder. The initial commitment fee rate is 0.50% per annum. Thecommitment 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

 

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·                  change our lines ofbusiness.

 

Pursuant to the terms of the credit agreement relating to the SeniorSecured Credit Facility, we are required to maintain a ratio of consolidatedsenior debt to Adjusted EBITDA (or senior leverage ratio) starting at a maximumof 5.1:1 and stepping down over time to 3.25:1 by the end of 2011. AdjustedEBITDA represents net income (loss) plus interest expense, net, provision(benefit) for income taxes and depreciation and amortization, further adjustedfor non-cash items, non-recurring items and other adjustment items permitted incalculating covenant compliance under our Senior Secured Credit Facility andthe Indentures (“Adjusted EBITDA”). As of September 26, 2009, we wererequired to maintain a senior leverage ratio not to exceed 4.50:1 and ouractual senior leverage ratio was within the required ratio at 4.00:1.

 

*10.875% Senior Notes and 11.75% Senior SubordinatedNotes*

 

The Indentures governing the $575.0 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 certain assetsto 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 Adjusted EBITDA to fixed charges ratio or having a ratio of atleast 2.00:1 on a pro forma basis after giving effect to such incurrence.Additionally, our ability to make certain restricted payments is also tied tohaving an Adjusted EBITDA to fixed charge ratio of at least 2.00:1 on a proforma basis. Our ratio of Adjusted EBITDA to fixed charges for the twelve monthsended September 26, 2009, measured on that date, was 1.68:1.Notwithstanding these limitations, the aggregate amount of term loan increasesand revolving commitment increases shall not exceed the greater of (i) $150.0 millionand (ii) the additional aggregate amount of secured indebtedness whichwould be permitted to be incurred as of any date of determination (assuming forthis purpose that the full amount of any revolving credit increase had beenutilized as of such date) such that, after giving pro forma effect to suchincurrence (and any other transactions consummated on such date), the seniorsecured leverage ratio for the immediately preceding test period would not begreater than 4.00:1. Fixed charges is defined in the Indentures as consolidatedinterest expense plus all cash dividends or other distributions paid on anyseries of preferred stock of any restricted subsidiary and all dividends orother distributions accrued on any series of disqualified stock.

 

*Covenant Compliance*

 

The following is a summary of our covenantrequirements and pro forma ratios as of September 26, 2009:

 

| ** **                                                                                                       | ** ** | **Covenant  Requirements** | ** ** | **Actual  Ratios** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **Senior Secured Credit Facility**                                                                               |       |                       |       |               |       |
| Maximum ratio of consolidated net senior secured  debt to Adjusted EBITDA                                        |       | 4.50:1                     |       | 4.00:1             |       |
| **10.875% Notes and 11.75% Notes**                                                                               |       |                       |       |               |       |
| Minimum ratio of Adjusted EBITDA to fixed charges  required to incur additional debt pursuant to ratio provision |       | 2.00:1                     |       | 1.68:1             |       |

 

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As described above, our Senior Secured Credit Facility consisting of a$1,065.0 million term loan facility and a $100.0 million revolvingcredit facility and the Indentures governing the $575.0 million of seniornotes and the $200.0 million of senior subordinated notes representsignificant components of our capital structure. Under our Senior SecuredCredit Facility, we are required to maintain specified senior secured leverageratios, which become more restrictive over time, and which are determined basedon our Adjusted EBITDA. If we fail to comply with the senior secured leverageratio under our Senior Secured Credit Facility, we would be in default underthe credit facility. Upon the occurrence of an event of default under theSenior Secured Credit Facility, the lenders could elect to declare all amountsoutstanding under the Senior Secured Credit Facility to be immediately due andpayable and terminate all commitments to extend further credit. If we wereunable to repay those amounts, the lenders under the Senior Secured CreditFacility could proceed against the collateral granted to them to secure thatindebtedness. We have pledged a significant portion of our assets as collateralunder the Senior Secured Credit Facility. Any acceleration under the SeniorSecured Credit Facility would also result in a default under the Indenturesgoverning the notes, which could lead to the noteholders electing to declarethe principal, premium, if any, and interest on the then outstanding notesimmediately due and payable. In addition, under the Indentures governing thenotes, 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 loss from discontinued operations,  interest expense, net, provision (benefit)for income taxes and depreciation and amortization, further adjusted fornon-cash items, non-recurring items and other adjustment items permitted incalculating 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 CreditFacility and the Indentures. Adjusted EBITDA is a material component of thesecovenants.

 

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 expensesthat may recur, vary greatly and are difficult to predict. While AdjustedEBITDA and similar measures are frequently used as measures of operations andthe ability to meet debt service requirements, Adjusted EBITDA is notnecessarily comparable to other similarly titled captions of other companiesdue to the potential 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 September 26, 2009.The terms and related calculations are defined in the credit agreement relatingto our Senior Secured Credit Facility and the Indentures.

 
| **(in thousands)**                                                                                | ** ** | **Three Months  Ended  September 26, 2009** | ** ** | **Twelve Months  Ended  September 26, 2009** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                        | ** ** | **(unaudited)**                                  | ** ** |
| Net loss attributable to DJO Finance LLC                                                          |       | $                                                | (11,374    | )                                                 | $          | (77,168 | ) |
| Loss from discontinued operations, net                                                            |       | 267                                              |       | 620                                               |       |
| Interest expense, net                                                                             |       | 38,962                                           |       | 159,501                                           |       |
| Income tax benefit                                                                                |       | (2,969                                           | )          | (40,616                                           | )          |
| Depreciation and amortization                                                                     |       | 27,163                                           |       | 126,114                                           |       |
| Non-cash items (a)                                                                                |       | 1,458                                            |       | 3,156                                             |       |
| Non-recurring items (b)                                                                           |       | 10,872                                           |       | 47,100                                            |       |
| Other adjustment items, before cost savings (c)                                                   |       | 536                                              |       | 15,343                                            |       |
| Other adjustment items—future cost savings  applicable for twelve month period only (d) |       | NA                                               |       | 13,162                                            |       |
| Adjusted EBITDA                                                                                   |       | $                                                | 64,915     |                                              | $          | 247,212 |   |

 

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(a)                                  Non-cash itemsare comprised of the following:

 
| **(in thousands)**         | ** ** | **Three Months  Ended  September 26, 2009** | ** ** | **Twelve Months  Ended  September 26, 2009** | ** ** |
|----------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                 | ** ** | **(unaudited)**                                  | ** ** |
| Stock compensation expense |       | $                                                | 909        |                                              | $          | 2,512 |   |
| Loss on disposal of assets |       | 549                                              |       | 644                                               |       |
| Total non-cash items       |       | $                                                | 1,458      |                                              | $          | 3,156 |   |

 

(b)                                 Non-recurringitems are comprised of the following:

 
| **(in thousands)**                    | ** ** | **Three Months  Ended  September 26, 2009** | ** ** | **Twelve Months  Ended  September 26, 2009** | ** ** |
|---------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                            | ** ** | **(unaudited)**                                  | ** ** |
| Employee severance and relocation (1) |       | $                                                | 156        |                                              | $          | 5,226 |   |
| Integration expense (2)               |       | 8,058                                            |       | 24,471                                            |       |
| ERP implementation                    |       | 2,658                                            |       | 17,403                                            |       |
| Total non-recurring items             |       | $                                                | 10,872     |                                              | $          | 47,100 |   |

 

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(1)         Employee severance andrelocation for the three months ended September 26, 2009 includedseverance in connection with integration activities following the DJO Mergerand restructuring at our international locations.   Employee severance and relocation for thetwelve months ended September 26, 2009 included $1.8 million of severancein connection with our recent company-wide headcount reduction and $3.4 millionof employee severance incurred in connection with the DJO Merger, certain otheracquisitions, and restructuring at our international locations.

 

(2)         Integration expense for thethree months ended September 26, 2009 included $4.5 million of integrationcosts accrued in connection with the integration of the operations of the Chattanooga site into our otherexisting sites and $3.6 million of integration costs in connection with the DJOmerger and other small acquisitions.  Integration expense for the twelve monthsended September 26, 2009 included $18.5 million, $6.6 million, and $5.4million of integration costs accrued in connection with the DJO Merger,restructuring at our international locations and certain other smalleracquisitions, and the integration of the operations of the Chattanooga siteinto our other existing sites, respectively, partially offset by a $6.0 millionreversal of an accrual made in 2008 for alleged reimbursement claims due to thefavorable settlement of the dispute.

 

(c)                                  Other adjustmentitems, before future cost savings, are comprised of the following:

 
| **(in thousands)**                                                           | ** ** | **Three  Months  Ended  September 26, 2009** | ** ** | **Twelve  Months  Ended  September 26, 2009** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **(unaudited)**                                   | ** ** |
| Blackstone monitoring fee                                                    |       | $                                                 | 1,749      |                                               | $          | 6,998 |   |
| Noncontrolling interest                                                      |       | 94                                                |       | 624                                                |       |
| Pre-acquisition EBITDA-applicable for the twelve  month period only (1) |       | NA                                                |       | 2,074                                              |       |
| Other (2)                                                                    |       | (1,307                                            | )          | 5,647                                              |       |
| Total other adjustment items, before cost savings                            |       | $                                                 | 536        |                                               | $          | 15,343 |   |

 

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(1)         Represents pre-acquisitionadjusted EBITDA for an Australia subsidiary acquired in February 2009 andtwo Canada subsidiaries acquired in August 2009.

 

(2)         Other adjustment items forthe three and twelve months ended September 26, 2009 included net foreigncurrency transaction (gains) losses.

 

(d)                                 Includes projectedcost savings related to headcount reductions, facilities consolidation andproduction efficiencies in connection with the DJO Merger and other smallacquisitions.

 

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**CriticalAccounting Policies and Estimates**

 

Our management’s discussion and analysis of financial condition andresults of operations is based upon our financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to reserves for contractual allowances, doubtful accounts,rebates, product returns and rental credits, goodwill and intangible assets,deferred tax assets and liabilities, and inventory. We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. To the extent that actual eventsdiffer from our estimates and assumptions, there could be a material impact onour financial statements.

 

We believe the following critical accounting policies affect our moresignificant judgments and estimates used in the preparation of our condensedconsolidated financial statements and this discussion and analysis of ourfinancial condition and results of operations.

 

***Reserves for Contractual Allowances,Doubtful Accounts, Rebates, Product Returns and Rental Credits***

 

We have established reserves to account for contractual allowances,doubtful accounts, rebates, product returns and rental credits. Significantmanagement judgment must be used and estimates must be made in connection withestablishing these reserves.

 

We maintain provisions for estimated contractual allowances forreimbursement amounts from our third party payor customers based on negotiatedcontracts and historical experience for non-contracted payors. We report theseallowances as reductions in our gross revenue. We estimate the amount of thereduction based on historical experience and invoices generated in the period,and we consider the impact of new contract terms or modifications of existingarrangements with our customers. We have contracts with certain third partypayors for our third party reimbursement billings, which call for specifiedreductions in reimbursement of billed amounts based upon contractualreimbursement rates. For the nine months ended September 26, 2009 and September 27,2008, we reserved for and reduced gross revenues from third party payors by 31%and 32%, respectively, for estimated allowances related to these contractualreductions.

 

Our reserve for doubtful accounts is based upon estimated losses fromcustomers who are billed directly and the portion of third party reimbursementbillings that ultimately become the financial responsibility of the end userpatients. Direct-billed customers represented approximately 67% and 73% of ournet revenues for the nine months ended September 26, 2009 and September 27,2008, respectively, and approximately 64% and 66% of our net accountsreceivable for the nine months ended September 26, 2009 and September 27,2008, respectively. We experienced write-offs of less than 1% of related netrevenues for the nine months ended September 26, 2009 and September 27,2008, respectively. Our third party reimbursement customers including insurancecompanies, managed care companies and certain governmental payors, such asMedicare, include all of our OfficeCare customers, most of our Empi customers,and certain other customers of our Domestic Rehabilitation Segment. Ourthird-party payor customers represented approximately 33% and 27% of our netrevenues for the nine months ended September 26, 2009 and September 27,2008, respectively, and approximately 36% and 34% of our net accountsreceivable for the nine months ended September 26, 2009 and September 27,2008, respectively. For the nine months ended September 26, 2009 and September 27,2008, we estimate bad debt expense to be approximately 7% and 5%, respectively,of gross revenues from these third party reimbursement customers. If thefinancial condition of our customers were to deteriorate resulting in animpairment of their ability to make payments or if third party payors were todeny claims for late filings, incomplete information or other reasons,additional provisions may be required. Additions to this reserve are reflectedas selling, general and administrative expense.

 

Our reserve for rebates accounts for incentives that we offer tocertain of our distributors. These rebates generally are attributable to salesvolume, sales growth and to reimburse the distributor for certain discounts. Werecord estimated reductions to revenue for customer rebate programs based uponhistorical experience and estimated revenue levels.

 

Our reserve for product returns accounts for estimated customer returnsof our products after purchase. These returns are mainly attributable to athird party payor’s refusal to provide reimbursement for the product or theinability of the product to adequately address the patient’s condition. Weprovide for this reserve by reducing gross revenue based on our historical rateof returns.

 

Our reserve for rental credit recognizes a timing difference betweenbilling for a sale and processing a rental credit associated with some of ourrehabilitation devices. Many insurance providers require patients to rent ourrehabilitation devices for a period of one to six months prior to purchase. Ifthe patient has a long-term need for the device, these insurance companies mayauthorize purchase of the device after such time period. When the device is purchased,most providers require that rental payments previously made on 

 

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thedevice be credited toward the purchase price. These credits are processed atthe time the payment is received for the purchase of the device, which createsa time lag between billing for a sale and processing the rental credit. Ourrental credit reserve estimates unprocessed rental credits based on the numberof devices converted to purchase. The reserve is calculated by first assessingthe number of our products being rented during the relevant period and ourhistorical conversion rate of rentals to sales, and then reducing our revenue bythe applicable amount. We provide for these reserves by reducing our grossrevenue. The cost to refurbish rented products is expensed as incurred as partof cost of sales.

 

***Inventory Reserves***

 

We provide reserves for estimated excess and obsolete inventories equalto the difference between the costs of inventories on hand plus future purchasecommitments and the estimated market value based upon assumptions about futuredemand. If future demand is less favorable than currently projected bymanagement, additional inventory write-downs may be required. We also providereserves for newer product inventories, as appropriate, based on any minimumpurchase commitments and our level of sales of the new products.

 

We consign a portion of our inventory to allow our products to beimmediately dispensed to patients. This requires a large amount of inventory tobe on hand for the products we sell through consignment arrangements. It alsoincreases the sensitivity of these products to obsolescence reserve estimates. Asthis inventory is not in our possession, we maintain additional reserves forestimated shrinkage of these inventories based on the results of periodicinventory counts and historical trends.

 

***Goodwill and Intangible Assets***

 

In accordance with ASC 350-20 (formerly SFAS No. 142, “Goodwilland Other Intangible Assets” (“SFAS No.142”)), we do not amortize goodwill. Inlieu of amortization, we are required to perform an annual review forimpairment. Goodwill is recorded as the difference, if any, between the aggregateconsideration paid for an acquisition and the fair value of the net tangibleand intangible assets acquired. The amounts and useful lives assigned tointangible assets acquired, other than goodwill, impact the amount and timingof future amortization, and the amount assigned to in-process research anddevelopment which is expensed immediately. The value of our intangible assets,including goodwill, could be impacted by future adverse changes such as: (i) anyfuture declines in our operating results, (ii) a further decline in thevaluation of comparable company stocks, (iii) a further significantslowdown in the worldwide economy or our industry or (iv) any failure tomeet the performance projections included in our forecasts of future operatingresults. We estimated the fair values of our reporting units primarily usingthe income approach valuation methodology that includes the discounted cashflow method, taking into consideration the market approach and certain marketmultiples as a validation of the values derived using the discounted cash flowmethodology. The discounted cash flows for each reporting unit were based ondiscrete financial forecasts developed by management for planning purposes.Cash flows beyond the discrete forecasts were estimated using a terminal valuecalculation, which incorporated historical and forecasted financial trends foreach identified reporting unit and considered long-term earnings growth ratesfor publicly traded peer companies. Future cash flows were discounted to presentvalue by incorporating the present value techniques discussed in FASB ConceptsStatement 7, “Using Cash FlowInformation and Present Value in Accounting Measurements,” or ConceptsStatement 7. Specifically, the income approach valuations included reportingunit cash flow discount rates ranging from 10.8% to 11.6% and terminal valuegrowth rates of 3%. Publicly available information regarding the marketcapitalization was also considered in assessing the reasonableness of thecumulative fair values of our reporting units estimated using the discountedcash flow methodology.  Significantmanagement judgment is required in the forecasts of future operating resultsthat are used in the discounted cash flow method of valuation. The estimates wehave used are consistent with the plans and estimates that we use to manage ourbusiness. It is possible, however, that the plans may change and estimates usedmay prove to be inaccurate. If our actual results, or the plans and estimatesused in future impairment analyses, are lower than the original estimates usedto assess the recoverability of these assets, we could incur significantimpairment charges.

 

We perform an impairment analysis on our goodwill on an annual basis inthe fourth quarter and in certain other circumstances when impairmentindicators are present. Our annual impairment test related to goodwill did notindicate any impairment.  As a result ofour sale, a portion of goodwill was allocated to the business sold based onrelative fair values.   The remainingportion of goodwill retained was tested for impairment in accordance with ASC350-20 in June 2009.  Our June 2009impairment test did not indicate any impairment.

 

Furthermore, ASC 350-30 (formerly SFAS No. 142)states that intangible assets with indefinite lives should be tested annuallyin lieu of being amortized.  Thistestwork compares the fair value of the intangible with its carryingamount.  To determine the fair value weapplied the relief from royalty method (“RFR”). Under the RFR method, the value of the trade name is determined bycalculating the present value of the after-tax cost savings associated withowning the asset and therefore not being required to pay royalties for its useduring the asset’s indefinite life. Significant judgments inherent in this analysis include the selection ofappropriate discount rates, estimating future cash flows and the identificationof appropriate terminal growth rate assumptions.  Discount rate assumptions are based on anassessment of the risk inherent in the projected future cash generated by therespective intangible assets.  Alsosubject to judgment are assumptions about royalty rates, which are based on theestimated rates at which similar brands and trademarks are being licensed inthe marketplace.

 

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***Deferred Tax Asset ValuationAllowance***

 

We recognize deferred tax assets and liabilities based on the differencesbetween the financial statement carrying amount and the tax bases of assets,liabilities and net operating loss carryforwards. We establish valuationallowances when the recovery of a deferred tax asset is not likely based onhistorical income, projected future income, the expected timing of thereversals of temporary differences and the implementation of tax-planningstrategies.

 

Our gross deferred tax asset balance was approximately $193.7 millionat September 26, 2009 and primarily related to reserves for accountsreceivable and inventory, accrued expenses, and net operating losscarryforwards (see Note 11 to our unaudited condensed consolidatedfinancial statements). As of September 26, 2009, we maintained a valuationallowance of $6.9 million due to uncertainties related to our ability torealize certain net operating loss carryforwards acquired in connection withprior year acquisitions.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES 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 debt. For our fixed rate debt, interest rate changes mayaffect 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 held constant. We are exposed tointerest rate risk as a result of our borrowings under our Senior SecuredCredit Facility, which bear interest at floating rates based on the LIBOR orthe prime rate of Credit Suisse. As of September 26, 2009, we had $1,049.0million of borrowings under our Senior Secured Credit Facility. On November 20,2007, we entered into an interest rate swap agreement related to the SeniorSecured Credit Facility for a notional amount of $515.0 million at a fixedLIBOR rate of 4.205% amortizing through an expiration date of December 2009(the notional amount was $435.0 million as of September 26, 2009). In February 2009,we entered into two additional non-amortizing interest rate swap agreements.The first is for a notional amount of $550.0 million at a fixed LIBOR rate of1.04% beginning February 2009 amortizing through December 2009 (thenotional amount was $550.0 million as of September 26, 2009). The secondis for a notional amount of $750.0 million at a fixed LIBOR rate of 1.88%beginning January 2010 amortizing through December 2010.   In August 2009, we entered into fournew non-amortizing interest swap agreements with notional amounts aggregating$300.0 million.  Each of the fouragreements has a term beginning January 2011 through December 2011.The four agreements are at a weighted average fixed LIBOR rate of 2.5825%.   The fair value of our interest rate swapagreement recorded in the accompanying condensed consolidated balance sheets asof September 26, 2009 and December 31, 2008 was a loss ofapproximately $18.6 million and $13.3 million, respectively, and isrecorded in other current and non-current liabilities. A hypothetical 1%increase in variable interest rates for the remaining portion of the SeniorSecured Credit Facility not covered by the swaps would have impacted our earningsand cash flow, for the nine months ended September 26, 2009, byapproximately $0.5 million. Our senior notes of approximately$775.0 million consisted of fixed rate notes at September 26, 2009.We may use additional derivative financial instruments where appropriate tomanage our interest rate risk. However, as a matter of policy, we do not enterinto derivative or other financial investments for trading or speculativepurposes.

 

***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. Our wholly ownedforeign 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 rates, respectively. However, as we continue to expand our businessthrough acquisitions and organic growth, the sales of our products that aredenominated in foreign currencies has increased as well as the costs associatedwith our foreign subsidiaries which operate in currencies other than the U.S.dollar. Accordingly, our future results could be materially impacted by changesin these or other factors. For the three and nine months ended September 26,2009, our average monthly sales denominated in foreign currencies wasapproximately $10.7 million and $12.4 million, respectively, of which $9.1million and $10.6 million, respectively, was derived from Euro denominatedsales. In addition, 

 

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ourexposure to fluctuations in foreign currencies arises because certain of oursubsidiaries enter into purchase or sale transactions using a currency otherthan its functional currency. Our Mexico-based manufacturing operations incurcosts that are largely denominated in Mexican Pesos. Accordingly, our futureresults could be materially impacted by changes in foreign exchange rates orother factors. Occasionally, we seek to reduce the potential impact of currencyfluctuations on our business through hedging transactions. At September 26,2009, we had 53 foreign exchange forward contracts, with a notional amount of$10.9 million and an aggregate fair market value of approximately $11.4million. These contracts expire weekly throughout the fiscal year 2009.  For the three and nine months ended September 26,2009, we recognized a gain of approximately $0.4 million and a loss ofapproximately $2.9 million, respectively, in the statement of operations onMexico Peso forward contracts.  For thethree and nine months ended September 27, 2008, we recognized a gain inthe statement of operations on Mexico Peso forward contracts of approximately$0.1 million and $0.9 million, respectively.

 

**ITEM 4. 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.

 

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***

 

There has been no change to our internal control over financialreporting (as that term is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during the quarter covered by this report that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**Part II. OTHER INFORMATION**

 

**ITEM 1.  LEGALPROCEEDINGS**

 

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.

 

The manufacture and sale of orthopedic devices and related productsexposes us to significant risks of product liability claims, lawsuits and productrecalls. From time to time, we have been, and we are currently, the subject ofa number of product liability claims and lawsuits relating to our products. Weare currently defendants in approximately 80 product liability cases related toa disposable drug infusion pump product manufactured by two third partymanufacturers that we distributed through our Bracing and Supports businessunit of our Domestic Rehabilitation segment. We discontinued our sale of theseproducts in the second quarter of 2009. These cases have been brought againstthe manufacturers and certain distributors of these pumps, and in some cases,the manufacturers of the anesthetics 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 liabilitycarrier and to our product liability carrier. The product liability carrier forboth of the two manufacturers has accepted coverage for our defense of theseclaims; however, both manufacturers have rejected our tenders of indemnity.   Our product liability carrier has alsoaccepted coverage of these cases, subject to customary reservations, and wasproviding us with the defense until the carrier for the manufacturers beganproviding a defense. The lawsuits allege damages ranging from unspecifiedamounts to claims between $1.0 million and $10.0 million. These casesare in varying stages of discovery.

 

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We maintain product liability insurance which is subject to annualrenewal and our recently renewed policy (together with excess policies)provides for coverage of up to a limit of $25 million, subject to aself-insured retention of $50,000 on non-invasive products (other than ourIceMan cold therapy product), a self-insured retention of $250,000 on invasiveproducts (other than our pain pump products) and a self-insured retention of$500,000 for pain pumps and the IceMan cold therapy product, with an aggregateself-insured retention of $1.0 million for all product liability claims. Webelieve our current product liability insurance coverage is adequate. However, ifa product liability claim or series of claims is brought against us foruninsured liabilities or in excess of our insurance coverage, our businesscould suffer materially. In addition, in certain instances, a product liabilityclaim could also result in our having to recall some of our products, whichcould result in significant costs to us. As of September 26, 2009 and December 31,2008, we have accrued approximately $2.0 million and $1.8 million,respectively, for product liability claims expenses based upon previous claimexperience in part due to the fact that in 2003 we exceeded the coverage limitsin effect at that time for certain historical product liability claimsinvolving one of our discontinued surgical implant products and such productsare excluded from coverage under our current policies.

 

Dueto the nature of our business, we are subject to a variety of audits bygovernment agencies and other private interests.  In the first quarter of 2008, we received aU.S. Food and Drug Administration (“FDA”) Form 483 “InspectionalObservations” in connection with an FDA audit of the Chattanooga division ofour Domestic Rehabilitation Segment, stating that we failed to report certaincustomer complaints claiming that our muscle stimulator devices malfunctioned,and that we did not adequately implement corrective and preventive action toprevent recurrence of potential product failures relating to our musclestimulator devices. The auditor also recommended that we recall a series ofultrasound devices that had experienced operating issues in 2005, and we areimplementing such a recall. We received a warning letter from the FDA in June 2008relating to reporting issues on the muscle stimulator device complaints andrequesting software verification and validation plans and reports regarding thecorrection of problems associated with the ultrasound product. We believe thatwe have addressed these areas of concern adequately. In a recent FDA audit ofour Chattanooga facility, as a follow-up to the warning letter we received in June 2008,the FDA issued no Form 483 “Inspectional Observations.”  However, we cannot assure you that the FDAwill not take further action along these lines in the future.

 

In the third quarter of 2009, we received an FDA Form 483“Inspectional Observations” in connection with an FDA audit of our DomesticSurgical Implant Segment, stating that we failed to follow our standardoperating procedures to ensure that the designs of certain products werecorrectly transferred into production; we failed to adequately analyze certainquality data to identify existing and potential causes of nonconforming productand quality problems, resulting in disposal or reworking of certainnonconforming parts in the later stages of our production processes; our complainthandling procedures were not well defined to ensure that all complaints areprocessed in a uniform and timely manner; and we failed to follow our standardoperating procedures related to procurement to minimize receipt ofnonconforming materials from suppliers. We are reviewing these inspectionalobservations to determine the appropriate remedial action. We cannot assure youthat the FDA will not take further action in the future, including issuing awarning letter related to these observations.

 

OnApril 15, 2009, we became aware of a *Qui Tam* actionfiled in Federal Court in Boston, Massachusetts in March 2005 and amendedin December 2007 that names us as defendants 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.  The case was sealed whenoriginally filed and unsealed in March 2009.  The plaintiff, or relator, alleges that thedefendants have engaged in Medicare fraud and violated Federal and state falseclaims acts from the time of the original introduction of the devices by eachdefendant to the present by seeking reimbursement for bone growth stimulatorsas a purchased item rather than a rental item. The relator also alleges that the defendants are engaged in othermarketing practices constituting violations of the Federal and various stateantikickback statutes.  Shortly beforebecoming aware of the *Qui Tam* action,we were advised that our bone growth stimulator business was the subject of aninvestigation by the DOJ, and on April 10, 2009, we were served with asubpoena under the Health InsurancePortability and Accountability Act seeking numerous documents relatingto the marketing and sale by us of bone growth stimulators.  We believe that this subpoena is related tothe DOJ’s investigation of the allegations in the *Qui Tam*action, although the DOJ has decided not to intervene in the *Qui Tam* action at this time. The Company believes that its marketing practices in the bone growthstimulation business are in compliance with applicable legal standards andintends to defend this case vigorously.

 

**ITEM 1A.  RISKFACTORS**

 

For a discussion of the Company’s potential risks or uncertainties,please see Part I, Item IA, of the Company’s Annual Report on Form 10-Kfor the fiscal year ended December 31, 2008 filed with the Commission on March 11,2009. Except for the following factors, there have been no material changes tothe risk factors disclosed in such Form 10-K.

 

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**Risks Related To Our Business**

 

***Recent changes in coverage andreimbursement policies for our products by Medicare or reductions inreimbursement rates for our products could adversely affect our business andresults of operations.***

 

The Medicare Modernization Act mandates a number of changes in theMedicare payment methodology and conditions for coverage of orthotic devicesand durable medical equipment, including many of our products. These changesinclude competitive bidding requirements, new clinical conditions for paymentand quality standards. Although these changes affect our products generally,specific products may be affected by some, but not all, of the MedicareModernization Act’s provisions.

 

Prefabricated orthoticdevices and certain durable medical equipment, including many of our products,may be subject to a competitive bidding process established under the MedicareModernization Act. In April 2007, the Centers for Medicare and MedicaidServices (“CMS”) issued final regulations in connection with the competitivebidding program. Under competitive bidding, Medicare will no longer reimbursefor certain products and services based on the Medicare fee schedule amount indesignated competitive bidding areas. Instead, CMS will provide reimbursementfor these 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, and bid pricesbriefly 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, the U.S. Congress enacted the Medicare Improvements for Patients andProviders Act of 2008 (MIPPA), which terminated round one contracts andrequired CMS to rebid those areas in 2009. The legislation also delays round two bidding until 2011 and makes aseries of changes to program requirements. The delay in bidding is financed by nationwide reductions in MedicareDMEPOS fee schedule payments for items that were subject to the first round ofbidding.  When it is eventuallyimplemented, the competitive bidding process may reduce the number of suppliersproviding certain items and services to Medicare beneficiaries and the amountspaid for such items and services within a given geographic area. None of ourproducts is included in the initial round of items subject to bidding; however,there is no assurance they will not be included in the future. Inclusion of anyof our products in Medicare competitive bidding or other Medicare reimbursementor coverage reductions could result in such products being sold in lesserquantities or for a lower price, or coverage for such products beingdiscontinued altogether. Any of these developments could have a materialadverse effect on our results of operations. In addition, if we are notselected to participate in the competitive bidding program in a particularregion, it could have a material adverse effect on our sales and profitability.

 

On August 7, 2009, CMSissued Transmittal 297 entitled “Compliance Standards for Consignment Closetsand Stock and Bill Arrangements” requiring a change in procedures in stock andbill arrangements for Medicare beneficiaries. When implemented, the Transmittal will require products dispensed to aMedicare beneficiary from the inventory in our OfficeCare accounts in physicianoffice settings to be fitted and billed to Medicare by the physician ratherthan by us.  Title to the product mustpass to the physician at the time the product is dispensed to the patient.  The effect of this change in most instanceswould be to convert a billing opportunity by us into a sale to the physician ata wholesale price.  The Transmittal wasoriginally scheduled to go into effect on September 8, 2009, but CMS hasdelayed the effective date until March 1, 2010.  During the period prior to the new effectivedate, we plan to meet with CMS to express our concerns over the new rule.  If the Transmittal goes into effect aswritten, it could adversely affect the revenue and profitability of ourOfficeCare business.

 

**ITEM 6. 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, 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, 2008 (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:  October 29, 2009 | By:                      | /s/  LESLIE H. CROSS |
|                         |                     | Leslie  H. Cross*President, Chief Executive Officer and Director* |
|                         |                     |   |
| Date:  October 29, 2009 | By:                      | /s/  VICKIE L. CAPPS |
|                         |                     | Vickie  L. Capps*Executive Vice President, Chief Financial  Officer and Treasurer* |

 

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